Chapter 12 Cash Flow Estimation and Risk Analysis 391NEW PROJECT ANALYSIS You must evaluate a proposal to buy a new milling machine.
The base price is $108,000, and shipping and installation costs would add another $12,500.
The machine falls into the MACRS 3-year class, and it would be sold after 3 years for
$65,000. The applicable depreciation rates are 33%, 45%, 15%, and 7% as discussed in
Appendix 12A. The machine would require a $5,500 increase in working capital (increased
inventory less increased accounts payable). There would be no effect on revenues, but
pretax labor costs would decline by $44,000 per year. The marginal tax rate is 35%, and the
WACC is 12%. Also, the firm spent $5,000 last year investigating the feasibility of using
the machine.
a. How should the $5,000 spent last year be handled?
b. What is the net cost of the machine for capital budgeting purposes, that is, the Year 0
project cash flow?
c. What are the project’s annual net cash flows during Years 1, 2, and 3?
d. Should the machine be purchased? Explain your answer.
REPLACEMENT ANALYSIS The Dauten Toy Corporation uses an injection molding
machine that was purchased 2 years ago. This machine is being depreciated on a
straight-line basis, and it has 6 years of remaining life. Its current book value is $2,100,
and it can be sold for $2,500 at this time. Thus, the annual depreciation expense is
$2,100/6 " $350 per year. If the old machine is not replaced, it can be sold for $500 at
the end of its useful life.
Dauten is offered a replacement machine that has a cost of $8,000, an estimated useful
life of 6 years, and an estimated salvage value of $800. This machine falls into the MACRS
5-year class; so the applicable depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%.
The replacement machine would permit an output expansion, so sales would rise by
$1,000 per year. Even so, the new machine’s greater efficiency would cause operating
expenses to decline by $1,500 per year. The new machine would require that inventories
be increased by $2,000, but accounts payable would simultaneously increase by $500.
Dauten’s marginal federal-plus-state tax rate is 40%, and its WACC is 15%. Should the
company replace the old machine?
REPLACEMENT ANALYSIS Mississippi River Shipyards is considering replacing an
8-year-old riveting machine with a new one that will increase earnings before depreciation
from $27,000 to $54,000 per year. The new machine will cost $82,500, and it will have an
estimated life of 8 years and no salvage value. The new machine will be depreciated over
its 5-year MACRS recovery period; so the applicable depreciation rates are 20%, 32%, 19%,
12%, 11%, and 6%. The applicable corporate tax rate is 40%, and the firm’s WACC is 12%.
The old machine has been fully depreciated and has no salvage value. Should the old
riveting machine be replaced by the new one? Explain your answer.
PROJECT RISK ANALYSIS The Butler-Perkins Company (BPC) must decide between two
mutually exclusive projects. Each costs $6,750 and has an expected life of 3 years. Annual
project cash flows begin 1 year after the initial investment and are subject to the following
probability distributions:PROJECT A PROJECT B
Probability Cash Flows Probability Cash Flows
0.2 $6,000 0.2 $ 0
0.6 6,750 0.6 6,750
0.2 7,500 0.2 18,000BPC has decided to evaluate the riskier project at 12% and the less risky project at 10%.
a. What is each project’s expected annual cash flow? Project B’s standard deviation
(σB) is $5,798, and its coefficient of variation (CVB) is 0.76. What are the values of σA
and CVA?
b. Based on the risk-adjusted NPVs, which project should BPC choose?
c. If you knew that Project B’s cash flows were negatively correlated with the firm’s
other cash flows whereas Project A’s flows were positively correlated, how might this
affect the decision? If Project B’s cash flows were negatively correlated with gross
domestic product (GDP) while A’s flows were positively correlated, would that
influence your risk assessment? Explain.
SCENARIO ANALYSIS Your firm, Agrico Products, is considering a tractor that would
have a net cost of $36,000, would increase pretax operating cash flows before taking
account of depreciation by $12,000 per year, and would be depreciated on a straight-line12-812-8
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Challenging 12-1212-12
Problems
12–15
Challenging
Problems
12–15