Week 6 solutions

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FIN 612 Managerial Finance
WeekSeven Assignment
Your assignment for this week is to complete the following questions and problems from Chapters 11 and 12.
Please submit your complete assignment in the course room by the due date.
Chapter 11 Questions
(11-2) Operating cash flows, rather than accounting profits, are used in project analysis. What is
the basis for this emphasis on cash flows as opposed to net income?
Net income basically shows the income which the project or company get after deducting cost of goods sold,
selling and general expenses, depreciation, amortizations, interest (if any), and tax from Revenue. In fact net
profit is unable to show the real picture of cash available. Operating Cash flows shows the real picture of cash
available because in cash flows non cash expenses items such as depreciation and amortization are add back.
Further, interest expense is not operating activity; it is financing activity which is not included on operating cash
flow. Therefore, company emphasis on cash flows as opposed to net income.
(11-4) Explain why sunk costs should not be included in a capital budgeting analysis but
opportunity costs and externalities should be included.
Sunk costs are those expenses which have already occurred. These costs do not really affect the decision
whether or not to accept the new project. Further, sunk cost is one time cost so it does not increase as the
company implements additional projects. Therefore sunk cost should not be included in a capital budgeting
analysis. For example, previous years R&D cost of company is sunk cost. Therefore, if company is going to
implement project this year R&D cost should be excluded.
Opportunity costs are those cash flows that company could have generated from assets the company already
own. Since company has to give up those cash flows to implement another projects, they have to include those
cash flows in capital budgeting. For example, if company has one building and company is using that building for
their own purpose. Now company is planning to rent that building for $1,000,000 per year. If company rent that
building then they have to rent another small building for their own purpose which cost them 500,000. While
analyzing this project, they have to include opportunity cost associated with renting new building as cash cost.
Externalities are effects a project has on other parts of the company as well as on the environment. For
example, when company introduces new products it may affect the sales volume of other product offered by
same company as well as sales volume of its competitors. This effect is also called cannibalization effect,
because the new business or new product eats the company’s existing business or product. The lost cash flow
should be adjusted on new projects.
(11-5) Explain how net operating working capital is recovered at the end of a project’s life and
why it is included in a capital budgeting analysis.
In order to support the new projects additional inventories are required and firm gets its additional inventories
from its vendors as a result account payable as well as accruals increases. While because of the expansion of
company towards new projects company’s revenue also increase and tie up as additional accounts receivable.
Therefore, the difference between increase in operating current assets and the increase in operating current
liabilities is the change in net operating working capital. At the end of the project’s life all the additional
account receivable are collected where as all additional inventories will be used. As all receivable will be
collected, all accruals and payable will be paid by the end of projects. In this way new operating working capital
is recovered at the end of a project life.
Capital budgeting is the technique of analyzing potential projects. Capital budgeting helps to identify the various
cost associated with project, cash flows of projects and ultimately help to make decision whether or not to
acquire that project. Since operating working capital (inventories) is essential element of project it is included on
capital budgeting analysis.
(11-7) Why are interest charges not deducted when a project’s cash flows are calculated for use in
a capital budgeting analysis?
Interest charges are usually not deducted when project cash flows are calculated in capital budgeting because, it
is best to separate investment decision from financing decisions.
First you decide to invest or not, based on the operating cash flow generated discounted at the weighted cost of
capital, which is based on a mix of debt and equity.
Then you decide how to finance the project/s,. So, interest charges is not considered in the project cash flows.
But interest cost is impliedly covered when the cash flows are discounted.
(11-8) Most firms generate cash inflows every day, not just once at the end of the year. In capital
budgeting, should we recognize this fact by estimating daily project cash flows and then
using them in the analysis? If we do not, will this bias our results? If it does, would the
NPV be biased up or down? Explain.
Estimating Cash Flows on a daily basis would be too cumbersome and unwieldy.
Estimating cash flows on an annual basis is good enough.
No it would never bias the results.
(11-11) In theory, market risk should be the only “relevant” risk. However, companies focus as
much on stand-alone risk as on market risk. What are the reasons for the focus on standalone risk?
Taking on a project with high degree of either stand-alone or corporate risk will not necessarily affect the firms
beta. However, if the project has highly uncertain returns and if those returns are highly correlated with returns
on firms other assets and with most other firms in the economy, the project will have a high degree of all types
of risks.
