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LAWTON ENTERPRISES

Lawton Enterprises is evaluating a project with the following characteristics:


Fixed capital investment is $2,000,000.
The initial investment in net working capital is $200,000. At the end of each year, net
working capital must be increased so that the cumulative investment in net working capital is

one-sixth of the next years projected sales.


The xed capital will be depreciated by five years MACRS rate. Rates are 20%, 32%,

19.20%, 11.52%, 11.52% & 5.76% respectively for six years.


Sales are $1,200,000 in year 1. They grow at a 25 percent annual rate for the next two years,

and then grow at a 10 percent annual rate for the last three years.
Fixed cash operating expenses are $150,000 for years 13 and $130,000 for years 46.
Variable cash operating expenses are 40 percent of sales in year 1, 39 percent of sales in year

2, and 38 percent in years 36.


Lawtons marginal tax rate is 30 percent.
Lawton will sell its xed capital investments for $150,000 when the project terminates and
recapture its cumulative investment in net working capital. Income taxes will be paid on any

gains.
The projects required rate of return is 18 percent.
If taxable income on the project is negative in any year, the loss will offset gains else-where
in the corporation, resulting in a tax savings.

Required
Determine whether this is a protable investment using the
1
2

Net Present Value


Internal Rate of Return

Clark Upholstery Company


Bo Humphries, chief financial officer of Clark Upholstery Company, expects the firms net
profits after taxes for the next 5 years to be as shown in the following table.

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Year

Net Profits After taxes

$100,000

150,000

200,000

250,000

320,000

Bo is beginning to develop the relevant cash flows needed to analyze whether to renew or
replace Clarks only depreciable asset, a machine that originally cost $30,000, has a current book
value of zero, and can now be sold for $20,000. (Note: Because the firms only depreciable asset
is fully depreciated its book value is zeroits expected net profits after taxes equal its operating
cash inflows.) He estimates that at the end of 5 years, the existing machine can be sold to net
$2,000 before taxes. Bo plans to use the following information to develop the relevant cash flows
for each of the alternatives.

Alternative 1
Renew the existing machine at a total depreciable cost of $90,000. The renewed machine would
have a 5-year usable life and would be depreciated under MACRS using a 5-year recovery
period. Renewing the machine would result in the following projected revenues and expenses
(excluding depreciation):

Year

Revenue

Expenses (Excl. depreciation)

$1,000,000

$801,500

1,175,000

884,000

1,300,000

918,100

1,425,000

943,000

1,550,000

968,100

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The renewed machine would result in an increased investment in net working capital of $15,000.
At the end of 5 years, the machine could be sold to net $8,000 before taxes.
Alternative 2
Replace the existing machine with a new machine that costs $100,000 and requires installation
costs of $10,000. The new machine would have a 5-year usable life and would be depreciated
under MACRS using a 5 year recovery period. The firms projected revenues and expenses
(excluding depreciation), if it acquires the machine, would be as follows:

Year

Revenue

Expenses (Excl. Depreciation)

$1,000,000

$764,500

1,175,000

839,800

1,300,000

914,900

1,425,000

989,900

1,550,000

998,900

The new machine would result in an increased investment in net working capital of $22,000. At
the end of 5 years, the new machine could be sold to net $25,000 before taxes. The firm is
subject to a 40% tax on both ordinary income and capital gains. As noted, the company uses
MACRS depreciation. (See Table 3.2 on page 100 for the applicable depreciation percentages.)
Required
A. Calculate the initial investment associated with each of Clark Upholsterys alternatives.
B. Calculate the incremental operating cash inflows associated with each of Clarks
alternatives. (Note: Be sure to consider the depreciation in year 6.)
C. Calculate the terminal cash flow at the end of year 5 associated with each of Clarks
alternatives.
D. Use your findings in parts a, b, and c to depict on a time line the relevant cash flows
associated with each of Clark Upholsterys alternatives.
E. Solely on the basis of your comparison of their relevant cash flows, which alternative
appears to be better? Why?

