Exam 11: Cash Flows and Other Topics in Capital Budgeting

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?

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?

Operating cash flow is equal to the change in EBIT less the change in interest expense,less the change in taxes,plus the change in depreciation.

A project's contribution-to-firm risk does allow for diversification within the firm.

Redrock Inc.is a household products firm that is considering developing a new detergent.In evaluating whether to go ahead with the new detergent project,which of the following statements is MOST correct?

A wildcat oil driller has enough capital to invest in only one project,that is,to drill one well in an East Texas oil field.A major oil company is drilling 100 wells in the same field.The probability of successfully striking oil is 10% for any well drilled in this field.Which of the following statements is MOST correct concerning the risk involved in these capital budgeting projects?

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 initial outlay required to fund this replacement project?

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.

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

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

Which of the following should NOT be included as investment costs in evaluating a capital asset?

Kelly Corporation is considering an investment proposal that requires an initial investment of $150,000 in equipment.Fully depreciated existing equipment may be disposed of for $40,000 pre-tax.The proposed project will have a five-year life,and is expected to produce additional revenue of $65,000 per year.Expenses other than depreciation will be $15,000 per year.The new equipment will be depreciated to zero over the five-year useful life,but it is expected to actually be sold for $20,000.Kelly has a 35% tax rate. a.What is the net initial outlay for the proposed project? b.What is the operating cash flow for years 1-4? c.What is the total cash flow at the end of year five (operating cash flow for year 5 plus terminal cash flow)?

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

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.

An asset with an original cost of $100,000 and a current book value of $20,000 is sold for $50,000 as part of a capital budgeting project.The company has a tax rate of 30%.This transaction will have what impact on the project's initial outlay?

The financial manager selecting one of two projects of differing risk should

A six-year project for Little Egypt,Inc.results in additional accounts receivable of $150,000,additional inventory of $50,000,and additional accounts payable of $80,000 today.What is the change in the NPV of a project solely due to the additional net working capital (NWC)needs? Assume a 14% discount rate,and the recovery of net working capital at the end of the project.

Sunk costs are cash outflows that will occur regardless of the current accept/reject decision,and therefore should be excluded from the analysis.

P.D.Corporation is considering the purchase of a high-speed lathe that has an invoice price of $250,000.The cost to ship the lathe to P.D.'s factory is $10,000,and the existing facilities will require modifications that are expected to cost $20,000.The machine will be depreciated on a straight-line basis over its useful life of 10 years,assuming no salvage value.P.D.Corporation is planning on paying for the lathe using a line of credit at the bank that has an interest rate of 6 percent per year.The lathe is expected to increase production and sales.Sales are expected to increase by $100,000 per year.Inventory and accounts receivable balances are expected to increase by $10,000 and $20,000 respectively.Expenses to operate the lathe are $25,000 per year.P.D.'s marginal tax rate is 40%. a.Calculate the initial outlay required to fund this project. b.Calculate the incremental after-tax cash flow in year one of the project.

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 an increase in net working capital requirements from the new diagnostic testing procedure is the