Calculating Project NPV 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?
Calculating Project NPV The Best Manufacturing Company is considering a new investment. Financial projections for the investment are tabulated here. The corporate tax rate is 34 percent. Assume all sales revenue is received in cash, all operating costs and income taxes are paid in cash, and all cash flows occur at the end of the year. All net working capital is recovered at the end of the project.
Compute the incremental net income of the investment for each year.
Compute the incremental cash flows of the investment for each year.
Suppose the appropriate discount rate is 12 percent. What is the NPV of the project?
Calculating Project NPV 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 percent and the required return is 12 percent. What is the project's NPV?
Calculating Project Cash Flow from Assets In the previous problem, 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?
NPV and Modified ACRS In the previous problem, suppose the fixed asset actually falls into the three-year MACRS class. All the other facts are the same. What is the project's year 1 net cash flow now? Year 2? Year 3? What is the new NPV?
Project Evaluation Your firm is contemplating the purchase of a new $850,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $75,000 at the end of that time. You will save $320,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $105,000 (this is a one-time reduction). If the tax rate is 35 percent, what is the IRR for this project?
Project Evaluation Dog Up! Franks is looking at a new sausage system with an installed cost of $420,000. This cost will be depreciated straight-line to zero over the project's five-year life, at the end of which the sausage system can be scrapped for $60,000. The sausage system will save the firm $135,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $28,000. If the tax rate is 34 percent and the discount rate is 10 percent, what is the NPV of this project?
Calculating Salvage Value An asset used in a four-year project falls in the five-year MACRS class for tax purposes. The asset has an acquisition cost of $8,400,000 and will be sold for $1,900,000 at the end of the project. If the tax rate is 35 percent, what is the aftertax salvage value of the asset?
Calculating NPV Howell Petroleum is considering a new project that complements its existing business. The machine required for the project costs $1.8 million. The marketing department predicts that sales related to the project will be $1.1 million per year for the next four years, after which the market will cease to exist. The machine will be depreciated down to zero over its four-year economic life using the straight-line method. Cost of goods sold and operating expenses related to the project are predicted to be 25 percent of sales. Howell also needs to add net working capital of $150,000 immediately. The additional net working capital will be recovered in full at the end of the project's life. The corporate tax rate is 35 percent. The required rate of return for Howell is 16 percent. Should Howell proceed with the project?
Calculating EAC You are evaluating two different silicon wafer milling machines. The Techron I costs $270,000, has a three-year life, and has pretax operating costs of $45,000 per year. The Techron II costs $370,000, has a five-year life, and has pretax operating costs of $48,000 per year. For both milling machines, use straight-line depreciation to zero over the project's life and assume a salvage value of $20,000. If your tax rate is 35 percent and your discount rate is 12 percent, compute the EAC for both machines. Which do you prefer? Why?
Cost-Cutting Proposals Massey Machine Shop is considering a four-year project to improve its production efficiency. Buying a new machine press for $530,000 is estimated to result in $230,000 in annual pretax cost savings. The press falls in the MACRS five-year class, and it will have a salvage value at the end of the project of $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. If the shop's tax rate is 35 percent and its discount rate is 14 percent, should Massey buy and install the machine press?
Comparing Mutually Exclusive Projects Hagar Industrial Systems Company (HISC) is trying to decide between two different conveyor belt systems. System A costs $360,000, has a four-year life, and requires $105,000 in pretax annual operating costs. System B costs $480,000, has a six-year life, and requires $65,000 in pretax annual operating costs. Both systems are to be depreciated straight-line to zero over their lives and will have zero salvage value. Whichever system is chosen, it will not be replaced when it wears out. If the tax rate is 34 percent and the discount rate is 11 percent, which system should the firm choose?
Comparing Mutually Exclusive Projects Suppose in the previous problem that HISC always needs a conveyor belt system; when one wears out, it must be replaced. Which system should the firm choose now?
Comparing Mutually Exclusive Projects Vandalay Industries is considering the purchase of a new machine for the production of latex. Machine A costs $2,400,000 and will last for six years. Variable costs are 35 percent of sales, and fixed costs are $180,000 per year. Machine B costs $5,400,000 and will last for nine years. Variable costs for this machine are 30 percent and fixed costs are $110,000 per year. The sales for each machine will be $10.5 million per year. The required return is 10 percent and the tax rate is 35 percent. Both machines will be depreciated on a straight-line basis. If the company plans to replace the machine when it wears out on a perpetual basis, which machine should you choose?
