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Profitability Index

*the present value of an investment's future cash flows divided by its initial cost * PV (cash flows) / Absolute value of initial investment

Profitability index

*the present value of an investment's future cash flows divided by its initial cost *PV(cash flows) / absolute value of the initial investment

advantages of Profitability Index

-Closely related to NPV, generally leading to identical decisions - considers all cash flows - considers time value of money -Easy to understand and communicate

Payback Summary

-Length of time until initial investment is recovered -Accept if payback < some specified target -Doesn't account for time value of money -Ignores cash flows after payback -Arbitrary cutoff period

after-tax salvage value

-Many projects will require an investment in long-term assets at the beginning of the project -This would need to be captured in the cash flow analysis (as a cash outflow) at the time of launch -At the end of the project, if there is value in this fixed asset, the after-tax salvage value needs to be determined

Today, Sweet Snacks is investing $491,000 in a new oven. As a result, the company expects its cashflows to increase by $64,000 a year for the next two years and by $98,000 a year for the following three years. How long must the firm wait until it recovers all of its initial investment?

-The project never pays back -The project never pays back because the total cash inflow is only $422,000.

Profitability index summary

-benefit-cost ratio -accept investment if PI > 1 - cannot be used to rank mutually exclusive projects

NPV summary

-difference between market value (PV of inflows) and cost - Accept if NPV > 0 - no serious flaws - preferred decision criterion

IRR summary

-discount rate that makes NPV = 0 -accept if IRR > required return -same decision as NPV with conventional cash flows -unreliable with - non-conventional cash flows and mutually exclusive projects

Pro Forma financial statements

-financial statements that project future years operations -pro forma income statement -pro forma balance sheet -summarizes all of the relevant information for a project - based on assumptions

Relevant Cash flows

-incremental cash flows for a project -include only cash flows that will only occur if the project is accepted - The stand-alone principle allows us analyze each project in isolation from the firm simply by focusing on incremental cash flows

sensitivity analysis

-investigation of what happens to NPV estimates when only one variable is changed -shows how changes in one input variable affect NPV or IRR -each variable is fixed except one -change one variable to see the effect on NPV or IRR -answers "what if" questions

erosion

-the cash flow of a new project that comes at the expense of a firm's existing projects -also known as "product cannibalization"

scenario analysis

-the determination of what happens to NPV estimates when we ask what-if questions -examines several possible situations: -worst case - base case or most likely case - best case -provides a range of possible outcomes

depreciation tax shield

-the tax savings that results from the depreciation deduction -calculated as depreciation multiplied by the corporate tax rate *depreciation x tax rate

IRR - issues

-there are situations where NPV and IRR give conflicting answers - non-convential cash flows - mutually-exclusive projects -use NPV when there is a conflict

side effect/erosion

-when a company launches a new product, there could be a "spillover" impacts on the sales of existing products (i.e. "side effects")

Empire Industries is considering adding a new product to its lineup. This product is expected to generate sales for four years after which time the product will be discontinued. What is the project's net present value at a required rate of return of 14.8 percent? Time 0−62,000 1 16,500 2 23,800 3 27,100 4 23,300

1,758.71 NPV = −$62,000 + $16,500 / 1.148 + $23,800 / 1.148^2 + $27,100 / 1.148^3 + $23,300 / 1.148^4

A firm is reviewing a project that has an initial cost of $67,000. The project will produce annual cash inflows, starting with Year 1, of $8,000, $13,400, $18,600, $24,100, and finally in Year 5, $37,900. What is the profitability index if the discount rate is 11 percent?

1.05 PI = ($8,000 / 1.11 + $13,400 / 1.11^2 + $18,600 / 1.11^3 + $24,100 / 1.11^4 + $37,900 / 1.11^5) / $67,000

operating cash flow formula first year of the project

= net income + dep = [expected - VC - FC] * [1-tax rate] + [$expansion / deprecationyear*tax rate]

payback period

= number of year + (year0 - year1 - year2)/year 3 = years

Profitability Index Formula

=(year1 / 1+discountrate + year2 / 1+discountrate^2 + year3 / 1+discountrate^3 +year4 / 1+discountrate^4) / initital

Today, Sweet Snacks is investing $491,000 in a new oven. As a result, the company expects its cash flows to increase by $64,000 a year for the next two years and by $98,000 a year for the following three years. How long must the firm wait until it recovers all of its initial investment?

The project never pays back The project never pays back because the total cash inflow is only $422,000.

Six years ago, China Exporters paid cash for a new packaging machine that cost $347,000. Three years ago, the firm spent $14,300 on repairs and modifications to the machine. The machine is now fully depreciated and has just sat idly in a back corner of the shop for the past seven months. The estimated value of the machine today is $157,500. The firm is considering using this machine in a new project. If it does so, what value should be assigned to this machine and included in the initial costs of the new project?

The relevant cost is the opportunity cost of $157,500.

The Market Farms purchased a parcel of land six years ago for $200,000. At that time, the firm invested $75,000 grading the site so that it would be usable. Since the firm wasn't ready to use the site itself at that time, it decided to lease the land for $40,000 a year. The Market Farms is now considering building a hotel on the site as the rental lease is expiring. The current value of the land is $225,000. The firm has no loans or mortgages secured by the property. What value should be included in the initial cost of the hotel project for the use of this land?

The relevant cost is the opportunity cost of $225,000.

The Green Tomato purchased a parcel of land six years ago for $389,900. At that time, the firm invested $128,000 grading the site so that it would be usable. Since the firm wasn't ready to use the site itself at that time, it decided to lease the land for $48,000 a year. The Green Tomato is now considering building a hotel on the site as the rental lease is expiring. The current value of the land is $415,000. The firm has no loans or mortgages secured by the property. What value should be included in the initial cost of the hotel project for the use of this land?

