12-1 REQUIRED INVESTMENT

Tannen Industries is considering an expansion. The necessary equipment would be purchased for $18 million, and the expansion would require an additional $2 million investment in net operating working capital. The tax rate is 40%.

a. What is the initial investment outlay?

b. The company spent and expensed $20,000 on research related to the project last year. Would this change your answer? Explain.

c. The company plans to use a building that it owns to house the project. The building could be sold for $1 million after taxes and real estate commissions. How would that fact affect your answer?

12-2 PROJECT CASH FLOW

Colsen Communications is trying to estimate the first-year cash flow (at Year 1) for a proposed project.

Sales revenues - $15 million

Operating costs (excluding depreciation) - 10.5 million

Depreciation - 3 million

Interest expense - 3 million

The financial staff has collected the following information on the project: The company has a 40% tax rate, and its WACC is 11%.

a. What is the project's cash flow for the first year t 1 ?

13-5 FINANCIAL LEVERAGE EFFECTS

Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $20 million in invested capital, has $4 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 50% and pays 12% interest on its debt, whereas LL has a 30% debt-to-capital ratio and pays only 10% interest on its debt. Neither firm uses preferred stock in its capital structure.

a. Calculate the return on invested capital (ROIC) for each firm.

b.Calculate the return on equity (ROE) for each firm.

c. Observing that HL has a higher ROE, LL's treasurer is thinking of raising the debt-to-capital ratio from 30% to 60% even though that would increase LL's interest rate on all debt to 15%. Calculate the new ROE for LL.