Take Test: MBA AF Final Exam

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Question $25$

It is April $30,2022.$ Caleb Jamal has worked for several years at SchoolStreet, Inc. Yesterday, the CEO informed Caleb that he would be retiring, effective immediately, and the Board of Directors has appointed Caleb the new CEO. After a brief celebration, Caleb arrives work today ready to accept his responsibilities. Caleb is immediately confronted with a number of investment and Corporate finance decisions.

Caleb$$s first priority is to understand the company$$s capital budgeting analysis. He is looking at upgrading the firm$$s production capacity in an effort to improve the company$$s competitive position. Caleb estimates that SchoolStreet$$s cost of capital is $10\%.$

Caleb is being assisted by Celestila Moonn, an UMB MBA intern at SchoolStreet. Moonn estimates that travel and hotel costs expended as a result of their research and the trade shows they attended amounted to $$8,000.$ Caleb considers the money well spent because he now had two great projects for improving SchoolStreets$$ competitiveness in the industry.

First of all, Caleb is considering replacing a HP$462$ copy machine. This machine was purchased for $$50,0003-$year ago and is being depreciated over $5$ years to a zero salvage value using straight$-$line depreciation. The firm has $2$ years of depreciation remaining on the old machine.

If Caleb decides to make the replacement, the HP$462$ copy machine can be sold today for $$10,000.$ The new HP $-777$ copy machine will cost the firm $$100,000.$ According to Moonn$$s projections, the new HP $-777$ machine will increase revenue by $$40,000$ per year for $3$ years but will also increase costs by $$5,000$ per year. The new HP $-777$ machine will be depreciated over a modified accelerated cost recovery system $($MACRS$)3-$year class life. At the end of year $3,$ the HP $-777$ machine will be sold for $$20,000.$ The firm$$s tax rate is $35$ percent.

Caleb is also considering an investment in a new HP $$XM$900$ digital copy machine. Moonn estimates that the new HP $$XM$900$ digital copy machine will cost $$50,000,$ and that shipping and installation costs will be $$7,500.$ The addition of the digital machine will require a $$2,000$ investment in spare parts inventory at the inception of the project, but these parts can be resold for $$2,000$ at the project$$s end. Compared with the manual process that SchoolStreet used to use for putting on faxing, emailing and copying, Moonn estimates that the new HP $$XM$900$ digital machine will reduce costs by $$25,000$ per year for $4$ years. The HP $$XM$900$ digital machine will be depreciated over a MACRS $5-$year class life. At the end of year $4,$ the equipment will be sold for $$8,000.$

Before making the final calculations, Caleb and Moonn discuss net present value analysis for the projects they are considering. Moonn tells Caleb, $$When calculating the net present value of the two new projects, we also need to account for the costs expended as a result of researching the project options.$$ Caleb makes a note on his legal pad and says to Moonn, $$There is no need to make any adjustments for inflation in our net present value calculations because inflation is included as part of the expected returns used to calculate our weighted average cost of capital.$$ After their conversation, Moonn and Caleb prepare their report to present to SchoolStreets$$ Board of Directors meeting for approval.

Depreciation schedules under MACRS are shown in the exhibit below:

Ownership Year

Class of Investment

$3-$Year

$5-$Year

$7-$Year

$10-$Year

$1$

$33\%$

$20\%$

$14\%$

$10\%$

$2$

$45\%$

$32\%$

$25\%$

$18\%$

$3$

$15\%$

$19\%$

$17\%$

$14\%$

$4$

$7\%$

$12\%$

$13\%$

$12\%$

$5$

$11\%$

$9\%$

$9\%$

$6$

$6\%$

$9\%$

$7\%$

$7$

$9\%$

$7\%$

$8$

$4\%$

$7\%$

$9$

$7\%$

$10$

$6\%$

$11$

$3\%$

$100\%$

$100\%$

$100\%$

$100\%$

The initial cash out flow and the year $2$ operating cash flows from the HP $$XM$900$ digital copy machine are c