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Essentials of Corporate Finance

Stephen Ross, Bradford D. Jordan

Chapter 9

Making Capital Investment Decisions - all with Video Answers

Educators

Chapter Questions

03:12

Problem 1

Kenny, Inc., is looking at setting up a new manufacturing plant in South Park. The company bought some.land six years ago for $\$ 8$ million in anticipation of using it as, a warehouse and distribution site, but the company has since decided to rent facilities elsewhere. The land would net $\$ 10.2$ million if it were sold today. The company now wants to build its new manufacturing plant on this land; the plant will cost $\$ 24$ million to build, and the site requires $\$ 900,000$ 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?

Rd
Reinhart Du Plessis
Numerade Educator
04:53

Problem 2

Winnebagel Corp. currently sells 19,000 motor homes per year at $\$ 65,000$ each, and 6,000 luxury motor coaches per year at $\$ 105,000$ each. The company wants to introduce a new portable camper to fill out its product line:
it hopes to sell 19,000 of these campers per year at $\$ 21,000$ each. An independent consultant has determined that if Winnebagel introduces the new campers, it should boost the sales of its existing motor homes by 2,500 units per year, and reduce the sales of its motor coaches by $\$ 00$ units per year. What is the amount to-use as the annual sales figure when evaluating this project? Why?

Amit Srivastava
Amit Srivastava
Numerade Educator
02:26

Problem 3

A proposed new investment has projected sales of $\$ 860,000$. Variable costs are 60 percent of sales, and fixed costs are $\$ 195,000$ depreciation is $\$ 86,000$. Prepare a pro forma income statement assuming a tax rate of 35 percent. What is the projected net income?

Breanna Ollech
Breanna Ollech
Numerade Educator
02:26

Problem 4

Consider the following income statement:
Fill in the missing numbers and then calculate the OCF. What is the depreciation tax shield?

Breanna Ollech
Breanna Ollech
Numerade Educator
00:48

Problem 5

A piece of newly purchased industrial equipment costs $\$ 860,000$ and is classified as seven-year property under MACRS. Calculate the annual depreciation allowances and end-of-the-year book values for this equipment.

Coach Rye
Coach Rye
Numerade Educator
02:26

Problem 6

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 35 percent, what is the aftertax cash flow from the sale of this asset?

Breanna Ollech
Breanna Ollech
Numerade Educator
02:26

Problem 7

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 $\$ 8,400,000$ and will be sold for $\$ 1,600,000$ at the end of the project. If the tax rate is 34 percent, what is the after-tax salvage value of the asset?

Breanna Ollech
Breanna Ollech
Numerade Educator
07:22

Problem 8

Herrera 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. The company currently sells 2,000 units 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 percent 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 38 percent, what is the annual OCF for the project?

Dale Sanford
Dale Sanford
Numerade Educator
02:26

Problem 9

Cochrane, Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of $\$ 2.7$ 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 $\$ 2,450,000$ in annual sales, with costs of $\$ 1,180,000$. If the tax rate is 35 percent, what is the OCF for this project?

Breanna Ollech
Breanna Ollech
Numerade Educator
00:57

Problem 10

In the previous problem, suppose the required return on the project is 14 percent. What is the project's NPV?

Manasvee Singh
Manasvee Singh
Numerade Educator
01:21

Problem 11

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 $\$ 300,000$ 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?

Nick Johnson
Nick Johnson
Numerade Educator
01:21

Problem 12

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?

Nick Johnson
Nick Johnson
Numerade Educator
02:26

Problem 13

Kolby's Korndogs is looking at a new sausage system with an installed cost of $\$ 560,000 .$ 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 $\$ 85,000 .$ The sausage system will save the firm $\$ 153,000$ per year in pretax operating costs, and the system requires an initial investment in net working capital of $\$ 38,000 .$ If the tax rate is 34 percent and the discount rate is 8 percent, what is the NPV of this project?

Breanna Ollech
Breanna Ollech
Numerade Educator
02:26

Problem 14

Your firm is contemplating the purchase of a new $\$ 780,000$ computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $\$ 45,000$ at the end of that time. You will save $\$ 310,000$ before taxes per year in order processing costs, and you will be able to reduce working capital by $\$ 55,000$ at the beginning of the project. Working capital will revert back to normal at the end of the project. If the tax rate is 35 percent, what is the IRR for this project?

Breanna Ollech
Breanna Ollech
Numerade Educator
02:40

Problem 15

In the previous problem, suppose your required return on the project is 20 percent and your pretax cost savings are $\$ 340,000$ per year. Will you accept the project? What if the pretax cost savings are only $\$ 280,000$ per year?

Nick Johnson
Nick Johnson
Numerade Educator
01:43

Problem 16

Automatic Transmissions, Inc., has the following estimates for its new gear assembly project: price $=\$ 1,280$ per unit; variable costs $=\$ 340$ per unit; fixed costs $=\$ 5.5$ million; quantity $=80,000$ units. Suppose the company believes all of its estimates are accurate only to within ±15 percent. What values should the company use for the four variables given here when it performs its best-case scenario analysis? What about the worst-case scenario?

