Question

Question 3: Coca-Cola Corp. needs to purchase new plastic moulding machines to meet the demand for its product. The cost of the equipment is $3,028,000. It is estimated that the firm will increase after tax cash flow (ATCF) by $611,671 annually for the next 5 years. The firm is financed with 40% debt and 60% equity, both based on current market values, though the firm has announced that it wants to quickly change its debt to equity ratio to 1.5. The firm's beta is 1.24, the risk free rate is 3.82% and the expected market return is 7.23%. Coca-Cola Corp.'s semi-annual bonds have 11.80% coupons, 22 years to maturity, and a quoted price of 91.547. Assume the firm's tax rate is 34%. The firm's last 5 dividends (the last in the list is D0) are 1.23, 1.60, 2.04, 2.51, and 2.87. Its current market price is $107.06.

Question 3, Short Answer D: Briefly explain which decision rule is best when trying to make a capital budget decision in this scenario where there are cleanup costs at the end of the project.

Answer 1

NPV is the best decision rule because :

• It measures the value generated by the project
• It gives a single number which can be used to make an accept/reject decision
• The cleanup costs at the end of the project are correctly taken into consideration with their time value

The IRR is not appropriate because the project has unconventional cash flows. A project has conventional cash flows when there is an initial cash outflow followed by cash inflows during every subsequent year until the final year. This project has unconventional cash flows because there is a cash outflow in the final year of the project. The IRR is not appropriate in this case because there may be multiple IRRs or the IRR may be indeterminable.