Kennedy Air Services is now in the final

year of a project. The

equipment originally cost $20 million, of which 80% has been depreciated. Kennedy can sell
the used equipment today for $5 million, and its tax rate is 40%. What is the equipments
after-tax net salvage value?

Cost 20
Salvage Value 4
Selling Price 5
Gain On Sale 1
Tax 0.4
Salvage Value After Tax 4.6
d
REPLACEMENT ANALYSIS The Chang Company is considering the purchase of a new
machine to replace an obsolete one. The machine being used for the operation has a book
value and a market value of zero. However, the machine is in good working order and
will last at least another 10 years. The proposed replacement machine will perform the
operation so much more efficiently that Changs engineers estimate that 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 firms WACC is 10%, and its marginal tax rate is 35%. Should
Chang buy the new machine? Explain.

0 1 2 3 4 5 6 7
-40000 9000 9000 9000 9000 9000 9000 9000
Tax 35%

NPV $55,301.10

NPV @ T=1 $15,301.10

Yes, it should be changed.

 8 9 10
9000 9000 9000
EQUIVALENT ANNUAL ANNUITY Corcoran Consulting is deciding which of two computer
systems to purchase. It can purchase state-of-the-art equipment (System A) for $20,000, which
will generate cash flows of $6,000 at the end of each of the next 6 years. Alternatively, the
company can spend $12,000 for equipment that can be used for 3 years and will generate cash
flows of $6,000 at the end of each year (System B). If the companys WACC is 10% and both
projects can be repeated indefinitely, which system should be chosen and what is its EAA

A -20000 6000 6000 6000 6000 6000 6000

B -12000 6000 6000 6000

NPV(A) $26,131.56 $6,131.56

NPV(B) $14,921.11 $2,921.11

EAA(A) $1,407.85
EAA(B) $1,174.62

Project A is better since EAA is higher and NPV

DEPRECIATION METHODS Kristin is evaluating a capital budgeting project that should
last 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 12A. The
companys 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?
SL MACRS
Cost 800,000
Life 4
SL-Dep 200000

Year 1 200000 264,000 64,000 25,600.0

Year 2 200000 360,000 160,000 64,000.0
Year 3 200000 120,000 (80,000) (32,000.0)
Year 4 200000 56,000 ### (57,600.0)

$633,973.09 $665,927.19
NPV 166,026.91 134,072.81
NPV after Tax 66,410.76 53,629 (12,782)

NPV $12,781.64

SL Method will give higher NPV by 12782

OPTIMAL CAPITAL BUDGET Marble Construction estimates that its WACC is 10% if equity
comes from retained earnings. However, if the company issues new stock to raise new
equity, it estimates that its WACC will rise to 10.8%. The company believes that it will
exhaust its retained earnings at $2,500,000 of capital due to the number of highly profitable
projects available to the firm and its limited earnings. The company is considering the
following seven investment projects:
Project Size IRR
A $ 650,000 14
B $ 1,050,000 13.5
C $ 1,000,000 11.2
D $ 1,200,000 11
E $ 500,000 10.7
F $ 650,000 10.3
G $ 700,000 10.2
Assume that each of these projects is independent and that each is just as risky as the firms
existing assets. Which set of projects should be accepted, and what is the firms optimal
capital budget?

Budget $ 2,500,000
Proect A,B,C,D $ 3,900,000

The Company should accept Project A B C D. since it has higher IRR

ABANDONMENT OPTION The Scampini Supplies Company recently purchased a new
delivery truck. The new truck costs $22,500; and it is expected to generate after-tax cash
flows, including depreciation, of $6,250 per year. The truck has a 5-year expected life. The
expected year-end abandonment values (salvage values after tax adjustments) for the truck
are given here. The companys WACC is 10%.

Year Annual After-Tax Cash Flow

Abandonment Value NPV 0f AV
0 -22500 0 -22500
1 6250 17500 23750 ($826.45) $82.55
2 6250 14000 20250 ($75.13) $7.51
3 6250 11000 17250 $1,188.44 $118.56
4 6250 5000 11250 $660.66 $66.34
5 6250 0 6250 $1,084.02 $107.98

a. Should the firm operate the truck until the end of its 5-year physical life; if not, what is
the trucks optimal economic life?
b. Would the introduction of abandonment values, in addition to operating cash flows,
ever reduce the expected NPV and/or IRR of a project? Explain.
0
Hampton Manufacturing estimates that its WACC is 12% if
equity comes from retained earnings However, if the company issues new stock to raise
new equity, it estimates that its WACC will rise to 12.5%. The company believes that it will
exhaust its retained earnings at $3,250,000 of capital due to the number of highly profitable
projects available to the firm and its limited earnings. The company is considering the
following seven investment projects:
Projects Sixe IRR
A $ 750,000 14
B $ 1,250,000 13.5
C $ 1,250,000 13.2
D $ 1,250,000 13
E $ 750,000 12.7
F $ 750,000 12.3
G $ 750,000 12.2

a. Assume that each of these projects is independent and that each is just as risky as the
firms existing assets. Which set of projects should be accepted, and what is the firms
optimal capital budget?
b. Now assume that Projects C and D are mutually exclusive. Project D has an NPV of
$400,000, whereas Project C has an NPV of $350,000. Which set of projects should be
accepted, and what is the firms optimal capital budget?
c. Ignore Part b and assume that each of the projects is independent but that management
decides to incorporate project risk differentials. Management judges Projects B, C, D,
and E to have average risk; Project A to have high risk; and Projects F and G to have
low risk. The company adds 2% to the WACC of those projects that are significantly
more risky than average, and it subtracts 2% from the WACC of those projects that are
substantially less risky than average. Which set of projects should be accepted, and
what is the firms optimal capital budget?

Budget $ 3,250,000
$ 16,250.00

a. Assume that each of these projects is independent and that each is just as risky as the
firms existing assets. Which set of projects should be accepted, and what is the firms
optimal capital budget?

Project A ,B , C ,D,E should be accepted.

Optimal Capital budget of the Project is 5,250,000

b. Now assume that Projects C and D are mutually exclusive. Project D has an NPV of
$400,000, whereas Project C has an NPV of $350,000. Which set of projects should be
accepted, and what is the firms optimal capital budget?

PRO D $ 400,000
PRO C $ 350,000

If Projects C and D are mutually exclusive, the firm will select Project D rather
than Project C, because Project Ds NPV is greater than Project Cs NPV. So, the
optimal capital budget is now $4 million, and consists of Projects A, B, D, and E.
 If Projects C and D are mutually exclusive, the firm will select Project D rather
than Project C, because Project Ds NPV is greater than Project Cs NPV. So, the
optimal capital budget is now $4 million, and consists of Projects A, B, D, and E.

c. Ignore Part b and assume that each of the projects is independent but that management
decides to incorporate project risk differentials. Management judges Projects B, C, D,
and E to have average risk; Project A to have high risk; and Projects F and G to have
low risk. The company adds 2% to the WACC of those projects that are significantly
more risky than average, and it subtracts 2% from the WACC of those projects that are
substantially less risky than average. Which set of projects should be accepted, and
what is the firms optimal capital budget?
Projects WACC
High Risk A 14.5 Reject
Avg Risk B,C,D,E 12.5 Accept
Low Risk F,G 10.2 Accept

Capital Optimal Budget $ 6,000,000