Download FM Exercise by Bingham and more Exercises Finance in PDF only on Docsity!
Answers to Warm-Up Exercises
E11-1. Categorizing a firm’s expenditures
Answer: In this case, the tuition reimbursement should be categorized as a capital expenditure since the outlay of funds is expected to produce benefits over a period of time greater than 1 year.
E11-2. Classification of project costs and cash flows Answer: $3.5 billion already spent—sunk cost (irrelevant) $350 million incremental cash outflow—relevant cash flow $15 million per year cash inflow—relevant cash flow $450 million for satellites—opportunity cost and relevant cash flow
E11-3. Finding the initial investment
Answer: $20,000 Purchase price of new machinery $3,000 Installation costs $4,500 After-tax proceeds from sale of old machinery $18,500 Initial investment
E11-4. Book value and recaptured depreciation
Answer: Book value $175,000 $124, 250 $50,
Recaptured depreciation $110,000 $50, 750 $59,
E11-5. Initial investment
Answer: Initial investment purchase price installation costs – after-tax proceeds from sale of old asset change in net working capital $55,000 $7,500 – $23,750 $2,000 $40,
Solutions to Problems
Note : The MACRS depreciation percentages used in the following problems appear in Chapter 4, Table 4.2. The percentages are rounded to the nearest integer for ease in calculation.
For simplification, 5-year-lived projects with 5 years of cash inflows are typically used throughout this chapter. Projects with usable lives equal to the number of years of cash inflows are also included in the end-of-chapter problems. It is important to recall from Chapter 4 that under the Tax Reform Act of 1986, MACRS depreciation results in n 1 years of depreciation for an n -year class asset. This means that in actual practice projects will typically have at least one year of cash flow beyond their recovery period.
P11-1. Classification of expenditures
LG 2; Basic a. Operating expenditure—lease expires within one year b. Capital expenditure—patent rights exist for many years c. Capital expenditure—research and development benefits last many years d. Operating expenditure—marketable securities mature in under one year e. Capital expenditure—machine will last over one year f. Capital expenditure—building tool will last over one year g. Capital expenditure—building will last for more than one year h. Operating expenditure—market changes require obtaining another report within a year
P11-2. Relevant cash flow and timeline depiction
LG 1, 2; Intermediate a. Year Cash Flow
This is a conventional cash flow pattern, where the cash inflows are of equal size, which is referred to as an annuity.
b.
This is a conventional cash flow pattern, where the subsequent cash inflows vary, which is referred to as a mixed stream.
c. Opportunity cost—Covol will not have to spend any funds for floor space but the lost cash inflow from the rent would be a cost to the firm. d. Sunk cost—The money for the storage facility has already been spent, and no matter what decision the company makes there is no incremental cash flow generated or lost from the storage building. e. Opportunity cost—Forgoing the sale of the crane costs the firm $180,000 of potential cash inflows.
P11-6. Personal finance: Sunk and opportunity cash flows
LG 2; Intermediate a. The sunk costs or cash outlays are expenditures that have been made in the past and have no effect on the cash flows relevant to a current situation. The cash outlays done before David and Ann decided to rent out their home would be classified as sunk costs. An opportunity cost or cash flow is one that can be realized from an alternative use of an existing asset. Here, David and Ann have decided to rent out their home, and all the costs associated with getting the home in ―rentable‖ condition would be relevant. b. Sunk costs (cash flows): Replace water heater Replace dish washer Miscellaneous repairs and maintenance Opportunity costs cash flows: Rental income Advertising House paint and power wash
P11-7. Book value
LG 3; Basic
Asset
Installed Cost
Accumulated Depreciation
Book Value A $ 950,000 $ 674,500 $275, B 40,000 13,200 26, C 96,000 79,680 16, D 350,000 70,000 280, E 1,500,000 1,170,000 330,
P11-8. Book value and taxes on sale of assets
LG 3, 4; Intermediate a. Book value $80,000 (0.71 $80,000) $23, b.
