Question 2, 5, 8 Exam coming, would like to make those questions clear with solutions

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EFB210 Finance 1 Tutorial 6: Capital Budgeting 2 Prescribed Reading: Lecture Notes Peirson et al. (2015) Business Finance o Ch. 6, Sections 6.1 to 6.6 & 6.8 Question 1 The net cash flows associated with projects are as follows: Year 0 1 2 3 A (1,500) 550 550 550 B (600) 240 240 240 The required rate of return for the projects is 10.00%. 4 550 240 5 550 240 Using marginal analysis and assuming that the projects were mutually exclusive, determine which investment is preferred and determine the rate of return which will generate the same NPV for the two projects. Question 2 (covered in class) Assume that a firm with a cost of capital of 10.00% must choose between two mutually exclusive projects having cash flows as shown below: Year 0 1 2 3 A (11,000) 2,000 4,000 10,000 B (12,000) 8,000 4,000 4,000 Using marginal analysis, determine which investment is preferred and determine the rate of return where the projects generate equivalent NPVs. Question 3 A firm is considering an investment proposal to replace a piece of machinery. The machine currently in use cost $6,000 three years ago, with a total estimated life of 8 years, and is being depreciated at a diminishing value rate of 25.00%. The new machine, which costs $25,000 and has a life of 5 years, will be depreciated using straight-line depreciation. If the company purchases the new machine, a. What is the annual depreciation expense for the new machine over the next 5 years? b. What is the marginal change to depreciation in your NPV analysis for each year? Page 1 of 11 Question 4 Based on the following information, provide a detailed discounted cash flow analysis and advise whether Sunrise Industries should purchase the additional printing press. Sunrise Industries Ltd. is considering the purchase of an additional printing press for $25,000. It is expected that additional cash revenue each year will be $24,000 before taxation. Cash costs are expected to be $13,000. The press will be depreciated on a straight-line basis over its useful life of five years. It is estimated the press will have a salvage value of $1,200 at the end of its useful life. The company tax rate is 30% and tax is paid in the year in which income is earned. The appropriate discount rate is 20%. Finally, there are no additional working capital requirements for the press. Question 5 A soft drink company is considering the purchase of an additional bottling machine. The new equipment will cost $100,000 and have a life of 5 years. It is expected to generate annual cash revenues of $50,000 and annual cash expenses of $20,000. The company will depreciated it at prime cost over its life, and it is expected to have a salvage value of $10,000 at the end of its life. An additional working capital of $10,000 is required at the beginning of the projects life, and will be recovered in the final year of operations. The company's required rate of return is 10%, company tax rate is 30% and tax is paid in the same year of income. Provide a detailed DCF analysis of this problem and indicate whether the company should purchase this bottling machine? Question 6 (covered in class) A new piece of equipment is expected to produce 330 widgets per year, which will sell for $1,000 each. Variable costs are 40% of sales and fixed costs are $50,000 per year. The investment has a capital expenditure of $400,000 and will require additional working capital of $50,000 which will be recovered in the last year of operations. The new investment will be depreciated prime cost over its 5 year life and is expected to have a salvage value of $60,000 at the end of its life. Company tax is 30% and is paid the year after income. The required rate of return on such an investment is 10%. a. Should the company purchase the new piece of equipment? b. What is the approximate breakeven price on the widgets? c. Is the project viable if the firm only sells 200 widgets per year? Page 2 of 11 Question 7 This example is a modified version of Peirson et al. (2012), Ch. 6 Problem 1. The boat division of Makestuff Ltd, a profitable, diversified company, purchased a machine 5 years ago for $75,000. When it was purchased the machine had an expected useful life of 15 years and an estimated value of zero at the end of its life. The machine currently has a market value of $10,000. The division manager reports that he can buy a new machine for $160,000 (including installation) which, over its 10-year life, will result in an expansion of sales from $100,000 to $110,000 per annum. In addition, it is estimated that the new machine will reduce annual