Questions and Problems

Basic ( Questions 1– 20)

1. Relevant Cash Flows [ LO1] Parker & Stone, Inc., is looking at setting up a new Page 348
manufacturing plant in South Park to produce garden tools. The company bought some
land six years ago for $2.8 million in anticipation of using it as a warehouse and
distribution site, but the company has since decided to rent these facilities from a
competitor instead. If the land were sold today, the company would net $3.2 million.
The company wants to build its new manufacturing plant on this land; the plant will
cost $14.3 million to build, and the site requires $825,000 worth of grading before it is
suitable for construction. What is the proper cash flow amount to use as the initial
investment in fixed assets when evaluating this project? Why?
2. Relevant Cash Flows [ LO1] Winnebagel Corp. currently sells 20,000 motor homes per
year at $103,000 each and 14,000 luxury motor coaches per year at $155,000 each. The
company wants to introduce a new portable camper to fill out its product line; it hopes
to sell 25,000 of these campers per year at $19,000 each. An independent consultant
has determined that if the company introduces the new campers, it should boost the
sales of its existing motor homes by 2,700 units per year and reduce the sales of its
motor coaches by 1,300 units per year. What is the amount to use as the annual sales
figure when evaluating this project? Why?
3. Calculating Projected Net Income [ LO1] A proposed new investment has projected
sales of $515,000. Variable costs are 36 percent of sales, and fixed costs are $173,000;
depreciation is $46,000. Prepare a pro forma income statement assuming a tax rate of
21 percent. What is the projected net income?
4. Calculating OCF [ LO1] Consider the following income statement:
$704,600
Sales
527,300
Costs
82,100
Depreciation
?
EBIT
Taxes (22%)
?
Net income
?
Fill in the missing numbers and then calculate the OCF. What is the depreciation tax shield?
5. OCF from Several Approaches [ LO1] A proposed new project has projected sales of
$215,000, costs of $104,000, and depreciation of $25,300. The tax rate is 23 percent.
Calculate operating cash flow using the four different approaches described in the chapter and
verify that the answer is the same in each case.
6. Calculating Depreciation [ LO1] A piece of newly purchased industrial equipment costs
$1.475 million and is classified as seven-year property under MACRS. Calculate the annual
depreciation allowances and end-of-the-year book values for this equipment.
7. Calculating Salvage Value [ LO1] Consider an asset that costs $745,000 and is Page 349
depreciated straight-line to zero over its eight-year tax life. The asset is to be used in a
five-year project; at the end of the project, the asset can be sold for $135,000. If the
relevant tax rate is 21 percent, what is the aftertax cash flow from the sale of this
asset?
8. Calculating Salvage Value [ LO1] An asset used in a four-year project falls in the five-
year MACRS class for tax purposes. The asset has an acquisition cost of $5.7 million
and will be sold for $1.8 million at the end of the project. If the tax rate is 21 percent,
what is the aftertax salvage value of the asset?
9. Calculating Project OCF [ LO1] Esfandairi Enterprises is considering a new three-
year expansion project that requires an initial fixed asset investment of $2.18 million.
The fixed asset will be depreciated straight-line to zero over its three-year tax life, after
which time it will be worthless. The project is estimated to generate $1.645 million in
annual sales, with costs of $610,000. If the tax rate is 21 percent, what is the OCF for
this project?
10. Calculating Project NPV [ LO1] In the previous problem, suppose the required
return on the project is 12 percent. What is the project’s NPV?
11. Calculating Project Cash Flow from Assets [ LO1] In the previous problem, suppose
the project requires an initial investment in net working capital of $250,000, and the
fixed asset will have a market value of $180,000 at the end of the project. What is the
project’s Year 0 net cash flow? Year 1? Year 2? Year 3? What is the new NPV?
12. NPV and MACRS [ LO1] In the previous problem, suppose the fixed asset actually
falls into the three-year MACRS class. All the other facts are the same. What is the
project’s Year 1 net cash flow now? Year 2? Year 3? What is the new NPV?
13. NPV and Bonus Depreciation [ LO1] In the previous problem, suppose the fixed
asset actually qualifies for 100 percent bonus depreciation in the first year. All the
other facts are the same. What is the project’s Year 1 net cash flow now? Year 2? Year
3? What is the new NPV?
