Reading 31- LOS a～ Q11 - 13

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

A)   $21,040.

B)   $34,650.

C)   $33,400.

D)   $22,690.

The correct answer was D)

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.

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

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

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

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

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

The correct answer was D)

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.

13．Karen Feasey, the Plant Manager of Industrial Coatings, is trying to decide whether or not 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:

§ Current 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)   $120,000.

C)   $130,000.

D)   $155,000.

The correct answer was A)

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