Capital Budgeting Part II Exercise

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Feb 20, 2024

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FIN 220 Capital Budgeting Chang Liu 1 1. FITCO is considering the purchase of new equipment. The equipment costs $350,000, and an additional $110,000 is needed to install it. The equipment will be depreciated straight-line to zero over a five-year life. The equipment will generate additional annual revenues of $265,000, and it will have annual cash operating expenses of $83,000. The equipment will be sold for $85,000 after five years. An inventory investment of $73,000 is required during the life of the investment. FITCO is in the 40% tax bracket, and its cost of capital is 10%. What is the project NPV? A. $52,122 B. $64,090 C. $97,449 2. After estimating a project’s NPV, the analyst is advised that the fixed capital outlay will be revised upward by $100,000. The fixed capital outlay is depreciated straight-line over an eight-year life. The tax rate is 40%, and the required rate of return is 10%. No changes in cash operating revenues, cash operating expenses, or salvage value are expected. What is the effect on the project NPV? A. $100,000 decrease B. $73,325 decrease C. $59,988 decrease 3. When assembling the cash flows to calculate an NPV or IRR, the project’s after-tax interest expenses should be subtracted from the cash flows for: A. the IRR calculation but not the NPV calculation. B. both the NPV calculation and the IRR calculation. C. neither the NPV calculation nor the IRR calculation. 4. Standard Corporation is investing $400,000 of fixed capital in a project that will be depreciated straight-line to zero over its 10-year life. Annual sales are expected to be $240,000, and annual cash operating expenses are expected to be $110,000. An investment of $40,000 in net working capital is required over the project’s life. The corporate income tax rate is 30%. What is the after-tax operating cash flow expected in Year 1? A $63,000 B $92,000 C $103,000

FIN 220 Capital Budgeting Chang Liu 2 5. Five years ago, Frater Zahn’s Company invested £38 million—£30 million in fixed capital and another £8 million in working capital—in a bakery. Today, Frater Zahn’s is selling the fixed assets for £21 million and liquidating the investment in working capital. The book value of the fixed assets is £15 million, and the marginal tax rate is 40%. The fifth year’s after-tax non-operating cash flow to Frater Zahn’s is closest to: A. £20.6 million. B. £23.0 million. C. £26.6 million. The following information relates to Questions 6–8 Nanjing Techno Group is considering the purchase of a new 60-ton stamping press. The press costs CNY360,000, and an additional CNY40,000 is needed to install it. The press will be depreciated straight-line to zero over a five-year life. The press will generate no additional revenues, but it will reduce cash operating expenses by CNY140,000 annually. The press will be sold for CNY120,000 after five years. An inventory investment of CNY60,000 is required during the life of the investment. Nanjing Techno is in the 40% tax bracket. 6. What is the Nanjing Techno net investment outlay? A. CNY400,000 B. CNY420,000 C. CNY460,000 7. Nanjing Techno’s incremental annual after-tax operating cash flow is closest to: A. CNY116,000. B. CNY124,000. C. CNY140,000. 8. What is the terminal year after-tax non-operating cash flow at the end of Year 5? A. CNY108,000. B. CNY132,000. C. CNY180,000.

