Determine the terminal cash flow associated with a proposed capital

LG 6 Determine the terminal cash flow associated with a proposed capital

expenditure. The terminal cash flow represents the after-tax cash flow (exclusive of operating cash inflows) that is expected from liquidation of a project. It is calculated for replacement projects by finding the difference between the after- tax proceeds from sale of the new and the old asset at termination and then adjusting this difference for any change in net working capital. Sale price and depreciation data are used to find the taxes and the after-tax sale proceeds on the new and old assets. The change in net working capital typically represents the reversion of any initial net working capital investment.

Opener-in-Review

The chapter opener talked about ExxonMobil’s considerable investment in long-term projects and the sometimes difficult task of having projects come in on budget. How are project cash flows affected by budget overruns? In the capital budgeting process, how should financial managers account for the

CHAPTER 11

Capital Budgeting Cash Flows

Self-Test Problems (Solutions in Appendix)

LG 3 LG 4 ST11–1 Book value, taxes, and initial investment Irvin Enterprises is considering the pur- chase of a new piece of equipment to replace the current equipment. The new equip- ment costs $75,000 and requires $5,000 in installation costs. It will be depreciated under MACRS using a 5-year recovery period. The old piece of equipment was pur- chased 4 years ago for an installed cost of $50,000; it was being depreciated under MACRS using a 5-year recovery period. The old equipment can be sold today for $55,000 net of any removal or cleanup costs. As a result of the proposed replace- ment, the firm’s investment in net working capital is expected to increase by $15,000. The firm pays taxes at a rate of 40%. (Table 4.2 on page 117 contains the applicable MACRS depreciation percentages.)

a. Calculate the book value of the old piece of equipment. b. Determine the taxes, if any, attributable to the sale of the old equipment. c. Find the initial investment associated with the proposed equipment replacement.

LG 3 LG 4 ST11–2 Determining relevant cash flows

A machine currently in use was originally pur- chased 2 years ago for $40,000. The machine is being depreciated under MACRS

LG 5 LG 6 using a 5-year recovery period; it has 3 years of usable life remaining. The current machine can be sold today to net $42,000 after removal and cleanup costs. A new

machine, using a 3-year MACRS recovery period, can be purchased at a price of $140,000. It requires $10,000 to install and has a 3-year usable life. If the new machine is acquired, the investment in accounts receivable will be expected to rise by $10,000, the inventory investment will increase by $25,000, and accounts payable will increase by $15,000. Earnings before depreciation, interest, and taxes are expected to be $70,000 for each of the next 3 years with the old machine and to be $120,000 in the first year and $130,000 in the second and third years with the new machine. At the end of 3 years, the market value of the old machine will equal zero, but the new machine could be sold to net $35,000 before taxes. The firm is subject to a 40% tax rate. (Table 4.2 on page 117 contains the applicable MACRS deprecia- tion percentages.)

a. Determine the initial investment associated with the proposed replacement

decision. b. Calculate the incremental operating cash inflows for years 1 to 4 associated with

the proposed replacement. ( Note: Only depreciation cash flows must be consid- ered in year 4.)

c. Calculate the terminal cash flow associated with the proposed replacement deci-

sion. ( Note: This is at the end of year 3.) d. Depict on a time line the relevant cash flows found in parts a, b, and c that are

associated with the proposed replacement decision, assuming that it is terminated at the end of year 3.

Warm-Up Exercises All problems are available in

LG 2 E11–1 If Halley Industries reimburses employees who earn master’s degrees and who agree to remain with the firm for an additional 3 years, should the expense of the tuition

PART 5

Long-Term Investment Decisions

LG 2 E11–2 Iridium Corp. has spent $3.5 billion over the past decade developing a satellite- based telecommunication system. It is currently trying to decide whether to spend an

additional $350 million on the project. The firm expects that this outlay will finish the project and will generate cash flow of $15 million per year over the next 5 years.

A competitor has offered $450 million for the satellites already in orbit. Classify the firm’s outlays as sunk costs or opportunity costs, and specify the relevant cash flows.

