1. You are working on a bid to build three amusement parks a year for the next two years.

This project
requires the purchase of $52,000 of equipment which will be depreciated using straight-line
depreciation to a zero book value over the two years (Y1 and Y2). The equipment can be sold at the end
of the project for $34,000 (at the end of Y2). You will also need $16,000 in net working capital over the
life of the project (Y0, Y1, Y2 but NWC will be converted in cash at the end of Y2.). The fixed costs
will be $10,000 a year and the variable costs will be $70,000 per park. Your required rate of return is
10 percent for this project and your tax rate is 35 percent. What is the minimal amount you should bid
per amusement park?

You should find out the bid price at NPV=0. First, you can calculate both net capital spending and net
working capital.
Net Capital Spending = 52000 (Y0) - After tax salvage value (Y2)
After Tax salvage value in Y2 = 34,000 - 0.35(34,000-0) = 22,100 where the book value in Y2 is zero
because of 26,000 deprecation each year.
Net working capital = 16000 (Y0) + 0 (No change in Y1) -16000 (Y2)

NPV = PV of OCF - PV of Net Capital Spending - PV of Net working Capital = 0

PV of Net Capital Spending = 52,000 - 22,100/(1.1)^2 = 33735.5
PV of Net working capital = 16,000 -16,000/1.1^2 = 2,776.6
PV of OCF = 33,735.5 + 2,776.9 = 36,512.4
Because OCF is same for two years, PV of OCF = OCF (1-1/(1.1)^2)/0.1 = 36,512.4
Therefore, OCF = 21,038.1
OCF = (Sales - Variable Costs - Fixed Costs - Depreciation) (1-0.35) + Deprecation = 21,038.1
(Sales - Variable Costs - Fixed Costs - Depreciation) = (21,038.1-26,000)/0.65 = -7,633.7
Sales = -7,633.7+ 70,000 (3) + 10,000 + 26,000 = 238366.3
Sales = amusement bid price x 3, Bid price = 79,455.4
2. X company considers buying a new machine since the machine reduces $ 50,000 production costs
every year from Y1 through Y3. If the company buys the new machine in Year 0 it has to sell the original
machine in Y0 as well. Since the company will exit the current business at the end of Y3, it should sell
the machine anyway at the end of Y3. The company should analyze incremental cash flows for new
machine in order to make a decision of buying a new machine. The following table shows all
information X company requires to calculate incremental cash flows in case of buying the new machine.
There are no working capital changes.

Original Machine New Machine

Initial Costs $200,000 $150,000
Annual depreciation $ 40,000 $ 50,000
Current Book Value $ 40,000 $150,000
Salvage Value Today $ 50,000 $ 150,000
Cost Savings 0 $ 50,000
Salvage Value in 3 years $ 20,000 $ 30,000
Required Return 10%
Tax Rate 40%

a) What are incremental cash flows of capital spending for buying the new machine?

1. When you buy new machine, costs of new machine =$150,000 and sell original machine
In Y0, costs of new machine = $ 150,000 (cash outflows)
You will sell the original machine. After tax salvage value = 50,000 – 0.4 (50,000-40,000) = $46,000
(cash inflows)
Total new cash inflow = -104,000

In Y3, opportunity costs of buying new machine is after tax salvage vale of the original machine because
the company loses the opportunity to sell old machine if the company buy new machine.
After tax salvage value of the original machine = $20,000 – 0.4(20,000-0) =$ 12,000 (cash outflows)
After tax salvage value of the new machine = $30,000 – 0.4 (30,000-0) = $18,000 (Cash inflows)
Total net cash inflow = 6,000

b) What are incremental cash flows of OCF for buying the new machine? You need to calculate
incremental OCF in Y1, Y2 and Y3. [Hint:∆ OCF = (∆EBIT) (1-Tax) + ∆Depreciation]

In Y1, ∆EBIT= Saving costs - (incremental depreciation) = 50,000- (50,000-40,000) = 40,000

OCF(Y1) =40,000 (1-0.4)+10,000 =24,000+10,000 =34,000 in Y1
OCF (Y1, Y2) = [50,000-(50,000)] (0.6) + 50000 = 50000 in Y2 and Y3
PV of OCF = 34,000/(1/1) + 50,000/(1.1)^2 + 50,000/(1.1)^3 = 109,791.1

c) Evaluate incremental cash flows for new machine with NPV and decide whether the company should
buy the new machine. (5 points)

NPV = -104,000+ 34,000/(1/1) + 50,000/(1.1)^2 + 50,000/(1.1)^3 + 6,000/(1.1)^3= 10,305.03

You should accept it.

3. Chapman Machine Shop is considering a 4-year project to improve its production efficiency. Buying
a new machine press for $600,000 in the beginning of Year 0 is estimated to result in $192,000 of
operating cash flows each year (Y1, Y2, Y3, Y4) after considering depreciation change of a new
machine. New machine will have a salvage value of $100,000 at the end of the project but its book
value is 5,000 at the end of the project. The project also requires inventory of $50,000 at the end of Year
0 (The current time is the beginning of Year 0.). The inventory will return to its original level when the
project ends. The shop's tax rate is 40 percent.
The beta of equity for Chapman Machine shop is 1.5. Market risk premium is 6% and risk free rate 4%.
Yield to Maturity for the company’s bond is 5%. The company’s debt to equity ratio is 1.

a) What is after-tax salvage value of new machine press?

100000-0.4(100000-5000) = 62000 in Year 4.

b) What is after- tax weight average cost of capital for this company? (This part has not been learned
yet. But, we will see this kind of question in the final exam. )

Cost of Equity = 1.5*6+4= 13

After Tax Cost of Debt = 5 * (0.6) =3
Cost of Capital = 13 (0.5) + 3 (0.5) = 6.5+1.5 = 8

c) Should the firm buy and install the machine press? Why or why not?

Y0 = -600,000

Present Value of OCF for Y1~Y4 = Annual OCF PVAIF (r=0.08, T=4)= 192,000 (3.3121) =
635,923.2
Present Value of Inventory = - 50,000/(1.08) = - 46,296.3

Y4 => PV of (after tax salvage value + change in net working capital)=(62,000+50,000)/(1.08)^4

=82,323.34

NPV = -600,000+635,923 -46296.3+82323.34 = 71,950.25

You should buy new machine.
4. Great Enterprises is analyzing two machines to determine which one they should purchase. The company
requires a 13 percent rate of return. Machine A has a cost of $285,000, annual operating costs of $8,500, and a 3-
year life. Machine B costs $210,000, has annual operating costs of $14,000, and has a 2-year life. Operating costs
are defined here as operating cash outflows caused by the machine. Whichever machine is purchased will be
replaced at the end of its useful life. After tax salvage value is zero. Which machine should Great Enterprises
select?

First, net working captial does not change with these machines. We don’t have to consider it.
Second, net capital spending of machine A is 285,000 (Y0). However, after tax salvage value is zero.
NPV are calculated for machine A and B and then use the concept of EAC (Equivalent Annual Costs)
to compare annualized costs of both machines.

5. Four years ago, Cheese Snacks, Inc. purchased land located beside their factory at a price of
$739,000. The land is currently valued at $825,000. The company is now considering building a new
warehouse on that land. The construction cost of the warehouse is estimated at $460,000. What is the
initial cash outflow that should be used when analyzing this project?

The opportunity costs should be included. But, which one is more important, book value or market
value? The market value should reflect the real costs. Thus, initial cash outflows = 825,000 + 460,000
= $1,285,000