Deck 10: Developing Project Cash Flows

Question 1

A firm is considering purchasing a machine that costs $65,000. It will be used for six years, and the salvage value at that time is expected to be zero. The machine will save $35,000 per year in labor, but it will incur $12,000 in operating and maintenance costs each year. The machine will be depreciated according to five-year MACRS. The firm's tax rate is 40%, and its after-tax MARR is 15%. Should the machine be purchased?

Answer 1

Capital investment is one of the crucial decisions in a business. Fixed assets are capital asset. Investment in fixed asset is considered here. Initially lump sum money is employed to buy the asset. Then asset renders service during its lifetime. Revenue is earned and cash flows are generated. Firm has to decide whether investment is justified or not.
Different techniques are available for taking such decisions. They are known as capital budgeting technique. Most of the techniques are using cash flow figures for taking decisions. Thus calculation of correct cash flow is very crucial.
Different techniques are available for taking such decisions. They are known as capital budgeting techniques. Most of the techniques are using cash flow figures for taking decisions. Thus calculation of correct cash flow is very crucial.
The problem requires initial investment of $65,000 to buy a machine. It has 6 years life. Resale value of machine after 6 years is zero. So, entire $65,000 will be depreciated during 6 years.
Depreciation is the value lost for using machine in production. In tax rule, modified accelerated cost recovery system (MACRS) is used for each group.
Further the method has assumed that capital asset will provide maximum service in initial years. So, high rate of depreciation is recommended. It is 200% of normal rate for asset life below 15 years. This rate is 150% for life of 15 years or more.
The problem is related with purchase of machine. Cost price is $65,000. Salvage value recoverable from machine after six years life is zero. So, entire $65,000 is depreciable.
Machine is depreciable for 5 years life span. So, in each year equal percentage will be recovered.
At the start of year zero, depreciable value of asset is 100% of initial cost. Divide it by 5 years. It is
. Since life is less than 15 years, take 2005 of normal rate. It is
. So in first year, depreciation rate is 40%.
However MACRS assumes that machine is introduced at the middle of year 1. So 50% first year depreciation rate will be applicable. It is
. Therefore, full 100% will be recovered in 6 years.
After charging 20% depreciation in year 1, leftover book value of machine is
. For 2 nd year, depreciation rate applicable will be 40% of 80% book value. It is
In this manner, calculate MACRS for remaining years. Remember MACRS rate cannot be less than straight line rate. It is a rate which is ascertained by dividing book value using number of year's life left. So, calculation of MACRS is shown in the table below:
Now consider cash flow from machine. Actual life of the machine is 6 years. In each year, it will save labor cost of $35,000. Also annual operating and maintenance cost is $12,000. So net cash inflow is
. It is revenue before tax.
From the above figure, deduct depreciation. You will get taxable net income. Now deduct tax to get net income after tax. Finally add back depreciation. It is needed to ascertain cash flow. Note that depreciation is a book entry. No cash is paid. So after add back, you will get annual cash flow.
Finally apply net present worth concept to judge acceptability of project. Procedures are-
1. Consider annual cash flow.
2. Calculate annual discounting factor of each year. It is present value of one dollar receivable in future. Formula is
. Here 'r' is discounting rate. It is minimum rate of return required to be earned for survival. Future cash flow period is 'n'.
3. Multiply annual net cash flow by the corresponding discounting factor. It will give present value of yearly net cash flow.
4. Add all annual present value calculated in step 3 to get gross present worth.
5. Finally deduct initial investment to get net present worth. If net present worth is positive, then project is accepted.
Here discounting rate is 15%. So net present worth calculation is made and following table is prepared.
Since net present worth is positive, project is
Machine should be purchased.

