rwjch10

This module begins our discussion of advanced capital budgeting methods. In Chapter 10, we learn to estimate relevant cash flows in Capital Budgeting. Chapter 10 is a very important chapter. In Chapter 11, we learn various statistical methods and breakeven analysis to estimate project risk. Chapter 11 will have a below average weight on the Final Exam, probably less than half the weight of Chapter 10. The materials in both Chapters are review in that we studied similar topics in BA 530. We review the topics for two reasons. The secondary reason is that estimating relevant cash flows is a critical skill in choosing good capital budgeting projects. The primary reason we study these chapters, is the topic of Real Options that will be covered in Module 7. Real Options are the ability to change your mind after you have accepted a capital budgeting project. This ability to change our mind often has great value. The result is the that we change our accept/reject rule. Our new rule is accept a project only if the Strategic Net Present Value is positive. In words, Strategic NPV = Passive NPV + Present value of options arising from the active management of the firm’s investment opportunities. Mathematically, Strategic Net Present Value = Passive NPV + Value of Real Options - Cost of Real Options.

All page numbers are references to Fundamentals of Corporate Finance, 12th edition by Ross, Westerfield, and Jordan (McGraw Hill, 2019)

Chapter 10

Things to Absorb

The most important material is to be able to identify Relevant Cash Flows, for both new and replacement Capital Budgeting projects. This includes calculating initial, operating, and terminal project cash flows. This includes how to handle sunk costs, opportunity costs, depreciation, and erosion/cannibalization. Know the basics of how to adjust for inflation (i.e. use real discount rates with real cash flows and nominal (inflation-adjusted) discount rates with nominal cash flows). When given information on real options, be able to identify the type of option, who is long, who is short, the underlying asset, the exercise price, and sometimes the premium.

Things You Do Not Need to Absorb

You will not need to be able to calculate a Bid price, Equivalent Annual Cost, and Break-even Replacement on the exam.

Things to Read

Read the Chapter. Remember your Capital Budgeting Methods and Cash Flows from BA 530. If you cannot remember your Capital Budgeting Methods, go back and review those materials.

Things to Do

Review Recognizing Relevant Capital Budgeting Cash Flows

Make 100 on the quiz. Be able to solve Concepts Review 1-4, 6-10 and End of Chapter Questions and Problems 1-3, 5-11, 13-15, 19-21, and 24. The calculations in this chapter take a lot of time, so I do not expect you to solve all of the previously listed problems. Expect to solve problems using the format in this handout, http://www.westga.edu/~chodges/pdf/capbudhintsadv.pdf. Similar to BA 530, you will have a complex Capital Budgeting Cash Flows Question on the Final Exam.

Calculator links: Most Calculator Types

  1. Watch the Chapter Introduction and Overview video. The PowerPoints for all of this chapter's videos are located here.
  2. Read pages 312-319.
  3. Watch the Relevant Cash Flows and Proforma Financial Statements video. Read pages 319-329. After this video you should be able to solve all of the suggested end of chapter calculations.
  4. Watch the Net Working Capital, Depreciation, Salvage Value and Calculating a Replacement Problem video. After this video, you should be able to answer end of chapter problems 1-3 and 5-7.
  5. Read the remainder of the chapter.
  6. Watch the video on Other Methods of Computing Cash Flow and a Comprehensive Problem.
  7. Make sure you think you could solve the suggested end of chapter Questions and Problems.  You can review the answer in both written and spreadsheet format in CourseDen.
  8. Below are audio solutions related to the estimation of cash flows. Use the following information to answer questions a-e. You have been asked by the president of your company to evaluate the proposed acquisition of new equipment. The equipment's basic price is $177,000, and shipping costs will be $3,500. It will cost another $26,600 to modify it for special use by your firm, and an additional $12,400 to install the equipment. The equipment falls in the MACRS 3-year class, and it will be sold after three years for $22,000. The equipment is expected to generate revenues of $173,000 per year with annual operating costs of $81,000. The firm's tax rate is 30.0%. Here is the MACRS depreciation schedule, Year 1=33%, Year 2=45%, Year 3=15%, Year 4= 7%.
    1. What is the net investment (initial outlay) for the project? Audio Solution
    2. What is the operating cash flow for year 1? | Audio Solution
    3. What is the operating cash flow for year 2? | Audio Solution
    4. What is the operating cash flow for year 3? | Audio Solution
    5. What is the value of the terminal year non-operating cash flows at the end of Year 3? (What is the after-tax cash flow associated with the sale of the equipment?) | Audio Solution

Use the following information to answer questions f-j. You have been asked by the president of your company to evaluate the proposed acquisition of new equipment. The equipment's basic price is $195,000, and shipping costs will be $3,900. It will cost another $23,400 to modify it for special use by your firm, and an additional $9,800 to install the equipment. The equipment falls in the MACRS 3-year class, and it will be sold after three years for $30,200. The equipment is expected to generate revenues of $179,000 per year with annual operating costs of $90,000. The firm's tax rate is 25.0%. Here is the MACRS depreciation schedule, Year 1=33%, Year 2=45%, Year 3=15%, Year 4= 7%.

