FIN60406 – CORPORATE FINANCE AUG 2018

TOPIC 3 (NPV & OTHER INVESTMENT RULES)

1. You are considering the following two mutually exclusive projects. Both projects will be
depreciated using straight-line depreciation to a zero book value over the life of the project.
Neither project has any salvage value.

Required rate of return:

 Project A = 10%
 Project B = 13%
Required payback period for both projects is 2 years.

a) If you apply Net Present Value (NPV) criterion, which project will you choose?

Answer:

Project B should be accepted and project A should be rejected.

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b) If you apply Internal Rate of Return (IRR) criterion, which project will you choose?

Answer:

Cash flows A

CF0 C01 F01 CO2 FO2 CO3 FO3 CPT IRR

-$75,000 $19,000 1 $48,000 1 $12,000 1 2.76%

Cash flows B

CF0 C01 F01 CO2 FO2 CO3 FO3 CPT IRR

-$70,000 $10,000 1 $16,000 1 $72,000 1 13.8%

Cash flow A IRR is lesser than the discount rate, therefore we should reject the project.
Meanwhile for cash flow B, the IRR is higher than discount rate, so we proceed.
However, because these are mutually exclusive projects, the IRR rule should not be
applied.

c) If you apply payback period criterion, which project will you choose?

Answer:

Neither project pays back within 2 years, thus they should both be rejected.

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d) If you apply Profitability Index (PI) criterion, which project will you choose?

Answer:

Formula
n
CFt
 (1  r ) t
PI  t 1

CF0

Cash flow A
PI = [ ($19,000/ 1.10 ) + ($48,000 / 1.102 ) + ($12,000 / 1.103 ) ] / $75,000 = 0.88

Cash flow B
PI = [ ($10,000/ 1.13 ) + ($16,000 / 1.132 ) + ($72,000 / 1.133 ) ] / $70,000 = 1.02

Cash flow A PI is below than 1 so reject this project. Meanwhile cash flow B the PI is
higher than 1 so accept cash flow B. However, because these are mutually exclusive
projects, the PI rule should not be applied.

e) Based on your above answer, which project will you finally choose?

Answer:

The final answer will be based on NPV result. Profitability Index and Internal Rate of
Return cannot be applied for mutually exclusive projects. Payback period method
doesn’t apply the time value of money concept. Therefore, the company should
choose cash flow B because it gives positive NPV compare to cash flow A.

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2. The Camel Company is considering two mutually exclusive projects with the following cash
flows. The required rate of return is 15%. Compute the incremental Internal Rate of Return
(IRR) and explain your decision.

Answer:

Incremental IRR is 13.94%. The discount rate is higher (15%) than the incremental IRR.
Since this is investment type of project, thus reject bigger project, Project A and accept
Project B.

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TOPIC 4 (CAPITAL INVESTMENT DECISION)

1. Bluedo's has sales of $435,000, depreciation of $35,000, and net working capital of $56,000.
The firm has a tax rate of 34% and a profit margin of 8%. The firm has no interest expense. What
is the amount of the operating cash flow?

Answer:

Profit margin = net income / sales

8% = Net income / $435,000
Net income = $34,800

OCF = Net income + depreciation = $34,800 + $35,000 = $69,800

2. Kurt's Kabinets is looking at a project that will require $80,000 in fixed assets and another
$20,000 in net working capital. The project is expected to produce sales of $110,000 with
associated costs of $70,000. The project has a 4-year life. The company uses straight-line
depreciation to a zero book value over the life of the project. The tax rate is 35%. What is the
operating cash flow for this project?

Answer:

Depreciation (SLM) = $80,000 4 = $20,000

Operating Cash Flow Tax Shield Approach

OCF (Year 1 – Year 4) = (Sales – Costs)(1 – t) + [t x Depreciation]
= [ ($110,000 - $70,000)(1 – 0.35) ] + (0.35 x $20,000)
= $33,000

3. A project will produce an operating cash flow of $7,300 a year for three years. The initial cash
investment in the project will be $11,600. The net after-tax salvage value is estimated at $3,500
and will be received during the last year of the project's life. What is the net present value of the
project if the required rate of return is 11%?

Answer:

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4. Bruno's, Inc. is analysing two machines to determine which one it should purchase. The company
requires a 14% rate of return and uses straight-line depreciation to a zero book value. Machine
A has a cost of $290,000, annual operating costs of $8,000, and a 3-year life. Machine B costs
$180,000, has annual operating costs of $12,000, and has a 2-year life. Whichever machine is
purchased will be replaced at the end of its useful life. Which machine should Bruno's purchase
and why? (Round your answer to whole dollars.)

Answer:

Machine B lowers the annual cost of the equipment by about $11,600, = ($132,912 -
$121,312).

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5. Margarite's Enterprises is considering a new project. The project will require $325,000 for new
fixed assets, $160,000 for additional inventory and $35,000 for additional accounts receivable.
Short-term debt is expected to increase by $100,000 and long-term debt is expected to increase
by $300,000. The project has a 5-year life. The fixed assets will be depreciated straight-line to a
zero book value over the life of the project. At the end of the project, the fixed assets can be sold
for 25% of their original cost. The net working capital returns to its original level at the end of the
project. The project is expected to generate annual sales of $554,000 and costs of $430,000.
The tax rate is 35% and the required rate of return is 15%. Advise Margarite’s on this new project.

