C214 11

If the NPV of multiple projects are positive, you should always accept all projects T/F

False There is normally capital rationing, meaning insufficient capital to accept all projects; thus you have to rank and prioritize.

TippingToys is considering the purchase of a new toy-making machine that will increase revenues by $50,000 a year and annual costs by $10,000. The new machine will replace an outdated machine with a current book vale of $10,000 but if scrapped now can only be sold for $6,000. The new machine will cost $100,000 with shipping and installation fees of $10,000. The machine will be depreciated via 5-year MACRS schedule (20.0%, 32.0%, 19.2%, 11.5%, 11.5%, 5.8%). The firm estimates that the new machine can be sold at the end of its five-year life for $20,000. The new machine will necessitate an investment of $30,000 in working capital that will be fully recovered at the end of the project. Tipping Toys has a 10% cost of capital and a corporate tax rate of 40%. What is the initial outlay?

Cost of New Machine (100,000) Installation/Shipping (10,000) Depreciable base (110,000) Working Capital (30,000) Price of Old 6,000 BV of Old (10,000) Gain/Loss (4,000) Tax 1,600 Net Sales of Old 7,600 Initial Outlay (132,400)

Initial Outlay $(5,000) Year 1 $3,000 Year 2 $3,500 Year 3 $3,200 Year 4 $2,800 Year 5 $2,500 What is the NPV if the discount rate is 20%?

$4,137 NPV = -5 + 3/1.21 + 3.5/1.22 + 3.2/1.23 + 2.8/1.24 + 2.5/1.25 = $4.137 (= $4,137)

Equipment is scrapped at the end of the project and has a book value of $20,000. The tax rate is 35%. The projected started with $75,000 of working capital. What is the terminal cash flow?

(20,000 * .35) + 75,000 = 82,000

A project has sales of $300,000, general expenses of $195,000, and depreciation expense of $25,000. The tax rate is 35%. What is the differential cash flow?

(300 - 195 - 25) * (1 - .35) + 25 = 77

Which one of the following items should be included in capital budgeting analysis?

-Training cost required to safely operate new equipment -The shipping cost of a new machine -The inflow from the sale of old equipment that is replaced by new equipment

From the following information, calculate the terminal cash flow. Proceeds from sale of equipment 100,000 Book value of equipment sold 50,000 Year 3 diff cash flow 225,000 Tax rate 40% Depreciation Yrs 1 to 5 125,000 Working capital return 75,000

100,000 - 50,000 = 50,000 Net realizable value * tax rate of .4 = 20,000 to be paid in taxes. 100,000 from buyer - taxes paid of 20,000 = 80,000 total salvage value + 75,000 in working capital return = 155,000 terminal cash flow

In order to start the new project, the firm has to replace an old machine with a remaining book value of $25,000. However, while still functional, the machine has no market value and will be scrapped if the new equipment is acquired. The new machine will cost the firm $220,000. In order to put the machine in working condition, ABC will spend $6,000 in installation and $4,000 in shipping. If the new machine is purchased net working capital will be increased by $10,000. The new machine will be depreciated via the straight-line depreciation method to a salvage value of $0. However, at the end of the new machine's five-year life, it can be sold for $30,000. If accepted, the new machine will increase annual revenues by $150,000 and will increase annual operating costs by $45,000. The company has a marginal tax rate of 40% and a cost of capital of 14%. The project will last 5 years. What is the initial outlay of this project?

Depreciable asset = Cost of New + Install + Ship = 220k + 6k + 4k = 230k Net cash from sale of old machine = MV of Old -/+ Tax effect = $0 + $10k = 10k Gain (Loss) = Sale price - BV = $0 - $25k = ($25k) (note: not cash). Initial outlay = cost of new + install + ship + increase in WC - net cash from sale of old = 220k + 6k + 4K + 10k - 10k = 230k

Suppose an asset that cost $250,000 is depreciated straight-line over 7 years. The salvage value is assessed as $5,000. What is the depreciation expense in Year 3?

