Chapter 10 Practice Problems

Which one of the following will increase a bid price?

an increase in the required rate of return

Changes in the net working capital requirements

can affect the cash flows of a project every year of the project's life.

The operating cash flow of a cost cutting project

can be positive even though there are no sales.

. Bruno's Lunch Counter is expanding and expects operating cash flows of $26,000 a year for 4 years as a result. This expansion requires $39,000 in new fixed assets. These assets will be worthless at the end of the project. In addition, the project requires $3,000 of net working capital throughout the life of the project. What is the net present value of this expansion project at a required rate of return of 16 percent?

-39,000 - 3,000 + 26000[1-(1/(1+.16)^4)/.16]+(3,000)/[(1.16)^4]= 32409.57

Gateway Communications is considering a project with an initial fixed asset cost of $2.46 million which will be depreciated straight-line to a zero book value over the 10-year life of the project. At the end of the project the equipment will be sold for an estimated $300,000. The project will not directly produce any sales but will reduce operating costs by $725,000 a year. The tax rate is 35 percent. The project will require $45,000 of inventory which will be recouped when the project ends. Should this project be implemented if the firm requires a 14 percent rate of return? Why or why not?

. Yes; The NPV is $466,940.57 Initial cash flow = -$2,460,000 - $45,000 = -$2,505,000 OCF = $725,000(1 - 0.35) + ($2,460,000/10)(0.35) = $557,350 Final cash flow = $45,000 + $300,000 (1 - 0.35) = $240,000

Net working capital

. can create either a cash inflow or a cash outflow at time zero of a project

Increasing which one of the following will increase the operating cash flow assuming that the bottom-up approach is used to compute the operating cash flow

. depreciation expense

The difference between a firm's future cash flows if it accepts a project and the firm's future cash flows if it does not accept the project is referred to as the project's:

. incremental cash flows

The operating cash flow for a project should exclude which one of the following?

. interest expense

Which one of the following is an example of a sunk cost?

1,200 paid to repair a machine last year

. Keyser Petroleum just purchased some equipment at a cost of $67,000. What is the proper methodology for computing the depreciation expense for year 2 if the equipment is classified as 5-year property for MACRS

67,000 0.32

Which one of the following statements is correct concerning bid prices?

A firm can submit a bid that is higher than the computed bid price and still break even

Which one of the following statements is correct

A project can create a positive operating cash flow without affecting sales

In a single sentence, explain how you can determine which cash flows should be included in the analysis of a project.

Any changes in cash flows that will result from accepting a new project should be included in the analysis of that project

Which one of the following is the depreciation method which allows accelerated write-offs of property under various lifetime classifications?

ACRS

67. You own some equipment that you purchased 4 years ago at a cost of $216,000. The equipment is 5-year property for MACRS. You are considering selling the equipment today for $75,500. Which one of the following statements is correct if your tax rate is 35 percent?

Accumulated depreciation4 = $216,000 (0.20 + 0.32 + 0.192 + 0.1152) = $178,675.20 Book Value4 = $216,000 - $178,675.20 = $37,324.80 Taxable gain on sale = $75,500 - $37,324.80 = $38,175.20 Tax due = $38,175.20 0.35 = $13,361.32 Aftertax salvage value = $75,500 - $13,361.32 = $62,138.68

Morris Motors just purchased some MACRS 5-year property at a cost of $216,000. Which one of the following will correctly give you the book value of this equipment at the end of year 2?

B. $216,000 (1 - 0.20 - 0.32)

A project will produce an operating cash flow of $14,600 a year for 8 years. The initial fixed asset investment in the project will be $48,900. The net aftertax salvage value is estimated at $11,000 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 12 percent?

B. $28,070.26

64. You just purchased some equipment that is classified as 5-year property for MACRS. The equipment cost $147,000. What will the book value of this equipment be at the end of 4 years should you decide to resell the equipment at that point in time?

Book Value4 = $147,000 (0.1152 + 0.0576) = $25,401.60

Consider an asset that costs $176,000 and is depreciated straight-line to zero over its 11-year tax life. The asset is to be used in a 7-year project; at the end of the project, the asset can be sold for $22,000. The relevant tax rate is 30 percent. What is the aftertax cash flow from the sale of this asset?

Book value at end of year 7 = $176,000 4/11 = $64,000 Aftertax salvage value = $22,000 + [($64,000 - $22,000) .30] = $34,600

68. Edward's Manufactured Homes purchased some machinery 2 years ago for $319,000. These assets are classified as 5-year property for MACRS. The company is replacing this machinery today with newer machines that utilize the latest in technology. The old machines are being sold for $140,000 to a foreign firm for use in its production facility in South America. What is the aftertax salvage value from this sale if the tax rate is 35 percent?

