Corporate Finance【 Reading 28】Sample 2012

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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.

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

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What is the initial cash outlay?

A) $45,000.

B) $75,000.

C) $15,000.

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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.

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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).

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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.

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Firehouse Company is investing in a €300 million project that is being depreciated on a straight-line basis to zero over a two-year life with no salvage value. The project will generate operating earnings of €130 million each year for the two years. The Firehouse’s weighted average cost of capital and required rate of return for the project is 10%. Firehouse’s tax rate is 30%. What is Firehouse’s economic profit for years 1 and 2?

Year 1

Year 2

A) €61 €76

B) -€20 -€20

C) €42 €22

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Note that this question is asking about economic profit, not economic income.

Economic profit is calculated as NOPAT - $WACC = EBIT(1-T) - $WACC

NOPAT = EBIT (1-Tax Rate) = €130 (1 - 0.3) = €91
$WACC Year 1 = 0.10 × €300 = €30
$WACC Year 2 = 0.10 × €150 = €15
Economic profit (Year 1) = €91 - €30 = €61
Economic profit (Year 2) = €91 - €15 = €76

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Paul Ulring, Chief Executive Officer of Arlington Machinery, has asked Sara Trafer about the benefits of using a variety of valuation models for evaluating capital projects. In response to Ulring’s questions, Trafer makes the following statements:

Statement 1:	The economic profit, residual income, and claims valuation methods of valuation should all result in the same valuation for an asset or project, despite the use of different discounts rates in the calculations.
Statement 2:	The claims valuation and economic profit valuation models both include cash flows that will flow to debt holders, and the cost of debt is a factor in both calculations.

Which is CORRECT regarding Trafer's statements?

A) Both are incorrect.

B) Both are correct.

C) Only one is correct.

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Trafer’s first statement is correct. In theory, all three of the different valuation approaches should lead to the same result, despite the economic profit method using the WACC, the residual income method using the cost of equity, and the claims valuation approach separately using the cost of debt and cost of equity as discount rates. Trafer’s second statement is also correct. The claims valuation approach looks at cash flows to equity holders and debt holders separately, while the economic profit method looks at cash flows from the perspective of all suppliers of capital, so debt holders’ concerns are included in both methods. Also, the discount rate used with the economic profit method is the WACC, while the claims valuation approach considers the cost of equity and the cost of debt separately, so the cost of debt is a factor in both calculations

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James Case and Erica Gallardo are considering differences between accounting income and economic income when evaluating capital projects. Case makes the following statements to Gallardo:
  

Statement 1:	One of the main reasons why accounting income and economic income will differ is that interest expense is subtracted when calculating accounting income, but is not considered when computing economic income.
Statement 2:	Another reason why accounting income and economic income may differ is that accounting depreciation is based on original costs while economic depreciation is based on market values.

Gallardo considers both of Case’s statements. Gallardo would find which statements CORRECT?

A) Neither are correct.

B) Only one is correct.

C) Both are correct.

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Case has accurately described the two major differences between accounting income and economic income. Accounting depreciation is based on the original cost of an investment, while economic depreciation is based on the market value of the asset. Also, the interest expense that is subtracted from accounting income is not considered when computing economic income because interest expenses are implicit in the required rate of return used to calculate the asset’s market value.

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Which of the following expressions is the least accurate calculation for economic income?

A) Economic income = cash flow - (beginning market value - ending market value).

B) Economic income = cash flow - dollar weighted average cost of capital.

C) Economic income = cash flow + change in market value.





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Economic income is defined as the after tax cash flow plus the change in market value of an investment. The change in market value can also be expressed as economic depreciation. Note that the dollar weighted average cost of capital is a term associated with economic profit, which is a different concept from economic income.

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Jackson Huang is an analyst for Oswald Technologies. Huang is considering a $150 million capital project that is expected to produce operating earnings before interest and taxes of $80 million per year for all three years of the project’s life. The project is being depreciated on a straight-line basis and at the end of 3 years the project will have zero salvage value. Huang believes the project is an average risk project for the firm and is planning to apply Oswald’s weighted average cost of capital (WACC) of 8% and tax rate of 30% to the project. Huang’s supervisor has asked him to use both the economic income and economic profit approaches to analyze the project. After completing his analysis, Huang makes the following statements to his supervisor.

Statement 1:	In the first year of the project’s life, the economic income exceeds the economic profit generated from the project.
Statement 2:	The discount rate applied to the economic profit to calculate the project’s net present value (NPV) will be identical to the economic rate of return earned by the project each year.

