Deck 10: Project Cash-Flow Analysis

Question 1

Identify which of the following costs are fixed and which are variable:
(a) Wages paid to temporary workers
(b) Property taxes on a factory building
(c) Property taxes on an administrative building
(d) Sales commission
(e) Electricity for machinery and equipment in a plant
(f) Heat and air conditioning for a plant
(g) Salaries paid to design engineers
(h) Regular maintenance on machinery and equipment
(i) Basic raw materials used in production
(j) Factory fire insurance

Answer 1

Fixed and Variable Costs:
Fixed costs refer to the costs that change over time but remain fixed to the quantity of production for a relevant time period. Hence fixed costs are time reliable and not depend on the levels of goods and services produced by a company.
Variable costs refer to the costs that vary depending on production volume of a company. Variable costs rise as production increases and fall as production decreases
a.Since a company tends to increase its production with minimum expenses will prefer temporary workers rather than permanent workers. Temporary workers will be paid less comparatively than permanent workers and this creates the variable costs in a company's budget. Hence, wages paid to temporary workers is a variable cost.
b.Whether a particular cost is a fixed or variable cost is based on how it reacts to the change in the business. Property taxes on factory building are a kind of overhead costs which is an indirect manufacturing expense of a company. Hence the property taxes on factory building are a fixed overhead cost as it is not charged directly in the finished goods.
c.Whether a particular cost is a fixed or variable cost is based on how it reacts to the change in the business. Hence, property tax on administrative building is a fixed cost.
d.Sales commission refers to the amount received by an individual from the sales apart from his regular salary income. Hence, sales commission to a sales person comes under variable cost of a company as variable cost does not change with the changes in the level of activity but affected by the changes in the particular activity.
e.
Company's overhead expenses include costs such as electricity for machinery and equipment in a plant is a variable cost. These costs are identified when there is a change in the volume of production in a company.
f.
Since heat and air-conditioning for a plant comes under company's overhead costs which are quite predictable and remains unchanged is termed as fixed cost.
g.
Since salaries paid to the design engineers are quite predictable and remains unchanged during a volume of production is termed as fixed cost.
h.
Regular maintenance on machinery and equipment is a kind of semi-variable fixed cost, which varies continuously but not at the direct proportion of volume of production changes. Hence, regular maintenance on machinery and equipment is a fixed cost.
i.
Since basic raw materials used in production varies in proportion to the change in volume of production is known as a variable cost.
j.
Since factory fire insurance are quite predictable and remains unchanged during a volume of production is termed as a fixed cost.

Question 2

J J Electric Company expects to have taxable income of $320,000 from its regular business over the next two years. The company is considering a new residential wiring project for a proposed apartment complex during year 0. This two-year project requires purchase of new equipment for $30,000. The equipment falls into the MACRS five-year class. The equipment will be sold after two years for $12,000. The project will bring in additional revenue of $100,000 each year, but it is expected to incur an additional operating cost of $40,000 each year. What is the income tax rate to use in year 1 for this project evaluation? (a) 39%
(b) 34%
(c) 33.77%
(d) 35.39%

Answer 2

Given information:
• Taxable income (TI) is $320,000.
• Revenue (R) is $100,000.
• Operating cost (C) per year is $40,000.
• Time period (N) is 2 years.
Tax rate for first year:
Tax rate can be calculated by using the following formula: …… (1)Salvage value after 2 year is $12,000. Hence, the depreciation (D) per year is .
Substitute the respective values in Equation (1) to calculate the tax rate. The tax rate is percent. Hence, option c is correct.

Question 3

Classify the following costs into either being product cost or period cost:
(a) Raw material costs
(b) Income taxes paid
(c) Interest expenses on borrowed funds
(d) Wages incurred in producing products
(e) Fire insurance premium paid on factory buildings
(f) Electric bill for the warehouse operation
(g) Salary paid for engineers
(h) Material handling cost related to production
(i) Salary paid for plant manager
(j) Leasing expense for forklift trucks in warehouse operation
(k) Mortgage payments on factory buildings

Answer 3

Product and period cost:
Product costs refer to all the cost included while manufacturing or purchasing a product, such as raw materials purchased and manufacturing overhead costs.
Period cost refers to all the cost that is not included while manufacturing or purchasing a product. Sales commission, office rent, administrative and selling cost are few examples of period costs.
Examples of product and period costs:
a.Since the purchase of raw materials includes in the cost of manufacturing or producing a product is a product cost.
b.Since income taxes paid is not included while manufacturing a product and seen as an administrative cost is refers to a period cost.
c.Since interest expenses on borrowed funds is not included while manufacturing a product and comes under selling cost is refers to a period cost.
d.Since the wages incurred in producing products includes in the cost of manufacturing or producing a product is a product cost.
e.
Since fire insurance premium paid on factory buildings is not included while manufacturing a product and seen as an administrative cost is refers to a period cost.
f.
Since electricity bill for the warehouse operation is not included while manufacturing a product and comes under selling cost is refers to a period cost.
g.
Since the salary paid for engineers is not included while manufacturing a product and seen as an administrative cost is refers to a period cost.
h.
Since the material handling cost related to production includes in the cost of manufacturing or producing a product is a product cost.
i.
Since salary paid for the plant manager is not included while manufacturing a product and seen as a marketing cost is refers to a period cost.
j.
Since leasing expense for fork-lift trucks in warehouse operation is not included while manufacturing a product and comes under selling or marketing cost is refers to a period cost.
k.
Since mortgage payments on factory buildings is not included while manufacturing a product and comes under selling or marketing cost is refers to a period cost.

Question 4

Consider the following financial data for an investment project: Required capital investment at n = 0: $100,000
Project service life: 10 years
Salvage value at n = 10: $15,000
Annual revenue: $150,000
Annual O M costs (not including depreciation): $50,000
Depreciation method for tax purpose: seven-year MACRS
Income tax rate: 40%.
Determine the project cash flow at the end of year 10.
(a) $69,000
(b) $73,000
(c) $66,000
(d) $67,000

Question 5

Some commonly known costs associated with manufacturing operations are listed below:
(a) Paint shop superintendent's salary
(b) Labor costs in assembling a product
(c) Rent on a factory building
(d) Radio-frequency identification (RFID) units embedded in the final product during shipping
(e) Depreciation on machinery
(f) Lubricants used for machines
(g) CPU chips used in notebook production
(h) Paint used in automobile production
(i) Janitorial and custodial salaries
(j) Coffee beans used in packaging roasted coffee
(k) Sugar used in icecream production
(l) Electricity for operation of machines
(m) Electricity for heating and cooling the factory building
(n) Glue used in electronic board production
Classify each cost as being either variable or fixed with respect to volume or level of activity.