Question 2

Let's reconsider Problem. Carrier Corporation, a market leader of air conditioning units, is gearing up to push new energy-efficient systems in the wake of the energy bill passed by Congress. Carrier Corporation says it has invested $8 million in developing new heat exchangers- -a major component in air-conditioners-that use less energy and are about 20% smaller and 30% lighter than current energy saving versions. Carrier's current energy-efficient models are almost double the size of its regular central air-conditioning units. The company speculates this model's bulk may have been a deterrent for homeowners. The new air conditioners are expected to hit the market in the second quarter of 2016. Cooling efficiency is measured by a standard called SEER: Seasonal Energy Efficiency Ratio. It's similar to the gas mileage system used on cars-the higher the number, the more money you save. Older systems had SEER numbers as low as 8; the new Carrier systems are rated at 18! (Federal standards will require a minimum SEER of 13 from January 2006). Translated into operating costs, this means that for every $100 you used to spend on electricity for cooling, you now can spend just $39.
Problem
Appliance makers are gearing up to push new energy-efficient systems in the wake of an energy bill that offers tax credits to homeowners who upgrade to electricity-saving appliances. In air conditioning, industry giant Carrier Corporation says it has invested $250 million in developing new heat exchangers-a major component in air-conditioners-that use less energy and are about 20% smaller and 30% lighter than current energy-saving versions. Carrier's current energy-efficient models are almost double the size of its regular central air-conditioning units. The company speculates that this model's bulk may have been a deterrent for homeowners. The new air conditioners were expected to hit the market in the first quarter of 2015.
Cooling efficiency is measured by a standard called SEER: Seasonal Energy Efficiency Ratio. It's similar to the gas mileage system used on cars- the higher the number, the more money you save. Older systems had SEER numbers as low as 8; the new Carrier systems are rated at 18! (Federal stand aids required a minimum SEER of 13 from January 2006.) Translated into operating costs, this means that for every $100 you used to spend on electricity for cooling, you now can spend just $39.
There are several issues involved in Carrier's pushing more efficient air-conditioning units. First, the market demand is difficult to estimate. Second, it is even more difficult to predict the useful life of the product, as market competition is ever increasing. Carrier's gross margin is about 25%. its operating margin is 8.3%, and its net margin is 7.45%. The expected retail price of the Delux Puron unit is about $4,236. Determine the required sales volume of the new air-conditioning unit to justify the capital investment of $250 million, assuming that Carrier's required return is 15%.
There are several issues involved in pushing more-efficient air-conditioning unit by Carrier.
First, the size of market demand is difficult to estimate. Second, it is even more difficult to predict the useful product life as market competition is ever increasing. Carrier's marketing department has plans to target sales of the new air-conditioning units to the larger office complexes, and if they are successful there, then the units could be marketed to a wide variety of businesses, including schools, hospitals, and eventually even to households.
The marketing vice president believes that annual sales would be 22,000 units if the units were priced at $8,200 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 2 years, once the "go" decision is made. The plant would require a 25-acre site, and Carrier currently has an option to purchase a suitable tract of land for $2.5 million. Building construction would begin in early 2014 and continue through 2015. The building, which would fall into MACRS 39-year class, would cost an estimated $12 million, and a $2 million payment would be due to the contractor on March 31, 2014, another $6 million on March 31, 2015 and remaining balance of $4 million payable on March 31, 2016.
The necessary manufacturing equipment would be installed late in 2015 and would be paid for on March 31, 2016. The equipment, which would fall into the MACRS 7-year class, would have a cost of $8.5 million, including transportation, plus another $500,000 for installation. To date, the company has spent $8 million on research and development associated with the new technology. The company already expensed $2 million of the R D costs, and the remaining $6 million has been capitalized and will be amortized over the life of the project. However, if Carrier decides not to go forward with the project, the capitalized R D expenditures could be written off as expenses on March 31, 2016.
The project would also require an initial investment in net working capital equal to 13% of the estimated sales in the first year. The initial working capital investment would be made on March 31. 2016, and on March 31 of each following year, the net working capital would be increased by an amount equal to 13% of any sales increase expected during the coming year. The project's estimated economic life is 6 years (not counting the construction period). At that time, the land is expected to have a market value of $1.5 million, the building a value of $1.8 million, and the equipment a value of $2.5 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 $7.5 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 expected to average 5% per year over the 6-year life of the project. (Note that the first year's sales would be $8,200 × 22,000 units = $180.4 million. The second year's sales would be 5% higher than $180.4 million, and so forth.)
Carrier's marginal combined tax rate is 38%; its weighted average cost of capital is 14.5% (meaning that their inflation-adjusted minimum attractive rate of return is 14.5% after tax); and the company's policy, for capital budgeting purposes, is to assume that cash flows occur at the end of each fiscal year (for Carrier, it is March 31). Since the plant would begin operations on April 1, 2016, the first operating cash flows would thus occur on March 31, 2017.
Questions:
1. Determine how you would treat the R D expenditures.
2. Determine the depreciation schedules for all assets.
3. Determine the taxable gains for each asset at the time of disposal (March 31, 2022).
4. Determine the amount of working capital requirement in each operating period.
5. Develop the project cash flows over the life of investment using an Excel spreadsheet.
Justify the investment based on (1) net present worth criteria and (2) internal rate of return.

Answer 2

Options of Buy or borrow and lease: The manager has to decide whether to borrow funds for the fixed asset or to purchase it from market or it can be taken on lease. While taking this decision, the important aspects which are required to be considered are the total value and the life span, in case of purchase. On the other hand, the rental payments and the production level at the end of the period are considered in case of lease.
Net Cash Flows: The net cash flows are defined as the difference between the cash inflows and outflows of a company at a particular period of time.
In the present case, the company, CC had the fixed overhead cost of $7.5 million with the MACRS 7 year class.
1.
It is needed to determine the treat the R D expenditures. It can be seen under two situations:
Situation 1: When the firm decides not to follow the project, then the expense in 2015 would be calculated as done below:
This amount will be written off and considered as the tax savings.
Situation 2: When the firm decides to follow the project, it would incur the opportunity cost of
.
2.
It is required to determine the depreciation schedules of the assets.
The land would have no depreciation. Building would fall under the depreciation class of 39- MACRS property and Equipment would fall under the depreciation class of 7- MACRS property.
3.
It is required to determine the taxable gains for each assets.
For the land asset , the taxable gain would be calculated as done below:
For the building asset , the taxable gain would be calculated as done below:
For the Equipment asset , the taxable gain would be calculated as done below:
Working notes for the calculation of Depreciation on building and equipment are given below:
The corresponding values are:
4.
It is required to determine the amount of working capital requirement in each period. For the year 2017, it can be calculated with the formula given below:
For the year 2018, it can be calculated with the formula given below:
5.
It is needed to find the project cash flow by determining the Net present worth criteria and IRR in the excel file.
It can be calculated with the appropriate formula in the spreadsheet given below:
The corresponding values are:
Hence, the calculated present worth is
.

