Test Bank Chapter 12 Planning Investments Capital Budgeting

Chapter 12

Planning Investments: Capital Budgeting

MATCHING

1. The capital budgeting process uses the four processes listed below, identify the sequence in which the processes occur starting with 1 and ending with 4.

_____ A. Financing the selected investment.

_____ B. Identifying long-term investment opportunities.

_____ C. Evaluating the investments.

_____ D. Selecting appropriate investment.

2. Match the following terms with the definitions and descriptions below.

A. Capital budgeting

B. Cost of capital

C. Goal incongruence

D. MACRS

E. Net present value

F. Operating leverage

G. Gain on disposal

H. Tax Shield

_____ 1. A condition in which an employee acts in his or her own best interest even if

the action is not in the company’s best interest

_____ 2. An event that reduces a company’s tax liability while not impacting pretax

cash outflows

_____ 3. The proportion of fixed cost associated with a project

_____ 4. Federal tax law on depreciation

_____ 5. When the proceeds of a sale exceed the book value of the asset sold

_____ 6. The rate of return used by a company to determine whether the

expected return on a potential long-term investment is large enough to merit

the acquisition of the investment

_____ 7. The process used for analyzing and selecting long-term investments

_____ 8. A method of evaluating investments that uses the time value of money to

assess whether the investment’s expected rate of return is sufficient to merit its

acquisition

3. Calculating Net Present Value requires the four steps listed below. Identify the sequence in which the steps occur starting with 1 and ending with 4.

_____ A. Calculate the present value of expected future cash flow using the cost of

capital

_____ B. Estimate the amount an timing of future cash flows associated with the

potential investment.

_____ C. Decide on whether or not to make the investment

_____ D. Calculate the Net Present Value

4. The process used for analysis and selection of the long-term investments of a business is called:

A) capital budgeting.

B) financial analysis.

C) operating analysis.

D) financial budgeting.

5. The first step in the capital budgeting process is:

A) evaluating the investments.

B) financing the selected investments.

C) selecting the appropriate investments.

D) identifying long-term investment opportunities.

6. The last step in the capital budgeting process is:

A) identifying long-term investment opportunities.

B) selecting the appropriate investments.

C) financing the selected investments.

D) evaluating the investments.

7. In which of the following steps in the capital budgeting process would net present value be used?

A) Identifying long-term investment opportunities

B) Selecting the appropriate investments

C) Financing the selected investments

D) Evaluating the investments

8. In which of the following steps in the capital budgeting process would sensitivity analysis be used?

A) Identifying long-term investment opportunities

B) Selecting the appropriate investments

C) Financing the selected investments

D) Evaluating the investments

9. Which of the following is the correct order of events in the capital budgeting process?

A) Identifying investment opportunities, selecting investments, financing investments, evaluating investments.

B) Financing investments, identifying investment opportunities, selecting investments, evaluating investments.

C) Identifying investment opportunities, financing investments, selecting investments, evaluating investments.

D) Identifying investment opportunities, evaluating investments, selecting investments, financing investments.

10. All of the following are operational investments except an investment in:

A) corporate bonds.

B) machinery.

C) a building.

D) a patent.

11. Which of the following is an operational investment?

1. Selling the company’s own stock for cash
2. Buying the stock of another company
3. Buying a patent
4. Buying office supplies

12. All of the following are operational investments except:

A) Buying equipment for the company.

B) Buying land with the intent of selling it a higher price in two years.

C) Buying a building for new manufacturing facility.

D) Buying new computers for the company office.

13. Which one of the following is not a reason for making an operational investment?

A) Needing to replace worn-out equipment or facilities

B) Needing to keep up with technological advances

C) Taking advantage of low-interest-rate financing

D) Expanding operating capacity

E) All of the above are reasons to acquire long-term operating investment.

14. A firm’s cost of capital represents all the following except:

A) the weighted average of the cost of both debt and equity financing.

B) the minimum rate that an investment is expected to generate before a company will buy the asset.

C) the cost of the long-term operating assets the firm acquires.

D) the hurdle rate of return.

