Capital Investment Project Cash Flows: Problem Set

CAPITAL INVESTMENT PROJECT CASH FLOWS: PROBLEM SET

(copyright © 2014 Joseph W. Trefzger)

1. Big Bluestem Blazers plans to spend $17,500,000 on new equipment to produce neckties. If the company buys this equipment, it will also have to make a $2,750,000 investment in net working capital, which is treated in capital budgeting analysis as being recouped at the end of the project’s 8-year expected life. Big Bluestem pays income tax at a 34% state-plus-federal combined marginal annual rate. Compute the period 0 net cash flow for the project.

2. A project team at Bluegill Blueprints is considering spending $40,000,000 to build and equip a new facility on 60 acres of land. A suitable local 60-acre lot is for salefor $9,480,000, a figure that capable appraisers view as the true market value of such a parcel. It turns out that Bluegill already owns a very similar 60-acre tract, which would be quite acceptable to the team. The company bought this acreagefor $7,980,000 several years ago to use in a project that ultimately was not completed. The team leader has told Bluegill’s top management that she will proceed on the assumption that the project, if accepted, will use the landBluegillalready owns, and thather analysis will attribute a $7,980,000 cost to the land component of the project. Is that figure the correct one to use? Does it even matter since the company already owns the land in question? Would the situation change if Bluegill had paid $11,520,000?

3. Cardinal Carbon Testing plans to undertake a new investment project, which is expected to generateadditional sales revenue (beyond the company’s existing sales) of $2,550,000 in the coming year. Accompanying cash-based production costisexpected to be $1,425,000 for the year, anddepreciation expense on the project’s long-lived equipment should be $860,000. Cardinal’smarginal income tax rate (federal-plus-state combined) is 32%. Calculate the net income, operating cash flow, and depreciation tax shield that the project is expected to generate for Cardinal in the coming year (year 1 of the project’s life).

4. Carlyle Car Wax is trying to estimate the year-4 operating cash flow for a proposed capital investment project with a 7-year expected life. Projections made by the firm’s analysts indicate that sales in the project’s fourth year will be $8,350,000; cash-based operating costs will be $4,275,000; depreciation will be $2,695,000; and $655,000

in interest will be paid to lenders. If Carlyle’s combined state and federal marginal income tax rate is 32% each year, what is the project’s expected fourth-year operating cash flow? What is its expected net cash flow?

5. Financial analysts at Eastern Tiger Salamander Corporation are completing their projections for a proposed capital investment. They expect annual cash-based operating costs for the project to be $6,820,000, and they have subtracted $2,480,000 in depreciation from each year’s expected revenue in computing the $1,521,000 annual expected net income for the project. If the company’s marginal income tax rate is a state-plus-federal combined 35%, what annual sales total and annual operating cash flow do the ETSanalysts expect the project to deliver?

6. Several years ago Fluorite Flavors paid $600,000 to buy packaging machines for its Taste Bud Buddies line of fine food flavorings. The machines are only 92% depreciated, but Fluoritewants to replace them with newer, more efficient models. A used equipment dealer has offered to pay $57,000 for the old machines. Fluorite pays income tax at a 36% combined state-plus-federal marginal rate. How much cash, net of income taxes, will Fluorite generate by selling the old machines? What if the pre-tax salvage value (the used equipment dealer’s quoted price) were instead $41,000? What if it were $48,000? What if there were no potential buyers, and thus no salvage value?

7. Kaskaskia Castings showed a $3,520,000 ending accounts receivable balanceon its balance sheet in the most recentmeasured year; the beginning balance was $3,270,000. The respective ending and beginning accounts payable balances were $4,245,000 and $3,780,000. The cash and inventory levelsdid not change during the year. Total sales revenue for the year was $5,400,000, withcash payments for production costs and income taxesof $2,200,000. What was Kaskaskia’s change in net working capital for the year? What was its operating cash flow?