Question 3

An automobile-manufacturing company is considering purchasing an industrial robot to do spot welding, which is currently done by skilled labor. The initial cost of the robot is $210,000, and the annual labor savings arc projected to be $150,000 If purchased, the robot will be depreciated under MACRS as a five-year recovery property. The robot will be used for seven years, at the end of which time, the firm expects to sell it for $60,000. The company's marginal tax rate is 35% over the project period. Determine the net after-tax cash flows for each period over the project life. Assume MARR = 15%.

Answer 3

It is given that the initial cost of the robot is $210,000 and it will help in saving $150,000 to the firm. The robot will be depreciated under MACRS as a five-year property. The useful life of the robot is 7 years and the salvage value of the robot is $60,000. The marginal tax rate is 35% per year and the MARR is 15%.
BTCF is the before tax cash flow. It shows the amount that the firm earns before paying any taxes.
Depreciation is the amount of loss in value the tool due to wear and tear. MACRS depreciation is calculated on the original value of machine.
The table below shows the rate of depreciation under MACRS:
Taxable income is calculated by deducting the amount of depreciation from the before tax cash flow.
Tax is the amount of tax that must be paid. The combined income tax rate is 39%.
After-tax cash flow is the cash flow of the firm after deducting the taxes from the before-tax cash flow.
Following is the screenshot of the formulae used in calculation of depreciation, taxable income and after-tax cash flow:
The result image is as follows:
The last column in the table is the salvage value of the robot. Following is the formula to calculate the after-tax salvage value:
Thus, the after-tax salvage value of the robot is $39,000.

Question 4

As Boeing and other aircraft manufactures are planning to use more aluminum lithium alloys for their future aircrafts, the American 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 develop a stronger, lighter material called aluminum lithium that will make aircraft sturdier and more fuel-efficient. Aluminum lithium, which has been sold commercially for only a few years as an alternative to composite materials, 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, which use a combination of copper, nickel, and magnesium to harden aluminium. 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 five years and 10% within 10 years. The proposed plant, which has an estimated service life of 12 years, would have a 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, 5 million for the next three years, and 8 million for the remaining life of the plant. Aluminum lithium costs $12 a pound to produce, and the firm would expect to sell it at $17 a pound. The buildings will be depreciated according to the 39-year MACRS real property class, with the buildings placed in service on July 1 of the first year. All manufacturing equipment and facilities will be classified as seven-year MACRS properties.
At the end of the project life, the land will be worth $8 million, the buildings $30 million, and the equipment $10 million. Assuming that the firm's marginal tax rate is 40% and its capital gains tax rate is 35%, determine the following:
(a) The net after-tax cash flows.
(b) The IRR for this investment.
(c) Whether the project is acceptable if the firm's MARR is 15%.

Question 5

You are considering constructing a luxury apartment building project that requires an investment of $15,500,000, which comprises $12,000,000 for the building and $3,500,000 for land. The building has 50 units. You expect the maintenance cost for the apartment building to be $350,000 the first year and $400,000 the second year, after which it will continue to increase by $50,000 in subsequent years. The cost to hire a manager for the building is estimated to be $85,000 per year. After five years of operation, the apartment building can be sold for $17,000,000. What is the annual rent per apartment unit that will provide a return on investment of 15% after tax? Assume that the building will remain fully occupied during the five years. Assume also that your tax rate is 35%. The building will be depreciated according to 39-year MACRS and will be placed in service in January during the first year of ownership and sold in December during the fifth year of ownership.

Question 6

Morgantown Mining Company is considering a new mining method a!, its Blacksville mine. The method, called longwall mining, is carried out by a robot. Coal is removed by the robot-not by tunneling like a worm through an apple, which leaves more of the target coal than is removed-but rather by methodically shuttling back and forth across the width of the deposit and devouring nearly everything. The method can extract about 75% of the available coal, compared with 50% for conventional mining, which is done largely with machines that dig tunnels. Moreover, the coal can be recovered far more inexpensively. Currently, at Blacksville alone, the company mines 5 million tons a year with 2,200 workers. By installing two longwall robot machines, the company can mine 5 million tons with only 860 workers. (A robot miner can dig more than 6 tons a minute.) Despite the loss of employment, the United Mine Workers union generally favors longwall mines for two reasons: The union officials are quoted as saying, (1) "It would be far better to have highly productive operations that were able to pay our folks good wages and benefits than to have 2,200 shovelers living in poverty," and (2) "Longwall mines are inherently safer in their design." The company projects the financial data given in Table upon installation of the longwall mining.
(a) Estimate the firm's net after-tax cash flows over the project life if the firm uses the unit-production method to depreciate assets. The firm's marginal tax rate is 40%.
(b) Estimate the firm's net after-tax cash flows if the firm chooses to depreciate the robots on the basis of MACRS (seven-year properly classification).

Question 7

A local delivery company has purchased a delivery truck for $15,000. The truck will be depreciated under MACRS as five-year property. The truck's market value (salvage value) is expected to decrease by $2,500 per year. It is expected that the purchase of the truck will increase its revenue by $10,000 annually. The O M costs are expected to be $3,000 per year. The firm is in the 40% tax bracket, and its MARR is 15%. If the company plans to keep the truck for only two years, what would be the equivalent present worth?