running costs from $70,000 to $50,000. If the required rate of return is 10% p.a... a couple more details: Depreciation is straight-line to Zero, rate = 1/life for old and new machine The new machine salvage is estimated to be $0 at the end of its life Tax is 30% and paid in the year income earned There are no additional working capital requirements a. Should the company replace the machine? b. Given the NPV in part a., what is the corresponding AE? c. If the new machine does not produce any additional sales, would the company purchase it? Question 8 (covered in class) The Pretty Polly Publishing Company operates a printing business in which it is using a photocopying machine that originally cost $60,000. The machine is only five years old but because of technological changes it has a current market salvage value of only $10,000. The machine is being depreciated over an estimated 15-year life with a zero salvage value. The machine would be operative for twenty years but the Commissioner of Taxation appreciates the technological changes of the printing industry and has been prepared to accept a 6 and two thirds percent straight-line rate of depreciation. The company tax rate is 30%. Management is thinking of replacing the photocopier with a less expensive machine which would cost $45,000. This replacement machine would have a ten-year technological life and it is estimated the salvage value at the end of this period would also be $10,000. It is anticipated that the smaller machine would reduce annual costs by $12,000. The Commissioner of Taxation has specified a 10% straight-line depreciation for this machine. The company has elected to use the straight-line method of depreciation and it feels that the appropriate discount rate for the use of photocopiers is 15%. There are no additional working capital requirements for the new machine. In analysing investments the company assumes all cash flows occur at year end except initial outlays. Taxes occur in the year after the income/expense. The manager is sure he should purchase the replacement machine but he does not know how to demonstrate this to the Board. a. Present an analysis to show the Board that it should purchase the replacement machine. b. Discuss whether the company should change its depreciation technique so that: i. It only depreciates the net value of the machine (that is, cost less salvage value); ii. It uses the diminishing value approach. c. If the company was to borrow to purchase the machine and use the cash flows generated by the machine to service the loan, how much can they afford to borrow? Page 3 of 11 Question 9 A company is considering whether it should improve its air fleet. Its current fleet is in good order and is considered to have a useful life of 2 years. In 2 years' time it could replace the existing fleet with a number of Super Jets. The company expects there will be no further improvements in the Super Jets so that once it replaces its existing fleet with Super Jets it will continue to replace in this manner every 5 years. From the following information, calculate the AE and NPV of the Superjets. Detail Additional Outlay Additional Annual Revenues Additional Annual Cash Expenses Depreciation Method Additional Working Capital Requirements Additional Salvage Value Opportunity Cost of Super Jets Company tax rate Amount (dollar amounts in millions) $750 $450 $144 Straight-Line 0 $200 12% 30% Question 10 A cafeteria is open 250 days a year. At lunch time, serving line facilities can accommodate 200 people per hour. However, at present, facilities are unable to handle the overflow of lunch customers with the result that 200 dissatisfied customers who don't wish to stand in line eat elsewhere daily. To tap this excess demand, the cafeteria is considering two alternatives: 1. 2. Installing two vending machines at a cost of $10,000 each; or Completely revamping present facilities with new equipment at a total cost of $100,000 Both the vending machines and serving line equipment have a useful life of 10 years and will be depreciated on a prime cost basis for tax purposes. The required rate of return for the cafeteria is 12%. At present, the average sale is $2.20 with a contribution margin (revenue minus variable costs) of 30%. This is expected to increase to 35% if new serving-line facilities are installed. The present equipment cost $45,000 five years ago and is being depreciated prime cost over its then estimated useful life of 15 years. The tax rate is 30% and tax is paid in the year the income is earned. Data for the vending machine alternative is as follows: Total service cost per year is $1,200; salvage value of each machine at the end of 10 years is $1,500. The