Chapter 8 - FINA 4310

Global Enterprises has spent $134,000 on research developing a new type of shoe. For this shoe to now be manufactured, the firm will need to expand into an empty building that it currently owns. The firm was offered $229,000 last week for that building. An additional $342, 000 will be required for new equipment and building improvements. Labor and material costs are estimated at $4.98 per pair of shoes. Interest expense on the loan needed to finance the production of this new shoe will be $17,800 a year. Which one of these correctly identifies the sunk costs?

$134,000 for research

Farris Industrial purchased a machine five years ago at a cost of $164,900. The machine is being depreciated using the straight-line method over eight years. The tax rate is 35 percent and the discount rate is 14 percent. If the machine is sold today for $42,500, what will the aftertax salvage value be?

Book value = $164,900 - 5 × ($164,900/8) = $61,837.50 Aftertax salvage value = $42,500 - .35 × ($42,500 - 61,837.50) = $49,268.13

Dilwater Furniture purchased a corner lot in Pittsburg five years ago at a cost of $890,000. The lot was recently appraised at $1,070,000. At the time of the purchase, the company spent $80,000 to grade the lot and another $120,000 to pave the lot for commuter parking. The company now wants to build a new retail store on the site. The building cost is estimated at $1.8 million. What amount should be used as the initial cash flow for this building project?

CF0 = $1,070,000 + 1,800,000 = $2,870,000

Which one of these statements related to MACRS depreciation is correct?

An asset will be depreciated faster using MACRS rather than the straight-line method.

Riverton Sails 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 ten years ago at a cost of $89,000 and spent $26,000 on grading and excavation costs at that time. Today, the land is valued at $221,000. The company currently has some unused equipment that it currently owns with a current market value of $45,000. This equipment could be used for producing awnings if $9,000 is spent for equipment modifications. Other equipment costing $315,000 will be required. What is the amount of the initial cash flow for this expansion project?

CF0 = $221,000 + 45,000 + 9,000 + 315,000 = $590,000

A project will produce an operating cash flow of $7,300 a year for three years. The initial cash outlay for equipment will be $11,600. The net aftertax salvage value of $3,500 will be received at the end of the project. The project requires $800 of net working capital that will be fully recovered. What is the net present value of the project if the required rate of return is 11 percent?

NPV = -$11,600 - 800 + $7,300[(1 - 1/1.113)/.11] + ($3,500 + 800)/1.113 = $8,583.24

The Java House is considering a project that will produce sales of $47,500 and increase cash expenses by $22,500. If the project is implemented, taxes will increase by $7,600. The additional depreciation expense will be $10,100. An initial cash outlay of $7,300 is required for net working capital. What is the amount of the operating cash flow using the top-down approach?

OCF = $47,500 - 22,500 - 7,600 = $17,400

Ernie's Electrical is evaluating a project that will increase sales by $39,000 and costs by $6,000. The project will initially cost $102,000 for fixed assets that will be depreciated straight-line to a zero book value over the 10-year life of the project. The applicable tax rate is 35 percent. What is the operating cash flow for this project?

OCF = ($39,000 - 6,000)(1 - .35) + ($102,000/10)(.35) = $25,020

Which one of these is a requirement when computing the net present value of a capital project?

Real cash flows must be discounted using a real rate

The sale of an asset creates an aftertax cash flow in an amount equal to the:

Sale price - Tax rate × (Sales price - Book value).

Walks Softly sells customized shoes. Currently, it sells 16,000 pairs of shoes annually at an average price of $68 a pair. The company is considering adding a lower-priced line of shoes that will sell for $39 a pair. Walks Softly estimates it can sell 7,000 pairs of the lower-priced shoes but will sell 1,000 less pairs of the higher-priced shoes by doing so. What is the amount of the sales that should be used when evaluating the addition of the lower-priced shoes?

Sales = (7,000 × $39) - (1,000 × $68) = $205,000

Down Under Boomerang, Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of $2.61 million. 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 $2,050,000 in annual sales, with costs of $745,000. The tax rate is 30 percent and the required return on the project is 15 percent. What is the project's NPV?