LG 3 LG 4 E11–3 Canvas Reproductions, Inc., has spent $4,500 dollars researching a new project. The project requires $20,000 worth of new machinery, which would cost $3,000 to

install. The company would realize $4,500 in after-tax proceeds from the sale of old machinery. If Canvas’s working capital is unaffected by this project, what is the ini- tial investment amount for this project?

LG 3 LG 4 E11–4 A few years ago, Largo Industries implemented an inventory auditing system at an installed cost of $175,000. Since then, it has taken depreciation deductions totaling $124,250. What is the system’s current book value? If Largo sold the system for $110,000, how much recaptured depreciation would result?

LG 5 E11–5 Bryson Sciences is planning to purchase a high-powered microscopy machine for $55,000 and incur an additional $7,500 in installation expenses. It is replacing sim-

ilar microscopy equipment that can be sold to net $35,000, resulting in taxes from a gain on the sale of $11,250. Because of this transaction, current assets will increase by $6,000 and current liabilities will increase by $4,000. Calculate the initial invest- ment in the high-powered microscopy machine.

Problems All problems are available in

LG 2 P11–1 Classification of expenditures Given the following list of outlays, indicate whether each is normally considered a capital expenditure or an operating expenditure. Explain your answers.

a. An initial lease payment of $5,000 for electronic point-of-sale cash register sys-

tems. b. An outlay of $20,000 to purchase patent rights from an inventor. c. An outlay of $80,000 for a major research and development program. d. An $80,000 investment in a portfolio of marketable securities. e. A $300 outlay for an office machine. f. An outlay of $2,000 for a new machine tool. g. An outlay of $240,000 for a new building. h. An outlay of $1,000 for a marketing research report.

LG 1 LG 2 P11–2 Relevant cash flow and timeline depiction For each of the following projects, determine the relevant cash flows, and depict the cash flows on a time line.

a. A project that requires an initial investment of $120,000 and will generate annual operating cash inflows of $25,000 for the next 18 years. In each of the

18 years, maintenance of the project will require a $5,000 cash outflow. b. A new machine with an installed cost of $85,000. Sale of the old machine will yield $30,000 after taxes. Operating cash inflows generated by the replacement

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Capital Budgeting Cash Flows

year of a 6-year period. At the end of year 6, liquidation of the new machine will yield $20,000 after taxes, which is $10,000 greater than the after-tax proceeds expected from the old machine had it been retained and liquidated at the end of year 6.

c. An asset that requires an initial investment of $2 million and will yield annual operating cash inflows of $300,000 for each of the next 10 years. Operating cash outlays will be $20,000 for each year except year 6, when an overhaul requiring an additional cash outlay of $500,000 will be required. The asset’s liquidation value at the end of year 10 is expected to be zero.

LG 3 P11–3 Expansion versus replacement cash flows Edison Systems has estimated the cash flows over the 5-year lives for two projects, A and B. These cash flows are summa-

rized in the table below. a. If project A were actually a replacement for project B and if the $12,000 initial investment shown for project B were the after-tax cash inflow expected from liq- uidating it, what would be the relevant cash flows for this replacement decision?

b. How can an expansion decision such as project A be viewed as a special form of a replacement decision? Explain.

Project A

Project B

Initial investment

Operating cash inflows

a After-tax cash inflow expected from liquidation.

LG 2 P11–4 Sunk costs and opportunity costs Masters Golf Products, Inc., spent 3 years and $1,000,000 to develop its new line of club heads to replace a line that is becoming obsolete. To begin manufacturing them, the company will have to invest $1,800,000 in new equipment. The new clubs are expected to generate an increase in operating cash inflows of $750,000 per year for the next 10 years. The company has deter- mined that the existing line could be sold to a competitor for $250,000.

a. How should the $1,000,000 in development costs be classified? b. How should the $250,000 sale price for the existing line be classified? c. Depict all of the known relevant cash flows on a time line.

