Chapter 9

Chapter 9
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1. Requirement 1: Fill in the missing numbers in the following income statement (Do not include the dollar signs ($)) : Sales $ 644,100 Costs 345,600 Depreciation 96,300 EBIT $ Taxes (35%) Net income $ Requirement 2: Calculate the OCF. (Do not include the dollar sign ($).) OCF $ Requirement 3: What is the depreciation tax shield? (Do not include the dollar sign ($).) Depreciation tax shield $ Explanation: To find the OCF, we need to complete the income statement as follows: Sales $ 64 4,1 00 Variable costs 34 5,6 00 Depreciatio n 96, 30 0
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EBIT $ 20 2,2 00 Taxes@35% 70, 77 0 Net income $ 13 1,4 30 The OCF for the company is: OCF = EBIT + Depreciation – Taxes OCF = $202,200 + 96,300 – 70,770 OCF = $227,730 The depreciation tax shield is the depreciation times the tax rate, so: Depreciation tax shield = Depreciation(T) Depreciation tax shield = 0.35($96,300) Depreciation tax shield = $33,705 The depreciation tax shield shows us the increase in OCF by being able to expense depreciation. 2. Cochrane, Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of $2.46 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $2,270,000 in annual sales, with costs of $1,260,000. Required: If the tax rate is 35 percent, what is the OCF for this project? (Do not include the dollar sign ($). Enter your answer in dollars, not millions of dollars (e.g., 1,234,567).) OCF $ Explanation: Using the tax shield approach to calculating OCF (Remember the approach is irrelevant; the final answer will be the same no matter which of the four methods you use.), we get:
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OCF = (Sales – Costs)(1 – T) + Depreciation(T) OCF = ($2,270,000 – 1,260,000)(1 – 0.35) + 0.35($2,460,000/3) OCF = $943,500 3. Cochrane, Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of $2.37 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $2,240,000 in annual sales, with costs of $1,230,000. Assume the tax rate is 35 percent and the required return on the project is 10 percent. Required: What is the project’s NPV? (Do not include the dollar sign ($). Negative amount should be indicated by a minus sign. Enter your answer in dollars, not millions of dollars (e.g., 1,234,567). Round your answer to 2 decimal places (e.g., 32.16).) Net present value $ Explanation: Using the tax shield approach to calculating OCF (Remember the approach is irrelevant; the final answer will be the same no matter which of the four methods you use.), we get: OCF = (Sales – Costs)(1 – T) + Depreciation(T) OCF = ($2,240,000 – 1,230,000)(1 – 0.35) + 0.35($2,370,000/3) OCF = $933,000 Since we have the OCF, we can find the NPV as the initial cash outlay, plus the PV of the OCFs, which are an
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