## Question

a. What is the initial investment outlay?

b. The company spent and expensed $150,000 on research related to the new product last year. Would this change your answer? Explain.

c. Rather than build a new manufacturing facility, the company plans to install the equipment in a building it owns but it is not now using. The building could be sold for $1.5 million after taxes and real estate commissions. How would this affect your answer?

Wendy’s boss wants to use straight-line depreciation for the new expansion project because he said it will give higher net income in earlier years and give him a larger bonus. The project will last 4 years and requires $1,700,000 of equipment. The company could use either straight line or the 3 year MACRS accelerated method. Under straight-line depreciation, the cost of the equipment would be depreciated

evenly over its 4-year life (ignore the half-year convention for the straight line method). The applicable MACRS depreciation rates are 33.33%, 44.45%, 14.81%, and 7.41%. The company’s WACC is 10%, and its tax rate is 40%.

a. What would the depreciation expense be each year under each method?

b. Which depreciation method would produce the higher NPV, and how much higher would it be?

c. Why might Wendy’s boss prefer straight-line depreciation?

The president of the company you work for has asked you to evaluate the proposed acquisition of a new chromatograph for the firm’s R&D department. The equipment’s basic price is $70,000 and it would cost another $15,000 to modify it for special use by your firm. The chromatograph, which falls into the MACRS 3-year class, would be sold after 3 years for $30,000. The MACRS rates for the first three years are 0.3333. 0.4445, and 0.1481. Use of the equipment would require an increase in net working capital (spare parts inventory) of $4,000. The machine would have no effect on revenues, but it is expected to save the firm $25,000 per year in before-tax operating costs, mainly labor. The firm’s marginal federalplus–state tax rate is 40%.

a. What is the year-0 net cash flow?

b. What are the net operating cash flows in Years 1,2, and 3?

c. What is the additional (nonoperating) cash flow in Year 3?

d. If the project’s cost of capital is 10%, should the chromatograph be purchased?

The Gilbert Instrument Corporation is considering replacing the wood steamer it currently uses to shape guitar sides. The steamer has 6 years of remaining life. If kept, the steamer will have depreciation expenses of $650 for five years and $325 for the sixth year. Its current book value is $3,575, and it can be sold on an internet auction site for $4,150 at this time. If the old steamer is not replaced, it can be sold for $800 at the end of its useful life.

Gilbert is considering purchasing the Side Steamer 3000, a higher end steamer, which costs $12,000 and has an estimated useful life of 6 years with an estimated salvage value of $1,500. This steamer falls into the MACRS 5-year class, so the applicable depreciation rates are 20.00%, 32.00%, 19.20%, 11.50%, 11.50% and 5.76%. The new steamer is faster and allows for an output expansion, so sales would rise by $2,000 per year; the new machine’s much greater efficiency would reduce operating expenses by $1,900 per year. To support the greater sales, the new machine would require that inventories increase by $2,900, but accounts payable would simultaneously increase by $700. Gilbert’s marginal federal-plusstate tax rate is 40%, and its WACC is 15%. Should it replace the old steamer? Shao Industries is considering a proposed project for its capital budget. The company estimates the project NPV is $12 million. This estimate assumes that the economy and market conditions will be average over the next few years. The company’s CEO, however, forecasts there is only a 50% chance that the economy will be average. Recognizing this uncertainty, she has also performed the following analysis:

Economic Scenario Possibility of Outcome NPV

Recession 0.05 -$70 million

Below average 0.20 -25 million

Average 0.50 12 million

Above average 0.20 20 million

Boom 0.05 30 million

What is the expected NPV, its standard deviation, and its coefficient of variation? The Bartum-Pulley Company (BPC) must decide between two mutually exclusive investment projects.

Each project costs $6,750 and has an expected life of 3 years. Annual net cash flows from each project begin 1 year after the initial investment is made and have the following probability distributions

Project A

Probability Net Cash Flows

0.2 $6000

0.6 6,750

0.2 7,500

Project B

Probability Net Cash Flows

0.2 $0

0.6 6,750

0.2 18,000

BPC has decided to evaluate the riskier project at a 12% rate and the less risky project at a 10% rate.

a. What is the expected value of the annual net cash flows from each project? What is the coefficient of the variation (CV)? (Hint ợB = $5,798 and CVB = 0.75)

b. What is the risk adjusted NPV of each project?

c. If it were known that Project B is negatively correlated with other cash flows of the firm whereas Project A is positively correlated, how would this affect the decision? If Project B’s cash flows were negatively correlated with gross domestic product would that influence your assessment of its risk?

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