Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
8-1
Chapter 8
Answers to Review Problems
Finance For Executives – 4th Edition
1. Pondering an investment offer.
The offer is not firidiculous.” The problem is that the cash flows in the deal have been incorrectly
specified. The $15,000 investment promises a $17,000 payoff in one year. The filess than 4 percent”
return calculation is presumably based on a payoff of $17,000 less 12 percent interest on $12,000 or a net
2. The effect of inflation on the investment decision.
The financial manager is correct. Why? The accountant is arguing that the projected cash flows (the
numerator in the equation) are nominal amounts. That is, they assume some rate of inflation. It is
impossible to predict inflation rates very far into the future, so taking the most recent government figures
3. Changing machines in a world without taxes.
For all questions from a. to d., the first issue is the estimation of the project’s economic or useful life. The
existing machine can last another 10 or more years. However, the new one, which will perform exactly
the same operations, has an economic life of only 5 years, which means that it will be obsolete within 5
8-2
a.
By changing machines, the cash position of Clampton will immediately decrease by $110,000, the
difference between the purchase price of the new machine ($110,000) and the resale price ($0) of the
existing one. And then, each year for the following 5 years, the cash flow of Clampton will increase by
$30,000.
Using a spreadsheet
A
B
C
D
E
F
G
1
Now
Year-end
1
Year-end
2
Year-end
3
Year-end
4
Year-end
5
2
3
Cash flow from project
-$110,000
$30,000
$30,000
$30,000
$30,000
$30,000
4
According to the net present value rule, the machine should be changed. Note that the depreciation
expenses related to the new machine have no effect on the decision, although it will negatively affect its
net profit in the next 5 years. This is totally rational since depreciation expenses are not cash expenses.
b.
c.
Using a spreadsheet
8-3
A
B
C
D
E
F
G
1
Now
Year-end
1
Year-end
2
Year-end
3
Year-end
4
Year-end
5
2
3
Cash flow from project
-$150,000
$40,000
$40,000
$40,000
$40,000
$40,000
10
1
2
3
4
5
11
12
Discounted cash inflows
$36,364
$33,058
$30,053
$27,321
$24,837
13
14
Accumulated discounted
cash flows
$36,364
$69,421
$99,474
$126,795
$151,631
15
According to the net present value rule, machine B should be purchased.
d.
If a mistake has been made, it is in the estimation of the economic life of Machine A. The decision taken
two years ago was taken with the assumption that its economic life was 5 years, when actually it was 2
years. Had the net present value analysis been done for 2 years instead of 5 years, Machine A would not
have been a positive net present value proposition.
8-4
4. Changing machines in a world with taxes.
a.
Using a spreadsheet
A
B
C
D
E
F
G
1
Now
Year-end
1
Year-end
2
Year-end
3
Year-end
4
Year-end
5
2
3
Purchase of new machine
-$110,000
Savings before depreciation
8
Change in Clampton’s
operating profit after tax
$4,800
$4,800
$4,800
$4,800
$4,800
9
Cash flow from project
-$110,000
$26,800
$26,800
$26,800
$26,800
$26,800
10
11
Cost of capital
8%
12
According to the net present value rule, the machine should not be changed, contrary to the case when the
company is not taxed, because the net present value is negative (minus $2,995). Taxes have three effects
on the estimation of the net present value:
• They decrease the cash flow after tax and before depreciation.
• They increase the cash flow by the amount of the depreciation tax shield (Tax rate × Depreciation
expenses).
8-5
b.
Using a spreadsheet
A
B
C
D
E
F
G
1
Now
Year-end
1
Year-end
2
Year-end
3
Year-end
4
Year-end
5
2
3
Purchase of new machine
-$110,000
4
Savings before depreciation and tax
$30,000
$30,000
$30,000
$30,000
$30,000
Increase in depreciation allowances
10
Change in Clampton’s operating
profit after tax
$9,600
$9,600
$9,600
$9,600
$9,600
11
Book value of old machine
$40,000
12
Tax credit from writing off old
machine
$16,000
13
Cash flow from project
-$94,000
$23,600
$23,600
$23,600
$23,600
$23,600
14
15
Cost of capital
8%
16
17
Net present value
$228
18
19
The values in rows 3, 4, 6, 9, 11, and 15 are data.