Book value2 = $319,000 (1 - 0.20 - 0.32) = $153,120 Tax on sale = ($140,000 - $153,120) 0.35 = -$4,592 (tax savings) After-tax cash flow = $140,000 + $4,592 = $144,592

66. Crafter's Supply purchased some fixed assets 2 years ago at a cost of $38,700. It no longer needs these assets so it is going to sell them today for $25,000. The assets are classified as 5-year property for MACRS. What is the net cash flow from this sale if the firm's tax rate is 30 percent?

Book value2 = $38,700 (1 - 0.20 - 0.32) = $18,576 Aftertax salvage = $25,000 + [($18,576 - $25,000) 0.30] = $23,072.80

Jasper Metals is considering installing a new molding machine which is expected to produce operating cash flows of $73,000 a year for 7 years. At the beginning of the project, inventory will decrease by $16,000, accounts receivables will increase by $21,000, and accounts payable will increase by $15,000. All net working capital will be recovered at the end of the project. The initial cost of the molding machine is $249,000. The equipment will be depreciated straight-line to a zero book value over the life of the project. The equipment will be salvaged at the end of the project creating a $48,000 aftertax cash flow. At the end of the project, net working capital will return to its normal level. What is the net present value of this project given a required return of 14.5 percent?

CF0 = -$249,000 + $16,000 - $21,000 + $15,000 = -$239,000 C07 = $73,000 + $48,000 - $16,000 + $21,000 - $15,000 = $111,000 npv $84,049.74

Sailcloth & More currently produces boat sails and is considering expanding its operations to include awnings for homes and travel trailers. The company owns land beside its current manufacturing facility that could be used for the expansion. The company bought this land 5 years ago at a cost of $319,000. At the time of purchase, the company paid $24,000 to level out the land so it would be suitable for future use. Today, the land is valued at $295,000. The company currently has some unused equipment that it currently owns valued at $38,000. This equipment could be used for producing awnings if $12,000 is spent for equipment modifications. Other equipment costing $490,000 will also be required. What is the amount of the initial cash flow for this expansion project?

CF0 = -$295,000 - $38,000 - $12,000 - $490,000 = -$835,000

. Kelly's Corner Bakery purchased a lot in Oil City 6 years ago at a cost of $280,000. Today, that lot has a market value of $340,000. At the time of the purchase, the company spent $15,000 to level the lot and another $20,000 to install storm drains. The company now wants to build a new facility on that site. The building cost is estimated at $1.47 million. What amount should be used as the initial cash flow for this project

CF0 = -$340,000 - $1,470,000 = -$1,810,000

63. Bernie's Beverages purchased some fixed assets classified as 5-year property for MACRS. The assets cost $87,000. What will the accumulated depreciation be at the end of year three?

Depreciation = $87,000 (0.20 + 0.32 + 0.192) = $61,944

What is the amount of the depreciation tax shield

Depreciation tax shield = $75,600 .32 = $24,192

62. The Lumber Yard is considering adding a new product line that is expected to increase annual sales by $238,000 and cash expenses by $184,000. The initial investment will require $96,000 in fixed assets that will be depreciated using the straight-line method to a zero book value over the 6-year life of the project. The company has a marginal tax rate of 32 percent. What is the annual value of the depreciation tax shield?

Depreciation tax shield = ($96,000/6) 0.32 = $5,120

65. Peterborough Trucking just purchased some fixed assets that are classified as 3-year property for MACRS. The assets cost $9,800. What is the amount of the depreciation expense in year 3?

Depreciation3 = $9,800 0.1481 = $1,451.38

Kwik 'n Hot Dogs is considering the installation of a new computerized pressure cooker that will cut annual operating costs by $23,000. The system will cost $39,900 to purchase and install. This system is expected to have a 4-year life and will be depreciated to zero using straight-line depreciation. What is the amount of the earnings before interest and taxes for this

Earnings before interest and taxes = $23,000 - ($39,900/4) = $13,025

54. Cool Comfort currently sells 300 Class A spas, 450 Class C spas, and 200 deluxe model spas each year. The firm is considering adding a mid-class spa and expects that if it does it can sell 375 of them. However, if the new spa is added, Class A sales are expected to decline to 225 units while the Class C sales are expected to decline to 200. The sales of the deluxe model will not be affected. Class A spas sell for an average of $12,000 each. Class C spas are priced at $6,000 and the deluxe model sells for $17,000 each. The new mid-range spa will sell for $8,000. What is the value of the erosion?

