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Tax Issues with Salvage Value

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					Problem Information

Project A:
Cost                                   $5,000        25%
Annual Net Cash Inflow                 $1,800
Life (Years)                                5

Project B:
Cost                                   $5,000
Cash Inflow, Yr. 1                      $500
Cash Inflow, Yr. 2                     $1,200
Cash Inflow, Yr. 3                     $2,000
Cash Inflow, Yr. 4                     $2,500
Cash Inflow, Yr. 5                     $2,000

Project C:
Cost                                   $5,000
Net cash flow per year                 $2,500
Life (Years)                                5
Income-tax rate                           25%

Project D:
Cost                                   $5,000
Sales, per year                         $4,000
Cash expenditures, per year             $1,500
Estimated Salvage Value                  $500
Income-tax rate                           25%
Project life (in years)                     5

Minimum rate of return on investment      8%     after-tax
       Annuity Factor, 4 years =        3.312
       Annuity Factor, 5 years =        3.993
       PV Factors:
           Yr 1 =                       0.926
           Yr 2 =                       0.857
           Yr 3 =                       0.794
           Yr 4 =                       0.735
           Yr 5 =                       0.681

Solution
Problem Information

Par-Value of Bonds                             $5,000,000
Par-Value of Pref Stock Outstanding            $5,000,000
Orig. selling price/sh pref stock                     $24
Par value per share, pref stock                       $25
Dividend per share, pref stock                         $3
Current market price per share, pref stock            $30
Par value per share of common stock                   $10
Current market price per share, common stock         $170
Coupon rate on bonds                                   9%
Original issuance price, bonds                        98%
Current market value of bonds                        110%
Effective income tax rate                             30%
Est. cost of equity capital (after-tax)               20%
Shares of common stock outstanding                  50,000

Solution
quirements

receive the first payment on December 31, 2000.
receive the first payment on January 1, 2000, the date the contract was signed.
g the owner is in the 45 percent income tax bracket, calculate your answer for requirement 1.
Exercise 20-37 After-Tax Net Present Value and IRR




             Purchase price and installation cost of new computer system   $   60,000
             Cost to operate each year                                     $   30,000
             Estimated useful life in years                                         4
             Expected cost reduction per year                              $   62,000
             Cost of capital                                                      10%
             Income tax bracket                                                   30%




Solution
Exercise 20-38 Basic Capital Budgeting Techniques, Uniform Net Cash Inflows, Spreadsheet Application




                  Purchase price of machine                              $ 500,000
                  Expected useful life in years                                 10
                  Expected net cash inflow per year                      $ 120,000
                  Percentage used to evaluate capital investments              12%




Solution
Exercise 20-39 Basic Capital Budgeting Techniques, Uneven Net Cash Inflows With Taxes, Spreadsheet Application




                                       Net                              Net
                                      Cash                             Cash
                         Year        Inflow                   Year     Inflow
                          1         $ 50,000                    6    $ 300,000
                          2            80,000                   7      270,000
                          3           120,000                   8      240,000
                          4           200,000                   9      120,000
                          5           240,000                  10        40,000

            Purchase price of machine                                $ 500,000
            Expected useful life in years                                   10
            Percentage used to evaluate capital investments                12%
            Combined tax rate                                              30%




Solution
Exercise 20-40 Basic Capital Budgeting Techniques, Uneven Net Cash Inflows and MACRS




                                               Net                           Net
                                              Cash                         Cash
                                Year          Inflow              Year     Inflow
                                 1          $   50,000             6     $ 300,000
                                 2              80,000             7        270,000
                                 3             120,000             8        240,000
                                 4             200,000             9        120,000
                                 5             240,000             10        40,000


                Purchase price of machine                                $ 500,000
                Expected useful life in years                                   10
                Percentage used to evaluate capital investments                12%
                Combined tax rate                                              30%




Solution
Exercise 20-41 Straightforward Capital Budgeting with Taxes




                 Cost of new machine                          $ 30,600
                 Machine's estimated useful life                     6
                 Estimated salvage value                      $    600
                 Annual cost savings                          $ 8,000
                 Cost of capital                                    8%
                 Income tax rate                                   40%
                 Net after-tax annual cash inflow             $ 5,000
                 PV factor, 8%, 6 years =                        0.630
                 Annuity factor, 8%, 6 years =                   4.623




