Corporate Finance【 Reading 28】Sample 2012

leadcfa

Jayco, Inc. is considering the purchase of a new machine for $60,000 that will reduce manufacturing costs by $5,000 annually.

• Jayco will use the MACRS accelerated method (5 year asset) to depreciate the machine, and expects to sell the machine at the end of its 6-year operating life for $10,000. (The percentages for the 5-year MACRS class are, beginning with year 1 and ending with year 6, 20%, 32%, 19%, 12%, 11%, and 6%.)
• The firm expects to be able to reduce net working capital by $15,000 when the machine is installed, but required working capital will return to the original level when the machine is sold after 6 years.
• Jayco's marginal tax rate is 40%, and it uses a 12% cost of capital to evaluate projects of this nature. Use this data for the next 4 questions.

What is the first year's modified accelerated cost recovery system (MACRS) depreciation?

A) $12,000.

B) $15,000.

C) $10,000.

---

The first year MACRS depreciation equals 60,000 × 20%, or 60,000 × 0.2 = 12,000.

---

What is the initial cash outlay?

A) $45,000.

B) $75,000.

C) $15,000.

---

Initial cash outlay = up-front costs (including cost) and changes in working capital. Here, the price of the machine is 60,000 and the working capital initally decreases 15,000 (which is a source of funds). Thus, the initial cash outlay = 60,000 cost − 15,000 working capital = 45,000.

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What is the first year's operating cash flow?

A) $4,800.

B) $7,800.

C) $3,000.

---

The first year's cash flow equals the after-tax impact of the 5,000 operating savings and the depreciation tax shield, or (5,000)(0.6) + (60,000)(0.2)(0.4) = 3,000 + 4,800 = 7,800.

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What is the terminal year's cash flow (not counting the last year's operating cash flow)?

A) $21,000.

B) ($9,000).

C) ($4,000).

---

The terminal cash flow = [sales (salvage) price] − (tax rate) × [sales (salvage) price − book value] ± change in working capital. Here, = 10,000 − (0.40) × (10,000 − 0) − 15,000 (increased working capital is a use of funds) = 10,000 – 4,000 − 15,000 = −9,000.

leadcfa

Erwin DeLavall, the Plant Manager of Patch Grove Cabinets, is trying to decide whether or not to replace the old manual lathe machine with a new computerized lathe. He thinks the new machine will add value, but is not sure how to quantify his opinion. He asks his colleague, Terri Wharten, for advice. Wharten‘s son just happens to be a Level II CFA candidate. DeLavall and Wharten provide the following information to Wharten’s son:

Company Assumptions:

• Tax rate: 40%

• Weighted average cost of capital (WACC): 13%

New Machine Assumptions:

• Cost of (includes shipping and installation): $90,000

• Salvage value at end of year 5: $15,000

• Depreciation Schedule: MACRS 7-year, with depreciation rates in years 1-5 of 14%, 25%, 17%, 13%, and 9%, respectively

• Purchase will initially increase current assets by $20,000 and will increase current liabilities by $25,000

• Impact on Operating Cash Flows Years 1- 5 (includes depreciation and taxes): $16,800 (assume equal amount each year for simplicity)

Old Machine Assumptions:

• Current Value: $30,000

• Book value: $13,000

Which of the following choices is most correct? Patch Grove Cabinets should:

A) replace the old lathe with the new lathe because the new one will add $3,760 to the firm's value.

B) replace the old lathe with the new lathe because the new one will add $10,316 to the firm's value.

C) not replace the old lathe with the new lathe because the new one will decrease the firm's value by $5,370.