Depreciation Expense = (250000 - 5000) / 7 = $35,000

Why is depreciation expense taken out of the net income calculation, yet added back at the end?

Depreciation expense is tax-deductible

What is the net equipment cost given the following when a new piece of equipment replaces an old one? Old equipment sells for 125,000 Book value of old equipment 22,000 Tax rate 40% New equipment cost 800,000 Site survey 18,000 Installation cost 20,000

125,000 - 22000 = 103,000 * .4 = 41,200 125,000 - 41,200 = 83,800 deducted from new equipment 800,000 + 20,000 - 83,800 = 736,200

TippingToys is considering the purchase of a new toy-making machine that will increase revenues by $50,000 a year and annual costs by $10,000. The new machine will replace an outdated machine with a current book vale of $10,000 but if scrapped now can only be sold for $6,000. The new machine will cost $100,000 with shipping and installation fees of $10,000. The machine will be depreciated via 5-year MACRS schedule (20.0%, 32.0%, 19.2%, 11.5%, 11.5%, 5.8%). The firm estimates that the new machine can be sold at the end of its five-year life for $20,000. The new machine will necessitate an investment of $30,000 in working capital that will be fully recovered at the end of the project. Tipping Toys has a 10% cost of capital and a corporate tax rate of 40%. What is the IRR of the project?

14.85%

If the investment is $140,000, what is the net present value, given a total present value of $154,606?

154,606 - 140,000 = 14,606

TippingToys is considering the purchase of a new toy-making machine that will increase revenues by $50,000 a year and annual costs by $10,000. The new machine will replace an outdated machine with a current book value of $10,000 but if scrapped now can only be sold for $6,000. The new machine will cost $100,000 with shipping and installation fees of $10,000. The machine will be depreciated via 5-year MACRS schedule (20.0%, 32.0%, 19.2%, 11.5%, 11.5%, 5.8%). The firm estimates that the new machine can be sold at the end of its five-year life for $20,000. The new machine will necessitate an investment of $30,000 in working capital that will be fully recovered at the end of the project. Tipping Toys has a 10% cost of capital and a corporate tax rate of 40%. What is the NPV of the project?

18824

What is the equipment cost subject to depreciation from the following initial outlay? Old equipment sells for (net of taxes) 55,000 New equipment at cost 190,000 Installation and shipping 18,000 Working capital 62,000

190 + 18 = 208

Equipment is sold for $30,000 at the end of a project. The working capital return is $50,000. The tax rate is 40%. What is the terminal cash flow?

30,000 - (30,000 * .4) + 50,000 = 68,000

A piece of equipment is to be sold at the end of the project. Its appraised value is $420,000. A company makes an offer for $350,000. The equipment has a book value of $75,000. The tax rate is 40%. What is the salvage value if the company accepts the offer?

350,000 - ((350,000 - 75,000) * .4) = 240,000

What is the initial outlay given the following information? Equipment price 375,000 Installation 10,000 Power survey 30,000 Shipping 8,000 Working capital 100,000 Project marketing report 15,000

493,000

A project is closing. Equipment is sold for $50,000, even though the book value was $75,000. The tax rate is 30%. The project started with $100,000 in working capital. What is the terminal cash flow?

50,000 - ((50,000-75,000)*.3) + 100,000 = 157,500

A project has net income of $750,000 including depreciation expense of $42,000. What is the differential cash flow?

750 + 42 = 792

A piece of equipment was sold at the end of the project. The project received $85,000 for the equipment that carried a book value of $75,000. The tax rate is 35%. What is the salvage value?