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J. SMYTHE, INC.
J. Smythe, Inc., manufactures ne furniture. The company is deciding whether to introduce a
new mahogany dining room table set. The set will sell for $5,600, including a set of eight chairs.
The company feels that sales will be 1,300; 1,325; 1,375; 1,450; and 1,320 sets per year for the
next ve years, respectively. Variable costs will amount to 45 percent of sales, and xed costs are
$1.7 million per year. The new tables will require inventory amounting to 10 percent of sales,
produced and stockpiled in the year prior to sales. It is believed that the addition of the new table
will cause a loss of 200 tables per year of the oak tables the company produces. These tables sell
for $4,500 and have variable costs of 40 percent of sales. The inventory for this oak table is also
10 percent. J. Smythe currently has excess production capacity. If the company buys the
necessary equipment today, it will cost $10.5 million. How-ever, the excess production capacity
means the company can produce the new table without buying the new equipment. The company
controller has said that the current excess capacity will end in two years with current production.
This means that if the company uses the current excess capacity for the new table, it will be
forced to spend the $10.5 million in two years to accommodate the increased sales of its current
products. In ve years, the new equipment will have a market value of $2.8 million if purchased
today, and $6.1 million if purchased in two years. The equipment is depreciated on a seven-year
MACRS schedule. The company has a tax rate of 38 percent, and the required return for the
project is 14 percent.
A. Should J. Smythe undertake the new project?
B. Can you perform an IRR analysis on this project? How many IRRs would you expect to
nd?
C. How would you interpret the protability index?

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BETHESDA MINING COMPANY


Bethesda Mining is a midsized coal mining company with 20 mines located in Ohio,
Pennsylvania, West Virginia, and Kentucky. The company operates deep mines as well as strip
mines. Most of the coal mined is sold under contract, with excess production sold on the spot
market. The coal mining industry, especially high-sulfur coal operations such as Bethesda, has
been hard-hit by environmental regulations. Recently, however, a combination of increased
demand for coal and new pollution reduction technologies has led to an improved market
demand for high-sulfur coal. Bethesda has just been approached by Mid-Ohio Electric Company
with a request to supply coal for its electric generators for the next four years. Bethesda Mining
does not have enough excess capacity at its existing mines to guarantee the contract. The
company is considering opening a strip mine in Ohio on 5,000 acres of land purchased 10 years
ago for $6 million. Based on a recent appraisal, the company feels it could receive $5 million on
an after-tax basis if it sold the land today.
Strip mining is a process where the layers of topsoil above a coal vein are removed and
the exposed coal is removed. Some time ago, the company would simply remove the coal and
leave the land in an unusable condition. Changes in mining regulations now force a company to
reclaim the land; that is, when the mining is completed, the land must be restored to near its
original condition. The land can then be used for other purposes. Because it is currently operating
at full capacity, Bethesda will need to purchase additional necessary equipment, which will cost
$30 million. The equipment will be depreciated on a seven-year MACRS schedule. The contract
runs for only four years. At that time the coal from the site will be entirely mined. The company
feels that the equipment can be sold for 60 percent of its initial purchase price. However,
Bethesda plans to open another strip mine at that time and will use the equipment at the new
mine.
The contract calls for the delivery of 600,000 tons of coal per year at a price of $34 per ton.
Bethesda Mining feels that coal production will be 650,000 tons, 725,000 tons, 810,000 tons, and
740,000 tons, respectively, over the next four years. The excess production will be sold in the
spot market at an average of $40 per ton. Variable costs amount to $13 per ton, and xed costs
are $2,500,000 per year. The mine will require a net working capital investment of 5 percent of
sales. The NWC will be built up in the year prior to the sales.
Bethesda will be responsible for reclaiming the land at termination of the mining. This will
occur in year 5. The company uses an outside company for reclamation of all the companys strip
mines. It is estimated the cost of reclamation will be $4 million. After the land is reclaimed, the
company plans to donate the land to the state for use as a public park and recreation area. This
will occur in year 6 and result in a charitable expense deduction of $6 million. Bethesda faces a
38 percent tax rate and has a 12 percent required return on new strip mine projects. Assume that
a loss in any year will result in a tax credit.
You have been approached by the president of the company with a request to analyze the
project. Calculate the payback period, protability index, average accounting return, net present

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value, internal rate of return, and modied internal rate of return for the new strip mine. Should
Bethesda Mining take the contract and open the mine?

