Capital Budgeting Problems

1. Capital Budgeting Problems • 6. OCF from Several Approaches A proposed new project has projected sales of $49,350, costs of $25,000, and depreciation of $6,175. The tax rate is 34 percent. Calculate operating cash flow using three different approaches and verify that the answer is the same in each case. • OCF=NI + Depreciation=11,995.5+6,175=18,170.5 • OCF=Sales-Costs-Tax=49,350-25,000-6,179.5=18,170.5 • OCF= (Sales-Costs)(1-T)+ Depreciation T=(49,350-25,000)(1-0.34)+ 6,175 0.34 • =18,170.5 • OCF= (Sales-Costs- Depreciation)(1-T)+ Depreciation • =(Sales-Costs)(1-T)+ Depreciation T • Tax=(Sales-Costs- Depreciation) T • OCF= Sales-Costs-(Sales-Costs- Depreciation) T • =(Sales-Costs)(1-T)+ Depreciation T

2. Capital Budgeting Problems • 8. Calculating Salvage Value Consider an asset that costs • $100,000 and is depreciated straight-line to zero over its eight-year tax life. The asset is to be used in a five-year project; at the end of the project, the asset can be sold for $20,000. If the relevant tax rate is 35 percent, what is the after-tax cashflow from the sale of this asset? • BV5=37,500 • SV5=20,000 • T=35% • NSV=SV5-(SV5-BV5) T=20,000-(20,000-37,500) 0.35=26,125

3. Capital Budgeting Problems • 24. Cost-Cutting Proposals Rosello’s Machine Shop is • considering a four-year project to improve its production efficiency. • Buying a new machine press for $200,000 is estimated to produce • $85,000 in annual pretax cost savings. The press falls in the • modified ACRS five-year class life, and has a salvage value at the • end of the project of $50,000. The press also requires an initial • investment in spare parts inventory of $15,000, along with an • additional $5,000 in inventory for each succeeding year of the • project. If the shop’s tax rate is 34 percent and its discount rate is • 13 percent, should Rosello’s buy and install the machine press.

4. Capital Budgeting Problems • CS0=200,000 5 year MACRS • Cost=-85,000 • NWC0=15,000 • NWC=5,000 for 1-3 • T=34% • k=13% • NSV4=SV4-(SV4-BV4) T=50,000-(50,000-34,560) 0.34=44,750.4

5. Capital Budgeting Problems • .

6. Capital Budgeting Problems • 29. Expansion Project Terminator Pest Control (TPC), Inc., projects unit sales for a new household-use laser-guided cockroach eradication system as follows: • The eradication system will require $875,000 in net working capital • to start, and additional net working capital investments each year • equal to 35 percent of the projected sales increase for the • following year.(Since sales are expected to fall in Year 5 then, • there is no NWC cash flow occuring for Year 4.) Total fixed costs are • $200,000 per year, variable production costs are $75 per unit, and the units are priced at $105 each.

7. Capital Budgeting Problems • The equipment needed to begin production has an installed cost of • $9,750,000. This equipment is mostly industrial machinery and • thus qualifies as seven-year modified ACRS property. In five years, • this equipment can be sold for about 28 percent of its acquisition • cost. TPC is in the 38 percent marginal tax bracket and has a • required return on all of its projects of 10 percent. Based on these • preliminary project estimates, what is the NPV of the project? What • is the IRR?

8. Capital Budgeting Problems

9. Capital Budgeting Problems

10. Capital Budgeting Problems • NPV=723,567.96

11. Capital Budgeting Problems • Replacement Project Topsider, Inc. is considering the purchase • of a new leather-cutting machine to replace an existing machine • which it purchased 2 years ago at a price of $10,000. The old • machine had an expected life of 5 years at the time it was purchased and • is being depreciated straight-line to zero. It can be sold for $5,000 • today. The replacement decision has no effect on net working capital • requirement. The new machine will reduce costs (before taxes) by $7,000 • per year. The new machine has a 3-year life, it costs $14,000, and can be • sold for an expected $2,000 at the end of the third year. The new machine • would be depreciated using the ACRS method. Assume a 40 percent tax • rate. The firm has a required return on all of its projects of 12 percent. • Based on these preliminary project estimates, what is the NPV of the • project?

12. Capital Budgeting Problems • SVnew=2,000 • BVnew=1,037.4 • NSVnew=2,000-(2,000-1,037.4) 0.4=1,614.96 • Cost=-7,000

13. Capital Budgeting Problems • NPV=3,956.87

14. Capital Budgeting Problems • 30. Calculating Required Savings A proposed cost-saving • device has an installed cost of $330,000. The device will be used • in a five-year project, but is classified as three-year modified ACRS • property for tax purposes. The required initial net working capital • investment is $20,000, the marginal tax rate is 35 percent, and the • project discount rate is 12 percent. The device has an estimated • Year 5 salvage value of $45,000. What level of pretax cost savings • do we require for this project to be profitable?

15. Capital Budgeting Problems • 3 year MACRS • NSV5=SV5-(SV5-BV5) T=45,000-(45,000-0) 0.35=29,250

16. Capital Budgeting Problems