Erosion = [(300 - 225) $12,000] + [(450 - 200) $6,000] = $2,400,000

Danielle's is a furniture store that is considering adding appliances to its offerings. Which of the following should be considered incremental cash flows of this project? I. utilizing the credit offered by a supplier to purchase the appliance inventory II. benefiting from increased furniture sales to appliance customers III. borrowing money from a bank to fund the appliance project IV. purchasing parts for inventory to handle any appliance repairs that might be necessary

I, II, and IV only

Pro forma statements for a proposed project should

I. be compiled on a stand-alone basis. II. include all the incremental cash flows related to the project. III. generally exclude interest expense. IV. include all project-related fixed asset acquisitions and disposals

When using the equivalent annual cost as a basis for deciding which equipment should be purchased, the equipment under consideration must fit which two of the following criteria?

I. differing productive lives III. required replacement at end of economic life

The equivalent annual cost considers which of the following?

I. required rate of return II. operating costs III. need for replacement IV. aftertax salvage value

Which one of the following is a correct method for computing the operating cash flow of a project assuming that the interest expense is equal to zero

NI + D

You are working on a bid to build two city parks a year for the next three years. This project requires the purchase of $180,000 of equipment that will be depreciated using straight-line depreciation to a zero book value over the 3-year project life. The equipment can be sold at the end of the project for $34,000. You will also need $20,000 in net working capital for the duration of the project. The fixed costs will be $16,000 a year and the variable costs will be $168,000 per park. Your required rate of return is 15 percent and your tax rate is 34 percent. What is the minimal amount you should bid per park? (Round your answer to the nearest $100)

NI = $75,373.65 - ($180,000/3) = $15,373.65 EBT = $15,373.65/(1 - 0.34) = $23,293.41 Sales = $23,293.41 + ($180,000/3) + $16,000 + ($168,000 2) = $435,293.41 Bid per park = $435,293.41/2 = $217,646.71 When rounded to the nearest $100, the bid price is $217,600

Colors and More is considering replacing the equipment it uses to produce crayons. The equipment would cost $1.37 million, have a 12-year life, and lower manufacturing costs by an estimated $304,000 a year. The equipment will be depreciated using straight-line depreciation to a book value of zero. The required rate of return is 15 percent and the tax rate is 35 percent. What is the net income from this proposed project?

Net income = [$304,000 - ($1,370,000/12)] [1 - 0.35] = $123,391.67

60. Bi-Lo Traders is considering a project that will produce sales of $28,000 and increase cash expenses by $17,500. If the project is implemented, taxes will increase by $3,000. The additional depreciation expense will be $1,600. An initial cash outlay of $1,400 is required for net working capital. What is the amount of the operating cash flow using the top-down approach?

OCF = $28,000 - $17,500 - $3,000 = $7,500

59. Northern Railway is considering a project which will produce annual sales of $975,000 and increase cash expenses by $859,000. If the project is implemented, taxes will increase from $141,000 to $154,000 and depreciation will increase from $194,000 to $272,000. The company is debt-free. What is the amount of the operating cash flow using the top-down approach?

OCF = $975,000 - $859,000 - ($154,000 - $141,000) = $103,000

The Pancake House has sales of $1,642,000, depreciation of $27,000, and net working capital of $218,000. The firm has a tax rate of 35 percent and a profit margin of 6 percent. The firm has no interest expense. What is the amount of the operating cash flow?

OCF = ($1,642,000 0.06) + $27,000 = $125,520

55. Jefferson & Sons is evaluating a project that will increase annual sales by $138,000 and annual costs by $94,000. The project will initially require $110,000 in fixed assets that will be depreciated straight-line to a zero book value over the 4-year life of the project. The applicable tax rate is 32 percent. What is the operating cash flow for this project?

OCF = ($138,000 - $94,000)(1 - 0.32) + ($110,000/4)(0.32) = $38,720

Phone Home, Inc. is considering a new 5-year expansion project that requires an initial fixed asset investment of $2.484 million. The fixed asset will be depreciated straight-line to zero over its 5-year tax life, after which time it will be worthless. The project is estimated to generate $2,208,000 in annual sales, with costs of $883,200. The tax rate is 32 percent and the required return on the project is 11 percent. What is the net present value for this project?

OCF = ($2,208,000 - $883,200)(1 - 0.32) + ($2,484,000/5)(0.32) = $1,059,840 npv= B. $1,433,059

61. A proposed expansion project is expected to increase sales of JL Ticker's Store by $35,000 and increase cash expenses by $21,000. The project will cost $24,000 and be depreciated using straight-line depreciation to a zero book value over the 4-year life of the project. The store has a marginal tax rate of 30 percent. What is the operating cash flow of the project using the tax shield approach?

