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Problems 201 Key Terms break-even p. 196 break-even analysis p. 196 canibalization p. 183 capital budget p. 178 capital budgeting p. 178 depreciation...

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Key Terms break-even p. 196 break-even analysis p. 196 canibalization p. 183 capital budget p. 178 capital budgeting p. 178 depreciation tax shield p. 189 EBIT break-even p. 197 free cah flow p. 186 incremental earnings p. 178 MACRS depreciation p. 192 marginal corporate tax rate p. 181 Further Reading Problems 201 opportunity cost p. 182 overhead expenses p. 184 project externalities p. 182 scenario analysis p. 198 sensitivity analysis p. 197 straight-line depreciation p. 180 sunk cost p. 184 tax loss caryorwards and carrybacks p. 195 terminal (continuation value) p. 194 trade credit p. 187 unlevered net income p. 181 For an excellent overview of the history of the concept of present value and its use in capital budgeting, see M. Rubinstein, "Great Moments in Financial Economics: 1. Present Value," Journl of Investment Management (First Quarter 2003). Irving Fisher was one of the first to apply the Law of One Price to propose that any capital project should be evauated in terms of its present value; see 1. Fisher, The &te of Interest: Its Nature, Deterination and Relation to Economic Phenomena (New York: Macmillan, 1907). L Fisher, The Theory of Interet: As Detrmined by Impatience to Spend Income and Opportnity to Invest It (New York: Macmilan, 1930); reprinted (New York: Auguni M. Kelley, 1955). The use of this approach for capital budgeting was later popularized in the following book: J. Dean. Capital Budgeting (New York: Columbia Universiry Press, 1951). We will revisit the topics of this chapter in greater depth in Par VI of this book- Additional readings for more advanced topics will be provided there. Problems All proble in this chapter are available in MyFinanceLab. An asterisk (') indicates proble with a higher leel of difculty. Forecasting Earnings 1. Pisa Pizza, a seller of frozen pizza, is considering introducing a healther version of its pizz that will be low in cholesterol and contain no trans fats. The firm expects that sales of the new pizza wil be $20 million per year. While many of these sales will be to new customers, Pisa Pizz estimates that 40% will come from customers who switch to the new, healthier pizza instead of buying the original version. a. Assume customers will spend the same amount on either version. What level of incre- mental sales is associated with introducing the new pizza? b. Suppose that 50% of the customers who will switch from Pisa Pizza's original pizz to its healthier pizza will switch to another brand if Pisa Pizza does not introduce a healthier piz. 'Wat level of incremental sales is associated with introducing the new pizza in this cae?
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202 Chapter 7 Fundamentals of Capita. Budgeting 2. Kokomochi is considering the launch of an advertising capaign for its latest dessert product, the Mini Mochi Munch. Kokomochi plans to spend $S million on TV, radio, and print adver- tising this year for the campaign. The ads are expected to boost sales of the Mini Mochi Munch by $9 milion this year and by $7 milion next year. In addition, the company expects that new consumers who try the Mini Mochi Munch will be more likely to try Kokomochi's other products. A5 a result, sales of other product are expected to rise by $2 milion each year. Kokomochi's gross profit margin for the Mini Mochi Munch is 3S%, and its gross profit margin averages 2S% for all other products. The company's marginal corporate tax rate is 3S% both this year and next year. What are the incremental earnings associated with the advertising capaign? 3. Home Builder Supply, a retailer in the horne improvement industry, currently operates seven retai outlets in Georgia and South Carolina. Management is contemplating building an eighth retai store across town from its most successful retail outler. The company aleady owns the land for this store, which currently has an abandoned warehouse located on it. Lat month, the marketing department spent $10,000 on market research to determine the extent of customer demand for the new store. Now Home Builder Supply must decide whether to build and open the new store. Which of the following should be included as part of the incremental earnings for the pro- posed new retail store? a. The cost of the land where the store wil be located. b. The cost of demolishing the abandoned warehouse and clearing the lor. c. The loss of sales in the existing retail outlet, if customers who prevously drove across town to shop at the existing outlet become customers of the new store instead. d. The $10,000 in market research spent to evaluate customer demand. e. Construction costs for the new store. f. The value of the land if sold. g. Interest expense on the debt borrowed to pay the construction costs. 4. Hyperion, Inc., currently sells its latest high-speed color printer, the Hyper sao, for $3S0. It plans to lower the price to $300 next year. Its cost of goods sold for the Hyper 500 is $200 per unit, and this year's sales are expected to be 20,000 units. a. Suppose that if Hyperion drops the price to $300 immediately, it ca increase this year's sales by 25% to 25,000 units. What would be the incremental impact on this year's EBIT of such a price drop? b. Suppose that for each printer sold, Hyperion expects additional sales of $75 per year on ink cartridges for the next three years, and Hyperion has a gross profit margin of 70% on ink caridges. What is the incremental impact on EBIT for the next three years of a price drop this year? 'l 5. Castle View Games would like to invest in a division to develop softare for video games. To evaluate this decision, the firm first attempts to project the working capital needs for this operation. Its chief financial offcer has developed the following estimates (in milions of dollars): Yea 1 Yea 2 Yea 3 Year 4 Yea 5 Cash G 12 15 15 15 Accounts receivable 21 22 24 24 24 Inventory 5 7 10 12 13 Accounts payable 18 22 24 25 30
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