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.
Multiplechoice 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 upfront cost (t = 0) of $2 million.
The machine will be depreciated on a straightline 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 aftertax 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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 Three '10
 DrKHShim
 Finance, Depreciation, Net Present Value

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