14. Project Evaluation [ LO1] Dog Up! Franks is looking at a new sausage system with
an installed cost of $385,000. This cost will be depreciated straight-line to zero over
the project’s five-year life, at the end of which the sausage system can be scrapped for
$60,000. The sausage system will save the firm $135,000 per year in pretax operating
costs, and the system requires an initial investment in net working capital of $35,000.
If the tax rate is 21 percent and the discount rate is 10 percent, what is the NPV of
this project?
15. NPV and Bonus Depreciation [ LO1] In the previous problem, suppose the fixed
asset actually qualifies for 100 percent bonus depreciation in the first year. What is the
new NPV?
16. Project Evaluation [ LO1] Your firm is contemplating the purchase of a new
$535,000 computer-based order entry system. The system will be depreciated straight-
 line to zero over its five-year life. It will be worth $30,000 at the end of that time. You
will save $165,000 before taxes per year in order processing costs, and you will be able
to reduce working capital by $60,000 (this is a one-time reduction). If the tax rate is
24 percent, what is the IRR for this project?
17. Project Evaluation [ LO2] In the previous problem, suppose your required return on
the project is 11 percent and your pretax cost savings are $150,000 per year. Will you
accept the project? What if the pretax cost savings are $100,000 per year? At what
level of pretax cost savings would you be indifferent between accepting the project and
not accepting it?
18. Calculating EAC [ LO4] A five-year project has an initial fixed asset investment of
$345,000, an initial NWC investment of $25,000, and an annual OCF of − $41,000.
The fixed asset is fully depreciated over the life of the project and has no salvage
value. If the required return is 11 percent, what is this project’s equivalent annual cost,
or EAC?
19. Calculating EAC [ LO4] You are evaluating two different silicon wafer milling Page 350
machines. The Techron I costs $265,000, has a three-year life, and has pretax
operating costs of $74,000 per year. The Techron II costs $445,000, has a five-year
life, and has pretax operating costs of $47,000 per year. For both milling machines,
use straight-line depreciation to zero over the project’s life and assume a salvage value
of $35,000. If your tax rate is 22 percent and your discount rate is 10 percent,
compute the EAC for both machines. Which do you prefer? Why?
20. Calculating a Bid Price [ LO3] Martin Enterprises needs someone to supply it with
110,000 cartons of machine screws per year to support its manufacturing needs over
the next five years, and you’ve decided to bid on the contract. It will cost you
$940,000 to install the equipment necessary to start production; you’ll depreciate this
cost straight-line to zero over the project’s life. You estimate that, in five years, this
equipment can be salvaged for $75,000. Your fixed production costs will be $850,000
per year, and your variable production costs should be $21.43 per carton. You also
need an initial investment in net working capital of $90,000. If your tax rate is 21
percent and you require a return of 12 percent on your investment, what bid price
should you submit?
INTERMEDIATE
(Q uestions 21–33)
21. Cost-Cutting Proposals [ LO2] Tanaka Machine Shop is considering a four-year project to
improve its production efficiency. Buying a new machine press for $445,000 is estimated to
result in $160,000 in annual pretax cost savings. The press falls in the MACRS five-year class,
and it will have a salvage value at the end of the project of $40,000. The press also requires an
initial investment in spare parts inventory of $20,000, along with an additional $2,800 in
inventory for each succeeding year of the project. If the shop’s tax rate is 22 percent and its
discount rate is 9 percent, should the company buy and install the machine press?
22. NPV and Bonus Depreciation [ LO1] Eggz, Inc., is considering the purchase of new
equipment that will allow the company to collect loose hen feathers for sale. The equipment
will cost $525,000 and will be eligible for 100 percent bonus depreciation. The equipment can
 be sold for $35,000 at the end of the project in five years. Sales would be $348,000 per year,
with annual fixed costs of $56,000 and variable costs equal to 35 percent of sales. The project
would require an investment of $40,000 in NWC that would be returned at the end of the
project. The tax rate is 22 percent and the required return is 9 percent. What is the project’s
NPV?