Capital Budgeting with Inflation Consider the following cash flows on two mutually exclusive projects:
The cash flows of project A are expressed in real terms, whereas those of project B are expressed in nominal terms. The appropriate nominal discount rate is 15 percent and the inflation rate is 4 percent. Which project should you choose?
Inflation and Company Value Sparkling Water, Inc., expects to sell 2.1 million bottles of drinking water each year in perpetuity. This year each bottle will sell for $1.25 in real terms and will cost $.75 in real terms. Sales income and costs occur at year-end. Revenues will rise at a real rate of 6 percent annually, while real costs will rise at a real rate of 5 percent annually. The real discount rate is 10 percent. The corporate tax rate is 34 percent. What is Sparkling worth today?
Calculating Nominal Cash Flow Etonic Inc. is considering an investment of $305,000 in an asset with an economic life of five years. The firm estimates that the nominal annual cash revenues and expenses at the end of the first year will be $230,000 and $60,000, respectively. Both revenues and expenses will grow thereafter at the annual inflation rate of 3 percent. Etonic will use the straight-line method to depreciate its asset to zero over five years. The salvage value of the asset is estimated to be $40,000 in nominal terms at that time. The one-time net working capital investment of $10,000 is required immediately and will be recovered at the end of the project. All corporate cash flows are subject to a 34 percent tax rate. What is the project's total nominal cash flow from assets for each year?
Cash Flow Valuation Phillips Industries runs a small manufacturing operation. For this fiscal year, it expects real net cash flows of $155,000. Phillips is an ongoing operation, but it expects competitive pressures to erode its real net cash flows at 5 percent per year in perpetuity. The appropriate real discount rate for Phillips is 11 percent. All net cash flows are received at year-end. What is the present value of the net cash flows from Phillips's operations?
Equivalent Annual Cost Bridgton Golf Academy is evaluating different golf practice equipment. The “Dimple-Max” equipment costs $63,000, has a three-year life, and costs $7,500 per year to operate. The relevant discount rate is 12 percent. Assume that the straight-line depreciation method is used and that the equipment is fully depreciated to zero. Furthermore, assume the equipment has a salvage value of $15,000 at the end of the project's life. The relevant tax rate is 34 percent. All cash flows occur at the end of the year. What is the equivalent annual cost (EAC) of this equipment?
Calculating Project NPV 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 percent. Is it worthwhile to buy the computer if the appropriate discount rate is 12 percent?
Calculating NPV and IRR for a Replacement A firm is considering an investment in a new machine with a price of $12 million to replace its existing machine. The current machine has a book value of $4 million and a market value of $3 million. The new machine is expected to have a four-year life, and the old machine has four years left in which it can be used. If the firm replaces the old machine with the new machine, it expects to save $4.5 million in operating costs each year over the next four years. Both machines will have no salvage value in four years. If the firm purchases the new machine, it will also need an investment of $250,000 in net working capital. The required return on the investment is 10 percent, and the tax rate is 39 percent. What are the NPV and IRR of the decision to replace the old machine?
Project Analysis and Inflation Sanders Enterprises, Inc., has been considering the purchase of a new manufacturing facility for $150,000. The facility is to be fully depreciated on a straight-line basis over seven years. It is expected to have no resale value after the seven years. Operating revenues from the facility are expected to be $70,000, in nominal terms, at the end of the first year. The revenues are expected to increase at the inflation rate of 5 percent. Production costs at the end of the first year will be $20,000, in nominal terms, and they are expected to increase at 6 percent per year. The real discount rate is 8 percent. The corporate tax rate is 34 percent. Sanders has other ongoing profitable operations. Should the company accept the project?
Calculating Project NPV With the growing popularity of casual surf print clothing, two recent MBA graduates decided to broaden this casual surf concept to encompass a “surf lifestyle for the home.” With limited capital, they decided to focus on surf print table and floor lamps to accent people's homes. They projected unit sales of these lamps to be 6,000 in the first year, with growth of 8 percent each year for the next five years. Production of these lamps will require $28,000 in net working capital to start. Total fixed costs are $80,000 per year, variable production costs are $20 per unit, and the units are priced at $48 each. The equipment needed to begin production will cost $145,000. The equipment will be depreciated using the straight-line method over a five-year life and is not expected to have a salvage value. The effective tax rate is 34 percent, and the required rate of return is 25 percent. What is the NPV of this project?
