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Fundamentals of Financial Management

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Fundamentals of Financial Management

12-2: PROJECT CASH FLOW Eisenhower Communications is trying to estimate the first-year net cash flow (at Year 1) for a proposed project. The financial staff has collected the following information on the project:

Sales revenues $10 million
Operating costs (excluding depreciation) $ 7 million
Depreciation $ 2 million
Interest expense $ 2 million

The company as a 40% tax rate and its WACC is 10%.

a. What is the project's net cash flow for the first year (t=1)?

b. If this project would cannibalize other projects by $1 million of cash flow before taxes per year, how would this change your answer to Part a?

c. Ignore Part b. If the tax dropped to 30%, how would that change your answer to Part a?

12-3: NET SALVAGE VALUE Kennedy Air Services is now in the final year of a project. The equipment originally cost $20 million, of which 80% has been depreciated. Kennedy can sell the used equipment today for $5 million, and its tax rate is 40%. What is the equipment's after-tax net salvage value?

12-10: REPLACEMENT ANALYSIS The Dauten Toy Corporation uses an injection molding machine that was purchases 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. Hus, 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-years 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 $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?

13-4: ABANDONMENT OPTION The Scampini Supplies Company recently purchased a new delivery truck. The new truck costs 22,500; and it is expected to generate after-tax cash flows, including depreciation, of $6,250 per year. The truck has a 5-year expected life. The expected year-end abandonment values (salvage values after tax adjustments) for the truck are given here. The company's WACC is 10%.

Year Annual After-Tax Cash Flow Abandonment Value
0 ($22,500) ---------
1 6,250 $17,500
2 6,250 $14,000
3 6,250 $11,000
4 6,250 $5,000
5 6,250 0

a. Should the firm operate the truck until the end of its 5-year physical life; if not, what is the truck's optimal economic life?

b. Would the introduction of abandonment values, in addition to operating, cash flows, ever reduce the expected NPV and / or IRR of a project? Explain.

13-7: REAL OPTIONS Nevada Enterprises is considering buying vacant lot that sell for $1.2 million. If the property is purchased, the company's plan is to spend another $5 million today (t=0) to build a hotel on the property. The after-tax cash flows from the hotel will depend critically on whether he state imposes a tourism tax in this year's legislative session. If the tax is imposed, the hotel is expected to produce after-tax cash flows of $600,000 at the end of each of the next 15 years. If the tax is not imposed, the hotel is expected to produce after-tax cash inflows of 1,200,000 at the end of each of the next 15 years. The project has a 12% WACC. Assume at the outset that the company does not have the option to delay the project.

a. What is the project's expected NPV if the tax is imposed?

b. What is the project's expected NPV if the tax is not imposed?

c. Given that there is a 50% change that the tax will be imposed, what is the project's expected NPV if management proceeds with it today?

d. While the company does not have an option to delay construction, it does have the option to abandon the project 1 year from now if the tax is imposed. If it abandons the project, it will sell the complete property 1 year from now at an expected price of $6 million. Once the project is abandoned, the company will no longer receive any cash inflows from it. Assuming that all cash flows are disconnected at 12%, will the existence of this abandonment option affect the company's decision to proceed with the project today? Explain.

e. Finally, assume that there is no option to abandon or delay the project, but that the company has an option to purchase an adjacent property in 1 year at a price of $1.5 million. If the tourism tax is imposed, he net present value of developing this property (as of t = 1) will be only $300, 000 (so it doesn't make sense to purchase the property for $1.5 million. However, if the tax is not imposed, the net present value of future opportunities from developing the property will be 4 million (as of = 1). Thus, under this scenario, it makes sense to purchase the property for $1.5 million. Assume that these cash flows are discounted at 12% and that the probability that the tax will be imposed is still 50%. How much will the company pay today for the option to purchase this property 1 year from now for $1.5 million?

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