Chapter 3

Problem 1
Info:
TelCo to decide if replace computer system
cost of capital
tax rate
SL depre
(000's)
Net BEFORE tax cost savings

12%
35%

Year
($)

2
350

3
350

4
300

Cost of new comp

1,000
ITC
15% first year
ITC reduces Telco's taxes by an amt = to 15% of equipment purchase price
old computer can be sold for
450
cost of old computer
1,250 3 years old
life
5 yrs
both computers have -0- salvage value
no ITC on old computer

5
300

depre/yr 200
150 ITC amt yr 1

a. What is the net investment required in the new system?

Net Investment = Cost - Salvage(old) + Tax from sale of old
cost of new machine
sale price of old machine
tax from sale of old

Net Investment

Book value of old machine

cost
3 yrs old SL D/E
Book value of old machine
old computer can be sold for

1,000
(450)
(18)

$ 532.50

b. Estimate the incremental operating CF's associated with the new system
Incremental CF's = after tax savings + (tax x net depreciation)
discount rate
12%
Year
1
2
3
Net BEFORE tax cost savings
($)
350
350
300
Tax at 35% tax rate
123
123
105
ITC tax credit yr 1
150
after tax savings
78
228
195
add: (tax x depre) of new comp
70
70
70

300

proceeds/loss
tax rate
tax

(50)
35%
(18)

4
300
105

5
300
105

195
70

195
70

Chap 3, prob 1

1,250
750
500
450

CF
Salvage value of new machine
tax on salvage value
Incremental CF's

148

148

PV =
investment
NPV =

298

298

265

265

265

265

$913.15
(532.50)
$380.65 The new computer should be purchased

c. If the new computer's salvage value at the end of 5 years is projected to be

$100,000, should TelCo purchase it?
salvage value
Book Value
cost
5 yr life D/E
Book value
Pay tax on:
tax rate
tax amt

100
1,000
1,000
100 salvage - BV
35%
35

Chap 3, prob 1

265
100 given
(35)
330

investment
NPV

$876.26 NPV or CF's

(532.50)
343.76

Chapter 3
Problem 3
Info:
Varico
Units sold/year
Ea. Unit needs electric motor, purchased 1 time per week
Cost per motor
Interest rate
Purchase amount
average inventory on hand (divide purchase amt by 2)
Foreign Firm to sell 100,000 motors at 9.50 ea.
Calculate the Opportunity cost of maintaining inventory =
avg. # of units on hand
price / unit
interest rate
Opportunity cost of maintaining inventory =
By buying the inventory weekly, no interest expense incurred.
The real cost of buying 100,000 motors today =
Units sold per yr x price per unit
Opportunity cost of maintaining inventory =
Result, does this exceed the cost to purchase weekly? A
Cost of purchasing motors weekly B
diff A - B

100,000
$

10.00
15%
100,000
50,000

$
$
$

$
$

Continue to purchase the motors weekly

Chap 3, prob 3

50,000
9.50
475,000.00
15%
71,250

950,000
71,250
1,021,250 A
1,000,000 B
(21,250)

exceeds cost to purchase weekly

Chapter 3
Problem 4
Info:
Specific Foods, Inc.
i). Calculate net income & operating CF's
Discount Rate

10%
0
(1,250,000)
(25,000)

Equipment purchase
Installation costs
a). Revenue
b). COGS @ 60% of sales
GM
Advertising & G&A
D/E on equipment; 10 yr life, SL
D/E on installation, 5 yr life, SL
Initial costs/expenses on equipment
EBIT
Taxes @ 35%
Net Income
Add back:
Deprec
OCF's
PV =

200,000 $
(120,000)
80,000
(10,000)
(125,000)
(5,000)

1,000,000 $
(600,000)
400,000
(10,000)
(125,000)
(5,000)

10

1,150,000 $ 1,322,500 $ 1,520,875 $ 1,749,006 $ 1,749,006 $ 1,486,655 $ 1,263,657 $ 1,074,108

