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Brigham chap 11 - Practice questions solution for chap 11

Human Resource Management (Air University)

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(11–1)
Investment Outlay
Talbot Industries is considering an expansion project. The necessary equipment could be purchased
for $9 million, and the project would also require an initial $3 million investment in net operating
working capital. The company’s tax rate is 40%.
a. What is the initial investment outlay?
b. The company spent and expensed $50,000 on research related to the project last year. Would this
change your answer? Explain.
c. The company plans to house the project in a building it owns but is not now using. The building
could be sold for $1 million after taxes and real estate commissions. How would this affect your
answer?

a. Equipment $ 9,000,000
NWC Investment 3,000,000
Initial investment outlay $12,000,000
b. No, last year’s $50,000 expenditure is considered a sunk cost and does not represent an incremental cash
flow. Hence, it should not be included in the analysis.
c. The potential sale of the building represents an opportunity cost of conducting the project in that building.
Therefore, the possible after-tax sale price must be charged against the project as a cost.

(11–2)
Operating Cash Flow
Cairn Communications is trying to estimate the first-year operating cash flow (at t = 1) for a proposed
project. The financial staff has collected the following information:
Projected sales $10 million
Operating costs (not including depreciation) $ 7 million
Depreciation $ 2 million
Interest expense $ 2 million
The company faces a 40% tax rate. What is the project’s operating cash flow for the first year (t = 1)?

Operating Cash Flows: t = 1

Sales revenues $10,000,000
Operating costs 7,000,000
Depreciation 2,000,000
Operating income before taxes $ 1,000,000
Taxes (40%) 400,000
Operating income after taxes $ 600,000
Add back depreciation 2,000,000
Operating cash flow $ 2,600,000

(11–3)
Net Salvage Value
Allen Air Lines is now in the terminal year of a project. The equipment originally cost $20 million, of
which 80% has been depreciated. Carter can sell the used equipment today to another airline for $5
million, and its tax rate is 40%. What is the equipment’s after-tax net salvage value?

Equipment's original cost $20,000,000

Depreciation (80%) 16,000,000
Book value $ 4,000,000
Gain on sale = $5,000,000 - $4,000,000 = $1,000,000.
Tax on gain = $1,000,000(0.4) = $400,000.
AT net salvage value = $5,000,000 - $400,000 = $4,600,000

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(11–4)
Replacement Analysis
The Chen Company is considering the purchase of a new machine to replace an obsolete one. The
machine being used for the operation has both a book value and a market value of zero; it is in good
working order, however, and will last physically for at least another 10 years. The proposed
replacement machine will perform the operation so much more efficiently that Chen’s engineers
estimate it will produce after-tax cash flows (labor savings and depreciation) of $9,000 per year. The
new machine will cost $40,000 delivered and installed, and its economic life is estimated to be 10
years. It has zero salvage value. The firm’s WACC is 10%, and its marginal tax rate is 35%. Should
Chen buy the new machine?

With a financial calculator, input the appropriate cash flows into the cash flow register, input I/YR = 10, and then
solve for NPV = $15,301.10. Thus, Chen should purchase the new machine.

(11–5)
Depreciation Methods
Wendy is evaluating a capital budgeting project that should last for 4 years. The project requires $800,000 of
equipment. She is unsure what depreciation method to use in her analysis, straight-line or the 3-year MACRS
accelerated method. Under straight-line depreciation, the cost of the equipment would be depreciated evenly
over its 4-year life (ignore the half-year convention for the straight-line method).