15. Horizons, Inc. paid $232,500 for a machine shipped FOB shipping point. Freight costs totaled $4,500, the sales tax was $11,300, and installation amounted to $9,800, with an additional $1,600 spent to repair the machine after a worker dropped it during installation. The total cost of the machine for accounting purposes was:

A) $232,500.

B) $248,400.

C) $258,100.

D) $259,700.

16. Ness Corporation purchased a machine with a cost of $100,000 and paid $500 in freight charges and $1,000 to have it installed. Ness failed to take advantage of a $2,000 discount it would have received if it had paid $98,000 cash within 10 days of the purchase. What is the cost of the machine?

1. $98,500
2. $101,500
3. $99,500
4. $98,500

17. Capital investments in operating assets are made:

A) for expansion purposes.

B) to comply with government mandates.

C) to replace unproductive operating assets.

D) all of the above are correct.

18. Capital budgeting is:

A) considered a short-term financing decision.

B) part of long-term organizational planning.

C) a type of short-term operating decision.

D) part of the marketing function.

19. A capital investment generates a satisfactory rate of return when its return is:

A) less than the prime rate.

B) greater than or equal to the firm’s cost of capital.

C) less than the current rate of a low risk corporate bond.

D) greater than or equal to the firm’s preferred stock dividend rate.

20. A capital investment generates a satisfactory rate of return when its return is:

A) greater than or equal to the cost of capital.

B) equal to or less than the cost of capital.

C) less than the cost of capital.

D) greater than the internal rate of return.

21. The weighted average cost of a firm’s debt and equity financing is referred to as the firm’s

A) prime rate.

B) hurdle rate.

C) debt to equity ratio.

D) time-adjusted rate of return.

22. Parker Pacific, Inc. has $2,000,000 in debt and $3,000,000 in stockholders’ equity. If the debt carries an interest rate of 14 percent, and the stockholders are demanding a 15 percent rate of return, Parker’s cost of capital is:

A) 14.2 percent.

B) 14.5 percent.

C) 14.6 percent.

D) 15.0 percent.

23. Calcutta Industries has $4,500,000 in debt and $5,500,000 in stockholders’ equity. If the debt carries an interest rate of 9 percent, and the stockholders are demanding a 16 percent rate of return, Calcutta’s cost of capital is:

A) 12.5 percent.

B) 12.85 percent.

C) 9 percent.

D) 16 percent.

24. Santana Enterprises has $7,000,000 in debt and $18,000,000 in total assets. If the debt carries an interest rate of 9 percent, and the stockholders are demanding a 13 percent rate of return, Santana’s cost of capital is:

A) 11.0 percent.

B) 11.4 percent.

C) 11.8 percent.

D) 13.0 percent.

25. Beijing Corporation has $5,000,000 in debt and $12,500,000 in total assets. If the debt carries an interest rate of 10 percent, and the stockholders are demanding a 17 percent rate of return, Beijing’s cost of capital is:

A) 13.5 percent.

B) 14.2 percent.

C) 14.8 percent.

D) 17.0 percent.

26. The net-present-value method uses a discount rate equal to the:

A) prime rate.

B) firm’s cost of capital.

C) firm’s return on assets.

D) rate of return demanded by stockholders.

27. When calculating net present value of an investment, the present value of the expected future cash flows represents:

A) The market value of the investment.

B) The cost of the investment.

C) The maximum price the firm will pay for the investment given the firm’s cost of capital.

D) The price of the asset at the market rate of interest in effect at that point in time.

28. Under the net-present-value method, if the cost of the asset is less than the present value of the future cash flows,

A) the net-present-value is negative.

B) the investment should not be made.

C) the investment’s expected return is greater than the firm’s cost of capital.

D) the firm’s cost of capital is greater than the rate of return on assets.

29. If the net-present-value of an investment is positive,

A) the purchasing the proposed investment is acceptable.

B) the discount rate is greater than the firm’s cost of capital.

C) the investment’s return is less than the firm’s cost of capital.

D) the cost of the asset is greater than the present value of the future cash flows.