8. Monarch Butterfly Monogramsjust bought some manufacturing equipment for $28,500,000. The U.S. federal government classifies this type of equipment as five-year property for claiming MACRS accelerated depreciation, and Monarch plans to use the equipment in a project with a 5-year life. The company’s managers expect to sell the used equipment for $2,315,000 at the end of year 5. If Monarch’s combined state-plus-federal marginal income tax rate is 39%, how much cash, net of income taxes, does Monarch expect to generate by selling the used equipment? What if the company instead sells the equipment for $985,000 at the end of year 6?

9. The asset most recently acquired by Painted Turtle Coatings, Inc.is a robotic paint sprayer, purchased for $1,365,000. The firm’s managers believe that the sprayer will last for seven years, and the U.S.government treats this type of industrial equipment as 7-year property for MACRS depreciation purposes, as well. What will the sprayer’s remaining book value be at the end of year4 if depreciation is recognized on a straight-line basis? What if Painted Turtleinstead depreciates using MACRS? If Painted Turtle’s combined state-plus-federal marginal income tax rate is 33%, what will the after-tax salvage value be under each depreciation method if the company ends up selling the sprayer at the end of year 4 for $605,000?

10. Grocery wholesalers currently buy 858,000 boxes of Purple Violet Products’ laundry detergent each year for $4.66 each, and 557,000 bottles of its chlorine bleach for $1.52 each. Purple Violet’s president, worried about competing firms’ more extensive product offerings,has encouraged the chief chemist to develop anall-fabric bleach. The company’s marketing department estimates that Purple Violet could sell 473,000 boxesto wholesalers each year for $2.36 each. A study of consumer buying patterns indicates that offering an all-fabric bleach would increase sales of Purple Violet’s detergent by 104,000 boxes per year, but reduce chlorine bleach sales by 89,000 bottles per year. In evaluating the all-fabric bleach project, what annual sales figure should Purple Violet’s financial analysts use?

The following information applies to problems 11 through 15. The managers of Square Dance Squeegees have decided to expand their company’s operations by creating a new line of snow scrapers. The long-lived equipment needed for producing the scraperscosts $7,560,000 and has a three-year expected life. If the project is undertaken, the company’s sales are expected to increase by $13,500,000 per year, and related cash-based operating costs are expected to rise by $9,275,000 per year. The company’s weighted average cost of capital for a project of this type is 12.5% per year, and its annual state-plus-federal combined marginal income tax rate is 38%.

11. In their initial analysis, the managers assume that they will depreciate the scraper equipment on a straight-line basis over athree-year expected project life, and that there will be no cash inflows or expenditures other than those specified above. Compute each year’s expected net cash flow, and the project’s NPV, based on these assumptions.

12. One Square Dance manager now reminds the project team that,in a manufacturing project of this type,the $430,000 cost of the first batch of inventory should be treated as an added year 0 cash outflow, and that same dollar amount should be treated as an offsetting year 3 cash inflow. (Each year’s $9,275,000 projected cost of goods sold includes numerous $430,000 expected inventory purchases.) Compute each year’s expected net cash flow, and the project’s net present value, based on this addedassumption.

13. Now the Square Dancemanagers determine that at the end of year 3 the scraper equipment should be worth $595,000 to a used machinery dealer. Compute each year’s expected net cash flow, and the project’s net present value, based on this more complete set of assumptions.

14. Now Square Dance’smanagers attempt a more refined analysis, in which they include all the dollar figures presented earlier along with the expectation that they would want the income tax benefits of depreciating the new equipment on an accelerated basis (the equipment is classified as 3-year property under the MACRS system). Compute each year’s expected net cash flow, and the project’s net present value, based on this fourth set of assumptions. How would your answers change if expected salvage value were only $380,000? What if it were exactly $560,196?

15. Finally the managers, noting that property in the 3-year MACRS class must be depreciated over four operating years, wonder whether Square Dance could extend the scraper project’s life by a year. They include all the dollar figures presented earlier, except that the expected salvage value at the end of a fourth year would be only $50,000. Compute each year’s expected net cash flow, and the project’s NPV, based on this final set of assumptions.

