BFIN525

Chapter 11

Problems Plus AK

(Extra Problem):
A Company need to start a new project for three years, and it need a new equipment that
costs $40,000.

The engineers requires a cost of $4,000 to install the equipment and its shipping cost is
$16,000. The equipment life is 4 years and it will depreciate at a rate of 25% each year,
and the company will sell the equipment at the third year at the end of the project at
$20,000.

The new project will increase the net working capital by $14,000.

The below is an expected information about the project

Year 1 2 3
Units Sold 500 1,000 700
Price/Unit $70 $70 $70
Total Variable $12,500 $25,000 $17,500
Costs

In addition, Fixed costs expected to be 2,000$ each year, the applicable tax rate is 40%,
and the project WACC is 10%.

Required:

a) Find the Initial Cash Outlay.

b) Find the project's cash flows at t = 1, t = 2 and t = 3.
c) Find the Terminal Cash Flow at t = 3.
d) What is the expected net present value (NPV) of the new business?

Solution

a)
Fixed capital investment = 40,000$+4,000$+16,000$ = 60,000$
Initial investment = 60,000$ + 14,000$ = 74,000$

b)

CF = (S – TVC – FC – D)(1-T%) + D
 CF1 = ((70x500)-(12,500)-2,000-15,000)(1-0.4)+15,000 = 18,300$
 CF2 = ((70x1000)-(25,000)-2000-15,000)(1-0.4) + 15,000 = 31,800$
 CF3 before Terminal value= ((70x700)-(17,500)-2000-15,000)(1-0.4) + 15,000 = 23,700$

 Depreciation = FCI x % of Depreciation = $60,000 x 25% = $15,000

Depreciation for year 1, 2, 3 and 4 = 15,000$ (since depreciation rate is
constant)

c)
Terminal value = S price of equipment +NWC – (S price –BV)t%
=20,000 + 14,000 – (20,000 – 15,000)(0.4) = 32,000$.
BV=$60,000 – (15,000+15,000+15,000)=$15,000
CF3 after adding TV = 23,700$ + 32,000$ = 55,700$.

d)

18,300 31,800 55,700

NPV = -74,000 + 1 + 2 + 3 = +$10,765.59
(1.1) (1.1) (1.1)

Using table Method

0 1 2 3
 Cost ($60,000)
NOWC (14,000)
Sales $35,000 $70,000 $49,000
Operating Cost 14,500 27,000 19,500
Depreciation 15,000 15,000 15,000
Oper. inc. before taxes $5,500 $ 28,000 $14,500
Taxes (40%) 2,200 11,200 5,800
Oper. inc. after taxes $ 3,300 $ 16,800 $ 8,700
+ Depreciation ________ 15,000 15,000 15,000
Net CFs ($74,000) $18,300 $31,800 $23,700
+ TV 32,000
$55,700

(11–1)
Talbot Industries is considering an expansion project. The necessary equipment could be
purchased for $9 million, and the project would also require an initial $3 million
investment in net operating working capital. The company’s tax rate is 40%.
a. What is the initial investment outlay?
b. The company spent and expensed $50,000 on research related to the project last year.
Would this change your answer? Explain.
c. The company plans to house the project in a building it owns but is not now using. The
building could be sold for $1 million after taxes and real estate commissions.
How would this affect your answer?
(11–2)
Cairn Communications is trying to estimate the first-year operating cash flow (at t = 1)
for a proposed project. The financial staff has collected the following information:
Projected sales $10 million
Operating costs (not including depreciation) $ 7 million
Depreciation $ 2 million
Interest expense $ 2 million
The company faces a 40% tax rate. What is the project’s operating cash flow for the first
year (t = 1)?
(11–3)
Allen Air Lines is now in the terminal year of a project. The equipment originally cost
$20 million, of which 80% has been depreciated. Carter can sell the used equipment
today to another airline for $5 million, and its tax rate is 40%. What is the equipment’s
after-tax net salvage value?

(11–4)
The Chen Company is considering the purchase of a new machine to replace an obsolete
one. The machine being used for the operation has both a book value and a market value
of zero; it is in good working order, however, and will last physically for at least another
10 years. The proposed replacement machine will perform the operation so much more
efficiently that Chen’s engineers estimate it will produce after-tax cash flows (labor
savings and depreciation) of $9,000 per year. The new machine will cost $40,000
delivered and installed, and its economic life is estimated to be 10 years. It has zero
salvage value. The firm’s WACC is 10%, and its marginal tax rate is 35%. Should Chen
buy the new machine?
(11–5)
Depreciation Methods
Wendy is evaluating a capital budgeting project that should last for 4 years. The project
requires $800,000 of equipment. She is unsure what depreciation method to use in her
analysis, straight-line or the 3-year MACRS accelerated method. Under straight-line
depreciation, the cost of the equipment would be depreciated evenly over its 4-year life
(ignore the half-year convention for the straight-line method).
The applicable MACRS depreciation rates are 33%, 45%, 15%, and 7%. The company’s
WACC is 10%, and its tax rate is 40%.
a. What would the depreciation expense be each year under each method?
b. Which depreciation method would produce the higher NPV, and how much
higher would it be?
(11–6)
The Campbell Company is evaluating the proposed acquisition of a new milling machine.
The machine’s base price is $108,000, and it would cost another $12,500 to modify it for
special use. The machine falls into the MACRS 3-year class, and it would be sold after 3
years for $65,000. The machine would require an increase in net working capital
(inventory) of $5,500. The milling machine would have no effect on revenues, but it is
expected to save the firm $44,000 per year in before-tax operating costs, mainly labor.
Campbell’s marginal tax rate is 35%.
a. What is the net cost of the machine for capital budgeting purposes?
(That is, what is the Year-0 net cash flow?)
b. What are the net operating cash flows in Years 1, 2, and 3?

c. What is the additional Year-3 cash flow (i.e., the after-tax salvage and the return of
working capital)?

d. If the project’s cost of capital is 12%, should the machine be purchased?