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##### Talbot Industries is considering an expansion project.

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Investment Outlay;Talbot Industries is considering an expansion project. The necessary equipment;could be purchased for $9 million, and the project would also require an initial;$3 million investment in net operating working capital. The company?s tax rate;is 40%.;a. What is the initial investment outlay?;b. The company spent and expensed $50,000 on research related to the project last;year. Would this change your answer? Explain.;c. The company plans to house the project in a building it owns but is not now;using. The building could be sold for $1 million after taxes and real estate commissions.;How would this affect your answer?;458 Part 4: Projects and Their Valuation;9781133665007, Financial Management: Theory and Practice, Michael C. Ehrhardt - ? Cengage Learning.;raigh tjs d isvtriabutaionl wreud wkithoouut exkprsesse aunthoir izmatioen;(11?2);Operating Cash Flow;Cairn Communications is trying to estimate the first-year operating cash flow;(at t = 1) for a proposed project. The financial staff has collected the following;information;Projected sales $10 million;Operating costs (not including depreciation) $ 7 million;Depreciation $ 2 million;Interest expense $ 2 million;The company faces a 40% tax rate. What is the project?s operating cash flow for the;first year (t = 1)?;(11?3);Net Salvage Value;Allen Air Lines is now in the terminal year of a project. The equipment originally;cost $20 million, of which 80% has been depreciated. Carter can sell the used equipment;today to another airline for $5 million, and its tax rate is 40%. What is the;equipment?s after-tax net salvage value?;(11?4);Replacement Analysis;The Chen Company is considering the purchase of a new machine to replace an obsolete;one. The machine being used for the operation has both a book value and a;market value of zero, it is in good working order, however, and will last physically;for at least another 10 years. The proposed replacement machine will perform the;operation so much more efficiently that Chen?s engineers estimate it will produce;after-tax cash flows (labor savings and depreciation) of $9,000 per year. The new machine;will cost $40,000 delivered and installed, and its economic life is estimated to;be 10 years. It has zero salvage value. The firm?s WACC is 10%, and its marginal tax;rate is 35%. Should Chen buy the new machine?;INTERMEDIATE;PROBLEMS 5?11;(11?5);Depreciation Methods;Wendy is evaluating a capital budgeting project that should last for 4 years. The;project requires $800,000 of equipment. She is unsure what depreciation method to;use in her analysis, 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%, 45%, 15%, and 7%, as discussed;in Appendix 11A. 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?;(11?6);New-Project Analysis;The Campbell Company is evaluating the proposed acquisition of a new milling machine.;The machine?s base price is $108,000, and it would cost another $12,500 to;modify it for special use. The machine falls into the MACRS 3-year class, and it;would be sold after 3 years for $65,000. The machine would require an increase in;net working capital (inventory) of $5,500. The milling machine would have no effect;on revenues, but it is expected to save the firm $44,000 per year in before-tax operating;costs, mainly labor. Campbell?s marginal tax rate is 35%.;a. What is the net cost of the machine for capital budgeting purposes?;(That is, what is the Year-0 net cash flow?);b. What are the net operating cash flows in Years 1, 2, and 3?;Chapter 11: Cash Flow Estimation and Risk Analysis 459;9781133665007, Financial Management: Theory and Practice, Michael C. Ehrhardt - ? Cengage Learning.;ringhtist reeselrvmed. di stkribuutiovn h oeut austhoir izkatiuon;c. What is the additional Year-3 cash flow (i.e., the after-tax salvage and the return;of working capital)?;d. If the project?s cost of capital is 12%, should the machine be purchased?;(11?7);New-Project Analysis;You have been asked by the president of your company to evaluate the proposed acquisition;of a new spectrometer 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 spectrometer, which falls into the MACRS 3-year class, would be;sold after 3 years for $30,000. Use of the equipment would require an increase in net;working capital (spare parts inventory) of $4,000. The spectrometer 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 federal-plus-state tax rate is 40%.;a. What is the net cost of the spectrometer? (That is, 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 spectrometer be purchased?;(11?8);Inflation Adjustments;The Rodriguez Company is considering an average-risk investment in a mineral water;spring project that has a cost of $150,000. The project will produce 1,000 cases of;mineral water per year indefinitely. The current sales price is $138 per case, and the;current cost per case is $105. The firm is taxed at a rate of 34%. Both prices and;costs are expected to rise at a rate of 6% per year. The firm uses only equity, and it;has a cost of capital of 15%. Assume that cash flows consist only of after-tax profits;since the spring has an indefinite life