LG 2 P11–5 Sunk costs and opportunity costs Covol Industries is developing the relevant cash flows associated with the proposed replacement of an existing machine tool with a new, technologically advanced one. Given the following costs related to the pro- posed project, explain whether each would be treated as a sunk cost or an opportunity cost in developing the relevant cash flows associated with the proposed replacement decision.

a. Covol would be able to use the same tooling, which had a book value of

PART 5

Long-Term Investment Decisions

b. Covol would be able to use its existing computer system to develop programs for operating the new machine tool. The old machine tool did not require these pro- grams. Although the firm’s computer has excess capacity available, the capacity could be leased to another firm for an annual fee of $17,000.

c. Covol would have to obtain additional floor space to accommodate the larger new machine tool. The space that would be used is currently being leased to another company for $10,000 per year.

d. Covol would use a small storage facility to store the increased output of the new machine tool. The storage facility was built by Covol 3 years earlier at a cost of $120,000. Because of its unique configuration and location, it is currently of no use to either Covol or any other firm.

e. Covol would retain an existing overhead crane, which it had planned to sell for its $180,000 market value. Although the crane was not needed with the old machine tool, it would be used to position raw materials on the new machine tool.

Personal Finance Problem

LG 2 P11–6 Sunk and opportunity cash flows Dave and Ann Stone have been living at their present home for the past 6 years. During that time, they have replaced the water

heater for $375, have replaced the dishwasher for $599, and have had to make mis- cellaneous repair and maintenance expenditures of approximately $1,500. They have decided to move out and rent the house for $975 per month. Newspaper adver- tising will cost $75. Dave and Ann intend to paint the interior of the home and power-wash the exterior. They estimate that that will run about $900.

The house should be ready to rent after that. In reviewing the financial situa- tion, Dave views all the expenditures as being relevant, and so he plans to net out the estimated expenditures discussed above from the rental income.

a. Do Dave and Ann understand the difference between sunk costs and opportunity costs? Explain the two concepts to them.

b. Which of the expenditures should be classified as sunk cash flows and which

should be viewed as opportunity cash flows?

LG 3 P11–7 Book value Find the book value for each of the assets shown in the accompanying table, assuming that MACRS depreciation is being used. ( Note: See Table 4.2 on page 117 for the applicable depreciation percentages.)

Recovery Elapsed time

period

since purchase

Asset

Installed cost

LG 3 LG 4 P11–8 Book value and taxes on sale of assets Troy Industries purchased a new machine 3 years ago for $80,000. It is being depreciated under MACRS with a 5-year recovery period using the percentages given in Table 4.2 on page 117 . Assume a 40% tax rate.

a. What is the book value of the machine? b. Calculate the firm’s tax liability if it sold the machine for each of the following

CHAPTER 11

Capital Budgeting Cash Flows

LG 3 LG 4 P11–9 Tax calculations For each of the following cases, determine the total taxes resulting from the transaction. Assume a 40% tax rate. The asset was purchased 2 years ago

for $200,000 and is being depreciated under MACRS using a 5-year recovery period. (See Table 4.2 on page 117 for the applicable depreciation percentages.)

a. The asset is sold for $220,000. b. The asset is sold for $150,000. c. The asset is sold for $96,000. d. The asset is sold for $80,000.

LG 3 P11–10 Change in net working capital calculation Samuels Manufacturing is considering the purchase of a new machine to replace one it believes is obsolete. The firm has

total current assets of $920,000 and total current liabilities of $640,000. As a result of the proposed replacement, the following changes are anticipated in the levels of the current asset and current liability accounts noted.

Marketable securities Inventories

Accounts payable

Notes payable Accounts receivable

a. Using the information given, calculate any change in net working capital that is expected to result from the proposed replacement action.

b. Explain why a change in these current accounts would be relevant in determining the initial investment for the proposed capital expenditure.

c. Would the change in net working capital enter into any of the other cash flow components that make up the relevant cash flows? Explain.

LG 3 LG 4 P11–11 Calculating initial investment Vastine Medical, Inc., is considering replacing its existing computer system, which was purchased 2 years ago at a cost of $325,000. The system can be sold today for $200,000. It is being depreciated using MACRS and a 5-year recovery period (see Table 4.2, page 117 ). A new computer system will cost $500,000 to purchase and install. Replacement of the computer system would not involve any change in net working capital. Assume a 40% tax rate.

a. Calculate the book value of the existing computer system. b. Calculate the after-tax proceeds of its sale for $200,000. c. Calculate the initial investment associated with the replacement project.