---

The valuation method that shows the project’s impact on the value of the firm is net present value (NPV). To calculate NPV, we need to determine the initial investment outlay, the operating cash flows, and the terminal year cash flows. Then, we discount the cash flows at the WACC. The calculations are as follows:

Step 1: Initial Investment Outlay:

= cost of new machine + proceeds/loss from old machine + change in net working capital (NWC)

= -$90,000 + $30,000 - $6,800 + $5,000 = -$61,800 (cash outflow)

Details of calculation:

·
Cost of new lathe = $90,000 outflow

·
Sale of Old Machine:

o
Sales price = $30,000 inflow

o
Tax/tax credit: $6,800 outflow

§
= (Sales price – book value)*(tax rate) = (30,000 – 13,000)*0.4

·
Change in NWC = $5,000 inflow

o
DNWC = D current assets - D current liabilities = 20,000 – 25,000 = -5,000 (a decrease in working capital is a source of funds)

Step 2: Operating Cash Flows (years 1-4): Given as $16,800 inflow

Step 3: Terminal Value:

= year 5 cash flow + return/use of NWC + proceeds/loss from disposal of new machine + tax/tax credit

= $16,800 - $5,000 + $15,000 + $1,920 = $28,720 inflow

Details of calculation:

·
Year 5 cash flow (given) = $16,800 inflow

·
Working capital (reverse 5,000 initial inflow) = $5,000 outflow

·
Sale of New Lathe:

o
Sales price = $15,000 inflow

o
Tax/tax credit: $1,920 inflow

§
= (Sales price – book value)*(tax rate)

§
Here, the Book value = Purchase price – depreciated amount. Using MACRS we have depreciated 78% of the value, or have 22% remaining. 0.22 * 90,000 = 19,800

§
Tax effect = (15,000 – 19,800)*(0.4) = -1,920, or a tax credit

Step 4: Calculate NPV:

NPV = -$61,800 + ($16,800 / 1.131) + ($16,800 / 1.132) +($16,800 / 1.133) +($16,800 / 1.134) +($28,720 / 1.135) = $3,759.

Since the NPV is positive, Patch Grove should replace the old lathe with the new one, because the new lathe will increase the firm’s value by the amount of the NPV, or $3,759.

You may also solve this problem quickly by using the cash flow (CF) key on your calculator.

[/table][table=98%]

Calculating NPVA with the HP12C®

Key Strokes

Explanation

Display

[f]→[FIN]→[f]→[REG]

Clear Memory Registers

0.00000

[f]→[5]

Display 5 decimals – you only need to do this once.

0.00000

61,800→[CHS]→[g]→[CF0]

Initial Cash Outlay

-61,800.00000

16,800→[g]→[CFj]

Period 1 Cash flow

16,800.00000

4→[g]→[Nj]

Cash Flow Occurs for 4 periods

4.00000

28,720→[g]→[CFj]

Period 5 Cash flow

28,720.00000

13→

WACC

13.00000

[f]→[NPV]

Calculate NPV

3,759.18363

Calculating NPVA with the TI Business Analyst II Plus→
Key Strokes	Explanation	Display
[2nd]→[Format]→[5]→[ENTER]	Display 5 decimals – you only need to do this once.	DEC= 5.00000
[CF]→[2nd]→[CLR WORK]	Clear Memory Registers	CF0 = 0.00000
61,800®[+/-]→[ENTER]	Initial Cash Outlay	CF0 = -61,800.00000
[↓]→16,800→[ENTER]	Period 1 Cash Flow	C01 = 16,800.00000
[↓] 4 [ENTER]	Frequency of Cash Flow 1	F01 = 4.00000
[↓]→28,720→[ENTER]	Period 2 Cash Flow	C02 = 28,720.00000
[↓]	Frequency of Cash Flow 2	F02 = 1.00000
[NPV]→13→[ENTER]	WACC	I = 13.00000
[↓]→[CPT]	Calculate NPV	NPV = 3,759.18363

leadcfa

Erwin DeLavall, the Plant Manager of Patch Grove Cabinets, is trying to decide whether or not to replace the old manual lathe machine with a new computerized lathe. He thinks the new machine will add value, but is not sure how to quantify his opinion. He asks his colleague, Terri Wharten, for advice. Wharten‘s son just happens to be a Level II CFA candidate. DeLavall and Wharten provide the following information to Wharten’s son:

Company Assumptions:

• Tax rate: 40%

• Weighted average cost of capital (WACC): 13%

New Machine Assumptions:

• Cost of (includes shipping and installation): $90,000

• Salvage value at end of year 5: $15,000

• Depreciation Schedule: MACRS 7-year, with depreciation rates in years 1-5 of 14%, 25%, 17%, 13%, and 9%, respectively

• Purchase will initially increase current assets by $20,000 and will increase current liabilities by $25,000

• Impact on Operating Cash Flows Years 1- 5 (includes depreciation and taxes): $16,800 (assume equal amount each year for simplicity)

Old Machine Assumptions:

• Current Value: $30,000

• Book value: $13,000

Which of the following choices is most correct? Patch Grove Cabinets should:

A) replace the old lathe with the new lathe because the new one will add $3,760 to the firm's value.

