Question

Lazy Q Ranches, one of the largest ranching consortiums in the world, is considering two projects. The first project, building a resort on one of its ranches in Montana and the other is to expand into Argentina and raise racehorses. The analysis is being done assuming a 10 year life for both projects. Lazy Q has a corporate tax rate of 25%, a required rate of return of 12% on projects and has a weighted average cost of capital of 6%. Details of the two options are provided as follows:

Resort Project:

The resort project would require a $20,500,000 investment. At the end of ten years, some of the equipment would have a salvage value of $300,000. The project would require additional working capital $450,000 in the form of an increase in the minimum balance required by their bank and this working capital would be released at the end of the project. The project would provide estimated net income each year as follows:

Sales............................................................... ..................... $6,500,000

Less variable expenses...................................                                              4,275,000

Contribution margin...................................... .............. $2,225,000

Less fixed expenses:

Fixed expenses*.................................                             .............................. $1,115,000

Net income....................................................                              ................... $1,111,000

*Depreciation is 10% of fixed expenses

Race Horse Project:

The race horse project would require a $10,875,000 investment. At the start of the project current buildings that are on the land being purchased to create the new facilities will be torn down and sold for scrap wood for $190,000. At the end of ten years, some of the equipment would have a salvage value of $80,000. The project would require additional working capital $210,000 in the form of an increase in the minimum balance required by their bank and this working capital would be released at the end of the project. The project would provide estimated net income each year as follows:

Sales...............................................................                              ................... $4,125,000

Less variable expenses...................................                                              1,900,000

Contribution margin......................................                              ............. $2,225,000

Less fixed expenses:

Fixed expenses*.................................                             ............................ $ 775,000

Net income....................................................                              .................. $1,475,000

*Depreciation is 8% of fixed expenses

Required:

A. For both projects compute the project’s net present value.

B. For both projects compute the project’s internal rate of return, to the nearest percentage.

C. What is the profitability index for each project? Explain what these indices mean.

D. For both projects compute the project’s payback period.

E. What would be the payback period for both projects if the annual revenues for each project were estimated to be:

Year	Resort Project Revenues	Racehorse Project Revenues
1	6,000,000	4,000,000
2	6,250,000	4,000,000
3	6,250,000	4,125,000
4	6,300,000	4,150,000
5	6,250,000	4,150,000
6	6,225,000	4,200,000
7	6,500,000	4,250,000
8	6,450,000	4,300,000
9	6,400,000	4,350,000
10	6,200,000	4,400,000

F. For both projects compute the simple rate of return.

G. Should the company accept the project? Why or why not?

Answer 1

A)

Taking weighted average cost of capital as discounting factor

Caculation of yearly cash inflow :

Resort. Race horse

Net income before tax. 1115000. 1475000

Less: tax@25%. 277500. 368750

Net income after tax. 832500. 1106250

Add: Depreciation.

(10%of1115000). 111500

(8%of775000). 62000

Cash inflow. 944000. 1168250

Present value of net cash inflow @6%=7.360*cash inflow yearly

Resort. Race horse

Present value

(7.360*944000). 6947840

(7.360*1168250). 8598320

Add PV of Salvage value.

And working capital realised 418500

.(0.558 *750000)

(0.558*290000). 161820

Total. 7366340. 8760140

Less initial cash out flow ( 2050000). (10875000)

Net present value 5316340. (2114860)