85,000 - ((85,000-75,000)*.35) = 81,500

Use the following information to calculate the payback period for the project. initial outlay $(10,000) year 1 $6,000 year 2 $7,000 year 3 $6,400 year 4 $5,600 year 5 $5,000

After year 1, the project is $4k short of "paying back" the initial investment ($10k initial investment - $6k year 1 inflow). The $4k needed to achieve payback will require 57% of year 2 inflows ($4k/$7k). Hence, the payback is: Payback Period = 1 + (4000/7000) = 1.57 years 1 + (4000/7000)=1.57

which of the following statements describes a problem associated with IRR? -IRR does not correctly rank mutually exclusive projects -IRR ignores some cash flows -all projects have multiple IRRs -IRR is more difficult to interpret than NPV

IRR does not correctly rank mutually exclusive projects

For capital budgeting analysis, the relevant cash flows from a new project are called:

Incremental cash flows

XYZ Company is considering the purchase of new equipment. The firm spent $12,000 on consulting several months ago as well as $7,000 on a market study about a year ago. In order to start the new project, the firm has to replace the old machine which has a book value of $0 and will be scrapped. The new machine will cost the firm $220,000. Additionally, XYZ will spend $7,000 in installation and $3,000 in shipping. Since the new machine will produce more, an investment in net working capital of $10,000 is required. The new machine will be depreciated using straight-line depreciation to a salvage value of $0. However, the realizable salvage value of the new machine at year 5 is expected to be $50,000. The project will increase annual revenues by $125,000 and will increase annual operating cost by $45,000. The company has a marginal tax rate of 34%. It has the cost of capital of 14% and the project will last 5 years. What is the initial outlay of this project?

Initial outlay = Price of New Machine + Shipping/Installation + Required NWC + Net Proceed from Sale of Old Machine = 220,000 + 10,000 + 10,000 + 0 = 240,000

Why is the NPV preferred over the IRR? (Choose two)

It measures the dollar value.; It is more reliable.

TippingToys is considering the purchase of a new toy-making machine that will increase revenues by $50,000 a year and annual costs by $10,000. The new machine will cost $100,000 with shipping and installation fees of $10,000. The machine will be depreciated via 5-year MACRS schedule (20.0%, 32.0%, 19.2%, 11.5%, 11.5%, 5.8%). The firm estimates that the new machine can be sold at the end of its five-year life for $20,000. The new machine will necessitate an investment of $30,000 in working capital that will be fully recovered at the end of the project. Tipping Toys has a 10% cost of capital and a corporate tax rate of 40%. What is the differential cash flow in Year 3?

MACRS Factoryear 3 -19.20% Depr Expyr3 -($110k x192)=21,120 Revenue -50,000 Cost -(10,000) Depreciation Expense -(21,120) EBIT-18,880 Tax (40%) -(7,552) NOPAT- 11,328 Add: Depreciation Exp -21,120 Differential Cash Flow3 -32,448 Total Cash Flow3 -32,448

What is the IRR given the following? Investment is $250,000. Yr 1 is $50,000, Yr 2 is $60,000, Yr 3 is $80,000, Yr 4 is $100,000, Yr 5 is $90,000, and the terminal cash flow is $45,000.

Make sure to add the TCF to Yr 5 for 135,000.

What is the differential cash flow given the following? Sales 50,000 Expenses (w/o depn) 30,000 Depreciation 10,000 Taxes (.40) 4,000

NI + depn 50,000 - 30,000 - 10,000 = 10,000 EBIT - taxes of 4,000 = 6,000 NI + 10,000 depn = 16,000 diff cash flow

if ranking conflicts occur among payback period, NPV and IRR, you generally should make a decision based on:

NPV

What are the NPV and IRR for an investment of $550,000 with annual differential cash flows as follows: Yr 1: $75,000, Yr 2: $90,000, Yr 3: $125,000, Yr 4: $100,000, Yr 5: $80,000, and a terminal cash flow of $180,000, if the company uses a discount rate of 7%?

NPV = - 37,593.89 IRR = 4.8369 Remember, the TCF is added to Yr 5 so the Yr 5 calc entry is 260,000.

Active Alarm is replacing its old machine with a new one. The old machine is being sold for $200,000 and it has a book value of $50,000. The tax rate for the firm is 40%. What is the net proceed from the sale of the old machine?

