IE 342 Fall 2021 - Study Set V

Q1: (Ch7.46.) Consider the investment projects given in Table P7.46. Assume that
MARR = 16%.

(a) Projects A and B are mutually exclusive.Assuming that both projects can be repeated
for an indefinite period, which one would you select on the basis of the IRR criterion?

(b) Suppose projects C and D are mutually exclusive. According to the IRR criterion,
which project would be selected?

(c) Suppose projects E and F are mutually exclusive. Which project is better according
to the MIRR criterion?

Answer: (a) Project A. (b) Project C. (c) Project E.

Q2: (Ch 9.29.) At the beginning of the fiscal year, the Borland Company acquired new
equipment at a cost of $89,000. The equipment has an estimated life of five years and an
estimated salvage value of $10,000.

(a) Determine the annual depreciation (for financial reporting) for each of the five years
of the estimated useful life of the equipment, the accumulated depreciation at the end
of each year, and the book value of the equipment at the end of each year. Use (1) the
straight-line method and (2) the double-declining-balance method for each.

(b) Determine the annual depreciation for tax purposes, assuming that the equipment falls
into a seven-year MACRS property class.

(c) Assume that the equipment was depreciated under seven-year MACRS. In the first
month of the fourth year, the equipment was traded in for similar equipment priced
at $92,000. The tradein allowance on the old equipment was $20,000, and cash was
paid for the balance. What is the cost basis of the new equipment for computing the
amount of depreciation for income tax purposes?

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 Answer: (a) D1 = $35, 600 D2 = $21, 360 D3 = $12, 816 D4 = $7, 690 D5 = $4, 614
(b) D1 = $12, 718 D2 = $21, 796 D3 = $15, 566 D4 = $11, 116 D5 = $7, 948 D6 = $7, 939
D7 = $7, 948 D8 = $3, 969.4
(c) $110,920

Q3: (Ch. 9.32.) A gold mine with an estimated deposit of 500,000 ounces of gold is pur-
chased for $80 million. The mine has a gross income of $48,365,000 for the year, obtained
from selling 52,000 ounces of gold. Mining expenses before depletion equal $22,250,000.
Compute the percentage depletion allowance. Would it be advantageous to apply cost de-
pletion rather than percentage depletion?

Answer: Yes. Percentage Depletion Allowance: $7,254,000 Cost Depletion: $8,230,000

Q4: (Ch. 9.36) The Dow Ceramic Company purchased a glassmolding machine in January
2010 for $180,000. The company has been depreciating the machine over an estimated useful
life of 10 years, assuming no salvage value, by the straight-line method of depreciation. For
tax purposes, the machine has been depreciated as seven-year MACRS property. At the
beginning of 2013, Dow overhauled the machine at a cost of $45,000. As a result of the
overhaul, Dow estimated that the useful life of the machine would extend five years beyond
the original estimate.

(a) Calculate the book depreciation for the year 2016.

(b) Calculate the tax depreciation for the year 2016.

Answer: (a) $14,250 (b) $23,926.5

Q5: (Ch. 9.48) The Florida Citrus Corporation estimates its taxable income for next
year at $2,500,000. The company is considering expanding its product line by introducing
pineapple–orange juice for the next year. The market responses could be good, fair, or
poor. Depending on the market response, the expected additional taxable incomes are (1)
$2,000,000 for a good response, (2) $500,000 for a fair response, and (3) a $100,000 loss
for a poor response. (a) Determine the marginal tax rate applicable to each situation. (b)
Determine the average tax rate that results from each situation.

Answer: (a) 34% (b) 34%

Q6: A company is considering investing in a new machine that costs $300,000. The
machine has a useful life of seven years but it will used only for three and will be sold for
$200,000 (constant dollars) after three years.

• The machine falls into MACRS 7-year class.

• The company takes a bank loan of $150,000 to invest in the project, at 10% interest
rate compounded annually, to be paid back in equal end-of-year payments.

