1.Raphael Restaurant is considering the purchase of a $12,000 soufflé maker. The soufflé maker
has an economic life of five years and will be fully depreciated by the straight line method. The machine will produce 1,900 soufflés per year, with each costing $2.20 to make and priced at $5.
Assume that the discount rate is 14 percent and the tax rate is 34 percent. Should Raphael
make the purchase? ANSWER: $2,855.63
2.Down Under Boomerang, Inc. is considering a new three-year expansion project that requires an
initial fixed asset investment of $2.4 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which it will be worthless. The project is estimated to
generate $2,050,000 in annual sales, with costs of $950,000. The tax rate is 35% and the
required return is 12 percent. What is the project’s NPV?ANSWER: -$10,177.89
3.In problem 2, suppose the project requires an initial investment in net working capital of
$285,000 and the fixed asset will have a market value of $225,000 at the end of the project.
What is the project’s year 0 net cash flow? Year 1? Year 2? Year 3? What is the new NPV?
ANSWER: $11,777.34
4.Scott Investors, Inc. is considering the purchase of a $450,000 computer with an economic life of
five years. The computer will be fully depreciated over five years using the straight-line method.
The market value of the computer will be $80,000 in five years. The computer will replace five office employees whose combined annual salaries are $140,000. The machine will also
immediately lower the firm’s required net working capital by $90,000. This amount of net
working capital will need to be replaced once the machine is sold. The corporate tax rate is 34%.
Is it worthwhile to buy the computer if the appropriate discount rate is 12 percent? ANSWER: $62,279.19
5.Molecugen has developed a new kind of cardiac diagnostic unit. Owing to the highly competitive
nature of the market, the sales department has forecast demand of 5,000 units in the first year and a decrease in demand of 10 percent a year after that (read this as per year). After five years, the project will be discontinued with no salvage value aside from the recovery of remaining
working capital. The marketing department forecasts a sales price of $15,000 a unit. Production estimates manufacturing costs of $5,000 a unit, and the finance department estimates general and administrative expenses of $15 million a year. The initial investment is estimated at $60 million. Working capital requirements are estimated at 30 percent of sales. Cost of capital is 10%. Assume straight-line depreciation and a tax rate of 35%.
a.No reduction in the quantity sold. ANSWER: $35,677,888
b.Sell some existing machinery right now (year 0) for 5,000,000 with a book value of 0.
ANSWER: $38,927,850
c.Sell some existing machinery for 5,000,000 (right now - year 0) with a book value of
2,000,000 which is intended to be depreciated (straight line) to zero over the next two
years. ANSWER: $39,020,450
d.Back to case (a) e xcept that the project won’t be liquidated and the cash flows will
continue forever.ANSWER: $189,045,455
6.Massey Machine Shop is considering purchasing a five-year project to improve its production
efficiency. Buying a new machine press for $480,000 is estimated to result in $180,000 in
annual pretax savings. The press will be depreciated straight line over 5 years to zero. It is
estimated at the end of 5 years we will be able to sell the machine for $70,000. The press also requires an initial investment in spare parts inventory of $20,000 along with an additional
$3,000 in inventory for each succeeding year of the project (except in the fifth year when no additional inventory is needed). If the shop’s tax rate is 35 percent and its discount rate is 15 percent, should Massey buy and install the Machine press? ANSWER: $34,800
7.Arnold Inc. is considering a proposal to manufacture high-end protein bars used as food
supplements by body builders. The project requires use of an existing warehouse, which the firm acquired three years ago for $1m and which it currently rents out for $120,000. Rental rates are not expected to change going forward. In addition to using the warehouse, the project requires an up-front investment into machines and other equipment of $1.4m. This investment can by fully depreciated straight-line over the next 10 years for tax purposes. However, Arnold Inc. expects to terminate the project at the end of eight years and to sell the machines and equipment for $500,000. Finally, the project requires an initial investment into net working capital equal to 10% of predicted first-year sales. Subsequently, net working capital is 10% of the predicted sales over the following year. Sales of protein bars are expected to be $4.8m in the first year and to stay constant eight years. Total manufacturing costs and operating
expenses (excluding depreciation) are 80% of sales, and profits are taxed at 30%.
a.What are the free cash flows of the project?
b.If the cost of capital is 15%, what is the NPV of the project?
Berk and DeMarzo (2011)
8. A bicycle manufacturer currently produces 300,000 units a year and expects output levels to
remain steady in the future. It buys chains from an outside supplier at a price of $2 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them.
Direct in-house production costs are estimated to be only $1.50 per chain. The necessary
machinery would cost $250,000 and would be obsolete after 10 years. The investment could be depreciated to zero for tax purposes using a 10-year straight-line depreciation schedule. The plant manager estimates that the operation would require additional working capital of $50,000 but argues that this sum can be ignored since it is recoverable at the end of the 10 years.
Expected proceeds from scrapping the machinery after 10 years are $20,000. If the company pays tax at a rate of 35% and the opportunity cost of capital is 15%, what is the net present value of the decision to produce the chains in-house instead of purchasing them from the
supplier?
Berk and DeMarzo (2011)