30. If the net-present-value of an investment is positive, which of the following is not true?

A) Purchasing the proposed investment is acceptable.

B) The expected return is greater than the firm’s cost of capital.

C) The expected return is less than the firm’s hurdle rate.

D) The cost of the asset is less than the maximum price the firm is willing to pay for the investment.

31. If the net-present value of an investment is positive, which of the following is true?

1. The net-present-value represents the amount of profit the company will make if it buys the asset.
2. It describes the actual amount of the expected return.
3. It indicates that the return the new asset will generate is expected to exceed the cost of capital.
4. It describes the amount of difference between the expected return and the cost of capital.

32. If the net-present value of an investment is negative, which of the following is true?

A) The negative amount represents the cash the company will lose if it makes the

investment.

B) The negative amount represents the amount the price of the investment must decrease

before the company would consider buying the operational asset.

C) The negative amount represents the difference between actual return and expected

rate of return.

D) The negative amount represents the difference in the expected rate of return and the

cost of capital.

33. Donnelly Company is considering investing in a sizable piece of equipment and their

analysis yielded a positive NPV of $23,500. Which of the following statements is not

true?

A) The new equipment will increase net income by $23,500.

B) Donnelly should buy the machine.

C) The new equipment is likely to generate a return greater than Donnelly’s cost of

capital.

D) The Donnelly Company should recover the cost of the new equipment.

34. If the net-present-value of an investment is negative,

A) The proposed investment should be rejected.

B) The firm’s cost of capital is greater than the discount rate.

C) The investment’s return is greater than the firm’s cost of capital.

D) The cost of the asset is less than the present value of the future cash flows.

35. All the following are part of the capital budgeting process. Which of them is not based on an estimate?

A) Amount of future cash flows

B) Cost of the asset

C) Timing of future cash flows

D) Cost of capital

36. Mega Corp conducted a NPV analysis that resulted in a negative NPV of $1,000. Which of the following statements is true?

A) The investment will reduce Mega’s net income by $1,000.

B) The investment will lose $1,000 over its life.

C) The cash flows from the investment will not exceed its cost.

D) All the statements are false.

37. Northstar, Inc. had sales of $650,000 and operating expenses of $480,000 for the year just ended. Included in the operating expenses was $35,000 of depreciation expense. If Northstar’s income tax rate is 40 percent, its net after-tax cash flows amounted to

A) $102,000.

B) $135,000.

C) $137,000.

D) $170,000.

38. Kaw Inc. had sales of $500,000 and cash operating expenses of $320,000 and depreciation expense of $50,000 for the year just ended. If Kaw’s income tax rate is 40 percent, its net after-tax cash flows amounted to:

A) $108,000.

B) $160,000.

C) $130,000.

D) $128,000.

39. Paderno Inc. had cash sales of $1,300,000 and operating expenses of $825,000 for the year just ended. Included in the operating expenses was $220,000 of depreciation expense with the rest being cash expenses. If Paderno’s income tax rate is 35 percent, its net after-tax cash flows amounted to:

A) $308,750.

B) $528,750.

C) $166,250.

D) $594,750.

40. Pro Care, Inc. sold equipment with a cost of $62,700 and accumulated depreciation of $39,500 for $24,800 cash. If Pro Care’s income tax rate is 30 percent, the after-tax cash inflow from the sale of the equipment was:

A) $25,920.

B) $25,280.

C) $24,800.

D) $24,320.

41. Burke Shoes sold machinery with a cost of $96,300 and accumulated depreciation of $54,200 for $32,500 cash. If Burke’s income tax rate is 30 percent, the after-tax cash inflow from the sale of the machinery was:

A) $39,220.

B) $32,500.

C) $22,750.

D) $35,380.

42. Roadmaster Corporation reported depreciation expense of $345,800 for the year just ended. Assuming a 35 percent income tax rate, the amount of the tax shield created by the depreciation was:

A) $121,030.

B) $224,770.

C) $345,800.

D) cannot be determined from the information given.

43. Ignoring income taxes, the maximum price Forecaster should pay for this machine is:

A) $82,910.