Soution
Exercise 20-42 Capital Budgeting with Tax and Sensitivity Analysis




               Cost of new machine                                   $   6,000
               Expected useful life                                         10
               Additional cash revenues per year                     $   1,200
               Income tax rate                                             35%
               PV Annuity Factor, 15%, 10 years                           5.019




Solution
Exercise 20-43 Basic Capital Budgeting




                 Current market value of old machinery                   $ 1,800
                 Cost of new machinery                                   $ 40,000
                 Annual pretax operating cash savings of new machinery   $ 12,500
                 Useful life of new machine in years                            4
                 Annual depreciation expense for new machine             $ 10,000
                 Investment in working capital for new machine           $ 3,000
                 Income tax rate                                              40%
                 After-tax cost of capital                                    10%




Solution
Problem 20-44 Equipment Replacement and Strategic Considerations
Background




Problem Information

                                           AccuDril   RoboDril
                                             X10       1010K
Original purchase price                    $120,000
Estimated salvage value                     $20,000
Original life (years)                            10
Elapsed time (usage, in years)                    8
Est. overhaul cost, three years from now   $100,000
Est. salvage value, new machine                  $0
Est. life of overhauled machine (years)           3
Effic. Gain, overhauled machine                 20%
Cost of new machine                                   $250,000
Training costs, new machine                            $30,000
Est. salvage value, overhauled machine                      $0
Est. life, new machine (in years)                            5
Units of output (per year)                   10,000      10,000
Machine-hours                                 8,000       4,000
Var. operating cost per machine hour         $10.00      $10.00
Selling price per unit                        $100        $100
Variable manufacturing cost                        $40           $40
     (not including machine-hours)
Other annual expenses                         $95,000       $55,000
      (tooling and supervising)
Disposable value—today                        $25,000
Trade-in allowance for new machine            $40,000
Disposable value—in five years                       0      $50,000

Devine Instrument Company’s wtd-average cost of capital (WACC)
                                                     Tax rate

20-44 Requirements

1. Determine the effect on cash flow for items that differ for the two alternatives.
2. Compute the payback period for purchasing RoboDril 1010K rather than having AccuDr
   in two years.
3. What is the present value of each decision alternative?
4. What other factors, including strategic issues, should the firm consider before making th


Solution
ic Considerations
                12%
                40%



the two alternatives.
10K rather than having AccuDril X10 overhauled


firm consider before making the final decision?
Problem 20-45 Sensitivity Analysis
Background




Problem Information

                                         AccuDril X10    RoboDril 1010K
Original purchase price                     $120,000
Estimated salvage value                      $20,000
Original life (years)                              10
Elapsed time (usage, in years)                      8
Est. overhaul cost, three years from now    $100,000
Est. salvage value, new machine                    $0
Est. life of overhauled machine (years)             3
Effic. Gain, overhauled machine                   20%
Cost of new machine                                           $250,000
Training costs, new machine                                    $30,000
Est. salvage value, overhauled machine                              $0
Est. life, new machine (in years)                                    5
Units of output (per year)                     10,000            10,000
Machine-hours                                   8,000             4,000
Var. operating cost per machine hour           $10.00            $10.00
Selling price per unit                          $100              $100
Variable manufacturing cost                       $40              $40
       (not including machine-hours)
Other annual expenses                        $95,000           $55,000
        (tooling and supervising)
Disposable value—today                       $25,000
Trade-in allowance for new machine           $40,000
Disposable value—in five years                       0         $50,000

Devine Instrument Company’s wtd-average cost of capital (WACC)
                                                      Tax rate

