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Chapter 12 - Chapter 12 Solutions to End-of-Chapter...

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Chapter 12 Solutions to End-of-Chapter Problems 12-1 a. Equipment $  9,000,000 NOWC Investment     3,000,000 Initial investment outlay $12,000,000 b. No, last year’s $50,000 expenditure is considered a sunk cost and does not represent  an incremental cash flow.  Hence, it should not be included in the analysis. c. The potential sale of the building represents an opportunity cost of conducting the project in  that building.   Therefore, the possible after-tax sale price must be charged against the  project as a cost. 12-2 a. Operating cash flows:  t = 1 Sales revenues $10,000,000 Operating costs   7,000,000 Depreciation     2,000,000 Operating income before taxes $  1,000,000 Taxes (40%)        400,000 Operating income after taxes $     600,000 Add back depreciation     2,000,000 Operating cash flow $  2,600,000 b. The cannibalization of existing sales needs to be considered in this analysis on an  after-tax basis, because the cannibalized sales represent sales revenue the firm would  realize without the new project but would lose if the new project is accepted.  Thus, the  after-tax effect would be to reduce the firm’s operating cash flow by $1,000,000(1 – T)  = $1,000,000(0.6) = $600,000.  Thus, the firm’s OCF would now be $2,000,000 rather  than $2,600,000. c. If the tax rate fell to 30%, the operating cash flow would change to: Operating income before taxes $1,000,000 Taxes (30%)      300,000 Operating income after taxes $   700,000 Add back depreciation   2,000,000 Operating cash flow $2,700,000 Thus, the firm’s operating cash flow would increase by $100,000.
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12-3 Equipment’s original cost $20,000,000 Depreciation (80%)   16,000,000 Book value $  4,000,000 Gain on sale = $5,000,000 – $4,000,000 = $1,000,000. Tax on gain = $1,000,000(0.4) = $400,000. AT net salvage value = $5,000,000 – $400,000 = $4,600,000. 12-4 a. The applicable depreciation values are as follows for the two scenarios: Scenario 1 Scenario 2 Year (Straight-Line)  (MACRS)     1 $200,000 $264,000 2 200,000 360,000 3 200,000 120,000 4 200,000 56,000 b. To find the difference in net present values under these two methods, we must  determine   the   difference   in   incremental  cash   flows   each   method   provides.     The  depreciation expenses cannot simply be subtracted from each other, as there are tax  ramifications due to depreciation expense. The full depreciation expense is subtracted  from Revenues to get operating income, and then taxes due are computed   Then,  depreciation is added to after-tax operating income to get the project’s operating cash  flow.  Therefore, if the tax rate is 40%, only 60% of the depreciation expense is actually  subtracted   out   during   the   after-tax   operating   income   calculation   and   the   full  depreciation expense is added back to calculate operating income.  So, there is a tax 
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