Question 8

National Parts, Inc., an auto-parts manufacturer, is considering purchasing a rapid prototyping system to reduce prototyping time for form, fit, and function applications in automobile parts manufacturing. An outside consultant has been called in to estimate the initial hardware requirement and installation costs. He suggests the following:
• Prototyping equipment: $187,000
• Posturing apparatus: $10,000
• Software: $15,000
• Maintenance: $36,000 per year by the equipment manufacturer
• Resin: Annual liquid polymer consumption of 400 gallons at $350 per gallon
• Site preparation: Some facility changes are required for the installation of the rapid prototyping system (e.g., certain liquid resins contain a toxic substance, so the work area must be well ventilated).
The expected life of the system is six years with an estimated salvage value of $30,000. The proposed system is classified as a five-year MACRS property. A group of computer consultants must be hired to develop customized software to run on the system. Software development costs will be $20,000 and can be expensed during the first lax year. The new system will reduce prototype development time by 75% and material waste (resin) by 25%. This reduction in development time and material waste will save the firm $314,000 and $35,000 annually, respectively.
The firm's expected marginal tax rate over the next six years will be 40%. The firm's interest rate is 20%.
(a) Assuming that the entire initial investment will be financed from the firm's retained earnings (equity financing), determine the after-tax cash flows over the life of the investment. Compute the NPW of this investment.
(b) Assuming that the entire initial investment will be financed through a local bank at an interest rate of 13% compounded annually, determine the net after-tax cash flows for the project. Compute the NPW of the investment.
(c) Suppose that a financial lease is available for the prototype system at $62,560 per year, payable at the beginning of each year. Compute the NPW of the investment with lease financing.
(d) Select the best financing option based on the rate of return on incremental investment

Question 9

A Los Angeles company is planning to market an answering device for people working alone who want the prestige that comes with having a secretary, but who cannot afford one. The device, called Tele-Receptionist, is similar to a voice-mail system. It uses digital-recording technology to create the illusion that a person is operating the switchboard at a busy office The company purchased a 40 000-ft 2 -building and converted it to an assembly plant for $600,000 ($100,000 worth of land and $500,000 worth of building). Installation of the assembly equipment, worth $500,000, was completed on December 31. The plant will begin operation on January 1. The company expects to have a gross annual income of $2,500,000 over the next five years. Annual manufacturing costs and all other operating expenses (excluding depreciation) are projected to be $1,280,000. For depreciation purposes, the assembly-plant building will be classified as a 39-year real property and the assembly equipment as a seven-year MACRS property. The properly value of the land and the building at the end of year 5 would appreciate as much as 15% over the initial purchase cost. The residual value of the assembly equipment is estimated to be about $50,000 at the end of year 5. The firm's marginal tax rate is expected to be about 40% over the project period. Determine the project's after-tax cash flows over the period of five years.

Question 10

National Office Automation, Inc. (NOAI) is a leading developer of imaging systems, controllers, and related accessories. The company's product line consists of systems for desktop publishing, automatic identification, advanced imaging, and office information markets. The firm's manufacturing plant in Ann Arbor, Michigan, consists of eight different functions: cable assembly, board assembly, mechanical assembly, controller integration, printer integration, production repair, customer repair, and shipping. The process to be considered is the transportation of pallets loaded with eight packaged desktop printers from printer integration to the shipping department. Several alternatives for minimizing operating and maintenance costs have been examined. The two most feasible alternatives are the following.
• Option 1: Use gas-powered lift trucks to transport pallets of packaged printers from printer integration to shipping. The truck also can be used to return printers that must be reworked. The trucks can be leased at a cost of $5,465 per year. With a maintenance contract costing $6,317 per year, the dealer will maintain the trucks. A fuel cost of $1,660 per year is expected. The truck requires a driver for each of the three shifts at a total cost of $58,653 per year for labor. It is estimated that transportation by truck would cause damages to material and equipment totaling $10,000 per year.
• Option 2 : Install an automatic guided vehicle system (AGVS) to transport pallets of packaged printers from printer integration to shipping and to return products that require rework. The AGVS, using an electrically powered cart and embedded wire-guidance system, would do the same job that the truck currently does, but without drivers. The total investment costs, including installation, are itemized as in Table.
NOAI could obtain a term loan for the full investment amount ($159,000) at a 10% interest rate. The loan would be amortized over five years with payments made at the end of each year. The AGVS falls into the seven-year MACRS classification, and it has an estimated service life of 10 years and no salvage value. If the AGVS is installed, a maintenance contract would be obtained at a cost of $20,000, payable at the beginning of each year. The firm's marginal tax rate is 35% and its MARR is 15%.
(a) Determine the net cash flows for each alternative over 10 years.
(b) Compute the incremental cash flows (option 2-option 1) and determine the rate of return on this incremental investment.
(c) Determine the best course of action based on the rate-of-return criterion.

Question 11

A highway contractor is considering buying a new trench excavator that costs $250,000 and can dig a 3-foot-wide trench at the rate of 16 feet per hour. With the machine adequately maintained, its production rate will remain constant for the first 1,200 hours of operation and then decrease by 2 feet per hour for each additional 400 hours thereafter. The expected average annual use is 400 hours, and maintenance and operating costs will be $50 per hour. The contractor will depreciate the equipment in accordance with a five-year MACRS. At the end of five years, the excavator will be sold for $60,000. Assuming that the contractor's marginal tax rate is 35% per year, determine the annual after-tax cash flow.