Question 6

Suppose that in Problem 10s.2, the firm borrowed the entire capital investment at 10% interest over 10 years. If the required principal and interest payments in year 10 are Principal payment: $14,795
Interest payment: $1,480,
What would be the net cash flow at the end of year 10?
(a) $46,725
(b) $63,000
(c) $62,112
(d) $53,317

Question 7

The accompanying figures depict a number of cost behavior patterns that might be found in a company's cost structure. The vertical axis on each graph represents total cost, and the horizontal axis on each graph represents level of activity (volume). For each of the given situations, identify the graph that illustrates the cost pattern involved. Any graph may be used more than once. (Adapted originally from the CPA exam; also found in R. H. Garrison and E. W. Noreen, Managerial Accounting, 9th edition, Irwin, 2009.)
(a) Electricity bill-a flat-rate fixed charge plus a variable cost after a certain number of kilowatt-hours are used.
(b) City water bill, which is computed as follows:
First 1,000,000 gallons $1,000 flat, or less
Next 10,000 gallons $0.003 per gallon used
Next 10,000 gallons $0.006 per gallon used
Next 10,000 gallons $0.009 per gallon used

(c) Depreciation of equipment, where the amount is computed by the straight-line method. When the depreciation rate was established, it was anticipated that the obsolescence factor would be greater than the wear-and-tear factor.
(d) Rent on a factory building donated by the city, where the agreement calls for a fixed-fee payment unless 200,000 labor-hours or more are worked, in which case no rent need be paid.
(e) Cost of raw materials, where the cost decreases by 5 cents per unit for each of the first 100 units purchased after which it remains constant at $2.50 per unit.
(f) Salaries of maintenance workers, where one maintenance worker is needed for every 1,000 machine hours or less (that is, 0 to 1,000 hours require one maintenance worker, 1,001 to 2,000 hours require two maintenance workers, etc.).
(g) Cost of raw materials used.
(h) Rent on a factory building donated by the county, where the agreement calls for rent of $100,000 less $1 for each direct labor-hour worked in excess of 200,000 hours, but a minimum rental payment of $20,000 must be paid.
(i) Use of a machine under a lease, where a minimum charge of $1,000 is paid for up to 400 hours of machine time. After 400 hours of machine time, an additional charge of $2 per hour is paid up to a maximum charge of $2,000 per period.

Question 8

A new absorption chiller system costs $360,000 and will save $52,500 in each of the next 12 years. The asset is classified as a seven-year MACRS property for depreciation purpose. The expected salvage value is $20,000. The firm pays taxes at a combined rate of 40% and has an MARR of 12%. What is the net present worth of the system? (a) $46,725
(b) $63,739
(c) $62,112
(d) $53,317

Question 9

Suppose that a company expects the following financial results from a project during its first year operation:
Sales revenue: $300,000
Variable costs: $100,000
Fixed costs: $50,000
Total unit produced and sold: 10,000 units
(a) Compute the contribution margin percentage.
(b) Compute the break-even point in units sold.

Question 10

A corporation is considering purchasing a machine that costs $120,000 and will save $ X per year after taxes. The cost of operating the machine, including maintenance and depreciation, is $20,000 per year after taxes. The machine will be needed for four years after which it will have a zero salvage value. If the firm wants a 14% rate of return after taxes, what is the minimum after-tax annual savings that must be generated to realize a 14% rate of return after taxes? (a) $50,000
(b) $61,184
(c) $91,974
(d) $101,974

Question 11

Suppose ADI Corporation's break-even sales volume is $500,000 with fixed costs of $250,000.
(a) Compute the contribution margin percentage.
(b) Compute the selling price if variable costs are $15 per unit.

Question 12

A corporation is considering purchasing a machine that will save $200,000 per year before taxes. The cost of operating the machine, including maintenance, is $80,000 per year. The machine costing $150,000 will be needed for five years, after which it will have a salvage value of $25,000. A straight-line depreciation with no half-year convention applies (i.e., 20% each year). If the firm wants 15% rate of return after taxes, what is the net present value of the cash flows generated from this machine? The firm's income tax rate is 40%. (a) $137,306
(b) $218,313
(c) $199,460
(d) $375,000

Question 13

Given the following information, answer the questions:
The ratio of variable cost per unit divided by selling price per unit equals 0.3.
Fixed costs amount to $60,000.
(a) Draw the cost-volume-profit diagram.
(b) What is the break-even point?
(c) What effect would an 8% decrease in selling price have on the break-even point from part (b)?

Question 14

A firm is trying to choose between two machines to manufacture a new line of office furniture. The financial data for each machine have been compiled as follows:

The firm's marginal tax rate is 40% and uses a 15% discount rate to value the projects. Also, assume that the required service period is indefinite.

Question 15

The Austin Electric Company has three product lines of surge protectors commonly used in PC and other electronic devices-A, B, and C-having a contribution margin of $3, $2, and $1, respectively. The president foresees sales of 200,000 units in the coming period, consisting of 20,000 units of A, 100,000 units of B, and 80,000 units of C. The company's fixed costs for the period are $255,000.
(a) What is the company's break-even point in units, assuming that the given sales mix is maintained?
(b) If the mix is maintained, what is the total contribution margin when 200,000 units are sold? What is operating income?
(c) What would be operating income if 20,000 units of A, 80,000 units of B, and 100,000 units of C were sold? What is the new break-even point in units if these relationships persist in the next period?

Question 16

What is the internal rate of return (after tax) of machine A? (a) 28%
(b) 39%
(c) 35%
(d) 43%

Question 17

Buffalo Environmental Service expects to generate a taxable income of $350,000 from its regular business in 2012. The company is also considering a new venture: cleaning up oil spills made by fishing boats in lakes. This new venture is expected to generate an additional taxable income of $180,000.
(a) Determine the firm's marginal tax rates before and after the venture.
(b) Determine the firm's average tax rates before and after the venture.

Question 18

What is the net present worth of machine B after tax over 3 years? (a) $6,394
(b) $6,233
(c) $5,562
(d) $7,070

Question 19

Scottsdale Print Shop expects to have an annual taxable income of $300,000 from its regular business over the next two years. The company is also considering the proposed acquisition of a new printing machine to expand current business to offer in its product catalog. The machine's installed price is $105,000. The machine falls into the MACRS five-year class, and it will have an estimated salvage value of $30,000 at the end of six years. The machine is expected to generate additional before-tax revenue of $120,000 per year.
(a) Determine the company's annual marginal (incremental) tax rates over the next two years with the proposed investment in the printing machine.
(b) Determine the company's annual average tax rates over the next two years with the machine.

Question 20

Using the replacement chain method (machine B can be replaced with an identical machine at the end of year 3), determine which project should be adopted after tax. (a) Machine A.
(b) Machine B.
(c) Either machine.
(d) Neither machine.

