# Financial Management 460 Problems

11–1)Investment OutlayTalbot Industries is considering an expansion project. The necessary equipmentcould be purchased for $9 million, and the project would also require an initial$3 million investment in net operating working capital. The company’s tax rateis 40%.a. What is the initial investment outlay?b. The company spent and expensed $50,000 on research related to the project lastyear. Would this change your answer? Explain.c. The company plans to house the project in a building it owns but is not nowusing. The building could be sold for $1 million after taxes and real estate commissions.How would this affect your answer?458 Part 4: Projects and Their Valuation9781133665007, Financial Management: Theory and Practice, Michael C. Ehrhardt – © Cengage Learning.raigh tjs d isvtriabutaionl wreud wkithoouut exkprsesse aunthoir izmatioen(11–2)Operating Cash FlowCairn Communications is trying to estimate the first-year operating cash flow(at t = 1) for a proposed project. The financial staff has collected the followinginformation:Projected sales $10 millionOperating costs (not including depreciation) $ 7 millionDepreciation $ 2 millionInterest expense $ 2 millionThe company faces a 40% tax rate. What is the project’s operating cash flow for thefirst year (t = 1)?(11–3)Net Salvage ValueAllen Air Lines is now in the terminal year of a project. The equipment originallycost $20 million, of which 80% has been depreciated. Carter can sell the used equipmenttoday to another airline for $5 million, and its tax rate is 40%. What is theequipment’s after-tax net salvage value?(11–4)Replacement AnalysisThe Chen Company is considering the purchase of a new machine to replace an obsoleteone. The machine being used for the operation has both a book value and amarket value of zero; it is in good working order, however, and will last physicallyfor at least another 10 years. The proposed replacement machine will perform theoperation so much more efficiently that Chen’s engineers estimate it will produceafter-tax cash flows (labor savings and depreciation) of $9,000 per year. The new machinewill cost $40,000 delivered and installed, and its economic life is estimated tobe 10 years. It has zero salvage value. The firm’s WACC is 10%, and its marginal taxrate is 35%. Should Chen buy the new machine?INTERMEDIATEPROBLEMS 5–11(11–5)Depreciation MethodsWendy is evaluating a capital budgeting project that should last for 4 years. Theproject requires $800,000 of equipment. She is unsure what depreciation method touse in her analysis, straight-line or the 3-year MACRS accelerated method. Understraight-line depreciation, the cost of the equipment would be depreciated evenlyover its 4-year life (ignore the half-year convention for the straight-line method).The applicable MACRS depreciation rates are 33%, 45%, 15%, and 7%, as discussedin Appendix 11A. The company’s WACC is 10%, and its tax rate is 40%.a. What would the depreciation expense be each year under each method?b. Which depreciation method would produce the higher NPV, and how muchhigher would it be?(11–6)New-Project AnalysisThe Campbell Company is evaluating the proposed acquisition of a new milling machine.The machine’s base price is $108,000, and it would cost another $12,500 tomodify it for special use. The machine falls into the MACRS 3-year class, and itwould be sold after 3 years for $65,000. The machine would require an increase innet working capital (inventory) of $5,500. The milling machine would have no effecton revenues, but it is expected to save the firm $44,000 per year in before-tax operatingcosts, mainly labor. Campbell’s marginal tax rate is 35%.a. What is the net cost of the machine for capital budgeting purposes?(That is, what is the Year-0 net cash flow?)b. What are the net operating cash flows in Years 1, 2, and 3?Chapter 11: Cash Flow Estimation and Risk Analysis 4599781133665007, Financial Management: Theory and Practice, Michael C. Ehrhardt – © Cengage Learning.ringhtist reeselrvmed. di stkribuutiovn h oeut austhoir izkatiuonc. What is the additional Year-3 cash flow (i.e., the after-tax salvage and the returnof working capital)?d. If the project’s cost of capital is 12%, should the machine be purchased?(11–7)New-Project AnalysisYou have been asked by the president of your company to evaluate the proposed acquisitionof a new spectrometer for the firm’s R&D department. The equipment’sbasic price is $70,000, and it would cost another $15,000 to modify it for special useby your firm. The spectrometer, which falls into the MACRS 3-year class, would besold after 3 years for $30,000. Use of the equipment would require an increase in networking capital (spare parts inventory) of $4,000. The spectrometer would have noeffect on revenues, but it is expected to save the firm $25,000 per year in before-taxoperating costs, mainly labor. The firm’s marginal federal-plus-state tax rate is 40%.a. What is the net cost of the spectrometer? (That is, what is the Year-0 net cashflow?)b. What are the net operating cash flows in Years 1, 2, and 3?c. What is the additional (nonoperating) cash flow in Year 3?d. If the project’s cost of capital is 10%, should the spectrometer be purchased?