FIN 220 Capital Budgeting Chang Liu 3 The following information relates to Questions 9–11 Bouchard Industries is a Canadian company that manufactures gutters for residential houses. Its management believes it has developed a new process that produces a superior product. The company must make an initial investment of C$190 million to begin production. If demand is high, cash flows are expected to be C$40 million per year. If demand is low, cash flows will be only C$20 million per year. Management believes there is an equal chance that demand will be high or low. The investment also gives the company a production-flexibility option allowing the company to add shifts at the end of the first year if demand turns out to be high. If the company exercises this option, net cash flows would increase by an additional C$5 million in Years 2–10. Bouchard’s opportunity cost of funds is 10%. The internal auditor for Bouchard Industries has made two suggestions for improving capital allocation processes at the company. The internal auditor’s suggestions are as follows: Suggestion 1 “In order to treat all capital allocation proposals in a fair manner, the investments should all use the risk-free rate for the required rate of return.” Suggestion 2 “When rationing capital, it is better to choose the portfolio of investments that maximizes the company NPV than the portfolio that maximizes the company IRR.” 9. What is the NPV (C$ millions) of the original project for Bouchard Industries without considering the production-flexibility option? A. –C$6.11 million B. –C$5.66 million C. C$2.33 million 10. What is the NPV (C$ millions) of the optimal set of investment decisions for Bouchard Industries including the production-flexibility option? A. –C$6.34 million B. C$7.43 million C. C$31.03 million 11. Should the capital allocation committee accept the internal auditor’s suggestions? A. No for Suggestions 1 and 2 B. No for Suggestion 1 and yes for Suggestion 2 C. Yes for Suggestion 1 and no for Suggestion 2

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FIN 220 Capital Budgeting Chang Liu 4 The following information relates to Questions 12–17 The capital budgeting committee for Laroache Industries is meeting. Laroache is a North American conglomerate that has several divisions. One of these divisions, Laroache Livery, operates a large fleet of vans. Laroache’s management is evaluating whether it is optimal to operate new vans for two, three, or four years before replacing them. The managers have estimated the investment outlay, annual after-tax operating expenses, and after-tax salvage cash flows for each of the service lives. Because revenues and some operating costs are unaffected by the choice of service life, they were ignored in the analysis. Laroache Livery’s opportunity cost of funds is 10%. The following table gives the cash flows in thousands of Canadian dollars (C$). Service Life Investment Year 1 Year 2 Year 3 Year 4 Salvage 2 years -40,000 -12,000 -15,000 20,000 3 years -40,000 -12,000 -15,000 -20,000 17,000 4 years -40,000 -12,000 -15,000 -20,000 -25,000 12,000 Schoeman Products, another division of Laroache, has evaluated several investment projects and now must choose the subset of them that fits within its C$40 million capital budget. The outlays and NPVs for the six projects are given below. Schoeman cannot buy fractional projects and must buy all or none of a project. The currency amounts are in millions of Canadian dollars. Project Outlay PV of Future Cash Flows NPV 1 31 44 13 2 15 21 6 3 12 16.5 4.5 4 10 13 3 5 8 11 3 6 6 8 2 Schoeman wants to determine which subset of the six projects is optimal. A final proposal comes from the division Society Services, which has an investment opportunity with a real option to invest further if conditions warrant. The crucial details are as follows: - The original project: - An outlay of C$190 million at time zero. - Cash flows of C$40 million per year for Years 1 – 10 if demand is “ high. ” - Cash flows of C$20 million per year for Years 1 – 10 if demand is “ low. ” - Additional cash flows with the optional expansion project: - An outlay of C$190 million at time one. - Cash flows of C$40 million per year for Years 2 – 10 if demand is “ high. ” - Cash flows of C$20 million per year for Years 2 – 10 if demand is “ low. ” - Whether demand is “high” or “low” in Years 1–10 will be revealed during the first year. The probability of “high” demand is 0.50, and the probability of “low” demand is 0.50.

FIN 220 Capital Budgeting Chang Liu 5 - The option to make the expansion investment depends on making the initial investment. If the initial investment is not made, the option to expand does not exist. - The required rate of return is 10%. Society Services wants to evaluate its investment alternatives. The internal auditor for Laroache Industries has made several suggestions for improving capital budgeting processes at the company. The internal auditor’s suggestions are as follows: Suggestion 1 “In order to put all capital budgeting proposals on an equal footing, the projects should all use the risk-free rate for the required rate of return.” Suggestion 2 “Because you cannot exercise both of them, you should not permit a given project to have both an abandonment option and an expansion/growth option.” Suggestion 3 “When rationing capital, it is better to choose the portfolio of investments that maximizes the company NPV than the portfolio that maximizes the company IRR.” Suggestion 4 “Project betas should be used for establishing the required rate of return whenever the project’s beta is different from the company’s beta.” 12. What is the optimal service life for Laroache Livery’s fleet of vans? A. Two years B. Three years C. Four years 13. The optimal subset of the six projects that Schoeman is considering consists of Projects: A. 1 and 5 B. 2, 3, and 4 C. 2, 4, 5, and 6 14. What is the NPV (C$ millions) of the original project for Society Services without considering the expansion option? A. −6.11 B. −5.66 C. 2.33 15. What is the NPV (C$ millions) of the optimal set of investment decisions for Society Services including the expansion option?

