The costs of research and development undertaken on the product during the past three years are sunk costs and should not be included in the evaluation of the project. Decisions made and costs incurred in the past cannot be changed. They should not affect the decision to accept or reject the project. d. Annual depreciation expense from the investment. Ans: Yes, the annual depreciation expense must be taken into account when calculating the cash flows related to a given project. While depreciation is not a cash expense that directly affects cash flow, it decreases a firm’s net income and hence lowers its tax bill for the year. Because of this depreciation tax shield, the firm has more cash on hand at the end of the year than it would have had without expensing depreciation. e. Dividend payments by the firm. Ans: No, dividend payments should not be treated as incremental cash flows. A firm’s decision to pay or not pay dividends is independent of the decision to accept or reject any given investment project. For this reason, dividends are not an incremental cash flow to a given project. Dividend policy is discussed in more detail in later chapters. f. The resale value of plant and equipment at the end of the project’s life. Ans:Yes, the resale value of plant and equipment at the end of a project’s life should be treated as an incremental cash flow. The price at which the firm sells the equipment is a cash inflow, and any difference between the book value of the equipment and its sale price will create accounting gains or losses that result in either a tax credit or liability.
FIN 322 Week 2 Tutorial Questions and Answers 8 | P a g e g. Salary and medical costs for production personnel who will be employed only if the project is accepted. Ans:Yes, salary and medical costs for production employees hired for a project should be treated as incremental cash flows. The salaries of all personnel connected to the project must be included as costs of that project. QP: 1. Calculating Project NPV Flatte Restaurant is considering the purchase of a $7,500 soufflé maker. The soufflé maker has an economic life of five years and will be fully depreciated by the straight-line method. The machine will produce 1,300 soufflés per year, with each costing $2.15 to make and priced at $5.25. Assume that the discount rate is 14 percent and the tax rate is 34 percent. Should the company make the purchase? Ans: Using the tax shield approach to calculating OCF, we get: OCF = (Sales – Costs)(1 – tC) + tCDepreciation OCF = [($5.25 × 1,300) – ($2.15 × 1,300)](1 – .34) + .34($7,500 / 5) OCF = $3,169.80 So, the NPV of the project is: NPV = –$7,500 + $3,169.80(PVIFA14%,5) NPV = $3,382.18 QP 3. Calculating Project NPV Down Under Boomerang, Inc., is considering a new three year expansion project that requires an initial fixed asset investment of $1.65 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which it will be worthless. The project is estimated to generate $1.24 million in annual sales, with costs of $485,000. The tax rate is 35 percent and the required return is 12 percent.
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