(11–8)Inflation AdjustmentsThe Rodriguez Company is considering an average-risk investment in a mineral waterspring project that has a cost of $150,000. The project will produce 1,000 cases ofmineral water per year indefinitely. The current sales price is $138 per case, and thecurrent cost per case is $105. The firm is taxed at a rate of 34%. Both prices andcosts are expected to rise at a rate of 6% per year. The firm uses only equity, and ithas a cost of capital of 15%. Assume that cash flows consist only of after-tax profits,since the spring has an indefinite life and will not be depreciated.a. Should the firm accept the project? (Hint: The project is a perpetuity, so youmust use the formula for a perpetuity to find its NPV.)b. Suppose that total costs consisted of a fixed cost of $10,000 per year plus variablecosts of $95 per unit, and suppose that only the variable costs were expected toincrease with inflation. Would this make the project better or worse? Continueto assume that the sales price will rise with inflation.(11–9)Replacement AnalysisThe Taylor Toy Corporation currently uses an injection-molding machine that waspurchased 2 years ago. This machine is being depreciated on a straight-line basis, andit has 6 years of remaining life. Its current book value is $2,100, and it can be sold for$2,500 at this time. Thus, the annual depreciation expense is $2,100/6 = $350 peryear. If the old machine is not replaced, it can be sold for $500 at the end of its usefullife.Taylor is offered a replacement machine that has a cost of $8,000, an estimateduseful life of 6 years, and an estimated salvage value of $800. Thismachine falls into the MACRS 5-year class, so the applicable depreciation ratesare 20%, 32%, 19%, 12%, 11%, and 6%. The replacement machine would permitan output expansion, so sales would rise by $1,000 per year; even so, the newmachine’s much greater efficiency would reduce operating expenses by $1,500per year. The new machine would require that inventories be increased by$2,000, but accounts payable would simultaneously increase by $500. Taylor’smarginal federal-plus-state tax rate is 40%, and its WACC is 15%. Should itreplace the old machine?460 Part 4: Projects and Their Valuation9781133665007, Financial Management: Theory and Practice, Michael C. Ehrhardt – © Cengage Learning.res evrvead. diustritbautio nt whithroiukt exsprie ssk auothosrizkatieon(11–10)Replacement AnalysisSt. Johns River Shipyards is considering the replacement of an 8-year-old rivetingmachine with a new one that will increase earnings before depreciation from$27,000 to $54,000 per year. The new machine will cost $82,500, and it will havean estimated life of 8 years and no salvage value. The new machine will be depreciatedover its 5-year MACRS recovery period, so the applicable depreciation rates are20%, 32%, 19%, 12%, 11%, and 6%. The applicable corporate tax rate is 40%, andthe firm’s WACC is 12%. The old machine has been fully depreciated and has noCHALLENGING salvage value. Should the old riveting machine be replaced by the new one?PROBLEMS 11–17(11–11)Scenario AnalysisShao Industries is considering a proposed project for its capital budget. The companyestimates the project’s NPV is $12 million. This estimate assumes that the economyand market conditions will be average over the next few years. The company’s CFO,however, forecasts there is only a 50% chance that the economy will be average. Recognizingthis uncertainty, she has also performed the following scenario analysis:EconomicScenarioProbability ofOutcome NPVRecession 0.05 ?$70 millionBelow average 0.20 ?25 millionAverage 0.50 12 millionAbove average 0.20 20 millionBoom 0.05 30 millionWhat is the project’s expected NPV, its standard deviation, and its coefficient ofvariation?(11–12)New-Project AnalysisMadison Manufacturing is considering a new machine that costs $250,000 and wouldreduce pre-tax manufacturing costs by $90,000 annually. Madison would use the3-year MACRS method to depreciate the machine, and management thinks the machinewould have a value of $23,000 at the end of its 5-year operating life. Theapplicable depreciation rates are 33%, 45%, 15%, and 7%, as discussed in Appendix11A. Working capital would increase by $25,000 initially, but it would be recoveredat the end of the project’s 5-year life. Madison’s marginal tax rate is 40%, and a 10%WACC is appropriate for the project.a. Calculate the project’s NPV, IRR, MIRR, and payback.b. Assume management is unsure about the $90,000 cost savings—this figure coulddeviate by as much as plus or minus 20%. What would the NPV be