B) replace the old lathe with the new lathe because the new one will add $10,316 to the firm's value.

C) not replace the old lathe with the new lathe because the new one will decrease the firm's value by $5,370.

---

The valuation method that shows the project’s impact on the value of the firm is net present value (NPV). To calculate NPV, we need to determine the initial investment outlay, the operating cash flows, and the terminal year cash flows. Then, we discount the cash flows at the WACC. The calculations are as follows:

Step 1: Initial Investment Outlay:

= cost of new machine + proceeds/loss from old machine + change in net working capital (NWC)

= -$90,000 + $30,000 - $6,800 + $5,000 = -$61,800 (cash outflow)

Details of calculation:

·
Cost of new lathe = $90,000 outflow

·
Sale of Old Machine:

o
Sales price = $30,000 inflow

o
Tax/tax credit: $6,800 outflow

§
= (Sales price – book value)*(tax rate) = (30,000 – 13,000)*0.4

·
Change in NWC = $5,000 inflow

o
DNWC = D current assets - D current liabilities = 20,000 – 25,000 = -5,000 (a decrease in working capital is a source of funds)

Step 2: Operating Cash Flows (years 1-4): Given as $16,800 inflow

Step 3: Terminal Value:

= year 5 cash flow + return/use of NWC + proceeds/loss from disposal of new machine + tax/tax credit

= $16,800 - $5,000 + $15,000 + $1,920 = $28,720 inflow

Details of calculation:

·
Year 5 cash flow (given) = $16,800 inflow

·
Working capital (reverse 5,000 initial inflow) = $5,000 outflow

·
Sale of New Lathe:

o
Sales price = $15,000 inflow

o
Tax/tax credit: $1,920 inflow

§
= (Sales price – book value)*(tax rate)

§
Here, the Book value = Purchase price – depreciated amount. Using MACRS we have depreciated 78% of the value, or have 22% remaining. 0.22 * 90,000 = 19,800

§
Tax effect = (15,000 – 19,800)*(0.4) = -1,920, or a tax credit

Step 4: Calculate NPV:

NPV = -$61,800 + ($16,800 / 1.131) + ($16,800 / 1.132) +($16,800 / 1.133) +($16,800 / 1.134) +($28,720 / 1.135) = $3,759.

Since the NPV is positive, Patch Grove should replace the old lathe with the new one, because the new lathe will increase the firm’s value by the amount of the NPV, or $3,759.

You may also solve this problem quickly by using the cash flow (CF) key on your calculator.

[/table][table=98%]

Calculating NPVA with the HP12C®

Key Strokes

Explanation

Display

[f]→[FIN]→[f]→[REG]

Clear Memory Registers

0.00000

[f]→[5]

Display 5 decimals – you only need to do this once.

0.00000

61,800→[CHS]→[g]→[CF0]

Initial Cash Outlay

-61,800.00000

16,800→[g]→[CFj]

Period 1 Cash flow

16,800.00000

4→[g]→[Nj]

Cash Flow Occurs for 4 periods

4.00000

28,720→[g]→[CFj]

Period 5 Cash flow

28,720.00000

13→

WACC

13.00000

[f]→[NPV]

