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DECISIONSPART I

Problems

1. An investment opportunity costing $180,000 is expected to yield net cash flows of

$60,000 annually for five years.

a. Find the NPV of the investment at a cutoff rate of 12%.

b. Find the payback period of the investment.

c. Find the IRR on the investment.

SOLUTION:

a. NPV: $36,300 [(3.605 x $60,000) - $180,000]

b. Payback period: 3 years ($180,000/$60,000)

c. IRR: between 18 % and 20% (3.0 is between 3.127 and 2.991)

2. Tofte is considering the purchase of a machine. Data are as follows:

Cost

Useful life

Annual straight-line depreciation

Expected annual savings in cash

operation costs

$100,000

10 years

$ 10,000

$ 18,000

a. Compute the annual net cash flows for the investment.

b. Compute the NPV of the project.

SOLUTION:

a. Annual net cash flows: $14,800 [$18,000 pretax - 40% x ($18,000 - $10,000

depreciation)]

3. Willow Company is considering the purchase of a machine with the following

characteristics.

Cost

Estimated useful life

Expected annual cash cost savings

$150,000

10 years

$35,000

Marquette's tax rate is 40%, its cost of capital is 12%, and it will use straight-line

depreciation for the new machine.

a. Compute the annual after-tax cash flows for this project.

b. Find the payback period for this project.

SOLUTION:

a. Annual cash flows: $27,000 [$35,000 - 40% x ($35,000 - $15,000)]

b. Payback period: 5.56 years ($150,000/$27,000)

4. Bilt-Rite Co. has the opportunity to introduce a new product. Bilt-Rite expects the

product to sell for $60 and to have per-unit variable costs of $40 and annual cash

fixed costs of $3,000,000. Expected annual sales volume is 250,000 units. The

equipment needed to bring out the new product costs $5,000,000, has a four-year

life and no salvage value, and would be depreciated on a straight-line basis. BiltRite's cost of capital is 10% and its income tax rate is 40%.

a. Find the increase in annual after-tax cash flows for this opportunity.

b. Find the payback period on this project.

c. Find the NPV for this project.

SOLUTION:

a. Increase in annual cash flows: $1,700,000

Income before taxes, 250,000 x ($60 - $40)

- $3,000,000 - $5,000,000/4

Income tax

750,000

(300,000)

---------$ 450,000

1,250,000

---------$1,700,000

Net income

Plus depreciation

Net cash flow

==========

b. Payback period: 2.94 years ($5,000,000/$1,700,000)

c. NPV: $389,000 [($1,700,000 x 3.170) - $5,000,000]

$120,000 annually for ten years.

a. Find the NPV of the investment at a cutoff rate of 12%.

b. Find the payback period of the investment.

c. Find the IRR on the investment.

SOLUTION:

a. NPV: $78,000 [(5.650 x $120,000) - $600,000]

b. Payback period: 5 years ($600,000/$120,000)

c. IRR: 15% (5.0 is about halfway between 5.216 and 4.833)

6. Scottso has an investment opportunity costing $300,000 that is expected to yield the

following cash flows over the next six years:

Year

Year

Year

Year

Year

Year

One

Two

Three

Four

Five

Six

$75,000

$90,000

$115,000

$130,000

$100,000

$90,000

a.

b.

c.

SOLUTION:

a. Payback period: 3.15 years (75,000 + 90,000 + 115,000 + .15 x 130,000)

b. Book rate of return: 33.3%

Average return: $100,000 ($600,000 total / 6 years)

Depreciation:

50,000 ($30,000 / 6 years)

------Average income $50,000

Average investment: $300,000 / 2 = $150,000

Book rate of return = $50,000 / 150,000 = 33.3%

c. NPV: $130,530

1

2

3

4

5

6

Cash

-----75,000

90,000

115,000

130,000

100,000

90,000

Investment

NPV

Factor

-----.909

.826

.751

.683

.621

.564

PV

-----68,175

74,340

86,365

88,790

62,100

50,760

------430,530

300,000

------130,530

======

Cost

Useful life

Annual straight-line depreciation

Expected annual savings in cash

operation costs

$160,000

10 years

$ ???

$ 33,000

a. Compute the annual net cash flows for the investment.

b. Compute the NPV of the project.

SOLUTION:

a. Annual net cash flows: $26,200 [$33,000 pretax - 40% x ($33,000 - $16,000

depreciation)]

b. NPV: Negative $11,970 [($26,200 x 5.650) - $160,000]

c. IRR: between 10% and 12% [factor of 6.107 (160,000/26,200) is between 6.145

and 5.650]

8. Scottso has an investment opportunity costing $180,000 that is expected to yield the

following cash flows over the next five years:

Year One

Year Two

Year Three

Year Four

Year Five

$ 30,000

$ 60,000

$ 90,000

$ 60,000

$ 30,000

a.

b.

c.

SOLUTION:

a. Payback period: 3.0 years (30,000 + 60,000 + 90,000)

b. Book rate of return: 20%

Average return: $54,000 ($270,000 total / 5 years)

Depreciation: 36,000 ($180,000 / 5 years)

-----Average income $18,000

Average investment: $180,000 / 2 = $90,000

Book rate of return = $18,000 / $90,000 = 20%

c. NPV: $6,930

1

2

3

4

5

Cash

-----30,000

60,000

90,000

60,000

30,000

Investment

NPV

Factor

-----.893

.797

.712

.636

.567

PV

-----26,790

47,820

64,080

38,160

17,010

------193,860

180,000

------13,860

======

characteristics.

Cost

$160,000

Estimated useful life

5 years

Expected annual cash cost savings $56,000

Expected salvage value

none

Reno's tax rate is 40%, its cost of capital is 12%, and it will use straight-line

depreciation for the new machine.

a. Compute the annual after-tax cash flows for this project.

b. Find the payback period for this project.

c. Compute the NPV for this project.

SOLUTION:

a. Annual cash flows: $46,400 [$56,000 - 40% x ($56,000 - 32,000)]

b. Payback period: 3.45 years ($160,000/$46,400)

c. NPV: $7,272 [($46,400 x 3.605) - $160,000]

10. Whitehall Co. has the opportunity to introduce a new product. Whitehall expects the

project to sell for $40 and to have per-unit variable costs of $27 and annual cash

fixed costs of $1,500,000. Expected annual sales volume is 200,000 units. The

equipment needed to bring out the new product costs $3,500,000, has a four-year

life and no salvage value, and would be depreciated on a straight-line basis.

Whitehall's cutoff rate is 10% and its income tax rate is 40%.

a. Find the increase in annual after-tax cash flows for this opportunity.

b. Find the payback period on this project.

c. Find the NPV for this project.

SOLUTION:

a. Increase in annual cash flows: $1,100,000

Income before taxes, [200,000 x ($40 - $27)

- $1,500,000 - $3,500,000/4]

Income tax

Net income

Plus depreciation

Net cash flow

b. Payback period: 3.47 years ($3,500,000/$1,010,000)

c. NPV: negative $298,300 [($1,010,000 x 3.170) - $3,500,000]

225,000

( 90,000)

---------$ 135,000

875,000

---------$1,010,000

==========

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