Question 21

Delta Electric Company expects to have an annual taxable income of $500,000 from its residential accounts over the next two years. The company is also bidding on a two-year wiring service job for a large apartment complex. This commercial service requires the purchase of a new truck equipped with wire-pulling tools at a cost of $50,000. The equipment falls into the MACRS five-year class and will be retained for future use (instead of being sold) after two years, indicating no gain or loss on this property. The project will bring in additional annual revenue of $200,000, but it is expected to incur additional annual operating costs of $100,000. Compute the marginal tax rates applicable to the project's operating profits for the next two years.

Question 22

10s)11 Phoenix Construction Ltd. is considering the acquisition of a new 18-wheeler. The truck's base price is $80,000, and it will cost another $20,000 to modify it for special use by the company.
This truck falls into the MACRS five-year class.
It will be sold after three years (project life) for $30,000.
The truck purchase will have no effect on revenues, but it is expected to save the firm $45,000 per year in before-tax operating costs, mainly in leasing expenses.
The firm's marginal tax rate (federal plus state) is 40%, and its MARR is 15%.
What is the net present worth of this acquisition?
(a) -$45,158 (loss)
(b) $532
(c) $1,677
(d) $2,742

Question 23

A small manufacturing company has an estimated annual taxable income of $195,000. Due to an increase in business, the company is considering purchasing a new machine that will generate additional (before-tax) annual revenue of $80,000 over the next five years. The new machine requires an investment of $100,000, which will be depreciated under the five-year MACRS method.
(a) What is the increment in income tax caused by the purchase of the new machine in tax year 1?
(b) What is the incremental tax rate associated with the purchase of the new equipment in year 1?

Question 24

A special purpose machine tool set would cost $20,000. The tool set will be financed by a $10,000 bank loan repayable in two equal annual installments at 10% compounded annually. The tool is expected to provide annual savings (material) of $30,000 for two years and is to be depreciated by the three-year MACRS method. This special machine tool will require annual O M costs in the amount of $5,000. The salvage value at the end of two years is expected to be $8,000. Suppose that it is expected a 6% annual inflation during the project period. Assuming a marginal tax rate of 40% and an MARR of 20% (inflation adjusted), what is the net present worth of this project? (a) $16,301
(b) $24,558
(c) $23,607
(d) $18,562

Question 25

Simon Machine Tools Company is considering the purchase of a new set of machine tools to process special orders over the next three years. The following financial information is available:
Without the project, the company expects to have a taxable income of $400,000 each year from its regular business over the next three years.
This three-year project requires the purchase of a new set of machine tools at a cost of $50,000. The equipment falls into the MACRS three-year class. The tools will be sold at the end of the project life for $10,000. The project will bring in additional annual revenue of $90,000, but it is expected to incur additional annual operating costs of $25,000.
(a) What are the additional taxable incomes (from undertaking the project) during years 1 through 3, respectively?
(b) What are the additional income taxes (from undertaking the new orders) during years 1 through 3, respectively?

Question 26

Jackson Heating Air Company had sales revenue of $2,250,000 from operations during tax-year 1. Here are some operating data on the company for that year:

(a) What is Jackson's taxable gains?
(b) What is Jackson's taxable income?
(c) What are Jackson's marginal and average tax rates?
(d) What is Jackson's net cash flow after tax?

Question 27

In 2012, Elway Aerospace Company had gross revenues of $1,200,000 from operations. The following financial transactions were posted during the year:

The old equipment had a book value of $75,000 at the time of sale.
(a) What is Elway's income tax liability?
(b) What is Elway's operating income?
(c) What is the net cash flow?

Question 28

An asset in the five-year MACRS property class cost $100,000 and has a zero estimated salvage value after six years of use. The asset will generate annual revenues of $300,000 and will require $100,000 in annual labor costs and $50,000 in annual material expenses. There are no other revenues and expenses. Assume a tax rate of 40%.
(a) Compute the after-tax cash flows over the project life.
(b) Compute the NPW at MARR = 12%. Is this investment acceptable?
(c) Compute the IRR for this project.

Question 29

An auto-part manufacturing company is considering the purchase of an industrial robot to do spot welding, which is currently done by skilled labor. The initial cost of the robot is $250,000, and the annual labor savings are projected to be $125,000. If purchased, the robot will be depreciated under MACRS as a seven-year recovery property. This robot will be used for five years after which the firm expects to sell it for $50,000. The company's marginal tax rate is 35% over the project period.
(a) Determine the net after-tax cash flows for each period over the project life.
(b) Is this a good investment at MARR of 15%?

Question 30

You are considering purchasing a new injection molding machine. This machine will have an estimated service life of 10 years with a negligible after-tax salvage value. Its annual net after-tax operating cash flows are estimated to be $60,000. If you expect a 15% rate of return on investment, what would be the maximum amount that you should spend to purchase the injection molding machine?

Question 31

A facilities engineer is considering a $50,000 investment in an energy management system (EMS). The system is expected to save $10,000 annually in utility bills for N years. After N years, the EMS will have a zero salvage value. In an after-tax analysis, how many years would N need to be in order for the engineer's company to earn a 10% return on the investment? Assume MACRS depreciation with a three-year class life and a 35% tax rate.

Question 32

A corporation is considering a proposal for the purchase of a machine that will save $130,000 per year before taxes. The cost of operating the machine, including maintenance, is $20,000 per year. The machine will be needed for five years after which it will have a zero salvage value. MACRS depreciation will be used, assuming a three-year class life. The marginal income-tax rate is 40%. If the firm wants 12% IRR after taxes, how much can it afford to pay for this machine?

Question 33

Atlanta Capital Leasing Company (ACLC) leases tractors to construction companies. The firm wants to set a three-year lease payment schedule for a tractor purchased at $53,000 from the equipment manufacturer. The asset is classified as a five-year MACRS property. The tractor is expected to have a salvage value of $22,000 at the end of three years of rental. ACLC will require the lessee to make a security deposit of $1,500 that is refundable at the end of the lease term. ACLC's marginal tax rate is 35%. If ACLC wants an after-tax return of 10%, what lease payment schedule should be set?

Question 34

You are interested in purchasing a machine that will save $200,000 per year before taxes. The cost of operating the machine, including maintenance, is $80,000 per year. The machine, which costs $150,000, will be needed for five years after which it will have a salvage value of $25,000. The machine would qualify for a 7-year MACRS property. What is the net present value of the cash flows generated from this machine at 15%? The firm's income tax rate is 40%.

Question 35

Peachtree Construction Company, a highway contractor, is considering the purchase of a new trench excavator that costs $300,000 and can dig a 3-foot-wide trench at the rate of 16 feet per hour. The contractor gets paid according to the usage of the equipment, $100 per hour. The expected average annual usage is 500 hours, and maintenance and operating costs will be $10 per hour. The contractor will depreciate the equipment by using a five-year MACRS, units-of-production method. At the end of five years, the excavator will be sold for $100,000.
(a) Assuming that the contractor's marginal tax rate is 35% per year, determine the annual after-tax cash flow.
(b) Is this a good investment if the contractor requires 15% return on investment?