20-45 Requirements
1. What is the maximum machine operating cost of the overhauled AccuDril for the replace
   decision to be an incorrect financial decision?
2. Use the Goal Seek function in Excel to determine the maximum amount that the annual
   operating costs for the new machine can be before changing the decision.
3. New technologies make it possible to overhaul this machine now for $80,000. Both the
   cost and the undepreciated cost (book value) of the existing asset are to be depreciated
   overhaul will improve its productivity by 20 percent and reduce the cost of a major overh
   years from now to $30,000. All overhaul costs will be depreciated using the straight-line
   overhaul, the machine will have no salvage value. Either overhaul can be scheduled du
   maintenance and will not affect production. Despite the old saying, ―If it ain’t broke, don
   you overhaul it now or wait for two years to do the overhaul as planned originally, assum
   that no funds are currently available to purchase RoboDril 1010K?
4. Performing the overhaul now also improves product quality. Management believes that
   quality improvement is rather subtle and very difficult to quantify. Should the firm overha

Solution
12%
40%
AccuDril for the replacement

amount that the annual after-tax
  decision.
  for $80,000. Both the overhaul
et are to be depreciated over two years. The
he cost of a major overhaul two
d using the straight-line method. With either
ul can be scheduled during regular
 g, ―If it ain’t broke, don’t fix it,‖ should
 anned originally, assuming

agement believes that the
Should the firm overhaul now?
Problem 20-46 Comparison of Capital Budgeting Techniques, Sensitivity, Analy
Background




Problem Information

                                                    Per Unit
Sales price                                              $195
Variable costs
   Manufacturing                 $90
   Marketing                       10        $100
Fixed costs
   Manufacturing                 $45
   Other                           25         70        $170
Net income                                               $25

Current capacity level (units)                        10,000
Estimated demand (units)                              25,000
Duration of increased demand (years)                       4
Investment cost, year 0                             $995,000
Estimated salvage value, after 4 years              $195,000
Estimated salvage value, after 10 years              $35,000
Estimated life of new equipment (in years)                10
% increase in capacity                                  200%
Additional fixed mfg costs (beyond deprec)          $250,000 per year
After-tax discount rate (WACC)                           14%
Income tax rate                                          30%
Additional fixed mktg costs per year                $200,000
Increase in output volume (units)                     10,000
20-46 Requirements

1. Assume that the equipment will be depreciated over a four-year period. What effects wi
   equipment have on net income in each of the four years?
2. What effect will the new equipment have on cash flows in each of the four years?
3. Compute the proposed investment’s payback period (in years)
4. Compute the book rate of return (ARR) based on the average investment.
5. Compute the net present value (NPV) of the proposed investment
6. Compute the internal rate of return (IRR) of the proposed investment
7. Management has decided to invest in the new equipment, but is unsure of the reliability
   of the estimates and as such has asked some what-if questions. Treat each of the follow
   cases independently.
        a. By how much can the unit variable cost for units produced by the new equipmen
           still justify the purchase of the equipment (i.e., have the investment generate an
           exactly 14 percent, its cost of capital)?
        b. The company is anticipating an increase in competition. Management believes t
           response, it will have to reduce the selling price of the product. By how much ca
           the selling price (of all units sold) and still be able to justify the purchase of the n

Solution
s, Sensitivity, Analysis
eriod. What effects will the new

 the four years?




 nsure of the reliability of some
Treat each of the following two

by the new equipment increase and
estment generate an after-tax IRR of

 anagement believes that, in
duct. By how much can the firm decrease
 the purchase of the new equipment?
Problem 20-47 Replacing a Small Machine: Capital Budgeting Techniques and
Background




Problem Information

                                      Machine in Use             SP1000
Capacity                              10,000 units/year          18,000
Materials                              $4.00 per unit             $3.00
Labor and other variable costs         $1.00 per unit             $0.20
Maintenance costs                      $1.00 per unit             $0.10
                                       $6.00 per unit             $3.30
Current contract:
     Number of units/year                           10,000
     Selling price, per unit                         $5.00
(For simplicity, assume that all revenues and expenses are received and paid at year-end




   Additional information:
     Current disposal value of existing machine                  $3,000
     Disposal value of machine five years from now               $1,000
     Remaining life of existing machine, in years                     5
     Estimated life of new machine, in years                          5
     Cost of new machine                                       $100,000
     Estimated salvage value of new machine, five years              $5,000
     Discount rate (WACC)                                           10.00%
     Income tax rate                                                20.00%
     Depreciation expense on existing machine, per year                 $0

20-47 Requirements

Compute
1. The effects on the cash flow each year, including year 0, if the new machine is purchas
2. The net present value (NPV) of the new machine.
3. The payback period of the new machine.
4. The internal rate of return (IRR) on the new machine, assuming that the new machine’s
   cash inflows are $25,000 and that neither the new machine nor the existing machine wi
   value at the end of the five-year period.
5. The internal rate of return (IRR) assuming that the after-tax cash in flows are as follows
   the estimated salvage value for both machines at the end of five years is $0.

