Bull Gator Industries is considering a new assembly line costing $6,000,000. The assembly line will be fully depreciated

Bull Gator Industries is considering a new assembly line costing $6,000,000. The assembly line will be fully depreciated by the simplified straight line method over its 5 year depreciable life. Operating costs of the new machine are expected to be $1,100,000 per year. The existing assembly line has 5 years remaining before it will be fully depreciated and has a book value of $3,000,000. If sold today the company would receive $2,400,000 for the existing machine. Annual operating costs on the existing machine are $2,100,000 per year. Bull Gator is in the 46 percent marginal tax bracket and has a required rate of return of 12 percent.

a.     Calculate the net present value of replacing the existing machine.

b.     Explain the impact on NPV of the following:

        i.      Required rate of return increases

        ii.    Operating costs of new machine are increased

        iii.   Existing machine sold for less

Answer: 

a. Calculate Initial Outlay

Purchase Price                                       $6,000,000

Sale of old                                               (2,400,000)

Tax savings from sale

($3,000,000 - 2,400,000).46                    (276,000)

Initial Outlay                                         $3,324,000

Free Cash Flows

Change in EBDIT                                  $1,000,000

-Increased Depreciation                         - 600,000

Change in EBIT                                        $400,000

-Taxes (at 46%)                                         - 184,000

+Change in Depreciation                     + 600,000

-Change in Working Capital                 -             0

-Change in Capital Spending               -             0

                                                                       $816,000

Depreciation on old machine

$3,000,000/5 = $600,000

Depreciation on new machine

$6,000,000/5 = $1,200,000

Increase Depreciation

= $600,000 - $1,200,000 = -$600,000

Calculate NPV

NPV = $816,000 × 3.605 - $3,324,000

NPV = -$382,320

b. i. NPV decreases because the present value of the future cash flows decreases

    ii. NPV decreases because cash flows decrease

    iii. NPV decreases because this reduces the cash flow from salvage sale

Krugman Construction Company is considering the purchase of a new crane at a cost of $600,000

Krugman Construction Company is considering the purchase of a new crane at a cost of $600,000. If the new crane is purchased the old crane will sold. It was purchased 5 years ago at a cost of $450,000. To date, the company has taken $200,000 in depreciation on the old crane. Compute the cash flow that would be realized from selling the old crane under each of the following scenarios. Krugman's marginal tax rate is 30%.

a. The crane is sold for $200,000

b. The crane is sold for $250,000

c. The crane is sold for $300,000

Answer: 
a. Sale results in a loss of $50,000 ($200,000 - $250,000 undepreciated cost). The loss results in a tax shelter of $50,000 × .3 =$15,000. The company will realize $200,000 + $15,000 = $215,000 on the sale of the old crane.

b. There is neither a profit nor a loss on disposal of the old crane. Krugman will realize $250,000 on the sale of the old crane.

c. There is a profit of $50,000 on disposal of the old crane which will result in a tax liability of $50,000(.3) = $15,000. Proceeds from sale of the crane will be $300,000 - $15,000 = $285,000.

Kahnemann Kookies is evaluating the replacement of an old oven with a new, more energy efficient model. The old oven cost $50,000, is 5 years old and is being depreciated over a life of 10 years to a value of $0.00. The new oven costs $60,000 and will be depreciated over 5 years with no salvage value. Kahnemann uses straight line depreciation, its tax rate is 40%. If the old oven is sold for $10,000, compute the net cost of the new oven.

Answer:  Annual depreciation on the old oven was $50,000/10 or $5,000 per year. Remaining depreciable value is $50,000 - 5($5,000) = $25,000. $10,000 - $25,000 = ($15,000). The loss on disposal of the old asset will result in a tax shelter of $15,000(.4) or $6,000. The net cost of the new machine is:

$60,000 less $10,000 from the sale of the old machine, less $6,0000 tax shelter = $44,000 net cost.

Kahnemann Kookies is evaluating the replacement of an old oven with a new, more energy efficient model. The old oven cost $50,000, is 5 years old and is being depreciated over a life of 10 years to a value of $0.00. The new oven costs $60,000 and will be depreciated over 5 years with no salvage value. Kahnemann uses straight line depreciation, its tax rate is 40%. Compute:

a. the change in annual depreciation that would result from purchasing the new machine.

b. the change in taxes each year that would result from purchasing the new machine.

Answer: 

a. Annual depreciation on the old machine is $50,000/10 = $5,000 per year. Depreciation on the new machine, if purchased, would $60,000/5 = $12,000 per year. Depreciation expense would increase by $12,000 - $5,000 = $7,000 per year.

b. The increase in depreciation expense would lower taxes by $7,000(.4) - $2,800 per year.