FIN 220 Capital Budgeting Chang Liu 6 A. 6.34 B. 12.68 C. 31.03 16. Should the capital budgeting committee accept the internal auditor’s first and second suggestions, respectively? A. No for Suggestions 1 and 2 B. No for Suggestion 1 and yes for Suggestion 2 C. Yes for Suggestion 1 and no for Suggestion 2 17. Should the capital budgeting committee accept the internal auditor’s third and fourth suggestions, respectively? A. No for Suggestions 3 and 4 B. Yes for Suggestions 3 and 4 C. No for Suggestion 3 and yes for Suggestion 4 18. Lombard Company is contemplating the purchase of a new high-speed widget grinder to replace the existing grinder. The existing grinder was purchased 2 years ago at an installed cost of $57,500; it was being depreciated under MACRS using a 5-year recovery period. The existing grinder is expected to have a usable life of 5 more years. The new grinder costs $101,700 and requires $4,700 in installation costs; it has a 5-year usable life and would be depreciated under MACRS using a 5-year recovery period. Lombard can currently sell the existing grinder for $70,800 without incurring any removal or cleanup costs. To support the increased business resulting from purchase of the new grinder, accounts receivable would increase by $40,400, inventories by $30,400, and accounts payable by $57,100. At the end of 5 years, the existing grinder would have a market value of zero; the new grinder would be sold to net $29,600 after removal and cleanup costs and before taxes. The firm is subject a 21% tax rate. The estimated earnings before depreciation, interest, and taxes over the 5 years for both the new and the existing grinder are shown in the following table: EBITDA Year New grinder Existing grinder 1 $43,900 $25,600 2 $43,900 $23,900 3 $43,900 $21,900 4 $43,900 $19,900 5 $43,900 $17,900

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FIN 220 Capital Budgeting Chang Liu 7 a. Calculate the initial investment associated with the replacement of the existing grinder by the new one. b. Determine the operating cash inflows associated with the proposed grinder replacement. (Note: Be sure to consider the depreciation in year 6.) New Grinder: Year 1 2 3 4 5 6 EBITDA - Depreciation = EBIT - Taxes = NOPAT + Depreciation = OCF Old Grinder: Year 1 2 3 4 5 6 EBITDA - Depreciation = EBIT - Taxes = NOPAT + Depreciation = OCF OCF: Year 1 2 3 4 5 6 OCF (New) - OCF (Old) = Incremental OCF (1) Installed cost of new asset Cost of new asset + Installation costs = Total cost of new asset (2) After-tax proceeds from sale of old asset Proceeds from sale of old asset - Tax on sale of old asset = Total proceeds from sale of old asset (3) Change in net working capital Initial Investment: (1) - (2) + (3)

FIN 220 Capital Budgeting Chang Liu 8 c. Determine the terminal cash flow expected at the end of year 5 from the proposed grinder replacement. (1) After-tax proceeds from sale of new asset Proceeds from sale of new asset - Tax on sale of new asset = Total proceeds from sale of new asset (2) After-tax proceeds from sale of old asset Proceeds from sale of old asset - Tax on sale of old asset = Total proceeds from sale of old asset (3) Recovery of net working capital Terminal cash flow: (1) - (2) + (3) d. Depict on the timeline the incremental cash flows associated with the proposed grinder replacement decision. Year 0 1 2 3 4 5 6 Incremental CF