The applicable MACRS depreciation rates are 33%, 45%, 15%, and 7%, as discussed in Appendix 11A. The
company’s WACC is 10%, and its tax rate is 40%.

a. What would the depreciation expense be each year under each method?
b. Which depreciation method would produce the higher NPV, and how much higher would it be?

a. Scenario 1 Scenario 2
Year (Straight Line) (MACRS)
1 $200,000 $264,000
2 200,000 360,000
3 200,000 120,000
4 200,000 56,000

Depreciation Expense Depreciation Expense

Year Difference (2 – 1) Diff. × 0.4 (MACRS) NPV
1 $ 64,000 $25,600 28,160
2 160,000 64,000 77,440
3 -80,000 -32,000 42,592
4 -144,000 -57,600 84,332.16

(11–6)
New-Project Analysis
The Campbell Company is evaluating the proposed acquisition of a new milling machine.
The machine’s base price is $108,000, and it would cost another $12,500 to modify it for special use. The
machine falls into the MACRS 3-year class, and it would be sold after 3 years for $65,000. The machine
would require an increase in net working capital (inventory) of $5,500. The milling machine would have no
effect on revenues, but it is expected to save the firm $44,000 per year in before-tax operating costs, mainly
labor. Campbell’s marginal tax rate is 35%.

a. What is the net cost of the machine for capital budgeting purposes? (That is, what is the Year-0 net cash
flow?)
b. What are the net operating cash flows in Years 1, 2, and 3?

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c. What is the additional Year-3 cash flow (i.e., the after-tax salvage and the return of working capital)?
d. If the project’s cost of capital is 12%, should the machine be purchased?

a. The net cost is $126,000:

Price ($108,000)
Modification (12,500)
Increase in NWC (5,500)
Cash outlay for new machine ($126,000)

b. The operating cash flows follow:

Year 1 Year 2 Year 3
1. After-tax savings $28,600 $28,600 $28,600 (44,000(1 - T) = $44,000(0.65))
2. Depreciation tax savings 13,918 18,979 6,326 (120500*(.33,.45.15)*.35)
Net cash flow $42,518 $47,579 $34,926

c. The terminal year cash flow is $50,702:

Salvage value $65,000
Tax on SV* (19,798) BV in Year 4 = $120,500(0.07) = $8,435.
*Tax on SV = ($65,000 - $8,435)(0.35) = $19,798.
Return of NWC 5,500
$50,702
d. The project has an NPV of $10,841; thus, it should be accepted.
Year Net Cash Flow PV @ 12%
0 ($126,000) ($126,000)
1 42,518 37,963
2 47,579 37,930
3 85,628 60,948
NPV = $ 10,841
(11–7)
New-Project Analysis
You have been asked by the president of your company to evaluate the proposed acquisition of a new
spectrometer for the firm’s R&D department. The equipment’s basic price is $70,000, and it would cost
another $15,000 to modify it for special use by your firm. The spectrometer, which falls into the MACRS
3-year class, would be sold after 3 years for $30,000. Use of the equipment would require an increase
in net working capital (spare parts inventory) of $4,000. The spectrometer would have no effect on
revenues, but it is expected to save the firm $25,000 per year in before-tax operating costs, mainly
labor. The firm’s marginal federal-plus-state tax rate is 40%.

a. What is the net cost of the spectrometer? (That is, what is the Year-0 net cash flow?)
b. What are the net operating cash flows in Years 1, 2, and 3?
c. What is the additional (non-operating) cash flow in Year 3?
d. If the project’s cost of capital is 10%, should the spectrometer be purchased?

a. The net cost is $89,000:

Price ($70,000)
Modification (15,000)
Change in NWC (4,000)
($89,000)
b. The operating cash flows follow:
Year 1 Year 2 Year 3
After-tax savings $15,000 $15,000 $15,000 $25,000(1 – T) = $25,000(0.6)
Depreciation shield 11,220 15,300 5,100 (85000*(.33,.45,.15)*.40)
Net cash flow $26,220 $30,300 $20,100

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c. The additional end-of-project cash flow is $24,380:

Salvage value $30,000
Tax on SV* (9,620) BV in Year 4 = $85,000(0.07) = $5,950
Return of NWC 4,000 ($30,000 - $5,950)(0.4) = $9,620.
$24,380

d. The project has an NPV of -$6,705. Thus, it should not be accepted.