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 • The new machine will generate an additional revenue of $130,000 (constant dollars).
The annual maintenance and operating cost of the machine is $60,000 (constant dol-
lars).
• There is a $30,000 working capital requirement at the beginning, which will be fully
recovered at the end of three years.
• The inflation free market interest rate is 12%, general inflation rate is estimated to be
5% per year during the project life.

(a) Fill the income statement and cash-flow statements (in actual dollars). Should the
company invest in this project?

Q7: (Ch 12.28) Jay Olsen, a writer of novels, just has completed a new thriller novel. A
movie company and a TV network both want exclusive rights to market his new title. If he
signs with the network, he will receive a single lump sum of $900, but if he signs with the
movie company, the amount he will receive depends on how successful the movie is at the
box office. (All $ units are in thousands.)
• TV Network: $900
• Movie

(a) Which option would you recommend based on the expected monetary value (EMV)
criterion? (Assume that he is a risk-neutral person interested in maximizing the expected
monetary value.)

(b) How much would he be willing to pay to know the true state of nature?

(c) Jay can send his novel to a prominent movie critic to assess the potential box office
success. From his past experience, the movie critic’s reliability of predicting the box office
success is as follows. Favorable prediction means that it is highly likely the movie would be
a box office success. It will cost $20 to get his novel evaluated by the movie critic.

For example, when the true state of nature is “S,” the movie critic will say “F” with a 20%
probability. Determine Jay’s strategy that maximizes the expected payoff after receiving the
movie critic’s report. In doing so, compute the EVPI after taking the critic. What is the
true worth of the novel critic? Should Jay take the critic?

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 Answer: (a) Movie option should be selected. (b) EVPI=$195 (c) EVPI=$143 EVSI=$50.
Since EV SI = $50 > $20, he should take the critic.

Q8: (Ch.14.3.) Komatsu Cutting Technologies is considering replacing one of its CNC
machines with one that is newer and more efficient. The firm purchased the CNC machine
10 years ago at a cost of $135,000. The machine had an expected economic life of 12 years
at the time of purchase and an expected salvage value of $12,000 at the end of the 12 years.
The original salvage estimate is still good, and the machine has a remaining useful life of two
years. The firm can sell this old machine now to another firm in the industry for $30,000.
The new machine can be purchased for $165,000, including installation costs. It has an
estimated useful (economic) life of eight years. The new machine is expected to reduce
cash operating expenses by $30,000 per year over its eight-year life, at the end of which the
machine is estimated to be worth only $5,000. The company has a MARR of 12%.

(a) If you decided to retain the old machine, what is the opportunity (investment) cost of
retaining the old asset?

(b) Compute the cash flows associated with retaining the old machine in years 0-2.

(c) Compute the annual equivalent value of cash flows associated with purchasing the new
machine in years 0-8.

(d) If the firm needs the service of these machines for an indefinite period and no technology
improvement is expected in future machines, what will be your decision?

Answer: (a) $30, 000 (b) Year 0: -$30,000 Year 1: -$30,000 Year 2: -$18,000
(c) Year 0: -$165,000 Years 1-7: $0, Year 8: $5,000
(d) Replace the defender. AEC(C)=$12,090 > AEC(D)=$4,218

Q9: (Ch.14.9.) General Foods Company is considering replacing an old food dispenser
which was purchased 10 years ago at a cost of $25,000. It has a current market value of
$4,000. If the firm spends $1000 to recalibrate the dispenser, it would extend the life of
the dispenser for another three years with following estimated market values and operating
costs: A computer-controlled new dispenser can be installed for $12,000. This dispenser
would have an estimated economic life of 5 years, with an annual equivalent cost of $5,900.

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(Note that I calculated the economic service life of the challenger here.) The firm’s MARR
is 12%. Ignore any income tax effects for this problem.

(a) What is the remaining economic service life of the old machine with overhaul?

(b) What is your decision – replace the defender now?

(c) In (b), if now is not the right time to replace the defender, when to replace it?

Answer: (a) N=2 (b) Do not replace now. (c) 2 years later.