Question 36

Tucson Solar Company builds residential solar homes. Because of an anticipated increase in business volume, the company is considering the acquisition of a loader at a cost of $54,000. This acquisition cost includes delivery charges and applicable taxes. The firm has estimated that if the loader is acquired, the following additional revenues and operating expenses (excluding depreciation) should be expected:

The projected revenue is assumed to be in cash in the year indicated, and all the additional operating expenses are expected to be paid in the year in which they are incurred. The estimated salvage value for the loader at the end of the sixth year is $8,000. The firm's incremental (marginal) tax rate is 35%.
(a) What is the after-tax cash flow if the loader is acquired?
(b) What is the equivalent annual cash flow the firm can expect by owning and operating this loader at an interest rate of 12%?

Question 37

An automaker is considering installing a three-dimensional (3-D) computerized styling system at a cost of $180,000 (including hardware and software). With the 3-D computer modeling system, designers will have the ability to view their design from many angles and to fully account for the space required for the engine and passengers. The digital information used to create the computer model can be revised in consultation with engineers, and the data can be used to run milling machines that make physical models quickly and precisely. The automaker expects to decrease turnaround time by 35% for new automobile models (from configuration to final design). The expected saving is $350,000 per year. The training and operating and maintenance cost for the new system is expected to be $80,000 per year. The system has a five-year useful life and can be depreciated as a five-year MACRS class. The system will have an estimated salvage value of $5,000. The automaker's marginal tax rate is 40%.
(a) Determine the annual cash flows for this investment.
(b) What is the return on investment for this project? The firm's MARR is 12%.

Question 38

The Manufacturing Division of Ohio Vending Machine Company is considering its Toledo plant's request for a half-inch-capacity automatic screw-cutting machine to be included in the division's 2013 capital budget:
Name of project: Mazda Automatic Screw Machine
Project cost: $68,701
Purpose of project: To reduce the cost of some of the parts that are now being subcontracted by this plant, to cut down on inventory by shortening lead time, and to better control the quality of the parts. The proposed equipment includes the following cost basis:

Anticipated savings: as shown in the accompanying table.
Tax depreciation method: seven-year MACRS.
Marginal tax rate: 40%.
MARR: 15%.

(a) Determine the net after-tax cash flows over the project life of six years. Assume a salvage value of $3,500.
(b) Is this project acceptable based on the PW criterion?
(c) Determine the IRR for this investment.

Question 39

Reconsider Problem 10.17. Suppose that the project requires a $30,000 investment in working capital at the beginning of the project and the entire amount will be recovered at the end of project life. How does this investment in working capital change the net cash flows series?

Question 40

Reconsider Problem 10.23. Suppose that the purchase also requires an investment in working capital in the amount of $50,000, which will be recovered in full at the end of year 5. Determine the net present worth of the project.
10.23 Peachtree Construction Company, a highway contractor, is considering the purchase of a new trench excavator that costs $300,000 and can dig a 3-foot-wide trench at the rate of 16 feet per hour. The contractor gets paid according to the usage of the equipment, $100 per hour. The expected average annual usage is 500 hours, and maintenance and operating costs will be $10 per hour. The contractor will depreciate the equipment by using a five-year MACRS, units-of-production method. At the end of five years, the excavator will be sold for $100,000.
(a) Assuming that the contractor's marginal tax rate is 35% per year, determine the annual after-tax cash flow.
(b) Is this a good investment if the contractor requires 15% return on investment?

Question 41

Consider a project with an initial investment of $300,000, which must be financed at an interest rate of 12% per year. Assuming that the required repayment period is six years, determine the repayment schedule by identifying the principal as well as the interest payments for each of the following repayment methods:
(a) Equal repayment of the principal: $50,000 principal payment each year
(b) Equal repayment of the interest: $36,000 interest payment each year
(c) Equal annual installments: $72,968 each year

Question 42

A special-purpose machine tool set would cost $30,000. The entire capital expenditure ($30,000) is to be borrowed with the stipulation that it be repaid by two equal end-of-year payments at 12% compounded annually. The tool is expected to provide annual savings (in material) of $45,000 for two years and is to be depreciated by the MACRS three-year recovery period. This special machine tool will require annual O M costs in the amount of $12,000. The salvage value at the end of two years is expected to be $9,000. Assuming a marginal tax rate of 40% and MARR of 15%, what is the net present worth of this project?

Question 43

The Balas Manufacturing Company is considering buying an overhead pulley system. The new system has a purchase price of $150,000, an estimated useful life and MACRS class life of five years, and an estimated salvage value of $10,000. The system is expected to enable the company to economize on electric power usage, labor, and repair costs, as well as to reduce the number of defective products made. A total annual savings of $95,000 will be realized if the new pulley system is installed. The company is in the 35% marginal tax bracket. The initial investment will be financed with 40% equity and 60% debt. The before-tax debt interest rate, which combines both short-term and long-term financing, is 12% with the loan to be repaid in equal annual installments over the project life.
(a) Determine the after-tax cash flows.
(b) Evaluate this investment project by using an MARR of 20%.
(c) Evaluate this investment project on the basis of the IRR criterion.

Question 44

A toy manufacturer is considering the installation of a new process machine for its toy manufacturing facility. The machine costs $350,000 installed, will generate additional revenues of $120,000 per year, and will save $50,000 per year in labor and material costs. The machine will be financed by a $250,000 bank loan repayable in three equal annual principal installments plus 9% interest on the outstanding balance. The machine will be depreciated by seven-year MACRS. The useful life of this process machine is 10 years at which time it will be sold for $20,000. The combined marginal tax rate is 40%.
(a) Find the year-by-year after-tax cash flow for the project.
(b) Compute the IRR for this investment.
(c) At MARR = 18%, is this project economically justifiable?

Question 45

Consider the following financial information about a retooling project at a computer manufacturing company:
The project costs $2 million and has a five-year service life.
The project can be classified as a seven-year property under the MACRS rule.
At the end of the fifth year, any assets held for the project will be sold. The expected salvage value will be about 10% of the initial project cost.
The firm will finance 40% of the project money from an outside financial institution at an interest rate of 10%. The firm is required to repay the loan with five equal annual payments.
The firm's incremental (marginal) tax rate on this investment is 35%.
The firm's MARR is 18%.
Use this financial information to complete the following tasks:
(a) Determine the after-tax cash flows.
(b) Compute the annual equivalent cost for this project.

Question 46

A manufacturing company is considering the acquisition of a new injection-molding machine at a cost of $110,000. Because of a rapid change in product mix, the need for this particular machine is expected to last only eight years after which time the machine is expected to have a salvage value of $10,000. The annual operating cost is estimated to be $8,000. The addition of this machine to the current production facility is expected to generate annual revenue of $60,000. The firm has only $70,000 available from its equity funds, so it must borrow the additional $40,000 required at an interest rate of 10% per year with repayment of principal and interest in eight equal annual amounts. The applicable marginal income tax rate for the firm is 40%. Assume that the asset qualifies for a seven-year MACRS property classification.
(a) Determine the after-tax cash flows.
(b) Determine the NPW of this project at MARR = 14%.