Year Net Cash Flow
0 ($89,000)
1 26,220
2 30,300
3 44,480
With a financial calculator, input the following: CF0 = -89000, CF1 = 26220, CF2 = 30300, CF3 = 44480, and
I/YR = 10 to solve for NPV = -$6,703.83

(11–8)
Inflation Adjustments
The Rodriguez Company is considering an average-risk investment in a mineral water spring project
that has a cost of $150,000. The project will produce 1,000 cases of mineral water per year indefinitely.
The current sales price is $138 per case, and the current cost per case is $105. The firm is taxed at a
rate of 34%. Both prices and costs are expected to rise at a rate of 6% per year. The firm uses only
equity, and it has a cost of capital of 15%. Assume that cash flows consist only of after-tax profits,
since the spring has an indefinite life and will not be depreciated.

a. Should the firm accept the project? (Hint: The project is a perpetuity, so you must use the formula
for a perpetuity to find its NPV.)
b. Suppose that total costs consisted of a fixed cost of $10,000 per year plus variable costs of $95 per
unit, and suppose that only the variable costs were expected to increase with inflation. Would this
make the project better or worse? Continue to assume that the sales price will rise with inflation.

a. Sales = 1,000($138) $138,000

Cost = 1,000($105) 105,000
Net before tax $ 33,000
Taxes (34%) 11,220
Net after tax $ 21,780
Not considering inflation, NPV is -$4,800. This value is calculated as
-$150,000 + = -$4,800. 15.0780,21$
Considering inflation, the real cost of capital is calculated as follows:
(1 + rr)(1 + i) = 1.15 (1 + rr)(1.06) = 1.15 rr = 0.0849.
Thus, the NPV considering inflation is calculated as
-$150,000 + = $106,537. 0849.0780,21$
After adjusting for expected inflation, we see that the project has a positive NPV and should be accepted. This
demonstrates the bias that inflation can induce into the capital budgeting process: Inflation is already reflected
in the denominator (the cost of capital), so it must also be reflected in the numerator.

b. If part of the costs were fixed, and hence did not rise with inflation, then sales revenues would rise faster
than total costs. However, when the plant wears out and must be replaced, inflation will cause the replacement
cost to jump, necessitating a sharp output price increase to cover the now higher depreciation charges.

(11–9)
Replacement Analysis
The Taylor Toy Corporation currently uses an injection-molding machine that was purchased 2 years
ago. This machine is being depreciated on a straight-line basis, and it has 6 years of remaining life. Its
current book value is $2,100, and it can be sold for $2,500 at this time. Thus, the annual depreciation

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expense is $2,100/6 = $350 per year. If the old machine is not replaced, it can be sold for $500 at the
end of its useful life.
Taylor is offered a replacement machine that has a cost of $8,000, an estimated useful life of 6 years,
and an estimated salvage value of $800. This machine falls into the MACRS 5-year class, so the
applicable depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. The replacement machine would
permit an output expansion, so sales would rise by $1,000 per year; even so, the new machine’s much
greater efficiency would reduce operating expenses by $1,500 per year. The new machine would
require that inventories be increased by $2,000, but accounts payable would simultaneously increase
by $500. Taylor’s marginal federal-plus-state tax rate is 40%, and its WACC is 15%. Should it replace
the old machine?

First determine the net cash flow at t = 0:

Purchase price ($8,000)
Sale of old machine 2,500
Tax on sale of old machine (160)a
Change in net working capital (1,500)b
Total investment ($7,160)
a The market value is $2,500 – $2,100 = $400 above the book value. Thus, there is a $400 recapture of
depreciation, and Taylor would have to pay 0.40($400) = $160 in taxes.
b The change in net working capital is a $2,000 increase in current assets minus a $500 increase in current
liabilities, which totals to $1,500.