The relevant cost is the opportunity cost of $415,000.

A proposed project will increase a firm's accounts payables. This increase is generally:

a cash inflow at Time zero and a cash outflow at the end of the project

Sunk Cost

a cost that has already been paid and cannot be recouped therefore it should not be considered in an investment decision

The pro forma income statements for a proposed investment should include all of the following except:

changes in net working capital

Scenario analysis

helps determine the reasonable range of expectations for a project's anticipated outcome

after-tax salvage

salvage amount - tax rate [salvage amount - book value]

Bruce Moneybags owns several restaurants and hotels near a local interstate. One restaurant, Beef and More, originally cost $1.8 million, is currently fully paid for, but needs modernized. Bruce is trying to decide whether to accept an offer and sell Beef and More, as is, for the offer price of $1.1 million or renovate the restaurant himself. The projected renovation cost is $1.3 million. The restaurant would need to be shut down completely during the renovation which would cause an aftertax net loss of $90,000 in today's dollars. The estimated present value of the cash inflows from the renovated restaurant is $3.2 million. When analyzing the renovation project, what cost, if any, should be included for the current restaurant?

$ Million

operating cash flow

*net income + depreciation *[(Sales-Cost) x (1- Tax Rate)] + (Depreciation x Tax Rate) *EBIT + Depreciation - taxes

A project will reduce costs by $42,700 but increase depreciation by $21,100. What is the operating cash flow if the tax rate is 35 percent?

$35140

China Importers would like to spend $215,000 to expand its warehouse. However, the company has a loan outstanding that must be repaid in 2.5 years and thus will need the $215,000 at that time. The warehouse expansion project is expected to increase the cash inflows by $60,000 in the first year, $140,000 in the second year, and $150,000 a year for the following 2 years. Should the firm expand at this time? Why or why not?

*Payback = 2 + ($215,000 − 60,000 − 140,000) / $150,000 = 2.10 years *Yes, the company should accept the expansion project because it pays back within the required 2.5 years.

payback period

*costs / cash flows

Cash flow from assets

*operating cash flow - net capital spending - change in net working capital

What is the net present value of a project with the following cash flows if the discount rate is 9 percent? Year Cash Flow 0−$55,000 1 21,500 2 24,750 3 29,450

8,297.15 NPV = −$55,000 + $21,500 / 1.09 + $24,750 / 1.09^2 + $29,450 / 1.09^3

side effects

= (sales projections + sales projections) - (last years sales + last years sales)

npv

= -year 0 + year1/1+disocount rate + year2/ 1+discountrate^2+year3 / 1+discountrate^3

if Payback Period < Predetermiend time limit (set my management)

ACCEPT THE PROJECT

Consider an asset that costs $311,000 and is depreciated straight-line to zero over its six-year tax life. The asset is to be used in a four-year project; at the end of the project, the asset can be sold for $58,000. If the relevant tax rate is 34 percent, what is the aftertax cash flow from the sale of this asset?

Aftertax salvage value = $58,000 − [$58,000 − ($311,000 × 2/6)] × .34 = $73,526.67

Guerilla Radio Broadcasting has a project available with the following cash flows : YearCash Flow 0−$14,800 1 6,100 2 7,400 3 5,100 4 4,700 What is the payback period?

Amount short after 2 years = $14,800 − 6,100 − 7,400 Amount short after 2 years = $1,300 Payback period = 2 + $1,300/$5,100 Payback period = 2.25 years

Power Manufacturing has equipment that it purchased 7 years ago for $1,950,000. The equipment was used for a project that was intended to last for 9 years. However, due to low demand, the project is being shut down. The equipment was depreciated using the straight-line method and can be sold for $280,000 today. The company's tax rate is 40 percent. What is the aftertax salvage value of the equipment?

Annual depreciation = $1,950,000/9 Annual depreciation = $216,667 Book value = $1,950,000 − 7($216,667) Book value = $433,333 Tax refund (due) = ($433,333 − 280,000)(.40) Tax refund (due) = $61,333 Aftertax salvage value = $280,000 + 61,333 Aftertax salvage value = $341,333

A 7-year project is expected to generate annual sales of 8,600 units at a price of $73 per unit and a variable cost of $44 per unit. The equipment necessary for the project will cost $293,000 and will be depreciated on a straight-line basis over the life of the project. Fixed costs are $175,000 per year and the tax rate is 34 percent. How sensitive is the operating cash flow to a $1 change in the per unit sales price?

Base OCF = [8,600($73 − 44) − 175,000](1 − .34) + .34($293,000/7) Base OCF = $63,335 New OCF = [8,600($74 − 44) − 175,000](1 − .34) + .34($293,000/7) Base OCF = $69,011 Change in OCF = ($63,335 − 69,011)/(73 − 74) Change in OCF = $5,676

You are analyzing a project and have developed the following estimates. The depreciation is $17,340 a year and the tax rate is 34 percent. What is the best-case operating cash flow?:

Best-case OCF = [5,900 ×($119-69) - $16,000] ×[1 - .34] + [$17,340 ×.34] = $190,035.60

You are analyzing a project and have developed the following estimates. The depreciation is $5,800 a year and the tax rate is 35 percent. What is the best-case operating cash flow? Base-Case Lower Bound Upper Bound Unit sales 800 750 850 Sales price per unit $29 $28 $30 VC per unit $13 $11 $15 Fixed costs $6,800 $6,000 $7,600

Best-case operating cash flow = [850 × ($30 − 11) − $6,000] × [1 − .35] + [$5,800 × .35] = $8,627.50

A new project is expected to generate an operating cash flow of $85,560 and will initially free up $10,475 in net working capital. Purchases of fixed assets costing $85,000 will be required to start up the project. What is the total cash flow for this project at Time zero?