For example, General mortors undertake decides to undertake a major expansion to build commuter airlines.
GM is not sure how its technology will work on a mass production basis, so there are great risks in the ventureits stand-alone risk is high.
Management also estimates that the project will do best if the economy is strong, for then people will have
more money to spend on the new planes. This means that the project will do well if GM's other division do well
and tend to do badly if other division do badly. This being the case the project will also have a high corporate
risk.Finally, GM's profits are highly correlated with those of most other firms, the projects beta will also be high.
Thu, this project will be riskier under all three types of risks.
Of the three, the market risk is theoretically the most relevant because it is one reflected in stock prices.
Unfortunately, market risk is also the most difficult to estimate because projects dont have market prices that
can be related to stock market returns. For this reason, most decision makers consider all three risk measures in
a judgemental manner and then classify projects into subjective risk categories.
Chapter 11Problems
(11-3) Allen Air Lines must liquidate some equipment that is being replaced. The equipment
originally cost $12 million, of which 75% has been depreciated. The used equipment can
be sold today for $4 million, and its tax rate is 40%. What is the equipment’s after-tax net
salvage value?
Book Value = 12000000*(1-.75) = 3000000
Gain on Sale = 4000000 - 3000000 = 1000000
After Tax Net Salvage Value = 4000000 - (1000000)*.40 = 360000
(11-4) Although the Chen Company’s milling machine is old, it is still in relatively good working
order and would last for another 10 years. It is inefficient compared to modern standards,
though, and so the company is considering replacing it. The new milling machine, at a
cost of $110,000 delivered and installed, would also last for 10 years and would produce
after-tax cash flows (labor savings and depreciation tax savings) of $19,000 per year. It
would have zero salvage value at the end of its life. The firm’s WACC is 10%, and its
marginal tax rate is 35%. Should Chen buy the new machine?
You need to calculate the NPV of the machine in this case
NPV = -110000 + 19000/(1+.10)^1 + 19000/(1+.10)^2 + 19000/(1+.10)^3 + 19000/(1+.10)^4 + 19000/(1+.10)^5 +
19000/(1+.10)^6 + 19000/(1+.10)^7 + 19000/(1+.10)^8 + 19000/(1+.10)^9 + 19000/(1+.10)^10 = 6746.77 or 6747
Yes, Chen should buy the new machine.
(11-6) The Campbell Company is considering adding a robotic paint sprayer to its
production line. The sprayer’s base price is $1,080,000, and it would cost another
$22,500 to install it. The machine falls into the MACRS 3-year class, and it would be
sold after 3 years for $605,000. The MACRS rates for the first three years are 0.3333,
0.4445, and 0.1481. The machine would require an increase in net working capital
(inventory) of $15,500. The sprayer would not change revenues, but it is expected to
save the firm $380,000 per year in before-tax operating costs, mainly labor.
Campbell’s marginal tax rate is 35%.
Part A:
0 Year Net Cash Flow = -1080000-22500-15500 = -1118000
Part B:
Annual Savings
Less Depreciation
Savings after Depreciation
Less Taxes
Savings after Taxes and Depreciation
Add Depreciation
Operating Cash Flow
Year1
380000
367463
12537
4388
8149
367463
375612
Year2
380000
490061
-110061
-38521
-71540
490061
418521
Part C:
Additional Cash Flow in Year 3 = 605000 + (605000 - 81695)*(.35) + 15500 = 803657
Year3
380000
163280
216720
75852
140868
163280
304148
Part D:
To calculate IRR, you need to put the value of NPV as 0 and use following equation to derive IRR
NPV = 0 = -1118000 + 375612/(1+r)^1 + 418521/(1+r)^2 + (304148 + 803657)/(1+r)^3
Solving for r, we get IRR as 25.87 or 26%
Yes, the machine should be purchased.
Chapter 12Problems
(12-1) Broussard Skateboard’s sales are expected to increase by 15% from $8 million in
2013 to $9.2 million in 2014. Its assets totaled $5 million at the end of 2013.