Answer:

Depreciation p.a. = $325,000 / 5 = $65,000

Salvage value = 25% x $325,000 = $81,250

After tax salvage value (ATSV) = MV + [ (BV – MV) x T ]

= $81,250 + [ (0 - $81,250) x 35% ]
= $52,812.50
Net working capital (NWC) = CA – CL
= $160,000 + $35,000 - $100,000
= $95,000

OCF tax shield approach

OCF (Year 1 – 5) = (Sales – Costs) (1 – tax rate) + (Depreciation x tax rate)
= ($554,000 - $430,000) (1 – 35%) + ($65,000 x 35%)
= $103,350

Year 0 Year 1 - 4 Year 5

Fixed assets cost ($325,000)
OCF $103,350 $103,350
NWC ($95,000) $95,000
ATSV $52,812.50
Cash flows ($420,000) $103,350 $251,162.50

The NPV of the project is:

Financial Calculator Method

CF0 C01 F01 C02 F02 I CPT NPV

($420,000) $103,350 4 $251,162.50 1 15 ($65.83)

Margarite's Enterprises should not proceed with this project because the NPV is negative.

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6. Ronnie's Custom Cars purchased some fixed assets two years ago for $39,000. The assets
are classified as 5-year property for MACRS. Ronnie is considering selling these assets now so
he can buy some newer fixed assets which utilize the latest in technology. Ronnie has been
offered $19,000 for his old assets. What is the net cash flow from the salvage value if the tax rate
is 34%?

Answer:

Year 1 depreciation = $39,000 x 20% = $7,800

Year 2 depreciation = $39,000 x 32% = $12,480
Total depreciation until Year 2 = $20,280

So, the book value of the equipment at the end of 2 years, which will be the initial investment minus
the accumulated depreciation, is:

Book value = $39,000 – $20,280 = $18,720

The asset is sold at a gain to book value, so this gain is taxable.

Aftertax salvage value = MV + [ (BV – MV) x Tax rate ]

Aftertax salvage value = $19,000 + [ ($18,720 – $19,000) x 34% ]
Aftertax salvage value = $18,904.80

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TOPIC 5 (RISK ANALYSIS – SENSITIVITY, SCENARIOS & BREAK EVEN) q80,46 - 48

1. The Mini-Max Company has the following cost information on its new prospective project.
Calculate the accounting and financial break - even point.

Initial investment: $700

Fixed costs are $200 per year
Variable costs: $3 per unit
Depreciation: $140 per year
Price: $8 per unit
Discount rate: 12%
Project life: 3 years
Tax rate: 34%

Answer:

Accounting Break - Even

QA = (FC + D)/(P – VC)
= ($200 + $140) / ($8 - $3) = 68 units

Financial Break – Even

PV N I/Y CPT PMT (EAC)

($700) 3 12 $291.44

QF = [EAC + FC(1 – tC) – D(tC)] / [(P – VC)(1 – tC)]

= [ $291.44 + $200 (1 – 34%) – ($140 x 34%) ]
($8 - $3) ( 1 – 34%)
= 113.89 ~ 114 units

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2. The Adept Co. is analyzing a proposed project which is required $1,500 initial investment. The company
expects to sell 2,500 units, give or take 10%. The expected variable cost per unit is $8 and the expected
fixed costs are $12,500. Cost estimates are considered accurate within a plus or minus 5% range. The
depreciation expense is $4,000. The sale price is estimated at $16 a unit, give or take 2%. The company
bases its sensitivity analysis on the expected case scenario. Calculate the base case, best case and
worst case OCF and NPV. Company tax rate is 35% and required return is 15%. Useful life is 5 years.

Answer:

Base case
OCF = [(P – v)Q – FC](1 – T) + (T x D )
= [ ($16 - $8) 2,500 - $12,500 ] ( 1 – 35%) + (35% x $4,000)
= $6,275

NPV – Financial calculator

CF0 C01 F01 I CPT NPV

-$1,500 $6,275 5 15 $19,534.77

Best case

OCF = [(P – v)Q – FC](1 – T) + (T x D )

= { [($16 x 1.02) – ($8 x 0.95) ] (2,500 x 1.1) } – ($12,500 x 0.95) ] x ( 1 – 35%) + (35%
x $4,000)
= $9,268.25

NPV – Financial calculator

CF0 C01 F01 I CPT NPV

-$1,500 $9,268.25 5 15 $29,568.61

Worst case

OCF = [(P – v)Q – FC](1 – T) + (T x D )

= { [($16 x 0.98) – ($8 x 1.05) ] (2,500 x 0.90) } – ($12,500 x 1.05) ] x ( 1 – 35%) + (35%
x $4,000)
= $3,515.75

NPV – Financial calculator

CF0 C01 F01 I CPT NPV

-$1,500 $3,515.75 5 15 $10,285.34

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