Now, examine the annual cash inflows:

Sales increase $1,000
Cost decrease 1,500
Increase in pre-tax revenues $2,500
After-tax revenue increase:
$2,500(1 – T) = $2,500(0.60) = $1,500.

Depreciation:
Year 1 2 3 4 5 6
New $1,600 $2,560 $1,520 $960 $880 $480
Old 350 350 350 350 350 350
Change $1,250 $2,210 $1,170 $610 $530 $130
Depreciation tax savings $ 500 $ 884 $ 468 $244 $212 $ 52

Net investment (7,160)

After-tax revenue increase 1,500 1,500 1,500 1,500 1,500 1,500
Depreciation tax savings 500 884 468 244 212 52
Working capital recovery 1,500
Salvage value of new machine 800
Tax on salvage value of new machine (320)
Opportunity cost of old machine (300)
Project cash flows (7,160) 2,000 2,384 1,968 1,744 1,712 3,232
The net present value of this incremental cash flow stream, when discounted at 15%, is $921.36. Thus, the
replacement should be made

(11–10)
Replacement Analysis
St. Johns River Shipyards is considering the replacement of an 8-year-old riveting machine with a new
one that will increase earnings before depreciation from $27,000 to $54,000 per year. The new machine
will cost $82,500, and it will have an estimated life of 8 years and no salvage value. The new machine
will be depreciated over its 5-year MACRS recovery period, so the applicable depreciation rates are
20%, 32%, 19%, 12%, 11%, and 6%. The applicable corporate tax rate is 40%, and the firm’s WACC is
12%. The old machine has been fully depreciated and has no salvage value. Should the old riveting
machine be replaced by the new one?

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1. Net investment at t = 0:
Cost of new machine $82,500
Net investment outlay (CF0) $82,500

2. After-tax
Year Earnings T(ΔDep) Annual CFt $27,000(1 – T) = $27,000(0.6) = $16,200
1 $16,200 $ 6,600 $22,800
2 16,200 10,560 26,760 Dep(82500*(.20,.32,.19,.12,.11,.06,0,0)*.40)
3 16,200 6,270 22,470
4 16,200 3,960 20,160 NPV@12% CF/(1.r)^t
5 16,200 3,630 19,830
6 16,200 1,980 18,180
7 16,200 0 16,200
8 16,200 0 16,200
104829 – 82500 = 22329
New machine shall be bought.

(11–11)
Scenario Analysis
Shao Industries is considering a proposed project for its capital budget. The company estimates the
project’s NPV is $12 million. This estimate assumes that the economy and market conditions will be
average over the next few years. The company’s CFO, however, forecasts there is only a 50% chance
that the economy will be average. Recognizing this uncertainty, she has also performed the following
scenario analysis:
Economic Scenario Probability of Outcome NPV
Recession 0.05 −$70 million
Below average 0.20 −25 million
Average 0.50 12 million
Above average 0.20 20 million
Boom 0.05 30 million
What is the project’s expected NPV, its standard deviation, and its coefficient of variation?

E(NPV) = 0.05(-$70) + 0.20(-$25) + 0.50($12) + 0.20($20) + 0.05($30)

= -$3.5 + -$5.0 + $6.0 + $4.0 + $1.5
= $3.0 million.
σNPV= [0.05(-$70 - $3)2 + 0.20(-$25 - $3)2 + 0.50($12 - $3)2 + 0.20($20 - $3)2 + 0.05($30 - $3)2]0.5
= $23.622 million.
CVNPV = = 7.874. $3.0 $23.622

