Exam 11: Cash Flows and Other Topics in Capital Budgeting

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?

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.

If the cash flows of an accepted investment project are negatively correlated with the average cash flow of the firm's existing assets,then the company's total exposure to risk can decrease.

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

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

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

For companies in competitive markets,the evolution and introduction of new products may serve more to preserve market share than to expand it.

A new machine can be purchased for $1,200,000.It will cost $35,000 to ship and $15,000 to modify the machine.A $12,000 recently completed feasibility study indicated that the firm can employ an existing factory owned by the firm,which would have otherwise been sold for $180,000.The firm will borrow $750,000 to finance the acquisition.Total interest expense for 5-years is expected to approximate $350,000.What is the investment cost of the machine for capital budgeting purposes?

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?

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?

Calculate the internal rate of return on the following projects: a.Initial outlay of $60,500 with an after-tax cash flow of $11,897 per year for eight years. b.Initial outlay of $647,000 with an after-tax cash flow of $118,000 per year for ten years. c.Initial outlay of $25,400 with an after-tax cash flow $11,788 per year for three years.

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

Sunk costs are

Sensitivity analysis involves changing one variable at a time.

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.

Butler Automotive developed a new diagnostic testing procedure that is expected to increase sales by $10,000 per month.As more drivers bring in their vehicles,Butler expects to also do more oil changes and brake repairs.As a result,inventory levels of oil and brake parts must be increased by $5,000.Revenues from oil changes and brake jobs are expected to increase by $4,000 per month.An example of a synergistic effect from the new diagnostic testing procedure is the

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.

A method for estimating a project's beta that attempts to identify publicly traded firms engage solely in the same business as the project is called the pure play method.

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.

Which of the following should be included in the initial outlay?