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Penn State - RUS 100 - NPV and Capital Budgeting 7 - Study Guide

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Penn State - RUS 100 - NPV and Capital Budgeting 7 - Study Guide

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background image NPV and Capital Budgeting 7.1        Which of the following should be treated as incremental cash flows when computing the NPV of an  investment? a. A reduction in the sales of a company’s other products caused by the investment
b. An expenditure on plant and equipment that has not yet been made and will be made only if the 
project is accepted c. Costs of research and development undertaken in connection with the product during the past three 
years
d. Annual depreciation expense from the investment
e.
Dividend payments by the firm f. The resale value of plant and equipment at the end of the project’s life g. Salary and medical costs for production personnel who will be employed only if the project is  accepted 7.2 Your company currently produces and sells steel-shaft golf clubs.  The Board of Directors wants you to 
consider the introduction of a new line of titanium bubble woods with graphite shafts.  Which of the 
following costs are not relevant?
I. Land you already own that will be used for the project, but otherwise will be sold for $700,000, its
market value.  
II. A $300,000 drop in your sales of steel-shaft clubs if the titanium woods with graphite shafts are 
introduced.  
III. $200,000 spent on Research and Development last year on graphite shafts.   a. I only
b. II only
c.
III only d. I and III only
e.
II and III only 7.3 The Best Manufacturing Company is considering a new investment. Financial projections for the 
investment are tabulated below. Cash flows are in $ thousands, and the corporate tax rate is 34 percent. 
Assume all sales revenue is received in cash, all operating costs and income taxes are paid in cash, and 
all cash flows occur at the end of the year.
Year 0 Year 1 Year 2 Year 3 Year 4 Investment $10,000 - - - - Sales Revenue - $7,000 $7,000 $7,000 $7,000 Operating Costs - 2,000 2,000 2,000 2,000 Depreciation - 2,500 2,500 2,500 2,500 Net Working Capital
(end of year)
200 250 300 200 - a. Compute the incremental net income of the investment in each year.
b. Compute the incremental cash flows of the investment in each year.
c. Suppose the appropriate discount rate is 12 percent. What is the NPV of the project?
background image 7.4 According to the February 7, 2002, issue of The Sports Universe, the Seattle Mariner’s designated runner, 
Andy Schneider, signed a three-year contract in January 2002 with the following provisions:
$1,400,000 signing bonus $2,500,000 salary per year for three years 10 years of deferred payments of $1,250,000 per year (these payments begin in year 4) Several bonus provisions that total as much as $750,000 per year for the three years of the contract Assume that Schneider has a 60-percent probability of receiving the bonuses each year, and that he signed 
the contract on January 1, 2002. Use the expected value of the bonuses as incremental cash flows. Assume 
that expected cash flows are discounted at 12.36 percent.  Ignore taxes.  Schneider’s signing bonus was 
paid on January 1, 2002.  Schneider’s salary and bonuses other than the signing bonus are paid at the end of
the year.  What was the present value of this contract in January when Schneider signed it?
7.5 Benson Enterprises is evaluating alternative uses for a three-story manufacturing and warehousing building 
that it has purchased for $225,000. The company can continue to rent the building to the present occupants 
for $12,000 per year.  The present occupants have indicated an interest in staying in the building for at least 
another 15 years. Alternatively, the company could modify the existing structure to use for its own 
manufacturing and warehousing needs. Benson’s production engineer feels the building could be adapted to
handle one of two new product lines. The cost and revenue data for the two product alternatives are as 
follows:
                                                                                                            Product A                               Product B Initial cash outlay for building modifications         $36,000    $54,000 Initial cash outlay for equipment         144,000    162,000 Annual pretax cash revenues (generated for 15 years)         105,000    127,500 Annual pretax expenditures (generated for 15 years)           60,000                           75,000 The building will be used for only 15 years for either Product A or Product B. After 15 years, the building 
will be too small for efficient production of either product line. At that time, Benson plans to rent the 
building to firms similar to the current occupants. To rent the building again, Benson will need to restore 
the building to its present layout. The estimated cash cost of restoring the building if Product A has been 
undertaken is $3,750. If Product B has been manufactured, the cash cost will be $28,125. These cash costs 
can be deducted for tax purposes in the year the expenditures occur.
Benson will depreciate the original building shell (purchased for $225,000) over a 30-year life to  zero, regardless of which alternative it chooses. The building modifications and equipment purchases for 
either product are estimated to have a 15-year life.  They will be depreciated by the straight-line method. 
The firm’s tax rate is 34 percent, and its required rate of return on such investments is 12 percent.
