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Unformatted text preview: lows. Depreciation is a noncash expense, but it is taxdeductible on the income statement. Thus depreciation causes taxes paid, an actual cash outflow, to be reduced by an amount equal to the depreciation tax shield, tcD. A reduction in taxes that would otherwise be paid is the same thing as a cash inflow, so the effects of the depreciation tax shield must be added in to get the total incremental aftertax cash flows. There are two particularly important considerations. The first is erosion. Will the “essentialized” book simply displace copies of the existing book that would have otherwise been sold? This is of special concern given the lower price. The second consideration is competition. Will other publishers step in and produce such a product? If so, then any erosion is much less relevant. A particular concern to book publishers (and producers of a variety of other product types) is that the publisher only makes money from the sale of new books. Thus, it is important to examine whether the new book would displace sales of used books (good from the publisher’s perspective) or new books (not good). The concern arises any time there is an active market for used product. 4. 5. 6. 7. 8. 9. 145 10. Definitely. The damage to Porsche’s reputation is a factor the company needed to consider. If the reputation was damaged, the company would have lost sales of its existing car lines. 11. One company may be able to produce at lower incremental cost or market better. Also, of course, one of the two may have made a mistake! 12. Porsche would recognize that the outsized profits would dwindle as more products come to market and competition becomes more intense. Solutions to Questions and Problems NOTE: All endofchapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic 1. Using the tax shield approach to calculating OCF, we get: OCF = (Sales – Costs)(1 – tC) + tCDepreciation OCF = [($5 × 1,900) – ($2.20 × 1,900)](1 – 0.34) + 0.34($12,000/5) OCF = $4,327.20 So, the NPV of the project is: NPV = –$12,000 + $4,327.20(PVIFA14%,5) NPV = $2,855.63 2. We will use the bottomup approach to calculate the operating cash flow for each year. We also must be sure to include the net working capital cash flows each year. So, the net income and total cash flow each year will be: Year 1 $8,500 1,900 4,000 $2,600 884 $1,716 $5,716 –$16,000 –200 –$16,200 –250 $5,466 Year 2 $9,000 2,000 4,000 $3,000 1,020 $1,980 $5,980 –300 $5,680 Year 3 $9,500 2,200 4,000 $3,300 1,122 $2,178 $6,178 –200 $5,978 Year 4 $7,000 1,700 4,000 $1,300 442 $858 $4,858 950 $5,808 Sales Costs Depreciation EBT Tax Net income OCF Capital spending NWC Incremental cash flow 146 The NPV for the project is: NPV = –$16,200 + $5,466 / 1.12 + $5,680 / 1.122 + $5,978 / 1.123 + $5,808 / 1.124 NPV = $1,154.53 3. Using the tax shield approach to calculating OCF, we get: OCF = (Sales – Costs)(1 – tC) + tCDepreciation OCF = ($2,050,000 – 950,000)(1 – 0.35) + 0.35($2,400,000/3) OCF = $995,000 So, the NPV of the project is: NPV = –$2,400,000 + $995,000(PVIFA12%,3) NPV = 10,177.89 4. The cash outflow at the beginning of the project will increase because of the spending on NWC. At the end of the project, the company will recover the NWC, so it will be a cash inflow. The sale of the equipment will result in a cash inflow, but we also must account for the taxes which will be paid on this sale. So, the cash flows for each year of the project will be: Year 0 1 2 3 Cash Flow – $2,685,000 995,000 995,000 1,426,250 = –$2,400,000 – 285,000 = $995,000 + 285,000 + 225,000 + (0 – 225,000)(.35) And the NPV of the project is: NPV = –$2,685,000 + $995,000(PVIFA12%,2) + ($1,426,250 / 1.123) NPV = $11,777.34 5. First we will calculate the annual depreciation for the equipment necessary for the project. The depreciation amount each year will be: Year 1 depreciation = $2,400,000(0.3330) = $799,200 Year 2 depreciation = $2,400,000(0.4440) = $1,065,600 Year 3 depreciation = $2,400,000(0.1480) = $355,200 So, the book value of the equipment at the end of three years, which will be the initial investment minus the accumulated depreciation, is: Book value in 3 years = $2,400,000 – ($799,200 + 1,065,600 + 355,200) Book value in 3 years = $180,000 The asset is sold at a gain to book value, so this gain is taxable. Aftertax salvage value = $225,000 + ($180,000 – 225,000)(0.35) Aftertax salvage value = $209,250 147 To calculate the OCF, we will use the tax shield approach, so the cash flow each year is: OCF = (Sales – Costs)(1 – tC) + tCDepreciation Year 0 1 2 3 Cash Flow – $2,685,000 994,720 1,087,960 1,333,570 = –$2,400,000 – 285,000 = ($1,100,000)(.65) + 0.35($799,200) = ($1,100,000)(.65)...
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This note was uploaded on 07/10/2010 for the course FIN 6301 taught by Professor Eshmalwi during the Spring '10 term at University of TexasTyler.
 Spring '10
 eshmalwi
 Finance, Corporate Finance

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