Sale Price
Capital Gain
Tax on Capital Gain
Depreciation Recovery
Tax on Recovery
Total Tax $100,000 $20,000 $8,000 $56,800 $22,720 $30, 56,000 0 0 32,800 13,120 13, 23,200 0 0 0 0 0 15,000 0 0 (8,200) (3,280) (3,280)
P11-9. Tax calculations
LG 3, 4; Intermediate Current book value $200,000 [(0.52 ($200,000)] $96,
(a) (b) (c) (d) Capital gain $ 20,000 $ 0 $0 $ 0 Recaptured depreciation 104,000 54,000 0 (16,000) Tax on capital gain 8,000 0 0 0 Tax on depreciation Recovery 41,600 21,600 0 (6,400) Total tax $ 49,600 $21,600 $0 ($6,400)
P11-10. Change in net working capital calculation
LG 3; Basic a. Current Assets Current Liabilities Cash (^) $15,000 Accounts payable (^) $90, Accounts receivable (^) 150,000 Accruals (^) 40, Inventory (^) 10, Net change $155,000 $130,
Net working capital current assets current liabilities NWC $155,000 $130, NWC $25, b. Analysis of the purchase of a new machine reveals an increase in net working capital. This increase should be treated as an initial outlay and is a cost of acquiring the new machine. c. Yes, in computing the terminal cash flow, the net working capital increase should be reversed.
P11-11. Calculating initial investment
LG 3, 4; Intermediate a. Book value $325,000 (1 0.20 – 0.32) $325,000 0.48 $156, b. Sales price of old equipment $200, Book value of old equipment 156, Recapture of depreciation $ 44, Taxes on recapture of depreciation $44,000 0.40 $17, After-tax proceeds $200,000 $17,600 $182, c. Cost of new machine $ 500, Less sales price of old machine (200,000) Plus tax on recapture of depreciation 17, Initial investment $ 317,
d. Loss on sale of existing asset $1,500 $2,900 ($1,400) Tax benefit $ 1,400 (0.40) $ 560
P11-14. Calculating initial investment
LG 3, 4; Challenge a. Book value ($60,000 0.31) $18, b. Sales price of old equipment $35, Book value of old equipment 18, Recapture of depreciation $16, Taxes on recapture of depreciation $16,400 0.40 $6, Sale price of old roaster $35, Tax on recapture of depreciation (6,560) After-tax proceeds from sale of old roaster $28, c. Changes in current asset accounts Inventory $ 50, Accounts receivable 70, Net change $ 120, Changes in current liability accounts Accruals $ (20,000) Accounts payable 40, Notes payable 15, Net change $ 35, Change in net working capital $ 85, d. Cost of new roaster $130, Less after-tax proceeds from sale of old roaster 28, Plus change in net working capital 85, Initial investment $186,
P11-15. Depreciation
LG 5; Basic Depreciation Schedule Year Depreciation Expense (^1) $68,000 0.20 $13, (^2) 68,000 0.32 21, 3 68,000 0.19 12, (^4) 68,000 0.12 8, (^5) 68,000 0.12 8, (^6) 68,000 0.05 3,
P11-16. Incremental operating cash inflows
LG 5; Intermediate a. Incremental profits before depreciation and tax $1,200,000 $480, $720,000 each year b. Year (1) (2) (3) (4) (5) (6) PBDT $720,000 $720,000 $720,000 $720,000 $720,000 $720, Depr. 400,000 640,000 380,000 240,000 240,000 100, NPBT 320,000 80,000 340,000 480,000 480,000 620, Tax 128,000 32,000 136,000 192,000 192,000 248, NPAT 192,000 48,000 204,000 288,000 288,000 372,
c.
Cash flow
(NPAT depreciation) PBDT Profits before depreciation and taxes NPBT Net profits before taxes NPAT Net profits after taxes
P11-17. Personal finance: Incremental operating cash inflows LG 5; Challenge Richard and Linda Thomson Incremental Operating Cash Flows Replacement of John Deere Riding Mower Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Savings from new and improved mower $500 $ 500 $500 $500 $500 — Annual maintenance cost 120 120 120 120 120 0 Depreciation*^360 576 342 216 216 Savings (loss) before taxes 20 (196) 38 164 164 (90) Taxes (40%) 8 (78) 15 66 66 (36) Savings (loss) after taxes 12 (118) 23 98 98 (54) Depreciation 360 576 342 216 216 90 Incremental operating cash flow $372 $ 458 $365 $314 $314 $ 36
*MACRS Depreciation Schedule Year Base MACRS Depreciation Year 1 $1,800 20.0% $ Year 2 1,800 32.0% 576 Year 3 1,800 19.0% 342 Year 4 1,800 12.0% 216 Year 5 1,800 12.0% 216 Year 6 1,800 5.0% 90
c.