According to the net present value rule, the machine should be changed because the net present value is
positive, although nearly insignificantly positive ($228).
8-6
5. Investing in the production of toys.
a.
The cash flows (CFt) generated by the project can be estimated from equation (8.2):
CFt = EBITt(1 – Taxt) + Dept – WCRt – Capext
Using a calculator
$ thousands
Now
Year 1 to 4
Year 5
1. Revenues
$10,800
$10,800
2. Unit produced in thousands (3,000 per month)
36
36
3. Raw material cost per thousand units
$95
$95
4. Total material cost (line 2 × line 3)
$3,420
$3,420
5. Direct cost ($130,000 per month)
$1,560
$1,560
b.
The net present value (NPV) in thousand dollars of the project is:
8-7
Using a spreadsheet
A
B
C
D
E
F
G
1
in thousands
Now
Year-end
1
Year-end
2
Year-end
3
Year-end
4
Year-end
5
2
3
Revenues
$10,800
$10,800
$10,800
$10,800
$10,800
4
Units produced
36
36
36
36
36
5
Raw material cost per
thousand units
$95
$95
$95
$95
$95
6
Total material cost
$3,420
$3,420
$3,420
$3,420
$3,420
7
Direct cost
$1,560
$1,560
$1,560
$1,560
$1,560
18
Tax on resale of equipment
$320
19
Total cash flow
-$16,435
$4,772
$4,772
$4,772
$4,772
$5,687
20
21
Cost of capital
12%
22
23
Net present value
$1,286.188
24
25
The values in rows 3, 4, 5, 7, 10, 12, 13, 16, 17, and 21 are data.
26
The formula in cell C6 is: =C4*C5. Then copy formula in cell C6 to cells D6, E6, F6, and G6.
8-8
6. The effect of accounts receivables, accounts payables, overhead, and financial costs on
the investment decision.
a.
The new product would increase both accounts receivable and accounts payable. Annual sales of $12
million spread evenly over the year would mean $32,877 per day ($12 million/365 days). If the collection
period on average were 50 days, this would mean an extra investment (an increase in the firm’s accounts
receivable) of $1,643,836 ($32,877 50). For simplicity, let us assume that this would take place at time
Using a spreadsheet
A
B
C
D
E
F
G
1
Now
Year-end
1
Year-end
2
Year-end
3
Year-end
4
Year-end
5
2
3
Increase in firm's accounts
receivable
$1,643,836
$0
$0
$0
$0
-
$1,643,836
4
Increase in firm's accounts
payable
$394,521
$0
$0
$0
$0
-$394,521
Increase in firm's
working capital
-
b.
The standard charge of one percent of revenues needs a careful look. While it is reasonable to expect
some impact on general overheads from the addition of a new product, an incremental cost amounting to
8-9
Using a spreadsheet
A
B
C
D
E
F
G
1
Now
Year-end
1
Year-end
2
Year-end
3
Year-end
4
Year-end
5
2
3
Overhead charges increase
$120,000
$120,000
$120,000
$120,000
$120,000
c.
The financing charge of 10 percent levied against the book value of assets used in the project is a fired
herring.” We should not bring financing costs into the cash flows since they are already included in the
discount rate. To deduct them from the cash flows would result in double-counting.
7. The effect of depreciation for tax purposes.
Using a spreadsheet
A move imposed by the tax authorities from MACRS to the straight-line method of depreciation will
systematically decrease the net present value of any investment project. In our case, the net present value
will decrease by $805 ($13,145 – $12,340) for an investment of $50,000.
