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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