Question 12

A small children's clothing manufacturer is considering an investment to computerize its management information system for material requirement planning, piece-goods coupon printing, and invoice and payroll services. An outside consultant has been retained to estimate the initial hardware requirement and installation costs. He suggests the following:
The expected life of the computer system is five years with no expected salvage value. The proposed system is classified as a five-year properly under the MACRS depreciation system. A group of computer consultants needs to be hired to develop various customized software packages to run on the system. Software development costs will be $20,000 and can be expensed during the first tax year. The new system will eliminate two clerks, whose combined annual payroll expenses are $72,000. Additional annual expenses to run this computerized system arc expected to be $15,000. Borrowing is not considered an option for this investment, nor is a tax credit available for the system. The firm's expected marginal tax rate over the next six years will be 35%. The firm's interest rate is 13%. Compute the after-tax cash flows over the life of the investment.

Question 13

Question 14

An asset in the five-year MACRS property class costs $150,000 and has a zero estimated salvage value after six years of use. The asset will generate annual revenues of $320,000 and will require $80,000 in annual labor 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 the investment acceptable?

Question 15

An automaker is considering installing a three-dimensional (3-D) computerized car-styling system at a cost of $230,000 (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 the turnaround time for designing a new automobile model (from configuration to final design) by 22%. The expected savings in dollars is $250,000 per year. The training and operating maintenance cost for the new system is expected to be $50,000 per year. The system has a five-year useful life and can be depreciated according to the five-year MACRS class. The system will have an estimated salvage value of $5,000. The automaker's marginal tax rate is 40%. Determine the annual cash flows for this investment. What is the return on investment for the project?

Question 16

A facilities engineer is considering a $55,000 investment in an energy management system (EMS). The system is expected to save $14,000 annually in utility bills for N years. After N years, the EMS will have a zero salvage value. In an after-tax analysis, what would N need to be in order for the investment to earn a 12% return? Assume MACRS depreciation with a three-year class life and a 35% tax rate.

Question 17

A corporation is considering purchasing a machine that will save.$150,000 per year before taxes. The cost of operating the machine (including maintenance) is $30,000 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 15% return on investment after taxes, how much can it afford to pay for this machine?.

Question 18

The Newport Company is planning to expand its current spindle product line. The required machinery would cost $520,000. The building that will house the new production facility would cost $1.5 million. The land would cost $350,000, and $250,000 working capital would be required. The product is expected to result in additional sales of $775,000 per year for 10 years, at which time the land can be sold for $500,000, the building for $800,000, and the equipment for $50,000. All of the working capital will be recovered. The annual disbursements for labor, materials, and all other expenses are estimated to be $465,000. The firm's income tax rate is 40%, and any capital gains will be taxed at 35%. The building will be depreciated according to a 39-year property class. The manufacturing facility will be classified as a seven-year MACRS. The firm's MARR is known to be 15% after taxes.
(a) Determine the projected net after-tax cash flows from this investment. Is the expansion justified?
(b) Compare the IRR of this project with that of a situation with no working capital.

Question 19

An industrial engineer proposed the purchase of RFID Fixed-Asset Tracking System for the company's warehouse and weave rooms. The engineer fell that the purchase would provide a better system of locating cartons in the warehouse by recording the locations of the cartons and storing the data in the computer. The estimated investment, annual operating and maintenance costs, and expected annual savings are as follows.
• Cost of equipment and installation: $85,500
• Project life 6 years
• Expected salvage value: $5,000
• Investment in working capital (fully recoverable at the end of the project life): $15,000
• Expected annual savings on labor and materials: $65,800
• Expected annual expenses: $9,150
• Depreciation method: five-year MACRS
The firm's marginal tax rate is 35%.
(a) Determine the net after-tax cash flows over the project life.
(b) Compute the IRR for this investment.
(c) At MARR = 18% , is the project acceptable?

Question 20

The Delaware Chemical Corporation is considering investing in a new composite material. R D engineers are investigating exotic metal-ceramic and ceramic-ceramic composites to develop materials that will withstand high temperatures, such as those to be encountered in the next generation of jet fighter engines. The company expects a three-year R D period before these new materials can be applied to commercial products.
The following financial information is presented for management review.
• R D cost: $5 million over a three-year period: $0.5 million at the beginning of year 1; $2.5 million at the beginning of year 2; and $2 million at the beginning of year 3. For tax purposes, these R D expenditures will be expensed rather than amortized.
• Capital investment: $5 million at the beginning of year 4. This investment consists of $2 million in a building and $3 million in plant equipment. The company already owns a piece of land as the building site.
• Depreciation method: The building (39-year real property class with the asset placed in service in January) and plant equipment (seven-year MACRS recovery class).
• Project life: 10 years after a three-year R D period.
• Salvage value: 10% of the initial capital investment for the equipment and 50% for the building (at the end of the project life).
• Total sales : $50 million (at the end of year 4), with an annual sales growth rate of 10% per year (compound growth) during the next five years (year 5 through year 9) and -10% (negative compound growth) per year for the remaining project life.
• Out of-pocket expenditures: 80% of annual sales.
• Working capital: 10% of annual sales (considered as an investment at the beginning of each production year and investments fully recovered at the end of the project life).
• Marginal tax rate: 40%.
(a) Determine the net after-tax cash flows over the project life.
(b) Determine the IRR for this investment.
(c) Determine the equivalent annual worth for the investment at MARR = 20%.