Calculating Project NPV You have been hired as a consultant for Pristine Urban-Tech Zither, Inc. (PUTZ), manufacturers of fine zithers. The market for zithers is growing quickly. The company bought some land three years ago for $1 million in anticipation of using it as a toxic waste dump site but has recently hired another company to handle all toxic materials. Based on a recent appraisal, the company believes it could sell the land for $800,000 on an aftertax basis. In four years, the land could be sold for $900,000 after taxes. The company also hired a marketing firm to analyze the zither market, at a cost of $125,000. An excerpt of the marketing report is as follows:
The zither industry will have a rapid expansion in the next four years. With the brand name recognition that PUTZ brings to bear, we feel that the company will be able to sell 3,100, 3,800, 3,600, and 2,500 units each year for the next four years, respectively. Again, capitalizing on the name recognition of PUTZ, we feel that a premium price of $780 can be charged for each zither. Because zithers appear to be a fad, we feel at the end of the four-year period, sales should be discontinued.
PUTZ feels that fixed costs for the project will be $425,000 per year, and variable costs are 15 percent of sales. The equipment necessary for production will cost $4.2 million and will be depreciated according to a three-year MACRS schedule. At the end of the project, the equipment can be scrapped for $400,000. Net working capital of $120,000 will be required immediately. PUTZ has a 38 percent tax rate, and the required return on the project is 13 percent. What is the NPV of the project? Assume the company has other profitable projects.
Calculating Project NPV Pilot Plus Pens is deciding when to replace its old machine. The machine's current salvage value is $1.8 million. Its current book value is $1.2 million. If not sold, the old machine will require maintenance costs of $520,000 at the end of the year for the next five years. Depreciation on the old machine is $240,000 per year. At the end of five years, it will have a salvage value of $200,000 and a book value of $0. A replacement machine costs $3 million now and requires maintenance costs of $350,000 at the end of each year during its economic life of five years. At the end of the five years, the new machine will have a salvage value of $500,000. It will be fully depreciated by the straight-line method. In five years a replacement machine will cost $3,500,000. Pilot will need to purchase this machine regardless of what choice it makes today. The corporate tax rate is 34 percent and the appropriate discount rate is 12 percent. The company is assumed to earn sufficient revenues to generate tax shields from depreciation. Should Pilot Plus Pens replace the old machine now or at the end of five years?
EAC and Inflation Office Automation, Inc., must choose between two copiers, the XX40 or the RH45. The XX40 costs $1,500 and will last for three years. The copier will require a real aftertax cost of $120 per year after all relevant expenses. The RH45 costs $2,300 and will last five years. The real aftertax cost for the RH45 will be $150 per year. All cash flows occur at the end of the year. The inflation rate is expected to be 5 percent per year, and the nominal discount rate is 14 percent. Which copier should the company choose?
Project Analysis and Inflation Dickinson Brothers, Inc., is considering investing in a machine to produce computer keyboards. The price of the machine will be $530,000, and its economic life is five years. The machine will be fully depreciated by the straight-line method. The machine will produce 15,000 keyboards each year. The price of each keyboard will be $40 in the first year and will increase by 5 percent per year. The production cost per keyboard will be $20 in the first year and will increase by 6 percent per year. The project will have an annual fixed cost of $75,000 and require an immediate investment of $25,000 in net working capital. The corporate tax rate for the company is 34 percent. If the appropriate discount rate is 15 percent, what is the NPV of the investment?
Project Evaluation Aguilera Acoustics, Inc. (AAI), projects unit sales for a new seven-octave voice emulation implant as follows:
Production of the implants will require $1,500,000 in net working capital to start and additional net working capital investments each year equal to 15 percent of the projected sales increase for the following year. Total fixed costs are $700,000 per year, variable production costs are $240 per unit, and the units are priced at $325 each. The equipment needed to begin production has an installed cost of $18,000,000. Because the implants are intended for professional singers, this equipment is considered industrial machinery and thus qualifies as seven-year MACRS property. In five years, this equipment can be sold for about 20 percent of its acquisition cost. AAI is in the 35 percent marginal tax bracket and has a required return on all its projects of 18 percent. Based on these preliminary project estimates, what is the NPV of the project? What is the IRR?
Calculating Required Savings A proposed cost-saving device has an installed cost of $540,000. The device will be used in a five-year project but is classified as three-year MACRS property for tax purposes. The required initial net working capital investment is $45,000, the marginal tax rate is 35 percent, and the project discount rate is 12 percent. The device has an estimated year 5 salvage value of $50,000. What level of pretax cost savings do we require for this project to be profitable?