Question 47

Suppose an asset has a purchase cost of $15,000, a life of five years, a salvage value of $3,000 at the end of five years, and a net annual before-tax revenue of $7,500. The firm's marginal tax rate is 35%. The asset will be depreciated by five-year MACRS.
(a) Determine the cash flow after taxes, assuming that the purchase cost will be entirely financed by the equity funds.
(b) Rework part (a), assuming that the entire investment would be financed by a bank loan at an interest rate of 9%.
(c) Given a choice between paying the purchase cost up front from the firm's equity and using the financing method of part (b), show calculations to justify which is the better choice at an interest rate of 9%.

Question 48

A construction company is considering the proposed acquisition of a new earthmover. The purchase price is $100,000, and an additional $25,000 is required to modify the equipment for special use by the company. The equipment falls into the MACRS five-year classification (tax life), and it will be sold after five years (project life) for $50,000. Purchase of the earthmover will have no effect on revenues, but it is expected to save the firm $60,000 per year in before-tax operating costs-mainly labor. The firm's marginal tax rate is 40%. Assume that the initial investment is to be financed by a bank loan at an interest rate of 10% payable annually. Determine the after-tax cash flows and the worth of investment for this project if the firm's MARR is known to be 12%.

Question 49

A leading regional airline that is now carrying 54% of all the passengers that pass through the Southeast is considering the possibility of adding a new long-range aircraft to its fleet. The aircraft being considered for purchase is the Boeing 717-200, which is quoted at $35 million per unit. Boeing requires a 10% down payment at the time of delivery, and the balance is to be paid over a 10-year period at an interest rate of 9% compounded annually. The actual payment schedule calls for making only interest payments over the 10-year period, with the original principal amount to be paid off at the end of the 10th year. The airline expects to generate $40 million per year by adding this aircraft to its current fleet but also estimates an operating and maintenance cost of $30 million per year. The aircraft is expected to have a 15-year service life with a salvage value of 15% of the original purchase price. If the airline purchases the aircraft, it will be depreciated by the seven-year MACRS property classification. The firm's combined federal and state marginal tax rate is 38%, and its MARR is 18%.
(a) Determine the cash flow associated with the debt financing.
(b) Is this project acceptable?

Question 50

The headquarters building, Building A, owned by a rapidly growing company, is not large enough for current needs. A search for enlarged quarters revealed two new alternatives that would provide sufficient room, enough parking, and the desired appearance and location; or the company could remodel its existing building to create more usable space. The company's three options are as follows:
Option 1: Lease Building B for $144,000 per year.
Option 2: Purchase Building C for $800,000, including a $150,000 cost for land.
Option 3: Remodel Building A.
It is believed that land values will not decrease over the ownership period, but the value of all structures will decline to 10% of the purchase price in 30 years. Annual property tax payments are expected to be 5% of the purchase price. The present headquarters building is already paid for and is now valued at $300,000. The land it is on is appraised at $60,000. The structure can be remodeled at a cost of $300,000 to make it comparable with the other alternatives. However, the remodeled Building A will occupy part of the existing parking lot. An adjacent, privately owned parking lot can be leased for 30 years under an agreement that the first year's rental of $9,000 will increase by $500 each year. The annual property taxes on the remodeled property will again be 5% of the present valuation plus the cost to remodel. The study period for the comparison is 30 years, and the desired rate of return on investments is 12%. Assume that the firm's marginal tax rate is 40% and the new building (C) and remodeled structure will be depreciated under MACRS at a real-property recovery period of 39 years. If the annual upkeep costs are the same for all three alternatives, which one is preferable?

Question 51

An international manufacturer of prepared food items needs 50,000,000 kWh of electrical energy a year with a maximum demand of 10,000 kW. The local utility presently charges $0.085 per kWh, a rate considered high throughout the industry. Because the firm's power consumption is so large, its engineers are considering installing a 10,000-kW steam-turbine plant. Three types of plant have been proposed as shown in the following table ($ units in thousands):

The service life of each plant is expected to be 20 years. The plant investment will be subject to a 20-year MACRS property classification. The expected salvage value of the plant at the end of its useful life is about 10% of the original investment. The firm's MARR is known to be 12%. The firm's marginal income-tax rate is 39%.
(a) Determine the unit power cost ($/kWh) for each plant.
(b) Which plant would provide the most economical power?

Question 52

H H Machine Systems Inc. needs to acquire a new lift truck for transporting final products to their warehouse. One alternative is to purchase the lift truck for $40,000, which will be financed by a bank loan at an interest rate of 12%. The loan must be repaid in four equal installments payable at the end of each year. Under the borrow-to-purchase arrangement, H H would have to maintain the truck at an annual cost of $1,200, payable at year-end. Alternatively, H H could lease the truck on a four-year contract for a lease payment of $11,000 per year. Each annual lease payment must be made at the beginning of each year. The truck would be maintained by the lessor. The truck falls into the five-year MACRS classification, and it has a salvage value of $10,000, which is the expected market value after four years, at which time H H plans to replace the truck, regardless of whether the company leases or buys. H H has a marginal tax rate of 40% and an MARR of 15%.
(a) What is H H's cost of leasing in present worth?
(b) What is H H's cost of owning in present worth?
(c) Should the truck be leased or purchased?

Question 53

Janet Wigandt, an electrical engineer for Instrument Control, Inc. (ICI), has been asked to perform a lease-buy analysis on a new pin-inserting machine for ICI's PC-board manufacturing operation. The details of the two options are as follows:
Buy option: The equipment costs $120,000. To purchase it, ICI could obtain a term loan for the full amount at 10% interest with four equal annual installments (end-of-year payments). The machine falls into a five-year MACRS property classification. Annual revenues of $200,000 and annual operating costs of $40,000 are anticipated. The machine requires annual maintenance at a cost of $10,000. Because technology is changing rapidly in pin-inserting machinery, the salvage value of the machine is expected to be only $20,000.
Lease option: BLI is willing to write a four-year operating lease on the equipment for payments of $44,000 at the beginning of each year. Under this operating-lease arrangement, BLI will maintain the asset, so the annual maintenance cost of $10,000 will be saved. ICI's marginal tax rate is 40%, and its MARR is 15% during the analysis period.
(a) What is ICI's present-worth (incremental) cost of owning the equipment?
(b) What is ICI's present-worth (incremental) cost of leasing the equipment?
(c) Should ICI buy or lease the equipment?