(690,000)
(793,500)
(912,525) (1,049,404) (1,049,404)
(891,993)
(758,194)
(644,465)
460,000
529,000
608,350
699,603
699,603
594,662
505,463
429,643
(10,000)
(10,000)
(10,000)
(10,000)
(10,000)
(10,000)
(10,000)
(10,000)
(125,000)
(125,000)
(125,000)
(125,000)
(125,000)
(125,000)
(125,000)
(125,000)
(5,000)
(5,000)
(5,000)

(60,000)
21,000
(39,000)

260,000
(91,000)
169,000

320,000
(112,000)
208,000

389,000
(136,150)
252,850

468,350
(163,923)
304,428

564,603
(197,611)
366,992

564,603
(197,611)
366,992

459,662
(160,882)
298,780

370,463
(129,662)
240,801

294,643
(103,125)
191,518

130,000
91,000

130,000
299,000

130,000
338,000

130,000
382,850

130,000
434,428

125,000
491,992

125,000
491,992

125,000
423,780

125,000
365,801

125,000
316,518

$2,120,065.46

ii). Find NPV using 10% cost of capital

Cost today:
Equipment cost
Installation
Initial expensed costs
Tax on the exp initial costs
Net Investment
PV
Less: investment
NPV:

1,250,000
25,000
875,000 given
(306,250)
1,843,750
$2,120,065.46
(1,843,750)
$276,315 The project should be accepted.

iii). Adding inflation, what is the project's NPV?

Discount Rate
Equipment purchase
Installation costs
a). Revenue
b). COGS @ 60% of sales (will grow 20%/yr from
600K level, until yr 6, remain same for yr 7, then
decline 15%/yr through yr 10)
GM
Advertising & G&A (5% inflation)

10%
0
(1,250,000)
(25,000)

200,000 $

(120,000)
80,000
(10,000)

1,000,000 $

(600,000)
400,000
(10,500)

10

1,150,000 $ 1,322,500 $ 1,520,875 $ 1,749,006 $ 1,749,006 $ 1,486,655 $ 1,263,657 $ 1,074,108

(720,000)
430,000
(11,025)

Chap 3, prob 4

(864,000)
458,500
(11,576)

(1,036,800)
484,075
(12,155)

(1,244,160)
504,846
(12,763)

(1,244,160)
504,846
(13,401)

(1,057,536)
429,119
(14,071)

(898,906)
364,751
(14,775)

(764,070)
310,039
(15,513)

D/E on equipment; 10 yr life, SL

D/E on installation, 5 yr life, SL
Initial costs/expenses on equipment
EBIT
Taxes @ 35%
Net Income
Add back:
Deprec
OCF's
PV =

(125,000)
(5,000)

(125,000)
(5,000)

(125,000)
(5,000)

(125,000)
(5,000)

(125,000)
(5,000)

(125,000)

(125,000)

(125,000)

(125,000)

(125,000)

(60,000)
21,000
(39,000)

259,500
(90,825)
168,675

288,975
(101,141)
187,834

316,924
(110,923)
206,000

341,920
(119,672)
222,248

367,083
(128,479)
238,604

366,445
(128,256)
238,189

290,048
(101,517)
188,531

224,977
(78,742)
146,235

169,525
(59,334)
110,192

130,000
91,000

130,000
298,675

130,000
317,834

130,000
336,000

130,000
352,248

125,000
363,604

125,000
363,189

125,000
313,531

125,000
271,235

125,000
235,192

$1,760,160.45

ii). Find NPV using 10% cost of capital

Cost today:
Equipment
Installation
Initial expensed costs (not depre)
Tax on the exp initial costs (35%)
Investment
PV
Less: investment
NPV:

1,250,000
25,000
875,000 given
(306,250)
1,843,750
$1,760,160.45
(1,843,750)
($83,590) The project should be rejected

Chap 3, prob 4