and will not be depreciated.;a. Should the firm accept the project? (Hint: The project is a perpetuity, so you;must use the formula for a perpetuity to find its NPV.);b. Suppose that total costs consisted of a fixed cost of $10,000 per year plus variable;costs of $95 per unit, and suppose that only the variable costs were expected to;increase with inflation. Would this make the project better or worse? Continue;to assume that the sales price will rise with inflation.;(11?9);Replacement Analysis;The Taylor Toy Corporation currently uses an injection-molding machine that was;purchased 2 years ago. This machine is being depreciated on a straight-line basis, and;it has 6 years of remaining life. Its current book value is $2,100, and it can be sold for;$2,500 at this time. Thus, the annual depreciation expense is $2,100/6 = $350 per;year. If the old machine is not replaced, it can be sold for $500 at the end of its useful;life.;Taylor is offered a replacement machine that has a cost of $8,000, an estimated;useful life of 6 years, and an estimated salvage value of $800. This;machine falls into the MACRS 5-year class, so the applicable depreciation rates;are 20%, 32%, 19%, 12%, 11%, and 6%. The replacement machine would permit;an output expansion, so sales would rise by $1,000 per year, even so, the new;machine?s much greater efficiency would reduce operating expenses by $1,500;per year. The new machine would require that inventories be increased by;$2,000, but accounts payable would simultaneously increase by $500. Taylor?s;marginal federal-plus-state tax rate is 40%, and its WACC is 15%. Should it;replace the old machine?;460 Part 4: Projects and Their Valuation;9781133665007, Financial Management: Theory and Practice, Michael C. Ehrhardt - ? Cengage Learning.;res evrvead. diustritbautio nt whithroiukt exsprie ssk auothosrizkatieon;(11?10);Replacement Analysis;St. Johns River Shipyards is considering the replacement of an 8-year-old riveting;machine with a new one that will increase earnings before depreciation from;$27,000 to $54,000 per year. The new machine will cost $82,500, and it will have;an estimated life of 8 years and no salvage value. The new machine will be depreciated;over its 5-year MACRS recovery period, so the applicable depreciation rates are;20%, 32%, 19%, 12%, 11%, and 6%. The applicable corporate tax rate is 40%, and;the firm?s WACC is 12%. The old machine has been fully depreciated and has no;CHALLENGING salvage value. Should the old riveting machine be replaced by the new one?;PROBLEMS 11?17;(11?11);Scenario Analysis;Shao Industries is considering a proposed project for its capital budget. The company;estimates the project?s NPV is $12 million. This estimate assumes that the economy;and market conditions will be average over the next few years. The company?s CFO;however, forecasts there is only a 50% chance that the economy will be average. Recognizing;this uncertainty, she has also performed the following scenario analysis;Economic;Scenario;Probability 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 project?s expected NPV, its standard deviation, and its coefficient of;variation?;(11?12);New-Project Analysis;Madison Manufacturing is considering a new machine that costs $250,000 and would;reduce pre-tax manufacturing costs by $90,000 annually. Madison would use the;3-year MACRS method to depreciate the machine, and management thinks the machine;would have a value of $23,000 at the end of its 5-year operating life. The;applicable depreciation rates are 33%, 45%, 15%, and 7%, as discussed in Appendix;11A. Working capital would increase by $25,000 initially, but it would be recovered;at the end of the project?s 5-year life. Madison?s marginal tax rate is 40%, and a 10%;WACC is appropriate for the project.;a. Calculate the project?s NPV, IRR, MIRR, and payback.;b. Assume management is unsure about the $90,000 cost savings?this figure could;deviate by as much as plus or minus 20%. What would the NPV be under each;of these extremes?;c. Suppose the CFO wants you to do a scenario analysis with different values for the;cost savings, the machine?s salvage value, and the working capital (WC) requirement.;She asks you to use the following probabilities and values in the scenario analysis;Scenario Probability;Cost;Savings;Salvage;Value WC;Worst case 0.35 $ 72,000 $18,000 $30,000;Base case 0.35 90,000 23,000 25,000;Best case 0.30 108,000 28,000 20,000;Calculate the project?s expected NPV, its standard deviation, and its coefficient;of variation. Would you recommend that the project be accepted?;Chapter 11: Cash Flow Estimation and Risk Analysis 461;9781133665007, Financial Management: Theory and Practice, Michael C. Ehrhardt - ? Cengage Learning.;s Neo a llpoweedr wuithsoutt euxpire svs auuthoorihzatieon;(11?13);Replacement Analysis;The Everly Equipment Company purchased a machine 5 years ago at a cost of;$90,000. The machine had an expected life of 10 years at the time of purchase, and;it is being depreciated by the straight-line method by $9,000 per year. If the machine;is not replaced, it can be sold for $10,000 at the end of its useful life.;A new machine can be purchased for $150,000, including installation costs. During;its 5-year life, it will reduce cash operating expenses by $50,000 per