P11-20. Determining incremental operating cash flows
LG 5; Intermediate
Year 1 2 3 4 5 6 Revenues: (000) New buses $1,850 $1,850 $1,830 $1,825 $1,815 $1, Old buses 1,800 1,800 1,790 1,785 1,775 1, Incremental revenue $50 $50 $40 $40 $40 $ Expenses: (000) New buses $460 $460 $468 $472 $485 $ Old buses 500 510 520 520 530 535 Incremental expense $ (40) $ (50) $ (52) $ (48) $ (45) $ (35) Depreciation: (000) New buses $ 600 $ 960 $ 570 $ 360 $ 360 $ 150 Old buses 324 135 0 0 0 0 Incremental depr. $276 $825 $570 $360 $360 $ Incremental depr. tax savings @40% 110 330 228 144 144 60 Net Incremental Cash Flows Cash flows: (000) Revenues $50 $50 $40 $40 $40 $ Expenses 40 50 52 48 45 35 Less taxes @40% (36) (40) (37) (35) (34) (34) Depr. tax savings 110 330 228 144 144 60 Net operating cash inflows $164 $390 $283 $197 $195 $
P11-21. Terminal cash flows—various lives and sale prices
LG 6; Challenge a. After-tax proceeds from sale of new asset 3-Year *^ 5-Year ^ 7-Year * Proceeds from sale of proposed asset $10,000 $10,000 $10, Tax on sale of proposed asset^ 16,880 400 4, Total after-tax proceeds—new $26,880 $9,600 $ 6, Change in net working capital 30,000 30,000 30, Terminal cash flow $56,880 $39,600 $36,
*1. Book value of asset [1 (0.20 0.32 0.19)] $180,000 $52, Proceeds from sale $10, $10,000 $52,200 ($42,200) loss $42,200 (0.40) $16,880 tax benefit
- Book value of asset [1 (0.20 0.32 0.19 0.12 0.12)] $180,000 $9, $10,000 $9,000 $1,000 recaptured depreciation $1,000 (0.40) $400 tax liability
- Book value of asset $ $10,000 $0 $10,000 recaptured depreciation $10,000 (0.40) $4,000 tax liability b. If the usable life is less than the normal recovery period, the asset has not been depreciated fully and a tax benefit may be taken on the loss; therefore, the terminal cash flow is higher. c. (1) (2) After-tax proceeds from sale of new asset Proceeds from sale of new asset $ 9,000 $170, Tax on sale of proposed asset*^0 (64,400) Change in net working capital 30,000 30, Terminal cash flow $39,000 $135,
- Book value of the asset $180,000 0.05 $9,000; no taxes are due
- Tax ($170,000 $9,000) 0.4 $64,400. d. The higher the sale price, the higher the terminal cash flow.
P11-22. Terminal cash flow—replacement decision
LG 6; Challenge After-tax proceeds from sale of new asset Proceeds from sale of new machine $75, Tax on sale of new machinel^ (14,360) Total after-tax proceeds—new asset $60, After-tax proceeds from sale of old asset Proceeds from sale of old machine (15,000) Tax on sale of old machine^2 6, Total after-tax proceeds—old asset (9,000) Change in net working capital 25, Terminal cash flow $76, (^1) Book value of new machine at end of year 4: [1 (0.20 0.32 0.19 0.12) ($230,000)] $39, $75,000 $39,100 $35,900 recaptured depreciation $35,900 (0.40) $14,360 tax liability (^2) Book value of old machine at end of year 4: $ $15,000 $0 $15,000 recaptured depreciation $15,000 (0.40) $6,000 tax benefit
P11-24. Relevant cash flows—no terminal value
LG 3, 4, 5; Challenge a. Installed cost of new asset Cost of new asset $76, Installation costs 4, Total cost of new asset $80, After-tax proceeds from sale of old asset Proceeds from sale of old asset (55,000) Tax on sale of old asset*^ 16, Total proceeds, sale of old asset (38,800) Initial investment $41,
- (^) Book value of old machine: [1 (0.20 0.32 0.19)] $50,000 $14, $55,000 $14,500 $40,500 gain on asset $35,500 recaptured depreciation 0.40 $14, $5,000 capital gain 0.40 2, Total tax on sale of asset $16,
b.
Calculation of Operating Cash Flow Year (1) (2) (3) (4) (5) (6) Old Machine PBDT $14,000 $16,000 $20,000 $18,000 $14,000 $ 0 Depreciation 6,000 6,000 2,500 0 0 0 NPBT $ 8,000 $10,000 $17,500 $18,000 $14,000 0 Taxes 3,200 4,000 7,000 7,200 5,600 0 NPAT $ 4,800 $ 6,000 $10,500 $10,800 $ 8,400 $ 0 Depreciation 6,000 6,000 2,500 0 0 0 Cash flow $10,800 $12,000 $13,000 $10,800 $ 8,400 $ 0
New Machine PBDT $30,000 $30,000 $30,000 $30,000 $30,000 $ 0 Depreciation 16,000 25,600 15,200 9,600 9,600 4, NPBT $14,000 $ 4,400 $14,800 $20,400 $20,400 (^) $4, Taxes 5,600 1,760 5,920 8,160 8,160 (^) 1, NPAT $ 8,400 $ 2,640 $ 8,880 $12,240 $12,240 (^) $2, Depreciation 16,000 25,600 15,200 9,600 9,600 4, Cash flow $24,400 $28,240 $24,080 $21,840 $21,840 $1,
Incremental After-tax cash flows $13,600 $16,240 $11,080 $11,040 $13,440 $1,
c.
