Homework, Chapters 6 & 7
1)______You are asked to determine the after tax cash flow associated with the sale of a sprocket machine at the end of year 2 for $100,000. The initial cost of the sprocket machine is $1,000,000. The corporate tax rate is 40%
The sprocket machine is being depreciated down to $0 using a MACRS depreciation schedule for three year assets, as given below:
Year / 1 / 2 / 3 / 4% of value / 33% / 45% / 15% / 7%
Depreciation = 1 Million x (.33 + .45) = 780,000; BV = 220,000
After tax CF = sales price – Tc (sales price – BV)
100,000 - .4 (100,000 – 220,000) = 148,000
2)Toys-B-We is considering a project to install new entertainment centers in their stores for customers to try-out video games before purchase. Compute the after tax cash flow for year 1.
i)Depreciation in year 1 will be $50,000.
ii)A $500,000 dollar debt issue will be used to fund the project. The debt will carry an 8% coupon rate.
iii)The project will increase revenues of electronic equipment and games by $100,000 per year. The increased cost associated with the sale of these products is $20,000 per year.
iv)Cash will increase by $10,000 in year 1, account receivable will increase by $20,000 and accounts payable will increase by $40,000.
v)The corporate tax rate is 30%
100,000 Revenues
- 20,000 Costs
- 50,000 Deprec
30,000 EBT
- 9,000 taxes
21,000 NI
+50,000 Deprec
+10,000 change in NWC (Change in NWC = 30,000-40,000 = -10,000; or a 10,000 inflow!)
81,000 Cash flow
Note: Debt issue has no cash flow associated with it. (It’s incorporated into the project’s discount rate through the WACC.)
3)_____C______Which of the following would not result in higher market risk for a project?
a) Projects that do better than the firm typical project when the economy is good, and worse than the firm’s typical project when the economy is bad
b) Projects with lower variable costs (greater fixed costs) of production
c) Projects with greater risk of future lawsuits than the firm’s typical project (such as projects involving experimental pharmaceuticals)
d) In fact, all of the above would result in higher market risk
4)Loveland Pet Supply plans to issue a $500,000, 10-year 10% bond, along with $500,000 in equity to fund a project to manufacture gourmet dog cookies. They expect that the equity issue will require the payment of $10,000 in additional dividends per year. Further, Loveland Pet Supply is planning for their project to occupy a vacant warehouse that they already own. The warehouse has been fully depreciated, but could be sublet for $12,000 a year were it not used for their project. Additionally, the project will require Loveland Pet Supply to hire a consultant in year 1 for $10,000 to test their cookies on dogs, to determine which flavors are preferred. What is the annual after tax cash flow associated with these items at the end of the first year? (Assume corporate tax rate = 30%)
With expenses noted as negative numbers
-12,000 sublet (opportunity cost)
- 10,000 consultant
- 22,000
- (-6,600 taxes)
- 15,400 (or a 15,400 after-tax expense)
5) For the three NPV problems included in your note packet, identify which cash flows would be included and which would be excluded in a capital budgeting analysis. (You need to perform the NPV analyses prior to exam I).
Practice Problems 1: SPROCKETS
Compute the NPV of the following project:
Only f would not be relevant to the analysis (although, technically, g and h are giving rates, not cash flows – but they are relevant to the analysis).
A project to manufacture SPROCKETS is being considered.
a)Initial outlay is $100,000 to be depreciated straight line down to $0 in 10 years. The machine will be sold in year 5 for 70,000 and the project will end at that time.
b)Revenues are expected to be $50,000, and decrease at a rate of 5% per year.
c)Actual expenses associated with the project are expected to be 20% of the expected revenues for each year.
d)Working capital will increase by $5,000 at time 0, increase by another $2000 in year 1, and decrease by $7,000 at the end of 5 years.
e)This project will decrease the sales revenue of the WIDGET division by $1000 (before tax) per year but will increase sales of the GADGET division by $2000 per year (before tax). All expenses associated with these divisions will remain unchanged.
f)The Sprocket project will be funded using a 100,000 10% bond issue.
g)The firm discounts risky cash flows by the risky rate, and riskless cash flows by the riskfree rate of 5%. The depreciation tax shield is the only riskless cash flow.
h)The corporate tax rate is 30%
i)If the project is accepted, the firm will hire consultants to decide how to market the SPROCKETS, at a cost of $4000 in year 1 (before tax)
j)The firm’s WACC is 12%. The above project is of average risk to the firm.
Practice problem 2: Compute the NPV of the following project to make widgets. The project will involve the following outlays:
The $25,000 in A is a sunk cost, and is not included. Note that the change in net working capital IS included in “C” at the end of the life of the project, even though the project is replaced with a “like project”. The cash flows in F are not included. In “G”, only the actual utility expenses are included. (H is data regarding rates, and technically, not a cash flow).