year. Sales;are not expected to change. At the end of its useful life, the machine is estimated to;be worthless. MACRS depreciation will be used, and the machine will be depreciated;over its 3-year class life rather than its 5-year economic life, so the applicable depreciation;rates are 33%, 45%, 15%, and 7%.;The old machine can be sold today for $55,000. The firm?s tax rate is 35%, and;the appropriate WACC is 16%.;a. If the new machine is purchased, what is the amount of the initial cash flow at;Year 0?;b. What are the incremental net cash flows that will occur at the end of Years 1;through 5?;c. What is the NPV of this project? Should Everly replace the old machine?;(11?14);Replacement Analysis;The Balboa Bottling Company is contemplating the replacement of one of its bottling;machines with a newer and more efficient one. The old machine has a book;value of $600,000 and a remaining useful life of 5 years. The firm does not expect;to realize any return from scrapping the old machine in 5 years, but it can sell it;now to another firm in the industry for $265,000. The old machine is being depreciated;by $120,000 per year, using the straight-line method.;The new machine has a purchase price of $1,175,000, an estimated useful life and;MACRS class life of 5 years, and an estimated salvage value of $145,000. The applicable;depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. It is expected to;economize on electric power usage, labor, and repair costs, as well as to reduce the;number of defective bottles. In total, an annual savings of $255,000 will be realized if;the new machine is installed. The company?s marginal tax rate is 35%, and it has a;12% WACC.;a. What is the initial net cash flow if the new machine is purchased and the old one;is replaced?;b. Calculate the annual depreciation allowances for both machines, and compute;the change in the annual depreciation expense if the replacement is made.;c. What are the incremental net cash flows in Years 1 through 5?;d. Should the firm purchase the new machine? Support your answer.;e. In general, how would each of the following factors affect the investment;decision, and how should each be treated?;(1) The expected life of the existing machine decreases.;(2) The WACC is not constant but is increasing as Balboa adds more projects;into its capital budget for the year.;(11?15);Risky Cash Flows;The Bartram-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;462 Part 4: Projects and Their Valuation;9781133665007, Financial Management: Theory and Practice, Michael C. Ehrhardt - ? Cengage Learning.;rigehts tivon w itkhoout erxpirlelssi zastioan;Project A Project B;Probability Net Cash Flows Probability Net Cash Flows;0.2 $ 6,000 0.2 $ 0;0.6 6,750 0.6 6,750;0.2 7,500 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 variation (CV)? (Hint:?B = $5,798 and CVB = 0.76.);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 (GDP), would that influence your assessment of its risk?;(11?16);Simulation;Singleton Supplies Corporation (SSC) manufactures medical products for hospitals;clinics, and nursing homes. SSC may introduce a new type of X-ray scanner designed to;identify certain types of cancers in their early stages. There are a number of uncertainties;about the proposed project, but the following data are believed to be reasonably accurate.;Probability Developmental Costs Random Numbers;0.3 $2,000,000 00?29;0.4 4,000,000 30?69;0.3 6,000,000 70?99;Probability Project Life Random Numbers;0.2 3 years 00?19;0.6 8 years 20?79;0.2 13 years 80?99;Probability Sales in Units Random Numbers;0.2 100 00?19;0.6 200 20?79;0.2 300 80?99;Probability Sales Price Random Numbers;0.1 $13,000 00?09;0.8 13,500 10?89;0.1 14,000 90?99;Probability;Cost per Unit (Excluding;Developmental Costs) Random Numbers;0.3 $5,000 00?29;0.4 6,000 30?69;0.3 7,000 70?99;SSC uses a cost of capital of 15% to analyze average-risk projects, 12% for low-risk;projects, and 18% for high-risk projects. These risk adjustments primarily reflect the;Chapter 11: Cash Flow Estimation and Risk Analysis 463;9781133665007, Financial Management: Theory and Practice, Michael C. Ehrhardt - ? Cengage Learning.. diisttriabut iopn wtiuthonut a utthooriizvatioon;uncertainty about each project?s NPV and IRR as measured by their coefficients of;variation. The firm is in the 40% federal-plus-state income tax bracket.;a. What is the expected IRR for the X-ray scanner project? Base your answer on;the expected values of the variables. Also, assume the after-tax ?profits? figure;that you develop is equal to annual cash flows. All facilities are leased, so depreciation;may be disregarded. Can you determine the value of?IRR short of actual;simulation or a fairly complex statistical analysis?;b. Assume that SSC uses a 15% cost of capital for this project. What is the project?s;NPV? Could you estimate?NPV without either simulation or a complex statistical;analysis?;c. Show the process by which a computer would perform a simulation analysis for;this project. Use the random numbers 44, 17, 16, 58, 1, 79, 83, 86, and 19, 62, 6;to illustrate the process with the first computer run. Actually calculate the firstrun;NPV and IRR. Assume the cash flows for each year are independent of cash;flows for other years. Also, assume the computer operates