Calculating a Bid Price Another utilization of cash flow analysis is setting the bid price on a project. To calculate the bid price, we set the project NPV equal to zero and find the required price. Thus the bid price represents a financial break-even level for the project. Guthrie Enterprises needs someone to supply it with 130,000 cartons of machine screws per year to support its manufacturing needs over the next five years, and you've decided to bid on the contract. It will cost you $830,000 to install the equipment necessary to start production; you'll depreciate this cost straight-line to zero over the project's life. You estimate that in five years this equipment can be salvaged for $60,000. Your fixed production costs will be $210,000 per year, and your variable production costs should be $8.50 per carton. You also need an initial investment in net working capital of $75,000. If your tax rate is 35 percent and you require a 14 percent return on your investment, what bid price should you submit?
Financial Break-Even Analysis The technique for calculating a bid price can be extended to many other types of problems. Answer the following questions using the same technique as setting a bid price; that is, set the project NPV to zero and solve for the variable in question.
In the previous problem, assume that the price per carton is $14 and find the project NPV. What does your answer tell you about your bid price? What do you know about the number of cartons you can sell and still break even? How about your level of costs?
Solve the previous problem again with the price still at $14—but find the quantity of cartons per year that you can supply and still break even. (Hint: It's less than 130,000.)
Repeat (b) with a price of $14 and a quantity of 130,000 cartons per year, and find the highest level of fixed costs you could afford and still break even. (Hint: It's more than $210,000.)
Calculating a Bid Price Your company has been approached to bid on a contract to sell 9,000 voice recognition (VR) computer keyboards a year for four years. Due to technological improvements, beyond that time they will be outdated and no sales will be possible. The equipment necessary for the production will cost $3.2 million and will be depreciated on a straight-line basis to a zero salvage value. Production will require an investment in net working capital of $75,000 to be returned at the end of the project, and the equipment can be sold for $200,000 at the end of production. Fixed costs are $600,000 per year, and variable costs are $165 per unit. In addition to the contract, you feel your company can sell 4,000, 12,000, 14,000, and 7,000 additional units to companies in other countries over the next four years, respectively, at a price of $275. This price is fixed. The tax rate is 40 percent, and the required return is 13 percent. Additionally, the president of the company will undertake the project only if it has an NPV of $100,000. What bid price should you set for the contract?
Replacement Decisions Suppose we are thinking about replacing an old computer with a new one. The old one cost us $650,000; the new one will cost $780,000. The new machine will be depreciated straight-line to zero over its five-year life. It will probably be worth about $140,000 after five years.
The old computer is being depreciated at a rate of $130,000 per year. It will be completely written off in three years. If we don't replace it now, we will have to replace it in two years. We can sell it now for $230,000; in two years it will probably be worth $90,000. The new machine will save us $125,000 per year in operating costs. The tax rate is 38 percent, and the discount rate is 14 percent.
Suppose we recognize that if we don't replace the computer now, we will be replacing it in two years. Should we replace now or should we wait? (Hint: What we effectively have here is a decision either to “invest” in the old computer—by not selling it—or to invest in the new one. Notice that the two investments have unequal lives.)
Suppose we consider only whether we should replace the old computer now without worrying about what's going to happen in two years. What are the relevant cash flows? Should we replace it or not? (Hint: Consider the net change in the firm's aftertax cash flows if we do the replacement.)
Project Analysis Benson Enterprises is evaluating alternative uses for a three-story manufacturing and warehousing building that it has purchased for $850,000. The company can continue to rent the building to the present occupants for $36,000 per year. The present occupants have indicated an interest in staying in the building for at least another 15 years. Alternatively, the company could modify the existing structure to use for its own manufacturing and warehousing needs. Benson's production engineer feels the building could be adapted to handle one of two new product lines. The cost and revenue data for the two product alternatives are as follows:
The building will be used for only 15 years for either product A or product B. After 15 years the building will be too small for efficient production of either product line. At that time, Benson plans to rent the building to firms similar to the current occupants. To rent the building again, Benson will need to restore the building to its present layout. The estimated cash cost of restoring the building if product A has been undertaken is $29,000. If product B has been manufactured, the cash cost will be $35,000. These cash costs can be deducted for tax purposes in the year the expenditures occur.
Benson will depreciate the original building shell (purchased for $850,000) over a 30-year life to zero, regardless of which alternative it chooses. The building modifications and equipment purchases for either product are estimated to have a 15-year life. They will be depreciated by the straight-line method. The firm's tax rate is 34 percent, and its required rate of return on such investments is 12 percent.
