Assignment 06

Cash Flow Estimation

1. You have been asked by the president of the Farr Construction Company to evaluate the
proposed acquisition of a new earth mover. The mover’s basic price is $50,000, and it
would cost another $10,000 to modify it for special use. Assume that the mover falls into
the MACRS 3-year class (33%, 45%, 15%), that it would be sold after 3 years for
$20,000, and that it would require an increase in net working capital (spare parts
inventory) of $2,000. The earth mover would have no effect on revenues, but it is
expected to save the firm $20,000 per year in before-tax operating costs (Hint: EBIT).
The firm’s marginal federal-plus-state tax rate is 40%.
a. What are the Year-0 cash flows?
b. What are the operating cash flows in Years 1, 2, and 3?
c. What are the additional (nonoperating) cash flows in Year 3?
d. If the project’s cost of capital is 10%, should the earth mover be purchased?
2. Talbot Industries is considering an expansion project. The necessary equipment could be
purchased for $9 million, and the project would also require an initial $3 million
investment in net operating working capital. The company’s tax rate is 40%. What is the
initial investment outlay?
3. Cairn Communications is trying to estimate the first-year operating cash flow (at t = 1)
for a proposed project. The financial staff has collected the following information:
Projected sales $10 million
Operating costs (not including depreciation) $ 7 million
Depreciation $ 2 million
Interest expense $ 2 million
The company faces a 40% tax rate. What is the project’s operating cash flow for the
first year (t = 1)?

4. Allen Air Lines is now in the terminal year of a project. The equipment originally cost
$20 million, of which 80% has been depreciated. Carter can sell the used equipment
today to another airline for $5 million, and its tax rate is 40%. What is the equipment’s
after-tax net salvage value?