P11-25. Integrative—determining relevant cash flows
LG 3, 4, 5, 6; Challenge a. Initial investment: Installed cost of new asset Cost of new asset $105, Installation costs 5, Total cost of new asset $110, After-tax proceeds from sale of old asset Proceeds from sale of old asset (70,000) Tax on sale of old asset*^ 16, Total proceeds from sale of old asset (53,520) Change in working capital 12, Initial investment $ 68,
- (^) Book value of old asset: [1 (0.20 0.32)] $60,000 $28, $70,000 $28,800 $41,200 gain on sale of asset $31,200 recaptured depreciation 0.40 $12, $10,000 capital gain 0.40 4, Total tax of sale of asset $16, b. Calculation of Operating Cash Inflows
Year
Profits before Depreciation and Taxes Depreciation
Net Profits before Taxes Taxes
Net Profits after Taxes
Operating Cash Inflows New Grinder 1 $43,000 $22,000 $21,000 $8,400 $12,600 $34, 2 43,000 35,200 7,800 3,120 4,680 39, 3 43,000 20,900 22,100 8,840 13,260 34, 4 43,000 13,200 29,800 11,920 17,880 31, 5 43,000 13,200 29,800 11,920 17,880 31, 6 0 5,500 5,500 2,200 3,300 2, Existing Grinder 1 $26,000 $11,400 $14,600 $5,840 $8,760 $20, 2 24,000 7,200 16,800 6,720 10,080 17, 3 22,000 7,200 14,800 5,920 8,880 16, 4 20,000 3,000 17,000 6,800 10,200 13, 5 18,000 0 18,000 7,200 10,800 10, 6 0 0 0 0 0 0
P11-26. Personal finance: Determining relevant cash flows for a cash budget
LG 3, 4, 5, 6; Challenge Jan and Deana Cash Flow Budget Purchase of Boat a. Initial investment Total cost of new boat Add: Taxes (6.5%) Initial investment
b. Operating cash flows Year 1 Year 2 Year 3 Year 4 Maint. & repair 12 months at $800 $(9,600) $(9,600) $(9,600) $(9,600) Docking fees 12 months at $500 $(6,000) $(6,000) $(6,000) $(6,000) Operating cash flows $(15,600) $(15,600) $(15,600) $(15,600) c. Terminal cash flow—end of year 4 Proceeds from the sale of boat $40, d. Summary of cash flows Cash Flow Year zero End of year 1 End of year 2 End of year 3 End of year 4
e. The ownership of the boat is virtually just an annual outflow of money. Across the four years, $96,950 will be spent in excess of the anticipated sales price in year 4. Over the same time period, the disposable income is only $96,000. Consequently, if the costs exceed the expected disposable income. If cash flows were adjusted for their timing, and noting that the proceeds from the sale of the new boat comes in first at the end of year 4, Jan and Deana are in a position where they will have to increase their disposable income in order to accommodate boat ownership. If a loan is needed, the monthly interest payment would be another burden. However, there is no attempt here to measure satisfaction of ownership.
P11-27. Integrative—determining relevant cash flows
LG 3, 4, 5, 6; Challenge a. Initial Investment A B Installed cost of new asset Cost of new asset $ 40,000 $ 54, Installation costs 8,000 6, Total proceeds, sale of new asset 48,000 60, After-tax proceeds from sale of old asset Proceeds from sale of old asset (18,000) (18,000) Tax on sale of old asset *^ 3,488 3, Total proceeds, sale of old asset (14,512) (14,512) Change in working capital 4,000 6, Initial investment $37,488 $51, *Book value of old asset: [1 (0.20 0.32 0.19)] ($32,000) $9,
b.
