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1. Which of the following statements is most correct?

a) When evaluating corporate projects it is important to include all sunk costs in the estimated cash
flows.
b) When evaluating corporate projects it is important to include all relevant externalities in the
estimated cash flows.
c) Interest expenses should be included in project cash flows.
d) Statements a and b are correct.
e) All of the statements above are correct.

2. A company is considering a proposed expansion to its facilities. Which of the following statements
is most correct?
a) In calculating the project's operating cash flows, the firm should not subtract out financing costs
such as interest expense, since these costs are already included in the WACC, which is used to
discount the project's net cash flows.
b) Since depreciation is a non-cash expense, the firm does not need to know the depreciation rate when
calculating the operating cash flows.
c) When estimating the project's operating cash flows, it is important to include any opportunity costs
and sunk costs, but the firm should ignore cash flows from externalities since they are accounted for
elsewhere.
d) Statements a and c are correct.
e) None of the statements above is correct.

3. Which of the following should a company consider in an analysis when evaluating a proposed
project?
a) The new project is expected to reduce sales of the company's existing products by 5% a year.
b) Vacant facilities not currently leased out could instead be leased out for $10 million a year.
c) The company spent $30 million last year to improve the vacant facilities in which the new project will
be housed.
d) Statements a and b are correct.
e) All of the statements above are correct.

4. Which of the following is not a cash flow that results from the decision to accept a project?
a) Changes in net operating working capital.
b) Shipping and installation costs.
c) Sunk costs.
d) Opportunity costs.
e) Externalities.

5. Hyperion Limited currently sells its latest high-speed colour printer, the Hyper 500, for $350. It
plans to lower the price to $300 next year. Its cost of goods sold for the Hyper 500 is $200 per unit,
and this years sales are expected to be 20,000 units.
a) Suppose that if Hyperion drops the price to $300 immediately, it can increase this years sales by 25%
to 25,000 units. What would be the incremental impact on this years EBIT of such a price drop?
Sales = 25,000 x 300 = 7,500,000 Sales = 20,000x 350 = 7,000,000
Variable Costs = 25,000 x 200 = 5,000,000 Variable Costs = 20,000 x 200 = 4,000,000
Gross Profit =7,500,000 5,000,000 = 2,500,000 Gross Profit = 7,000,000 5000,000 = 3,000,000
EBIT increase = 2,500,000 3,000,000 = -500,000
b) Suppose that for each printer sold, Hyperion expects additional sales of $75 per year on ink
cartridges for the next three years, and Hyperion has a gross profit margin of 70% on ink cartridges.
What is the incremental impact on EBIT for the next three years of a price drop this year?
Extra units sold = 25,000 20,000 = 5,000
Additional ink sales = 5,000 x 75 = 375,000
Additional profit = 375,000 x 70% = 262,500
Year 1: 262,500 500,000 = -237,500
Year 2: 262,500
Year 3: 262,500

6. Consider the following income statement:
Sales $734,800
Costs 327,600
Depreciation 102,000
EBIT ?
Tax (30%) ?
Net Income ?
Fill in the missing numbers and then calculate the OCF. What is the depreciation tax shield?
EBIT = 734,800 327,600 102,000 = 305,200
Tax = 305,200 x 30% = 91,560
Net income = 305,200 91,560 = 213,640
OCF = (734,800 327,600) x (1 0.30) + (102,000 x 30%) = 315,640
Depreciation Tax Shield = 102,000 x 30% = 30,600

7. Sounds Music Company is considering the sale of a new sound board used in recording studios. The
new board would sell for $27,000 and the company expects to sell 1,600 per year. Sounds currently
sells 2,000 of its existing model per year. If the new model is introduced, sales of the existing model
will fall to 1,850 units per year. The old board retails for $22,500. Variable costs are 55% of sales,
depreciation on the equipment to produce the new board will be $1,500,000 per year, and fixed costs
are $1,300,000 per year. If the tax rate is 30%, what is the annual OCF for the project?
Sales = ( 27,000 x 1,600 ) ( 150 x 22,500 ) = 39,825,000
Variable Costs = 39,825,000 x 55% = 21,903,750
Fixed Costs = 1,300,000
OCF = ( 39,825,000 21,903,750 1,300,000) x ( 1 30% ) + ( 1,500,000 x 30% ) = 12,084,875

8. Given the choice, would a firm prefer to use diminishing value depreciation or straight-line
depreciation? Why?
A firm would choose a depreciation method which corresponds with their intentions with regards to tax
purposes. A firm would prefer to use diminishing value depreciation if they wish to pay less taxes in the
early stages of depreciation rather than later on because this method of depreciation produces a larger
depreciation expense within the first few years when compared to the straight-line depreciation. A firm
would prefer to use straight-line depreciation if they wish to pay less taxes in the later stages when
compared to the diminishing value method as the expense will be larger within the last few years.