23. Comparing Mutually Exclusive Projects [ LO1] Rust Industrial Systems Company is trying to
decide between two different conveyor belt systems. System A costs $295,000, has a four-year
life, and requires $77,000 in pretax annual operating costs. System B costs $355,000, has a six-
year life, and requires $83,000 in pretax annual operating costs. Both systems are to be
depreciated straight-line to zero over their lives and will have zero salvage value. Whichever
project is chosen, it will not be replaced when it wears out. If the tax rate is 21 percent and the
discount rate is 8 percent, which project should the firm choose?
24. Comparing Mutually Exclusive Projects [ LO4] Suppose in the previous problem that the
company always needs a conveyor belt system; when one wears out, it must be replaced.
Which project should the firm choose now?
25. Calculating a Bid Price [ LO3] Consider a project to supply 100 million postage stamps per
year to the U.S. Postal Service for the next five years. You have an idle parcel of land available
that cost $750,000 five years ago; if the land were sold today, it would net you $1.1 million
aftertax. The land can be sold for $1.3 million after taxes in five years. You will need to install
$5.4 million in new manufacturing plant and equipment to actually produce the stamps; this
plant and equipment will be depreciated straight-line to zero over the project’s five-year life.
The equipment can be sold for $575,000 at the end of the project. You will also need $450,000
in initial net working capital for the project, and an additional investment of $40,000 in every
year thereafter. Your production costs are .29 cents per stamp, and you have fixed costs of $1.1
million per year. If your tax rate is 23 percent and your required return on this project is 10
percent, what bid price should you submit on the contract?
26. Interpreting a Bid Price [ LO3] In the previous problem, suppose you were going to Page 351
use a three-year MACRS depreciation schedule for your manufacturing equipment and
you could keep working capital investments down to only $25,000 per year. How would
this new information affect your calculated bid price? What if you used 100 percent
bonus depreciation?
27. Comparing Mutually Exclusive Projects [ LO4] Vandelay Industries is considering the
purchase of a new machine for the production of latex. Machine A costs $2.1 million
and will last for six years. Variable costs are 35 percent of sales, and fixed costs are
$315,000 per year. Machine B costs $4.8 million and will last for nine years. Variable
costs for this machine are 30 percent of sales and fixed costs are $355,000 per year.
The sales for each machine will be $10 million per year. The required return is 10
percent, and the tax rate is 24 percent. Both machines will be depreciated on a straight-
line basis. If the company plans to replace the machine when it wears out on a
perpetual basis, which machine should it choose?
28. Equivalent Annual Cost [ LO4] Light-emitting diode (LED) light bulbs have become
required in recent years, but do they make financial sense? Suppose a typical 60-watt
incandescent light bulb costs $.45 and lasts for 1,000 hours. A 7-watt LED, which
provides the same light, costs $2.25 and lasts for 40,000 hours. A kilowatt-hour of
 electricity costs $.121, which is about the national average. A kilowatt-hour is 1,000
watts for 1 hour. If you require a 10 percent return and use a light fixture 500 hours per
year, what is the equivalent annual cost of each light bulb?
29. Break-Even Cost [ LO2] The previous problem suggests that using LEDs instead of
incandescent bulbs is a no-brainer. However, electricity costs actually vary quite a bit
depending on location and user type (you can get information on your rates from your
local power company). An industrial user in West Virginia might pay $.04 per kilowatt-
hour whereas a residential user in Hawaii might pay $.25. What’s the break-even cost
per kilowatt-hour in the previous problem?
30. Break-Even Replacement [ LO2] The previous two problems suggest that using LEDs
is a good idea from a purely financial perspective unless you live in an area where
power is relatively inexpensive, but there is another wrinkle. Suppose you have a
residence with a lot of incandescent bulbs that are used on average 500 hours a year.
The average bulb will be about halfway through its life, so it will have 500 hours
remaining (and you can’t tell which bulbs are older or newer). At what cost per
kilowatt-hour does it make sense to replace your incandescent bulbs today?
31. Issues in Capital Budgeting [ LO1] Before LEDs became a popular replacement for Page 352
incandescent light bulbs, compact fluorescent lamps (CFLs) were hailed as the new
generation of lighting. However, CFLs had even more wrinkles. In no particular order:
1. Incandescent bulbs generate a lot more heat than CFLs.
2. CFL prices will probably decline relative to incandescent bulbs.
3. CFLs unavoidably contain small amounts of mercury, a significant environmental hazard, and
special precautions must be taken in disposing of burned-out units (and also in cleaning up a
broken lamp). Currently, there is no agreed-upon way to recycle a CFL. Incandescent bulbs
pose no disposal∕breakage hazards.
