Practice Exercises

1. Marie's Fashions is considering a project that will require $28,000 in net working capital and
$87,000 in fixed assets. The project is expected to produce annual sales of $75,000 with
associated costs of $57,000. The project has a 5-year life. The company uses straight-line
depreciation to a zero book value over the life of the project. The tax rate is 30 percent. What is
the operating cash flow for this project?

a. OCF = ($75,000 - $57,000)(1 - 0.30) + ($87,000/5)(0.30) = $17,820


2. The Pancake House has sales of $1,642,000, depreciation of $27,000, and net working capital of
$218,000. The firm has a tax rate of 35 percent and a profit margin of 6 percent. The firm has no
interest expense. What is the amount of the operating cash flow?

a. OCF = ($1,642,000 0.06) + $27,000 = $125,520

3. A proposed expansion project is expected to increase sales of JL Ticker's Store by $35,000 and
increase cash expenses by $21,000. The project will cost $24,000 and be depreciated using
straight-line depreciation to a zero book value over the 4-year life of the project. The store has a
marginal tax rate of 30 percent. What is the operating cash flow of the project using the tax
shield approach?

a. OCF = ($35,000 - $21,000) (1 - 0.30) + ($24,000/4) (0.30) = $11,600

4. Bruno's Lunch Counter is expanding and expects operating cash flows of $26,000 a year for 4
years as a result. This expansion requires $39,000 in new fixed assets. These assets will be
worthless at the end of the project. In addition, the project requires $3,000 of net working
capital throughout the life of the project. What is the net present value of this expansion project
at a required rate of return of 16 percent?
a.


5. Jasper Metals is considering installing a new molding machine which is expected to produce
operating cash flows of $73,000 a year for 7 years. At the beginning of the project, inventory will
decrease by $16,000, accounts receivables will increase by $21,000, and accounts payable will
increase by $15,000. All net working capital will be recovered at the end of the project. The
initial cost of the molding machine is $249,000. The equipment will be depreciated straight-line
to a zero book value over the life of the project. The equipment will be salvaged at the end of
the project creating a $48,000 aftertax cash flow. At the end of the project, net working capital
will return to its normal level. What is the net present value of this project given a required
return of 14.5 percent?
a. CF
0
= -$249,000 + $16,000 - $21,000 + $15,000 = -$239,000
C0
7
= $73,000 + $48,000 - $16,000 + $21,000 - $15,000 = $111,000


6. Gateway Communications is considering a project with an initial fixed asset cost of $2.46 million
which will be depreciated straight-line to a zero book value over the 10-year life of the project.
At the end of the project the equipment will be sold for an estimated $300,000. The project will
not directly produce any sales but will reduce operating costs by $725,000 a year. The tax rate is
35 percent. The project will require $45,000 of inventory which will be recouped when the
project ends. Should this project be implemented if the firm requires a 14 percent rate of
return? Why or why not?
a. Initial cash flow = -$2,460,000 - $45,000 = -$2,505,000
OCF = $725,000(1 - 0.35) + ($2,460,000/10)(0.35) = $557,350
Final cash flow = $45,000 + $300,000 (1 - 0.35) = $240,000

Yes positive NPV of $466,940.57


7. Samuelson Electronics has a required payback period of three years for all of its projects.
Currently, the firm is analyzing two independent projects. Project A has an expected payback
period of 2.8 years and a net present value of $6,800. Project B has an expected payback period
of 3.1 years with a net present value of $28,400. Which projects should be accepted based on
the payback decision rule?
a. Project A shorter payback


8. The Green Fiddle is considering a project that will produce sales of $87,000 a year for the next 4
years. The profit margin is estimated at 6 percent. The project will cost $90,000 and will be
depreciated straight-line to a book value of zero over the life of the project. The firm has a
required accounting return of 11 percent. This project should be _____ because the AAR is
_____ percent
a.

9. Motor City Productions sells original automotive art on a prepaid basis as each piece is uniquely
designed to the customer's specifications. For one project, the cash flows are estimated as
follows.

Based on the internal rate of return (IRR), should this project be accepted if the required return
is 9 percent?
a. $5,500 $5,900/(1 + IRR) = 0; IRR = 7.27 percent Accept


10. A project that provides annual cash flows of $12,600 for 12 years costs $67,150 today. At what
rate would you be indifferent between accepting the project and rejecting it?
a. The IRR of 15.40%


11. Jerilu Markets has a beta of 1.09. The risk-free rate of return is 2.75 percent and the market rate
of return is 9.80 percent. What is the risk premium on this stock?
a. Risk premium = 1.09 (0.098 - 0.0275) = 7.68 percent

12. . The common stock of Jensen Shipping has an expected return of 16.3 percent. The return on
the market is 10.8 percent and the risk-free rate of return is 3.8 percent. What is the beta of this
stock?
a. E(r) = 0.163 = 0.038 + (0.108 - 0.038); = 1.79