Capital Budgeting Analysis

You are required to work  the following problem, using a discounted cash flow (NPV) analysis. You should model your answer on the text approach in Chapter 8.

“Henry  Hall is considering replacing an old machine with a new one. The old machine (purchased 5 years ago) cost $300,000, while the proposed new one will cost

$250,000.

“The new machine will be depreciated prime cost to $50,000 over its 5 year life. Henry estimates that it will be worth $40,000 (salvage value) after 5 years.The old

machine is being depreciated at prime cost to zero over its original expected life of 10 years. However, Henry can sell the old machine today for $78,000.

“The new machine will save the owner $50,000 a year in cooling costs. This was estimated one year ago in a feasibility study on the new machine conducted for Henry by

an external firm of consultants, and which cost Henry $15,000. Henry still considers that these savings will be achieved.

“With the new machine, a one-off amount of cleaning supplies at a cost of $5,000 will be required. and Henry estimates that accounts receivable will increase by

$15,000. Both of these increases in working capital will be recouped at the end of the new machine’s life in five years time..

“Henry’s cost of capital is 10%. The tax rate is 30%. Tax is paid in the year in which earnings are received.

“REQUIRED.

(a)    Calculate the net present value of the proposed change, that is, the net benefit or net loss in present vaklue terms of the proposed changeover.

(b)    Should Henry purchase the new machine? State clearly why.”

THE CAPITAL ASSET PRICING MODEL

Assignment Overview

1. For each of the scenarios below, explain whether or not it represents a diversifiable or an undiversifiable risk. Please consider the issues from the viewp01oint of investors. Explain your reasoning.

a. There’s a substantial unexpected increase in inflation.

b. There’s a major recession in the U.S.

c. A major lawsuit is filed against one large publicly traded corporation.

2. Use the CAPM to answer the following questions:

a. Find the Expected Rate of Return on the Market Portfolio given that the Expected Rate of Return on Asset “i” is 12%, the Risk-Free Rate is 4%, and the Beta (b) for Asset “i” is 1.2.

b. Find the Risk-Free Rate given that the Expected Rate of Return on Asset “j” is 9%, the Expected Return on the Market Portfolio is 10%, and the Beta (b) for Asset “j” is 0.8.

c. What do you think the Beta (ß) of your portfolio would be if you owned half of all the stocks traded on the major exchanges? Explain.

3. In one page explain what you think is the main ‘message’ of the Capital Asset Pricing Model to corporations and what is the main message of the CAPM to investors?

Assignment Expectations
The Case report should be a two-page report. Please show your work for quantitative questions.

Required Reading
I personally recommend reading up on the basic concepts behind the Capital Asset Pricing Model first before worrying about the formula. But still many of you are eager to learn the formulas first, so here are a few links below. But don’t fixate on the formulas, spend an equal if not greater amount of time reading up on the basic concepts:

Investopedia (n.d.). Capital Asset Pricing Model, retrieved from: http://www.investopedia.com/terms/c/capm.asp

MoneyChimp, (n.d.) CAPM calculator, retrieved from: http://www.moneychimp.com/articles/valuation/capm.htm

QFinance, (n.d.) Capital Asset Pricing Model, retrieved from: http://www.financepractitioner.com/asset-management-calculations/capital-asset-pricing-model

Value Based Management, (n.d.) Capital Asset Pricing Model, retrieved from: http://www.valuebasedmanagement.net/methods_capm.html

To gain a deeper understanding of the CAPM and associated concepts beyond just the formula, read:

Damodaran, A. (n.d). Picking the right projects: Investment analysis. Retrieved from:
http://pages.stern.nyu.edu/~adamodar/pdfiles/cfovhds/inv.pdf

Risk and Return (1991). The Economist, 318, 72-73

This Article on Investment Analysis is a highly comprehensive overview on measuring risk and the use of the CAPM. This article is a good place to start because it will give you an idea of how the CAPM is used in the “real world” as well as demonstrate the basic concepts of this Module.

Financial Markets (2015) Pearson Learning Solution, New York

Managing Risk and Return (2015) Pearson Learning Sol