CF0 = $10,475 − 85,000 = −$74,525

A project has an annual operating cash flow of $52,620. Initially, this four-year project required $5,160 in net working capital, which is recoverable when the project ends. The firm also spent $39,700 on equipment to start the project. This equipment will have a book value of $17,014 at the end of Year 4. What is the cash flow for Year 4 of the project if the equipment can be sold for $15,900 and the tax rate is 35 percent?

CF4 = $52,620 + 5,160 + 15,900 − [($15,900 − 17,014) × .35] = $74,069.90

A project has an annual operating cash flow of $52,620. Initially, this four-year project required $5,160 in net working capital, which is recoverable when the project ends. The firm also spent $39,700 on equipment to start the project. This equipment will have a book value of $17,014 at the end of Year 4. What is the cash flow for Year 4 of the project if the equipment can be sold for $15,900 and the tax rate is 35 percent?

CF4 = $52,620 + 5,160 + 15,900- [($15,900 -17,014) ×.35] = $74,069.90

A project has projected values of: unit sales = 1,650, price per unit = $19, variable cost per unit = $7, fixed costs per year = $4,700. The depreciation is $1,100 a year and the tax rate is 34 percent. What effect would a decrease of $1 in the variable cost per unit have on the operating cash flow?

Change in OCF = (1,650 × $1) × (1 − .34) = $1,089 A decrease in variable costs will increase the operating cash flow.

A project has projected values of: unit sales = 1,650, price per unit = $19, variable cost per unit = $7, fixed costs per year = $4,700. The depreciation is $1,100 a year and the tax rate is 34 percent. What effect would a decrease of $1 in the variable cost per unit have on the operating cash flow

Change in OCF = (1,650 ×$1) ×(1 -.34) = $1,089 A decrease in variable costs will increase the operating cash flow

You are analyzing a project and have developed the following estimates: unit sales = 2,150, price per unit = $84, variable cost per unit = $57, fixed costs per year = $13,900. The depreciation is $8,300 a year and the tax rate is 35 percent. What effect would an increase of $1 in the selling price have on the operating cash flow?

Change in OCF = (2,150 × $1) × (1 − .35) = $1,397.50

Newton Industries is considering a project and has developed the following estimates: unit sales = 4,800, price per unit = $67, variable cost per unit = $42, annual fixed costs = $11,900. The depreciation is $14,700 a year and the tax rate is 34 percent. What effect would an increase of $1 in the selling price have on the operating cash flow?

Change in OCF = (4,800 ×$1) ×(1 - .34) = $3,168

Which one of the following will increase the operating cash flow as computed using the tax shield approach?

Decrease in fixed costs

A project has sales of $600,000, costs of $366,500, depreciation of $34,500, interest expense of $5,500, and a tax rate of 21 percent. What is the value of the depreciation tax shield?

Depreciation tax shield = $34,500 × .21 = $7,245.00

The internal rate of return is the

Discount rate that results in a zero net present value for the project

A cost-cutting project will decrease costs by $52,000 a year. The annual depreciation on the project's fixed assets will be $5,000 and the tax rate is 21 percent. What is the amount of the change in the firm's operating cash flow resulting from this project?

EBT $47,000.00 (52,000 − 5,000)^ Taxes (21%) −9,870.00 Net income $37,130.00 Depreciation 5,000.00 OCF $42,130.00

Which one of the following terms is most commonly used to describe the cash flows of a new project that are simply an offset of reduced cash flows for a current project?

Erosion

Which of the following create cash inflows from net working capital?

Increase in accounts payable and decrease in inventory

Assume an all-equity firm has positive net earnings. The operating cash flow of this firm:

Increases when the tax rate decreases

Any changes to a firm's projected future cash flows that are caused by adding a new project are referred to as:

Incremental cash flows

Which of the following is an indicator that an investment is acceptable? Assume cash flows are conventional.

Internal rate of return that exceeds the required return

which tax rate is most relevant for after-tax flows?

Marginal tax rate

disadvantages of Profitability Index

May lead to incorrect decisions in comparisons of mutually exclusive investments (can conflict with NPV)

Valley Forge and Metal purchased a truck five years ago for local deliveries. Which one of the following costs related to this truck is the best example of a sunk cost? Assume the truck has a usable life of five years.

Money spent last month repairing a damaged front fender

Valley Forge and Metal purchased a truck five years ago for local deliveries. Which one of the following costs related to this truck is the best example of a sunk cost? Assume the truck has a usable life of five years.

Money spent last month repairing a damaged front fender

Which is the net present value of a project with the following cash flows if the discount rate is 13.6%? Year CAsh FLow 0 -63,600 1 18,200 2 34,600 3 35,900

NPV = -$63,600 + $18,200 / 1.136 + $34,500 / 1.136^2 + $35,900 / 1.136^3 NPV = $3,643.38

Lakeside Winery is considering expanding its winemaking operations. The expansion will require new equipment costing $708,000 that would be depreciated on a straight-line basis to a zero balance over the four-year life of the project. The equipment can be sold for $220,000 after the four years. The project requires $46,000 initially for net working capital, all of which will be recouped at the end of the project. The projected operating cash flow is $211,500 a year. What is the net present value of this project if the relevant discount rate is 13 percent and the tax rate is 34 percent?