Calculate NPV

3,759.18363

Calculating NPVA with the TI Business Analyst II Plus→
Key Strokes	Explanation	Display
[2nd]→[Format]→[5]→[ENTER]	Display 5 decimals – you only need to do this once.	DEC= 5.00000
[CF]→[2nd]→[CLR WORK]	Clear Memory Registers	CF0 = 0.00000
61,800®[+/-]→[ENTER]	Initial Cash Outlay	CF0 = -61,800.00000
[↓]→16,800→[ENTER]	Period 1 Cash Flow	C01 = 16,800.00000
[↓] 4 [ENTER]	Frequency of Cash Flow 1	F01 = 4.00000
[↓]→28,720→[ENTER]	Period 2 Cash Flow	C02 = 28,720.00000
[↓]	Frequency of Cash Flow 2	F02 = 1.00000
[NPV]→13→[ENTER]	WACC	I = 13.00000
[↓]→[CPT]	Calculate NPV	NPV = 3,759.18363

leadcfa

Alias, Inc. is a maker of plastic containers for the food and beverage industry. Bruce Atkinson, Alias’ director of operations, is looking at upgrading the firm’s manufacturing capacity in an effort to improve the firm’s competitive position.
Atkinson is being assisted by Linda Ralston, a financial analyst recently hired by Alias. Over the last three months, Ralston and Atkinson have been going to trade shows and conducting other research on different machines and processes used in the plastic container industry. Ralston estimates that travel and hotel costs expended as a result of their research amounted to $8,000. Atkinson considers the money well spent because he now had two great ideas for improving Alias’ competitiveness in the industry.
The first of these ideas is that Atkinson is considering replacing a bottle blow molding machine. This machine was purchased for $50,000 3 years ago and is being depreciated for tax purposes over 5 years to a zero salvage value using straight-line depreciation. The firm has 2 years of depreciation remaining on the old machine.
If Atkinson decides to make the replacement, the old machine can be sold today for $10,000. The new machine will cost the firm $100,000. According to Ralston’s projections, the new machine will increase revenue by $40,000 per year for 3 years but will also increase costs by $5,000 per year. The machine will be depreciated over a modified accelerated cost recovery system (MACRS) 3-year class life. At the end of year 3, the equipment will be sold for $20,000. The firm’s tax rate is 35%.
Atkinson is also considering an investment in a new silk screen labeling machine that can put labels on Alias plastic bottles as part of the manufacturing process. Ralston estimates that the new labeling machine will cost $50,000, and that shipping and installation costs will be $7,500. The addition of the labeling machine will require a $2,000 investment in spare parts inventory at the inception of the project, but these parts can be resold for $2,000 at the project’s end. Compared with the manual process that Alias used to use for putting on labels, Ralston estimates that the new machine will reduce costs by $25,000 per year for 4 years. The labeling machine will be depreciated over a MACRS 5-year class life. At the end of year 4, the equipment will be sold for $8,000.
Depreciation schedules under MACRS are shown in the exhibit below:

Ownership Year	Class of Investment
	3-Year	5-Year	7-Year	10-Year
1	33%	20%	14%	10%
2	45%	32%	25%	18%
3	15%	19%	17%	14%
4	7%	12%	13%	12%
5		11%	9%	9%
6		6%	9%	7%
7			9%	7%
8			4%	7%
9				7%
10				6%
11				3%
	100%	100%	100%	100%

Before making the final calculations, Atkinson and Ralston discuss net present value analysis for the projects they are considering. Ralston tells Atkinson, “when calculating the net present value of the two new projects, we also need to account for the costs expended as a result of researching the project options.” Atkinson makes a note on his legal pad and says to Ralston, “There is no need to make any adjustments for inflation in our net present value calculations because inflation is included as part of the expected returns used to calculate our weighted average cost of capital.” After their conversation, Ralston and Atkinson prepare their report to present to Alias’ CEO. The initial investment outlay for purchasing the new bottle blow molding machine is closest to:

A) −$90,000.

B) −$100,000.

C) −$86,500.

---

The initial outlay is the cost of the new machine minus the market value of the old machine plus/minus any tax consequences that arise from selling the old machine. The new machine’s cost is $100,000.

The old machine can be sold for $10,000, however considering that the machine’s initial cost was $50,000 and has 3 years of accumulated straight-line depreciation, the book value of the old machine is $50,000 − (3 × 10,000) = $20,000. This means that the sale of the machine will result in a (10,000 − 20,000) = −10,000 loss. The loss will result in tax savings for Alias equal to 0.35 × 10,000 = $3,500.

