Cash Flow Estimation-Sample Problems

1. When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT: Student Response 1. The value of a building owned by the firm that will be used for this project. 2. The salvage value of assets used for the project that will be recovered at the end of the projects life. 100% 3 Previous expenditures . associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes. 4. A decline in the sales of an existing product, provided that decline is directly attributable to this project. 5. Changes in net working capital Value Correct Answer Feedback

Student Response attributable to the project. Score: 2. 10/10

Value Correct Answer

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As assistant to the CFO of Boulder Inc., you must estimate the Year 1 cash flow for a project with the following data. What is the Year 1 cash flow? Sales revenues $12,700 Depreciation $4,000 Other operating $6,000 costs Tax rate 35.0% Student Value Response 1. $4,950 2. $4,495 3. $5,410 4 $5,755 . 5. $6,165 General Sales revenues $12,700 Feedback: 6,000 Operating costs (excl. depr.) 4,000 Depreciation Operating income (EBIT) $2,700 rate = 35% 945 Taxes After-tax EBIT $1,755 + Depreciation 4,000 Cash flow, Year 1 $5,755 Score: 3. Your company, RMU Inc., is considering a new project whose data are shown below. What is the project's Year 1 cash flow? Sales revenues $23,500 Depreciation $8,000 Other operating costs $12,000 Tax rate 35.0% Student Value Response 1. $12,125 Correct Answer Feedback 10/10 100% Correct Answer Feedback

Student Value Response 2. $9,864 3. $10,686 4. $7,809 5 $10,275 . 100%

Correct Answer Feedback

General Sales revenues $23,500 Feedback: 12,000 Operating costs (excl. depr.) 8,000 Depreciation Operating income (EBIT) $3,500 rate = 35% 1,225 Taxes After-tax EBIT $2,275 + Depreciation 8,000 Cash flow, Year 1 $10,275 Score: 4. Your company, CSUS Inc., is considering a new project whose data are shown below. The required equipment has a 3-year tax life, and the accelerated rates for such property are 33%, 45%, 15%, and 7% for Years 1 through 4. Revenues and other operating costs are expected to be constant over the project's 10-year expected operating life. What is the project's Year 4 cash flow? Equipment cost (depreciable basis) $70,000 Sales revenues, each year $41,000 Operating costs (excl. depr.) $25,000 Tax rate 35.0% Student Value Response 1. $9,930 2 $12,115 . 3. $10,185 4. $11,270 5. $11,275 General Equipment cost Feedback: Depreciation rate, Year 4 Sales revenues Operating costs (excl. depr.) Depreciation Operating income (EBIT) rate =35% Taxes After-tax EBIT + Depreciation Cash flow, Year 4 $70,000 7.0% $41,000 25,000 4,900 $11,100 3,885 $7,215 4,900 $12,115 100% Correct Answer Feedback 10/10

Score: 5.

10/10

Temple Corp. is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, would be depreciated by the straight-line method over its 3-year life, and would have a zero salvage value. No new working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's NPV? Risk-adjusted WACC Net investment cost (depreciable basis) Straight-line depr. rate Sales revenues, each year Operating costs (excl. depr.), each year Tax rate Student Value Response 1 $32,256 . 2. $34,191 3. $29,675 4. $36,449 5. $27,417 General WACC 10.0% Years Feedback: Investment cost Sales revenues Operating costs (excl. depr.) Depreciation rate = 33.333% Operating income (EBIT) rate = 35% Taxes After-tax EBIT + Depreciation Cash flow NPV Score: 6. Liberty Services is now at the end of the final year of a project. The equipment originally cost $30,000, of which 75% has been depreciated. The firm can sell the used equipment today for $6,000, and its tax rate is 40%. What is the equipments after-tax salvage value for use in a capital budgeting analysis? Note that if the equipment's final market value is less than its book value, the firm will receive a tax credit as a result of the sale. Student Value Response Correct Answer Feedback 10/10 $32,256 0 1 2 3 $73,500 25,000 21,667 $26,833 9,392 $17,441 21,667 $39,108 100% 10.0% $65,000 33.3333% $73,500 $25,000 35.0%

Correct Answer Feedback

$73,500 $73,500 25,000 25,000 21,667 21,667 $26,833 $26,833 9,392 9,392 $17,441 $17,441 21,667 21,667 $39,108 $39,108

Student Value Response 2. $6,670 3. $7,660 4. $8,250 5 $6,600 . 100%

Correct Answer Feedback

General % depreciated on equip. Feedback: Tax rate Equipment cost Accumulated depr. Current book value of equipment Market value of equipment Gain (or loss): Market value Book value Taxes paid on gain ( ) or credited (+) on loss

75% 40% $30,000 22,500 $7,500 6,000 -$1,500 600

AT salvage value = market value +/ taxes Score: 7. 10/10

$6,600

Marshall-Miller & Company is considering the purchase of a new machine for $50,000, installed. The machine has a tax life of 5 years, and it can be depreciated according to the following rates. The firm expects to operate the machine for 4 years and then to sell it for $12,000. If the marginal tax rate is 40%, what will the after-tax salvage value be when the machine is sold at the end of Year 4? Year 1 2 3 4 5 6 Depreciation Rate 0.20 0.32 0.19 0.12 0.11 0.06 Correct Answer Feedback

Student Value Response 1. $12,600 2. $10,400 3. $13,100 4 $10,600 . 5. $9,800 100%