OCF = ($35,000 - $21,000) (1 - 0.30) + ($24,000/4) (0.30) = $11,600

56. Marie's Fashions is considering a project that will require $28,000 in net working capital and $87,000 in fixed assets. The project is expected to produce annual sales of $75,000 with associated costs of $57,000. The project has a 5-year life. The company uses straight-line depreciation to a zero book value over the life of the project. The tax rate is 30 percent. What is the operating cash flow for this project?

OCF = ($75,000 - $57,000)(1 - 0.30) + ($87,000/5)(0.30) = $17,820

The Beach House has sales of $784,000 and a profit margin of 11 percent. The annual depreciation expense is $14,000. What is the amount of the operating cash flow if the company has no long-term debt?

OCF = ($784,000 0.11) + $14,000 = $100,240

Phone Home, Inc. is considering a new 6-year expansion project that requires an initial fixed asset investment of $5.994 million. The fixed asset will be depreciated straight-line to zero over its 6-year tax life, after which time it will be worthless. The project is estimated to generate $5,328,000 in annual sales, with costs of $2,131,200. The tax rate is 31 percent. What is the operating cash flow for this project?

OCF = (5,328,000 - $2,131,200)(1 - 0.31) + ($5,994,000/6)(0.31) = $2,515,482

What is the formula for the tax-shield approach to OCF? Explain the two key points the formula illustrates

OCF = (Sales - Costs) (1 - T) + Depreciation T The formula illustrates that cash income and expenses affect OCF on an aftertax basis. The formula also illustrates that even though depreciation is a non-cash expense it does affect OCF because of the tax savings realized from the depreciation expense.

You own a house that you rent for $1,100 a month. The maintenance expenses on the house average $200 a month. The house cost $219,000 when you purchased it 4 years ago. A recent appraisal on the house valued it at $239,000. If you sell the house you will incur $14,000 in real estate fees. The annual property taxes are $4,000. You are deciding whether to sell the house or convert it for your own use as a professional office. What value should you place on this house when analyzing the option of using it as a professional office?

Opportunity cost = $239,000 - $14,000 = $225,000

Mason Farms purchased a building for $729,000 eight years ago. Six years ago, repairs were made to the building which cost $136,000. The annual taxes on the property are $11,000. The building has a current market value of $825,000 and a current book value of $494,000. The building is totally paid for and solely owned by the firm. If the company decides to use this building for a new project, what value, if any, should be included in the initial cash flow of the project for this building?

Opportunity cost = $825,000

Nelson Mfg. owns a manufacturing facility that is currently sitting idle. The facility is located on a piece of land that originally cost $159,000. The facility itself cost $1,460,000 to build. As of now, the book value of the land and the facility are $159,000 and $458,000, respectively. The firm owes no debt on either the land or the facility at the present time. The firm received a bid of $1,500,000 for the land and facility last week. The firm's management rejected this bid even though they were told that it is a reasonable offer in today's market. If the firm was to consider using this land and facility in a new project, what cost, if any, should it include in the project analysis?

Relevant cost = $1,500,000

Webster & Moore paid $139,000, in cash, for a piece of equipment 3 years ago. At the beginning of last year, the company spent $21,000 to update the equipment with the latest technology. The company no longer uses this equipment in its current operations and has received an offer of $89,000 from a firm that would like to purchase it. Webster & Moore is debating whether to sell the equipment or to expand its operations so that the equipment can be used. When evaluating the expansion option, what value, if any, should the firm assign to this equipment as an initial cost of the project?

Relevant value = $89,000

. Three years ago, Knox Glass purchased a machine for a 3-year project. The machine is being depreciated straight-line to zero over a 5-year period. Today, the project ended and the machine was sold. Which one of the following correctly defines the aftertax salvage value of that machine? (T represents the relevant tax rate)

Sale price + (Book value - Sale price) T

Winnebagel Corp. currently sells 28,200 motor homes per year at $42,300 each, and 11,280 luxury motor coaches per year at $79,900 each. The company wants to introduce a new portable camper to fill out its product line. It hopes to sell 19,740 of these campers per year at $11,280 each. An independent consultant has determined that if Winnebagel introduces the new campers, it should boost the sales of its existing motor homes by 4,700 units per year, and reduce the sales of its motor coaches by 1,222 units per year. What is the amount that should be used as the annual sales figure when evaluating this project?