Question 21

Refer Problem to the data in Problem If the firm expects to borrow the initial investment ($15,500,000) at 10% over five years (paying back the loan in equal annual payments of $4,088,861), determine the project's net cash flows.
Problem
You are considering constructing a luxury apartment building project that requires an investment of $15,500,000, which comprises $12,000,000 for the building and $3,500,000 for land. The building has 50 units. You expect the maintenance cost for the apartment building to be $350,000 the first year and $400,000 the second year, after which it will continue to increase by $50,000 in subsequent years. The cost to hire a manager for the building is estimated to be $85,000 per year. After five years of operation, the apartment building can be sold for $17,000,000. What is the annual rent per apartment unit that will provide a return on investment of 15% after tax? Assume that the building will remain fully occupied during the five years. Assume also that your tax rate is 35%. The building will be depreciated according to 39-year MACRS and will be placed in service in January during the first year of ownership and sold in December during the fifth year of ownership.

Question 22

In Problem to finance the industrial robot, the company will borrow the entire amount from a local bank, and the loan will be paid off at the rate of $30,000 per year, plus 10% on the unpaid balance. Determine the net after-tax cash flows over the project life.
Problem
An automobile-manufacturing company is considering purchasing an industrial robot to do spot welding, which is currently done by skilled labor. The initial cost of the robot is $210,000, and the annual labor savings arc projected to be $150,000 If purchased, the robot will be depreciated under MACRS as a five-year recovery property. The robot will be used for seven years, at the end of which time, the firm expects to sell it for $60,000. The company's marginal tax rate is 35% over the project period. Determine the net after-tax cash flows for each period over the project life. Assume MARR = 15%

Question 23

Refer to the financial data in Problem. Suppose that 50% of the initial investment of $230,000 will be borrowed from a local bank at an interest rate of 11 % over five years (to be paid off in five equal annual payments). Recompute the after tax cash flow.
Problem
An automaker is considering installing a three-dimensional (3-D) computerized car-styling system at a cost of $230,000 (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 the turnaround time for designing a new automobile model (from configuration to final design) by 22%. The expected savings in dollars is $250,000 per year. The training and operating maintenance cost for the new system is expected to be $50,000 per year. The system has a five-year useful life and can be depreciated according to the five-year MACRS class. The system will have an estimated salvage value of $5,000. The automaker's marginal tax rate is 40%. Determine the annual cash flows for this investment. What is the return on investment for the project?

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 (material) savings of $30.000 for two years and is to be depreciated by the MACRS three-year recovery period The tool will require annual O M costs in the amount of $5,000. The salvage value at the end of the two years is expected to be $8,000. Assuming a marginal tax rate of 40% and MARR of 15%, what is the net present worth of this project? You may use Table as a worksheet for your calculation.

Question 25

The A.M.I. Company is considering installing a new process machine for the firm's manufacturing facility. The machine costs $220,000 installed, will generate additional revenues of $85,000 per year, and will save $65,000 per year in labor and material costs. The machine will be financed by a $120,000 bank loan repayable in three equal annual principal installments, plus 9% interest on the outstanding balance. The machine will be depreciated using seven-year MACRS. The useful life of the machine is 10 years, after which 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 the project economically justifiable?

Question 26

Consider the following financial information about a retooling project at a computer manufacturing company:
• The project costs $2.5 million and has a five-year service life.
• The retooling project can be classified as seven-year properly under die 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 the investment is 35%.
• The firm's MARR is 18%.
With the preceding financial information,
(a) Determine the after-tax cash flows.
(b) Compute the annual equivalent worth for this project.

Question 27

A fully automatic chucker and bar machine is to be purchased for $45,000. The money will be borrowed with the stipulation that it be repaid with six equal end-of-year payments at 12% compounded annually. The machine is expected to provide annual revenue of $13,000 for six years and is to be depreciated by the MACRS seven-year recovery period. The salvage value at the end of six years is expected to be $4,000. Assume a marginal tax rate of 35% and a MARR of 15%.
(a) Determine the after-tax cash flow for this asset over six years.
(b) Determine whether the project is acceptable on the basis of the IRR criterion.

Question 28

A manufacturing company is considering acquiring a new injection-molding machine at a cost of $ 150,000. 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 $11,000. The addition of the machine to the current production facility is expected to generate an annual revenue of $48,000. The firm has only $100,000 available from its equity funds, so it must borrow the additional $50,000 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 10%. Assume that the asset qualifies for a seven year MACRS property class.
(a) Determine the after-tax cash flows.
(b) Determine the NPW of this project at MARR = 14%.

Question 29

Suppose an asset has a first cost of $8,000, a life of five years, a salvage value of $2,000 at the end of five years, and a net annual before-tax revenue of $2,500. The firm's marginal tax rate is 35%. The asset will be depreciated by three-year MACRS.
(a) Using the generalized cash flow approach, determine the cash flow after taxes.
(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 the financing methods of parts (a) and (b), show calculations to justify your choice of which is the better one at an interest rate of 9%.

Question 30

A construction company is considering acquiring a new earthmover. The purchase price is $110,000, and an additional $25,000 is required to modify the equipment for special use by the company. The equipment falls into the MACRS seven-year classification (the tax life), and it will be sold after five years (the project life) for $50,000. The purchase of the earthmover will have no effect on revenues, but the machine is expected to save the firm $68,000 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 by using the generalized cash flow approach and the worth of the investment for this project if the firm's MARR is known to be 12%.