                          Year 0            $0 (see below)
                          Year 1       $20,000
                          Year 2       $22,000
                          Year 3       $25,000
                          Year 4       $30,000
                          Year 5       $40,000

6. By how much can the variable costs of the new machine increase (or decrease) and the
be indifferent on the replacement, assuming all the other costs will be as estimated?


Solution
eting Techniques and Sensitivity Analysis




 SP1000
          units/year
          per unit
          per unit
          per unit
          per unit



ved and paid at year-end.)
new machine is purchased.


g that the new machine’s annual
r the existing machine will have salvage

sh in flows are as follows and that
 e years is $0.




ase (or decrease) and the company
 ll be as estimated?
Problem 20-48 Capital Budgeting with Sum-of-Years’-Digits Depreciation
Background

Bernie Company purchased a new machine, with an estimated useful life of five years and
The machine is expected to produce net cash inflows from operations, before income taxe

            Year 1                              $9,000
            Year 2                             $12,000
            Year 3                             $15,000
            Year 4                              $9,000
            Year 5                              $8,000

Problem Information

Investment outlay, year 0                      $45,000
Estimated salvage value, year 5                     $0
Estimated useful life (years)                        5




Percent for evaluating capital investments
            Income tax bracket

20-48 Requirements

Set up an Excel spreadsheet to determine:
1. The Payback period of the proposed investment.
2. The Net present value (NPV) of the proposed investment.
3. The Internal rate of return (IRR) of the proposed investment.
4. The discounted payback period of the proposed project
(CPA Adapted)


Solution
igits Depreciation


 useful life of five years and no salvage value, for $45,000.
rations, before income taxes, as follows:




                    10%
                    24%
Problem 20-49 Working Backward: Determine Initial Investment Based on Book
Background




Problem Information


Life of new machine                 10 years
Estimated salvage value            $0
Net before tax cash inflow     $6,750
Book rate of return (ARR)         10%
The firm’s tax rate               20%

20-49 Requirements

What is the cost of the new machine?
(CPA Adapted)


Solution
vestment Based on Book Rate of Return
Problem 20-50 Working Backward: Determine Initial Investment Based on Inter
Background




Problem Information

Useful life                                          6 years
Estimated salvage value                            $0
Expected annual cash inflow from operations   $20,000
Time-adjusted rate of return (IRR)                10%
Tax bracket                                       20%

20-50 Requirements

What was the cost of the machine?
(CPA Adapted)


Solution
tment Based on Internal Rate of Return
Problem 20-51 Working Backward: Determine Periodic Cash Flow Based on Bo
Background




Problem Information

Useful life                                      5 years
Estimated salvage value                        $0
New machine                               $60,000
Book rate of return                           15%
The firm’s tax rate                           25%

20-51 Requirements

What is the expected annual pre-tax cash flow from operations from this investment?
(CPA Adapted)


Solution
Cash Flow Based on Book (Accounting) Rate of Return




 om this investment?
Problem 20-52 Machine Replacement and Sensitivity Analysis Without Conside
Background




Problem Information

Model KC12                                                             $5,000
The estimated salvage value                                              $600
Estimated life                                                             11
Model AC1 Purchase price                                               $8,000
Current salvage value, Model KC12                                      $3,000
Estimated savings per year, cash operating costs                         $750
Estimated salvage value, Model AC1                                       $400
Estimated life of model AC1                                                10
Discount rate (WACC)                                                  12.00%

20-52 Requirements

1. Compute, for AC1, the
   a. Payback period.
   b. Book rate of return (ARR) using the average investment; assume that any loss on th
      of the existing machine is spread out evenly over the 10-year life of the new machine
   c. Net present value. (NPV)
   d. Internal rate of return. (IRR)
2. Should the firm purchase AC1? Why?
3. What is the minimum (or maximum) savings that AC1 must have without altering your d


