4. A firm is evaluating a new machine to replace an existing, older machine. The old (existing) machine is being depreciated at $20,000 per year,

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3 4. A firm is evaluating a new machine to replace an existing, older machine. The old (existing) machine is being depreciated at $20,000 per year, whereas the new machine's depreciation will be $18,000. The firm's marginal tax rate is 30 percent. Everything else equal, if the new machine is purchased, what effect will the change in depreciation have on the firm's incremental operating cash flows? a. There should be no effect on the firm's cash flows, because depreciation is a noncash expense. b. Operating cash flows will increase by $2,000. c. Operating cash flows will increase by $1,400. d. Operating cash flows will decrease by $600. e. None of the above is correct 3

4 5. Stanton Inc. is considering the purchase of a new machine which will reduce manufacturing costs by $5,000 annually and increase earnings before depreciation and taxes by $6,000 annually. Stanton will use the MACRS method to depreciate the machine, and it expects to sell the machine at the end of its 5 year operating life for $10,000 before taxes. Stanton's marginal tax rate is 40 percent, and it uses a 9 percent required rate of return to evaluate projects of this type. If the machine's cost is $40,000, what is the project's NPV? a. $1,014 b. $2,292 c. $7,550 d. $817 e. $5,040 4

5 6. Real Time Systems Inc. is considering the development of one of two mutually exclusive new computer models. Each will require a net investment of $5,000. The cash flow figures for each project are shown below: Period Project A Project B 1 $2,000 $3, ,500 2, ,250 2,900 Model B, which will use a new type of laser disk drive, is considered a high risk project, while Model A is of average risk. Real Time adds 2 percentage points to arrive at a risk adjusted discount rate when evaluating a high risk project. The rate used for average risk projects is 12 percent. Which of the following statements regarding the NPVs for Models A and B is most correct? a. NPV A = $380; NPV B = $1,815. b. NPV A = $197; NPV B = $1,590. c. NPV A = $380; NPV B = $1,590. d. NPV A = $5,380; NPV B = $6,590. e. None of the above statements is correct. 5

6 7. Arizona Rock, an all equity firm, currently has a beta of 1.25, and r RF = 7 percent and r M = 14 percent. Suppose the firm sells 10 percent of its assets (beta = 1.25) and purchases the same proportion of new assets with a beta of 1.1. What will be the firm's new overall required rate of return, and what rate of return must the new assets produce in order to leave the stock price unchanged? a %; % b %; 14.7% c %; 14.7% d %; % e %; 15.75% 6

7 8. Klott Company encounters significant uncertainty with its sales volume and price in its primary product. The firm uses scenario analysis in order to determine an expected NPV, which it then uses in its budget. The base case, best case, and worst case scenarios and probabilities are provided in the table below. What is Klott's expected NPV, standard deviation of NPV, and coefficient of variation of NPV? Probability of Unit Sales Sales NPV Outcome Volume Price (In Thousands) Worst case ,000 $3,600 $6,000 Base case ,000 4, ,000 Best case ,000 4, ,000 a. Expected NPV = $35,000; σnpv = 17,500; CV NPV = 2.0. b. Expected NPV = $35,000; σnpv = 11,667; CV NPV = c. Expected NPV = $10,300; σnpv = 12,083; CV NPV = d. Expected NPV = $13,900; σnpv = 8,476; CV NPV = e. Expected NPV = $10,300; σnpv = 13,900; CV NPV =

