Module 9 McGraw-Hill Connect Finance

Your firm is contemplating the purchase of a new $731,500 computer-based order entry system. The system will be depreciated straight-line to zero over its seven-year life. It will be worth $41,000 at the end of that time. You will save $161,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $36,000 at the beginning of the project. Working capital will revert back to normal at the end of the project. Required: If the tax rate is 30 percent, what is the IRR for this project?

Explanation: First, we will calculate the annual depreciation of the new equipment. It will be: Annual depreciation charge = $731,500 / 7 Annual depreciation charge = $104,500 The aftertax salvage value of the equipment is: Aftertax salvage value = $41,000(1 - .30) Aftertax salvage value = $28,700 Using the tax shield approach, the OCF is: OCF = $161,000(1 - .30) + .30($104,500) OCF = $144,050 Now we can find the project IRR. There is an unusual feature that is a part of this project. Accepting this project means that we will reduce NWC. This reduction in NWC is a cash inflow at Year 0. This reduction in NWC implies that when the project ends, we will have to increase NWC. So, at the end of the project, we will have a cash outflow to restore the NWC to its level before the project. We must also include the aftertax salvage value at the end of the project. The IRR of the project is: NPV = 0 = -$731,500 + 36,000 + $144,050(PVIFAIRR%,7) + [($28,700 - 36,000) / (1 + IRR)7] IRR = 10.09%

Winnebagel Corp. currently sells 28,500 motor homes per year at $75,500 each and 7,500 luxury motor coaches per year at $117,500 each. The company wants to introduce a new portable camper to fill out its product line; it hopes to sell 23,500 of these campers per year at $21,500 each. An independent consultant has determined that if Winnebagel introduces the new campers, it should boost the sales of its existing motor homes by 3,100 units per year and reduce the sales of its motor coaches by 900 units per year. Required: What is the amount to use as the annual sales figure when evaluating this project?

Explanation: Sales due solely to the new product line are: 23,500($21,500) = $505,250,000 Increased sales of the motor home line occur because of the new product line introduction; thus: 3,100($75,500) = $234,050,000 in new sales is relevant. Erosion of luxury motor coach sales is also due to the new mid-size campers; thus: 900($117,500) = $105,750,000 loss in sales is relevant. The net sales figure to use in evaluating the new line is thus: Net sales = $505,250,000 + 234,050,000 - 105,750,000 Net sales = $633,550,000

Kenny, Inc., is looking at setting up a new manufacturing plant in South Park. The company bought some land six years ago for $7.4 million in anticipation of using it as a warehouse and distribution site, but the company has since decided to rent facilities elsewhere. The land would net $10.2 million if it were sold today. The company now wants to build its new manufacturing plant on this land; the plant will cost $21.4 million to build, and the site requires $890,000 worth of grading before it is suitable for construction. Required: What is the proper cash flow amount to use as the initial investment in fixed assets when evaluating this project?

Explanation: The $7.4 million acquisition cost of the land six years ago is a sunk cost. The $10.2 million current aftertax value of the land is an opportunity cost if the land is used rather than sold off. The $21.4 million cash outlay and $890,000 grading expenses are the initial fixed asset investments needed to get the project going. Therefore, the proper year zero cash flow to use in evaluating this project is Cash flow = $10,200,000 + 21,400,000 + 890,000 Cash flow = $32,490,000

A proposed new investment has projected sales of $844,000. Variable costs are 53 percent of sales, and fixed costs are $188,080; depreciation is $100,500. Assume a tax rate of 30 percent. Required: What is the projected net income?

Explanation: We need to construct an income statement. The income statement is: Sales $844,000 Variable costs 447,320 Fixed costs 188,080 Depreciation 100,500 EBIT $108,100 Taxes (@30%) 32,430 Net income $75,670

Your firm is contemplating the purchase of a new $749,000 computer-based order entry system. The system will be depreciated straight-line to zero over its seven-year life. It will be worth $45,000 at the end of that time. You will save $165,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $40,000 at the beginning of the project. Working capital will revert back to normal at the end of the project. If the tax rate is 40 percent, what is the IRR for this project? If the tax rate is 40 percent, what is the IRR for this project?

First, we will calculate the annual depreciation of the new equipment. It will be: Annual depreciation charge = $749,000 / 7 Annual depreciation charge = $107,000 The aftertax salvage value of the equipment is: Aftertax salvage value = $45,000(1 - .40) Aftertax salvage value = $27,000 Using the tax shield approach, the OCF is: OCF = $165,000(1 - .40) + .40($107,000) OCF = $141,800 Now we can find the project IRR. There is an unusual feature that is a part of this project. Accepting this project means that we will reduce NWC. This reduction in NWC is a cash inflow at Year 0. This reduction in NWC implies that when the project ends, we will have to increase NWC. So, at the end of the project, we will have a cash outflow to restore the NWC to its level before the project. We must also include the aftertax salvage value at the end of the project. The IRR of the project is: NPV = 0 = -$749,000 + 40,000 + $141,800(PVIFAIRR%,7) + [($27,000 - 40,000) / (1 + IRR)7] IRR = 8.90%

Kenny, Inc., is looking at setting up a new manufacturing plant in South Park. The company bought some land six years ago for $8.4 million in anticipation of using it as a warehouse and distribution site, but the company has since decided to rent facilities elsewhere. The land would net $11.2 million if it were sold today. The company now wants to build its new manufacturing plant on this land; the plant will cost $22.4 million to build, and the site requires $990,000 worth of grading before it is suitable for construction.