Sales = (19,740 $11,280) + (4,700 $42,300) + (-1,222 $79,900) = $323,839,400

The Fluffy Feather sells customized handbags. Currently, it sells 18,000 handbags annually at an average price of $89 each. It is considering adding a lower-priced line of handbags that sell for $59 each. The firm estimates it can sell 7,000 of the lower-priced handbags but will sell 3,000 less of the higher-priced handbags by doing so. What is the amount of the sales that should be used when evaluating the addition of the lower-priced handbags?

Sales = (7,000 $59) + (-3,000 $89) = $146,000

Can the initial cash flow at time zero for a project ever be a positive value? If yes, give an example. If no, explain why not

The initial cash flow can be a positive value. For example, if a project reduced net working capital by an amount that exceeded the initial cost for fixed assets, the initial cash flow would be a positive amount.

The bid price always assumes which one of the following?

The net present value of the project is zero.

Dexter Smith & Co. is replacing a machine simply because it has worn out. The new machine will not affect either sales or operating costs and will not have any salvage value at the end of its 5-year life. The firm has a 34 percent tax rate, uses straight-line depreciation over an asset's life, and has a positive net income. Given this, which one of the following statements is correct?

The new machine will generate positive operating cash flows, at least in the first few years of its life.

What is the primary purpose of computing the equivalent annual costs when comparing two machines? What is the assumption that is being made about each machine

The primary purpose is to compute the annual cost of each machine on a comparable basis so that the least expensive machine can be identified given that the machines generally have differing lives and costs. The assumption is that whichever machine is acquired, it will be replaced at the end of its useful life

The depreciation tax shield is best defined as the

amount of tax that is saved because of the depreciation expense

Which one of the following would make a project unacceptable?

an equivalent annual cost that exceeds that of an alternative project

Which one of the following is a project cash inflow? Ignore any tax effects

decrease in accounts receivable

The net book value of equipment will:

decrease slower under straight-line depreciation than under MACRS

. Decreasing which one of the following will increase the acceptability of a project?

equivalent annual cost

Dan is comparing three machines to determine which one to purchase. The machines sell for differing prices, have differing operating costs, differing machine lives, and will be replaced when worn out. Which one of the following computational methods should Dan use as the basis for his decision?

equivalent annual cost

The annual annuity stream of payments that has the same present value as a project's costs is referred to as which one of the following

equivalent annual cost

Which one of the following best describes pro forma financial statements?

financial statements showing projected values for future time periods

Kelley's Baskets makes handmade baskets for distribution to upscale retail outlets. The firm is currently considering making handmade wreaths as well. Which one of the following is the best example of an incremental operating cash flow related to the wreath project?

hiring additional employees to handle the increased workload should the firm accept the wreath project

The top-down approach to computing the operating cash flow

ignores noncash expenses

The stand-alone principle advocates that project analysis should be based solely on which one of the following costs?

incremental

You are considering the purchase of a new machine. Your analysis includes the evaluation of two machines which have differing initial and ongoing costs and differing lives. Whichever machine is purchased will be replaced at the end of its useful life. You should select the machine which has the

lowest equivalent annual cost

The option that is foregone so that an asset can be utilized by a specific project is referred to as which one of the following

opportunity cost

All of the following are related to a proposed project. Which of these should be included in the cash flow at time zero?

purchase of $1,400 of parts inventory needed to support the project 6,500 of equipment needed to commence the project

Which of the following should be included in the analysis of a new product?

reduction in sales for a current product once the new product is introduced increase in accounts receivable needed to finance sales of the new product market value of a machine owned by the firm which will be used to produce the new product

. Which one of the following best illustrates erosion as it relates to a hot dog stand located on the beach

selling fewer hot dogs because hamburgers were added to the menu

The fact that a proposed project is analyzed based on the project's incremental cash flows is the assumption behind which one of the following principles

stand-alone principle

G & L Plastic Molders spent $1,200 last week repairing a machine. This week the company is trying to decide if the machine could be better utilized if they assigned it a proposed project. When analyzing the proposed project, the $1,200 should be treated as which type of cost?

sunk

Which one of the following costs was incurred in the past and cannot be recouped

sunk

The current book value of a fixed asset that was purchased two years ago is used in the computation of which one of the following?

tax due on the salvage value of that asset

Which one of the following best describes the concept of erosion?

the cash flows of a new project that come at the expense of a firm's existing cash flows

The bottom-up approach to computing the operating cash flow applies only when

the interest expense is equal to zero.

The bid price is

the minimum price you should charge if you want to financially breakeven

The equivalent annual cost method is useful in determining:

which one of two machines should be purchased when the machines are mutually exclusive, have different machine lives, and will be replaced once they are worn out

A company that utilizes the MACRS system of depreciation

will have a greater tax shield in year two of a project than it would have if the firm had opted for straight-line depreciation, given the same depreciation life