8 9. Meals on Wings Inc. supplies prepared meals for corporate aircraft (as opposed to public commercial airlines), and it needs to purchase new broilers. If the broilers are purchased, they will replace old broilers purchased 10 years ago for $105,000 and which are being depreciated on a straight line basis to a zero salvage value (15 year depreciable life). The old broilers can be sold for $60,000. The new broilers will cost $200,000 installed and will be depreciated using MACRS over their 5 year class life; they will be sold at their book value at the end of the 5th year. The firm expects to increase its revenues by $18,000 per year if the new broilers are purchased, but cash expenses will also increase by $2,500 per year. If the firm's required rate of return is 10 percent and its tax rate is 34 percent, what is the NPV of the broilers? a. $61,019 b. $17,972 c. $28,451 d. $44,553 e. $5,021 You have been asked by the president of your company to evaluate the proposed acquisition of a new special purpose truck. The truck's basic price is $50,000, and it will cost another $10,000 to modify it for special use by your firm. The truck falls into the MACRS three year class, and it will be sold after three years for $20,000. Use of the truck will require an increase in net working capital (spare parts inventory) of $2,000. The truck will have no effect on revenues, but it is expected to save the firm $20,000 per year in before tax operating costs, mainly labor. The firm's marginal tax rate is 40 percent. [MACRS table required] 10. What is the initial investment outlay for the truck? (That is, what is the Year 0 net cash flow?) a. $50,000 b. $52,600 c. $55,800 d. $62,000 e. $65, What is the incremental operating cash flow in Year 1? a. $17,820 b. $18,254 c. $19,920 d. $20,121 e. $21, What is the terminal (nonoperating) cash flow at the end of Year 3? a. $10,000 b. $12,000 c. $15,680 d. $16,000 e. $18, Your company must ensure the safety of its work force. Two plans are being considered for the next 10 years: (1) Install a high electrified fence around the property at a cost of $100,000. Maintenance and electricity would then cost $5,000 per year over the 10 year life of the fence. (2) Hire security guards at a cost of $25,000 paid at the end of each year. Because the company plans to build new headquarters with a "state of the art" security system in 10 years, the plan will only be in effect until that time. Your company's required rate of return is 15 percent for average projects, and that rate is normally adjusted up or down by 2 percentage points for high and lowrisk projects. Plan 1 is considered to be of low risk because its costs can be predicted quite accurately. Plan B, on the other hand, is a high risk project because of the difficulty of predicting wage rates. What is the proper PV of costs for the better project? a. $104, b. $116, c. $123, d. $127, e. $135, Your company is considering a machine that will cost $1,000 at Time 0 and which can be sold after 3 years for $100. To operate the machine, $200 must be invested at Time 0 in inventories; these funds will be recovered when the machine is retired at the end of Year 3. The machine will produce sales revenues of $900/year for 3 years; variable operating costs (excluding depreciation) will be 50 percent of sales. Operating cash inflows will begin 1 year from today (at Time 1). The machine will have depreciation expenses of $500, $300, and $200 in Years 1, 2, and 3, respectively. The company has a 40 percent tax rate, enough taxable income from other assets to enable it to get a tax refund from this project if the project's income is negative, and a 10 percent required rate of return. Inflation is zero. What is the project's NPV? a. $6.24 b. $7.89 c. $8.87 d. $9.15 e. $ Your company is considering a machine which will cost $50,000 at Time 0 and which can be sold after 3 years for $10,000. $12,000 must be invested at Time 0 in inventories and receivables; these funds will be recovered when the operation is closed at the end of Year 3. The facility will produce sales revenues of $50,000/year for 3 years; variable operating costs (excluding depreciation) will be 40 percent of sales. No fixed costs will be incurred. Operating cash inflows will begin 1 year from today (at t = 1). By an act of Congress, the machine will have depreciation expenses of $40,000, $5,000, and $5,000 in Years 1, 2, and 3 respectively. The company has a 40 percent tax rate, enough taxable income from other assets to enable it to get a tax refund on this project if the project's income is negative, and a 15 percent required rate of return. Inflation is zero. What is the project's NPV? a. $7, b. $12, c. $17, d. $24, e. $32, After a long drought, the manager of Long Branch Farm is considering the installation of an irrigation system which will cost $100,000. It is estimated that the irrigation system will increase revenues by $20,500 annually, although operating expenses other than depreciation will also increase by $5,000. The system will be depreciated using MACRS over its depreciable life (5 years) to a zero salvage value. If the tax rate on ordinary income is 40 percent, what is the project's IRR? a. 12.6% b. 1.3% c. 13.0% d. 10.2% e. 4.8% 8