Al's Fabrication Shop is purchasing a new rivet machine to replace an existing one

Al's Fabrication Shop is purchasing a new rivet machine to replace an existing one. The new machine costs $8,000 and will require an additional cost of $1,000 for modification and training. It will be depreciated using simplified straight line depreciation over five years. 

The new machine operates much faster than the old machine and with better quality. Consequently, sales are expected to increase by $2,100 per year for the next five years. While it is faster, it is fully automated and will result in increased electricity costs for the firm by $700 per year. It will, however, save about $850 per year in labor costs. 

The old machine is 20 years old and has already been fully depreciated. If the firm's marginal tax rate is 28%, compute the after tax incremental cash flows for the new machine for years 1 through 5.

A) $2,698

B) $450

C) $2,124

D) $1,620

National Geographic is replacing an old printing press with a new one. The old press is being sold for $350,000 and it has a net book value of $75,000. Assume that National Geographic is in the 40% income tax bracket. How much will National Geographic pay in income taxes from the sale?

A) $140,000

B) $45,000

C) $110,000

D) $87,010

The relevant depreciation expense for a replacement investment is the difference between depreciation on the new asset(s) and the old asset(s).

Answer:  TRUE

The salvage value of equipment should not be considered when replacing it with new equipment.

Answer:  FALSE

When replacing old assets with new assets, it is safe to assume that working capital requirements will remain the same.

The original cost and expected life of old assets are critical considerations in replacement decisions.

Answer:  FALSE

Taxes may have a significant effect on the cost of replacing an old asset with a new asset.

Answer:  TRUE

A firm is trying to determine whether to replace an existing asset. The proposed asset has a purchase

A firm is trying to determine whether to replace an existing asset. The proposed asset has a purchase price of $50,000 and has installation costs of $3,000. The asset will be depreciated over its five year life using the straight-line method. 

The new asset is expected to increase sales by $17,000 and non-depreciation expenses by $2,000 annually over the life of the asset. Due to the increase in sales, the firm expects an increase in working capital during the asset's life of $1,500, and the firm expects to be able to sell the asset for $6,000 at the end of its life. 

The existing asset was originally purchased three years ago for $25,000, has a remaining life of five years, and is being depreciated using the straight-line method. The expected salvage value at the end of the asset's life (i.e., five years from now) is $5,000; however, the current sale price of the existing asset is $20,000, and its current book value is $15,625. 

The firm's marginal tax rate is 34 percent and its required rate of return is 12 percent.

If the new machine is purchased, depreciation expense will increase or decrease by

A) increase $8,000.

B) increase $6,900.

C) increase $6,300.

D) decrease $5,000.

Increased taxes on the sale of the old machine are

A) $1,487.50.

B) $2,500.50.

C) $3,823.50.

D) $4,312.50.

If the new machine is purchased, operating cash flow for years 1 through 5 will increase or decrease by how much?

A) Increase $15,000

B) Decrease $9,900

C) Increase $12,142

D) Increase $5,346

What would cause the initial cash outlay of an investment decision to be affected by the sale of an existing asset?

A) If the investment decision is a replacement decision

B) If the asset being purchased is technologically superior

C) If the asset being sold has exceeded its MACR's recovery allowance period

D) All of the above

Tversky and Co. have devised a new psychological test for investors' risk tolerance. They expect to sell 10,000 tests

Tversky and Co. have devised a new psychological test for investors' risk tolerance. They expect to sell 10,000 tests in the first year at $150 each. Cash costs associated with producing, administering and scoring the test are $50 per unit. In the second year, volume is expected to be the same, but both the price and the costs will increase 2.5%. Forecast gross profit in the second year.

Answer: 

Revenue                               10,000 units × $150 × 1.025 =  $1,537,500

Cash Costs                          10,000 units × $50 × 1.025 =         512,500

Gross Profit                                                                                                                                         $1,025,000

When computing the NPV of a project, if cash flows are discounted at the real cost of capital, then the cash flows should not be adjusted for inflation.

Answer:  TRUE

When computing the NPV of a project, it is important to consistently use either nominal dollars and nominal rates or real dollars and real rates.

Answer:  TRUE

When computing project cash flows, it is necessary to apply the same rate of inflation to all costs and revenues.

Answer:  FALSE

What is meant by "real dollars" and the "real" discount rate? How can they be used to account for inflation when evaluating capital budgeting proposals?