4. Depending on a light’s location (or the number of lights), there can be a nontrivial cost to
change bulbs (i.e., labor cost in a business).
5. Coal-fired power generation accounts for a substantial portion of the mercury emissions in
the United States, though the emissions will drop sharply in the relatively near future.
6. Power generation accounts for a substantial portion of CO2 emissions in the United States.
7. CFLs are more energy and material intensive to manufacture. On-site mercury contamination
and worker safety are issues.
8. If you install a CFL in a permanent lighting fixture in a building, you will probably move long
before the CFL burns out.
9. Even as CFLs began to replace incandescent light bulbs, LEDs were in the latter stages of
development. At the time, LEDs were much more expensive than CFLs, but costs were
coming down. LEDs last much longer than CFLs and use even less power. Plus, LEDs don’t
contain mercury.
Q ualitatively, how would these issues affect your position in the CFL versus incandescent light
bulb debate? Some countries banned incandescent bulbs. Does your analysis suggest such a move
was wise? Are there other regulations short of an outright ban that make sense to you?
32. Replacement Decisions [ LO2] Your small remodeling business has two work vehicles. One is
 a small passenger car used for job site visits and for other general business purposes. The other
is a heavy truck used to haul equipment. The car gets 25 miles per gallon (mpg). The truck gets
10 mpg. You want to improve gas mileage to save money, and you have enough money to
upgrade one vehicle. The upgrade cost will be the same for both vehicles. An upgraded car will
get 40 mpg; an upgraded truck will get 12.5 mpg. The cost of gasoline is $2.65 per gallon.
Assuming an upgrade is a good idea in the first place, which one should you upgrade? Both
vehicles are driven 12,000 miles per year.
33. Replacement Decisions [ LO2] In the previous problem, suppose you drive the truck x miles
per year. How many miles would you have to drive the car before upgrading the car would be
the better choice? (H int: Look at the relative gas savings.)
CHALLENGE
(Q uestions 34–40)
34. Calculating Project NPV [ LO1] You have been hired as a consultant for Pristine Page 353
Urban-Tech Z ither, Inc. (PUTZ ), manufacturers of fine zithers. The market for zithers
is growing quickly. The company bought some land three years ago for $1.9 million in
anticipation of using it as a toxic waste dump site but has recently hired another
company to handle all toxic materials. Based on a recent appraisal, the company
believes it could sell the land for $2.2 million on an aftertax basis. In four years, the
land could be sold for $2.4 million after taxes. The company also hired a marketing
firm to analyze the zither market, at a cost of $275,000. An excerpt of the marketing
report is as follows:
The zither industry will have a rapid expansion in the next four years. With the
brand name recognition that PUTZ brings to bear, we feel that the company will
be able to sell 5,200, 5,900, 6,500, and 4,800 units each year for the next four
years, respectively. Again, capitalizing on the name recognition of PUTZ , we feel
that a premium price of $435 can be charged for each zither. Because zithers
appear to be a fad, we feel at the end of the four-year period, sales should be
discontinued.

PUTZ believes that fixed costs for the project will be $375,000 per year, and variable
costs are 20 percent of sales. The equipment necessary for production will cost $2.85
million and will be depreciated according to a three-year MACRS schedule. At the end
of the project, the equipment can be scrapped for $405,000. Net working capital of
$150,000 will be required immediately. PUTZ has a tax rate of 22 percent, and the
required return on the project is 13 percent. What is the NPV of the project?
35. NPV and Bonus Depreciation [ LO1] In the previous problem, suppose the fixed asset
actually qualifies for 100 percent bonus depreciation in the first year. What is the new
NPV?