under eachof these extremes?c. Suppose the CFO wants you to do a scenario analysis with different values for thecost savings, the machine’s salvage value, and the working capital (WC) requirement.She asks you to use the following probabilities and values in the scenario analysis:Scenario ProbabilityCostSavingsSalvageValue WCWorst case 0.35 $ 72,000 $18,000 $30,000Base case 0.35 90,000 23,000 25,000Best case 0.30 108,000 28,000 20,000Calculate the project’s expected NPV, its standard deviation, and its coefficientof variation. Would you recommend that the project be accepted?Chapter 11: Cash Flow Estimation and Risk Analysis 4619781133665007, Financial Management: Theory and Practice, Michael C. Ehrhardt – © Cengage Learning.s Neo a llpoweedr wuithsoutt euxpire svs auuthoorihzatieon(11–13)Replacement AnalysisThe Everly Equipment Company purchased a machine 5 years ago at a cost of$90,000. The machine had an expected life of 10 years at the time of purchase, andit is being depreciated by the straight-line method by $9,000 per year. If the machineis not replaced, it can be sold for $10,000 at the end of its useful life.A new machine can be purchased for $150,000, including installation costs. Duringits 5-year life, it will reduce cash operating expenses by $50,000 per year. Salesare not expected to change. At the end of its useful life, the machine is estimated tobe worthless. MACRS depreciation will be used, and the machine will be depreciatedover its 3-year class life rather than its 5-year economic life, so the applicable depreciationrates are 33%, 45%, 15%, and 7%.The old machine can be sold today for $55,000. The firm’s tax rate is 35%, andthe appropriate WACC is 16%.a. If the new machine is purchased, what is the amount of the initial cash flow atYear 0?b. What are the incremental net cash flows that will occur at the end of Years 1through 5?c. What is the NPV of this project? Should Everly replace the old machine?(11–14)Replacement AnalysisThe Balboa Bottling Company is contemplating the replacement of one of its bottlingmachines with a newer and more efficient one. The old machine has a bookvalue of $600,000 and a remaining useful life of 5 years. The firm does not expectto realize any return from scrapping the old machine in 5 years, but it can sell itnow to another firm in the industry for $265,000. The old machine is being depreciatedby $120,000 per year, using the straight-line method.The new machine has a purchase price of $1,175,000, an estimated useful life andMACRS class life of 5 years, and an estimated salvage value of $145,000. The applicabledepreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. It is expected toeconomize on electric power usage, labor, and repair costs, as well as to reduce thenumber of defective bottles. In total, an annual savings of $255,000 will be realized ifthe new machine is installed. The company’s marginal tax rate is 35%, and it has a12% WACC.a. What is the initial net cash flow if the new machine is purchased and the old oneis replaced?b. Calculate the annual depreciation allowances for both machines, and computethe change in the annual depreciation expense if the replacement is made.c. What are the incremental net cash flows in Years 1 through 5?d. Should the firm purchase the new machine? Support your answer.e. In general, how would each of the following factors affect the investmentdecision, and how should each be treated?(1) The expected life of the existing machine decreases.(2) The WACC is not constant but is increasing as Balboa adds more projectsinto its capital budget for the year.(11–15)Risky Cash FlowsThe Bartram-Pulley Company (BPC) must decide between two mutually exclusiveinvestment projects. Each project costs $6,750 and has an expected life of 3 years.Annual net cash flows from each project begin 1 year after the initial investment ismade and have the following probability distributions:462 Part 4: Projects and Their Valuation9781133665007, Financial Management: Theory and Practice, Michael C. Ehrhardt – © Cengage Learning.rigehts tivon w itkhoout erxpirlelssi zastioanProject A Project BProbability Net Cash Flows Probability Net Cash Flows0.2 $ 6,000 0.2 $ 00.6 6,750 0.6 6,7500.2 7,500 0.2 18,000BPC has decided to evaluate the riskier project at a 12% rate and the less riskyproject at a 10% rate.a. What is the expected value of the annual net cash flows from each project? Whatis the coefficient of variation (CV)? (Hint: ?B = $5,798 and CVB = 0.76.)b. What is the risk-adjusted NPV of each project?c. If it were known that Project B is negatively correlated with other cash flows ofthe firm whereas Project A is positively correlated, how would this affect thedecision? If Project B’s cash flows were negatively correlated with gross domesticproduct (GDP), would that influence your assessment of its risk?