Linh Vu
Linh Vu
Numerade Educator
02:17

Problem 17

For the company in the previous problem, suppose management is most concerned about the impact of its price estimate on the project's profitability. How could you address this concern for Automatic Transmissions? Describe how you would calculate your answer. What values would you use for the other forecast variables?

Jake Zanazzi
Jake Zanazzi
Numerade Educator
07:22

Problem 18

We are evaluating a project that costs $\$ 1,440,000$, has a six year life, and has no salvage value. Assume that depreciation is straight-line to zero over the life of the project. Sales are projected at 95,000 units per year. Price per unit is $\$ 36.50$, variable cost per unit is $\$ 22.75,$ and fixed costs are $\$ 830,000$ per year. The tax rate. is 35 percent, and we require a 13 percent return on this project.
a. Calculate the base-case cash flow and NPV. What is the sensitivity of NPV to changes in the sales figure? Explain what your answer tells you about a 500 -unit decrease in projected sales.
b. What is the sensitivity of OCF to changes in the variable cost figure? Explain what your answer tells you about a $\$ 1$ decrease in estimated variable costs.

Dale Sanford
Dale Sanford
Numerade Educator
03:11

Problem 19

In the previous problem, suppose the projections given for price, quantity, variable costs, and fixed costs are all accurate to within ±10 percent. Calculate the best-case and worst-case NPV figures.

Manasvee Singh
Manasvee Singh
Numerade Educator
42:33

Problem 20

Pappy's Potato has come up with a new product, the Potato Pet (they are freeze-dried to last longer). Pappy's paid $\$ 120,000$ for a marketing survey to determine the viability of the product. It is felt that Potato Pet will generate sales of $\$ 525,000$ per year. The fixed costs associated with this will be $\$ 178,000$ per year, and variable costs will amount to 20 percent of sales. The equipment necessary for production of the Potato Pets will cost $\$ 540,000$ and will be depreciated in a straight-line manner for the four years of the product life (as with all fads, it is felt the sales will end quickly). This is the only initial cost for the production. Pappy's is in a 40 percent tax bracket and has a required return of 13 percent. Calculate the payback period, NPV, and IRR.

Oluwadamilola Ameobi
Oluwadamilola Ameobi
Numerade Educator
06:24

Problem 21

CSM Machine Shop is considering a four-year project to improve its production efficiency. Buying a new machine press for $\$ 510,000$ is estimated to result in $\$ 218,000$ 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 $\$ 64,000 .$ The press also requires an initial investment in spare parts inventory of $\$ 21,000,$ along with an additional $\$ 3,000$ in inventory for each succeeding year of the project. If the shop's tax rate is 34 percent and its discount rate is 11 percent, should the company buy and install the machine press?

AG
Ankit Gupta
Numerade Educator
02:26

Problem 22

Consider a three-year project with the following information: initial fixed asset investment $=\$ 730,000 ;$ straight-line depreciation to zero over the five-year life; zero salvage value; price $=\$ 31.75 ;$ variable costs $=$ $\$ 19.50 ;$ fixed costs $=\$ 185,000 ;$ quantity sold $=80,000$ units; tax rate $=34$ percent. How sensitive is OCF to changes in quantity sold?

Breanna Ollech
Breanna Ollech
Numerade Educator
01:52

Problem 23

Ypy are considering a new product launch. The project will $\cos t \$ 890,000,$ have a four-year life, and have no salvage value; depreciation is straight-line to zero. Sales are projected at 190 units per year; price per unit will be $\$ 18,200,$ variable cost per unit will be $\$ 14,600,$ and fixed costs will be $\$ 295,000$ per year. The required return on the project is 12 percent, and the relevant tax rate is
35 percent.
a. Based on your experience, you think the unit sales, variable cost, and fixed cost projections given here are probably accurate to within ±10 percent. What are the upper and lower bounds for these projections? What is the base-case NPV? What are the best-case and worst-case scenarios?
b. Evaluate the sensitivity of your base-case NPV to changes in fixed costs.

Amy Jiang
Amy Jiang
Numerade Educator
08:16

Problem 24

McGilla 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 $\$ 150,000$ 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 per year 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 $\$ 1,000,000$ 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 also 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 40 percent, and the cost of capital is 14 percent. Calculate the payback period, the $\mathrm{NPV}$, and the IRR.

Oluwadamilola Ameobi
Oluwadamilola Ameobi
Numerade Educator
02:33

Problem 25

Aguilera Acoustics, Inc. (AAI) projects unit sales for a new seven-octave voice emulation implant as follows: Production of the implants will require $\$ 1,500,000$ 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 $\$ 850,000$ per year, variable production costs are $\$ 240$ per unit, and the units are priced at $\$ 340$ each. The equipment needed to begin production has an installed cost of $\$ 22,000,000 .$ 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 ofits acquisition cost. AAI is in the 35 percent marginal tax bracket and has a required return on all its projects of 18 percent. Based on these preliminary project estimates, what is the NPV of the project? What is the IRR?

Rajesh Singh
Rajesh Singh
Numerade Educator
00:36

Problem 26

A proposed cost-saving device has an installed cost of $\$ 540,000 .$ 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 $\$ 40,000$, 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 $\$ 60,000 .$ What level of pretax cost savings do we require for this project to be profitable?

Madysn Cardinal
Madysn Cardinal
Numerade Educator