For simplicity, assume all cash flows occur at the end of the year. The initial outlays for modifications and equipment will occur today (year 0), and the restoration outlays will occur at the end of year 15. Benson has other profitable ongoing operations that are sufficient to cover any losses. Which use of the building would you recommend to management?
Project Analysis and Inflation The Biological Insect Control Corporation (BICC) has hired you as a consultant to evaluate the NPV of its proposed toad ranch. BICC plans to breed toads and sell them as ecologically desirable insect control mechanisms. They anticipate that the business will continue into perpetuity. Following the negligible start-up costs, BICC expects the following nominal cash flows at the end of the year:
The company will lease machinery for $25,000 per year. The lease payments start at the end of year 1 and are expressed in nominal terms. Revenues will increase by 5 percent per year in real terms. Labor costs will increase by 3 percent per year in real terms. Other costs will increase by 1 percent per year in real terms. The rate of inflation is expected to be 6 percent per year. BICC's required rate of return is 10 percent in real terms. The company has a 34 percent tax rate. All cash flows occur at year-end. What is the NPV of BICC's proposed toad ranch today?
Project Analysis and Inflation Sony International has an investment opportunity to produce a new HDTV. The required investment on January 1 of this year is $175 million. The firm will depreciate the investment to zero using the straight-line method over four years. The investment has no resale value after completion of the project. The firm is in the 34 percent tax bracket. The price of the product will be $550 per unit, in real terms, and will not change over the life of the project. Labor costs for year 1 will be $16.75 per hour, in real terms, and will increase at 2 percent per year in real terms. Energy costs for year 1 will be $4.35 per physical unit, in real terms, and will increase at 3 percent per year in real terms. The inflation rate is 5 percent per year. Revenues are received and costs are paid at year-end. Refer to the following table for the production schedule:
The real discount rate for Sony is 8 percent. Calculate the NPV of this project.
Project Analysis and Inflation After extensive medical and marketing research, Pill, Inc., believes it can penetrate the pain reliever market. It is considering two alternative products. The first is a medication for headache pain. The second is a pill for headache and arthritis pain. Both products would be introduced at a price of $5.25 per package in real terms. The headache-only medication is projected to sell 4 million packages a year, whereas the headache and arthritis remedy would sell 6 million packages a year. Cash costs of production in the first year are expected to be $2.45 per package in real terms for the headache-only brand. Production costs are expected to be $2.75 in real terms for the headache and arthritis pill. All prices and costs are expected to rise at the general inflation rate of 5 percent.
Either product requires further investment. The headache-only pill could be produced using equipment costing $15 million. That equipment would last three years and have no resale value. The machinery required to produce the broader remedy would cost $21 million and last three years. The firm expects that equipment to have a $1 million resale value (in real terms) at the end of year 3.
Pill, Inc., uses straight-line depreciation. The firm faces a corporate tax rate of 34 percent and believes that the appropriate real discount rate is 13 percent. Which pain reliever should the firm produce?
Calculating Project NPV J. Smythe, Inc., manufactures fine furniture. The company is deciding whether to introduce a new mahogany dining room table set. The set will sell for $5,600, including a set of eight chairs. The company feels that sales will be 1,800, 1,950, 2,500, 2,350, and 2,100 sets per year for the next five years, respectively. Variable costs will amount to 45 percent of sales, and fixed costs are $1.9 million per year. The new tables will require inventory amounting to 10 percent of sales, produced and stockpiled in the year prior to sales. It is believed that the addition of the new table will cause a loss of 250 tables per year of the oak tables the company produces. These tables sell for $4,500 and have variable costs of 40 percent of sales. The inventory for this oak table is also 10 percent of sales. J. Smythe currently has excess production capacity. If the company buys the necessary equipment today, it will cost $16 million. However, the excess production capacity means the company can produce the new table without buying the new equipment. The company controller has said that the current excess capacity will end in two years with current production. This means that if the company uses the current excess capacity for the new table, it will be forced to spend the $16 million in two years to accommodate the increased sales of its current products. In five years, the new equipment will have a market value of $3.1 million if purchased today, and $7.4 million if purchased in two years. The equipment is depreciated on a seven-year MACRS schedule. The company has a tax rate of 40 percent, and the required return for the project is 14 percent.
Should J. Smythe undertake the new project?
Can you perform an IRR analysis on this project? How many IRRs would you expect to find?
How would you interpret the profitability index?