FIN 302- Exam #2 Notes (Madalyn) - Exam 2 Wrap up Chapter 6...

Exam 2
• Wrap up Chapter 6.
• Other Issues:
o What to use: Allocated vs. actual overhead?
 Answer: Use actual
 Overhead that is occurring as a result of your project occurring,
actual overhead just not what the company is going to bill to your
division.
 Actual overhead NOT allocated overhead (proportion of floor space/
factory/ relative size of your facility).
• (Review) taxes from asset sale:
o Initial outlay, change in NWC not subject to taxation.
o Asset sales revenue (at end of project) are taxable…but only the amount of
the capital gain.
• Net Revenue from sale of asset= Sales price-Tc(Sales price- book value)
• In class: Excel capital budgeting: What is Analysis
4) Valuing projects with cash flows of unequal risk: Discount riskless cash
flows by risk free rate, and risky cash flows by risky rate (or WACC if
appropriate).
 Example: Initial outlay: $100,000, no salvage value
 Dep = $20,000 for 5 yrs, riskless cash flow
 Revenues (risky) $60,000 for 5 yrs
 Expenses (risky) $20,000 for 5 yrs
 Expenses (riskless – contracted labor) $10,000 for 5 yrs
 Riskless rate = 5%
 Risky rate = 10%
 Tax rate = 30%
PV
After-
tax PV
0 1 2 3 4 5
-100000 -100000
init
outlay -100000
Revs 60000 60000 60000 60000 60000
227447 159213 PV of rev 54545 49587 45079 40981 37255
Exp (risky) -20000 -20000 -20000 -20000 -20000
-75816 -53071 PV of exp -18182 -16529 -15026 -13660 -12418
Exp (riskless) -10000 -10000 -10000 -10000 -10000
-43295
-
30306.3 PV of exp -9524 -9070 -8638 -8227 -7835
Dep Tax shield 6000 6000 6000 6000 6000
25977 25977 PV of DTS 5714 5442 5183 4936 4701
1

NPV 1813
2

Practice Problems 1: SPROCKETS
Compute the NPV of the following project:
A project to manufacture SPROCKETS is being considered.
a) Initial outlay is $100,000 to be depreciated straight line down to $0 in
10 years. The machine will be sold in year 5 for 50,000 and the
project will end at that time .
b) Revenues are expected to be $50,000 in year 1, and decrease at a rate
of 5% per year.
c) Variable expenses associated with the project are expected to be 20%
of sales (revenues) for each year.
d) Working capital will increase by $15,000 at time 0, increase by
another $13,000 in year 1, and decrease by $28,000 at the end of 5
years.
e) This project will decrease the sales revenue of the WIDGET division
by $10,000 (before tax) per year but will increase sales of the
GADGET division by $20,000 per year (before tax). All expenses
associated with these divisions will remain unchanged.
f) The Sprocket project will be funded with a $100,000, 10% bond issue.
g) The firm discounts risky cash flows by the risky rate, and riskless cash
flows by the risk free rate of 5%. The depreciation tax shield is the
only riskless cash flow.
h) The corporate tax rate is 30%
i) If the project is accepted , the firm will hire consultants to decide how
to market the SPROCKETS, at a cost of $4000 in year 1 (before tax)
j) The firm’s WACC is 12%. The above project is of average risk to the
firm.
3

Practice problem 2: Compute the NPV of the following project to make WIDGETS. The project
will involve the following outlays:
A) A $25,000 study conducted last month determined that the Widgets project will produce annual
revenues of $600,000 , and require annual variable costs estimated at 1/3 rd of sales. Revenues will
increase at the rate of inflation of 5% per year . (I.e., the second year of revenues will be 5% greater than