(11–12)
New-Project Analysis
Madison Manufacturing is considering a new machine that costs $250,000 and would reduce pre-tax
manufacturing costs by $90,000 annually. Madison would use the 3-year MACRS method to depreciate
the machine, and management thinks the machine would have a value of $23,000 at the end of its 5-
year operating life. The applicable depreciation rates are 33%, 45%, 15%, and 7%, as discussed in
Appendix 11A. Working capital would increase by $25,000 initially, but it would be recovered at the end
of the project’s 5-year life. Madison’s marginal tax rate is 40%, and a 10% WACC is appropriate for the
project.
a. Calculate the project’s NPV, IRR, MIRR, and payback.
b. Assume management is unsure about the $90,000 cost savings—this figure could deviate by as
much as plus or minus 20%. What would the NPV be under each of these extremes?
c. Suppose the CFO wants you to do a scenario analysis with different values for the cost savings, the
machine’s salvage value, and the working capital (WC) requirement. She asks you to use the following
probabilities and values in the scenario analysis:

Scenario Probability Cost Savings Salvage Value WC

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Worst case 0.35 $ 72,000 $18,000 $30,000

Base case 0.35 90,000 23,000 25,000
Best case 0.30 108,000 28,000 20,000

Calculate the project’s expected NPV, its standard deviation, and its coefficient of variation. Would you
recommend that the project be accepted?

12 a. 0 1 2 3 4 5
Initial investment ($250,000)
Net working capital (25,000)

Cost savings $90,000 $ 90,000 $90,000 $90,000 $90,000

Depreciationa 82,500 112,500 37,500 17,500 0
Oper. inc. before taxes $ 7,500 ($ 22,500) $52,500 $72,500 $90,000
Taxes (40%) 3,000 (9,000) 21,000 29,000 36,000
Oper. Inc. (AT) $ 4,500 ($ 13,500) $31,500 $43,500 $54,000
Add: Depreciation 82,500 112,500 37,500 17,500 0
Oper. CF $87,000 $ 99,000 $69,000 $61,000 $54,000
Return of NWC $25,000
Sale of Machine 23,000
Tax on sale (40%) (9,200)
Project cash flows ($275,000) $87,000 $ 99,000 $69,000 $61,000 $92,800
NPV = $37,035.13
IRR = 15.30%
MIRR = 12.81%
Payback = 3.33 years

If savings increase by 20%, then savings will be (1.2)($90,000) = $108,000.

If savings decrease by 20%, then savings will be (0.8)($90,000) = $72,000.
(1) Savings increase by 20%:
012345
Initial investment ($250,000)
Net working capital (25,000)
Cost savings $108,000 $108,000 $108,000 $108,000 $108,000
Depreciation 82,500 112,500 37,500 17,500 0
Oper. inc. before taxes $ 25,500 ($ 4,500) $ 70,500 $ 90,500 $108,000
Taxes (40%) 10,200 (1,800) 28,200 36,200 43,200
Oper. Inc. (AT) $ 15,300 ($ 2,700) $ 42,300 $ 54,300 $ 64,800
Add: Depreciation 82,500 112,500 37,500 17,500 0
Oper. CF $ 97,800 $109,800 $ 79,800 $ 71,800 $ 64,800
Return of NWC $ 25,000
Sale of Machine 23,000
Tax on sale (40%) (9,200)
Project cash flows ($275,000) $ 97,800 $109,800 $ 79,800 $ 71,800 $103,600
NPV = $77,975.63
(2) Savings decrease by 20%:
012345
Initial investment ($250,000)
Net working capital (25,000)
Cost savings $72,000 $ 72,000 $72,000 $72,000 $72,000
Depreciation 82,500 112,500 37,500 17,500 0
Oper. inc. before taxes ($10,500) ($ 40,500) $34,500 $54,500 $72,000
Taxes (40%) (4,200) (16,200) 13,800 21,800 28,800
Oper. Inc. (AT) ($ 6,300) ($ 24,300) $20,700 $32,700 $43,200
Add: Depreciation 82,500 112,500 37,500 17,500 0
Oper. CF $76,200 $ 88,200 $58,200 $50,200 $43,200

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Return of NWC $25,000

Sale of Machine 23,000
Tax on sale (40%) (9,200)
Project cash flows ($275,000) $76,200 $ 88,200 $58,200 $50,200 $82,000
NPV = -$3,905.37