General Year Depr. Rate Feedback: 1 0.20 2 0.32

Basis $50,000 $50,000

Annual Year-end Book Value Depr. $10,000 $40,000 $16,000 $24,000

3 4 5 6

0.19 0.12 0.11 0.06 1.00

$50,000 $50,000 $50,000 $50,000

$9,500 $6,000 $5,500 $3,000 $50,000 $12,000 8,500 $3,500 1,400

$14,500 $8,500 $3,000 $0

Gross sales proceeds Book value, end of Year 4 Profit Tax on profit rate =40%

AT salvage value = market value +/ taxes Score: 8. 10/10

$10,600

Suppose Walker Publishing Company is considering bringing out a new finance text whose projected revenues include some revenues that will be taken away from another of Walker's books. The lost sales on the older book are a sunk cost and as such should not be considered in the analysis for the new book. Student Value Response 1. True 2 False . Score: 9. Stanton Inc. is considering the purchase of a new machine which will reduce manufacturing costs by $5,000 annually and increase earnings before depreciation and taxes by $6,000 annually. Stanton will use the MACRS method to depreciate the machine, and it expects to sell the machine at the end of its 5-year operating life for $10,000 before taxes. Stanton's marginal tax rate is 40 percent, and it uses a 9 percent cost of capital to evaluate projects of this type. If the machine's cost is $40,000, what is the project's NPV? Student Value Response 1. $2,292 2. $ 817 3. $1,014 4. $5,040 5 $7,550 . 0% Correct Answer Feedback 10/10 100% Correct Answer Feedback

General Time line: Feedback:

NPV = ? Depreciation cash flows: MACRS Year Percent 1 0.20 2 0.32 3 0.19 4 0.12 5 0.11 6 0.06 Project analysis worksheet: Depreciable Basis $40,000 40,000 40,000 40,000 40,000 40,000 Annual Depreciation $ 8,000 12,800 7,600 4,800 4,400 2,400 $40,000

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III

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Year: 0 Initial outlay 1) Machine cost ($40,000) 2) Decrease in -NWC 3) Total net inv. ($40,000) Operating cash flows 4) Inc. in earnings before deprec. & tax $ 5) After-tax increase in earnings (line 4 0.6) 6) Before tax reduction in cost 7) After tax reduction in cost (line 6 0.4) 8) Deprec. (from table) 9) Deprec. tax savings (line 8 0.4) 10) Net operating CFs (line 5 + 7 + 9) $ Terminal year CFs 11) Estimated salvage value 12) Tax on salvage value ($10,000 $2,400)(0.4) 13) Return of NWC 14) Total termination CFs Net CFs 15) Total Net CFs ($40,000) $

6,000 $ 6,000 $6,000 $6,000 $ 6,000 3,600 5,000 3,600 5,000 3,600 5,000 3,600 5,000 3,600 5,000

3,000 3,000 8,000 12,800 3,200 5,120

3,000 7,600 3,040

3,000 4,800 1,920

3,000 4,400 1,760

9,800 $11,720 $9,640 $8,520 $ 8,360 $10,000 (3,040) -6,960 9,800 $11,720 $9,640 $8,520 $15,320

Numerical solution: NPV= $40,000 + $9,800(1/1.09) + $11,720(1/1.092) + $9,640(1/1.093) + $8,520(1/1.094) + $15,320(1/1.095) = $40,000 + $9,800(0.9174) + $11,720(0.8417) + $9,640(0.7722) +

$8,520(0.7084) + $15,320(0.6499) = $2,291.29 $2,292. Financial calculator solution: Inputs: CF0 = 40,000; CF1 = 9,800; CF2 = 11,720; CF3 = 9,640; CF4 = 8,520; CF5 = 15,320; I = 9. Output: NPV = $2,291.90 $2,292. Score: 10. Foxglove Corp. is faced with an investment project. The following information is associated with this project: Year 1 2 3 4 Net Income* $50,000 60,000 70,000 60,000 Allowable Depreciation for 3-Yr. MACRS class 0.33 0.45 0.15 0.07 0/10

*Assume no interest expenses and a zero tax rate. The project involves an initial investment of $100,000 in equipment that falls in the 3-year MACRS class and has an estimated salvage value of $15,000. In addition, the company expects an initial increase in net operating working capital of $5,000 which will be recovered in year 4. The cost of capital for the project is 12 percent. What is the project's net present value? (Round your final answer to the nearest whole dollar.) Student Value Response 1. $153,840 0% 2. $182,344 3. $159,071 4. $168,604 5. $162,409 General Step 1 Feedback: Calculate depreciation: Dep 1 = 100,000(0.33) Dep 2 = 100,000(0.45) Dep 3 = 100,000(0.15) Dep 4 = 100,000(0.07) = 33,000. = 45,000. = 15,000. = 7,000. Correct Answer Feedback

Step 2

Calculate cash flows: CF 0 = 100,000 5,000 = 105,000. CF 1 = 50,000 + 33,000 = 83,000. CF 2 = 60,000 + 45,000 = 105,000. CF 3 = 70,000 + 15,000 = 85,000. CF 4 = 60,000 + 7,000 + 5,000 + 15,000 = 87,000. Calculate NPV: Use CF key on calculator. Enter cash flows shown above. Enter I/YR = 12%. Solve for NPV = $168,604.

Step 3

Score:

0/10