Ch 11 &12 Capital Budgeting

Problem #1 1. Anderson Systems is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that if a project's projected NPV is negative, it should be rejected. WACC: 9.00% Year 0 1 2 3 Cash flows -$1,000 $500 $500 $500

Problem #1 Problem #1

Problem #2 2. Taggart Inc. is considering a project that has the following cash flow data. What is the project's payback? Year 0 1 2 3 Cash flows -$1,150 $500 $500 $500

Problem #2 2.30 years 500+ 500+ 150/500= 2.3 YEARS

Payback Example Examine the three projects and note the mistake we would make if we insisted on only taking projects with a payback period of 2 years or less.

Problem #3 3. Simms Corp. is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be less than the WACC or negative, in both cases it will be rejected.

Problem #3 Year 0 1 2 3 Cash flows -$1,000$425 $425 $425

Problem #4 As a member of GOLD Corporation's financial staff, you must estimate the Year 1 operating net cash flow for a proposed project with the following data.  What is the Year 1 operating cash flow?         Sales $66,000       Depreciation                   $20,000       Other operating costs       $34,000       Interest expense                $8,000       Tax rate                           35%

Problem #4 Sales Revenue                                                 $66,000 Operating costs(x-depr)                                 $34,000 Depreciation expense                                      $20,000 ____________________________________________ Operating income (EBIT)                                $12,000 -Taxes                                                                -$4,200 ____________________________________________ After-tax EBIT                                                  $7,800 + Depreciation                                                   $20,000 ____________________________________________ Operating cash flow                                           $27,800

Problem #5 DelL Software is considering a new project whose data are shown below. The equipment that would be used has a 5-year tax life, after which it will be worthless, and it will be depreciated by the straight line method over 5 years. Revenues and other operating costs are expected to be constant over the project's 5-year life.  What is the project's operating cash flow during Year 1?         Equipment cost (depreciable basis)       $100,000       Straight line depreciation rate           20%       Sales $150,000       Operating costs excl. depr’n              $50,000       Tax rate                                     50%

Problem #5 Sales Revenues                                          $150,000 -Operating costs (x-depr)                           -$50,000 -Basis x rate = depreciation =                     -$20,000                                                                   -------------- Operating income (EBIT)                             $80,000 -Taxes                                                           -$ 40,000                                                                    ------------- After-tax EBIT                                             $40,000 +Depreciation                                               $20,000 __________________________________________ Operating cash flow, Year 1                         $60,000 

Problem #6 Ahwanee Resorts 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 the project's 3 year life, and would have 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? (Hint: Cash flows are constant in Years 1-3.)         WACC  10%       Net investment cost (depreciable basis)        $100,000       Straight line depr™n rate                        33.33%       Sales revenues                                  $200,000       Operating costs excl. depr™n                    $60,000       Tax rate                                            50%

Problem #6 Solution:

Problem #7 7.Big DIG Services is now in the final year of a project.  The equipment originally cost $2 million, of which 50% has been depreciated.  Big DIG can sell the used equipment today for $1.2 million, and its tax rate is 50%.  What is the equipment’s after-tax net salvage value?

Problem #7 Equipment cost                                                    $2,000,000 -Accumulated depr'n                                            $1,000,000 Current BV of equipment                                      1,000,000 Market value                                                          $1,200,000 Gain(loss) on sale of equip                                    $200,000 Taxes paid (credited)                                              100,000 After-tax net salvage value                                      100,000

Problem #8 You work for Beta Inc., and you must estimate the Year 1 operating net cash flow for a proposed project with the following data.  What is the Year 1 operating cash flow?         Sales $42,000       Depreciation                    $8,000       Other operating costs     $12,000       Tax rate                            50%

Problem #8 Sales revenues                       $42,000 -Operating costs (x-depr)    $12,000 -Depreciation expense          $8,000                                             --------------- Operating income (EBIT)     $22,000 -Taxes                                      $ 11,000 After-tax EBIT                        $11,000 + Depreciation                         $8,000 Operating cash flow              $19,000