Net Sale = Sale price - (Sale price - Book Value) x Tax Rate = 200,000 - (200,000 - 50,000) X 0.4 = $140,000

_____ does not consider everything. You have to go outside of the shell and consider all dimensions of the firm/project.

Number crunching

The depreciable asset (aka depreciable base) in the initial outlay calculation is the :

Purchase price of a new asset + shipping/installation cost

Initial outlay for a capital project is calculated as:

Purchase price of the asset + Shipping/Installation + Investment in WC - Net Proceeds from Sale of Old Asset Note that the investment in WC is usually positive. Further, net proceeds from the sale of the old asset are usually positive and represent a reduction in the initial outlay; however, it is possible for net proceeds to be negative (thus increasing the initial outlay).

TippingToys is considering the purchase of a new toy-making machine that will increase revenues by $50,000 a year and annual costs by $10,000. The new machine will cost $100,000 with shipping and installation fees of $10,000. The machine will be depreciated via 5-year MACRS schedule (20.0%, 32.0%, 19.2%, 11.5%, 11.5%, 5.8%). The firm estimates that the new machine can be sold at the end of its five-year life for $20,000. The new machine will necessitate an investment of $30,000 in working capital that will be fully recovered at the end of the project. Tipping Toys has a 10% cost of capital and a corporate tax rate of 40%. What is the terminal cash flow of the project?

Recapture WC-30,000 Sale of new equipment-20,000 BV of New-(6380) Gain/Loss- 13,620 Tax-(5448) Net Cash from Sale-14,552 Terminal CF-44552

If a firm is considering a new project which will generate the following cash flows: IO = -145, YR1 = 100, YR2 = 100, YR3 = 100, YR4 = 100, YR5 = -275, what is the IRR of the project? Assume that the discount rate of the project is 12.76%

Since there are multiple sign changes in cash flows, there are multiple IRRs which are 8.78% and 26.65%. IRR cannot be used in this circumstance.

ABC Corp is considering a project requiring the purchase of new equipment. The firm spent $20,000 on a market assessment four months ago as well as $14,000 for a feasibility study a year ago. In order to start the new project, the firm has to replace an old machine with a remaining book value of $25,000 (note: this is the original salvage value of the old machine; as such, it is fully depreciated). While still functional, the machine has no market value and will be scrapped if the new equipment is acquired. The new machine will cost the firm $220,000. In order to put the machine in working condition, ABC will spend $6,000 in installation and $4,000 in shipping. If the new machine is purchased net working capital will be increased by $10,000. The new machine will be depreciated via the straight-line depreciation method to a salvage value of $0. However, at the end of the new machine's five-year life, it can be sold for $30,000. The corporate tax rate is 40%. If accepted, the new machine will increase annual revenues by $150,000 and will increase annual operating cost by $45,000. The company has a marginal tax rate of 40% and a cost of capital of 14%. The project will last 5 years. What is the tax implication from the sale of the new machine at Year 5 (the end of its useful life)?

Tax liabilities of $12,000 The machine is fully depreciated to a book value of $0. Hence, all of the sale proceeds are taxable. Tax liability = (Realizable salvage value - Book value) X Tax Rate = (30,000 - 0) X 0.40 = $12,000.

TippingToys is considering the purchase of a new toy-making machine that will increase revenues by $50,000 a year and annual costs by $10,000. The new machine will replace an outdated machine with a current book value of $10,000 but if scrapped now can only be sold for $6,000. The new machine will cost $100,000 with shipping and installation fees of $10,000. The machine will be depreciated via 5-year MACRS schedule (20.0%, 32.0%, 19.2%, 11.5%, 11.5%, 5.8%). The firm estimates that the new machine can be sold at the end of its five-year life for $20,000. The new machine will necessitate an investment of $30,000 in working capital that will be fully recovered at the end of the project. Tipping Toys has a 10% cost of capital and a corporate tax rate of 40%. What is the tax implication of selling the old machine?

Tax shield of $1,600 Sale of Old 6,000 BV of Old (10,000) Gain (Loss) (4,000) Tax shield 1,600

Why would you reject a project based on NPV?

The NPV is a negative number.