Question 54

Oregon Machinery Company (OMC) has decided to acquire a screw machine. One alternative is to lease the machine on a three-year contract for a lease payment of $22,000 per year with payments to be made at the beginning of each year. The lease would include maintenance. The second alternative is to purchase the machine outright for $97,000, financing the investment with a bank loan for the net purchase price and amortizing the loan over a three-year period at an interest rate of 12% per year (annual payment = $40, 386).
Under the borrow-to-purchase arrangement, the company would have to maintain the machine at an annual cost of $6,000, payable at year-end. The machine falls into the seven-year MACRS classification, and it has a salvage value of $45,000, which is the expected market value at the end of year 3. After three years, the company plans to replace the machine regardless of whether it leases or buys. The tax rate is 40%, and the MARR is 15%.
(a) What is OMC's PW cost of leasing?
(b) What is OMC's PW cost of owning?
(c) From the financing analyses in parts (a) and (b), what are the advantages and disadvantages of leasing and owning?

Question 55

Gentry Machines, Inc., has just received a special job order from one of its clients.
The following financial data on the order have been collected:
This two-year project requires the purchase of a special-purpose piece of equipment for $55,000. The equipment falls into the MACRS five-year class.
The machine will be sold at the end of two years for $27,000 (today's dollars).
The project will bring in an additional annual revenue of $114,000 (actual dollars), but it is expected to incur an additional annual operating cost of $53,800 (today's dollars).
To purchase the equipment, the firm expects to borrow $50,000 at 10% over a two-year period (equal annual payments of $28,810 in actual dollars). The remaining $5,000 will be taken from the firm's retained earnings.
The firm expects a general inflation of 5% per year during the project period. The firm's marginal tax rate is 40%, and its market interest rate is 18%.
(a) Compute the after-tax cash flows in actual dollars.
(b) What is the equivalent present worth of this amount at time 0?

Question 56

Hugh Health Product Corporation is considering the purchase of a computer to control plant packaging for a spectrum of health products. The following data have been collected:
First cost = $130,000 to be borrowed at 9% interest, where only interest is paid each year and the principal is due in a lump sum at the end of year 2.
Economic service life = six years.
Estimated selling price in year-0 dollars = $20,000.
Depreciation method = five-year MACRS property.
Marginal income-tax rate = 40% (remains constant).
Annual revenue = $155,000 (today's dollars).
Annual expense (not including depreciation and interest) = $88,000 (today's dollars).
Market interest rate = 18%.
(a) An average general inflation rate of 5%, affecting all revenues, expenses, and the salvage value, is expected during the project period. Determine the cash flows in actual dollars.
(b) Compute the net present worth of the project under inflation.
(c) Compute the net-present-worth loss (or gain) due to inflation.
(d) Compute the present-worth loss (or gain) due to borrowing.

Question 57

J. F. Manning Metal Company is considering the purchase of a new milling machine during year 0. The machine's base price is $135,000, and it will cost another $15,000 to modify the machine for special use by the firm, resulting in a $150,000 cost base for depreciation. The machine falls into the MACRS seven-year property class. The machine will be sold after three years for $80,000 (actual dollars). Use of the machine will require an increase in net working capital (inventory) of $10,000 at the beginning of the project year. The machine will have no effect on revenues, but it is expected to save the firm $80,000 (today's dollars) per year in before-tax operating costs-mainly labor. The firm's marginal tax rate is 40%, and this rate is expected to remain unchanged over the project's duration. However, the company expects that the labor cost will increase at an annual rate of 5% and that the working-capital requirement will grow at an annual rate of 8% caused by inflation. The selling price of the milling machine is not affected by inflation. The general inflation rate is estimated to be 6% per year over the project period. The firm's market interest rate is 20%.
(a) Determine the project cash flows in actual dollars.
(b) Determine the project cash flows in constant (time-zero) dollars.
(c) Is this project acceptable?

Question 58

Suppose a business is considering the purchase of a $40,000 machine whose operation will result in increased sales of $30,000 per year and increased operating costs of $10,000; additional profits will be taxed at a rate of 50%. Depreciation is assumed to be taken on a straight-line basis over four years with no expected salvage value. What will happen to this project's real rate of return if inflation during the next four years is expected to be 10% compounded annually?

Question 59

Fuller Ford Company is considering the purchase of a vertical drill machine. The machine will cost $50,000 and will have an eight-year service life. The selling price of the machine at the end of eight years is expected to be $5,000 in today's dollars. The machine will generate annual revenues of $20,000 (today's dollars) but is expected to have an annual expense (excluding depreciation) of $8,000 (today's dollars). The asset is classified as a seven-year MACRS property. The project requires a working-capital investment of $10,000 at year 0. The marginal income-tax rate for the firm is averaging 35%. The firm's market interest rate is 18%.
(a) Determine the internal rate of return of this investment.
(b) Assume that the firm expects a general inflation rate of 5%, but that it also expects an 8% annual increase in revenue and working capital and a 6% annual increase in expenses, caused by inflation. Compute the real (inflation-free) internal rate of return. Is this project acceptable?

Question 60

You have $10,000 cash, which you want to invest. Normally, you would deposit the money in a savings account that pays an annual interest rate of 6%. However, you are now considering the possibility of investing in a bond. Your marginal tax rate is 30% for both ordinary income and capital gains. You expect the general inflation rate to be 3% during the investment period. You can buy a high-grade municipal bond costing $10,000 that pays interest of 9% ($900) per year. This interest is not taxable. A comparable high-grade corporate bond is also available that is just as safe as the municipal bond but pays an interest rate of 12% ($1,200) per year. This interest is taxable as ordinary income. Both bonds mature at the end of year 5.
(a) Determine the real (inflation-free) rate of return for each bond.
(b) Without knowing your MARR, can you make a choice between these two bonds?

Question 61

Air Florida is considering two types of engines for use in its planes, each of which has the same life, same maintenance costs, and same repair record:
Engine A costs $100,000 and uses 50,000 gallons of fuel per 1,000 hours of operation at the average service load encountered in passenger service.
Engine B costs $200,000 and uses 32,000 gallons of fuel per 1,000 hours of operation at the same service load.
Both engines are estimated to operate for 10,000 service hours before any major overhaul of the engines is required. If fuel currently costs $1.25 per gallon and its price is expected to increase at a rate of 8% because of inflation, which engine should the firm install for an expected 2,000 hours of operation per year? The firm's marginal income-tax rate is 40%, and the engine will be depreciated by the units-of-production method. Assume that the firm's market interest rate is 20%. It is estimated that both engines will retain a market value of 40% of their initial cost (actual dollars) if they are sold on the market after 10,000 hours of operation.
(a) Using the present-worth criterion, which project would you select?
(b) Using the annual-equivalence criterion, which project would you select?
(c) Using the future-worth criterion, which project would you select?

