B8. (Incremental cash flows and NPV) The Miller Corporation is considering a new product.

An outlay of $6 million is required for equipment to produce the new product, and additional net working capital of $500,000 is required to support production and marketing. The equipment will be depreciated on a straight-line basis to a zero book value over eight years. Although the depreciable life is eight years, the project is expected to have a productive life of only six years, and it will have a salvage value of zero at that time (removal cost = scrap value). Revenues minus expenses for the first two years of the project will be $5 million per year but, because of competition, revenues minus expenses in years 3 through 6 will be only $3 million. The cost of capital for this project is 16%, and the relevant tax rate is 35%. Compute the NPV of Millers new product.

Outlay NWC Depreciation YEAR Savings Less Despreciation expense Operating revenue

$6,000,000 $500,000 $750,000 per year 0

COC Tax Rate

0.16 0.35

1 2 3 4 5,000,000 5,000,000 3,000,000 3,000,000 $262,500 $262,500 $262,500 $262,500 $4,737,500 $4,737,500 $2,737,500 $2,737,500

Q2. Explain the basic cash flows that are included in the net cash flow for the initial investment. Initial investment, annual net cash flows, and terminal cash flows. Initial investment: the net cash outlay in a period when the asset is purchased. Annual net cash flows: investment expected to generate annual flows from operations afer the initial cash outlay. Terminal cash flows: Salvage value. Q12. Suppose that you invested $10,000 in an asset that is depreciated as five-year property under the modified accelerated cost recovery system. Explain how you would calculate the investments depreciation charges. YEAR 1 20% 2 32% 3 19.20% 4 11.52% 5 11.52%

A3. (MACRS depreciation) Modigliani Jet Ski Company also purchased some special tools for a total of $150,000. The tools are classed as three-year property. a. What is the annual depreciation charge for these assets? b. If Modiglianis marginal tax rate is 40%, what is the annual depreciation tax shield? c. Discounted at 8%, what is the present value of the depreciation tax shields? YEAR MARCS Tax Rate Tax Shield PV of Tax Shield 1 2 3 4 33.33% 44.45% 14.81% 7.41% $49,995 $66,675 $22,215.00 $11,115.00 $19,998 $26,670 $8,886.00 $4,446.00 ($18,516.67) ($22,865.23) ($7,053.99) ($3,267.94)

A7. (Investment in working capital) Nelson Stores expansion plans are expected to increase its inventories by $30 million. Nelson will also increase its accounts receivable by $15 million and its accounts payable by $8 million. What investment in net working capital is required? Investment in NWC $23 Million

B4. (Incremental cash flows and NPV) Johnson&Johnson currently has a machine that has five years of useful life remaining. Its current net book value is $50,000, and it is being straightline depreciated to its expected zero salvage value in five years. It generates $60,000 per year in sales revenue, requiring $30,000 in operating expenses, excluding depreciation. If the firm sells the machine now, it could get $30,000 for it. The firm is considering buying a new machine to replace this one. The new machine will have a useful life of five years and a salvage value of $5,000. It costs $65,000. It is expected to generate $70,000 in sales revenue and require $25,000 in operating expenses annually, excluding depreciation. The projects cost of capital is 10%, the firm will use straight-line depreciation to $5,000 over five years, and the relevant tax rate is 40%. Compute the NPV from replacing the old machine.

Initial investment

$6,500,000

5 6 3,000,000 3,000,000 $262,500 $262,500 $2,737,500 $2,737,500

7 0 0

8 0 0

6 5.76%

Marginal Tax Rate Cost

40% $150,000

$30 $15 $8