Exam 11: Cash Flows and Other Topics in Capital Budgeting

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.

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 incremental free cash flow for year one?

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.

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

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 ________.

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?

The use of risk-adjusted discount rates is based on the concept that investors require a higher rate of return for more risky projects.

Any increase in interest payments caused by a project should be counted in the incremental cash flows.

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?

If an old asset is sold for its depreciated,or book,value,then no taxes result and there is no tax effect from the sale.

Overhead costs are sometimes incremental cash flows and other times are considered sunk costs.

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.

The pure play method

One method of accounting for systematic risk for a project involves identifying a publicly traded firm that is engaged in the same business as that project and using its required rate of return to evaluate the project.This method is referred to as

The recapture of net working capital at the end of a project will

Financial theory assumes that individuals are risk averse.

The initial outlay includes the cost of purchasing the asset and getting it operational,including the purchase price,shipping and installation,and any training costs for employees who will be operating the equipment,and any increases in working capital requirements.

Accounting profits,adjusted for taxes and differences in accounting methods,provide the best measure of relevant cash flows for capital budgeting purposes.

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

Waterford Industries is considering the purchase of a new machine.It will replace an existing but obsolete machine that will be sold for $50,000.The existing machine is 8 years old,cost $200,000,had a 10-year useful life,and is being depreciated to zero using the straight-line method.Waterford's income tax rate is 35%.What is the after-tax salvage value of the old machine?