LG 3 LG 4 P11–12 Initial investment—Basic calculation Cushing Corporation is considering the pur- chase of a new grading machine to replace the existing one. The existing machine was purchased 3 years ago at an installed cost of $20,000; it was being depreciated under MACRS using a 5-year recovery period. (See Table 4.2 on page 117 for the applicable depreciation percentages.) The existing machine is expected to have a usable life of at least 5 more years. The new machine costs $35,000 and requires

PART 5

Long-Term Investment Decisions

under MACRS. The existing machine can currently be sold for $25,000 without incurring any removal or cleanup costs. The firm is subject to a 40% tax rate. Calculate the initial investment associated with the proposed purchase of a new

grading machine. LG 3 LG 4 P11–13 Initial investment at various sale prices Edwards Manufacturing Company (EMC)

is considering replacing one machine with another. The old machine was purchased 3 years ago for an installed cost of $10,000. The firm is depreciating the machine under MACRS, using a 5-year recovery period. (See Table 4.2 on page 117 for the applicable depreciation percentages.) The new machine costs $24,000 and requires $2,000 in installation costs. The firm is subject to a 40% tax rate. In each of the fol- lowing cases, calculate the initial investment for the replacement.

a. EMC sells the old machine for $11,000. b. EMC sells the old machine for $7,000. c. EMC sells the old machine for $2,900. d. EMC sells the old machine for $1,500.

LG 3 LG 4 P11–14 Calculating initial investment DuPree Coffee Roasters, Inc., wishes to expand and modernize its facilities. The installed cost of a proposed computer-controlled

automatic-feed roaster will be $130,000. The firm has a chance to sell its 4-year-old roaster for $35,000. The existing roaster originally cost $60,000 and was being depreciated using MACRS and a 7-year recovery period (see Table 4.2 on page 117 ). DuPree is subject to a 40% tax rate.

a. What is the book value of the existing roaster? b. Calculate the after-tax proceeds of the sale of the existing roaster. c. Calculate the change in net working capital using the following figures:

Anticipated Changes in Current Assets and Current Liabilities

Accounts payable

Accounts receivable

Cash Notes payable

d. Calculate the initial investment associated with the proposed new roaster.

LG 5 P11–15 Depreciation

A firm is evaluating the acquisition of an asset that costs $64,000 and requires $4,000 in installation costs. If the firm depreciates the asset under MACRS, using a 5-year recovery period (see Table 4.2 on page 117 for the appli- cable depreciation percentages), determine the depreciation charge for each year.

LG 5 P11–16 Incremental operating cash inflows

A firm is considering renewing its equipment to meet increased demand for its product. The cost of equipment modifications is $1.9 million plus $100,000 in installation costs. The firm will depreciate the equip- ment modifications under MACRS, using a 5-year recovery period. (See Table 4.2 on page 117 for the applicable depreciation percentages.) Additional sales revenue

CHAPTER 11

Capital Budgeting Cash Flows

expenses and other costs (excluding depreciation and interest) will amount to 40% of the additional sales. The firm is subject to a tax rate of 40%. ( Note: Answer the following questions for each of the next 6 years.)

a. What incremental earnings before depreciation, interest, and taxes will result from the renewal?

b. What incremental net operating profits after taxes will result from the renewal? c. What incremental operating cash inflows will result from the renewal?

Personal Finance Problem LG 5 P11–17 Incremental operating cash flows Richard and Linda Thomson operate a local lawn maintenance service for commercial and residential property. They have been using a John Deere riding mower for the past several years and feel it is time to buy

a new one. They would like to know the incremental (relevant) cash flows associated with the replacement of the old riding mower. The following data are available.