Q10: (Ch.14.12) A five-year-old defender has a current market value of $4,000 and
expected OM costs of $3,000 this year, increasing by $1,500 per year. Future market values
are expected to decline by $1,000 per year. The machine can be used for another three years.
The challenger costs $6,000 and has OM costs of $2,000 per year, increasing by $1,000 per
year. The machine will be needed for only three years, and the salvage value at the end of
that time is expected to be $2,000. The MARR is 15%.

• Determine the annual cash flows for retaining the old machine for three years.

• Determine whether now is the time to replace the old machine. First show the annual
cash flows for the challenger.

Answer: Replace now.

Q11: (Ch14.20.) The Georgia Ceramic Company has an automatic glaze sprayer that
has been used for the past 10 years. The sprayer can be used for another 10 years and will
have a zero salvage value at that time. The annual operating and maintenance costs for the
sprayer amount to $15,000 per year. Due to an increase in business, a new sprayer must be
purchased. Georgia Ceramic is faced with two options.

• Option 1: If the old sprayer is retained, a new smaller capacity sprayer will be purchased
at a cost of $48,000, and it will have a $5,000 salvage value in 10 years. This new sprayer
will have annual operating and maintenance costs of $12,000. The old sprayer has a
current market value of $6,000.

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 • Option 2: If the old sprayer is sold, a new sprayer of larger capacity will be purchased
for $84,000. This sprayer will have a $9,000 salvage value in 10 years and will have
annual operating and maintenance costs of $24,000.

Which option should be selected at MARR = 15%

Answer: Option 1.

Q12: (Ch14.24.) An existing asset that cost $16,000 two years ago has a market value
of $12,000 today, an expected salvage value of $2,000 at the end of its remaining useful life
of six more years, and annual operating costs of $4,000. A new asset under consideration as
a replacement has an initial cost of $10,000, an expected salvage value of $4,000 at the end
of its economic life of three years, and annual operating costs of $2,000. It is assumed that
this new asset could be replaced by another one identical in every respect after three years
at a salvage value of $4,000, if desired. Use a MARR of 11%, a six-year study period, and
PW calculations to decide whether the existing asset should be replaced by the new one.

Answer: Replace now.

Q13: (Ch.14.42.) Five years ago, a conveyor system was installed in a manufacturing
plant at a cost of $35,000. It was estimated that the system, which is still in operating
condition, would have a useful life of eight years with a salvage value of $3,000. It was also
estimated that if the firm continues to operate the system, its market values and operating
costs for the next three years would be as follows.

A new system can be installed for $43,500; it would have an estimated economic life of 10
years with a salvage value of $3,500. Operating costs are expected to be $1,500 per year
throughout the service life of the system. The firm’s MARR is 18%. The system

• Decide whether to replace the existing system now.

• If the decision is to replace the existing system, when should replacement occur?

Answer: Keep the defender.

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 Q14: (Ch 16.10) The U.S. Department of Interior is planning to build a dam and construct
a hydroelectric power plant. In addition to producing electric power, this project will provide
flood control, irrigation, and recreational benefits. The estimated benefits and costs expected
to be derived from the three alternatives under consideration are listed as follows:

The interest rate is 5%, and the life of each project is estimated to be 40 years.

(a) Find the benefit–cost ratio for each alternative.

(b) Select the best alternative, according to BC(i).

(c) Select the best alternative, according to PI(i).

Answer: (a) BC(A) = 1.45, BC(B) = 1.46, BC(C) = 1.59. (b) Alternative C. (c)
P I(A) = 1.06, P I(B) = 1.36, P I(C) = 1.73 Alternative C.

Q15: (Ch.16.15) The government is considering undertaking four projects. These projects
are mutually exclusive, and the estimated present worth of their costs and the present worth
of their benefits are shown in millions of dollars in Table P16.15. All of the projects have
the same duration.

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 Assuming no do-nothing alternative, which alternative would you select? Justify your
choice by using a benefit–cost (BC(i)) analysis on incremental investment.

Answer: Select A4 .