GOODWEEK TIRES, INC.


After extensive research and development, Goodweek Tires, Inc., has recently developed
a new tire, the Super Tread, and must decide whether to make the investment necessary to
produce and market it. The tire would be ideal for drivers doing a large amount of wet weather
and off-road driving in addition to normal freeway usage. The research and development costs so
far have totaled about $10 million. The SuperTread would be put on the market beginning this
year, and Goodweek expects it to stay on the market for a total of four years. Test marketing
costing $5 million has shown that there is a signicant market for a SuperTread-type tire.
As a nancial analyst at Goodweek Tires, you have been asked by your CFO, Adam
Smith, to evaluate the SuperTread project and provide a recommendation on whether to go ahead
with the investment. Except for the initial investment that will occur immediately, assume all
cash ows will occur at year-end Goodweek must initially invest $120 million in production
equipment to make the Super-Tread. This equipment can be sold for $51 million at the end of
four years. Goodweek intends to sell the SuperTread to two distinct markets:
1. The original equipment manufacturer (OEM) market: The OEM market consists primarily of
the large automobile companies (like General Motors) that buy tires for new cars. In the OEM
market, the SuperTread is expected to sell for $36 per tire. The variable cost to produce each tire
is $18.
2. The replacement market: The replacement market consists of all tires purchased after the
automobile has left the factory. This market allows higher margins; Goodweek expects to sell the
SuperTread for $59 per tire there. Variable costs are the same as in the OEM market.
Goodweek Tires intends to raise prices at 1 percent above the ination rate; variable costs
will also increase at 1 percent above the ination rate. In addition, the SuperTread project will
incur $25 million in marketing and general administration costs the rst year. This cost is
expected to increase at the ination rate in the subsequent years.
Goodweeks corporate tax rate is 40 percent. Annual ination is expected to remain
constant at 3.25 percent. The company uses a 15.9 percent discount rate to evaluate new product
decisions. Automotive industry analysts expect automobile manufacturers to produce 2 mil-lion
new cars this year and production to grow at 2.5 percent per year thereafter. Each new car needs
four tires (the spare tires are undersized and are in a different category). Goodweek Tires expects
the SuperTread to capture 11 percent of the OEM market.
Industry analysts estimate that the replacement tire market size will be 14 million tires
this year and that it will grow at 2 percent annually. Goodweek expects the SuperTread to capture
an 8 percent market share.
The appropriate depreciation schedule for the equipment is the seven-year MACRS
depreciation schedule. The immediate initial working capital requirement is $11 million.
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Thereafter, the net working capital requirements will be 15 percent of sales. What are the NPV,
payback period, discounted payback period, AAR, IRR, and PI on this project?

NATIONAL FOODS
National Foods is considering producing a new candy, Nasty-As-Can-Be. National has spent two
years and $450,000 developing this product. National has also test marketed Nasty, spending
$100,000 to conduct consumer surveys and tests of the product in 25 states.
Based on previous candy products and the results in the test marketing, management
believes consumers will buy 4 million packages each year for ten years at 50 cents per package.
Equipment to produce Nasty will cost National $1,000,000 and $300,000 of additional net
working capital will be required to support Nasty sales. National expects production costs to
average 60% of Nastys net revenues, with overhead and sales expenses totaling $525,000 per
year. The equipment has a life of ten years, after which time it will have no salvage value.
Working capital is assumed to be fully recovered at the end of ten years. Depreciation is straightline (no salvage) and Nationals tax rate is 45%. The required rate of return for projects of similar
risk is 8%.
A. Should National Foods produce this new candy? What is the basis of your recommendation?
B. Would your recommendation change if production costs average 65% of net revenues instead
of 60%? How sensitive is your recommendation to production costs?
C. Would your recommendation change if the equipment were depreciated according to
MACRS as a ten-year asset instead of using straight-line?
D. Suppose that competitors are expected to introduce similar candy products to compete with
Nasty, such that dollar sales will drop by 5% each year following the rst year. Should
National Foods produce this new candy considering this possible drop in sales? Explain.

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