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) + tC(Depreciation) OCF = ($2,050,000 − 745,000)(1 − .30) + .30($2,610,000 / 3) OCF = $1,174,500 Since we have the OCF, we can find the NPV as the initial cash outlay plus the PV of the OCFs, which are an annuity, so the NPV is: NPV = −$2,610,000 + $1,174,500(PVIFA15%,3) NPV = $71,647.90

Howell Petroleum is considering a new project that complements its existing business. The machine required for the project costs $3.97 million. The marketing department predicts that sales related to the project will be $2.67 million per year for the next four years, after which the market will cease to exist. The machine will be depreciated down to zero over its four-year economic life using the straight-line method. Cost of goods sold and operating expenses related to the project are predicted to be 25 percent of sales. Howell also needs to add net working capital of $320,000 immediately. The additional net working capital will be recovered in full at the end of the project's life. The corporate tax rate is 35 percent. The required rate of return for Howell is 13 percent. What is the NPV for this project?

We will begin by calculating the initial cash outlay, that is, the cash flow at Year 0. To undertake the project, we will have to purchase the equipment and increase net working capital. So, the cash outlay today for the project will be: Equipment -$3,970,000 NWC - 320,000 Total -$4,290,000 Using the bottom-up approach to calculating the operating cash flow, we find the operating cash flow each year will be: Sales $ 2,670,000 Costs 667,500 Depreciation 992,500 EBT $ 1,010,000 Tax 353,500 Net income $ 656,500 The operating cash flow is: OCF = Net income + Depreciation OCF = $656,500 + 992,500 OCF = $1,649,000 To find the NPV of the project, we add the present value of the project cash flows. We must be sure to add back the net working capital at the end of the project life, since we are assuming the net working capital will be recovered. So, the project NPV is: NPV = −$4,290,000 + $1,649,000(PVIFA13%,4) + $320,000 / 1.134 NPV = $811,165.21

You are evaluating two different silicon wafer milling machines. The Techron I costs $249,000, has a three-year life, and has pretax operating costs of $66,000 per year. The Techron II costs $435,000, has a five-year life, and has pretax operating costs of $39,000 per year. For both milling machines, use straight-line depreciation to zero over the project's life and assume a salvage value of $43,000. If your tax rate is 35 percent and your discount rate is 10 percent, compute the EAC for both machines.

We will need the aftertax salvage value of the equipment to compute the EAC. Even though the equipment for each product has a different initial cost, both have the same salvage value. The aftertax salvage value for both is: Aftertax salvage value = $43,000(1 − .35) Aftertax salvage value = $27,950 To calculate the EAC, we first need the OCF and NPV of each option. The OCF and NPV for Techron I is: OCF = −$66,000(1 − .35) + .35($249,000 / 3) OCF = −$13,850 NPV = −$249,000 − $13,850(PVIFA10%,3) + ($27,950 / 1.103) NPV = −$262,443.65 EAC = −$262,443.65 / (PVIFA10%,3) EAC = −$105,532.48 And the OCF and NPV for Techron II is: OCF = −$39,000(1 − .35) + .35($435,000 / 5) OCF = $5,100 NPV = −$435,000 + $5,100(PVIFA10%,5) + ($27,950 / 1.105) NPV = −$398,312.24 EAC = −$398,312.24 / (PVIFA10%,5) EAC = −$105,073.76 The two milling machines have unequal lives, so they can only be compared by expressing both on an equivalent annual basis, which is what the EAC method does. Thus, you prefer the Techron II because it has the lower (less negative) annual cost.

The book value of an asset is primarily used to compute the: The book value of an asset is primarily used to compute the:

amount of tax due on the sale of an asset.

Sunk costs include any cost that:

has previously been incurred and cannot be changed.

The cash flows for a project include the:

incremental operating cash flow, as well as the capital spending and net working capital requirements.

The most valuable investment given up if an alternative investment is chosen is referred to as a(n):

opportunity cost.