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CHAPTER 10
Making Capital Investment Decisions
1.
(LO1)
The $5 million acquisition cost of the land six years ago is a sunk cost. The $5.3 million current aftertax value of the land is
an opportunity cost if the land is used rather than sold off. The $11.6 million cash outlay and $425,000 grading expenses are the
initial fixed asset investments needed to get the project going. Therefore, the proper year zero cash flow to use in evaluating this
project is
$5,300,000 + 11,600,000 + 425,000 = $17,325,000
2.
(LO1)
Sales due solely to the new product line are:
19,000($12,000) = $228,000,000
Increased sales of the motor home line occur because of the new product line introduction; thus:
4,500($45,000) = $202,500,000
in new sales is relevant. Erosion of luxury motor coach sales is also due to the new midsize campers; thus:
900($85,000) = $76,500,000 loss in sales
is relevant. The net sales figure to use in evaluating the new line is thus:
$228,000,000 + 202,500,000 – 76,500,000 = $354,000,000
3.
(LO1)
We need to construct a basic income statement. The income statement is:
Sales
$ 740,000
Variable costs
444,000
Fixed costs
173,000
Depreciation
75,000
EBT
$
48,000
Taxes@35%
16,800
Net income
$
31,200
4.
(LO3)
To find the OCF, we need to complete the income statement as follows:
Sales
$ 876,400
Costs
547,300
Depreciation
128,000
EBIT
$ 201,100
Taxes@34%
68,374
Net income
$ 132,726
The OCF for the company is:
OCF = EBIT + Depreciation – Taxes
OCF = $201,100 + 128,000 – 68,374
OCF = $260,726
The depreciation tax shield, also called the CCA tax shield, is the depreciation times the tax rate, so:
Depreciation tax shield = t
c
Depreciation
Depreciation tax shield = .34($128,000)
Depreciation tax shield = $43,520
The depreciation tax shield shows us the increase in OCF by being able to expense depreciation.
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5.
(LO3)
To calculate the OCF, we first need to calculate net income. The income statement is:
Sales
$ 96,000
Variable costs
49,000
Depreciation
4,500
EBT
$ 42,500
Taxes@35%
14,875
Net income
$ 27,625
Teaching note: focus on the first approach and the tax shield approach.
Using the most common financial calculation for OCF, we get:
OCF = EBIT + Depreciation – Taxes
OCF = $42,500 + 4,500 – 14,875
OCF = $32,125
The topdown approach to calculating OCF yields:
OCF = Sales – Costs – Taxes
OCF = $96,000 – 49,000 – 14,875
OCF = $32,125
The taxshield approach is:
OCF = (Sales – Costs)(1 – t
C
) + t
C
Depreciation
OCF = ($96,000 – 49,000)(1 – .35) + .35(4,500)
OCF = $32,125
And the bottomup approach is:
OCF = Net income + Depreciation
OCF = $27,625 + 4,500
OCF = $32,125
All four methods of calculating OCF should always give the same answer.
6.
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 Spring '11
 dr.lee

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