Hi there, I'm working on this I got stuck at part C... I don't understand what its asking me to do there...
4. Ezback, Inc. is trying to establish itself as the best alternative to zip drive and computer
backup devices. The first step is to establish competitive pricing.
Ezback will generate two possible cash flow streams, depending on price.
Cash Flow
Price/drive Year 1 Year 2
$250 $230,000 $400,000
$350 $300,000 $340,000
a.) If Ezback’s cost of capital is 11%, which price has a higher NPV if the current project costs
$500,000?
NPV 250$ = -500000 + (230,000)/(1.11)+ 400,000/(1.11)^2
NPV 350$ = -500000 + (300,000)/(1.11)+ 340,000/(1.11)^2
b.) Due to lower short-term cash flows the company will be required to increase its weighting in
debt if the price is $250. The result is an increased cost of capital of 14% under the $250 price.
How will your decision change?
NPV 250$ = -500000 + (230,000)/(1.14)+ 400,000/(1.14)^2
NPV 350$ = -500000 + (300,000)/(1.11)+ 340,000/(1.11)^2
and yeah Like I said... everything after this is greek to me...?
c.) Ezback’s CFO would like to price the drives at $250 because the extra debt would have a tax
shield of $50,000. Marketing thinks that an increase in debt would concern potential customers
about the firm’s long-term viability. Thus, they state there was a 20% chance the drive could
only sell for $150. If we assume that cash flows are directly proportional to prices, what impact
does this decision have on our decision?
d.) Ignoring the tax shield, what is the total cost of financial distress, considering both increased
cost of funds and possible lower prices, under the $250 price?
e.) Factoring in the benefit of the debt tax shield, what is the net cost of financial distress?
f.) Ezback has the option to reduce the quality of its drives. In doing so, it can reduce its price
without resorting to debt. The problem is a reduction in year 2 cash flows by $35,000. Should
Ezback elect a lower quality drive or increased financial distress (factoring in the benefit of the
debt tax shield)?
g.) The union representing Ezback employees would like a wage increase which would cause
annual cash flows to drop $5,000. Which strategy would Ezback management employ to
strengthen its bargaining position, lower quality drive or increased financial distress (factoring
the benefit of the debt tax shield)?
4. Ezback, Inc. is trying to establish itself as the best alternative to zip drive and computer
backup devices. The first step is to establish competitive pricing.
Ezback will generate two possible cash flow streams, depending on price.
Cash Flow
Price/drive Year 1 Year 2
$250 $230,000 $400,000
$350 $300,000 $340,000
a.) If Ezback’s cost of capital is 11%, which price has a higher NPV if the current project costs
$500,000?
NPV 250$ = -500000 + (230,000)/(1.11)+ 400,000/(1.11)^2
NPV 350$ = -500000 + (300,000)/(1.11)+ 340,000/(1.11)^2
b.) Due to lower short-term cash flows the company will be required to increase its weighting in
debt if the price is $250. The result is an increased cost of capital of 14% under the $250 price.
How will your decision change?
NPV 250$ = -500000 + (230,000)/(1.14)+ 400,000/(1.14)^2
NPV 350$ = -500000 + (300,000)/(1.11)+ 340,000/(1.11)^2
and yeah Like I said... everything after this is greek to me...?
c.) Ezback’s CFO would like to price the drives at $250 because the extra debt would have a tax
shield of $50,000. Marketing thinks that an increase in debt would concern potential customers
about the firm’s long-term viability. Thus, they state there was a 20% chance the drive could
only sell for $150. If we assume that cash flows are directly proportional to prices, what impact
does this decision have on our decision?
d.) Ignoring the tax shield, what is the total cost of financial distress, considering both increased
cost of funds and possible lower prices, under the $250 price?
e.) Factoring in the benefit of the debt tax shield, what is the net cost of financial distress?
f.) Ezback has the option to reduce the quality of its drives. In doing so, it can reduce its price
without resorting to debt. The problem is a reduction in year 2 cash flows by $35,000. Should
Ezback elect a lower quality drive or increased financial distress (factoring in the benefit of the
debt tax shield)?
g.) The union representing Ezback employees would like a wage increase which would cause
annual cash flows to drop $5,000. Which strategy would Ezback management employ to
strengthen its bargaining position, lower quality drive or increased financial distress (factoring
the benefit of the debt tax shield)?