NPV = -$708,000 - 46,000 + ($211,500 ×{1 - [1 / (1 + .13)^4]} / .13) + {$46,000 + [$220,000 × (1 - .34)]} / (1 + .13)^4 NPV = -$7,632.77

Explanation Item 20 Item 20 3.03 of 3.03 points awarded Item Scored Bruno's Lunch Counter is expanding and expects operating cash flows of $20,200 a year for 5 years as a result. This expansion requires $51,000 in new fixed assets. These assets will be worthless at the end of the project. In addition, the project requires $4,600 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 12 percent?

NPV = 0 = −$51,000 − 4,600 + 20,200(PVIFA12%,5) + 4,600/1.12^5 NPV = $19,827

What is the net present value of a project with the following cash flows if the discount rate is 9 percent? YearCash Flow 0−$15,000.00 1 4,800.00 2 5,700.00 3 6,250.00

NPV = −$15,000 + $4,800 / 1.09 + $5,700 / 1.092 + $6,250 / 1.093 NPV = −$972.61

What is the net present value of a project with the following cash flows if the discount rate is 12 percent? YearCash flow 0−$27,500 1 14,800 2 19,400 3 5,200

NPV = −$27,500 + $14,800 / 1.12 + $19,400 / 1.12^2 + $5,200 / 1.12^3 NPV = $4,881.10

Lakeside Winery is considering expanding its winemaking operations. The expansion will require new equipment costing $708,000 that would be depreciated on a straight-line basis to a zero balance over the four-year life of the project. The equipment can be sold for $220,000 after the four years. The project requires $46,000 initially for net working capital, all of which will be recouped at the end of the project. The projected operating cash flow is $211,500 a year. What is the net present value of this project if the relevant discount rate is 13 percent and the tax rate is 34 percent?

NPV = −$708,000 − 46,000 + ($211,500 × {1 − [1 / (1 + .13)^4]} / .13) + {$46,000 + [$220,000 × (1 − .34)]} / (1 + .13)^4 NPV = −$7,632.77

A proposed project requires an initial cash outlay of $75,000 for equipment and an additional cash outlay of $25,000 in Year 1 to cover operating costs. During Years 2 through 4, the project will generate cash inflows of $50,000 a year. What is the net present value of this project at a discount rate of 12.2 percent?

NPV = −$75,000 + (−$25,000 / 1.122) + $50,000 / 1.122^2 + $50,000 / 1.122^3 + $50,000 / 1.122^4 NPV = $9,385.06

NPV - forecasting risk

The possibility that errors in projected cash flows will lead to incorrect decisions Also called- "estimation risk"

What is the NPV of the following set of cash flows at a discount rate of zero percent? What if the discount rate is 15%?

NPV0 percent = -$21,400 + 11,600 / 1.0 + 13,500 / 1.0^2 + 12,200 / 1.0^3 NPV0 percent = $15,900 NPV15 percent = -$21,400 + 11,600 / 1.15 + 13,500 / 1.15^2 + 12,200 / 1.15^3 NPV15 percent = $6,916.59

What is the NPV of the following set of cash flows at a discount rate of zero percent? What if the discount rate is 15 percent? YearCash Flow 0−$21,400 1 11,600 2 13,500 3 12,200

NPV0 percent = −$21,400 + 11,600 / 1.0 + 13,500 / 1.02 + 12,200 / 1.03 NPV0 percent = $15,900 NPV15 percent = −$21,400 + 11,600 / 1.15 + 13,500 / 1.152 + 12,200 / 1.153 NPV15 percent = $6,916.59

Charles Henri is considering investing $37,800 in a project that is expected to provide him with cash inflows of $11,600 at the end of each of the first two years and $20,000 at the end of the third year. What is the project's NPV at a discount rate of 0 percent? At 5 percent? At 10 percent?

NPV0% = −$37,800 + $11,600 / 1.0 + $11,600 / 1.02 + $20,000 / 1.03 = $5,400 NPV5% = −$37,800 + $11,600 / 1.05 + $11,600 / 1.052 + $20,000 / 1.053N = $1,045.91 NPV10% = −$37,800 + $11,600 / 1.10 + $11,600 / 1.102 + $20,000 / 1.103 = −$2,641.47

What is the net present value of the following set of cash flows at a discount rate of 7 percent? At 14 percent? YearCash Flow 0−$35,000 1 10,000 2 10,000 3 12,000 4 15,000

NPV7% = −$35,000 + $10,000 / 1.07 + $10,000 + 1.072 + $12,000 / 1.073 + $15,000/1.074 NPV7% = $4,319.18 NPV14% = −$35,000 + $10,000 / 1.14 + $10,000 + 1.142 + $12,000 / 1.143 + $15,000/1.144 NPV14% = −$1,552.53

You are considering the following two mutually exclusive projects. The required return on each project is 14 percent. Which project should you accept and what is the best reason for that decision? Year Project A Project B 0 −$24,000 −$21,000 1 9,500 6,500 2 16,200 9,800 3 8,700 15,200

NPVA = −$24,000 + $9,500 / 1.14 + $16,200 / 1.142 + $8,700 / 1.143 NPVA = $2,670.96 NPVB = −$21,000 + $6,500 / 1.14 + $9,800 / 1.142 + $15,200 / 1.143 NPVB = $2,502.10 Payback has several flaws and is not the best method of comparison. The profitability index should not be used to evaluate mutually exclusive projects of varying sizes. The decision should be made based on net present value. *Project A; because it has a higher net present value

A debt-free firm has net income of $142,658, taxes of $37,921.75, and depreciation of $27,500. What is the operating cash flow?

Net Income $142,658.00 Depreciation 27,500.00 OCF $170,158.00

A debt-free firm has net income of $210,000, taxes of $55,822.78, and depreciation of $42,000. What is the operating cash flow?

Net Income $210,000.00 Depreciation 42,000.00 OCF $252,000.00

Which of the following is generally considered to be the best form of analysis if you have to select a single method to analyze a variety of investment opportunities?

