Assignment

| March 31, 2017

Question
The SiclanCompany is considering opening a new office. The company owns the building and would sell it for $74,000 after taxes if it does not open the new office. The building has been depreciated down to a zero book value. The equipment that will be used in the building costs $69,000. The equipment that would be used has a 3 year tax life, depreciated straight-line, with 0 scrap value. (If the company tried to sell the equipment at end of year 3, it would receive 0 sales proceeds).No new working capital is required.

WACC = 15%

Due to opening the office and using the equipment, additional annual Revenues = $100,000

Additional annual Operating cost, excluding depreciation = $20,000

Tax rate = 30%

a. What is the required cash outflow associated with the acquisition of a new machine at t = 0?

b. What is the project’s NPV?

c. Rework the same problem for Siclancompany using MACRS depreciation method instead of straight line depreciation. The equipment that would be used has a 3 year tax life, depreciated using MACRS, with a 0 salvage value. No new working capital is required. What is the project NPV?

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Remember that Equipment with a 3-year tax life is depreciated over 4 calendar years under MACRS (due to the MACRS ½-year convention).

Note: If you scrap the equipment after 3 years, then you would get a tax reduction due to the fact that you had not fully depreciated the machine before you “scrapped” it.

2. Buckeye Books – another Capital Budgeting Problem

Buckeye Books is considering opening a new production facility in Toledo. The firm uses free cash flow discounted by the cost of capital. The firm has the following information:

The up-front cost of the facility at t=0 is $10 million. The facility will be depreciated on a straight line basis to 0 over 5 years.

The company will operate the facility for 5 years. It can be sold for $3 million at t=5.

Interest expense will increase by $50,000/year with this project.

The firm spent $750,000 on a feasibility study a year and a half ago. The study concluded that opening a new facility would be profitable.

If the facility is opened, Buckeye will need additional inventory at t=0 of $2 million. Accounts payable will increase by $1 million at t=0. All working capital will be recovered at t=5.

If the facility is opened, it will increase sales by $7 million/year in year 1 and costs will increase by $3 million/year. Inflation is expected to be 4%/year for the life of the project. Inflation will not impact year 1 revenues and costs, but will impact revenues and costs in years 2-5.

The tax rate is 40%.

If the project is not done, the land on which the facility would be built will be sold for $5 million immediately.

Compute the cash flows for years 0, 1, 5 (You can compute the cash flows for years 2, 3, 4, also, if you wish.) If you have computed the cash flows for all years 0-5, then you can find the IRR and MIRR. You can also find the NPV, if we give you a required return (WACC).

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