HELLENIC OPEN UNIVERSITY

SCHOOL OF SOCIAL SCIENCES

MASTER IN BUSINESS ADMINISTRATION (MBA)
1


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SUBJECT 1 (4 marks)

Caterpillar currently uses a machine that was purchased two years ago. This piece of equipment, for
tax purposes, is being fully depreciated on a straight-line basis. However, Caterpillar expects to sell
the machine for !500 in the end of its useful life. Today the old machine has 6 years of remaining
life, its current book value is !2,400, and it can be sold for !3,000.

Caterpillar wants to evaluate the replacement of the old machine with a new one that costs !8,000
and has an estimated useful life of 6 years. For tax purposes the new machinery is being fully
depreciated at 20%, 32%, 19%, 12%, 11% and 6% in the years 1-6 respectively, however Caterpillar
expects to sell it for !800 in the end of its useful life.

The replacement machine will expand the output capacity of Caterpillar, causing sales to rise by
!1,000 per year. Furthermore, the new machine's much greater efficiency would even cause
operating expenses to decline by !1,500 per year.

Currently (year 0) the new machine would require the company to increase inventories by !2,000,
but accounts payable would simultaneously increase by !500. The net working capital is expected
to recover in the sixth year.

Caterpillar uses the net present value method to evaluate capital budgeting projects. Should the
company replace or not the old machine? Take into account that the companys tax rate is 40% and
its cost of capital is 14%. (Forget decimal points and rounding).


SUBJECT 2 (3 marks)

The director of capital budgeting for Wal-Mart has asked you to analyze a proposed capital
investment. The project has a cost of !10,000, and the real cost of capital for the company is
12%. The projects expected nominal cash flows are as follows:

Year Cash
Flows

0 (10,000)
1 8,125
2 4,320
3 4,740
4 1,690


HELLENIC OPEN UNIVERSITY
SCHOOL OF SOCIAL SCIENCES
MASTER IN BUSINESS ADMINISTRATION (MBA)
2




The retail index over the years 0 to 4 is expected to be as follows:

0 1 2 3 4

100 125 144 158 169 Retail Index
-- 25% 15% 10% 7% Change

Calculate the project's payback period, net present value (NPV) (Forget decimal points and
rounding), and profitability index (PI) (Four decimal points and no rounding).

Apart from the procedure you have just used could you suggest an alternative approach to
calculate the payback period, NPV, and PI?

What is the most common mistake done by financial analysts in evaluating projects under
conditions of inflation?


SUBJECT 3 (3 marks)

Colgate is expanding and needs to estimate the total cost of raising new funds. Management has
made the following policy decision and collected the following information.

Target weights: Debt 40%, Preferred stock 10% and Common equity 50%

Investors are expected to require a rate of return of 14% on new bond issues, and floatation costs
are expected to be minimal. The firms tax rate is 30%.

Preferred stock holders currently expect a 15% return. Flotation costs will reduce the proceeds to
the firm by 5% of the market price, which is !80.

The common stock has a beta of 1.5. The risk-free rate is 10%, and the expected return on the
market as a whole is 18%. No new common stock will be sold so all additions to equity will be
made through retained earnings.

Calculate the weighted average cost of capital for Colgate (Two decimal points and no rounding).





HELLENIC OPEN UNIVERSITY
SCHOOL OF SOCIAL SCIENCES
MASTER IN BUSINESS ADMINISTRATION (MBA)
3





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