Capital Budgeting and Cash Flow Principles

Problems

1. Stockholm Company is considering the sale of a machine

with the following characteristics.

Book value $120,000

Remaining useful life 5 years
Annual straight-line depreciation $ 24,000
Current market value $ 70,000

If the company sells the machine its cash operating

expenses will increase by $30,000 per year due to an
operating lease. The tax rate is 40%.

a. Find the cash flow from selling the machine.

b. Calculate the increase in annual net cash outflows

as a result of selling the machine.

2. Pepin Company is considering replacing a machine that

has the following characteristics.

Book value $100,000

Remaining useful life 5 years
Annual straight-line depreciation $ ???
Current market value $ 60,000

The replacement machine would cost $150,000, have a

five-year life, and save $50,000 per year in cash
operating costs. It would be depreciated using the
straight-line method. The tax rate is 40%.

a. Find the net investment required to replace the

existing machine.

b. Compute the increase in annual income taxes if the

company replaces the machine.

c. Compute the increase in annual net cash flows if

the company replaces the machine.
3. Cable Company is considering the purchase of a machine
with the following characteristics.

Cost $100,000
Useful life 10 years
Expected annual cash cost savings $30,000

Cable's income tax rate is 40% and its cost of capital

is 12%. Cable expects to use straight-line depreciation
for tax purposes.

a. Compute the expected increase in annual net cash

flow for this project.

b. Compute the profitability index for the project.

c. How would the profitability index for this project

be affected if Cable were to use MACRS depreciation
for tax purposes and the machine fell into the 7-
year MACRS class? (increase decrease not
affected) Circle the appropriate answer.
SOLUTION:Prob. 1

a. Cash flow from sale: $90,000 ($70,000 + 40% tax savings on the
$50,000 tax loss)

b. Increase in annual cash outflows: $27,600 ($30,000 pretax cost

increase - $2,400 decrease in income taxes; the $30,000 increase
in cash costs is partially offset by losing a $24,000 depreciation
deduction)

SOLUTION:Prob. 2

a. Net investment: $74,000 [$150,000 - $60,000 - 40%($100,000 -

60,000)]

b. Increase in income taxes: $16,000 [40% x ($50,000 pretax flow -

$30,000 depreciation + $20,000 lost depreciation)]

c. Increase in cash flows: $34,000 ($50,000 - $16,000 increase in

income taxes)

SOLUTION:Prob. 3

a. Increase in annual net cash flow: $22,000 [$30,000 - (40% x

($30,000 - $10,000)]

b. Profitability index: 1.24 [($22,000 x 5.65)/$100,000]

c. Effect on profitability index: Increase (PI would increase

because the tax shield of depreciation would occur earlier and so
be more valuable when considering the time value of money.)