Miami Dade College, Miami - FIN 3403

Chapter 12

1)A company is considering a new project. The CFO plans to calculate the project’s NPV by estimating the relevant cash flows for each year of the project’s life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flow), then discounting those cash flows at the company’s overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows?

 

1. 1. All sunk costs that have been incurred relating to the project.
   2. All interest expenses on debt used to help finance the project.
   3. The investment in working capital required to operate the project, even if that investment will be recovered at the end of the project’s life.
   4. Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year.
   5. Effects of the project on other divisions of the firm, but only if those effects lower the project’s own direct cash flows.

 

 

2. Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product?

 

1. 1. Using some of the firm's high-quality factory floor space that is currently unused to produce the proposed new product. This space could be used for other products if it is not used for the project under consideration.
   2. Revenues from an existing product would be lost as a result of customers switching to the new product.
   3. Shipping and installation costs associated with a machine that would be used to produce the new product.
   4. The cost of a study relating to the market for the new product that was completed last year. The results of this research were positive, and they led to the tentative decision to go ahead with the new product. The cost of the research was incurred and expensed for tax purposes last year.
   5. It is learned that land the company owns and would use for the new project, if it is accepted, could be sold to another firm.

 

3. A company is considering a proposed new plant that would increase productive capacity. Which of the following statements is CORRECT?

 

1. 1. In calculating the project's operating cash flows, the firm should not deduct financing costs such as interest expense, because financing costs are accounted for by discounting at the WACC. If interest were deducted when estimating cash flows, this would, in effect, “double count” it.

1. 2. Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating the operating cash flows.
   3. When estimating the project’s operating cash flows, it is important to include both opportunity costs and sunk costs, but the firm should ignore the cash flow effects of externalities since they are accounted for in the discounting process.
   4. Capital budgeting decisions should be based on before-tax cash flows.
   5. The WACC used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax basis.

 

 

4. Fool Proof Software is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, and the allowed depreciation rates for such property are 33%, 45%, 15%, and 7% for Years 1 through 4. Revenues and other operating costs are expected to be constant over the project's 10-year expected life. What is the Year 1 cash flow?

 

Equipment cost (depreciable basis)                                      $65,000

Sales revenues, each year                                                    $60,000

Operating costs (excl. deprec.)                                             $25,000 Tax rate                                                                                                        35.0%

 

a. $30,258

b. $31,770

c. $33,359

d. $35,027

e. $36,778

 

 

5. Your company, CSUS Inc., is considering a new project whose data are shown below. The required equipment has a 3-year tax life, and the accelerated rates for such property are 33%, 45%, 15%, and 7% for Years 1 through 4. Revenues and other operating costs are expected to be constant over the project's 10-year expected operating life. What is the project's Year 4 cash flow?

 

Equipment cost (depreciable basis)                                      $70,000

Sales revenues, each year                                                    $42,500

Operating costs (excl.	deprec.)	$25,000
Tax rate		35.0%
a. $11,814 b. $12,436 c. $13,090 d. $13,745 e. $14,432

 

 

6. Temple Corp. is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, would be depreciated by the straight-line method over its 3-year life, and would have a zero salvage value. No new working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's NPV?

 

Risk-adjusted WACC		10.0%
Net investment cost (depreciable	basis)	$65,000
Straight-line deprec. rate		33.3333%
Sales revenues, each year		$65,500
Operating costs (excl. deprec.),	each year	$25,000
Tax rate		35.0%

a. $15,740

b. $16,569

c. $17,441

d. $18,359

e. $19,325

 

 

 

7. Liberty Services is now at the end of the final year of a project. The equipment originally cost $22,500, of which 75% has been depreciated. The firm can sell the used equipment today for

 

a. $5,558 b. $5,850 c. $6,143 d. $6,450 e. $6,772

$6,000, and its tax rate is 40%. What is the equipment’s after- tax salvage value for use in a capital budgeting analysis? Note that if the equipment's final market value is less than its book value, the firm will receive a tax credit as a result of the sale.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

8. Marshall-Miller & Company is considering the purchase of a new machine for $50,000, installed. The machine has a tax life of 5 years, and it can be depreciated according to the following rates. The firm expects to operate the machine for 4 years and then to sell it for $12,500. If the marginal tax rate is 40%, what will the after-tax salvage value be when the machine is sold at the end of Year 4?

 

	Year	Depreciation Rate
	1	0.20
	2	0.32
	3	0.19
	4	0.12
	5	0.11
	6	0.06
a. $8,878 b. $9,345