Question
A firm purchases a capital asset (for example production equipment) at a cost of $1 billion (Initial capital expenditure that will be used for five
A firm purchases a capital asset (for example production equipment) at a cost of $1 billion (Initial capital expenditure that will be used for five years straight line depreciated with zero remaining value) which generates an income (after COGS and other expenses) stream over a five year period of either o $132 million. With probability firm does not incur liability claims o $532 million. With probability firm incur liability claims Assume the income streams with the probability in each year remains the same. (The actual realization may not the same). Depreciation is straight-line (i.e. equal installments over 5 years). i.e. the tax rate shield from depreciation is 200 million per year. Assume the tax rate is 34% for all levels of income. (Note if the net income zero or negative, the tax liability is zero as well. Also, negative net income does not necessarily mean negative cash flows). The discount rate is assumed to be 6%. Please show how risk management can add values to firm through reduction of expected tax payments. Step 1: Please determine the expected net cash flow from year 0 (today) to year 5. A) To get the expected net cash flow, you need first to determine the EBT (Earning before Tax), which is the income (after COGS and other expenses) minus depreciation, in each scenario in each year. Note based on the assumption each years potential income stream are the same, the EBT of each scenario in each year also are the same. You just need write down for one year. B) Then apply the tax rate to determine the taxes payment in each scenario. (Similar argument as previous step, you just need write down one year) C) Then determine the net cash flow (which is EBT tax payment + Depreciation) in each scenario. (Similar argument as previous step, you just need write down one year) Probability Year 0 1 2 3 4 5 50% High Income Scenario 50% Low Income Scenario Expected Cash Flow Step 2: Please use excel NPV function or PV function to determine the firms value given 6% interest rate.
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