as follows: (1) A developmental;cost and a project life are estimated for the first run using the first;two random numbers. (2) Next, sales volume, sales price, and cost per unit are;estimated using the next three random numbers and used to derive a cash flow;for the first year. (3) Then, the next three random numbers are used to estimate;sales volume, sales price, and cost per unit for the second year, hence the cash;flow for the second year. (4) Cash flows for other years are developed similarly;on out to the first run?s estimated life. (5) With the developmental cost and the;cash flow stream established, NPV and IRR for the first run are derived and;stored in the computer?s memory. (6) The process is repeated to generate perhaps;500 other NPVs and IRRs. (7) Frequency distributions for NPV and IRR;are plotted by the computer, and the distributions? means and standard deviations;are calculated.;(11?17);Decision Tree;The Yoran Yacht Company (YYC), a prominent sailboat builder in Newport, may;design a new 30-foot sailboat based on the ?winged? keels first introduced on the;12-meter yachts that raced for the America?s Cup.;First, YYC would have to invest $10,000 at t = 0 for the design and model tank;testing of the new boat. YYC?s managers believe there is a 60% probability that this;phase will be successful and the project will continue. If Stage 1 is not successful, the;project will be abandoned with zero salvage value.;The next stage, if undertaken, would consist of making the molds and producing;two prototype boats. This would cost $500,000 at t = 1. If the boats test well, YYC;would go into production. If they do not, the molds and prototypes could be sold for;$100,000. The managers estimate the probability is 80% that the boats will pass testing;and that Stage 3 will be undertaken.;Stage 3 consists of converting an unused production line to produce the new design.;This would cost $1 million at t = 2. If the economy is strong at this point, the;net value of sales would be $3 million, if the economy is weak, the net value would be;$1.5 million. Both net values occur at t = 3, and each state of the economy has a;probability of 0.5. YYC?s corporate cost of capital is 12%.;a. Assume this project has average risk. Construct a decision tree and determine the;project?s expected NPV.;b. Find the project?s standard deviation of NPV and coefficient of variation of;NPV. If YYC?s average project had a CV of between 1.0 and 2.0, would this;project be of high, low, or average stand-alone risk?;464 Part 4: Projects and Their Valuation;9781133665007, Financial Management: Theory and Practice, Michael C. Ehrhardt - ? Cengage Learning.;ringht s Neou disstrib uotiolno allaow ejdu wimthouat elxpareass n;SPREADSHEET PROBLEM;(11-18);Build a Model: Issues in;Capital Budgeting;Start with the partial model in the file Ch11 P18 Build a Model.xls on the textbook?s;Web site. Webmasters.com has developed a powerful new server that would be used;for corporations? Internet activities. It would cost $10 million at Year 0 to buy the equipment;necessary to manufacture the server. The project would require net working capital;at the beginning of a year in an amount equal to 10% of the year?s projected sales;NOWC0 = 10%(Sales1). The servers would sell for $24,000 per unit, and Webmasters;believes that variable costs would amount to $17,500 per unit. After Year 1, the sales;price and variable costs will increase at the inflation rate of 3%. The company?s nonvariable;costs would be $1 million at Year 1 and would increase with inflation.;The server project would have a life of 4 years. If the project is undertaken, it;must be continued for the entire 4 years. Also, the project?s returns are expected to;be highly correlated with returns on the firm?s other assets. The firm believes it;could sell 1,000 units per year.;The equipment would be depreciated over a 5-year period, using MACRS rates. The;estimated market value of the equipment at the end of the project?s 4-year life is $500,000.;Webmasters? federal-plus-state tax rate is 40%. Its cost of capital is 10% for average-risk;projects, defined as projects with an NPV coefficient of variation between 0.8 and 1.2.;Low-risk projects are evaluated with aWACC of 8% and high-risk projects at 13%.;a. Develop a spreadsheet model, and use it to find the project?s NPV, IRR, and;payback.;b. Now conduct a sensitivity analysis to determine the sensitivity of NPV to changes in;the sales price, variable costs per unit, and number of units sold. Set these variables?;values at 10% and 20% above and below their base-case values. Include a graph in;your analysis.;c. Now conduct a scenario analysis. Assume that there is a 25% probability that best-case;conditions, with each of the variables discussed in part b being 20% better than its;base-case value, will occur. There is a 25% probability of worst-case conditions, with;the variables 20% worse than base, and a 50% probability of base-case conditions.;d. If the project appears to be more or less risky than an average project, find its riskadjusted;NPV, IRR, and payback.;e. On the basis of information in the problem, would you recommend that the project be;accepted?

Paper#30357 | Written in 18-Jul-2015

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