9. Castle View Games would like to invest in a division to develop software for video games.
To evaluate this decision, the firms first attempts to project the working capital needs for this
operation. Its chief financial officer has developed the following estimates (in millions of
dollars). Assuming that Castle View currently does not have any working capital invested in this
division, calculate the cash flows associated with changes in working capital for the first five
years of the investment.

Year 1 2 3 4 5
Cash 6 12 15 15 15
Accounts Receivable 21 22 24 24 24
Inventory 5 7 10 12 13
Accounts Payable 18 22 24 25 30
Working Capital 14 19 25 26 22
Net Working Capital +14 +5 +6 +1 -4

10. Consider an asset that costs $670,000 and is 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 $95,000. If the relevant tax rate is 30%, what is the after-tax cash flow from
the sale of this asset?
Book Value = 670,000 x 3/8 = 251,250
Capital Gain = 95,000 251,250 = -156250
After-Tax Cash Flow = 95,000 ( -156250 x 30% ) = 141,875

11. Green Tree Golf has decided to sell a new line of golf clubs. The clubs will sell for $675 per set and
have a variable cost of $340 per set. The company has spent $280,000 for a marketing study that
determined the company will sell 70,000 sets per year for seven years. The marketing study also
determined that the company will lose sales of 9,000 sets of its high priced clubs. The high-priced
clubs sell at $1,100 and have variable costs of $550. The company will also increase sales of its cheap
clubs by 12,000 sets per year. The cheap clubs sell for $300 and have variable costs of $100 per set.
The fixed costs each year will be $10,800,000. The company has also spent $1,700,000 on research and
development for the new clubs. The plant and equipment required will cost $19,800,000 and will be
depreciated on a straight-line basis. The new clubs will require an increase in net working capital of
$1,500,000 that will be returned at the end of the project. The tax rate is 30%, and the cost of capital
is 14%. Calculate the payback period and the NPV.
Annually:
EBIT = (70,000 x (675 340)) (9,000 x (1,100-550)) + (12,000 x (300-100)) 10,800,000 19,800,000/7
EBIT = 23,450,000 4,950,000 + 2,400,000 10,800,000 2,828,571.43 = 7,271,428.57
OCF = 7271528.57 * (1 0.30) + 2,828,571.43 = 7,918,571.43
Payback period = ( 19,800,000 + 1,500,000 ) / (7,918,571.43 ) = 2.69 years
NPV = 19,800,000 + 1,500,000 1,500,000 + 7,918,571.43

12. Mr Suds is considering introducing a new detergent. The firm has collected the following
information about the proposed product from various divisions within the firm and through a market
research survey that cost $45,000.
The project has an anticipated economic life of 4 years.
The company will have to purchase a new machine to produce the detergent. The machine has an
up-front cost (t = 0) of $2 million. The machine will be depreciated on a straight-line basis over 4 years
(that is, the company's depreciation expense will be $500,000 in each of the first four years (t = 1, 2, 3,
and 4). The company anticipates that the machine will last for four years, and that after four years, its
salvage value will equal zero.
If the company goes ahead with the proposed product, it will have an effect on the company's net
operating working capital. At the outset, t = 0, inventory will increase by $140,000 and accounts
payable will increase by $40,000. At t = 4, the net operating working capital will be recovered after the
project is completed.
The detergent is expected to generate sales revenue of $1 million the first year (t = 1), $2 million the
second year (t = 2), $2 million the third year (t = 3), and $1 million the final year (t=4). Each year the
operating costs (not including depreciation) are expected to equal 50 percent of sales revenue.
The company's interest expense each year will be $100,000.
The new detergent is expected to reduce the after-tax cash flows of the company's existing products
by $250,000 a year (t = 1, 2, 3, and 4).
The company's overall WACC is 10 percent. However, the proposed project is riskier than the
average project for Parker; the project's WACC is estimated to be 12 percent.
The company's tax rate is 40 percent.
Net Working Capital = 140,000 40,000 = 100,000
Initial Outlay = 2,000,000 + 100,000 = 2,100,000

Year 1 OCF = ( 1,000,000 500,000 ) x ( 1 0.4 ) + ( 500,000 x 0.40 ) = 500,000
Year 2 OCF = ( 2,000,000 1,000,000 ) x ( 1 0.4 ) + ( 500,000 x 0.40 ) = 800,000
Year 3 OCF = ( 2,000,000 1,000,000 ) x ( 1 0.4 ) + ( 500,000 x 0.40 ) = 800,000
Year 4 OCF = ( 1,000,000 500,000 ) x ( 1 0.4 ) + ( 500,000 x 0.40 ) = 500,000