How should Huang’s supervisor respond to his statements?

A) Agree with both.

B) Agree with neither.

C) Agree with one only.

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To answer the first question, we need to calculate the economic income and economic profit for the first year of the project. Economic income is the after-tax cash flow plus the change in market value for an investment.

Cash flow = operating income (1 − T) + depreciation = $80(1 − 0.30) + $50 = $106 million.

Next determine the current market value of the project as: (106 / 1.08) + (106 / 1.082) + (106 / 1.083) = $273.17 million. The value after Year 1 = (106 / 1.08) + (106 / 1.082) = $189.03 million. The change in market value = (273.17 − 189.03) = $84.4 million. The economic income is $106 − $84.4 = $21.86 million.

Economic profit = NOPAT − $WACC = EBIT(1 − T) − $WACC
Economic profit (Year 1) = $80(1 − 0.30) − 0.08($150) = $44 million

Huang’s supervisor should disagree with the first statement as the economic profit of $44 million exceeds the economic income of $22 million.

Huang’s supervisor should agree with the second statement. The discount rate applied to the economic profit to determine the project’s NPV is the WACC. The economic rate of return using the economic income approach will be equal to the WACC, so the rates are identical. We can take the first year’s economic income divided by the market value of the project and see that the economic rate of return is the same as the WACC. ($22 / $273) = 0.08, or 8%.

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Firehouse Company is investing in a €300 million project that is being depreciated on a straight-line basis over a two-year life with no salvage value. The project will generate operating earnings of €130 million each year for the two years. The required rate of return for the project is 10% and Firehouse’s tax rate is 30%. What is Firehouse’s economic income for years 1 and 2?

Year 1

Year 2

A) €61 €76

B) €42 €22

C) -€20 -€20

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Note that this question is asking about economic income, not economic profit.

First, determine the after-tax cash flow for Years 1 and 2 as:

Cash flow = operating income (1-T) + depreciation = €130 (1 - 0.30) + 150 = €241

Next, determine the current market value of the project as:

Market value = (241 / 1.102) + (241 / 1.101) = €418; market value after year 1 = (241 / 1.101) = €219

Constructing a table, we see that the economic income for years 1 and 2 are €42 and €22 respectively. Note also that the economic rate of return is equal to the required return on the project.

	Year 1	Year 2
Beginning market value	€418	€219
Ending market value	219	0
Change in market value	-199	-219
After-tax cash flow	241	241
Economic income	€42	€22
Economic rate of return	10%	10%

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The most appropriate definition of economic income is:

A) cash flow minus economic depreciation.

B) accounting income minus economic depreciation.

C) cash flow.

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economic income = cash flow − economic depreciation
where:
economic depreciation = (beginning market value − ending market value)
Economic income is not the same as economic profit.

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Which of the following is most likely to cause a problem when evaluating a capital budgeting project?

A) Including overhead costs in the total cost of a capital project.

B) Taking on the pet projects of management without going through the complete capital budgeting process.

C) Avoiding the use of IRR when evaluating mutually exclusive projects.

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Pet projects that influential managers want the company to invest in will ideally receive the same scrutiny received by other investments. Another potential concern with management’s pet projects is that overly optimistic projections will make the project appear more profitable than it really is. Note that using IRR for mutually exclusive projects will tend to steer management toward smaller, short term projects with high IRRs and may not lead management to the same decision as the more appropriate NPV method. Overhead costs are often difficult to estimate, but should be included in the cost of a capital project

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Sharon Kelley and Joyce Wening are discussing potential capital projects for the Flagstaff Corporation. Kelley is concerned about making errors in the capital budgeting decision making process and wants to take necessary steps to avoid such errors. In response to Kelley’s concerns, Wening makes the following statements:

Statement 1:	We should avoid including factors such as management time and information technology support since these are sunk costs that should not be attributed to the project.
Statement 2:	Once we have determined a set of profitable project options, we should stop considering other alternatives in order to focus our resources on making sure that we are not omitting relevant cash flows or double counting cash flows for our existing set of projects.

A) Both are correct.

B) Only one is correct.

C) Both are incorrect.

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Wening’s first statement is incorrect. Overhead costs are difficult quantify, but project costs should include any overhead costs that are attributable to a project. Wening’s second statement is also incorrect. Failure to consider investment alternatives is a major capital budgeting pitfall. Generating good investment ideas is the most important step in the capital budgeting process. Managers need to make sure they are not avoiding the consideration of “better” projects simply because the existing project under consideration is “good.”