Answer:  Real dollars are used to represent prices or expenses in the absence of inflation. If an item sells for $10 one year and $10.30 the following year solely because of inflation and not because of other factors such as supply and demand, the price would still be stated as $10 "real" dollars. When using real dollars, the interest rate is also disinflated. With 3% inflation, a 10% interest rate is disinflated to 10% - 3% = 7% or more precisely, (1.10/1.03) - 1 = 6.8%.

In 2013, Sunny Electronics expects to sell 100,000 3-D television sets for an average price of $1,000

In 2013, Sunny Electronics expects to sell 100,000 3-D television sets for an average price of $1,000. Expected production costs are $600 per unit. In 2014, volume is expected to increase by 10%, while inflation will increase both the sales price and the cost per unit by 3%. In nominal dollars, expected gross profit for 2014 is

A) $40 million.

B) $45.32 million.

C) $48.20 million.

D) $50 million.

In 2013, Sunny Electronics expects to sell 100,000 3-D television sets for an average price of $1,000. Expected production costs are $600 per unit. In 2014, volume is expected to increase by 10%, while inflation will increase both the sales price and the cost per unit by 3%. In real dollars, expected gross profit for 2014 is

A) $40 million.

B) $45.32 million.

C) $48.2 0 million.

D) $50 million.

In 2013, Sunny Electronics expects to sell 100,000 3-D television sets for an average price of $1,000. Expected production costs are $600 per unit. In 2014, volume is expected to increase by 10%, Inflation will increase the cost per unit by 3%, but to attract more buyers, Sunny will reduce the price to $950. In nominal dollars, expected gross profit for 2014 is

A) $45.32 million.

B) $40 million.

C) $38 million.

D) $36.52 million.

Greenspan Inc. discounts cash flows at a nominal rate of 10%. Inflation over the next few years is expected to average 3%. Which of the following would be a correct adjustment for inflation when computing net present value?

A) Discount cash flows at 10%; increase revenues and expenses by 3% each year.

B) Discount cash flows at 13%; increase revenues and expenses by 3% each year.

C) Discount cash flows at 7%; ignore inflation when forecasting revenues and expenses.

D) Either A or C would be acceptable.

Nominal cash flows are expressed in terms of their purchasing power in a base year.

Answer:  FALSE

The real discount rate includes expected inflation.

Answer:  FALSE

Cape Cod Cranberry Products is evaluating the introduction of a new line of juice drinks consisting of cranberry juice

Cape Cod Cranberry Products is evaluating the introduction of a new line of juice drinks consisting of cranberry juice blended with sweeter juices such as apple or grape. In the first year the product line is introduced, sales are forecasted at $2,000,000, Cost of Goods Sold at $1,200,000, other cash expenses at $300,000, depreciation expense at $800,000. The company has many other profitable product lines. It's marginal tax rate is 35%. Compute operating cash flow for the first year.

Answer: 

Sales                                                                                         $2,000,000

Cost of Goods Sold                                               (1,200,000)

Gross Profit                                                                                $800,000

Other Cash Exp.                                                                                (300,000)

Depreciation                                                                       (800,000)

Net Operating Income                                     (300,000)

Taxes 35%                                                                                           (105,000)

NOPAT (loss)                                                                     (195,000)

Depreciation                                                                       (800,000)

Operating Cash Flow                                       $605,000

LaVigne Wineries is purchasing a new wine press. The equipment will cost $250,000. Transportation and installation will cost another $35,000. Because of increased production, inventories will increase by $15,000. The press will be depreciated using the straight line method to a book value of $0.00 over its useful life of 7 years. Compute depreciation for each year of the project.

Answer:  For depreciation purposes, the cost of the asset includes transportation, but not, of course, working capital investments. ($250,000 + $35,000)/7 = $40,714.29 depreciation expense per year.

Marguerite's Florist is considering the purchase of a new delivery van. It will cost $25,000 plus another $3,000 to have it painted in the company's characteristic floral motif. The van will be depreciated over 5 years using MACRS percentages and a half year convention. Compute depreciation for the second year in the life of the van.

Answer:  For depreciation purposes, the cost of the asset includes repainting, so the base is $25,000 + $3,000) = $28,000. The second year rate 32% so depreciation will be $28,000 × .32 = $8,960.

What is the advantage, if any, to using MACRS rather than straight line depreciation?

Answer:  Assuming that a company is profitable and pays taxes, MACRS allows more of the cost of the asset to be written off in the first few years of its life. The faster write-off reduces taxable income in the early years and raises it in the later years. Because of the time value of money, NPV will be higher if taxes can be deferred and cash flow is higher the early years of a project.