Question 62

K G Chemical Company has just received a special subcontracting job from one of its clients. This two-year project requires the purchase of a special-purpose painting sprayer for $60,000. This equipment falls into the MACRS five-year class. After the subcontracting work is completed at the end of two years, the painting sprayer will be sold for $40,000 (actual dollars). The painting system will require an increase in the company's net working capital (for spare-parts inventory, such as spray nozzles) of $5,000. This investment in working capital will be fully recovered at the project termination. The project will bring in an additional annual revenue of $120,000 (today's dollars), but it is expected to incur an additional annual operating cost of $60,000 (today's dollars). It is projected that, because of inflation, there will be sales-price increases at an annual rate of 5%, which implies that annual revenues will also increase at an annual rate of 5%. An annual increase of 4% for expenses and working-capital requirements is expected. The company has a marginal tax rate of 30%, and it uses a market interest rate of 15% for project evaluation during the inflationary period. The firm expects a general inflation of 8% during the project period.
(a) Compute the after-tax cash flows in actual dollars.
(b) What is the rate of return on this investment (real earnings)?
(c) Is this special order profitable?

Question 63

Land Development Corporation is considering the purchase of a bulldozer. The bulldozer will cost $100,000 and will have an estimated salvage value of $30,000 at the end of six years. The asset will generate annual before-tax revenues of $80,000 over the next six years. The asset is classified as a five-year MACRS property. The marginal tax rate is 40%, and the firm's market interest rate is known to be 18%. All dollar figures represent constant dollars at time zero and are responsive to the general inflation rate f.
(a) With f = 6% compute the after-tax cash flows in actual dollars.
(b) Determine the real rate of return of this project on an after-tax basis.
(c) Suppose that the initial cost of the project will be financed through a local bank at an interest rate of 12% and with an annual payment of $24,323 over six years. With this additional condition, rework part (a).
(d) From your answer to part (a), determine the PW loss due to inflation.
(e) From your answer to part (c), determine how much the project has to generate
in additional before-tax annual revenues in actual dollars (equal amount) in order to make up the inflation loss.

Question 64

USA Aluminum Company is considering making a major investment of $150 million ($5 million for land, $45 million for buildings, and $100 million for manufacturing equipment and facilities) to produce a stronger, lighter material, called aluminum lithium, that will make aircraft sturdier and more fuel efficient. Aluminum lithium has been sold commercially as an alternative to composite materials for only a few years. It will likely be the material of choice for the next generation of commercial and military aircraft because it is so much lighter than conventional aluminum alloys. Another advantage of aluminum lithium is that it is cheaper than composites. The firm predicts that aluminum lithium will account for about 5% of the structural weight of the average commercial aircraft within 5 years and 10% within 10 years. The proposed plant, which has an estimated service life of 12 years, would have a production capacity of about 10 million pounds of aluminum lithium, although domestic consumption of the material is expected to be only 3 million pounds during the first four years, five million for the next three years, and eight million for the remaining plant life. Aluminum lithium costs $15 a pound to produce, and the firm would expect to sell it at $28 a pound. The building, which will be placed in service on July 1 of the first year, will be depreciated according to the 39-year MACRS real property class. All manufacturing equipment and facilities will be classified as seven-year MACRS property. At the end of project life, the land will be worth $8 million, the building $30 million, and the equipment $10 million. The firm's marginal tax rate is 40%, and its capital gains tax rate is 35%.
(a) Determine the net after-tax cash flows.
(b) Determine the IRR for this investment.
(c) Determine whether the project is acceptable if the firm's MARR is 15%.

Question 65

The Pittsburgh division of Vermont Machinery, Inc., manufactures drill bits. One of the production processes for a drill bit requires tipping, whereby carbide tips are inserted into the bit to make it stronger and more durable. This tipping process usually requires four or five operators, depending on the weekly work load. The same operators are also assigned to the stamping operation, where the size of the drill bit and the company's logo are imprinted on the bit. Vermont is considering acquiring three automatic tipping machines to replace the manual tipping and stamping operations. If the tipping process is automated, the division's engineers will have to redesign the shapes of the carbide tips to be used in the machine. The new design requires less carbide, resulting in savings on materials. The following financial data have been compiled:
Project life: six years.
Expected annual savings: reduced labor, $56,000; reduced material, $75,000; other benefits (reduced carpal tunnel syndrome and related problems), $28,000; reduced overhead, $15,000.
Expected annual O M costs: $22,000.
Tipping machines and site preparation: equipment costs (for three machines), including delivery, $180,000; site preparation, $20,000.
Salvage value: $30,000 (total for the three machines) at the end of six years.
Depreciation method: seven-year MACRS.
Investment in working capital: $25,000 at the beginning of the project year, which will be fully recovered at the end of the project year.
Other accounting data: marginal tax rate of 39%; MARR of 18%. To raise $200,000, Vermont is considering the following financing options:
Option 1: Finance the tipping machines by using retained earnings.
Option 2: Secure a 12% term loan over six years (with six equal annual installments).
Option 3: Lease the tipping machines. Vermont can obtain a six-year financial lease on the equipment (maintenance costs are taken care of by the lessor) for payments of $55,000 at the beginning of each year.
(a) Determine the net after-tax cash flows for each financing option.
(b) What is Vermont's PW cost of owning the equipment by borrowing?
(c) What is Vermont's PW cost of leasing the equipment?
(d) Recommend the best course of action for Vermont.

