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1 Capital Budgeting Problems 6. OCF from Several Approaches A proposed new project has projected sales of $49,350, costs of $25,000, and depreciation of $6,175. The tax rate is 34 percent. Calculate operating cash flow using three different approaches and verify that the answer is the same in each case. OCF=NI + Depreciation=11, ,175=18,170.5 OCF=Sales-Costs-Tax=49,350-25,000-6,179.5=18,170.5 OCF= (Sales-Costs)(1-T)+ Depreciation T=(49,350-25,000)(1-0.34)+ 6, =18,170.5 OCF= (Sales-Costs- Depreciation)(1-T)+ Depreciation =(Sales-Costs)(1-T)+ Depreciation T Tax=(Sales-Costs- Depreciation) T OCF= Sales-Costs-(Sales-Costs- Depreciation) T =(Sales-Costs)(1-T)+ Depreciation T

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2 Capital Budgeting Problems 8. Calculating Salvage Value Consider an asset that costs $100,000 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 $20,000. If the relevant tax rate is 35 percent, what is the after-tax cashflow from the sale of this asset? BV 5 =37,500 SV 5 =20,000 T=35% NSV=SV 5 -(SV 5 -BV 5 ) T=20,000-(20,000-37,500) 0.35=26,125

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3 Capital Budgeting Problems 24. Cost-Cutting Proposals Rosellos Machine Shop is considering a four-year project to improve its production efficiency. Buying a new machine press for $200,000 is estimated to produce $85,000 in annual pretax cost savings. The press falls in the modified ACRS five-year class life, and has a salvage value at the end of the project of $50,000. The press also requires an initial investment in spare parts inventory of $15,000, along with an additional $5,000 in inventory for each succeeding year of the project. If the shops tax rate is 34 percent and its discount rate is 13 percent, should Rosellos buy and install the machine press.

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4 Capital Budgeting Problems CS 0 =200,000 5 year MACRS Cost=-85,000 NWC 0 =15,000 NWC=5,000 for 1-3 T=34% k=13% NSV 4 =SV 4 -(SV 4 -BV 4 ) T=50,000-(50,000-34,560) 0.34=44,750.4

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5 Capital Budgeting Problems.

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6 29. Expansion Project Terminator Pest Control (TPC), Inc., projects unit sales for a new household-use laser-guided cockroach eradication system as follows: The eradication system will require $875,000 in net working capital to start, and additional net working capital investments each year equal to 35 percent of the projected sales increase for the following year.(Since sales are expected to fall in Year 5 then, there is no NWC cash flow occuring for Year 4.) Total fixed costs are $200,000 per year, variable production costs are $75 per unit, and the units are priced at $105 each.

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7 Capital Budgeting Problems The equipment needed to begin production has an installed cost of $9,750,000. This equipment is mostly industrial machinery and thus qualifies as seven-year modified ACRS property. In five years, this equipment can be sold for about 28 percent of its acquisition cost. TPC is in the 38 percent marginal tax bracket and has a required return on all of its projects of 10 percent. Based on these preliminary project estimates, what is the NPV of the project? What is the IRR?

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8 Capital Budgeting Problems

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10 Capital Budgeting Problems NPV=723,567.96

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11 Capital Budgeting Problems Replacement Project Topsider, Inc. is considering the purchase of a new leather-cutting machine to replace an existing machine which it purchased 2 years ago at a price of $10,000. The old machine had an expected life of 5 years at the time it was purchased and is being depreciated straight-line to zero. It can be sold for $5,000 today. The replacement decision has no effect on net working capital requirement. The new machine will reduce costs (before taxes) by $7,000 per year. The new machine has a 3-year life, it costs $14,000, and can be sold for an expected $2,000 at the end of the third year. The new machine would be depreciated using the ACRS method. Assume a 40 percent tax rate. The firm has a required return on all of its projects of 12 percent. Based on these preliminary project estimates, what is the NPV of the project?

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12 Capital Budgeting Problems SV new =2,000 BV new =1,037.4 NSV new =2,000-(2,000-1,037.4) 0.4=1, Cost=-7,000

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13 Capital Budgeting Problems NPV=3,956.87

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14 Capital Budgeting Problems 30. Calculating Required Savings A proposed cost-saving device has an installed cost of $330,000. The device will be used in a five-year project, but is classified as three-year modified ACRS property for tax purposes. The required initial net working capital investment is $20,000, the marginal tax rate is 35 percent, and the project discount rate is 12 percent. The device has an estimated Year 5 salvage value of $45,000. What level of pretax cost savings do we require for this project to be profitable?

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15 Capital Budgeting Problems 3 year MACRS NSV 5 =SV 5 -(SV 5 -BV 5 ) T=45,000-(45,000-0) 0.35=29,250

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16 Capital Budgeting Problems

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