Accounting Chapter 21 Homework Lucky Seven Assume That The Discount Received

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SOLUTION EXHIBIT 21-24

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21-25 (40 min.) New equipment purchase, income taxes.

Nikola Inc. is considering the purchase of a new industrial electric motor to improve efficiency at

its Rochester plant. The motor has an estimated useful life of 5 years. The estimated pretax cash

flows for the motor are shown in the table that follows, with no anticipated change in working

capital. Nikola has a 10% after-tax required rate of return and a 30% income tax rate. Assume

depreciation is calculated on a straight-line basis for tax purposes. Assume all cash flows occur

at year-end except for initial investment amounts.

Required:

1. Calculate (a) net present value, (b) payback period, (c) discounted payback period, and (d)

internal rate of return.

2. Compare and contrast the capital budgeting methods in requirement 1.

SOLUTION

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SOLUTION EXHIBIT 21-25

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21-26 (20 min.) Project choice, taxes.

Harrison Ventures has invested in a variety of retail outlets in key mall locations. Harrison is

contemplating an investment in upgrading the furnishings and fittings of these properties. The

upgrades will require an up-front investment of $100,000. Harrison estimates that they will yield

incremental margins of $43,000 annually due to higher foot traffic and sales and require

incremental cash maintenance costs of $15,000 annually. Harrison expects the life span of these

improvements at 5 years and estimates a terminal disposal value of $20,000.

Harrison faces a 30% income tax rate. It depreciates assets on a straight-line basis (to terminal

value) for tax purposes. The required rate of return on investments is 12%.

Required:

1. What is the expected increase in annual net income from investing in the improvements?

2. Calculate the accrual accounting rate of return based on average investment.

3. Is the project worth investing in from an NPV standpoint?

4. Suppose the tax authorities are willing to let Harrison depreciate the project down to zero

over its useful life. If Harrison plans to liquidate the project in 5 years, should it take this

option? Quantify the impact of this choice on the NPV of the project.

SOLUTION

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21-27 (40 min.) Customer value.

Ortel Telecom sells telecommunication products and services to a variety of small businesses.

Two of Ortel’s key clients are Square and Cloudburst, both fast-growing technology start- ups

located in New York City. Ortel has compiled information regarding its transactions with Square

and Cloudburst for 2014, as well as its expectations regarding their interactions for the next 3

years:

Ortel’s transactions with Square and Cloudburst are in cash. Assume that they occur at year-end.

Ortel is headquartered in the Cayman Islands and pays no income taxes. The owners of Ortel

insist on a required rate of return of 12%.

Required:

1. What is the expected net cash flow from Square and Cloudburst for the next 3 years?

2. Based on the net present value from cash flows over the next 3 years, is Cloudburst or Square

a more valuable customer for Ortel?

3. Cloudburst threatens to switch to another supplier unless Ortel gives a 10% price reduction

on all sales starting in 2015. Calculate the 3-year NPV of Cloudburst after incorporating the

10% discount. Should Ortel continue to transact with Cloudburst? What other factors should

it consider before making its final decision?

SOLUTION

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$513,430

21-28 (60 min.) Selling a plant, income taxes.

(CMA, adapted) The Lucky Seven Company is an international clothing manufacturer. Its

Redmond plant will become idle on December 31, 2014. Peter Laney, the corporate controller,

has been asked to look at three options regarding the plant:

▪ Option 1: The plant, which has been fully depreciated for tax purposes, can be sold

immediately for $900,000.

▪ Option 2: The plant can be leased to the Preston Corporation, one of Lucky Seven’s

suppliers, for 4 years. Under the lease terms, Preston would pay Lucky Seven $220,000

rent per year (payable at year-end) and would grant Lucky Seven a $40,000 annual

discount off the normal price of fabric purchased by Lucky Seven. (Assume that the

discount is received at year-end for each of the 4 years.) Preston would bear all of the

plant’s ownership costs. Lucky Seven expects to sell this plant for $150,000 at the end of

the 4-year lease.

▪ Option 3: The plant could be used for 4 years to make souvenir jackets for the Olympics.

Fixed over- head costs (a cash outflow) before any equipment upgrades are estimated to be

$20,000 annually for the 4-year period. The jackets are expected to sell for $55 each.

Variable cost per unit is expected to be $43. The following production and sales of jackets

are expected: 2015, 18,000 units; 2016, 26,000 units; 2017, 30,000 units; 2018, 10,000

units. In order to manufacture the jackets, some of the plant equipment would need to be

upgraded at an immediate cost of $160,000. The equipment would be depreciated using the

straight-line depreciation method and zero terminal disposal value over the 4 years it would

be in use. Because of the equipment upgrades, Lucky Seven could sell the plant for

$270,000 at the end of 4 years. No change in working capital would be required.

Lucky Seven treats all cash flows as if they occur at the end of the year, and it uses an after-tax

required rate of return of 10%. Lucky Seven is subject to a 35% tax rate on all income, including

capital gains.

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Required:

1. Calculate net present value of each of the options and determine which option Lucky Seven

should select using the NPV criterion.

2. What nonfinancial factors should Lucky Seven consider before making its choice?

SOLUTION

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SOLUTION EXHIBIT 21-28

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21-29 (60 min.) Equipment replacement, no income taxes.

Clean Chips is a manufacturer of prototype chips based in Dublin, Ireland. Next year, in 2015,

Clean Chips expects to deliver 535 prototype chips at an average price of $55,000. Clean Chips’

marketing vice president forecasts growth of 65 prototype chips per year through 2021. That is,

demand will be 535 in 2015, 600 in 2016, 665 in 2017, and so on.

The plant cannot produce more than 525 prototype chips annually. To meet future demand,

Clean Chips must either modernize the plant or replace it. The old equipment is fully depreciated

and can be sold for $4,300,000 if the plant is replaced. If the plant is modernized, the costs to

modernize it are to be capitalized and depreciated over the useful life of the updated plant. The

old equipment is retained as part of the modernize alternative. The following data on the two

options are available:

Clean Chips uses straight-line depreciation, assuming zero terminal disposal value. For

simplicity, we assume no change in prices or costs in future years. The investment will be made

at the beginning of 2015, and all transactions thereafter occur on the last day of the year. Clean

Chips’ required rate of return is 10%.

There is no difference between the modernize and replace alternatives in terms of required

working capital. Clean Chips has a special waiver on income taxes until 2021.

Required:

1. Sketch the cash inflows and outflows of the modernize and replace alternatives over the

2015–2021 period.

2. Calculate payback period for the modernize and replace alternatives.

3. Calculate net present value of the modernize and replace alternatives.

4. What factors should Clean Chips consider in choosing between the alternatives?

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SOLUTION

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21-30 (40 min.) Equipment replacement, income taxes (continuation of 21-29).

Assume the same facts as in Problem 21-29, except that the plant is located in Austin, Texas.

Clean Chips has no special waiver on income taxes. It pays a 30% tax rate on all income.

Proceeds from sales of equipment above book value are taxed at the same 30% rate.

Required:

1. Sketch the after-tax cash inflows and outflows of the modernize and replace alternatives over

the 2015–2021 period.

2. Calculate the net present value of the modernize and replace alternatives.

3. Suppose Clean Chips is planning to build several more plants. It wants to have the most

advantageous tax position possible. Clean Chips has been approached by Spain, Malaysia,

and Australia to construct plants in their countries. Use the data in Problem 21-29 and this

problem to briefly describe in qualitative terms the income tax features that would be

advantageous to Clean Chips.

SOLUTION

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