Solution
 is Without Considering Taxes




me that any loss on the disposal
 e of the new machine.



 ithout altering your decision in requirement 2?
Problem 20-53 Value of Accelerated Depreciation
Background




Problem Information


Cost of new asset                      $100,000
Estimated life of asset, in years             4
Estimated salvage value                      $0
Discount rate                               8%
Income tax rate                            40%

20-53 Requirements

1. What is the present value of the tax benefits resulting from calculating depreciation usin
   the sum-of the- years’-digits method as opposed to the straight-line method on this asse
2. What is the present value of the tax benefits resulting from calculating depreciation usin
   the doubledeclining-balance method as opposed to straight-line method on this asset?
3. What is the present value of the tax benefits resulting from using MACRS as opposed t
   depreciation? The asset qualifies as a three-year asset. Use the half-year convention.
(CPA Adapted)

Solution
 ting depreciation using
e method on this asset?
 ting depreciation using
 ethod on this asset?
MACRS as opposed to straight-line
alf-year convention.
Problem 20-54 Capital Budgeting with Sensitivity Analysis
Background




Problem Information


                     Income Statement for 2007
Rental revenue                                        $2,000,000
Expenses
  Operations                              $950,000
  Administration                             70,000
  Property taxes                            280,000
  Depreciation (straight line)              100,000    1,400,000
Net income before taxes                                $600,000
Income taxes at 40 percent                               240,000
Net income after taxes                                 $360,000

Years remaining on lease                                      8
Bank lending rate                                           12%
Owner's Cost of capital (discount rate)                     10%
Investor group's cost of capital                            12%
Seller's tax bracket                                        40%
Buyer's tax bracket                                              30%
PV Annuity Factor (Table 2, page 871), 8 years, 12% =           4.968
PV Annuity Factor (Table 2, page 871), 8 years, 10% =           5.335




20-54 Requirements

1. What is the maximum the buyer should pay?
2. What is the minimum selling price Meidi can accept if she has to pay George a 5 percen
   assume that Meidi would want to be compensated for the lost rental incomes, plus any
   she’d have to pay in conjunction with the sale, plus the sales commission paid to the br
3. What is the maximum the buyer would be willing to pay if the purchase is for a MACRS
   Use the half-year convention.

Solution
ysis
has to pay George a 5 percent commission?
ost rental incomes, plus any capital gains tax
es commission paid to the broker.
he purchase is for a MACRS five-year property?
Problem 20-55 Cash Flow Analysis and NPV
Background




Problem Information




Leasing per month                           $5,000
Warehouse’s estimated sales value         $200,000
 Buildings original cost                   $60,000
Depreciation                                $1,500
Current net book value                      $7,500
Remodeling cost                           $100,000
Est salvage value, remodeling cost              $0
Years for depreciation                           5
Increm Invest in Net W/Capital            $600,000
Recovering of Investment in Net W/C       $600,000
Warehouse will be condemned (in years)          10
Receive from the condemnation             $200,000
Sales                                     $900,000
Operation expenses                        $500,000
Nonrecurring sales promotion costs       $100,000
Nonrecurring termination costs
       (at the end of year 5)                $50,000
The minimum annual rate of return                14%
Tax bracket                                      40%

20-55 Requirements

1. Show how you would handle the individual items in determining whether the company s
   to lease the space or convert it to a factory outlet.

2. After analyzing all relevant data, compute the net present value. Indicate which course
   only on these data, should be taken.

Solution
ining whether the company should continue


value. Indicate which course of action, based
Problem 20-56 Machine Replacement with Tax Considerations
Background




Problem Information

Special-purpose molding machine cost         $2,500,000
Original est life of molding machine                  4 years
Remaining useful life of molding machine              3 years
Current salvage value of molding machine       $300,000
Salvage value of molding machine in 3 yrs       $50,000
New, vastly more efficient machine            $2,000,000
Current cash manufacturing costs per year     $1,800,000
Revised cash mfg costs per year               $1,000,000
Disposal value                                        $0
Income tax rate                                     45%
Discount rate (cost of capital)               8.00%

20-56 Requirements

Using the net present value technique, show whether the firm should purchase the new m