There are 5 years of remaining useful life on the old mower. The old mower has a zero book value. The new mower is expected to last 5 years. The Thomsons will follow a 5-year MACRS recovery period for the new mower. Depreciable value of the new mower is $1,800. They are subject to a 40% tax rate. The new mower is expected to be more fuel efficient, maneuverable, and durable

than previous models and can result in reduced operating expenses of $500 per year. The Thomsons will buy a maintenance contract that calls for annual payments of

$120. Create an incremental operating cash flow statement for the replacement of Richard

and Linda’s John Deere riding mower. Show the incremental operating cash flow for the next 6 years.

LG 5 P11–18 Incremental operating cash inflows—Expense reduction Miller Corporation is con- sidering replacing a machine. The replacement will reduce operating expenses (that

is, increase earnings before depreciation, interest, and taxes) by $16,000 per year for each of the 5 years the new machine is expected to last. Although the old machine has zero book value, it can be used for 5 more years. The depreciable value of the new machine is $48,000. The firm will depreciate the machine under MACRS using

a 5-year recovery period (see Table 4.2 on page 117 for the applicable depreciation percentages) and is subject to a 40% tax rate. Estimate the incremental operating cash inflows generated by the replacement. (Note: Be sure to consider the deprecia- tion in year 6.)

LG 5 P11–19 Incremental operating cash inflows Strong Tool Company has been considering purchasing a new lathe to replace a fully depreciated lathe that will last 5 more

years. The new lathe is expected to have a 5-year life and depreciation charges of $2,000 in year 1; $3,200 in year 2; $1,900 in year 3; $1,200 in both year 4 and year 5; and $500 in year 6. The firm estimates the revenues and expenses (excluding depre- ciation and interest) for the new and the old lathes to be as shown in the table at the

PART 5

Long-Term Investment Decisions

New lathe

Old lathe

Expenses

Expenses

(excluding depreciation

(excluding depreciation

Year

Revenue

and interest)

Revenue

and interest)

a. Calculate the operating cash inflows associated with each lathe. (Note: Be sure to consider the depreciation in year 6.)

b. Calculate the incremental (relevant) operating cash inflows resulting from the

proposed lathe replacement.

c. Depict on a time line the incremental operating cash inflows calculated in part b.

LG 5 P11–20 Determining incremental operating cash inflows Scenic Tours, Inc., is a provider of bus tours throughout the New England area. The corporation is considering the

replacement of 10 of its older buses. The existing buses were purchased 4 years ago at a total cost of $2,700,000 and are being depreciated using MACRS and a 5-year recovery period (see Table 4.2, page 117 ). The new buses would have larger pas- senger capacity and better fuel efficiency as well as lower maintenance costs. The total cost for 10 new buses is $3,000,000. Like the older buses, the new ones would

be depreciated using MACRS and a 5-year recovery period. Scenic is subject to a tax rate of 40%. The accompanying table presents revenues and cash expenses (excluding depreciation and interest) for the proposed purchase as well as the present fleet. Use all of the information given to calculate incremental (relevant) operating cash inflows for the proposed bus replacement.

Year

1 2 3 4 5 6 With the proposed new buses

$1,815,000 $1,800,000 Expenses (excluding

depreciation and interest)

With the present buses

Revenue

$1,775,000 $1,750,000 Expenses (excluding

depreciation and interest)

LG 6 P11–21 Terminal cash flow—Various lives and sale prices Looner Industries is currently analyzing the purchase of a new machine that costs $160,000 and requires $20,000

in installation costs. Purchase of this machine is expected to result in an increase in net working capital of $30,000 to support the expanded level of operations. The

CHAPTER 11

Capital Budgeting Cash Flows

(see Table 4.2 on page 117 for the applicable depreciation percentages) and expects to sell the machine to net $10,000 before taxes at the end of its usable life. The firm is subject to a 40% tax rate.

a. Calculate the terminal cash flow for a usable life of (1) 3 years, (2) 5 years, and

(3) 7 years.

b. Discuss the effect of usable life on terminal cash flows using your findings in part a.

c. Assuming a 5-year usable life, calculate the terminal cash flow if the machine were sold to net (1) $9,000 or (2) $170,000 (before taxes) at the end of 5 years.

d. Discuss the effect of sale price on terminal cash flow using your findings in part c.