Net present value

British Metals is reviewing its current accounts to determine how a proposed project might affect the account balances. The firm estimates the project will initially require $81,000 in additional current assets and $57,000 in additional current liabilities. The firm also estimates the project will require an additional $8,000 a year in current assets in each of the first three of the four years of the project. How much net working capital will the firm recoup at the end of the project assuming that all net working capital can be recaptured?

Net working capital recovery = $81,000 − 57,000 + (3 × $8,000) = $48,000

You have calculated the pro forma net income for a new project to be $46,140. The incremental taxes are $22,750 and incremental depreciation is $16,810. What is the operating cash flow?

OCF = $46,140 + 16,810 OCF = $62,950

A cost-cutting project will decrease costs by $68,300 a year. The annual depreciation will be $17,400 and the tax rate is 35 percent. What is the operating cash flow for this project?

OCF = $68,300(1 − .35) + .35($17,400) OCF = $50,485

The Sausage Hut is looking at a new sausage system with an installed cost of $187,400. This cost will be depreciated straight-line to zero over the project's four-year life, at the end of which the sausage system can be scrapped for $25,000. The sausage system will save the firm $69,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $9,000, which will be recouped at project end. If the tax rate is 34 percent and the discount rate is 12 percent, what is the NPV of this project?

OCF = $69,000 (1 − .34) + ($187,400 /4)(.34) = $61,469 NPV = −$187,400 − 9,000 + ($61,469 × {1 − [1 / (1 + .12)^4]} / .12) + {$9,000 + [$25,000 × (1 − .34)]} / (1 + .12)^4 NPV = $6,508.54

A project is expected to generate annual revenues of $117,700, with variable costs of $74,800, and fixed costs of $15,300. The annual depreciation is $3,850 and the tax rate is 35 percent. What is the annual operating cash flow?

OCF = ($117,700 − 74,800 − 15,300)(1 − .35) + .35($3,850) OCF = $19,288

Outdoor Sports is considering adding a miniature golf course to its facility. The course would cost $138,000, would be depreciated on a straight-line basis over its five-year life, and would have a zero salvage value. The estimated income from the golfing fees would be $72,000 a year with $24,000 of that amount being variable cost. The fixed cost would be $11,600. In addition, the firm anticipates an additional $14,000 in revenue from its existing facilities if the golf course is added. The project will require $3,000 of net working capital, which is recoverable at the end of the project. What is the net present value of this project at a discount rate of 12 percent and a tax rate of 34 percent?

OCF = ($72,000 -24,000 -11,600 + 14,000) ×(1 - .34) + ($138,000/5) ×.34 = $42,648 NPV = -$138,000 - 3,000 + ($42,648 ×{1 - [1 / (1.12)^5]} / .12) + ($3,000 / 1.12^5) = $14,438.78

A 9-year project is expected to provide annual sales of $161,000 with costs of $90,000. The equipment necessary for the project will cost $285,000 and will be depreciated on a straight-line method over the life of the project. You feel that both sales and costs are accurate to +/-10 percent. The tax rate is 35 percent. What is the annual operating cash flow for the worst-case scenario?

OCF = [$161,000(.90) − 90,000(1.10)](1 − .35) + .35($285,000/9) OCF = $40,918

Your local athletic center is planning a $1.08 million expansion to its current facility. This cost will be depreciated on a straight-line basis over a 20-year period. The expanded area is expected to generate $489,000 in additional annual sales. Variable costs are 46 percent of sales, the annual fixed costs are $129,400, and the tax rate is 34 percent. What is the operating cash flow for the first year of this project?

OCF = [$489, 000 - (.46 ×$489,000) - $129,400] ×[1 -.34] + [$1,080,000 /20 ×.34] OCF = $107,235.60

A gym owner is considering opening a location on the other side of town. The new facility will cost $1.45 million and will be depreciated on a straight-line basis over a 20-year period. The new gym is expected to generate $555,000 in annual sales. Variable costs are 51 percent of sales, the annual fixed costs are $89,700, and the tax rate is 35 percent. What is the operating cash flow?

OCF = [$555,000 − .51($555,000) − 89,700](1 − .35) + .35($1,450,000/20) OCF = $143,838

Burke's Corner currently sells blue jeans and T-shirts. Management is considering adding fleece tops to its inventory to provide a cooler weather option. The tops would sell for $57 each with expected sales of 4,100 tops annually. By adding the fleece tops, management feels the firm will sell an additional 265 pairs of jeans at $69 a pair and 400 fewer T-shirts at $30 each. The variable cost per unit is $37 on the jeans, $21 on the T-shirts, and $33 on the fleece tops. With the new item, the depreciation expense is $37,000 a year and the fixed costs are $74,000 annually. The tax rate is 34 percent. What is the project's operating cash flow?

OCF = [4,100($57 − 33) + 265($69 − 37) − 400($30 − 21) − 74,000](1 − .34) + .34($37,000) Cash flow = $31,905

Burke's Corner currently sells blue jeans and T-shirts. Management is considering adding fleece tops to its inventory. The tops would sell for $49 each with expected sales of 3,200 tops annually. By adding the fleece tops, management feels the company will sell an additional 150 pairs of jeans at $79 a pair and 220 fewer T-shirts at $18 each. The variable cost per unit is $36 on the jeans, $7 on the T-shirts, and $21 on the fleece tops. The project's depreciation expense is $23,000 a year and the fixed costs are $21,000 annually. The tax rate is 34 percent. What is the project's operating cash flow?