Worst-case scenario:
012345
Initial investment ($250,000)
Net working capital (30,000)
Cost savings $72,000 $ 72,000 $72,000 $72,000 $72,000
Depreciation 82,500 112,500 37,500 17,500 0
Oper. inc. before taxes ($10,500) ($ 40,500) $34,500 $54,500 $72,000
Taxes (40%) (4,200) (16,200) 13,800 21,800 28,800
Oper. Inc. (AT) ($ 6,300) ($ 24,300) $20,700 $32,700 $43,200
Add: Depreciationa 82,500 112,500 37,500 17,500 0
Oper. CF $76,200 $ 88,200 $58,200 $50,200 $43,200
Return of NWC $30,000
Sale of Machine 18,000
Tax on sale (40%) (7,200)
Project cash flows ($280,000) $76,200 $ 88,200 $58,200 $50,200 $84,000
NPV = -$7,663.52
Base-case scenario:
This was worked out in Part a. NPV = $37,035.13.
Best-case scenario:
012345
Initial investment ($250,000)
Net working capital (20,000)
Cost savings $108,000 $108,000 $108,000 $108,000 $108,000
Depreciation 82,500 112,500 37,500 17,500 0
Oper. inc. before taxes $ 25,500 ($ 4,500) $ 70,500 $ 90,500 $108,000
Taxes (40%) 10,200 (1,800) 28,200 36,200 43,200
Oper. Inc. (AT) $ 15,300 ($ 2,700) $ 42,300 $ 54,300 $ 64,800
Add: Depreciationa 82,500 112,500 37,500 17,500 0
Oper. CF $ 97,800 $109,800 $ 79,800 $ 71,800 $ 64,800
Return of NWC $ 20,000
Sale of Machine 28,000
Tax on sale (40%) (11,200)
Project cash flows ($270,000) $ 97,800 $109,800 $ 79,800 $ 71,800 $101,600
NPV = $81,733.79. Answers and Solutions: 11 - 18
Prob. NPV Prob. × NPV
Worst-case 0.35 ($ 7,663.52) ($ 2,682.23)
Base-case 0.35 37,035.13 12,962.30
Best-case 0.30 81,733.79 24,520.14
E(NPV) $34,800.21
σNPV = [(0.35)(-$7,663.52 – $34,800.21)2 + (0.35)($37,035.13 – $34,800.21)2 + (0.30)($81,733.79 –
$34,800.21)2]½
= [$631,108,927.93 + $1,748,203.59 + $660,828,279.49]½
= $35,967.84.
CV = $35,967.84/$34,800.21 = 1.03.

(11–13)
Replacement Analysis
The Everly Equipment Company purchased a machine 5 years ago at a cost of $90,000. The machine
had an expected life of 10 years at the time of purchase, and it is being depreciated by the straight-line

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method by $9,000 per year. If the machine is not replaced, it can be sold for $10,000 at the end of its
useful life.
A new machine can be purchased for $150,000, including installation costs. During its 5-year life, it will
reduce cash operating expenses by $50,000 per year. Sales are not expected to change. At the end of
its useful life, the machine is estimated to be worthless. MACRS depreciation will be used, and the
machine will be depreciated over its 3-year class life rather than its 5-year economic life, so the
applicable depreciation rates are 33%, 45%, 15%, and 7%.
The old machine can be sold today for $55,000. The firm’s tax rate is 35%, and the appropriate WACC is
16%.

a. If the new machine is purchased, what is the amount of the initial cash flow at Year 0?
b. What are the incremental net cash flows that will occur at the end of Years 1 c. What is the NPV of
this project? Should Everly replace the old machine?
c. What is the NPV of this project? Should Everly replace the old machine?

a. Old depreciation = $9,000 per year.