Required: What is the proper cash flow amount to use as the initial investment in fixed assets when evaluating this project?The $8.4 million acquisition cost of the land six years ago is a sunk cost. The $11.2 million current aftertax value of the land is an opportunity cost if the land is used rather than sold off. The $22.4 million cash outlay and $990,000 grading expenses are the initial fixed asset investments needed to get the project going. Therefore, the proper year zero cash flow to use in evaluating this project is Cash flow = $11,200,000 + 22,400,000 + 990,000 Cash flow = $34,590,000

Your firm is contemplating the purchase of a new $669,000 computer-based order entry system. The system will be depreciated straight-line to zero over its six-year life. It will be worth $55,000 at the end of that time. You will be able to reduce working capital by $50,000 at the beginning of the project. Working capital will revert back to normal at the end of the project. Assume the tax rate is 35 percent.

Requirement 1: Suppose your required return on the project is 9 percent and your pretax cost savings are $205,000 per year. What is the NPV of the project? Explanation: First, we will calculate the annual depreciation of the new equipment. It will be: Annual depreciation charge = $669,000 / 6 Annual depreciation charge = $111,500 The aftertax salvage value of the equipment is: Aftertax salvage value = $55,000(1 - .35) Aftertax salvage value = $35,750 To evaluate the project with a $205,000 cost savings, we need the OCF to compute the NPV. Using the tax shield approach, the OCF is: OCF = $205,000(1 - .35) + .35($111,500) OCF = $172,275 NPV = - $669,000 + 50,000 + $172,275(PVIFA9%,6) + [($35,750 - 50,000) / (1.09)6] NPV = $145,314.82 Requirement 2: Suppose your required return on the project is 9 percent and your pretax cost savings are $145,000 per year. What is the NPV of the project? The NPV with a $145,000 cost savings is: OCF = $145,000(1 - .35) + .35($111,500) OCF = $133,275 NPV = - $669,000 + 50,000 + $133,275(PVIFA9%,6) + [($35,750 - 50,000) / (1.09)6] NPV = - $29,636.01 We would accept the project if cost savings were $205,000, and reject the project if the cost savings were $145,000.

Winnebagel Corp. currently sells 29,200 motor homes per year at $79,000 each and 8,200 luxury motor coaches per year at $121,000 each. The company wants to introduce a new portable camper to fill out its product line; it hopes to sell 24,200 of these campers per year at $25,000 each. An independent consultant has determined that if Winnebagel introduces the new campers, it should boost the sales of its existing motor homes by 3,800 units per year and reduce the sales of its motor coaches by 970 units per year. Required: What is the amount to use as the annual sales figure when evaluating this project?

Sales due solely to the new product line are: 24,200($25,000) = $605,000,000 Increased sales of the motor home line occur because of the new product line introduction; thus: 3,800($79,000) = $300,200,000 in new sales is relevant. Erosion of luxury motor coach sales is also due to the new mid-size campers; thus: 970($121,000) = $117,370,000 loss in sales is relevant. The net sales figure to use in evaluating the new line is thus: Net sales = $605,000,000 + 300,200,000 - 117,370,000 Net sales = $787,830,000

An asset used in a four-year project falls in the five-year MACRS class (MACRS Table) for tax purposes. The asset has an acquisition cost of $7,200,000 and will be sold for $1,760,000 at the end of the project. Required: If the tax rate is 35 percent, what is the aftertax salvage value of the asset?

To find the book value at the end of four years, we need to find the accumulated depreciation for the first four years. We could add the MACRS depreciation amounts for each of the first four years and multiply this percentage times the cost of the asset. We can then subtract this from the asset cost. Doing so, we get: BV4 = $7,200,000 - 7,200,000(.2000 + .3200 + .1920 + .1152) BV4 = $1,244,160 The asset is sold at a gain to book value, so this gain is taxable. Aftertax salvage value = $1,760,000 + ($1,244,160 - 1,760,000)(.35) Aftertax salvage value = $1,579,456.00

An asset used in a four-year project falls in the five-year MACRS class (MACRS Table) for tax purposes. The asset has an acquisition cost of $8,900,000 and will be sold for $1,930,000 at the end of the project. Required: If the tax rate is 30 percent, what is the aftertax salvage value of the asset?

To find the book value at the end of four years, we need to find the accumulated depreciation for the first four years. We could add the MACRS depreciation amounts for each of the first four years and multiply this percentage times the cost of the asset. We can then subtract this from the asset cost. Doing so, we get: BV4 = $8,900,000 - 8,900,000(.2000 + .3200 + .1920 + .1152) BV4 = $1,537,920 The asset is sold at a gain to book value, so this gain is taxable. Aftertax salvage value = $1,930,000 + ($1,537,920 - 1,930,000)(.30) Aftertax salvage value = $1,812,376.00

Cochrane, Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of $2,160,000. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $2,170,000 in annual sales, with costs of $1,160,000. Required: If the tax rate is 40 percent, what is the OCF for this project?

Using the tax shield approach to calculating OCF (Remember the approach is irrelevant; the final answer will be the same no matter which of the four methods you use.), we get: OCF = (Sales - Costs)(1 - TC) + Depreciation(TC) OCF = ($2,170,000 - 1,160,000)(1 - .40) + .40($2,160,000 / 3) OCF = $894,000

Cochrane, Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of $2,370,000. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $2,240,000 in annual sales, with costs of $1,230,000. Required: If the tax rate is 35 percent, what is the OCF for this project?

Using the tax shield approach to calculating OCF (Remember the approach is irrelevant; the final answer will be the same no matter which of the four methods you use.), we get: OCF = (Sales - Costs)(1 - TC) + Depreciation(TC) OCF = ($2,240,000 - 1,230,000)(1 - .35) + .35($2,370,000 / 3) OCF = $933,000