Solution
ns




purchase the new machine.
Problem 20-57 Equipment Replacement
Background




Problem Information

Computer desk                              $30
Annual normal capacity                100,000
Direct labor per hour                    $8.00
Time to produce a desk (hours)               2
Desk requires (board feet)                   8
Hard board cost (per board foot)         $0.25
Fixed costs                            $25,000
Variable costs                           $0.30
Saw carrying (book) value              $20,000
Saw Depreciation                        $2,000
Expected salvage value                      $0
Utility costs increase (per unit)        $0.10
New saw cost                                              $100,000
Estimated useful life (years)                                   10
Estimated salvage value                                    $10,000
Old one to Whalers                                          $4,000
Reduction in DL cost, if new saw purchased                 50.00%
Income tax rate                                               40%
Expected after-tax return on investment                       15%


20-57 Requirements

1. As a financial analyst for Oilers, you are charged with analyzing the purchase of the new
   preparing a report for the president, you must determine the following for management’
         a. The contribution margin per unit under current operating conditions.
         b. The standard overhead rate (application rate) per unit under current operating co
         c. The budget line for indirect manufacturing costs (manufacturing overhead), assum
            and installation of the new saw.
        d. The new saw’s manufacturing overhead standard rate (application rate) per unit, b
           capacity of 100,000 units.
        e. The contribution margin per unit, assuming the sales price remains unchanged, if
           purchased and installed.
        f. The net additional investment for the new saw, assuming that Oilers decides to pu
        g. The expected net additional cash flow per year if the new saw is purchased and in
           the company sells all that it produces.
2. The firm will be able to reduce approximately half of the hourly production workers curre
    if the new saw is purchased. The plant has been in its current location for more than 50
    40 percent of the households in this small southeast Ohio town have at least one mem
    the firm. Should the firm purchase the state-of-the-art equipment?
(IMA Adapted)

Solution
nalyzing the purchase of the new saw. In
e the following for management’s consideration:
 erating conditions.
  unit under current operating conditions.
manufacturing overhead), assuming the purchase

 rate (application rate) per unit, based on a normal

les price remains unchanged, if the new saw is

suming that Oilers decides to purchase and install it.
 he new saw is purchased and installed. Assume that

  hourly production workers currently on its payroll
current location for more than 50 years. Over
 hio town have at least one member who works for
equipment?
Problem 20-58 Equipment Replacement, MACRS
Background




Problem Information
Existing Pump:
   Original Cost                               $400,000
   Time (hours) per unit produced                      6 hours
New pump’s cost                                 $608,000
Installing, testing, and debugging               $12,000
Salvage value, end of 4 years                    $80,000
MACRS rates (rounded) would be as follows:
        Year 1                      33%
        Year 2                      45%
        Year 3                      15%
        Year 4                       7%
Current salvage value of old pump              $50,000
Selling price per unit                         $3,500
Current full-cost per unit produced            $2,450

Annual pretax cash savings                    $125,000
Output is expected to increase by:
     units in 2010                               30
     units in both 2011 and 2012                 50
     units in 2013                               70
Time (hours) per unit produced                    2        hours
Reduction in manufacturing costs                $150       (per unit, in addition to the $125
Income tax rate                                 40%
After-tax discount rate (WACC)                  15%

20-58 Requirements

1. Determine whether VacuTech should purchase the new pump by calculating the net pre
  January 1, 2010, of the estimated after-tax cash flows that would result from its acquisiti
2. Describe the factors, other than the net present value, that VacuTech should consider b
   pump replacement decision.
(CMA Adapted)
Solution
unit, in addition to the $125,000 savings noted above)




mp by calculating the net present value at
 ould result from its acquisition.
VacuTech should consider before making the
Problem 20-59 Joint Venture
Background




Problem Information

Joint venture (percent ownership)                       49%
Required investment outlay                      $3,000,000
Equity interest (percent of the expected net cash flows)80%
Expected yearly net cash flows                    $900,000
Expected time frame (years)                              10
Cost of capital                                         10%
Minimum acceptable IRR                                  20%

PV annuity factor, 10 years, 20% =                   4.192

20-59 Requirements

Should Perez invest in the project?


