Repeat Problem 4 with the change that Arrowsmith Lumber’s cost of capital is 12.5%.
Problem 4
The timber rights to a tract of forest can be purchased for $220,000. The harvesting agreement would allow 25% of the timber to be cut in each of the first, second, fourth and fifth years. The purchaser of the timber rights would be required to replant, at its expense, the logged areas in Years 3 and 6. Arrowsmith Lumber calculates that its profit in each of the four cutting years would be $90,000 and that the cost of replanting the harvested areas in each of Years 3 and 6 would be $30,000.
a. Should Arrowsmith Lumber buy the timber rights if its cost of capital is 10%?
b. By what amount would the economic value of Arrowsmith Lumber be increased or decreased if it proceeded with purchasing the timber rights for $220,000?