Chapter Review and Self Test Problems

10.1 Capital Budgeting for Project X Based on the following information for Project X, should we undertake the venture? To answer, first prepare a pro forma income statement for each year. Next, calculate operating cash flow. Finish the problem by determining total cash flow and then calculating NPV assuming a 28 percent required return. Use a 34 percent tax rate throughout. For help, look back at our shark attractant and power mulcher examples.

Project X involves a new type of graphite composite in-line skate wheel. We think we can sell 6,000 units per year at a price of $1,000 each. Variable costs will run about $400 per unit, and the product should have a four-year life.

Fixed costs for the project will run $450,000 per year. Further, we will need to invest a total of $1,250,000 in manufacturing equipment. This equipment is seven-year MACRS property for tax purposes. In four years, the equipment will be worth about half of what we paid for it. We will have to invest $1,150,000 in net working capital at the start. After that, net working capital requirements will be 25 percent of sales.

10.2 Calculating Operating Cash Flow Mont Blanc Livestock Pens, Inc., has projected a sales volume of $1,650 for the second year of a proposed expansion project. Costs normally run 60 percent of sales, or about $990 in this case. The depreciation expense will be $100, and the tax rate is 35 percent. What is the operating cash flow? Calculate your answer using all of the approaches (including the top-down, bottom-up, and tax shield approaches) described in the chapter.

10.3 Spending Money to Save Money? For help on this one, refer back to the computerized inventory management system in Example 10.3. Here, we're contemplating a new automatic surveillance system to replace our current contract security system. It will cost $450,000 to get the new system. The cost will be depreciated straight-line to zero over the system's four-year expected life. The system is expected to be worth $250,000 at the end of four years after removal costs.

We think the new system will save us $125,000, before taxes, per year in contract security costs. The tax rate is 34 percent. What are the NPV and IRR on buying the new system? The required return is 17 percent.

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