Exam 11: Cash Flows and Other Topics in Capital Budgeting

LEE Corporation intends to purchase equipment for $1,500,000.The equipment has a 5-year useful life and will be depreciated on a straight-line basis.Addition of the equipment requires additional working capital of $20,000.The $20,000 is expected to be recaptured at the end of the project.LEE's marginal tax rate is 40%.Use of the equipment is expected to change the company's reported EBIT by $600,000 in year one,$700,000 in year two,$550,000 in year three,$200,000 in year four,and $100,000 in year five.Due to changing market conditions,the equipment did have a salvage value of $100,000 at the end of year five. a.Calculate the initial outlay and the incremental free cash flows over the life of the project. b.If the risk-adjusted discount rate for this project is 20%,calculate the project's net present value and internal rate of return and comment on the acceptability of the project.

Dave Company,Inc.is considering purchasing a new grinding machine with a useful life of five years.The initial outlay for the machine is $165,000.The expected cash inflows are as follows: Given that the firm has a 10% required rate of return,what is the NPV?

Give an example of an option to delay a project.Why might this be of value?

Cash flows associated with a project's termination generally include the salvage value of the project net of any taxes associated with the sale.

A company is expanding and has already signed a lease on new office space that costs $10,000 per month.The company also needs a new information system and hired a consultant to recommend new software.The consultant was paid $5,000 for her recommendation.Now the company is trying to make a choice between three competing software products.In the capital budgeting decision to purchase new software,the monthly rent for the office space is ________ and the consultant's fee is ________.

The risk-adjusted discount rate for a replacement decision will be less than the rate used by the same firm when considering a new product line.

Increased depreciation expenses affect tax-related cash flows by

Hershey's expects to sell $2 million of its new candy bar,although $200,000 of this amount would have been spent on its existing candy bar.The $2 million is the appropriate cash inflow for the new candy bar project,while the $200,000 will be counted against the return on the old candy bar.

A major corporation is considering a capital budgeting project that involves the development of a new technology.The controller estimates the net present value to be negative,yet argues that the company should invest in the project.Which of the following statements is MOST correct?

The most relevant measure of risk for capital budgeting is project standing alone risk.

The initial outlay includes the immediate cash outflow necessary to purchase the asset and put it in operating order.

A typical decision rule used in simulation is to accept the project if the probability is sufficiently high that the net present value is positive.

As part of its expansion project,A.J.Industries Equipment Division has expanded its office space by 200 square feet.The company's administrative overhead is allocated based on the square footage of each business segment.Although the total administrative overhead for the company will remain the same,the Equipment Division will be charged more for administrative overhead.For the Equipment Division expansion project,the administrative overhead is an example of a(n)

Synergistic benefits from an investment project include cannibalism.

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 initial outlay required to fund this project?

Which of the following is NOT considered in the calculation of incremental cash flows?

To be included in a capital budgeting analysis,all incremental free cash flows must be expensed on the company's books,otherwise generally accepted accounting principles will be violated.

A grocery store decides to offer beer for sale and this decision results in more potato chip sales.This is an example of a synergistic effect.

One example of a terminal cash flow is the recapture of the net working capital associated with the project.

LaSalle Industries is considering the purchase of a new strapping machine,which will cost $150,000,plus an additional $10,500 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 generate new sales of $45,000 per year and is expected to save $16,000 in labor and electrical expenses over the next 5-years.The machine is expected to have a salvage value of $20,000.LaSalle's income tax rate is 35%.What is the machine's IRR?