Why would you reject this project based on the IRR?

The discount rate is higher than the IRR.

If a WACC of 15.00% is used to compute the NPV, what does the IRR computed in question 110, above, tell about the project?

The project is acceptable.

One of the weaknesses of payback period is that:

The time value of money is not considered. The weaknesses of the payback approach are that the method does not: 1) incorporate required rate/risk adjustment, 2) consider time value of money, or 3) consider all the cash flows.

Which of the following changes will most likely increase the incremental cash flow in the early years of a long-lived project?

Using MACRS instead of straight-line depreciation. MACRS is an accelerated depreciation method that provides big depreciation expense in the early years and small depreciation expense in later years (as compared to straight-line). Depreciation is a non-cash expense included only for its impact on taxes. Hence, the only impact depreciation expense has on cash flow is through tax expense. Big depreciation expense in the early years reduces tax expense in the early years. Hence, since taxes are real cash outflows, MACRS will increase project cash flows in the early years.

The total cost of a new machine including the shipping and the installation was $250,000. Using the 3-year MACRS schedule, determine the depreciation expense in year 2. The factors for the three-years schedule are: year 1 = 33.33%, year 2 = 44.45%, year 3 = 14.81%, and year 4 = 7.41%

Using the tables, depreciation for each year is calculated as: Depr.expense = factori x cost. Hence, for year 2 depreciation expense = .4445 x $250,000 = $111,125.

The total cost of a new machine, including the shipping and installation, is $250,000. Using the 3-year MACRS schedule, determine the depreciation expense in year 3. Year 1 -3-YR MACRS (%) 33.33% Year 2 -3-YR MACRS (%)44.45% Year 3 -3-YR MACRS (%)14.81% Year 4 - 3-YR MACRS (%)7.41%

Year 1 33.33% Depreciation Expenses -.3333x$250000=83,325 Year 2 44.45% Depreciation Expenses -.4445x250000=111,125 Year 3 14.81% Depreciation Expenses -.1481x250000=37025 Year 4 7.41% Depreciation expenses -.074x250000=18,525

Use the following information to answer the question. Initial outlay $(5,000) year 1 $3,000 year 2 $3,500 year 3 $3,200 year 4 $2,800 year 5 $2,500

Year 1 cash flow will be used to payback a part of the initial outlay and $2,000 will be left to payback still. Since Year 2 has more cash inflow than needed to achieve payback, payback period can be calculated as: 1 + (2000/3500) = 1.57 years.

examples of risk mitigation strategies discussed in the textbook?

analyze the project under different economic situations change the required rate of return to observe changes in NPV Evaluate the project with the addition of a partner examples of sensitivity analysis, partnering, and simulation analysis which were all mentioned as risk mitigation strategies.

which three pieces of data are needed to perform a capital budget analysis

annual cash flows for the life of the new project cash flow when the firm terminates the project initial cost of the new project

part of the capital budgeting calculation

calculating the estimated value of stock when the firm terminates the project

what affects differential cash flows

change in the depreciation schedule increase in the marginal tax rate of a company decrease in the projected annual revenue

what problems associated with payback period

firm cutoffs are subjective does not consider any required rate of return does not consider time value of money

essential to evaluate projects

incorporating the required rate of return considering time value of money including all cash flows of the project

what is involved into the calculation of initial outlay according to the textbook

investing in working capital purchase price of the equipment shipping cost

capital budgeting is the

process of deciding which projects increase firm value

Incremental cash flows are the

relevant cash flows in capital budgeting analysis. In simplest form, this is cash in - cash out occurring in each period as a result of accepting the project.

the terminal cash flow is

the cash flows associated with unwinding the project

examples of sunk cost

the cost of a market study conducted prior to the decision cost of feasibility consulting incurred before the decision point

what should be included in the capital budgeting calculation

the cost of scrapping an old machine to replace with a new machine

The cutoff in the payback method is subject; but,

this is a weakness of the approach.

what should be considered when evaluating a potential capital project

timing of the cash flows size of the initial investment riskiness of the project