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Depreciation/Working Capital

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1. XYZ Company is considering offering a cash discount to speed up the collection of accounts receivable. Currently the firm has an average collection period of 65 days, annual sales are 35,000 units, the per-unit price is $40, and the per-unit variable cost is $29. A 2% cash discount is being considered. XYZ estimates that 80% of its customers will take the 2% discount. If sales are expected to rise to 37,000 units per year and the firm has a 15% required rate of return, what minimum average collection period is required to approve the cash discount plan?

2. a. Describe the overall objective of working capital management.

b. Suggest several reasons why the strategy of carrying a low level of current assets could potentially lead to higher profits. Also suggest several reasons why this strategy would likely increase the firm's risk?

3. (27 points) The XYZ Company is considering the purchase of a new machine to replace an old one, which was purchased three years ago for $180,000. It was being depreciated under the MACRS method with a 5-year recoverable life. XYZ has been offered $130,000 for the old machine. The new machine would cost $350,000 plus an additional $20,000 to install. It will be depreciated under the MACRS with a 5-year recoverable life, and it has a 5-year usable life. The factory space where the new machine will be placed was painted 2 years ago at a cost of $1,000. The new machine also requires an increase of $10,000 in net working capital. The firm's tax rate is 30%. Over its 5 year life, the new machine is expected to reduce operating costs by $100,000 per year. The firm would use a discount rate of 14% for this type of project.

(5 year MACRS: 20%, 32%, 19%, 12%, 12%, 5%)

a. Calculate the initial investment associated with the purchase of the new machine.

b. Calculate the incremental operating cash inflows for years 1 and 4 only of the new machine.

c. Calculate the Net Present Value (NPV), Internal Rate of Return (IRR) and the Payback Period for this proposed project. Use the cash flows determined in parts a and b. In addition, assume cash inflows of $60,000 for year 2, $75,000 for year 3 and $50,000 for year 5.
d. Would you accept or reject this project? Why?

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Solution Summary

The solution examines depreciation and working capital for XYZ company. The overall working capital management is discussed.

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b. Suggest several reasons why the strategy of carrying a low level of current assets could potentially lead to higher profits. Also suggest several reasons why this strategy would likely increase the firm's risk?

Financing of Current Assets also involves a trade-off between risk and return. A firm can choose from short- ...

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