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and then grow at a 10 percent annual rate for the last three years.
Fixed cash operating expenses are $150,000 for years 13 and $130,000 for years 46.
Variable cash operating expenses are 40 percent of sales in year 1, 39 percent of sales in year
gains.
The projects required rate of return is 18 percent.
If taxable income on the project is negative in any year, the loss will offset gains else-where
in the corporation, resulting in a tax savings.
Required
Determine whether this is a protable investment using the
1
2
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Year
$100,000
150,000
200,000
250,000
320,000
Bo is beginning to develop the relevant cash flows needed to analyze whether to renew or
replace Clarks only depreciable asset, a machine that originally cost $30,000, has a current book
value of zero, and can now be sold for $20,000. (Note: Because the firms only depreciable asset
is fully depreciated its book value is zeroits expected net profits after taxes equal its operating
cash inflows.) He estimates that at the end of 5 years, the existing machine can be sold to net
$2,000 before taxes. Bo plans to use the following information to develop the relevant cash flows
for each of the alternatives.
Alternative 1
Renew the existing machine at a total depreciable cost of $90,000. The renewed machine would
have a 5-year usable life and would be depreciated under MACRS using a 5-year recovery
period. Renewing the machine would result in the following projected revenues and expenses
(excluding depreciation):
Year
Revenue
$1,000,000
$801,500
1,175,000
884,000
1,300,000
918,100
1,425,000
943,000
1,550,000
968,100
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The renewed machine would result in an increased investment in net working capital of $15,000.
At the end of 5 years, the machine could be sold to net $8,000 before taxes.
Alternative 2
Replace the existing machine with a new machine that costs $100,000 and requires installation
costs of $10,000. The new machine would have a 5-year usable life and would be depreciated
under MACRS using a 5 year recovery period. The firms projected revenues and expenses
(excluding depreciation), if it acquires the machine, would be as follows:
Year
Revenue
$1,000,000
$764,500
1,175,000
839,800
1,300,000
914,900
1,425,000
989,900
1,550,000
998,900
The new machine would result in an increased investment in net working capital of $22,000. At
the end of 5 years, the new machine could be sold to net $25,000 before taxes. The firm is
subject to a 40% tax on both ordinary income and capital gains. As noted, the company uses
MACRS depreciation. (See Table 3.2 on page 100 for the applicable depreciation percentages.)
Required
A. Calculate the initial investment associated with each of Clark Upholsterys alternatives.
B. Calculate the incremental operating cash inflows associated with each of Clarks
alternatives. (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 of Clarks
alternatives.
D. Use your findings in parts a, b, and c to depict on a time line the relevant cash flows
associated with each of Clark Upholsterys alternatives.
E. Solely on the basis of your comparison of their relevant cash flows, which alternative
appears to be better? Why?
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J. SMYTHE, INC.
J. Smythe, Inc., manufactures ne furniture. The company is deciding whether to introduce a
new mahogany dining room table set. The set will sell for $5,600, including a set of eight chairs.
The company feels that sales will be 1,300; 1,325; 1,375; 1,450; and 1,320 sets per year for the
next ve years, respectively. Variable costs will amount to 45 percent of sales, and xed costs are
$1.7 million per year. The new tables will require inventory amounting to 10 percent of sales,
produced and stockpiled in the year prior to sales. It is believed that the addition of the new table
will cause a loss of 200 tables per year of the oak tables the company produces. These tables sell
for $4,500 and have variable costs of 40 percent of sales. The inventory for this oak table is also
10 percent. J. Smythe currently has excess production capacity. If the company buys the
necessary equipment today, it will cost $10.5 million. How-ever, the excess production capacity
means the company can produce the new table without buying the new equipment. The company
controller has said that the current excess capacity will end in two years with current production.
This means that if the company uses the current excess capacity for the new table, it will be
forced to spend the $10.5 million in two years to accommodate the increased sales of its current
products. In ve years, the new equipment will have a market value of $2.8 million if purchased
today, and $6.1 million if purchased in two years. The equipment is depreciated on a seven-year
MACRS schedule. The company has a tax rate of 38 percent, and the required return for the
project is 14 percent.
A. Should J. Smythe undertake the new project?
B. Can you perform an IRR analysis on this project? How many IRRs would you expect to
nd?
C. How would you interpret the protability index?
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value, internal rate of return, and modied internal rate of return for the new strip mine. Should
Bethesda Mining take the contract and open the mine?
Thereafter, the net working capital requirements will be 15 percent of sales. What are the NPV,
payback period, discounted payback period, AAR, IRR, and PI on this project?
NATIONAL FOODS
National Foods is considering producing a new candy, Nasty-As-Can-Be. National has spent two
years and $450,000 developing this product. National has also test marketed Nasty, spending
$100,000 to conduct consumer surveys and tests of the product in 25 states.
Based on previous candy products and the results in the test marketing, management
believes consumers will buy 4 million packages each year for ten years at 50 cents per package.
Equipment to produce Nasty will cost National $1,000,000 and $300,000 of additional net
working capital will be required to support Nasty sales. National expects production costs to
average 60% of Nastys net revenues, with overhead and sales expenses totaling $525,000 per
year. The equipment has a life of ten years, after which time it will have no salvage value.
Working capital is assumed to be fully recovered at the end of ten years. Depreciation is straightline (no salvage) and Nationals tax rate is 45%. The required rate of return for projects of similar
risk is 8%.
A. Should National Foods produce this new candy? What is the basis of your recommendation?
B. Would your recommendation change if production costs average 65% of net revenues instead
of 60%? How sensitive is your recommendation to production costs?
C. Would your recommendation change if the equipment were depreciated according to
MACRS as a ten-year asset instead of using straight-line?
D. Suppose that competitors are expected to introduce similar candy products to compete with
Nasty, such that dollar sales will drop by 5% each year following the rst year. Should
National Foods produce this new candy considering this possible drop in sales? Explain.
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