roblem 2You have been asked by the president of the Farr Construction Company to

evaluate the proposed acquisition of a new earth mover. The mover?s basic price is $

200,000, and it would cost another $30,000 to modify it for special use. Assume that the mover falls into the MACRS 5 year class, it would be sold after 4 years for $60,000, and it would require an increase in net operating workingcapital (spare parts inventory) of $10,000. The earth mover would have no effect on revenues, but it is expected to save the firm $50,000 per year in before tax operating costs, mainly labor. The firm?s marginal federal-plus-state tax rate is 40 percent and the project?s cost of capital is 10 percent. Evaluate the project using the NPV rule and the IRR rule.

Problem 1 - Evaluating a New Project Year 0 Project- 5 Year Life Building Purchase Equipment Purchase Total Initial Investment $ Year 1 Year 2 Year 3 Year 4 Year 5 (20,000,000) (10,000,000) (30,000,000) Unit Sales Price per Unit Total Sales $ Variable Cost per Unit Total Variable Costs $ Total Fixed Costs 30,000 30,000 30,000 30,000 30,000 6,000 $ 6,120 $ 6,242 $ 6,367 $ 6,495 180,000,000 183,600,000 187,272,000 191,017,440 194,837,789 (4,000) $ (4,080) $ (4,162) $ (4,245) $ (4,245) (120,000,000) (122,400,000) (124,848,000) (127,344,960) (127,344,960) (20,000,000) Depreciation Rate (39 Year) Building Depreciation Depreciation Rate (5 Year) Equipment Depreciation Total Depreciation Costs $ Earnings Before Income Tax (EBIT) $ Tax Rate Total Taxes (20,402,000) (20,606,020) (20,812,080) 1.30% (260,000) 20.00% (2,000,000) $ (2,260,000) 2.60% (520,000) 32.00% (3,200,000) $ (3,720,000) 2.60% (520,000) 19.00% (1,900,000) $ (2,420,000) 2.60% (520,000) 12.00% (1,200,000) $ (1,720,000) 2.60% (520,000) 11.00% (1,100,000) (1,620,000) 37,740,000 $ 37,280,000 $ 39,602,000 $ 41,346,460 $ 45,060,749 40% (15,096,000) Net Operating Profits (NOPAT) (20,200,000) 40% (14,912,000) 40% (15,840,800) 40% (16,538,584) 40% (18,024,299) $ 22,644,000 $ 22,368,000 $ 23,761,200 $ 24,807,876 $ 27,036,449 $ 2,260,000 $ 24,904,000 $ 3,720,000 $ 26,088,000 $ 2,420,000 $ 26,181,200 $ 1,720,000 $ 26,527,876 $ 1,620,000 28,656,449 NOWC Percentage Required 10% 10% 10% 10% 10% Net Operating Working Capital $ 18,000,000.00 $18,360,000.00 $18,727,200.00 $19,101,744.00 $19,483,778.88 $ Increase in NOWC ### $ (360,000) $ (367,200) $ (374,544) $ (382,035) $ 10% 19,483,779 Add Back Depreciation Operating Cash Flow Total Annual Project Cash Flow $ (18,000,000) $ 24,544,000 $ 25,720,800 $ 25,806,656 $ 26,145,841 $ 48,140,228 Terminal Year Cash Flow Building Sale (MV) Less: Book Value of Building Profit on Sale Tax on Loss (40%) Net Salvage Value on Building 10,000,000 (27,660,000) $ (17,660,000) 7,064,000 $ 2,936,000 Equipment Sale (MV) Less: Book Value of Equipment Profit on Sale Tax on Profit (40%) Net Salvage Value on Equipment $ $ 2,000,000 (600,000) 1,400,000 560,000 1,440,000 Total Net Salvage Value $ 4,376,000 521,841 $ 22,516,228 Free Cash Flow $ Required Rate of Return (WACC) NPV $ (43,624,000) $ 12.00% (31,273,154) (1,080,000) $ 96,800 $ 182,656 $ IRR -12.37% Problem 2 - Evaluating a Cost Saving Project Year 0 Acquisition - 5 Year Life Earth Mover Installation Costs Total Initial Investment $ Year 1 Year 2 Year 3 Year 4 (200,000) (30,000) (230,000) Savings in Costs $ 50,000 $ 50,000 $ 50,000 $ 50,000 Depreciation Rate (5 Year) Total Depreciation Costs $ 20.00% (46,000) $ 32.00% (73,600) $ 19.00% (44,160) $ 12.00% (26,496) Earnings Before Income Tax (EBIT) $ 4,000 $ (23,600) $ 5,840 $ 23,504 Tax Rate Total Taxes $ 40.00% 1,600 $ 40.00% (9,440) $ 40.00% 2,336 $ 40.00% 9,402 Net Operating Profits (NOPAT) $ 2,400 $ (14,160) $ 3,504 $ 14,102 Add Back Depreciation Operating Cash Flow $ $ 46,000 $ 48,400 $ 73,600 $ 59,440 $ 44,160 $ 47,664 $ 27,600 40,598 - - - 10,000 10,000 48,400 $ 59,440 $ 47,664 $ 50,598 $ $ 60,000 (39,744) 20,256 8,102 51,898 47,664 $ 102,496 Net Operating Working Capital Increase in NOWC 10,000 (100,000) Total Annual Project Cash Flow $ (240,000) $ Terminal Year Cash Flow Machine Sale Less: Book Value of Machine Profit on Sale Tax on Profit (40%) Net Salvage Value on Equipment Free Cash Flow $ (240,000) $ Required Rate of Return (WACC) ?? NPV $ IRR (41,059) 2.64% 48,400 $ 59,440 $ Problem 3 - Evaluating a Replacement Project Year 0 Acquisition - 5 Year Life New Machinery Sale - Old Machine Total Initial Investment $ Year 1 Year 2 Year 3 Year 4 (160,000) 100,000 (60,000) New Sales Old Sales Change in Sales 120,000 (70,000) 50,000 120,000 (70,000) 50,000 120,000 (70,000) 50,000 120,000 (70,000) 50,000 New Costs Old Costs Change in Costs (40,000) 20,000 (20,000) (40,000) 20,000 (20,000) (40,000) 20,000 (20,000) (40,000) 20,000 (20,000) New Depreciation Old Depreciation Change in Depreciation (30,000) 10,000 (20,000) (30,000) 10,000 (20,000) (30,000) 10,000 (20,000) (30,000) 10,000 (20,000) Earnings Before Income Tax (EBIT) $ 10,000 $ 10,000 $ 10,000 $ 10,000 40.00% 40.00% 40.00% 40.00% Tax Rate Total Taxes ?? ?? ?? ?? Net Operating Profits (NOPAT) ?? ?? ?? ?? Add Back Depreciation Operating Cash Flow ?? ?? ?? ?? ?? ?? ?? ?? Net Operating Working Capital ?? Increase in NOWC ?? ?? ?? ?? ?? ?? ?? ?? ?? Total Annual Project Cash Flow ?? ?? ?? ?? ?? ?? ?? ?? ?? Free Cash Flow ?? Required Rate of Return (WACC) ?? NPV ?? IRR ?? NOT NEEDED NOT NEEDED NOT NEEDED NOT NEEDED