For   simplicity,  assume   all   cash   flows   occur   at   the   end   of   the   year.   The   initial   outlays   for modifications and equipment will occur today (year 0), and the restoration outlays will occur at the end of
year 15.  Benson has other profitable ongoing operations that are sufficient to cover any losses.  Which use
of the building would you recommend to management?
7.6 Dickinson Brothers, Inc., is considering investing in a machine to produce computer keyboards.  The price
of the machine will be $400,000 and its economic life is five years.  The machine will be fully depreciated
by the straight-line method. The machine will produce 10,000 keyboards each year. The price of each
keyboard will be $40 in the first year and will increase by 5 percent per year. The production cost per
keyboard will be $20 in the first year and will increase by 10 percent per year. The corporate tax rate for the
company is 34 percent. If the appropriate discount rate is 15 percent, what is the NPV of the investment?
background image 7.7 Scott Investors, Inc., is considering the purchase of a $500,000 computer with an economic life of five
years.  The computer will be fully depreciated over five years using the straight-line method.  The market
value of the computer will be $100,000 in five years.   The computer will replace five office employees
whose   combined   annual   salaries   are   $120,000.    The   machine   will   also  immediately   lower   the   firm’s
required net working capital by $100,000.   This amount of net working capital will need to be replaced
once the machine is sold.  The corporate tax rate is 34 percent.  Is it worthwhile to buy the computer if the
appropriate discount rate is 12 percent?
7.8 The Gap is considering buying cash register software from Microsoft so that it can more effectively deal
with its retail sales.  The software package costs $750,000 and will be depreciated down to zero using the
straight-line method over its five-year economic life. The marketing department predicts that sales will be
$600,000 per year for the next three years, after which the market will cease to exist. Cost of goods sold
and operating expenses are predicted to be 25 percent of sales. After three years the software can be sold
for $40,000. The Gap also needs to add net working capital of $25,000 immediately. The additional net
working capital will be recovered in full at the end of the project life. The corporate tax rate for the Gap is
35 percent and the required rate of return relevant to the project is 17 percent. What is the NPV of the new
software?
7.9 Commercial Real Estate, Inc., is considering the purchase of a $4 million building.  The company will enter
into a long-term lease to commercial tenants, with payments made annually.  The building will be fully 
depreciated over 20 years via the straight-line method.  In addition, the market value of the building will be 
zero at that time.  The annual lease payments will increase at 3 percent per year.  The appropriate discount 
rate for all cash flows is 12 percent.  The corporate tax rate is 34 percent.  What is the least amount of 
money that Commercial Real Estate should ask for the first-year lease payment? Assume that the first lease 
payment is made immediately after the signing of the contract.
7.10 Royal Dutch Petroleum is considering a new project that complements its existing business.  The machine 
required for the project costs $2 million.  The marketing department predicts that sales related to the project
will be $1.2 million per year for the next four years, after which the market will cease to exist.  The 
machine will be depreciated down to zero over its 5-year economic life using the straight-line method.  
Cost of goods sold and operating expenses related to the project are predicted to be 25 percent of sales.  
After four years the machine can be sold for $150,000.  Royal Dutch also needs to add net working capital 
of $100,000 immediately.  The additional net working capital will be recovered in full at the end of the 
project’s life.  The corporate tax rate 35 percent.  The required rate of return for Royal Dutch Petroleum is 
16.55 percent.  Should Royal Dutch proceed with the project?  
7.11 Majestic Mining Corporation (MMC) is negotiating the purchase of a new piece of equipment for its 
current operations.  MMC wants to know the maximum price that it should be willing to pay for the 
equipment.  You are given the following facts:
a. The new equipment would replace existing equipment with a current market value of $20,000.
b.
The new equipment would not affect revenues, but before-tax operating costs would be reduced by
$10,000 per year for eight years.  These savings in cost occur at year-end.
c. The old equipment is now five years old.  It is expected to last for another eight years, and will 
have no resale value at that time.  It was purchased for $40,000 and is being depreciated to zero by
the straight-line method over 10 years.
d. The new equipment will be depreciated to zero by the straight-line method over five years.  MMC 
expects to sell the equipment for $5,000 at the end of eight years.  The proceeds from this sale will
be subject to taxes at the ordinary corporate income tax rate of 34 percent.
e. MMC has profitable ongoing operations.
f. The appropriate discount rate is 8 percent.

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School: Pennsylvania State University
Department: Russian
Course: Corporate Finance
Term: Spring 2014
Tags:
Description: NPV and Capital Budgeting 7
Uploaded: 07/08/2017
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