Calculation of Operating Cash Inflows
Year
Profits before Depreciation and Taxes
Depre- ciation
Net Profits before Taxes Taxes
Net Profits after Taxes
Operating Cash Inflows Hoist A 1 $21,000 $9,600 $11,400 $4,560 $6,840 $16, 2 21,000 15,360 5,640 2,256 3,384 18, 3 21,000 9,120 11,880 4,752 7,128 16, 4 21,000 5,760 15,240 6,096 9,144 14, 5 21,000 5,760 15,240 6,096 9,144 14, 6 0 2,400 (^) 2,400 960 1,440 960 Hoist B 1 $22,000 $12,000 $10,000 $4,000 $6,000 18, 2 24,000 19,200 4,800 1,920 2,880 22, 3 26,000 11,400 14,600 5,840 8,760 20, 4 26,000 7,200 18,800 7,520 11,280 18, 5 26,000 7,200 18,800 7,520 11,280 18, 6 0 3,000 3,000 1,200 1,800 1, Existing Hoist 1 $14,000 $3,840 $10,160 $4,064 $6,096 $9, 2 14,000 3,840 10,160 4,064 6,096 9, 3 14,000 1,600 12,400 4,960 7,440 9, 4 14,000 0 14,000 5,600 8,400 8, 5 14,000 0 14,000 5,600 8,400 8, 6 0 0 0 0 0 0
Calculation of Incremental Cash Inflows Incremental Cash Flow Year Hoist A Hoist B Existing Hoist Hoist A Hoist B 1 $16,440 $18,000 $9,936 $6,504 $8, 2 18,744 22,080 9,936 8,808 12, 3 16,248 20,160 9,040 7,208 11, 4 14,904 18,480 8,400 6,504 10, 5 14,904 18,480 8,400 6,504 10, 6 960 1,200 0 960 1,
P11-28. Integrative—complete investment decision
LG 1, 2, 3, 4, 5, 6; Challenge a. Initial investment: Installed cost of new press Cost of new press $2,200, After-tax proceeds from sale of old asset Proceeds from sale of existing press (1,200,000) Taxes on sale of existing press*^ 480, Total after-tax proceeds from sale (720,000) Initial investment $1,480,
- (^) Book value $ $1,200,000 $0 $1,200,000 income from sale of existing press $1,200,000 income from sale (0.40) $480, b.
Calculation of Operating Cash Flows
Year Revenues Expenses Depreciation
Net Profits before Taxes Taxes
Net Profits after Taxes
Cash Flow 1 $1,600,000 $800,000 $440,000 $360,000 $144,000 $216,000 $656, 2 1,600,000 800,000 704,000 96,000 38,400 57,600 761, 3 1,600,000 800,000 418,000 382,000 152,800 229,200 647, 4 1,600,000 800,000 264,000 536,000 214,400 321,600 585, 5 1,600,000 800,000 264,000 536,000 214,400 321,600 585, 6 0 0 110,000 110,000 44,000 66,000 44,
c. Payback period 2 years ($62,400 $647,200) 2.1 years
d. PV of cash inflows: CF 0 $1,480,000, CF 1 $656,000, CF 2 $761,600, CF 3 $647,200, CF 4 $585,600, CF 5 585,600, CF 6 $44, Set I 11 Solve for NPV $959,
Year CF PVIF11%, n PV 1 $656,000 0.901 $ 591, 2 761,600 0.812 618, 3 647,200 0.731 473, 4 585,600 0.659 385, 5 585,600 0.593 347, 6 44,000 0.535 23, $2,439,
1 2 3 4 5 6
(1 IRR) (1 IRR) (1 IRR) (1 IRR) (1 IRR) (1 IRR)
IRR 35%
Calculator solution: 35.04% e. The NPV is a positive $959,289 and the IRR of 35% is well above the cost of capital of 11%. Based on both decision criteria, the project should be accepted.
P11-29. Integrative—investment decision
LG 1, 2, 3, 4, 5, 6; Challenge a. Initial investment: Installed cost of new asset Cost of the new machine $1,200, Installation costs 150, Total cost of new machine $1,350, After-tax proceeds from sale of old asset Proceeds from sale of existing machine (185,000) Tax on sale of existing machine*^ (79,600) Total after-tax proceeds from sale (264,600) Increase in net working capital 25, Initial investment $1,110, *Book value $384, $185,000 $384,000 $199,000 loss from sale of existing press $199,000 loss from sale (0.40) $79,
Calculation of Operating Cash Flows New Machine
Year
Reduction in Operating Costs Depreciation
Net Profits before Taxes Taxes
Net Profits after Taxes
Cash Flow
1 $350,000 $270,000 $80,000 $32,000 $48,000 $318, 2 350,000 432,000 82,000 32,800 49,200 382, 3 350,000 256,500 93,500 37,400 56,100 312, 4 350,000 162,000 188,000 75,200 112,800 274, 5 350,000 162,000 188,000 75,200 112,800 274, 6 0 67,500 67,500 27,000 40,500 27,
