a. -$15,394 b. -$14,093 c. -$58,512 d. -$21,493 e. -$46,901 [MACRS table required] (13.2) New project NPV Answer: b Diff: M 63 . Stanton Inc. is considering the purchase of a new machine which will reduce manufacturing costs by $5,000 annually and increase earnings be- fore depreciation and taxes by $6,000 annually. Stanton will use the MACRS method to depreciate the machine, and it expects to sell the ma- chine at the end of its 5-year operating life for $10,000 before taxes. Stanton's marginal tax rate is 40 percent, and it uses a 9 percent cost of capital to evaluate projects of this type. If the machine's cost is $40,000, what is the project's NPV? a. $1,014 b. $2,292 c. $7,550 d. $ 817 e. $5,040 Page 16 Chapter 13: Capital Budgeting: Cash Flows and Risk
(13.2) New project NPV Answer: c Diff: M 64 . Parker Products manufactures a variety of household products. The com- pany is considering introducing a new detergent. The company’s CFO has collected the following information about the proposed product. (Note: You may or may not need to use all of this information, use only the information that is relevant.) ∙ The project has an anticipated economic life of 4 years. ∙ The company will have to purchase a new machine to produce the de- tergent. 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 af- ter 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 out- set, t = 0, inventory will increase by $140,000 and accounts payable will increase by $40,000. At t = 4, the net operating working capi- tal 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 mil- lion the third year (t = 3), and $1 million the final year (t = 4). Each year the operating costs (not including depreciation) are ex- pected 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 $250,000 a year (t = 1, 2, 3, and 4). ∙ The company’s overall WACC is 10 percent. However, the proposed project is riskier than the average project for Parker; the project’s WACC is estimated to be 12 percent. ∙ The company’s tax rate is 40 percent. What is the net present value of the proposed project? a. -$ 765,903.97 b. -$1,006,659.58 c. -$ 824,418.62 d. -$ 838,997.89 e. -$ 778,583.43 Chapter 13: Capital Budgeting: Cash Flows and Risk Page 17
(13.6) Risky projects Answer: d Diff: M 65 . Cochran Corporation has a weighted average cost of capital of 11 per- cent for projects of average risk. Projects of below-average risk have a cost of capital of 9 percent, while projects of above-average risk have a cost of capital equal to 13 percent. Projects A and B are mutu- ally exclusive, whereas all other projects are independent. None of the projects will be repeated.
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