How is the pro forma statement we used in this chapter for computing OCF different from an accountant’s income statement? (LG1)
The two major differences are that we don’t count interest when computing OCF, and that we add back depreciation at the end.
4. Everything else held constant, would you rather depreciate a project with straight-line depreciation or with DDB? (LG4)
DDB would be best.
5. Everything else held constant, would you rather depreciate a project with DDB depreciation or deduct it under a Section 179 deduction? (LG4)
Since a section 179 deduction would allow you to expense the assets immediately rather than depreciating it over multiple periods, this would maximize the project’s NPV, and you would prefer it.
Problems 3, 6, 7, 8, 10; pp. 417-419
12-3 EAC Approach You are trying to pick the least-expensive car for your new delivery service. You have two choices: the Scion xA, which will cost $14,000 to purchase and which will have OCF of 2 $1,200 annually throughout the vehicle’s expected life of three years as a delivery vehicle; and the Toyota Prius, which will cost $20,000 to purchase and which will have OCF of 2 $650 annually throughout that vehicle’s expected 4-year life. Both cars will be worthless at the end of their life. If you intend to replace whichever type of car you choose with the same thing when its life runs out, again and again out into the foreseeable future, and if your business has a cost of capital of 12 percent, which one should you choose? (LG7)
The Scion xA, because it has an EAC of 2 $7,028.89.
12-6 Project Cash Flows KADS, Inc., has spent $400,000 on research to develop a new computer game. The firm is planning to spend $200,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $50,000. The machine has an expected life of three years, a $75,000 estimated resale value, and falls under the MACRS 7-year class life. Revenue from the new game is expected to be $600,000 per year, with costs of $250,000 per year. The firm has a tax rate of 35 percent, an opportunity cost of capital of 15 percent, and it expects net working capital to increase by $100,000 at the beginning of the project. What will the cash flows for this project be? (LG3)
12-7 Depreciation Tax Shield Your firm needs a computerized machine tool lathe which costs $50,000 and requires $12,000 in maintenance for each year of its 3-year life. After three years, this machine will be replaced. The machine falls into the MACRS 3-year class life category. Assume a tax rate of 35 percent and a discount rate of 12 percent. Calculate the depreciation tax shield for this project in year 3. (LG4)
12-8 After-Tax Cash Flow from Sale of Assets If the lathe in the previous problem can be sold for $5,000 at the end of year 3, what is the after-tax salvage value? (LG4)
12-10 Change in NWC You are evaluating a project for The Tiff-any golf club, guaranteed to correct that nasty slice. You estimate the sales price of The Tiff-any to be $400 per unit and sales volume to be 1,000 units in year 1; 1,500 units in year two; and 1,325 units in year
three. The project has a 3-year life. Variable costs amount to $225 per unit and fixed costs are $100,000 per year. The project requires an initial investment of $165,000 in assets, which will be depreciated straight-line to zero over the 3-year project life. The actual market value of these assets at the end of year 3 is expected to be $35,000. NWC requirements at the beginning of each year will be approximately 20 percent of the projected sales during the coming year. The tax rate is 34 percent and the required return on the project is 10 percent. What change in NWC occurs at the end of year 1? (LG3)
Sales will go from $400,000 to $600,000 between years 1 and 2, so NWC will have to increase from $80,000 to $120,000, an increase of $40,000.
Chapter 13 Questions 3, 5, 6; pp. 455
Problems 17, 18, 19, 21, 22; p. 458
3. Is it possible for a company to initiate two products that target the same market that are not mutually exclusive? (LG1)
Yes, if there is opportunity for both products.
5. Under what circumstances could payback and discounted payback be equal? (LG2)
They would be equal if i = 0.
6. Could a project’s MIRR ever exceed its IRR? (LG4)
Yes, MIRR would be greater than IRR if a project with normal cash flows had a negative NPV.
Use this information to answer the next six questions. If a particular decision method should not be used, indicate why.
Suppose your firm is considering investing in a project with the cash flows shown below, that the required rate of return on projects of this risk class is 8 percent, and that the maximum allowable payback and discounted payback statistics for the project are 3.5 and 4.5 years, respectively.
Time 0 1 2 3 4 5 6
Cash Flow -$5,000 $1,200 $2,400 $1,600 $1,600 $1,400 $1,200
13-17 Payback Use the payback decision rule to evaluate this project; should it be accepted or rejected? (LG2)
13-18 Discounted Payback Use the discounted payback decision rule to evaluate this project; should it be accepted or rejected? (LG2)
13-19 IRR Use the IRR decision rule to evaluate this project; should it be accepted or rejected? (LG4)
IRR 19.33% and since IRR > i, this project should be accepted.
13-21 NPV Use the NPV decision rule to evaluate this project; should it be accepted or rejected? (LG3)
13-22 PI Use the PI decision rule to evaluate this project; should it be accepted or rejected? (LG6)