CHAPTER 7: Questions Quiz 2 see BMA for the question text and Appendix B for the answers

Quiz 8 see BMA for the question text and Appendix B for the answers

Exercise No. 13. Ms. T. Potts, the treasurer of Ideal China, has a problem. The company has just ordered a new kiln for $400,000. Of this sum, $50.000 is described by the supplier as an installation cost. Ms. Potts does not know whether the Internal Revenue Service (IRS) will permit the company to treat this cost as a tax-deductible current expense or as a capital investment. In the latter case, the company could depreciate the $50.000 using the 5-year MACRS tax depreciation schedule. How will the IRSs decision affect the after-tax cost of the kiln? The tax rate is 35% and the opportunity cost of capital 5%.

If the $50,000 is expensed at the end of year 1, the present value of the tax shield is:

0.35 $50,000 = $16,667 1.05

If instead, the $50,000 expenditure is capitalized and then depreciated using a five-year MACRS depreciation schedule, the value of the tax shield is:

0.20 0.32 0.192 0.1152 0.1152 0.0576 [0.35 $50,000] + + + + + = $15,306 2 1.05 3 1.05 4 1.05 5 1.05 6 1.05 1.05
If the cost can be expensed, then the tax shield is larger and thus the after-tax cost of the kiln is lower.

Exercise No.18. Marsha Jones has bought a used Mercedes horse transporter for her Connecticut estate. It cost $35,000. The object is to save on horse transporter rentals. Marsha had been renting a transporter every other week for $200 per day plus $1 per mile. Most of the trips are 80 or 100 miles in total. Marsha usually gives the driver a $40 tip. With the new transporter she will only have to pay for diesel fuel and

maintenance, at about $0.45 per mile. Insurance costs for Marshas transporter are $1,200 per year. The transporter will probably be worth $15,000 (in real terms) after eight years, when Marshas horse Nike will be ready to retire. Is the transporter a positive-NPV investment? Assume a nominal discount rate of 9% and a 3% forecasted inflation rate. Marshas transporter is a personal outlay, not a business or financial investment, so taxes can be ignored. The table below shows the real cash flows. The NPV is computed using the real rate, which is computed as follows: (1 + rnominal) = (1 + rreal) (1 + inflation rate) 1.09 = (1 + rreal) (1.03) rreal = 0.0583 = 5.83%

Investment Savings Insurance Fuel Net Cash Flow Discount factor DCF NPV

(35.000)

1 8.580 (1.200) (1.053) 6.327

2 8.580 (1.200) (1.053) 6.327

3 8.580 (1.200) (1.053) 6.327

4 8.580 (1.200) (1.053) 6.327

5 8.580 (1.200) (1.053) 6.327

6 8.580 (1.200) (1.053) 6.327

7 8.580 (1.200) (1.053) 6.327

(35.000) 1,0000 (35.000) 14.087,9

8 15.000 8.580 (1.200) (1.053) 21.327

0,9449 0,8929 0,8437 0,7972 0,7533 5.978,5 5.649,1 5.337,9 5.043,9 4.766,0

0,7118 0,6726 0,6355 4.503,4 4.255,4 13.553,7

*Note that savings come from the transporter rental, mileage cost and tips (all multiplied by 26 times which is the amount of trips done each year).

Exercise No.19. United Pigpen is considering a proposal to manufacture high-protein hog feed. The project would make use of an existing warehouse, which is currently rented out to a neighboring firm. The next years rental charge on the warehouse is $100.000, and thereafter the rent is expected to grow in line with inflation at 4% a year. In addition to using the warehouse, the proposal envisages an investment in plant and equipment of $1.2 million. This could be depreciated for tax purposes straight-line over 10 years. However, Pigpen expects to terminate the project at the end of eight years and to resell the plant and equipment in year 8 for $400.000. Finally, the project requires an initial investment in working capital of $350.000. Thereafter, working capital is forecasted to be 10% of sales in each of years 1 through 7. Year 1 sales of hog feed are expected to be $4.2 million, and thereafter sales are forecasted to grow by 5% a year, slightly faster than the inflation rate. Manufacturing

costs are expected to be 90% of sales, and profits are subject to a tax at 35%. The cost of capital is 12%. What is the NPV of Pigpens project?

In $ thousands:
Detail/Year 0 Sales Manufacturing Costs Depreciation Rent Earnings Before Taxes Taxes Cash Flow from Operations Working Capital 350,00 Change in W.C. 350,00 Initial Investment and 1.200,00 disposal Tax on assets disposal Net Cash Flow Discount Factor (r=12%) DCF NPV (1.550,00) 1,00 (1.550,00) 85,80 1 4.200,0 3.780,0 120,00 100,00 200,00 70,0 250,00 420,00 70,00 2 4.410,0 3.969,0 120,00 104,00 217,00 76,0 261,05 441,00 21,00 3 4.630,5 4.167,5 120,00 108,16 234,89 82,2 272,68 463,05 22,05 4 4.862,0 4.375,8 120,00 112,49 253,72 88,8 284,92 486,20 23,15 5 5.105,1 4.594,6 120,00 116,99 273,53 95,7 297,79 510,51 24,31 6 5.360,4 4.824,3 120,00 121,67 294,37 103,0 311,34 536,04 25,53 7 5.628,4 5.065,6 120,00 126,53 316,31 110,7 325,60 562,84 26,80 8 5.909,8 5.318,8 120,00 131,59 339,39 118,8 340,60 (562,84) 400,00 56,00 180,00 0,89 160,71 240,05 0,80 191,37 250,63 0,71 178,39 261,76 0,64 166,36 273,48 0,57 155,18 285,82 0,51 144,80 298,80 0,45 135,16 1.247,44 0,40 503,82

***Note that the taxes on assets disposal takes into account the tax shields coming from the $240,000 of depreciation that were not taken into account in the cash flow from operations. This means that they are calculated as: 35%*(400-240).

Exercise No 26. See BMA for the question text With a 6-year life, the equivalent annual cost (at 8%) of a new jet is: $1,100,000/4.623 = $237,941 If the jet is replaced at the end of year 3 rather than year 4, the company will incur an incremental cost of $237,941 in year 4. The present value of this cost is: $237,941/1.084 = $174,894 The present value of the savings is:

t =1

80,000 = $206,168 1.08 t

The president should allow wider use of the present jet because the present value of the savings is greater than the present value of the cost.