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week07_TutorialQuestions

# week07_TutorialQuestions - SCHOOL OF BANKING AND FINANCE...

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FINS 1613 Tutorial Answers 1 SCHOOL OF BANKING AND FINANCE FINS1613 BUSINESS FINANCE Semester 2, 2010 TUTORIAL QUESTIONS WEEK 7 – Capital Budgeting Applications II Please note that some answers are exact when rounded to 2 or 3 decimal places because of the use of PV tables rather than calculators. Multiple-choice Questions 1. Consider the following proposal to enter a new line of business: The new business will require the company to purchase additional fixed assets that will cost \$600,000 at t = 0. For tax and accounting purposes, these costs will be depreciated on a straight- line basis over three years. (Annual depreciation will be \$200,000 per year at t = 1, 2, and 3.). At the end of three years, the company will get out of the business and will sell the fixed assets at a salvage value of \$100,000. The project will require a \$50,000 increase in net operating working capital at t = 0, which will be recovered at t = 3. The company's marginal tax rate is 35 percent. The new business is expected to generate \$2 million in sales each year (at t = 1, 2, and3). The operating costs excluding depreciation are expected to be \$1.4 million per year. The project's cost of capital is 12 percent. What is the project's net present value (NPV)? a. \$536,697 b. \$ 86,885 c. \$ 81,243 d. \$ 56,331 e. \$561,609

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FINS 1613 Tutorial Answers 2 2. (Note: You may or may not need to use all of this information, use only relevant information.) Mr Suds is considering introducing a new detergent. The firm has collected the following information about the proposed product from various divisions within the firm and through a market research survey that cost \$45,000. The project has an anticipated economic life of 4 years. The company will have to purchase a new machine to produce the detergent. The machine has an up-front cost (t = 0) of \$2 million. The machine will be depreciated on a straight-line basis over 4 years (that is, the company's depreciation expense will be \$500,000 in each of the first four years (t = 1, 2, 3, and 4). The company anticipates that the machine will last for four years, and that after four years, its salvage value will equal zero. If the company goes ahead with the proposed product, it will have an effect on the company's net operating working capital. At the outset, t = 0, inventory will increase by \$140,000 and accounts payable will increase by \$40,000. At t = 4, the net operating working capital will be recovered after the project is completed. The detergent is expected to generate sales revenue of \$1 million the first year (t = 1), \$2 million the second year (t = 2), \$2 million the third year (t = 3), and \$1 million the final year (t=4). Each year the operating costs (not including depreciation) are expected to equal 50 percent of sales revenue. The company's interest expense each year will be \$100,000. The new detergent is expected to reduce the after-tax cash flows of the company's existing products by \$250,000 a year (t = 1, 2, 3, and 4). The company's overall WACC is 10 percent. However, the proposed project is riskier than the average project for Parker; the project's WACC is estimated to be 12 percent. The company's tax rate is 40 percent. What is the net present value of the proposed project?
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week07_TutorialQuestions - SCHOOL OF BANKING AND FINANCE...

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