Exam 11: Cash Flows and Other Topics in Capital Budgeting

Snow Fun Corporation 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 project's contribution to firm risk is relevant for undiversified investors or when bankruptcy costs exist.

The initial outlay for a new project is an example of an opportunity cost.

A weakness in the capital budgeting process is the funds for an investment proposal obtained by issuing bonds,and the respective interest payments,are not considered in the capital budgeting process.

The initial outlay of a project may be reduced by the after-tax salvage value of replaced equipment.

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.

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

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.

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

Acme Auto Repair developed a new diagnostic testing procedure that is expected to increase sales by $10,000 per month.As more drivers bring in their vehicles,Acme 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

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.J.B.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.J.B.'s marginal tax rate is 40%.What is the amount of the initial outlay?

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

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.

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

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

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

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?

Creighton 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.Creighton's income tax rate is 35%.Creighton uses a 12.5% discount rate for capital budgeting purposes.What is the machine's NPV?

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.