Exam 11: Cash Flows and Other Topics in Capital Budgeting

Bellington,Inc.is considering the purchase of new,sophisticated machinery for a special three-year project.The machinery requires a special lubricating oil that probably will never be used,but must be available at all times should the machine break down.Bellington purchases $2,000 of lubricating oil to keep on hand just in case it is needed.At the end of the three-year project,it is expected the lubricating oil can be sold back to the distributor for $2,000.Which of the following statements is MOST correct?

Which of the following should be included in an analysis of a new project's cash flows?

A new machine can be purchased for $1,800,000.It will cost $35,000 to ship and $15,000 to fine-tune the machine.The new machine will replace an older version that is fully depreciated and will be sold for $200,000.The firm's income tax rate is 35%.What is the initial outlay for capital budgeting purposes?

AFB,Inc.is considering replacing an old machine with a new one.Two months ago their chief engineer completed a training seminar on the new machine's operation and efficiency.The $3,000 cost for this training session has already been paid.If the new machine is purchased,it would require $7,000 in installation and modification costs to make it suitable for operation in the factory.The old machine originally cost $80,000 five years ago and is being depreciated by $10,000 per year.The new machine will cost $100,000 before installation and modification.It will be depreciated by $12,000 per year.The old machine can be sold today for $12,000.The marginal tax rate for the firm is 40%.Compute the relevant initial outlay in this capital budgeting decision.

If the increase in net working capital is recovered entirely at the end of the project,then it may be ignored.

Propell Inc.is considering the purchase of a new machine that will cost $178,000,plus an additional $12,000 to ship and install.The new machine will have a 5-year useful life and will be depreciated using the straight-line method.The machine is expected to generate new sales of $85,000 per year and is expected to increase operating costs by $10,000 annually.Propell's income tax rate is 40%.What is the projected incremental cash flow of the machine for year 1?

J.B.Enterprises 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.J.B.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.Which of the following statements concerning the change in working capital is MOST accurate?

It is important to consider a new project's affect on the cash flows of existing projects because of

Financial theory assumes that individuals are risk averse.

Your company is considering the replacement of an old delivery van with a new one that is more efficient.The old van cost $40,000 when it was purchased 5 years ago.The old van is being depreciated using the simplified straight-line method over a useful life of 8 years.The old van could be sold today for $7,000.The new van has an invoice price of $80,000,and it will cost $6,000 to modify the van to carry the company's products.Cost savings from use of the new van are expected to be $28,000 per year for 5 years,at which time the van will be sold for its estimated salvage value of $18,000.The new van will be depreciated using the simplified straight-line method over its 5-year useful life.The company's tax rate is 35%.Working capital is expected to increase by $5,000 at the inception of the project,but this amount will be recaptured at the end of year five.What is the terminal cash flow?

AFB 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.AFB'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 years 2 through 10 of the project?

Capital budgeting decisions are based on free cash flow because free cash flow better reflects when money is received and available for reinvestment than account profits.

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 initial outlay for the new machine is

As a rule,any cash flows that are not affected by the accept/reject criterion should not be included in capital-budgeting analysis.

Three of the most common options that can add value to a capital budgeting project are the option to delay the project,the option to expand the project,and the option to abandon the project.

Interest expenses are not included as incremental free cash flows because the cost of funds is recognized when cash flows are discounted back to present value.

Alloy Corp.is considering the acquisition of a new processing line.The processor can be purchased for $3,750,000; it will have a 10-year useful life.It will cost $165,000 to ship and $85,250 to install the processor.A recently completed feasibility study that was performed at a cost of $65,000 indicated that the processor would produce a positive NPV.The processor will be depreciated using the straight-line method to zero expected salvage value.Studies have shown that employee-training expenses will be $125,000.What will be the annual depreciation expense of the processing line for capital budgeting purposes?

A project's annual free cash flow is the change in operating cash flow less any change in net working capital and less any change in capital spending.

If bankruptcy costs and/or shareholder under diversification are an issue,what measure of risk is relevant when evaluating project risk in capital budgeting?

The initial outlay includes the cost of purchasing the asset and getting is operational,but this excludes any training costs for employees which should be included as part of differential cash flows over the life of the project.