LG 6 P11–22 Terminal cash flow—Replacement decision Russell Industries is considering replacing a fully depreciated machine that has a remaining useful life of 10 years

with a newer, more sophisticated machine. The new machine will cost $200,000 and will require $30,000 in installation costs. It will be depreciated under MACRS using

a 5-year recovery period (see Table 4.2 on page 117 for the applicable depreciation percentages). A $25,000 increase in net working capital will be required to support the new machine. The firm’s managers plan to evaluate the potential replacement over a 4-year period. They estimate that the old machine could be sold at the end of

4 years to net $15,000 before taxes; the new machine at the end of 4 years will be worth $75,000 before taxes. Calculate the terminal cash flow at the end of year 4 that is relevant to the proposed purchase of the new machine. The firm is subject to

a 40% tax rate.

LG 3 LG 4 P11–23 Relevant cash flows for a marketing campaign Marcus Tube, a manufacturer of LG

high-quality aluminum tubing, has maintained stable sales and profits over the past 5 LG 6 10 years. Although the market for aluminum tubing has been expanding by 3% per

year, Marcus has been unsuccessful in sharing this growth. To increase its sales, the firm is considering an aggressive marketing campaign that centers on regularly run- ning ads in all relevant trade journals and exhibiting products at all major regional and national trade shows. The campaign is expected to require an annual tax- deductible expenditure of $150,000 over the next 5 years. Sales revenue, as shown in the accompanying income statement for 2012, totaled $20,000,000. If the pro- posed marketing campaign is not initiated, sales are expected to remain at this level in each of the next 5 years, 2013 through 2017. With the marketing campaign, sales

Marcus Tube Income Statement for

Marcus Tube Sales Forecast

the Year Ended December 31, 2012

Year Sales revenue

Sales revenue

Less: Cost of goods sold (80%)

Gross profits

Less: Operating expenses

General and administrative expense (10%)

Depreciation expense

Total operating expense

Earnings before interest and taxes

Less: Taxes (rate = 40%)

Net operating profit after taxes

PART 5

Long-Term Investment Decisions

are expected to rise to the levels shown in the accompanying table for each of the next 5 years; cost of goods sold is expected to remain at 80% of sales; general and administrative expense (exclusive of any marketing campaign outlays) is expected to remain at 10% of sales; and annual depreciation expense is expected to remain at $500,000. Assuming a 40% tax rate, find the relevant cash flows over the next

5 years associated with the proposed marketing campaign.

LG 3 LG 4 P11–24 Relevant cash flows—No terminal value Central Laundry and Cleaners is consid- LG

ering replacing an existing piece of machinery with a more sophisticated machine. 5 The old machine was purchased 3 years ago at a cost of $50,000, and this amount

was being depreciated under MACRS using a 5-year recovery period. The machine has 5 years of usable life remaining. The new machine that is being considered costs $76,000 and requires $4,000 in installation costs. The new machine would be depre- ciated under MACRS using a 5-year recovery period. The firm can currently sell the old machine for $55,000 without incurring any removal or cleanup costs. The firm is subject to a tax rate of 40%. The revenues and expenses (excluding depreciation and interest) associated with the new and the old machines for the next 5 years are given in the table below. (Table 4.2 on page 117 contains the applicable MACRS depreciation percentages.)

New machine

Old machine

Expenses Expenses

Year

Revenue

(excl. depr. and int.)

Revenue

(excl. depr. and int.)

a. Calculate the initial investment associated with replacement of the old machine by the new one.

b. Determine the incremental operating cash inflows associated with the proposed replacement. ( Note: Be sure to consider the depreciation in year 6.)

c. Depict on a time line the relevant cash flows found in parts a and b associated

with the proposed replacement decision.

