Practice
Problems – Chapter 6
1.
The following income statement pertains to the last year of a
project under consideration:
Revenue
15,000
Manufacturing cost
8,000
Depreciation
1,200
Interest
1,000
Pre-tax income
4,800
Tax (@ 40%) 1,920
Net Income
2,880
Working
capital employed during the last year is $1,500.
The income statement is based on straight line depreciation.
Tax returns will be based on accelerated depreciation, which will be
$500.
a)
Compute net cash flows for purposes of capital budgeting.
b)
Why is accelerated depreciation less than straight line depreciation?
2.
A four year project requires a
capital investment of $500,000. The
assets will be classified as 3-year assets under IRS rules, and depreciated at
the rates given in Table 6.4 in the textbook (p. 128).
The expected salvage value at the end of 4 years is $30,000.
Projected operating data for each of the four years is as follows:
(1)
(2)
(3)
(4)
Sales
(units)
20,000
30,000
32,000
33,000
Sale
price/unit 20 22 21 21
Variable
cost/unit
11
12.5
13.5
14
Fixed
costs
55,000
65,000
75,000
85,000
Interest
Charges
8,000
8,500
9,100
9,800
The
project requires initial working capital of $5,000.
Working capital requirements will increase by $3,000, $600 and $400
respectively for each subsequent year. The
firm has a tax rate of 34%. One
consequence of accepting this project is that the firm will lose sales of some
existing products. The firm
estimates that EBIT for the existing business will decline by $10,000 in the
first year, and $8,000 in each subsequent year.
Compute the project’s net cashflows for time 0 through time 4.
3.
Given below are the income statements, and other information, for the
last two years of Looking Glass Inc.’s new project.
Compute the operating cashflows for each year.
Year 4
Year 5
Revenue
32,000
35,000
Manufacturing cost
20,000
21,500
Depreciation 2,400
1,600
Interest
3,200
3,300
Pre-tax income 6,400
8,600
Tax (@ 40%)
2,560
3,440
Net Income
3,840
5,160
Working
capital requirement for the third year was $1,600; for the last two years, it
will be $1,800 and $1,900, respectively. The income statements are based on the
accelerated depreciation the firm will use in its income tax returns.
Straight line depreciation for both years would be $3,200.
4.
Given below are the projected income statements for a project with a four
year life. Compute the project’s
net cashflows for each year.
Year 1
Year 2
Year 3
Year 4
Revenue 23,000
24,500
26,250
28,300
Manufacturing cost
11,000
11,550
12,200
13,000
Depreciation
2,900
2,900
2,900
2,900
Interest
3,200
3,350
3,550
3,800
Pre-tax income
5,900
6,700
7,600
8,600
Tax (@ 40%)
2,360
2,680
3,040
3,440
Net Income
3,540
4,020
4,560
5,160
The
project requires capital investment of $100,000.
The working capital requirement will be $2,000 for the first year, $2,100
for the second year, $2,250 for the third year, and $2,400 for the last year.
The income statements are based on straight line depreciation. The accelerated
depreciation the firm will use in its income tax returns will be 4,400, 3,200, 2,400 and
1,600, respectively.
5. Using the information provided for United Pigpen in question #11 on page 144 of the textbook, compute the project’s net cashflows for each year.
6.
A firm is choosing between two different machines to manufacture a
product. Machine A will cost $8,000, last for 6 years and produce equal annual
cash inflows of $3,600. Machine B will cost $13,000, last for 8 years and
produce equal annual cash inflows of $5,700.
The salvage value of both machines at the end of their useful lives is
zero. If the required return for
both machines is 15%, which should the firm choose?
7.
Keelhaul Trawlers Inc. has to choose between two different machines for
processing its catch of shrimp. Both
machines will yield the same production. Machine
A will cost $36,000, last for 4 years, and generate net cashflows of $15,000
each year. Machine B will cost
$52,000, last for 6 years, and generate net cash flows of $16,000 each year.
Both machines will be depreciated down to a zero book value, and have no
salvage value at the end of their lives. The
required return for both machines is 15%.
a)
Which machine should the firm buy?
b)
Try to make the decision only IRR alone (by examining the IRR of the
incremental cashflows). What is the
reason why this does not give the correct answer?
8. Bagwell Enterprises is deciding when to replace an existing machine. If the machine is nor replaced today, it will last for 2 more
years. The efficiency of the
machine has declined substantially in recent years, and will decline further
each year it remains in use. In
real terms, the net cash flow the machine would generate are:
Time
Net Cash Flow
0
600
1
500
2
400
A replacement machine with the same production capacity would cost
$20,000 and will produce net cash flows of $4,600 each year over its
8-year life. The cost and cashflows
are in real terms, and will be the same no matter when the machine is purchased.
If the real required return is 12% p.a., when should the existing machine
be replaced?
9.
The Three Happiness restaurant must decide when to replace an existing
machine. If the machine is not
replaced today, it will last for 3 more years.
The efficiency of the machine will decline each year. In real terms, net cashflows from the machine, and its
salvage value are as folows:
Time
Net Cash Flow Salvage
Value
0
3,000
1,500
1
2,000
1,000
2
1,200
500
3
500
0
A
replacement machine with the same production capacity would cost
$9,000 and will produce net cash flows of $5,000 each year over its
6-year life. The cost and cashflows
are in real terms, and will be the same no matter when the machine is purchased.
If the real required return is 8% p.a., when should the existing machine
be replaced?
11.
The Eaglecrest Winery wants to decide how long to age its 2000 Merlot.
The wine is expected to have the following wholesale value (per bottle)
at different points in time:
Time 0
Time 1
Time 2
Time 3
Time 4
$8.99
$10.75
$12.50
$13.75
$14.99
If storage costs are negligible, and the required return for wine storage is 10%, when should they sell their wine?
12.
Afterlife Entertainment Corp has a project that would have an NPV of
$2,400 if it is taken today. If
they wait and take the project in the future, it will generate the following
NPVs at different points in time:
1
2
3
4
NPV
2,850 3,225
3,515 3,725
a)
If the required return in 11%, when should they take the project?
b)
Here and Now Inc. approaches them, wanting to buy the rights to the project.
How much should they sell the project rights for?
13. Question # 17 from the book (page 145).
14.
Kreamy Kold Kustard Co. faces seasonal demand for its products.
They have 2 existing machines. The
production capacity of each machine is 5,000 gallons/year.
In spring/summer the machines produce at 100% of capacity (and produce
2,500 each). In fall/winter, they
produce at 40% of capacity (and produce 1,000 each).
The machines have an indefinite life, and an operating cost of $1.50 per
gallon. New machines are available.
They would cost $30,000 each, would have the same production capacity, an
indefinite life and an operating cost of $1 per unit.
If the required return is 5%, should you replace any of the old machines
with new ones?
15.
A snow shovel manufacturer owns 2 existing machines.
The production capacity of each machine is 12,000 shovels/year.
In fall/winter the machines produce at 100% of capacity (and produce
6,000 each). In spring/summer, they
produce at 60% of capacity (and produce 3,600 each).
The machines have an indefinite life, and an operating cost of $4 per
shovel. New machines are available.
They would cost $100,000, would have the same production capacity, an
indefinite life and an operating cost of $3.25 per unit.
If the required return is 5%, should you replace any of the old machines
with new ones?