price of a full lunch is $2.20 and the contribution margin is 20%. It is estimated that 70% of the dissatisfied customers will use the vending machines and will have a full lunch. The estimated salvage value of the present equipment is zero at the end of the 10 year period. Data for the new serving line facilities is as follows: Yearly salary for an extra check-out person $10,000; current salvage value on old equipment $15,000; salvage value of the new equipment at the end of 10 years is $20,000; cost of dismantling old equipment is $2,000. It is estimated that all of the previously dissatisfied customers will use the new facilities. The additional contribution margin on existing sales will increase revenues by $10,000 per year. a. b. Prepare a schedule of cash flows relevant to the evaluation of each of these alternatives. Which alternative is preferred under NPV analysis? MULTIPLE CHOICE Page 4 of 11 The following information relates to Questions 11 - 14 A bicycle manufacturer is considering the possibility of manufacturing Retro City Bicycles for the trendy youths. The initial outlay for the new machinery required is $1,800,000 and will be depreciated using straight-line depreciation over its 5 year life. It is expected to have a salvage value of $80,000 and the end of the 5 years. The company has estimated that each bicycle will be sold at a price of $550, variable costs will be $220 per bicycle, and fixed costs will be $500,000 per year. The required rate of return on such an investment is 10%, company tax rate is 30% and tax is paid in the year of income. Question 11 To the nearest 50 units, how many bikes must the company sell to breakeven? a. b. c. d. e. 3,000 3,050 3,100 3,150 42 Question 12 The company's best case scenario involves selling 5,000 bikes. The NPV for this scenario is a. b. c. d. e. -$ 55,584 $ 0 $ 1,695,760 $41,100,988 42 Question 13 If the company was to use diminishing value depreciation, what Gain/Loss on Sale would they report in year 5? a. b. c. d. e. $ 0 -$59,968 $80,000 Cannot be determined 42 Question 14 Which of the following statements is correct? a. b. c. d. e. NPV would increase if diminishing value depreciation was used. NPV decreases as the discount rate increases. The AE would give the same decision as NPV in this instance. All of the above A and B Page 5 of 11 ANSWERS Question 1 A minus B cash flows (selected to give standard cash flows). Year 0 1 2 3 4 A (1,500) 550 550 550 550 B (600) 240 240 240 240 A-B (900) 310 310 310 310 5 550 240 310 n NPV = CF t ( 1+ r)t t =0 [ NPV A B=900+ 310 1 1 /0.1=275.14 1.15 This is the difference in the NPVs reported from part a. n NPV = CF t ( 1+ IRR)t =0 t =0 [ IRR A B , 0=900+310 1 1 / IRR 21.36 ( 1+ IRR )5 This IRR corresponds to the point where the two lines intersect on the graph in part b. These results indicate that investment A is preferred to investment B when the required rate of return is less than 21.36%. However, if the required return was greater than 21.36% but less than 28.65%, investment B is preferred. For rates of return above 28.65%, neither investment is preferred as both would have negative NPVs. Question 2 Covered in Tutorial Question 3 Here we are evaluating the marginal effect of depreciation only. Since depreciation reduces taxable income, this will have an impact on tax payable and consequently it will impact the net cash flows. a. As this is straight-line depreciation, the depreciation amount is constant over the 5-years. Depr . New= Outlay 25,000 = =$ 5,000 life 5 Note that the depreciation is calculated based on a residual balance of zero. Unless told otherwise, this is the approach employed in Finance 1. b. The question is asking how much does depreciation change when the old equipment is replaced. To calculate this 'change' amount, simply add back the depreciation forgone from the old equipment to the depreciation for the new equipment. Note that the asset has been already depreciated for 3 years. c. Over page Page 6 of 11 Question 3c. These amounts have been claimed and do not enter the NPV analysis. Question 4 NPV > 0. Therefore, purchase machine. Page 7 of 11 Question 5 NPV > 0. Therefore, purchase machine. Question 6 Covered in Tutorial Page 8 of 11 Question 7 a. NPV > 0. Therefore, purchase machine. Note that cash flows from years 1-9 are an annuity, hence disc. fact is based on the PV annuity formula. b. {[ } 1 /r ( 1+r )n 1 11,313/ 1 /0.1 ( 1+0.1 )10 AE=NPV / 1 {[ } 1,841 c. NO. The NPV will be -31,699. Page 9 of 11 Question 8 Covered in Tutorial Question 9 Page 10 of 11 Question 10 Revamp of Facilities Vending Machines b. Select revamp as it has the higher NPV. Question 11 Question 12 Question 13 Question 14 B C B D Page 11 of 11