FM W11

Week 11 A
1. Dave and Ann Stone have been living at their present home for the past 6 years. During
that time, they have replaced the water heater for $375, have replaced the dishwasher for
$599, and have had to make miscellaneous repair and maintenance expenditures of
approximately $1,500. They have decided to move out and lease the house for $975 per
month. Newspaper advertising will cost $75. Dave and Ann intend to paint the interior of
the home and power- wash the exterior. They estimate that that will run about $900. The
house should be ready to rent after that. In reviewing the financial situation, Dave views
all the expenditures as being relevant, and so he plans to net out the estimated
expenditures discussed above from the rental income.
a) Do Dave and Ann understand the difference between sunk costs and opportunity costs?
Explain the two concepts to them.
They have not understood the concept between sunk costs and opportunity costs since Dave
saw all expenditures as being relevant. So to make them understand, we have give explanation
between those two:
- Sunk costs are cash outlays that have already been made (past outlays) and therefore
have no effect on the cash flows relevant to a current decision.
- Opportunity costs are cash flows that could be realized from the best alternative use of
an owned asset. They therefore represent cash flows that will not be realized as a result
of employing that asset in the proposed project.
b) Which of the expenditures should be classified as sunk cash flows and which should be
viewed as opportunity cash flows?
- Sunk cost: water heater replacement cost of $375, dishwasher for $599, and
miscellaneous repair and maintenance expenditures of approximately $1,500
- Opportunity cost: Newspaper advertising $75, painting the interior of the home and
power-washing the exterior $900. Had this expense not incurred, it may take more time
to find a tenant or the tenant may not be willing to pay a high rental as paint may be
peeling or the exterior is dirty.
2. For each of the following projects, determine the relevant cash flows, and depict the
cash flows on a timeline.
a) A project that requires an initial investment of $120,000 and will generate annual operating
cash inflows of $25,000 for the next 18 years. In each of the 18 years, maintenance of the.The
project will require a $5,000 cash outflow.
b) A new machine with an installed cost of $85,000. Sale of the old machine will yield
$30,000 after taxes. Operating cash inflows generated by the replacement will exceed the
operating cash inflows of the old machine by $20,000 in each year of a 6-year period. At the
end of year 6, liquidation of the new machine will yield $20,000 after taxes, which is $10,000
greater than the after-tax proceeds expected from the old machine had it been retained and
liquidated at the end of year 6.
3. DuPree Coffee Roasters, Inc., wishes to expand and modernize its facilities. The
installed cost of a proposed computer-controlled automatic-feed roaster will be $130,000.
The firm has a chance to sell its 4-year-old roaster for $35,000. The existing roaster
originally cost $60,000 and was being depreciated using MACRS and a 7 years recovery
period. DuPree is subject to a 40% tax rate.
a) What is the book value of the existing roaster?

b) Calculate the after-tax proceeds of the sale of the existing roaster.
c) Calculated the change in net working capital using the following figures:
d) Calculate the initial investment associated with the proposed new roaster.
WEEK 11B
Lombard Company is contemplating the purchase of a new high-speed widget grinder to

replace the existing grinder. The existing grinder was purchased 2 years ago at an
installed cost of $60,000; it was being depreciated under MACRS using a 5-year recovery
period. The existing grinder is expected to have a usable life of 5 more years. The new
grinder costs $105,000 and requires $5,000 in installation costs; it has a 5-year usable life
and would be depreciated under MACRS using a 5-year recovery period. Lombard can
currently sell the existing grinder for $70,000 without incurring any removal or cleanup
costs. To support the increased business resulting from purchase of the new grinder,
accounts receivable would increase by $40,000,
inventories by $30,000, and accounts payable by $58,000. At the end of5 years, the
existing grinder would have a market value of zero; the new grinder would be sold to net
$29,000 after removal and cleanup costs and before taxes. The firm is subject a 40% tax
rate. The estimated earnings before depreciation, interest, and taxes over the 5 years for
both the new and the existing grinder are shown in the following table.
a) Calculate the initial investment associated with the replacement of the existing grinder by
the new one.
b) Determine the incremental operating cash inflows associated with the proposed grinder
replacement. (Note: Be sure to consider the depreciation in year 6.)
c) Determine the terminal cash flow expected at the end of year 5 from the proposed grinder
Replacement.
d) Depict on a timeline the relevant cash flows associated with the proposed grinder
replacement decision.
e) Calculate Payback Period, Net Present Value, and Internal Rate of Return if the cost of
capital is 15%.
f) How is the conclusion this proposed replacement decision, go or no-go if the management
I want to pay it back in 4 years.

FM W11

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Week 11 A

a) What is the book value of the existing roaster?

Lombard Company is contemplating the purchase of a new high-speed widget grinder to

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