Question 66

H-Robot Incorporated (HRI), a world leader in the robotics industry, produces a line of industrial robots and peripheral equipment, which perform many routine assembly-line tasks. The company enjoyed much success in the past when automobile manufacturers and other durable goods producers sought to cut costs by automating the production process. However, increased competition, particularly from Japanese firms, had caused HRI's management to be concerned about the company's growth potential. Therefore, HRI's research and development department has been applying industrial-robot technology to develop a line of household robots. The household robot is designed to function as a maid, mainly performing such tasks as vacuuming floors and carpets. This R D effort has now reached the stage where a decision must be made on whether to go forward with production.
HRI's marketing department has plans to target sales of the robots to households with working mothers in the United States, and if it is successful there, then the robots could be marketed even to college students or households in other countries. Additional data follow.
The marketing vice president believes that annual sales would be somewhere between 150,000 and 300,000 units (most likely, 200,000 units) if the robots were priced at $400 each.
The engineering department has estimated that the firm would need a new manufacturing plant; this plant could be built and made ready for production in two years once the "go" decision is made. The plant would require a 35-acre site, and HRI currently has an option to purchase a suitable tract of land for $2.5 million. Building construction would begin in early 2013 and continue through 2014. The building, which would fall into the MACRS 39-year class, would cost an estimated $10.5 million. A $3.5-million payment would be due to the contractor on December 31, 2012, and another $7 million payable on December 31, 2014.
The necessary manufacturing equipment would be installed late in 2014 and would be paid for on December 31, 2014. The equipment, which would fall into the MACRS seven-year class, would have a cost of $18.5 million, including transportation, plus another $500,000 for installation.
To date, the company has spent $12 million on research and development associated with the household robot. The company has expenses of $4 million for the R D costs; the remaining $8 million already has been capitalized and will be amortized over the life of the project. However, if HRI decides not to go forward with the project, the capitalized R D expenditures could be written off on December 31, 2012.
The project would also require an initial investment in net working capital equal to 12% of the estimated sales in the first year. The initial working capital investment would be made on December 31, 2014. On December 31 of each following year, net working capital would be increased by an amount equal to 12% of any sales increase expected during the coming year.
The project's estimated economic life is eight years (not counting the construction period). At the end of that time, the land is expected to have a market value of $4.5 million, the building a value of $3 million, and the equipment a value of $3.5 million.
The production department has estimated that variable manufacturing costs would total 65% of dollar sales, and that fixed overhead costs, excluding depreciation, would be $8.5 million for the first year of operations. Sales prices and fixed overhead costs, other than depreciation and amortization, are projected to increase with inflation, which is estimated to average 5% per year over the eight-year life of the project. (Note that the first year's sales would be $400 * 200,000 units = $80 million. The second year's sales would be 5% higher than $80 million, and so forth.)
HRI's marginal combined tax rate is 38%; its weighted average cost of capital is 15% (meaning that its minimum attractive rate of return is 15%); and the company's policy, for capital budgeting purposes, is to assume that cash flows occur at the end of each year.
Since the plant would begin operations on January 1, 2015, the first operating cash flows would thus occur on December 31, 2015. Assume that the current decision point is December 31, 2012.
(a) Develop the project cash flows, after taxes, over the life of the project. Use Excel to prepare the project cash flow worksheet.
(b) Determine the equivalent net worth of the project at the time of commercialization.
(c) Determine the equivalent annual worth of the project and the unit profit per production.
(d) Determine the internal rate of return of the project.
(e) Determine the break-even annual unit sales to justify the investment.
(f) Suppose that the unit sale price could decline 3% annually over the previous year's price due to market competition. (But all other costs, other than depreciation and amortization, would increase at an annual rate of 5%.) What is your course of action?

Question 67

A H Chemical Corporation is a multinational manufacturer of industrial chemical products. A H has made great progress in energy-cost reduction and has implemented several cogeneration projects in the United States and Puerto Rico, including the completion of a 35-megawatt (MW) unit in Chicago and a 29-MW unit in Baton Rouge. The division of A H being considered for one of its more recent cogeneration projects is at a chemical plant located in Texas. The plant has a power usage of 80 million kilowatt-hours (kWh) annually. However, on average, it uses 85% of its 10-MW capacity, which would bring the average power usage to 68 million kWh annually. Texas Electric presently charges $0.09 per kWh of electric consumption for the A H plant, a rate that is considered high throughout the industry. Because A H's power consumption is so large, the purchase of a cogeneration unit is considered to be desirable. Installation of the cogeneration unit would allow A H to generate its own power and to avoid the annual $6,120,000 expense to Texas Electric. The total initial investment cost would be $10,500,000. This would cover $10,000,000 for the purchase of the power unit itself-a gas-fired 10-MW Allison 571-and engineering, design, and site preparation. The remaining $500,000 would include the purchase of interconnection equipment, such as poles and distribution lines, that would be used to interface the cogenerator with the existing utility facilities.
As A H's management has decided to raise the $10.5 million by selling bonds, the company's engineers have estimated the operating costs of the cogeneration project. The annual cash flow is composed of many factors: maintenance costs, overhaul costs, expenses for standby power, and other miscellaneous expenses. Maintenance costs are projected to be approximately $500,000 per year. The unit must be overhauled every three years, at a cost of $1.5 million per overhaul. Standby power is the service provided by the utility in the event of a cogeneration-unit trip or scheduled maintenance outage. Unscheduled outages are expected to occur four times annually with each outage averaging 2 hours in duration at an annual expense of $6,400. In addition, overhauling the unit takes approximately 100 hours and occurs every three years, requiring another triennial standby-power cost of $100,000. Miscellaneous expenses, such as additional personnel and insurance, are expected to total $1 million. Fuel (spot gas) will be consumed at a rate of 8,000 BTU per kWh, including the heat-recovery cycle. At $2.00 per million BTU, the annual fuel cost will reach $1,280,000. Due to obsolescence, the expected life of the cogeneration project will be 12 years, after which Allison will pay A H $1 million for the salvage of all equipment. Revenues will be incurred from the sale of excess electricity to the utility company at a negotiated rate. Since the chemical plant will consume, on average, 85% of the unit's 10-MW output, 15% of the output will be sold at $0.04 per kWh, bringing in an annual revenue of $480,000. A H's marginal tax rate (combined federal and state) is 36%, and its minimum required rate of return for any cogeneration project is 27%. The anticipated costs and revenues are summarized as follows:

(a) If the cogeneration unit and other connecting equipment could be financed by issuing corporate bonds at an interest rate of 9%, compounded annually, determine the net cash flow from the cogeneration project.
(b) If the cogeneration unit can be leased, what would be the maximum annual lease amount that A H should be willing to pay?

Question 68

Wilson Machine Tools, Inc., a manufacturer of fabricated metal products, is considering the purchase of a high-tech computer-controlled milling machine at a cost of $95,000. The cost of installing the machine, preparing the site, wiring, and rearranging other equipment is expected to be $15,000. This installation cost will be added to the cost of the machine in order to determine the total cost basis for depreciation. Special jigs and tool dies for the particular product will also be required at a cost of $10,000. The milling machine is expected to last 10 years, but the jigs and dies for only five years. Therefore, another set of jigs and dies has to be purchased at the end of five years. The milling machine will have a $10,000 salvage value at the end of its life, and the special jigs and dies are worth only $300 as scrap metal at any time in their lives. The machine is classified as a seven year MACRS property, and the special jigs and dies are classified as a three-year MACRS property. With the new milling machine, Wilson expects additional annual revenue of $80,000 from increased production. The additional annual production costs are estimated as follows: materials, $9,000; labor, $15,000; energy, $4,500; and miscellaneous O M costs, $3,000. Wilson's marginal income-tax rate is expected to remain at 35% over the project life of 10 years. All dollar figures are in today's dollars. The firm's market interest rate is 18%, and the expected general inflation rate during the project period is estimated at 6%.
(a) Determine the project cash flows in the absence of inflation.
(b) Determine the internal rate of return for the project based on your answer to part (a).
(c) Suppose that Wilson expects the following price increases during the project period: materials at 4% per year, labor at 5% per year, and energy and other O M costs at 3% per year. To compensate for these increases in prices, Wilson is planning to increase annual revenue at the rate of 7% per year by charging its customers a higher price. No changes in salvage value are expected for the machine, the jigs, and the dies. Determine the project cash flows in actual dollars.
(d) From your answer to part (c), determine the real (inflation-free) rate of return of the project.
(e) Determine the economic loss (or gain) in present worth caused by inflation.