risk analysis - (111 Investment Outlay Talbot Industries is...

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(11–1) Investment Outlay Talbot Industries is considering an expansion project. The necessary equipment could be purchased for $9 million, and the project would also require an initial $3 million investment in net operating working capital. The company’s tax rate is 40%. a. What is the initial investment outlay? b. The company spent and expensed $50,000 on research related to the project last year. Would this change your answer? Explain. c. The company plans to house the project in a building it owns but is not now using. The building could be sold for $1 million after taxes and real estate commissions. How would this affect your answer? a. Equipment $ 9,000,000 NWC Investment 3,000,000 Initial investment outlay $12,000,000 b. No, last year’s $50,000 expenditure is considered a sunk cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis. c. The potential sale of the building represents an opportunity cost of conducting the project in that building. Therefore, the possible after-tax sale price must be charged against the project as a cost. (11–2) Operating Cash Flow Cairn Communications is trying to estimate the first-year operating cash flow (at t = 1) for a proposed project. The financial staff has collected the following information: Projected sales $10 million Operating costs (not including depreciation) $ 7 million Depreciation $ 2 million Interest expense $ 2 million The company faces a 40% tax rate. What is the project’s operating cash flow for the first year (t = 1)? Operating Cash Flows: t = 1 Sales revenues $10,000,000 Operating costs 7,000,000 Depreciation 2,000,000 Operating income before taxes $ 1,000,000 Taxes (40%) 400,000 Operating income after taxes $ 600,000 Add back depreciation 2,000,000 Operating cash flow $ 2,600,000 (11–3) Net Salvage Value Allen Air Lines is now in the terminal year of a project. The equipment originally cost $20 million, of which 80% has been depreciated. Carter can sell the used equipment today to another airline for $5 million, and its tax rate is 40%. What is the equipment’s after-tax net salvage value? Equipment's original cost $20,000,000 Depreciation (80%) 16,000,000 Book value $ 4,000,000 Gain on sale = $5,000,000 - $4,000,000 = $1,000,000. Tax on gain = $1,000,000(0.4) = $400,000. AT net salvage value = $5,000,000 - $400,000 = $4,600,000
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(11–4) Replacement Analysis The Chen Company is considering the purchase of a new machine to replace an obsolete one. The machine being used for the operation has both a book value and a market value of zero; it is in good working order, however, and will last physically for at least another 10 years. The proposed replacement machine will perform the operation so much more efficiently that Chen’s engineers estimate it will produce after-tax cash flows (labor savings and depreciation) of $9,000 per year. The new machine will cost $40,000 delivered and installed, and its economic life is estimated to be 10 years. It has zero salvage value. The firm’s WACC is 10%, and its marginal tax rate is 35%. Should Chen buy the new machine?
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