Solution
Problem 20-60 Risk and NPV
Background




Problem Information

Acquisition cost                                          $1,500,000
After-tax net cash inflow per year                          $275,000
Life of project (in years)                                         12
Current after-tax cost of capital                                12%
Revised (alternative) cost of capital                            15%

PV annuity factor: 12 years, 12% =                             6.1940
PV annuity factor: 12 years, 15% =                             5.4210

20-60 Requirements

1. Should Morgan accept the project if its after-tax cost of capital is 12 percent?
2. If Morgan is correct and uses 15 percent, does that change the investment decision?
3. Use the built-in function in Excel to estimate the project’s IRR. Use the Goal Seek funct
   calculate the maximum amount that can be invested up front in order to generate an ec
   return equal to the 15 percent rate of return specified by management as appropriate fo
   investment.
4. Is adjusting the discount rate or the desired rate of return an effective way to deal with r


Solution
capital is 12 percent?
nge the investment decision?
s IRR. Use the Goal Seek function in Excel to
front in order to generate an economic rate of
 management as appropriate for the proposed

n an effective way to deal with risk or uncertainty?
Problem 20-61 Sensitivity Analysis
Background




Problem Information

Initial outlay                                     $3,500,000
After-tax net cash inflows                           $600,000
Original estimate, investment life (years)                 15
Plant’s useful life (i.e., alternative estimate)           12
Cost of capital                                          14%

PV annuity factor, 15 years, 14%                        6.142
PV annuity factor, 12 years, 14%                       5.660

20-61 Requirements

1. Will the project be accepted if 15 years’ useful life is assumed? What if 12 years of usef
2. How many years will be needed for the Seattle facility to earn at least a 14 percent retu


Solution
What if 12 years of useful life is used?
least a 14 percent return?
Problem 20-62 Uneven Cash Flows , NPV
Background




Problem Information


Net cash inflows:
  year 0 (initial investment outlay)     ($15,000,000)
  year 1                                      $0
  year 2                                  $1,000,000
  year 3                                  $1,000,000
  year 4                                  $2,500,000
  year 5                                  $3,000,000
  year 6                                  $3,000,000
  year 7                                  $3,000,000
  year 8                                  $3,000,000
  year 9                                  $3,000,000
  year 10                                 $3,000,000
Lease agreement expires (end of year)                10
Cost of capital                                    12%
PV annuity factor, 6 years, 12%                   4.111


20-62 Requirements

Compute the net present value and the IRR for this venture. What is the break-even sellin
for this investment, i.e., the price that would yield a NPV of $0?
Solution
at is the break-even selling price
Problem 20-63 Environment Cost Management
Background




Problem Information


                                         Powder Paint System
                       Solvent Paint System
Initial investment            $400,000 $1,200,000
Unit paint cost                     0.19         0.2
Estimated life in years               10          10
Annual units                   2,000,000   2,000,000

The firm will incur additional environmental costs with the solvent paint system but not with
powder paint system. The firm estimates annual environmental costs for the solvent paint
follows:

                                  Units      Unit Cost
Monthly pit cleaning                 12        $1,000
Hazardous waste disposal            183          3,000
Superfund fee                    18,690           0.17
Worker training                        2         1,500
Insurance                              1        10,000
Amortization of air-emission permit 0.2          1,000
Air-emission fee                   44.6             25
Record keeping                     0.25         45,000
Wastewater treatment                   1        50,000

Discount rate (WACC)                          12%
Income tax rate                               40%

MACRS depreciation percentages, 10-year property:
                           Year            %
                             1          10.00%
                             2          18.00%
                              3          14.40%
                              4          11.52%
                              5          9.22%
                              6          7.37%
                              7          6.55%
                              8          6.55%
                              9          6.56%
                              10         6.55%
                              11         3.28%
                                        100.00%


20-63 Requirements

1. What is the difference in cost in today’s dollar for the two systems?
2. What is the most the firm is willing to pay for the powder-based system?
   (Adapted from German Boer, Margaret Curtin, and Louis Hoyt, ―Environmental Cost Ma
   Management Accounting [September 1998], pp. 28–38.)


Solution
system but not with the
r the solvent paint system as
ronmental Cost Management,‖

				
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