    1. What is the net investment (initial outlay) for the project? | Audio Solution
    2. What is the operating cash flow for year 1? | Audio Solution
    3. What is the operating cash flow for year 2? | Audio Solution
    4. What is the operating cash flow for year 3? | Audio Solution
    5. What is the value of the terminal year non-operating cash flows at the end of Year 3? (What is the after-tax cash flow associated with the sale of the equipment?) | Audio Solution
    6. The Target Copy Company is contemplating the replacement of its old printing machine with a new model costing $55,000. The old machine, which originally cost $33,000, has 4 years of expected life remaining and a current book value of $29,000 versus a current market value of $17,000. Both machines are in the 7-year MACRS class. If we buy the new machine our inventory levels will go from $6,000 to $8,000. Inventory levels will return to normal at the end of the project. Our annual sales will go from $10,000 to $14,000. Target's corporate tax rate is 32 percent. If Target sells the old machine at market value, what is the initial after-tax outlay for the new printing machine? Since this is a cash outlay, be sure to use the - sign when writing your answer. Show your answer to the nearest $.01 Do not use the $ symbol in your answer? | Audio Solution
    7. Your company plans to produce a product for two more years and then to shut down production. You are considering replacing an old machine used in production with a new machine. The Old machine originally cost $818 and was bought Three (3) years ago (i.e. it has depreciated for three years). It could be sold today for $367 or sold in two years for $121. The New machine would cost $703 and could be sold in two years for $231. The new machine is more efficient than the old machine and would reduce waste, and therefore the cost of materials, by $300 per year. Due to the lower waste, we could also have a one-time reduction in inventory of 21. The firm's tax rate is 43%. Both machines are in the 4 year MACRS class, with depreciation amounts of 15%, 45%, 33% and 7%. What are the Operating Cash Flows in the first year (Year 1) with the new machine? | Audio Solution
    8. The Target Copy Company is contemplating the replacement of its old printing machine with a new model costing $ 819. The new machine will operate for 3 years and then project will be shut down and all equipment sold. The old machine, which originally cost $ 601, has 2 years of depreciation remaining and a current book value of 22% of the original cost. The old machine has a current market value of $ 281 and should be worth $ 215 at the end of 3 years. The new printing machine could be sold for $ 269 in 3 years. If we buy the new machine our inventory levels will go from $600 to $900. Inventory levels will return to normal at the end of the project. Our annual sales will go from $15,000 to $20,000. Target's corporate tax rate is 25 percent. Both machines are in the 3-year MACRS class, with rates of 33% for year 1, 45% for year 2, 15% for year 3, and 7% for year 4. What are the expected Terminal Cash Flows at the end of year 3, if we replace the old printing machine? This could be a cash inflow or a cash outlay. Be sure to use the - sign should this be a cash outflow. Show your answer to the nearest $.01 Do not use the $ symbol in your answer. | Audio Solution
    9. Hit or Miss Sports is introducing a new product this year. If it's see-at-night soccer balls are a hit, the firm expects to be able to sell 50,000 units a year at a price of $60 each. If the new product is a bust, only 30,000 units can be sold at a price of $55. The variable cost of each ball is $30, and fixed costs are zero. The cost of the manufacturing equipment is $6 million, and the project life is estimated at 10 years. The firm will use straight-line depreciation over the 10-year life of the project. The firm's tax rate is 35% and the discount rate is 12%. a. If each outcome is equally likely, what is expected NPV? Will the firm accept the project? b. Suppose now that the firm can abandon the project and sell off the manufacturing equipment for $5.4 million if demand for the balls turns out to be weak. The firm will make the decision to continue or abandon after the first year of sales. Does the option to abandon change the firm's decision to accept the project? | Audio Solution
    10. Hit or Miss Sports is introducing a new product this year. If it's see-at-night soccer balls are a hit, the firm expects to be able to sell 50,000 units a year at a price of $60 each. If the new product is a bust, only 30,000 units can be sold at a price of $55. The variable cost of each ball is $30, and fixed costs are zero. The cost of the manufacturing equipment is $6 million, and the project life is estimated at 10 years. The firm will use straight-line depreciation over the 10-year life of the project. The firm's tax rate is 35% and the discount rate is 12%.
      1. If each outcome is equally likely, what is expected NPV? Will the firm accept the project?
      2. Now suppose that Hit or Miss Sports from the previous problem can expand production if the project is successful. By paying its workers overtime, it can increase production by 25,000 units; the variable cost of each ball will be higher, however, equal to $35 per unit. By how much does this option to expand production increase the NPV of the project? | Audio Solution
  1. Review the remaining above suggested questions and problems. Be prepared for a 60-80 minute quiz over Chapter 10.
Home   BA531   OldF2FExams   BA530