LG 3 LG 4 P11–25 Integrative—Determining relevant cash flows Lombard Company is contemplating LG

the purchase of a new high-speed widget grinder to replace the existing grinder. The 5 LG 6 existing grinder was purchased 2 years ago at an installed cost of $60,000; it was

being depreciated under MACRS using a 5-year recovery period. The existing grinder is expected to have a usable life of 5 more years. The new grinder costs $105,000 and requires $5,000 in installation costs; it has a 5-year usable life and would be depreciated under MACRS using a 5-year recovery period. Lombard can currently sell the existing grinder for $70,000 without incurring any removal or cleanup costs. To support the increased business resulting from purchase of the new grinder, accounts receivable would increase by $40,000, inventories by $30,000, and accounts payable by $58,000. At the end of 5 years, the existing grinder would have

CHAPTER 11

Capital Budgeting Cash Flows

and cleanup costs and before taxes. The firm is subject a 40% tax rate. The esti- mated earnings before depreciation, interest, and taxes over the 5 years for both the new and the existing grinder are shown in the following table. (Table 4.2 on page 117 contains the applicable MACRS depreciation percentages.)

Earnings before depreciation, interest, and taxes

Year

New grinder

Existing grinder

a. Calculate the initial investment associated with the replacement of the existing grinder by the new one.

b. Determine the incremental operating cash inflows associated with the proposed grinder replacement. ( Note: Be sure to consider the depreciation in year 6.)

c. Determine the terminal cash flow expected at the end of year 5 from the pro- posed grinder replacement.

d. Depict on a time line the relevant cash flows associated with the proposed grinder replacement decision.

Personal Finance Problem

LG 3 LG 4 P11–26 Determining relevant cash flows for a new boat Jan and Deana have been

LG 5 LG dreaming about owning a boat for some time and have decided that estimating its

6 cash flows will help them in their decision process. They expect to have a disposable annual income of $24,000. Their cash flow estimates for the boat purchase are as

follows:

Negotiated price of the new boat

Sales tax rate (applicable to purchase price)

Boat trade-in Estimated value of new boat in 4 years

Estimated monthly repair and maintenance

Estimated monthly docking fee

Using these cash flow estimates, calculate the following: a. The initial investment b. Operating cash flow c. Terminal cash flow d. Summary of annual cash flow e. Based on their disposable annual income, what advice would you give Jan and

PART 5

Long-Term Investment Decisions

LG 3 LG 4 P11–27 Integrative—Determining relevant cash flows Atlantic Drydock is considering LG 5 LG

replacing an existing hoist with one of two newer, more efficient pieces of equip- 6 ment. The existing hoist is 3 years old, cost $32,000, and is being depreciated under

MACRS using a 5-year recovery period. Although the existing hoist has only 3 years (years 4, 5, and 6) of depreciation remaining under MACRS, it has a remaining usable life of 5 years. Hoist A, one of the two possible replacement hoists, costs $40,000 to purchase and $8,000 to install. It has a 5-year usable life and will be depreciated under MACRS using a 5-year recovery period. Hoist B costs $54,000 to purchase and $6,000 to install. It also has a 5-year usable life and will be depreci- ated under MACRS using a 5-year recovery period.

Increased investments in net working capital will accompany the decision to acquire hoist A or hoist B. Purchase of hoist A would result in a $4,000 increase in net working capital; hoist B would result in a $6,000 increase in net working capital. The projected earnings before depreciation, interest, and taxes with each alternative

hoist and the existing hoist are given in the following table.

Earnings before depreciation, interest, and taxes

Year

With hoist A

With hoist B

With existing hoist

The existing hoist can currently be sold for $18,000 and will not incur any removal or cleanup costs. At the end of 5 years, the existing hoist can be sold to net $1,000 before taxes. Hoists A and B can be sold to net $12,000 and $20,000 before taxes, respectively, at the end of the 5-year period. The firm is subject to a 40% tax rate. (Table 4.2 on page 117 contains the applicable MACRS deprecia-

tion percentages.)

a. Calculate the initial investment associated with each alternative. b. Calculate the incremental operating cash inflows associated with each alterna-

tive. ( Note: Be sure to consider the depreciation in year 6.) c. Calculate the terminal cash flow at the end of year 5 associated with each alter-

native. d. Depict on a time line the relevant cash flows associated with each alternative.