OCF = {[3,200 × ($49 − 21)] + [150 × ($79 − 36)] + [−220 × ($18 − 7)] − $21,000} × {1 − .34} + {$23,000 × .34} = $55,755.80

Burke's Corner currently sells blue jeans and T-shirts. Management is considering adding fleece tops to its inventory. The tops would sell for $49 each with expected sales of 3,200 tops annually. By adding the fleece tops, management feels the company will sell an additional 150 pairs of jeans at $79 a pair and 220 fewer T-shirts at $18 each. The variable cost per unit is $36 on the jeans, $7 on the T-shirts, and $21 on the fleece tops. The project's depreciation expense is $23,000 a year and the fixed costs are $21,000 annually. The tax rate is 34 percent. What is the project's operating cash flow?

OCF = {[3,200 ×($49 -21)] + [150 ×($79 -36)] + [-220 ×($18 -7)] - $21,000} ×{1 -.34} + {$23,000 ×.34} = $55,755.80

Ed owns a store that caters primarily to men. Each of the answer options represents an item related to a planned store expansion. Each of these items should be included in the expansion analysis with the exception of the cost:

Of the blueprints that have been drawn of the expansion area

A debt-free firm has net income of $107,400, taxes of $38,700, and depreciation of $19,300. What is the operating cash flow?

Operating cash flow = $107,400 + $19,300 = $126,700

Kite Flite is considering making and selling custom kites in two sizes. The small kites would be priced at $12 and the large kites would be $39. The variable cost per unit is $5 and $14, respectively. Jill, the owner, feels that she can sell 1,900 of the small kites and 1,400 of the large kites each year. The fixed costs would be only $1,890 a year and the tax rate is 34 percent. What is the annual operating cash flow if the annual depreciation expense is $380?

Operating cash flow = [1,900 ×($12-5) + 1,400 ×($39-14) - $1,890] ×[1 -.34] + [$380 ×.34] = $30,759.80

A firm is reviewing a project that has an initial cost of $67,000. The project will produce annual cash inflows, starting with Year 1, of $8,000, $13,400, $18,600, $24,100, and finally in Year 5, $37,900. What is the profitability index if the discount rate is 11 percent?

PI = ($8,000 / 1.11 + $13,400 / 1.11^2 + $18,600 / 1.11^3 + $24,100 / 1.11^4 + $37,900 / 1.11^5) / $67,000 PI = 1.05

initial cost

PI = (year1 / 1+discountrate + year2 / 1+ discountrate^2 = year3 / 1+ discountrate^3 + year4 / 1+discountratre^4) / initial. cost USE ALGEBRA

The net present value of a project's cash inflows is $2,716 at a discount rate of 12 percent. The profitability index is 1.09 and the firm's tax rate is 34 percent. What is the initial cost of the project?

PI = 1.09 = $2,716 / Initial cost Initial cost = $2,491.74

A project has expected cash inflows, starting with Year 1, of $900, $1,200, $1,500, and finally in Year 4, $2,000. The profitability index is 1.11 and the discount rate is 12 percent. What is the initial cost of the project?

PI = 1.11 = ($900 / 1.12 + $1,200 / 1.12^2 + $1,500 / 1.12^3 + $2,000 / 1.124) / Initial cost Initial cost = $3,692.71

A project has expected cash inflows, starting with Year 1, of $900, $1,200, $1,500, and finally in Year 4, $2,000. The profitability index is 1.11 and the discount rate is 12 percent. What is the initial cost of the project?

PI = 1.11 = ($900 / 1.12 + $1,200 / 1.12^2 + $1,500 / 1.12^3 + $2,000 / 1.12^4) / Initial cost Initial cost = $3,692.71

A project with an initial cost of $31,800 is expected to provide cash flows of $12,600, $12,900, $16,000, and $10,500 over the next four years, respectively. If the required return is 8.8 percent, what is the project's profitability index?

PI = [$12,600/(1 + .088) + $12,900/(1 + .088)^2 + $16,000/(1 + .088)^3 + $10,500/(1 + .088)^4]/$31,800PI = 1.333

A project has the following cash flows: YearCash Flows 0−$128,400 1 50,600 2 63,800 3 51,600 4 28,100 The required return is 8.9 percent. What is the profitability index for this project?

PI = [$50,600/(1 + .089) + $63,800/(1 + .089)^2 + $51,600/(1 + .089)^3 + $28,100/(1 + .089)^4]/$128,400 PI = 1.248

A project has the following cash flows. What is the payback period? YearCash Flow 0−$20,000 1 8,000 2 11,000 3 12,000 4 15,000

Payback = 2 + ($20,000 − 8,000 − 11,000) / $12,000 = 2.08 years

A project has the following cash flows. What is the payback period? Year CF 0 -28000 1 11600 2 11600 3 6500 4 6500

Payback = 2 + ($28,000 -11,600 -11,600)/$6,500 = 2.74 years

A project has the following cash flows. What is the payback period? YearCash Flow 0−$45,000 1 20,000 2 23,500 3 24,000 4 25,000

Payback = 2 + ($45,000 − 20,000 − 23,500) / $24,000 = 2.06 years

What is the payback period for a project with the following cash flows? YearCash Flow 0−$75,000 1 15,000 2 23,000 3 35,000 4 25,000

Payback = 3 + ($75,000 − 15,000 − 23,000 − 35,000) / $25,000 = 3.08 years

What is the payback period for a project with the following cash flows? Year CF 0 -75000 1 15000 2 23000 3 35000 4 25000

Payback = 3+ ($75,000 -15,000 -23,000 -35,000)/$25,000 = 3.08 years

A project that costs $27,500 today will generate cash flows of $9,600 per year for seven years. What is the project's payback period?