Question 31

Federal Express (FedEx) is considering adding 18 used Boeing 757 jets by buying the twin engine planes to replace some of its oldest, least-efficient freighters, Boeing 727s. FedEx pays about $10 million each, then FedEx spends about $5 million each to refit the planes to carry cargo. FedEx is required to make 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 12% compounded annually. The actual payment schedule calls for only interest payments over the 10-year period with the original principal amount to be paid off at the end of the 10th year. FedEx expects to generate $45 million per year in fuel savings by adding these aircrafts to its current fleet. The aircraft is expected to have a 15-year service life with a salvage value of 15% of the original purchase price. If the aircrafts are bought, they will be depreciated by the seven-year MACRS property classifications. The firm's combined federal and state marginal tax rate is 38%, and its required minimum attractive rate of return is 18%.
(a) Use the generalized cash-flow approach to determine the cash flow associated with the debt financing.
(b) Is this project acceptable?

Question 32

The Pittsburgh Division of Vermont Machinery, Inc. manufactures drill bits. One of the production processes of a drill bit requires tipping, whereby carbide tips are inserted into the bit to make it stronger and more durable. The tipping process usually requires four or five operators, depending on the weekly workload. The same operators are assigned to the stamping operation, in which the size of the drill bit and the company's logo are imprinted into the bit. Vermont is considering acquiring three automatic tipping machines to replace the manual tipping and stamping operations. If the tipping process is automated, Vermont engineers will have to redesign the shapes of the carbide tips to be used in the machines. The new design requires less carbide, resulting in a savings of material. The following financial data have been compiled.
• Project life: Six years.
• Expected annual savings: Reduced labor, $56,000; reduced material, $75,000; other benefits (reduction in carpal tunnel syndrome and related problems), $28,000; and reduced overhead, $15,000.
• Expected annual O M costs: $22,000.
• Tipping machines and site preparation: Equipment costs (three machines), including delivery, $180,000; site preparation. $20,000.
• Salvage value: $30,000 (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. That same amount will be fully recovered at the end of the project year.
• Other accounting data: Marginal tax rate of 39% and MARR of 18%. To raise $200,000, Vermont is considering the following financing options:
• Option 1 : Use the retained earnings of the tipping machines to finance them.
• Option 2 : Secure a 12%) term loan over six years (to be paid off in six equal annual installments).
• Option 3 : Lease the tipping machines. Vermont can obtain a six-year financial lease on the equipment (with, however, no maintenance service) 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 present-value cost of owning the equipment by borrowing?
(c) What is Vermont's present-value cost of leasing the equipment?
(d) Recommend the best course of action for Vermont.

Question 33

The headquarters building owned by a rapidly growing company is not large enough for the company's current needs. A search for larger quarters revealed two new alternatives that would provide sufficient room, enough parking, and the desired appearance and location. The company now has three options:
• Option 1 : Lease the new quarters for $144,000 per year.
• Option 2: Purchase the new quarters for $800,000. including a $150,000 cost for land.
• Option 3: Remodel the current headquarters building.
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 to other alternatives. However, the remodeling 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 of remodeling. The new quarters are expected to have a service life of 30 years, and the desired rate of return on investments is 12%. Assume that the firm's marginal tax rate is 40% and that the new building and remodeled structure will be depreciated under MACRS using 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 34

An international manufacturer of prepaid food items needs 50,000,000 kWh of electrical energy a year, with a maximum demand of 10,000 kW. The local utililty company currently charges $0,085 per kWh-a rate considered high throughout the industry. Because the firm's power consumption is so large, its engineers are considering installing a 10,000-kW steam-turbine plant. Three types of plant have been proposed (units in thousands of dollars) and are given in Table.
The service life of each plant is expected to be 20 years. The plant investment will be subject to a 20-year MACRS property classification. The expected salvage value of the plant at the end of its useful life is about 10% of its original investment. The firm's MARR is known to be 12%. The firm's marginal income tax rate is 39%.
(a) Determine the unit power cost ($/kWh) for each plant.
(b) Which plant would provide the most economical power?

Question 35

The Prescott Welding Company needs to acquire a new lift truck for transporting its final product to the warehouse. One alternative is to purchase the truck for $45,000, which will be financed by the bank 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, Prescott Welding would have to maintain the truck at an annual cost of $1,200, also payable at year-end. Alternatively, Prescott Welding could lease the truck under a four-year contract for a lease payment of $12.000 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 Prescott Welding plans to replace the truck, irrespective of whether it leases or buys. Prescott Welding has a marginal tax rate of 40% and a MARR of 15%.
(a) What is Prescott Welding's cost of leasing in present worth?
(b) What is Prescott Welding's cost of owning in present worth?
(c) Should the truck be leased or purchased?

Question 36

Janet Wigandt, an electrical engineer for Instrument Control, Inc. (ICI), has been asked to perform a lease-buy analysis of a new pin-inserting machine for ICI's PC-board manufacturing that has a project life of four years with annual revenues of $200,000.
• Buy Option: The equipment costs $120,000. To purchase it, ICI could obtain a term loan for the full amount at 10% interest, which is payable in four equal end-of-year annual installments. The machine falls into a five-year MACRS property classification. 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: Business Leasing, Inc. (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 arrangement, BLI will maintain the asset so that the annual maintenance cost of $10,000 will be saved. ICT's marginal tax rate is 40%, and its MARR is 15% during the analysis period.
(a) What is Id's present-value (incremental) cost of owning the equipment?
(b) What is id's present-value (incremental) cost of leasing the equipment?
(c) Should ICT buy or lease the equipment?