Broussard is already at full capacity, so its assets must grow at the same rate as
projected sales. At the end of 2013, current liabilities were $1.4 million, consisting
of $450,000 of accounts payable, $500,000 of notes payable, and $450,000 of
accruals. The after-tax profit margin is forecasted to be 6%, and the forecasted
payout ratio is 40%. Use the AFN equation to forecast Broussard’s additional funds
needed for the coming year.
AFN = $238,800
Sales expected in 2013
=$9,200,000
After-tax profit margin
($9,200,000*6%)=$552,000
Dividend payments [$552,000*40%]=$220,800
Addition to retained earnings [$552,000 - $220,800]=$331,200
All the profits after the payment of dividend will be an addition to retained earnings. As the assets are already
at full capacity, all the assets should grow at the sales rate. It is to be noted that if the assets were not at full
capacity, only the spontaneous assets would increase.
Increase in assets = $5,000,000*15%=$750,000
Increase in liabilities = [$450,000+$450,000]*15%=$135,000
For current liabilities, only the accounts payable and accruals are treated as spontaneous liabilities. Notes
payable is not considered spontaneous for AFN calculation. AFN = Increase in assets Increase in liabilities
Addition to retained earnings $750,000 - $135,000 - $331,200=$283,800 ANSWER
(12-8) Stevens Textiles’s 2013 financial statements are shown here:
Balance Sheet as of December 31, 2013 (Thousands of Dollars)
Cash
$ 1,080
Accounts payable
Receivables
6,480
Accruals
2,880
Inventories
9,000
Line of credit
0
Total current assets
$16,560
Notes payable 2,100
Net fixed assets
12,600
Total current liabilities
Mortgage bonds 3,500
Common stock 3,500
______Retained earnings 12,860
Total assets
$29,160 Total liabilities and equity $ 29,160
$ 4,320
$ 9,300
Income Statement for December 31, 2013 (Thousands of Dollars)
Sales
$36,000
Operating costs 32,440
Earnings before interest and taxes $ 3,560
Interest 460
Pre-tax earnings
$ 3,100
Taxes (40%)
1,240
Net income
$ 1,860
Dividends (45%)
$ 837
Addition to retained earnings
$ 1,023
a. Suppose 2014 sales are projected to increase by 15% over 2013 sales. Use the
forecasted financial statement method to forecast a balance sheet and income
statement for December 31, 2014. The interest rate on all debt is 10%, and cash
earns no interest income. Assume that all additional debt in the form of a line of
credit is added at the end of the year, which means that you should base the
forecasted interest expense on the balance of debt at the beginning of the year. Use
the forecasted income statement to determine the addition to retained earnings.
Assume that the company was operating at full capacity in 2013, that it cannot sell
off any of its fixed assets, and that any required financing will be borrowed as
notes payable. Also, assume that assets, spontaneous liabilities, and operating costs
are expected to increase by the same percentage as sales. Determine the additional
funds needed.
b. What is the resulting total forecasted amount of the line of credit?
a. Stevens Textiles Pro Forma Income Statement December 31, 2014
2006
Forecast Basis
Sales
36000
1.15 x Sales
Operating Costs
32,440
.9011 x sales (07)
EBIT
3,560
2007
41,400
37,306
4,094
Interest
EBT
Taxes (40%)
Net Income
Dividends
Addition to RE
460
3,100
1,249
1,860
837
1,023
Stevens Textiles Pro Forma Balance Sheet
December 31, 2014 (Thousands of Dollars)
Forecast
Basis %
2006
2007 Sales
Cash
10,800
.0300
Acc. Rec.
6480
.1883
Inventories
9000
.2005
Total Curr.
16560
Assets
Fixed Assets
12600
.3500
Total Assets
29160
Acc. Payable
4320
.1200
Accruals
2880
.0800
Notes
2100
Payable
Total Curr.
9300
Liablities
Long-term
3500
debt
Total Debt
12800
Common
3500
Stock
Retained
12860
Earnings
Total
29160
Liablities and
Eq.
AFN = 2128
b. Notes payable: $4228
.1 x Debt (06)
Additions
Pro Forma
1,242
7452
10350
19044
14490
33534
4968
3312
2100
1.166*
560
35,34
1,414
2,120
954
1,166
Financing
+2128
Pro Forma
after
Financing
1242
7452
10350
19044
14490
33534
4968
3312
4228
10380
12508
3500
3500
13880
3500
16008
3500
14026
14026
31406
33534
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