Payback period = $27,500/$9,600Payback period = 2.86 years

Baker's Supply imposes a payback cutoff of 3.5 years for its international investment projects. If the company has the following two projects available, which project(s), if either, should it accept? Year Cash Flow (A) Cash Flow (B) 0 −$62,000 −$26,000 1 7,100 15,600 2 9,800 8,400 3 28,700 1,900 4 45,900 1,100

PaybackA = 3 + [($62,000 − 7,100 − 9,800 − 28,700)/$45,900] = 3.36 years PaybackB = 3 + [($26,000 − 15,600 − 8,400 − 1,900)/$1,100 = 3.09 years The firm should accept both projects.

Which one of the following indicates that a project should be rejected? Assume the cash flows are normal, i.e., the initial cash flow is negative.

Profitability index less than 10

A five-year project is expected to generate annual revenues of $159,000, variable costs of $72,500, and fixed costs of $15,000. The annual depreciation is $19,500 and the tax rate is 21 percent. What is the annual operating cash flow?

Revenue $159,000.00 Variable Costs −72,500.00 Fixed Costs −15,000.00 Depreciation −19,500.00 EBT $52,000.00 Taxes (21%) −10,920.00 Net Income $41,080.00 Depreciation 19,500.00 OCF $60,580.00

Your local athletic center is planning a $1.2 million expansion to its current facility. This cost will be depreciated on a straight-line basis over a 20-year period. The expanded area is expected to generate $745,000 in additional annual sales. Variable costs are 39* percent of sales, the annual fixed costs are $140,000, and the tax rate is 21 percent. What is the operating cash flow for the first year of this project?

Sales $745,000.00 Variable costs −290,550.00 (Sales * 0.39)^ Fixed costs −140,000.00 Depreciation -60,000.00 (1,200,000 / 20 Years)^ EBT $254,450.00 Taxes (21%) −53,434.50 Net income $201,015.50 Depreciation 60,000.00 OCF $261,015.50

Lee's currently sells 13,800 motor homes per year at $87,900 each, and 1,100 luxury motor coaches per year at $139,900 each. The company wants to introduce a low-range camper to fill out its product line; it hopes to sell 7,200 of these campers per year at $17,500 each. An independent consultant has determined that if the company introduces the new campers, it should boost the sales of its existing motor homes by 1,100 units per year, and reduce the sales of its luxury motor coaches by 610 units per year. What amount should be used as the annual sales figure when evaluating this project?

Sales = (1,100 × $87,900) + (−610 × $139,900) + (7,200 × $17,500) = $137,351,000

Lee's currently sells 13,800 motor homes per year at $87,900 each, and 1,100 luxury motor coaches per year at $139,900 each. The company wants to introduce a low-range camper to fill out its product line; it hopes to sell 7,200 of these campers per year at $17,500 each. An independent consultant has determined that if the company introduces the new campers, it should boost the sales of its existing motor homes by 1,100 units per year, and reduce the sales of its luxury motor coaches by 610 units per year. What amount should be used as the annual sales figure when evaluating this project?

Sales = (1,100 ×$87,900) + (-610 ×$139,900) + (7,200 ×$17,500) = $137,351,000

Cusic Music Company is considering the sale of a new sound board used in recording studios. The new board would sell for $24,600, and the company expects to sell 1,630 per year. The company currently sells 1,980 units of its existing model per year. If the new model is introduced, sales of the existing model will fall to 1,650 units per year. The old board retails for $23,000. Variable costs are 52 percent of sales, depreciation on the equipment to produce the new board will be $1,095,000 per year, and fixed costs are $3,225,000 per year. If the tax rate is 23 percent, what is the annual OCF for the project?

Sales of new $40,098,000 Lost sales of old -7,590,000 Variable costs 16,904,160 Fixed costs 3,225,000 depreciation 1,095,000 EBIT $11,283,840 Tax 2,595,283 Net income $8,688,557 OCF = EBIT + Depreciation - Taxes OCF = $11,283,840 + 1,095,000 - 2,595,283 OCF = $9,783,557

Outdoors Essentials sells specialty equipment for mountain climbers. Its sales for last year included $255,000 of tents and $ 550,000 of climbing gear. For next year, management has decided to sell specialty sleeping bags also. As a result of this change, sales projections for next year are $300,000 of tents, $600,000 of climbing gear, and $110,000 of sleeping bags. How much of next year's sales are derived from the side effects of adding the new product to its sales offerings?

Side effects = ($300,000 + 600,000) − ($255,000 + 550,000) = $95,000

Green Woods sells specialty equipment for mountain climbers. Its sales for last year included $387,000 of tents and $718,000 of climbing gear. For next year, management has decided to sell specialty sleeping bags also. As a result of this change, sales projections for next year are $411,000 of tents, $806,000 of climbing gear, and $128,000 of sleeping bags. How much of next year's sales are derived from the side effects of adding the new product to its sales offerings?

Side effects = ($411,000 + 806,000) - ($387,000 + 718,000) = $112,000

Sherpa Outfitters sells specialty equipment for mountain climbers. Its sales for last year included $488,500 of tents and $800,000 of climbing gear. For next year, management has decided to sell specialty sleeping bags also. As a result of this change, sales projections for next year are $537,350 of tents, $880,000 of climbing gear, and $150,000 of sleeping bags. How much of next year's sales are derived from the side effects of adding the new product to its sales offerings?

Side effects = ($537,350 + 880,000) − ($488,500 + 800,000) = $128,850

erosion example

Some loyal Blue Hen Brewery customers will buy the new higher-alcohol products instead of buying existing Blue Hen Brewery products -This new product will "erode" or "cannibalize" existing product lines -This is a relevant cash flow impact that should be considered in the investment analysis for the new product

Which one of the following principles refers to the assumption that a project will be evaluated based on its incremental cash flows?