Question 37

Consider the following lease-versus-borrow-and-purchase problem.
• Borrow-and-purchase option:
1. Jensen Manufacturing Company plans to acquire sets of special industrial tools with a four-year life and a cost of $200,000- delivered and installed. The tools will be depreciated by the MACRS three-year classification.
2. Jensen can borrow the required $200,000 at a rate of 10% over four years. Four equal end-of-year annual payments would be made in the amount of $63,094 = $200,000( A/P , 10%, 4). The annual interest and principal payment schedule, along with the equivalent present worth of these payments, is
3. The estimated salvage value for the tool sets at the end of four years is $20,000.
4. If Jensen borrows and buys, it will have to bear the cost of maintenance, which will be performed by the tool manufacturer at a fixed contract rate of $10,000 per year.
• Lease option:
1. Jensen can lease the tools for four years at an annual rental charge of $70,000 - payable at the end of each year.
2. The lease contract specifies that the lessor will maintain the tools at no additional charge to Jensen.
Jensen's lax rate is 40%. Any gains will also be taxed at 40%.
(a) What is Jensen's PW of after-tax cash flow of leasing at i = 15%?
(b) What is Jensen's PW of after-tax cash flow of owning at i = 15%?

Question 38

Tom Hagstrom needs a new car for his business. One alternative is to purchase the car outright for $28,000 and to finance the car with a bank loan for the net purchase price. The bank loan calls for 36 equal monthly payments of $881.30 at an interest rate of 8.3%) compounded monthly. Payments must be made at the end of each month. The terms of each alternative are
If Tom takes the lease option, he is required to pay $500 for a security deposit, which is refundable at the end of the lease, and $696 a month at the beginning of each month for 36 months. If the car is purchased, it will be depreciated according to a five-year MACRS property classification. The car has a salvage value of $15,400, which is the expected market value after three years, at which time Tom plans to replace the car, irrespective of whether he leases or buys. Tom's marginal tax rate is 28%). His MARR is known to be 13 % per year.
(a) Determine the annual cash flows for each option.
(b) Which option is belter?

Question 39

The Boggs Machine Tool Company has decided to acquire a pressing machine. One alternative is to lease the machine under a three-year contract for a lease payment of $15,000 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 $100.000, which involves financing the machine 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 = $41,635).
Under the borrow-to-purchase arrangement, the company would have to maintain the machine at an annual cost of $5,000. which is payable at year-end. The machine falls into a five-year MACRS classification and has a salvage value of $50.000, which is the expected market value at the end of year 3, at which time, the company plans to replace the machine, irrespective of whether it leases or buys. Boggs has a tax rate of 40% and a MARR or 15%).
(a) What is Boggs' PW cost of leasing?
(b) What is Boggs' PW cost of owning?
(c) From the financing analysis in parts (a) and (b), what are the advantages and disadvantages of leasing and owning?

Question 40

An asset is to be purchased for $25,000. The asset is expected to provide revenue of $10.000 a year and have operating costs of $2,500 a year. The asset is considered to be a seven-year MACRS property. The company is planning to sell the asset at the end of year 5 for $5,000. Given that the company's marginal tax rate is 30%? and that it has a MARR of 10% for any project undertaken, answer the following questions.
(a) What is the net cash flow for each year, given that the asset is purchased with borrowed funds at an interest rate of 12% with repayment in five equal end-of-year payments?
(b) What is the net cash flow for each year, given that the asset is leased at a rate of $5,500 payable at beginning of each year (a financial lease)?
(c) Which method (if either) should be used to obtain the new asset?

Question 41

Enterprise Capital Leasing Company is in the business of leasing 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 properly. The tractor is expected to have a salvage value of $22,000 at the end of three years' rental. Enterprise will require a lessee to make a security deposit in the amount of $1,500 that is refundable at the end of the lease term. Enterprise's marginal tax rate is 35%. If Enterprise wants an after-tax return of 10%, what lease payment schedule should be set?

Question 42

You are considering purchasing industrial equipment to meet the peak demand which will last only two years. The equipment costs $100,000 and has an estimated market value of $40,000 at the end of two years. The expected marginal income tax rate during the project period is known to be 40%. Your firm's interest rate (discount rate) is also 12%. Two types of financing arc considered, where revenues and O M expenses are not affected by the type of financing.
• Option 1 (Debt financing): Assuming that the equipment will be financed entirely from a bank loan at 10% over 2 years. You can make an arrangement to pay only the interest each year over the project period by deferring the principal payment until the end of 2 years. For tax purpose, the machine will be depreciated by a straight-line method with zero salvage value over 5 years (no half-year convention).
• Option 2 (Lease financing): Now you are considering the possibility of leasing the equipment under a two-year contract for a lease payment of $42,000 per year, payable at the beginning of each year.
Determine the net incremental after-tax cash flows under Option 1.
Determine the net incremental after-tax cash flows under Option 2.
What annual lease payment (before tax) would make the two options economically indifferent?