Exam 11: Cash Flows and Other Topics in Capital Budgeting

Lasalle Industries is considering the purchase of a new machine that will cost $250,000,plus an additional $10,000 to ship and install.The new machine will have a 5-year useful life and will be depreciated to zero using the straight-line method.The machine is expected to have a salvage value of $30,000 at the end of year five.LaSalle's income tax rate is 40%.The additional net working capital from this project of $50,000 is expected to return to its pre-project level upon termination.What is the non-operating terminal cash flow of the machine?

Since stockholders are able to reduce their exposure to risk by efficiently diversifying their holdings of securities,there is no reason for individual firms to seek diversification of their holdings of assets.

Depreciation is a non-cash deduction so it may be ignored in the calculation of a project's incremental after-tax cash flows.

Mountain Recreation,Inc.is considering a new product line.The company currently manufactures several lines of snow skiing apparel.The new products,insulated ski bikinis,are expected to generate sales of $1.2 million per year for the next five years.They expect that during this five-year period,they will lose about $150,000 each year in sales on their existing lines of longer ski pants.The new line will require no additional equipment or space in the plant and can be produced in the same manner as the apparel products.The new project will,however,require that the company spend an additional $50,000 per year on insurance in case customers sue for frostbite.Also,a new marketing director would be hired to oversee the line at $75,000 per year in salary and benefits.Because of the different construction of the bikinis,an increase in inventory of $9,000 would be required initially.If the marginal tax rate is 35%,compute the incremental after-tax cash flows for years 1-5.

Capital budgeting projects that expand sales are more likely to involve increases in working capital than are projects that involve the replacement of existing assets.

QRW Corp.needs to replace an old lathe with a new,more efficient model.The old lathe was purchased for $50,000 nine years ago and has a current book value of $5,000.(The old machine is being depreciated on a straight-line basis over a ten-year useful life.)The new lathe costs $100,000.It will cost the company $10,000 to get the new lathe to the factory and get it installed.The old machine will be sold as scrap metal for $2,000.The new machine is also being depreciated on a straight-line basis over ten years.Sales are expected to increase by $8,000 per year while operating expenses are expected to decrease by $12,000 per year.QRW's marginal tax rate is 40%.Additional working capital of $3,000 is required to maintain the new machine and higher sales level.The new lathe is expected to be sold for $5,000 at the end of the project's ten-year life.What is the incremental free cash flow during year 1 of the project?

Tillamook Farms invests in a new kind of frozen dessert called polar cream that becomes very popular.So many new customers come to the store that the sales of existing ice cream products are increased.The extra sales revenue

Which of the following is NOT an important consideration in measuring risk for a capital budgeting project for a well-diversified firm?

Accounting profits are used to make capital budgeting decisions because generally accepted accounting principles ensure that profits are the best measure of a company's economic activity.

AFB,Inc.requires an investment in equipment of $600,000 to replace existing equipment.The existing equipment will produce after-tax salvage value of $70,000.Net working capital requirements are increased by $50,000.What is the total cash outflow at time zero?

What is the most commonly used method for incorporating risk into the capital-budgeting decision? How is this technique related to Principle 3: Risk Requires a Reward?

In general,a project's free cash flows will fall into one of three categories: (1)incremental costs,(2)sunk costs,and (3)opportunity costs.

Solar Confectionary develops a new candy bar and plans to sell each bar for $1.Solar predicts that 1 million candy bars will be sold in the first year if the new candy bar is produced and sold,and includes $1 million of incremental revenues in its capital budgeting analysis.A senior executive in the company believes that 1 million candy bars will be sold,but lowers the estimate of incremental revenue to $700,000.What would explain this change?

Sunk costs are

KLE Holdings is considering a capital budgeting project with a life of 7 years that requires an initial outlay of $277,400.The probability distribution for annual incremental cash flows is as follows: a.The risk-adjusted required rate of return for this project is 12%.Calculate the risk-adjusted net present value of the project and the project's IRR. b.Should the project be accepted?

Humongous Corporation is a multidivisional conglomerate.The Food Division is undergoing a capital budgeting analysis and must estimate the division's beta.This division has a different level of systematic risk than is typical for Humongous Corporation as a whole.The most appropriate method for estimating this beta is

The guiding rule in deciding if a free cash flow is incremental is to look at the company with,versus without,the new project.

You are analyzing the purchase of new equipment.Since you are not an expert on this type of equipment,you hire a consulting firm to make recommendations.The consultant charged you $1,500 and recommended the purchase of the latest model from ACME Corp.of America.The equipment costs $80,000,and it will cost another $10,000 to modify it for special use by your firm.The equipment will be depreciated on a straight-line basis over six years with no salvage value.You expect the equipment will be sold after three years for $28,000.Use of the equipment will require an increase in your company's net working capital of $4,000,but this $4,000 will be recovered at the end of year three.The use of the equipment will have no effect on revenues,but it is expected to save the firm $50,000 per year in before-tax operating costs.Your company's marginal tax rate is 35%.What is the terminal cash flow for this project?

Changes in capital spending are not incorporated directly into capital budgeting problems because the amounts are included in the operating cash flows through the inclusion of depreciation expense.

Trinitron,Inc.purchased a new molding machine for $85,000.The company paid $8,000 for shipping and another $7,000 to get the machine integrated with the company's existing assets.Trinitron,Inc.must maintain a supply of special lubricating oil just in case the machine breaks down.The company purchased a supply of oil for $4,000.The machine is to be depreciated on a straight-line basis over its expected useful life of 8 years.Trinitron is replacing an old machine that was purchased 6 years ago for $50,000.The old machine was being depreciated on a straight-line basis over a ten year expected useful life.The machine was sold for $15,000.Trinitron's marginal tax rate is 40%.What is the amount of the initial outlay?