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Principles of Finance - Capital Budgeting: Cash Flow Estimation and Risk | FIN 3403, Study notes of Finance

Material Type: Notes; Professor: Besley; Class: Principles of Finance; Subject: Finance; University: University of South Florida; Term: Unknown 1989;

Typology: Study notes

Pre 2010

Uploaded on 02/09/2009

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PRINCIPLES OF FINANCE
FIN 3403
Capital Budgeting: Cash Flow Estimation and Risk
1. The CFO of Genham Publishing Corporation is evaluating a proposal to purchase a new
printing machine that will help the firm to more efficiently produce the magazines it
publishes. If the new printer is purchased, it will replace an existing printer. The new
printer has a purchase price of $130,000. In addition, it costs $8,000 to ship the printer to
Genham, and $3,000 will have to be paid to modify existing facilities to install the printer.
Genham expects sales to increase by $40,000 if it purchases the new printer. Even though
sales will increase, raw materials, labor costs, and other operating expenses are not
expected to change if the new printer is purchased, because the new machine is more
efficient than the existing machine. These estimates were provided by a consultant
Genham hired a few months. The consultant was paid $10,000 to evaluate the new printer
and to estimate the effects on operations of replacing the existing printer. The estimated life
of the new printer is five years, which is the same as the estimated remaining life of the old
printer. In five years, it is estimated that the new printer can be sold for $20,000 and that
the old printer can be sold for $6,000 if the firm decides not to purchase the new printer.
The existing printer, which was purchased two years ago for $90,000, currently has a
market value equal to $18,000. Both the new printer and the existing printer fall in the
MACRS 5-year class for the purposes of determining depreciation. Genham’s required rate
of return is 15 percent and its marginal tax rate is 35 percent. Should Genham purchase the
new printer? Support your answer with computations. Compute both the net present value
(NPV) and the internal rate of return (IRR) for the project.
2. The CFO of Genham just learned that the new printer that is being evaluated is considered
a much riskier investment than its existing, or average, assets. Generally, when projects that
are considered much riskier than the “average” assets are evaluated, Genham adds three
percentage points to its required rate of return when computing the NPV. Based on this
new information, should Genham purchase the project?
SOLUTION
Initial Investment Outlay:
New printer purchase price (130,000)
Shipping ( 8,000)
Installation ( 3,000)
Sale of old printer 18,000
Tax on sale of old printer 8,820*
Initial investment outlay (114,180)
Book value of old asset = 90,000 - 90,000(0.20 + 0.32) = 43,200 (The asset is two years old and being
depreciated using MACRS 10-year life rates.)
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PRINCIPLES OF FINANCE

FIN 3403

Capital Budgeting: Cash Flow Estimation and Risk

1. The CFO of Genham Publishing Corporation is evaluating a proposal to purchase a new

printing machine that will help the firm to more efficiently produce the magazines it

publishes. If the new printer is purchased, it will replace an existing printer. The new

printer has a purchase price of $130,000. In addition, it costs $8,000 to ship the printer to

Genham, and $3,000 will have to be paid to modify existing facilities to install the printer.

Genham expects sales to increase by $40,000 if it purchases the new printer. Even though

sales will increase, raw materials, labor costs, and other operating expenses are not

expected to change if the new printer is purchased, because the new machine is more

efficient than the existing machine. These estimates were provided by a consultant

Genham hired a few months. The consultant was paid $10,000 to evaluate the new printer

and to estimate the effects on operations of replacing the existing printer. The estimated life

of the new printer is five years, which is the same as the estimated remaining life of the old

printer. In five years, it is estimated that the new printer can be sold for $20,000 and that

the old printer can be sold for $6,000 if the firm decides not to purchase the new printer.

The existing printer, which was purchased two years ago for $90,000, currently has a

market value equal to $18,000. Both the new printer and the existing printer fall in the

MACRS 5-year class for the purposes of determining depreciation. Genham’s required rate

of return is 15 percent and its marginal tax rate is 35 percent. Should Genham purchase the

new printer? Support your answer with computations. Compute both the net present value

(NPV) and the internal rate of return (IRR) for the project.

2. The CFO of Genham just learned that the new printer that is being evaluated is considered

a much riskier investment than its existing, or average, assets. Generally, when projects that

are considered much riskier than the “average” assets are evaluated, Genham adds three

percentage points to its required rate of return when computing the NPV. Based on this

new information, should Genham purchase the project?

SOLUTION

Initial Investment Outlay:

New printer purchase price (130,000) Shipping ( 8,000) Installation ( 3,000) Sale of old printer 18, Tax on sale of old printer 8,820* Initial investment outlay (114,180)

Book value of old asset = 90,000 - 90,000(0.20 + 0.32) = 43,200 (The asset is two years old and being depreciated using MACRS 10-year life rates.)

Gain on the sale of the old asset = $18,000 - $43,200 = $(25,200) Tax on the gain = $(25,200)(0.35) = $(8,820) This is a negative tax, which is a tax “refund.”

Incremental Operating Cash Flows:

Δ in sales 40,000 40,000 40,000 40,000 40, Δ in depreciation** (11,100) (34,320) (16,890) (11,520) (15,510) Δ in taxable income 28,900 5,680 23,110 28,480 24, Δ in taxes (10,115) (1,988) (8,089) (9,968) (8,572)

Incremental operating CF = Δ in sales + Δ in taxes 29,885 38,012 31,912 30,032 43,

** Δ Depreciation 1 2 3 4 5 New printera^ (28,200) (45,120) (26,790) (16,920) (15,510) Old printerb^ (17,100) (10,800) ( 9,900) ( 5,400) 0 11,100 34,320 16,890 11,520 15,

a (^) New printer depreciation = $141,000(% depreciated). The % depreciated each year is 0.20, 0.32, 0.19,

0.12, and 0.11 for Years 1-5, respectively.

b (^) Old printer depreciation = $90,000(% depreciated). The % depreciated each year is 0.19, 0.12, 0.11,

0.06, and 0.0, respectively. Remember that the old printer is two years old; so the depreciation rates for Years 3-7 are used here.

Terminal Cash Flow:

Salvage of new printer 20, Tax on sale of new printerd^ (4,039) Salvage of old printer (a CF not received if the new printer is purchased) (6,000) Tax on sale of old printer (a CF not paid if the new printer is purchased)e^ 2, 12,

d (^) Book value of new printer at the end of five years = $141,000(0.06) = 8,

Gain on the sale of the new printer = 20,000 – 8,460 = 11, Tax on gain = 11,540(0.35) = 4,

e (^) Book value of old printer at the end of five years if it still exists = 0 (the printer will be fully depreciated)

Gain on the sale of the old printer if still exists = 6,000 – 0 = 6,000 (this is the amount the firm will lose receive if it replaces the old printer) Tax on gain = 6,000(.035) = 2,100 (this amount will not have to be paid if the firm replaces the old printer)

NPV 114 , 18012345

IRR = 17.15%