(11–16)SimulationSingleton Supplies Corporation (SSC) manufactures medical products for hospitals,clinics, and nursing homes. SSC may introduce a new type of X-ray scanner designed toidentify certain types of cancers in their early stages. There are a number of uncertaintiesabout the proposed project, but the following data are believed to be reasonably accurate.Probability Developmental Costs Random Numbers0.3 $2,000,000 00–290.4 4,000,000 30–690.3 6,000,000 70–99Probability Project Life Random Numbers0.2 3 years 00–190.6 8 years 20–790.2 13 years 80–99Probability Sales in Units Random Numbers0.2 100 00–190.6 200 20–790.2 300 80–99Probability Sales Price Random Numbers0.1 $13,000 00–090.8 13,500 10–890.1 14,000 90–99ProbabilityCost per Unit (ExcludingDevelopmental Costs) Random Numbers0.3 $5,000 00–290.4 6,000 30–690.3 7,000 70–99SSC uses a cost of capital of 15% to analyze average-risk projects, 12% for low-riskprojects, and 18% for high-risk projects. These risk adjustments primarily reflect theChapter 11: Cash Flow Estimation and Risk Analysis 4639781133665007, Financial Management: Theory and Practice, Michael C. Ehrhardt – © Cengage Learning.. diisttriabut iopn wtiuthonut a utthooriizvatioonuncertainty about each project’s NPV and IRR as measured by their coefficients ofvariation. The firm is in the 40% federal-plus-state income tax bracket.a. What is the expected IRR for the X-ray scanner project? Base your answer onthe expected values of the variables. Also, assume the after-tax “profits” figurethat you develop is equal to annual cash flows. All facilities are leased, so depreciationmay be disregarded. Can you determine the value of ?IRR short of actualsimulation or a fairly complex statistical analysis?b. Assume that SSC uses a 15% cost of capital for this project. What is the project’sNPV? Could you estimate ?NPV without either simulation or a complex statisticalanalysis?c. Show the process by which a computer would perform a simulation analysis forthis project. Use the random numbers 44, 17, 16, 58, 1; 79, 83, 86; and 19, 62, 6to illustrate the process with the first computer run. Actually calculate the firstrunNPV and IRR. Assume the cash flows for each year are independent of cashflows for other years. Also, assume the computer operates as follows: (1) A developmentalcost and a project life are estimated for the first run using the firsttwo random numbers. (2) Next, sales volume, sales price, and cost per unit areestimated using the next three random numbers and used to derive a cash flowfor the first year. (3) Then, the next three random numbers are used to estimatesales volume, sales price, and cost per unit for the second year, hence the cashflow for the second year. (4) Cash flows for other years are developed similarly,on out to the first run’s estimated life. (5) With the developmental cost and thecash flow stream established, NPV and IRR for the first run are derived andstored in the computer’s memory. (6) The process is repeated to generate perhaps500 other NPVs and IRRs. (7) Frequency distributions for NPV and IRRare plotted by the computer, and the distributions’ means and standard deviationsare calculated.(11–17)Decision TreeThe Yoran Yacht Company (YYC), a prominent sailboat builder in Newport, maydesign a new 30-foot sailboat based on the “winged” keels first introduced on the12-meter yachts that raced for the America’s Cup.First, YYC would have to invest $10,000 at t = 0 for the design and model tanktesting of the new boat. YYC’s managers believe there is a 60% probability that thisphase will be successful and the project will continue. If Stage 1 is not successful, theproject will be abandoned with zero salvage value.The next stage, if undertaken, would consist of making the molds and producingtwo prototype boats. This would cost $500,000 at t = 1. If the boats test well, YYCwould go into production. If they do not, the molds and prototypes could be sold for$100,000. The managers estimate the probability is 80% that the boats will pass testingand that Stage 3 will be undertaken.Stage 3 consists of converting an unused production line to produce the new design.This would cost $1 million at t = 2. If the economy is strong at this point, thenet value of sales would be $3 million; if the economy is weak, the net value would be$1.5 million. Both net values occur at t = 3, and each state of the economy has aprobability of 0.5. YYC’s corporate cost of capital is 12%.a. Assume this project has average risk. Construct a decision tree and determine theproject’s expected NPV.b. Find the project’s standard deviation of NPV and coefficient of variation ofNPV. If YYC’s average project had a CV of between 1.0 and 2.0, would thisproject be of high, low, or average stand-alone risk?464 Part 4: Projects and Their Valuation9781133665007, Financial Management: Theory and Practice, Michael C. Ehrhardt – © Cengage Learning.ringht s Neou disstrib uotiolno allaow ejdu wimthouat elxpareass nSPREADSHEET PROBLEM