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Capital Budgeting

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Accounting - Relevant cash flows/NPO Terminal Value. See attached file for full problem description.

ABC Company is considering replacing an existing hoist with one of the two newer
more efficient pieces of equipment. The existing hosit is three years old, cost is
$32,000 and is being depreciated under MACRS using a 5 year recovery period.
It has a remaining economic lfie of 5 yrs. With no salvage value. The existing hoist
can currently be sold for $18,000.
Hoist A, one of the two possible replacement hosits, costs $40,000 to purchase and
$8,000 to install. It has a 5 hyr. Economic life and will be depreciated under MACRS
using a 5 yr. recovery period.
Hoist B costs $54,000 to install. It also has a 5 yr. economic life and will be
depreciated under MACRS using a 5 yr. recovery period.
The project Earnings before depreciatio, interest, and taxes for the existing and both
alternativ e hoists are:
EARNINGS BEFORE DEPRECIATION, INTEREST AND TAXES

Year Hoist A Hoist B Existing Hoist
1 21,000 22,000 14,000
2 21,000 24,000 14,000
3 21,000 26,000 14,000
4 21,000 26,000 14,000
5 21,000 26,000 14,000

ABC company is subject to a 40% tax rate for both capital gains and ordinary income.
Here are the questions relevant to the above problem.

a. Calculate the initial investment associated with each investment
b Calcula te incremental operating cash flows associated with each
alternative (be sure to consider the d epreciation in year-6)
c Calculate the NPV associated with each alternative, using a 12% discount rate
d Calculate the IRR associated with each alternative
e Calculate the payback associated with each alternative
f Made a very brief recommendation to the firms' Board of Directors-
What should it do? And why?

Problem number 2
Relevant cash flows-Npo terminal value
CLAc is considering replacing an existing piece of machinery with a more sophisticated
machine. The old machine was purchased 3 years ago at a cost of $50,000 and this
amount was being depreciated under MACRS using a 5 yr. recovery period. The machine
has 5 years of usable life remaining. The new machine that is being consdiered costs
$76,000 and requires $4,000 in installation costs. The new machine would be depreciated
under MACRS using a 5 yr. recovery period. The firm can currently sell the old machine
for $55,000 without incurring any removal ro cleanup costs. The firm is subject to a tax
rate of 40%. The revenues and expenses (excluding depreciation and interest)
associated with the new and the old machines for the next 5 years. Are given in the table
below.
New Machine Old Machine
Year Revenue Expenses Revenue
(excl.depr.&int.
1 750,000 720,000 674,000
2 750,000 720,000 676,000
3 750,000 720,000 680,000
4 750,000 720,000 678,000
5 750,000 720,000 674,000

Based on above information:
1 compute the NPV assuming a 12% discount rate
2 Compute the IRR
3 Compute the Payback period
4 Would you invest in this project? Why/why not?

MACRS: modified accelerated cost recovery system
depreciation methods
NPV: Net Present Value
IRR: Internal Rate of Return
Payback Period: Is the amount of time required for the firm to recover its initial
investment in a project as calculated from cash inflows.
The payback period is generally viewed as an unsophisticated captial
budgeting technique, because it does not explicitly consider
the itme value of money.

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Solution Summary

The solution has two capital budgeting problems - Choosing amoung hoists and replacement of a machine

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See Also This Related BrainMass Solution

Cost of Capital, Capital Budgeting, Capital Structure, Forecasting, and Working Capital Management

Please see attachment use word or excel but please show how you got the answer.

Question 1: (Cost of Capital)

You are provided the following information on a company. The total market value is $38 million. The company's capital structure, shown here, is considered to be optimal.
(see attached file for data)

a. What is the after-tax cost of debt? (assume the company's effective tax rate = 40%)
b. Assuming a $4 dividend paid annually, what is the required return for preferred shareholders (i.e. component cost of preferred stock)? (assume floatation costs = $0.00)
c. Assuming the risk-free rate is 1%, the expected return on the stock market is 7%, and the company's beta is 1.0, what is the required return for common stockholders (i.e., component cost of common stock)?
d. What is the company's weighted average cost of capital (WACC)?

Question 2: (Capital Budgeting)

It's time to decide how to use the money your firm is expected to make this year. Two investment opportunities are available, with net cash flows as follows:
(See attached file for data)

a. Calculate each project's Net Present Value (NPV), assuming your firm's weighted average cost of capital (WACC) is 7%
b. Calculate each project's Internal rate of Return (IRR).
c. Plot NPV profiles for both projects on a graph).
d. Assuming that your firm's WACC is 7%:
(1) If the projects are independent which one(s) should be accepted?
(2) If the projects are mutually exclusive which one(s) should be accepted?

Question 3: (Capital Structure)

Aaron Athletics is trying to determine its optimal capital structure. The company's capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table:
(See attached file for data)

The company's tax rate, T, is 40 percent. The company uses the CAPM to estimate its cost of common equity, Rs. The risk-free rate is 1 percent and the market risk premium is 6 percent. Aaron estimates that if it had no debt its beta would be 1.0. (i.e., its "unlevered beta," bU, equals 1.0.)

On the basis of this information, what is the company's optimal capital structure, and what is the firm's cost of capital at this optimal capital structure?

Question 4: (Forecasting)

A firm has the following balance sheet:
(See attached file for data)

Sales for the year just ended were $6,000, and fixed assets were used at 80 percent of capacity. Current assets and accounts payable vary directly with sales. Sales are expected to grow by 20 percent next year, the expected net profit margin is 5 percent, and the dividend payout ratio is 80 percent.

How much additional funds (AFN) will be needed next year, if any?

Question 5: Working Capital Management

The Chickman Corporation has an inventory conversion period of 60 days, a receivables collection period of 30 days, and a payables deferral period of 30 days. Its annual credit sales are $6,000,000, and its annual cost of goods sold (COGS) is 60% of sales.

a. What is the length of the firm's cash conversion cycle?
b. What is the firm's investment in accounts receivable?
c. What is the company's inventory turnover ratio?
d. Identify three ways in which the company could reduce its cash conversion cycle?
e. What are the possible risks of reducing the cash conversion cycle per your recommendations in part d?

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