36. Project Evaluation [ LO1] Aria Acoustics, Inc. (AAI), projects unit sales for a new
seven-octave voice emulation implant as follows:
Year Unit Sales

1 71,000
 2 84,000
3 103,000
4 95,000
5 64,000
Production of the implants will require $2.3 million in net working capital to start and
additional net working capital investments each year equal to 15 percent of the projected sales
increase for the following year. Total fixed costs are $2.9 million per year, variable production
costs are $285 per unit, and the units are priced at $410 each. The equipment needed to begin
production has an installed cost of $14.8 million. Because the implants are intended for
professional singers, this equipment is considered industrial machinery and thus qualifies as
seven-year MACRS property. In five years, this equipment can be sold for about 20 percent of
its acquisition cost. The tax rate is 21 percent and the required return is 18 percent. Based on
these preliminary project estimates, what is the NPV of the project? What is the IRR?
37. Calculating Required Savings [ LO2] A proposed cost-saving device has an installed cost of
$905,000. The device will be used in a five-year project but is classified as three-year MACRS
property for tax purposes. The required initial net working capital investment is $65,000, the
tax rate is 22 percent, and the project discount rate is 9 percent. The device has an estimated
Year 5 salvage value of $125,000. What level of pretax cost savings do we require for this
project to be profitable?
38. Financial Break-Even Analysis [ LO2] To solve the bid price problem presented in the text, we
set the project NPV equal to zero and found the required price using the definition of OCF.
Thus the bid price represents a financial break-even level for the project. This type of analysis
can be extended to many other types of problems.
a. In Problem 20, assume that the price per carton is $33 and find the project NPV. What does
your answer tell you about your bid price? What do you know about the number of cartons
you can sell and still break even? How about your level of costs?
b. Solve Problem 20 again with the price still at $33, but find the quantity of cartons per year
that you can supply and still break even. (H int: It’s less than 110,000.)
c. Repeat (b) with a price of $33 and a quantity of 110,000 cartons per year, and find the
highest level of fixed costs you could afford and still break even. (H int: It’s more than
$850,000.)
39. Calculating a Bid Price [ LO3] Your company has been approached to bid on a contract to
sell 5,000 voice recognition (VR) computer keyboards per year for four years. Due to
technological improvements, beyond that time they will be outdated and no sales will be
possible. The equipment necessary for the production will cost $3.4 million and will be
depreciated on a straight-line basis to a zero salvage value. Production will require an initial
investment in net working capital of $395,000 which will be returned at the end of the project,
and the equipment can be sold for $325,000 at the end of production. Fixed costs are $595,000
per year, and variable costs are $85 per unit. In addition to the contract, you feel your company
can sell 12,300, 14,600, 19,200, and 11,600 additional units to companies in other countries
over the next four years, respectively, at a price of $180. This price is fixed. The tax rate is 23
percent, and the required return is 10 percent. Additionally, the president of the company will
 undertake the project only if it has an NPV of $100,000. What bid price should you set for the
contract?
40. Replacement Decisions [ LO2] Suppose we are thinking about replacing an old Page 354
computer with a new one. The old one cost us $1.4 million; the new one will cost $1.7
million. The new machine will be depreciated straight-line to zero over its five-year life.
It will probably be worth about $325,000 after five years.
The old computer is being depreciated at a rate of $281,000 per year. It will be
completely written off in three years. If we don’t replace it now, we will have to replace
it in two years. We can sell it now for $450,000; in two years, it will probably be worth
$130,000. The new machine will save us $315,000 per year in operating costs. The tax
rate is 22 percent, and the discount rate is 12 percent.
a. Suppose we recognize that if we don’t replace the computer now, we will be replacing it in
two years. Should we replace it now or should we wait? [ H int: What we effectively have here
is a decision either to “invest” in the old computer (by not selling it) or to invest in the new
one.] Notice that the two investments have unequal lives.
b. Suppose we consider only whether we should replace the old computer now without
worrying about what’s going to happen in two years. What are the relevant cash flows?
Should we replace it or not? (H int: Consider the net change in the firm’s aftertax cash flows
if we do the replacement.)
EXCEL MASTER IT%! PROBLEM

For this Master It! assignment, refer to the Conch Republic Electronics minicase below. For your
convenience, we have entered the relevant values in the case such as the price and variable cost. For
this project, answer the following questions:
a. What is the profitability index of the project?
b. What is the IRR of the project?
c. What is the NPV of the project?
d. At what price would Conch Republic Electronics be indifferent to accepting the project?
e. At what level of variable costs per unit would Conch Republic Electronics be indifferent to
accepting the project?