Book value = $90,000 – 5($9,000) = $45,000.
Gain = $55,000 – $45,000 = $10,000.
Tax on book gain = $10,000(0.35) = $3,500.
Price ($150,000)
SV (old machine) 55,000
Tax effect (3,500)
Initial outlay ($ 98,500)

b. Recovery Depreciable Depreciation Depreciation Change in

Year Percentage Basis Allowance, New Allowance, Old Depreciation

1 33% $150,000 $49,500 $9,000 $40,500
2 45 150,000 67,500 9,000 58,500
3 15 150,000 22,500 9,000 13,500
4 7 150,000 10,500 9,000 1,500
5 9,000 (9,000)

CFt = (ΔOperating expenses)(1 – T) + (ΔDepreciation)(T).

CF1 = ($50,000)(0.65) + ($40,500)(0.35) = $32,500 + $14,175 = $46,675.
CF2 = ($50,000)(0.65) + ($58,500)(0.35) = $32,500 + $20,475 = $52,975.
CF3 = ($50,000)(0.65) + ($13,500)(0.35) = $32,500 + $4,725 = $37,225.
CF4 = ($50,000)(0.65) + ($1,500)(0.35) = $32,500 + $525 = $33,025.
CF5 = ($50,000)(0.65) + (-$9,000)(0.35) = $32,500 - $3,150 = $29,350

(11–14)
Replacement Analysis
The Balboa Bottling Company is contemplating the replacement of one of its bottling machines with a
newer and more efficient one. The old machine has a book value of $600,000 and a remaining useful
life of 5 years. The firm does not expect to realize any return from scrapping the old machine in 5
years, but it can sell it now to another firm in the industry for $265,000. The old machine is being
depreciated by $120,000 per year, using the straight-line method.
The new machine has a purchase price of $1,175,000, an estimated useful life and MACRS class life of
5 years, and an estimated salvage value of $145,000. The applicable depreciation rates are 20%, 32%,
19%, 12%, 11%, and 6%. It is expected to economize on electric power usage, labor, and repair costs,
as well as to reduce the number of defective bottles. In total, an annual savings of $255,000 will be
realized if the new machine is installed. The company’s marginal tax rate is 35%, and it has a 12%
WACC.
a. What is the initial net cash flow if the new machine is purchased and the old one is replaced?
b. Calculate the annual depreciation allowances for both machines, and compute the change in the
annual depreciation expense if the replacement is made.

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c. What are the incremental net cash flows in Years 1 through 5?

d. Should the firm purchase the new machine? Support your answer.

14 a. Cost of new machine ($1,175,000)

Salvage value, old 265,000
Savings due to loss on sale ($600,000 – $265,000) × 0.35 117,250
Cash outlay for new machine ($ 792,750)

b. Recovery Depreciable Depreciation Depreciation Change in

Year Percentage Basis Allowance, New Allowance, Old Depreciation
1 20% $1,175,000 $235,000 $120,000 $115,000
2 32 1,175,000 376,000 120,000 256,000
3 19 1,175,000 223,250 120,000 103,250
4 12 1,175,000 141,000 120,000 21,000
5 11 1,175,000 129,250 120,000 9,250

c. CFt = (ΔOperating expenses)(1 – T) + (ΔDepreciation)(T).

CF1 = ($255,000)(0.65) + ($115,000)(0.35) = $165,750 + $40,250 = $206,000.
CF2 = ($255,000)(0.65) + ($256,000)(0.35) = $165,750 + $89,600 = $255,350.
CF3 = ($255,000)(0.65) + ($103,250)(0.35) = $165,750 + $36,138 = $201,888.
CF4 = ($255,000)(0.65) + ($21,000)(0.35) = $165,750 + $7,350 = $173,100.
CF5 = ($255,000)(0.65) + ($9,250)(0.35) = $165,750 + $3,238 = $168,988

(792,750) 206,000 255,350 201,888 173,100 168,988

118,925*
287,913
NPV = $11,820
Since the NPV is positive, the project should be accepted. To buy the new machine would increase the value of
the firm by $11,820.

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