LG 1 LG 2 P11–28 Integrative—Complete investment decision Wells Printing is considering the pur- LG

chase of a new printing press. The total installed cost of the press is $2.2 million. 3 LG 4 This outlay would be partially offset by the sale of an existing press. The old press

LG 5 LG 6 has zero book value, cost $1 million 10 years ago, and can be sold currently for $1.2 million before taxes. As a result of acquisition of the new press, sales in each of the next 5 years are expected to be $1.6 million higher than with the existing press, but product costs (excluding depreciation) will represent 50% of sales. The new press will not affect the firm’s net working capital requirements. The new press will

CHAPTER 11

Capital Budgeting Cash Flows

40% tax rate. Wells Printing’s cost of capital is 11%. ( Note: Assume that the old and the new presses will each have a terminal value of $0 at the end of year 6.)

a. Determine the initial investment required by the new press. b. Determine the operating cash inflows attributable to the new press. (Note: Be

sure to consider the depreciation in year 6.) c. Determine the payback period. d. Determine the net present value (NPV) and the internal rate of return (IRR)

related to the proposed new press. e. Make a recommendation to accept or reject the new press, and justify your

answer.

LG 1 LG 2 P11–29 Integrative—Investment decision Holliday Manufacturing is considering the LG 3 LG

replacement of an existing machine. The new machine costs $1.2 million and 4 requires installation costs of $150,000. The existing machine can be sold currently

LG 5 LG 6 for $185,000 before taxes. It is 2 years old, cost $800,000 new, and has a $384,000 book value and a remaining useful life of 5 years. It was being depreciated under

MACRS using a 5-year recovery period (see Table 4.2 on page 117 ) and therefore has the final 4 years of depreciation remaining. If it is held for 5 more years, the machine’s market value at the end of year 5 will be $0. Over its 5-year life, the new machine should reduce operating costs by $350,000 per year. The new machine will

be depreciated under MACRS using a 5-year recovery period. The new machine can be sold for $200,000 net of removal and cleanup costs at the end of 5 years. An

increased investment in net working capital of $25,000 will be needed to support operations if the new machine is acquired. Assume that the firm has adequate oper- ating income against which to deduct any loss experienced on the sale of the existing machine. The firm has a 9% cost of capital and is subject to a 40% tax rate.

a. Develop the relevant cash flows needed to analyze the proposed replacement. b. Determine the net present value (NPV) of the proposal. c. Determine the internal rate of return (IRR) of the proposal. d. Make a recommendation to accept or reject the replacement proposal, and justify

your answer. e. What is the highest cost of capital that the firm could have and still accept the

proposal? Explain.

LG 2 P11–30 ETHICS PROBLEM Cash flow projections are a central component to the analysis of new investment ideas. In most firms, the person responsible for making these projections is not the same person who generated the investment idea in the first place. Why?

Spreadsheet Exercise

Damon Corporation, a sports equipment manufacturer, has a machine currently in use that was originally purchased 3 years ago for $120,000. The firm depreciates the machine under MACRS using a 5-year recovery period. Once removal and cleanup costs are taken into consideration, the expected net selling price for the present machine will be $70,000.

Damon can buy a new machine for a net price of $160,000 (including installation costs of $15,000). The proposed machine will be depreciated under MACRS using a

PART 5

Long-Term Investment Decisions

needs will change—accounts receivable will increase $15,000, inventory will increase $19,000, and accounts payable will increase $16,000.

Earnings before depreciation, interest, and taxes (EBDIT) for the present machine are expected to be $95,000 for each of the successive 5 years. For the proposed machine, the expected EBDIT for each of the next 5 years are $105,000, $110,000, $120,000, $120,000, and $120,000, respectively. The corporate tax rate ( T) for the

firm is 40%. (Table 4.2 on page 117 contains the applicable MACRS depreciation percentages.)

Damon expects to be able to liquidate the proposed machine at the end of its 5-year usable life for $24,000 (after paying removal and cleanup costs). The present machine is expected to net $8,000 upon liquidation at the end of the same period. Damon expects to recover its net working capital investment upon termination of the project. The firm is subject to a tax rate of 40%.