The total initial investment outlay for the new machine is:

−$100,000 + 10,000 + 3,500 = −$86,500

(Study Session 8, LOS 28.a)

---

The year 1 operating cash flow for the new bottle blow molding machine is closest to:

A) $34,300.

B) $30,800.

C) $22,750.

---

The operating cash flows equal the after-tax benefit plus the tax savings from depreciation. In the case of a replacement project, you must take the difference between the additional depreciation from the new asset minus the lost depreciation from the old asset. The firm gave up $10,000 per year for of depreciation on the old asset for years 1 and 2 of the new asset’s life.

CF1 = (revenue − cost)1 × (1 − tax rate) + net depreciation1 × (tax rate)
((40,000 − 5,000) × 0.65) + [((0.33 × 100,000) − 10,000) × (0.35)] = $30,800

(Study Session 8, LOS 28.a)

---

The total cash flow from the bottle blow molding machine in year 3 is closest to:

A) $28,000.

B) $48,000.

C) $43,450.

---

The total cash flow for the terminal year is equal to the operating cash flow plus the non-operating (or terminating) cash flow.
The operating cash flow equals:

CF3 = (revenue − cost)3 × (1 − tax rate) + net depreciation3 × (tax rate)
((40,000 – 5,000) × 0.65) + [((0.15 × 100,000) − 0) × 0.35)] = $28,000

The non-operating cash flow equals the market or salvage value plus/minus tax consequences of selling it. The new machine will be sold for $20,000. The book value after 3 years of depreciation is $100,000 × (1.00 - 0.33 - 0.45 - 0.15) = $7,000. So, the gain equals $20,000 – $7,000 = $13,000.
The firm will pay taxes on the gain of:

13,000 × 0.35 = $4,550

Total terminal year cash flow = $28,000 + $20,000 – $4,550 = $43,450

Note: Once we have the project’s estimated cash flows, the next step in the process would be to calculate the net present value and internal rate of return for the project. (Study Session 8, LOS 28.a)

---

The initial cash flow for the labeling machine is closest to:

A) −$59,500.

B) −$50,000.

C) −$57,500.

---

The initial outlay is the cost of the labeling machine, the shipping and installation costs, and the increase in net working capital (in this case the increase in spare parts inventory):

(−$50,000) + (−$7,500) + (−$2,000) = −$59,500.

(Study Session 8, LOS 28.a)

---

The year 2 operating cash flow for the labeling machine is closest to:

A) $21,040.

B) $34,650.

C) $22,690.

---

The operating cash flows equal the after-tax benefit plus the tax savings from depreciation.

CF2 = Benefit2 × (1 − tax rate) + depreciation2 ×  (tax rate)
($25,000 × 0.65) + ($57,500 × 0.32 × 0.35) = $22,690

Note that the shipping and installation costs are part of the depreciable basis for the machine. (Study Session 8, LOS 28.a)

---

With regard to the conversation between Ralston and Atkinson concerning NPV analysis:

A) Ralston’s statement is incorrect; Atkinson’s statement is correct.

B) Ralston’s statement is incorrect; Atkinson’s statement is incorrect.

C) Ralston’s statement is correct; Atkinson’s statement is incorrect.

---

The hotel and travel costs expended to research the projects would be expended whether Alias decided to take on the projects or not. The research costs are a sunk cost, which is a cash outflow that has previously been committed or has already occurred. Since these costs are not incremental, they should not be included as part of the analysis. Therefore Ralston’s statement is incorrect.
Atkinson’s statement is also incorrect. Although it is true that the expected inflation is built into the expected returns used to calculate the weighted average cost of capital, Atkinson and Ralston still need to adjust the project cash flows upward to account for inflation. If no adjustments are made to the project cash flows to account for inflation, the NPV will be biased downward. (Study Session 8, LOS 28.g)

JoeyDVivre

Karen Feasey, the Plant Manager of Industrial Coatings, is trying to decide whether to replace the old coatings machine with a new computerized machine. Her executive assistant gathers the following information:

Company Assumptions:

• Tax rate: 40%

• Weighted average cost of capital (WACC): 13%

New Machine Assumptions:

• Cost of (includes shipping and installation): $150,000

• Salvage value at end of year 5: $35,000

• Depreciation Schedule: MACRS 7-year, with depreciation rates in years 1-5 of 14%,25%, 17%, 13%, and 9%, respectively

• Purchase will initially increase current assets by $15,000 and will increase current liabilities by $10,000

• Impact on Operating Cash Flows Years 1- 5 (includes depreciation and taxes): $28,000 (assume equal amount each year for simplicity)

Old Machine Assumptions:

• Sell old machine for current market value: $25,000

• Book value: $15,000

During the process of making the decision whether or not to replace the old machine, Feasey calculates the initial cash outlay as approximately:

A) $134,000.

B) $155,000.

C) $130,000.

---

The initial investment outlay is calculated as follows:
cost of new machine + proceeds/loss from old machine + change in net working capital (NWC) = -$150,000 + $25,000 - $4,000 - $5,000 = -$134,000 (cash outflow)

Details of calculation:

• Cost of new machine = $150,000 outflow

• Sale of Old Machine:

Sales price = $25,000 inflow

Tax/tax credit: $4,000 outflow

= (Sales price – book value)*(tax rate) = (25,000 – 15,000)*0.4

• Change in NWC = $5,000 outflow

                              Δ NWC = Δ current assets - Δ current liabilities = 15,000 – 10,000 = 5,000

JoeyDVivre

Financial leverage would NOT be increased if a firm financed its next project with:

A) common stock.

B) preferred stock.

C) bonds with embedded call options.

---

Financial leverage is the result of financing assets with fixed income securities such as bonds or preferred stock. Each of these alternatives has a required payment component that increases the risk of the firm beyond that arising solely from business risk.

JoeyDVivre

Norine Benson is studying for the Level I CFA examination and is having difficulty with the broader concepts of capital budgeting. Her study partner, Henri Manz, tests her understanding by asking her to identify which of the following statements is most accurate?

A) An analyst can ignore inflation since price level expectations are built into the weighted average cost of capital (WACC).

B) For mutually exclusive projects, the decision rule is to pick the project that has the highest net present value (NPV).

C) Replacement decisions involve mutually exclusive projects.

---

Because replacement decisions involve either keeping the old asset or replacing the old asset, the projects are mutually exclusive.

The decision rule for NPV is to pick the project with the highest positive NPV. Only projects with positive NPV add to the company’s value. If neither project has a positive NPV, neither project should be chosen. Because the WACC is adjusted for inflation, the analyst must adjust project cash flows upward to reflect inflation. If the cash flows are not adjusted for inflation, the NPV will be biased downward. (Reverse the preceding logic for deflation.)

JoeyDVivre

An increase in expected inflation will generally:

A) leave weighted average cost of capital (WACC) unchanged.

B) increase the weighted average cost of capital (WACC).

C) decrease the weighted average cost of capital (WACC).

---

Required rates of return on investments generally exceed inflation. An increase in expected inflation will generally increase the required return on equity and debt; therefore, the WACC will rise as inflation rises.

JoeyDVivre

With respect to capital budgeting and measuring net present value, to avoid biases from an increase in expected inflation, an analyst should revise:

A) weighted average cost of capital (WACC) up and cash flows down.

B) weighted average cost of capital (WACC) down and cash flows up.

C) both weighted average cost of capital (WACC) and cash flows up.

---

Required rates of return on investments generally exceed inflation. An increase in expected inflation will generally increase the required return on equity and debt; therefore, the WACC will rise as inflation rises. To avoid a downward bias on net present value, cash flows should be adjusted up to reflect inflation effects.

JoeyDVivre

With respect to capital budgeting, expected inflation is incorporated into the weighted average cost of capital (WACC) by:

A) none of these since inflation is not related to the WACC.

B) adjusting the separate component for inflation in the WACC.

C) adjusting expected returns in response to changes in inflation.

---

Expected inflation is built into net present value calculations because inflation expectations are impounded in the expected returns used to calculate the WACC.