Question One:

You have been asked by the president of the Farr Construction Company to evaluate the proposed

acquisition of a new earth mover. The movers basic price is $50,000, and it would cost another $10,000 to

modify it for special use. Assume that the mover has a MACRS 3-year recovery period (33%, 45%, 15%,

7%), it would be sold after 3 years for $20,000, and it would require an increase in net working capital

(spare parts inventory) of $2000. The earth mover would 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 firms marginal federal-

plus-state tax rate is 40%.

a.

What is the net cost of the earth mover? (i.e. what is the time 0 cash flow?

b.

What are the operating cash flows?

c.

What are the terminal (end of the project) cash flows?

d.

If the projects cost of capital is 10%, should the earth mover be purchased?

Question Two:

In capital budgeting and cost of capital analyses, the firm should always consider retained earnings as the

first source of capital, since this is a free source of funding to the firm.

(true/false/uncertain)

Explain your answer.