16. Fire Prevention Consultants (FPC) is closing, following the recent destruction of its building, vehicles, and equipment in a fire. Tully Monster Safety Advisors, hoping to use its existing facilities to support added business, can buy the right to fulfill contracts with FPC’s clients over the next six years for a $26,000 up-front payment, plus

a 7% annual share of revenues to FPC’s retired owner. Tully Monster would plan to spend an added $80,000 for special fire testing equipment, which the government assigns to the 5-year MACRS class. Tully Monster’s managers think that by providing services under the contracts they can increase revenues by amounts that will start at $45,000 in the first year, and then grow by $2,000 per year for another five years. At that point they would expect to devote more effort to other business activities, and to sell the fire prevention operations (client list and used equipment) for $19,500. Safety industry statistics suggest that ordinary cash-based operating costs average 35% of revenues. If the estimated annual cost of capital for this type of project is 8%, and if its federal-plus-state marginal income tax rate is 31%, should Tully Monster buy the right to fulfill the FPC contracts?

17. Vandalia Vinyl manufactures vinyl siding, which it cuts to building contractors’ specifications. The firm’s managersworry that their very old cutting equipment leads to tremendous waste of materials, and haveconsidered buying a new computer-guided cutting machine. Having this new machine would not be expected to increase Vandalia’s revenues, but it would reduce before-tax operating costs by an estimated $78,500 annually for 3 years, until the operation moves into a new facility with all state-of-the-art equipment. A newmachinery dealer lists the cutting machine at $198,000, and Vandalia would have to spend an additional $12,000 to modify it for the vinylmanufacturing operation. After looking at used equipment prices, the Vandalia managers think they will be able to sell the cutting machine (which is classified by the government as 3-year MACRS property) at the end of year 3 for $23,500. Vandalia faces a 36% marginal (combined federal-plus-state) income tax rate, and the managers estimate the annual cost of capital for a project of this type as 9.5%. Compute the relevant net cash flows, and determine whether the cutting machine should be purchased.

18. White OakWine Cellars is considering a new Prairie Presidential Wine Coolers product line, to honor U.S. Presidents who grew up in Illinois. Each 4-pack would contain one bottle each of Lincoln Lime, Grant Grape, Reagan Raspberry, and Hillary Sour Nut. The project would require the purchase of $1,818,000 in equipment, which would be depreciated straight-line over the project’s8-year expected life. There would be no expected salvage value for the equipment, and no expected need for added investment in inventory. Cash-based production costs (primarily labor and materials) would be $2.46 per 4-pack. After studying the beverage market, White Oak’s managers feel that if average overall economic conditions were to prevail over the ensuing 8 years (a60% likelihood) they could sell 655,000 4-packs per year to wholesalers, at a price of $3.10 each. They also believe, however, that sales would be affected by economic conditions, falling by about 9% from the base estimate if the project period turned out to have a weak overall economy (a 15% likelihood) or rising by about 9% from the base with a strong overall economy(25% likelihood). White Oak’s combined federal-plus-state marginal income tax rate is 34%, and its managers estimate the annual cost of capital for a project of this type to be 10.25%. Use a scenario analysis to compute the wine cooler project’s net present value.

19. The managers of White-Tailed Deer Women’s Wear have considered making a new line of exercise outfits. The project would require a $4,942,000 initial investment in sewing machinery, which would be depreciated straight-line over a seven-year life and have no remaining salvage value. Cash-based fixed costs (those other than depreciation

on the equipment) would be $620,000 per year, and cash-based variable cost per outfit produced would be $24. The company’s marginal income tax rate is a federal-plus-state combined 32%. White-Tailed Deer’s sales director feels confident that major retail chains would buy the outfits for $36 each, but is less sure about herestimate that retailers would buy 285,000 of the outfits each year. The company’s chief financial officer feels that the project is worth doing so long as the annual netcash flow is “at least not too far below” the $2,129,920 that would accompany 285,000 units sold. How sensitive is net cash flow to changes in quantity sold?

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Trefzger/FIL 240 & 404 Topic 7 Problems: Cash Flow Analysis