Stand-alone principle

Weston Steel purchased a new coal furnace six years ago at a cost of $2.2 million. Last year, the government changed the emission requirements and this furnace cannot meet those standards. Thus, the company can no longer use the furnace, nor has it been able to locate anyone willing to purchase the furnace. Given the current situation, the furnace is best described as which type of cost?

Sunk

Payback Period

THe amount of time for an investment to generate cash flows sufficient to recover its intial cost - a break-even type measure

Consider an asset that costs $680,000 and is depreciated straight-line to zero over its 9-year tax life. The asset is to be used in a 5-year project; at the end of the project, the asset can be sold for $159,000. If the relevant tax rate is 24 percent, what is the aftertax cash flow from the sale of this asset?

The asset has a useful life of 9 years and we want to find the book value of the asset after 5 years. With straight-line depreciation, the depreciation each year will be: Annual depreciation = $680,000/9 Annual depreciation = $75,556 So, after 5 years, the accumulated depreciation will be: Accumulated depreciation = 5($75,556) Accumulated depreciation = $377,778 The book value at the end of Year 5 is thus: BV5 = $680,000 - 377,778 BV5 = $302,222 The asset is sold at a loss to book value, so the depreciation tax shield of the loss is recaptured. Aftertax salvage value = $159,000 + ($302,222 - 159,000)(.24) Aftertax salvage value = $193,373 To find the taxes on salvage value, remember to use the equation: Taxes on salvage value = (BV - MV)TC This equation will always give the correct sign for a tax inflow (refund) or outflow (payment).

Which of the following statements is correct

The payback period ignores the time value of money

Which one of the following statements is correct?

The payback period ignores the time value of money.

The Corner Market has decided to expand its retail store by building on a vacant lot it currently owns. This lot was purchased four years ago at a cost of $299,000, which the firm paid in cash. To date, the firm has spent another $38,000 on land improvements, all of which was also paid in cash. Today, the lot has a market value of $329,000. What value should be included in the analysis of the expansion project for the cost of the land?

The current market value of the land

The Corner Market has decided to expand its retail store by building on a vacant lot it currently owns. This lot was purchased four years ago at a cost of $299,000, which the firm paid in cash. To date, the firm has spent another $38,000 on land improvements, all of which was also paid in cash. Today, the lot has a market value of $329,000. What value should be included in the analysis of the expansion project for the cost of the land?

The current market value of the land

Internal Rate of Return (IRR)

The discount rate that makes the NPV=0

An investment has conventional cash flows and a profitability index of 1.0. GIven this, which one of the following must be true?

The net present value is equal to zero.

Shelton Co. purchased a parcel of land six years ago for $860,500. At that time, the firm invested $132,000 in grading the site so that it would be usable. Since the firm wasn't ready to use the site itself at that time, it decided to lease the land for $47,500 a year. The company is now considering building a warehouse on the site as the rental lease is expiring. The current value of the land is $912,000. What value should be included in the initial cost of the warehouse project for the use of this land?

The opportunity cost of the building is what it could be sold for today, or $912,000

The net present value of an investment represents the difference between the investment's

cost and its market value

Book value

initial cost - accumulated depreciation

which one of the following is an indicator that an investment is acceptable? assume cash flows are conventional

internal rate of return that exceeds the required return

Both Projects A and B are acceptable as independent projects. However, the selection of either one of these projects eliminates the option of selecting the other project. Which one of the following terms best describes the relationship between Project A and Project B?He et pre

mutually exclusive

Relevant Cash Flows

opportunity costs, side effects/erosion, net working capital, tax effects, after tax salvage value

Which of the following indicates that a project is expected to create value for its owners?

positive net present value

Which one of the following indicates that a project is expected to create value for its owners?

positive net present value

Scenario analysis is best described as the determination of the:

reasonable range of project outcomes

Jamie is analyzing the estimated net present value of a project under various conditions by revising the sales quantity, sales price, and the cost estimates. The type of analysis that Jamie is doing is best described as:

scenario analysis

net salvage cash flows

selling price - (selling price - book value)(corporate tax rate)

after-tax salvage value

selling price - [(selling price - book value) x tax rate]

Kate is analyzing a proposed project to determine how changes in the sales quantity would affect the project's net present value. What type of analysis is being conducted?

sensitivity analysis

Weston Steel purchased a new coal furnace six years ago at a cost of $2.2 million. Last year, the government changed the emission requirements and this furnace cannot meet those standards. Thus, the company can no longer use the furnace, nor has it been able to locate anyone willing to purchase the furnace. Given the current situation, the furnace is best described as which type of cost?

sunk

The analysis of a new project should exclude

sunk costs

Not relevant cash flows

sunk costs financing costs

The amount by which a firm's tax bill is reduced as a result of the depreciation expense is referred to as the depreciation:

tax shield

opportunity cost

the most desirable alternative given up if a particular investment is undertaken if the project being considered is using an asset that has alternative uses and value, then it is a relevant cash flow

The Shoe Box is considering adding a new line of winter footwear to its product lineup. When analyzing the viability of this addition, the company should include all of the following in its analysis with the exception of:

the research and development costs to produce the current winter footwear samples.

Thrill Rides is considering adding a new roller coaster to its amusement park. The addition is expected to increase its overall ticket sales. In particular, the company expects to sell more tickets for its current roller coaster and experience extremely high demand for its new coaster. Sales for its boat ride are expected to decline but food and beverage sales are expected to increase significantly. All of the following are side effects associated with the new roller coaster with the exception of the:

ticket sales for the new coaster

If an investment is producing a return that is equal to the required return, the investment's net present value will be:

zero


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