Ch 12-1 Tuesday, April 17, 2007 Soln.

1. Truman industries is considering an expansion. The necessary equipment would be purchased for $9 million, and it would also an additional $3 million investment in working capital. The tax rate is 40 percent.

a. what is the initial investment outlay?

b. The company spent and expensed $50,000 on research related to the project last year. Would this change your answer? Explain.

c. The company plans to use a building it owns but is not now using to house the project. The building could be sold for $ 1 million after taxes and real estate commissions. How could that affect your answer?

a. Equipment $ 9,000,000

NOWC Investment 3,000,000

Initial investment outlay $12,000,000

b. No, last year’s $50,000 expenditure is considered a sunk cost and does not represent

an incremental cash flow. Hence, it should not be included in the analysis.

c. The potential sale of the building represents an opportunity cost of conducting the project inthat building. Therefore, the possible after-tax sale price must be charged against theproject as a cost.

2. Eisenhower communications is trying to estimate the first-year net operating cash flow (at year 1) for a proposed project. The financial staff has collected the following information on the project:

Sales revenue$10 million

Operating costs (excluding depreciation)$ 7 million

Depreciation$ 2 million

Interest expense$ 2 million

The company has a 40 percent tax rate, and its WACC is 10 percent

  1. What is the project’s operating cash flow for the first year?
  2. If this project would cannibalize other projects by $1 million of cash flow before taxes per year. How would this change your answer to part a?
  3. Ignore part b. if the TR dropped to 30%, how would that change your answer to part a?

a.

b. b. The cannibalization of existing sales needs to be considered in this analysis on an

after-tax basis, because the cannibalized sales represent sales revenue the firm would

realize without the new project but would lose if the new project is accepted. Thus,

the after-tax effect would be to reduce the firm’s operating cash flow by $1,000,000(1

– T) = $1,000,000(0.6) = $600,000. Thus, the firm’s OCF would now be $2,000,000

rather than $2,600,000.

c.

3. Huang Industries is considering a proposed project whose estimated NPV is $12 million. This estimate assumes that economic conditions will be ‘average’, however the CFO realizes that conditions could be better or worse, so she performed a scenario analysis and obtained these results:

Economic scenarioProb. Of outcomeNPV

Recession0.05$70 mil

Below average0.20$25 mil

Average0.50$12 mil

Above average0.20$20 mil

Boom0.05$30 mil

Calculate the project’s expected NPV, Std. deviation, and CV

4. Kennedy air services is now in the final year of a project. The equipment originally cost $20 million, of which 80% has been depreciated. Kennedy can sell the used equipment today for $5 mil and its TR is 40%. What is the equipment’s after-tax net salvage value?