A
B
C
D
E
F
G
H
1
Now
Year-end
1
Year-end
2
Year-end
3
Year-end
4
Year-end
5
Year-end
6
2
3
Cost of automobile
$50,000
4
I. Under MACRS
5
MACRS allowances
20.00%
32.00%
19.20%
11.52%
11.52%
5.76%
8-10
14
II. Under straight-line system
15
Depreciation allowance
$8,333
$8,333
$8,333
$8,333
$8,333
$8,333
16
Depreciation tax shield
$2,833
$2,833
$2,833
$2,833
$2,833
$2,833
17
18
Present value of tax
shield
$12,340
19
20
The values in rows 3, 5, 7, and10 are data
8. The effect of cannibalization.
These three items must each be handled differently. The $500,000 market study is a sunk cost. It has
already been made and paid for. Whether the new project is taken or not, the cash flow has occurred.
Therefore, this sum should be left out of the analysis.
Using a spreadsheet
A
B
C
D
E
F
G
1
Now
Year-end
1
Year-end
2
Year-end
3
Year-end
4
Year-end
5
2
3
Loss of rental revenue
$100,000
$100,000
$100,000
$100,000
$100,000
4
5
Cost of capital
11%
9. Break-even analysis.
Using a spreadsheet
A
B
C
D
E
F
G
1
Now
Year-end
1
Year-end
2
Year-end
3
Year-end
4
Year-end
5
2
I. Base case
3
Initial investment
-
$1,000,000
4
Number of snowmobiles sold
100
100
100
100
100
10
Depreciation expense
$200,000
$200,000
$200,000
$200,000
$200,000
11
Operating profit (EBIT)
$175,000
$175,000
$175,000
$175,000
$175,000
12
Tax rate
40%
40%
40%
40%
40%
13
Operating profit after tax
$105,000
$105,000
$105,000
$105,000
$105,000
14
Cash flow from the project
-
$1,000,000
$305,000
$305,000
$305,000
$305,000
$305,000
8-12
22
The formula in cell C8 is: =C7*C4. Then copy formula in cell C8 to cells D8, E8, F8, and G8.
28
29
II. Break- even analysis
30
Number of snowmobiles
sold per year
50
60
70
80
90
100
31
Net present value
-$412,428
-$298,704
-$184,981
-$71,257
$42,466
$156,190
32
a.
The spreadsheet analysis indicates that the project should be undertaken for the expected sale of 100
snowmobiles per year since the net present value is positive under this assumption ($156,190).
b.
The graph shows that the break-even sales level, which is the number of snowmobiles to sell every year
Net present value
Number of units
8-13
so that
Cash flow = [Revenues – Variable costs – Fixed costs – Depreciation expenses] × (1 – Tax rate) +
Depreciation expenses
Let Q be the number of snowmobiles sold per year. Then:
Unit sales price = $10
Unit variable cost = $5
Tax rate = 40 percent
Fixed costs = $125
Depreciation expenses = $200
Replacing the variables in the above equation by their values, we get:
Q = [$1,000 – PV($5)]/PV($3)
The present value of an annuity of $5 per year at 10 percent is $18.95, that of an annuity of $3 is $11.37,
so that:
Q = [$1,000 – $18.95]/$11.37 = 87
10. Bid price.
The cash flows of the project are:
A
B
C
D
E
F
G
1
Now
Year-end
1
Year-end
2
Year-end
3
Year-end
4
Year-end
5
The value of the cash flow, CF, for which the project’s net present value is zero, must verify the following
equation:
55432 )10.1(
000,30$
)10.1(
CF
)10.1(
CF
)10.1(
CF
)10.1(
CF
)10.1(
CF
000,130$0 +
+
+
+
+
+
+
+
+
+
+
+−=
or
From equation 8.2:
CF = EBIT (1 – Tax) + Depreciation expenses
(Note there is no change in working capital requirement nor any new capital expenditure expected over
the five-year period.)
8-15
so that
$15,633 = Revenues – $80,000 – $20,000
Revenues = $80,000 + $20,000 + $15,633 = $115,633
Maintainit Inc. must submit a bid of no less than $115,633 per year for the project to have a positive net
present value.