A) A $25,000 study conducted last month determined that the Widgets project will produce annual revenues of $600,000, and require annual expenses of $200,000 at the end of year 1. Revenues will increase at the rate of inflation of 5% per year, starting in year 2. Costs will increase at 8% per year, starting in year 2. The project will continue through year 5.
B) Cost of the Widget machine: $1,000,000, to be incurred at the start of the project (time = 0) & depreciated as a 7-year class asset using MACRS . The Widget machine will be sold for $100,000 at the end of year 5.
MACRS depreciation schedule:
1 / 2 / 3 / 4 / 5 / 6 / 7 / 814% / 25% / 17% / 13% / 9% / 9% / 9% / 4%
C) At the start of the project, cash will increase by $50,000, Accounts Receivable will increase by $40,000, and inventory will increase by $50,000. Accounts Payable will increase by $20,000. At the end of year 5, there is a 95% probability that the widget machine will be replaced by a new widget machine, which will require similar levels of cash, accounts receivable and inventory and have similar amounts of accounts payable as that associated with the old machine. However, if the widget project were not to be continued, the working capital would be recaptured at the end of year 5.
D) The widget project will be housed in a warehouse that the company already owns, and has fully depreciated. If the warehouse were not used to house this project, it could be leased for (before tax) revenues of $50,000 per year, to be paid at the end of years 1-5.
E) [Note: “Cogs” in this question refers to a piece of machinery, not “cost of goods sold”] Since Widgets and Cogs are interchangeable parts, the widget project will decrease the sales revenues of Cogs by $50,000 per year, but decrease costs of manufacturing Cogs by $20,000 per year. Since Cogs are produced by contracted laborers, the costs will be unaffected by inflation – however, Cog revenues increase at the inflation rate, starting in year 2.
F) The project will be funded through a 1,000,000 10% 5-year bond issue, with interest paid annually, at the end of each year.
G) The project will take up 10% of the area in the warehouse, and associated costs will be allocated by the firm’s accountants to the firm’s widget division, based on 10% of the total warehouse overhead. Overhead to keep the warehouse heated, and electricity to keep the warehouse operational is $100,000 per year, total. However, the actual cost of the utilities to run the widget machine = $20,000 per year.
H) The firm’s cost of debt (before tax) is 10%. The firm’s cost of equity is 16%, and the riskless rate is 6%. The firm’s debt/asset ratio is 40%. The firm discounts riskless cash flows by the riskless rate. The project is of average risk for the firm – however the firm’s discounts riskless cash flows by the riskless rate. Riskless cash flows are any contracted cash flows and the depreciation tax shield.
Assume a corporate tax rate of 30%.
Practice Problem III: Compute the NPV of the following project to make Gadgets.
This problem will be extra credit, after the exam (take-home).
1)ABC Corp is considering a 5-year project to manufacture GADGETS. They anticipate the following cash flows. The corporate tax rate is 25%.The firm discounts all cash flows by a rate of 15%, except for riskless cash flows, which they discount at a rate of 6%. Only the depreciation tax shield and other cash flows listed as “known with certainty” are discounted at the riskless rate.
2)The GADGET machine will cost $1.5 million– to be paid in two installments; $1 million at the time of purchase and $500,000 at the end of the first year.
3)The GADGET project is somewhat unusual, in that it will DECREASE net working capital by $50,000 at time=0 and INCREASE net working capital by $50,000 at time = 5, when NWC is recaptured. However, the firm expects to buy another GADGET machine at the end of year 5, causing NWC to decrease by $50,000 at that time.
4)The GADGET machine will be depreciated, straight line, over 10 years, down to 0. However, the GADGET machine will be sold at the end of year 5 for $600,000. At this time, the project will be discontinued.
5)Revenues associated with this project are expected to be $900,000 in year 1, and will increase at a rate of 8% per year. The gadgets are contracted to be sold to the military, so the revenues are known with certainty.
6)Expenses associated with the project (excluding utilities) are expected to be 40% of revenues in year 1 (only), and increase at a rate of 5% per year, thereafter. Unlike revenues, expenses are not known with certainty.
7)The GADGET project will be housed in a warehouse that the company already owns. If the GADGET project were not housed there, the warehouse could be leased to NBC Co on a five-year lease, for $200,000 per year, before taxes.
8)The GADGET project will occupy 10% of the floor space in the warehouse. 10% of the warehouse’s total utilities (of $10,000 per year – including the GADGET machine) will be allocated to the division producing the GADGETS. However, actual warehouse utility bills will increase by $50,000 as a direct result of the GADGET project.
9)The firm’s net revenues of “thingamajigs” will decrease by $100,000 in year 1, as a direct result of the gadget project. If the firm decides not to produce Gadgets, net revenues of thingamajigs would increase at a rate of 5% per year.
10)If the project is accepted, the firm will contract with quality control consultants for $100,000 at time=1, to ensure sufficient quality control, as per government contract specifications.
11)The project will be funded with an equity issue, requiring $20,000 in additional dividends per year.