B) $80,364.

C) $65,251.

D) $49,250.

44. Ignoring income taxes, the net-present-value of the investment in the machine is:

A) $(16,500).

B) $(499).

C) $ 14,614.

D) $ 17,160.

45. Ignoring income taxes, Forecaster should:

A) not purchase the machine since the net-present-value is negative.

B) not purchase the machine since the net-present-value is positive.

C) purchase the machine since the net-present-value is negative.

D) purchase the machine since the net-present-value is positive.

46. Ignoring income taxes, the maximum price Briarwood should pay for this equipment is:

A) $110,530.

B) $148,079.

C) $156,600.

D) $191,930.

47. Ignoring income taxes, the net-present-value of the investment in the equipment is:

A) $(41,270).

B) $(3,721).

C) $4,800.

D) $40,130.

48. Ignoring income taxes, Briarwood should:

A) not purchase the equipment since the net-present-value is negative.

B) not purchase the equipment since the net-present-value is positive.

C) purchase the equipment since the net-present-value is negative.

D) purchase the equipment since the net-present-value is positive.

49. Ignoring income taxes, the net-present-value of the investment in the computer is:

A) $(3,791).

B) $(709).

C) $3,500.

D) $10,781.

50. Ignoring income taxes, Union should:

A) not purchase the equipment since the net-present-value is negative.

B) not purchase the equipment since the net-present-value is positive.

C) purchase the equipment since the net-present-value is negative.

D) purchase the equipment since the net-present-value is positive.

51. Which of the following must be estimated in order to compute the net present value of an investment?

A) Cost of capital, future cash flows, and initial cost

B) Cost of capital, future cash flows, and initial cost

C) Initial cost, future cash flows, and residual value

D) Initial cost, future income tax rates, and residual value

52. Which of the following statements about the effect of depreciation on cash flows is correct?

A) It does not affect cash flows because it is a noncash expense

B) It directly increases cash outflows, just like any other expense

C) It decreases cash outflows because it reduces a firm’s income tax liability

D) It affects cash flows only in those cases where an investment produces future revenues

53. If a firm sells an asset at a gain, this indicates that the sales proceeds exceeded the:

A) cost of the asset.

B) fair value of the asset.

C) book value of the asset.

D) accumulated depreciation on the asset.

54. A method for assessing how changes in cash flows and/or cost of capital would affect a investment decision is:

A) capital budgeting.

B) sensitivity analysis.

C) net present value analysis.

D) time-adjusted rate of return analysis.

55. If income taxes are not considered, how are the following used in the computation of the net present value?

A)

B)

C)

D)

56. If net present value is computed using after-tax cash flows, which of following are included in the computation of the net present value?

A)

B)

C)

D)

57. If income taxes are not considered, which of the following is true when computing net present value?

INCLUDE EXCLUDE

A) Depreciation Losses

B) Gains Residual Value

C) Residual Value Losses

D) Disposal Cost Gains

58. Londo Company has a zero net present value based on a 10 percent cost of capital. What is the expected rate of return for this project?

A) 10 percent

B) Less than 10 percent

C) More than 10 percent

D) Unable to determine from the information given

59. After arriving at a positive net present value, you recently presented an investment proposal to the investment committee at your company. The committee directs you to recompute the net present value after adjusting the required rate of return for the higher-than-normal riskiness of the proposal. How would you change the rate of return?

A) Increase it

B) Decrease it

C) Make no change

D) Unable to determine from the information given

60. All things being equal, an increase in the desired rate of return due to risk will do which of the following to a positive net present value?

A) Increase the net present value

B) Decrease the net present value

C) Have no impact on the net present value

D) Unable to determine from the information given.

Answer B Difficulty: Hard

61. After arriving at a positive net present value, you recently presented an investment proposal to the CFO of your company. The CFO remarks that income tax rates are expected to decrease in the next few years. How will a decrease in estimated tax rates affect the net present value?

A) Increase it

B) Decrease it

C) Have no effect

D) Unable to determine from the information given

62. Spivey Corp just conducted an NPV analysis on a $2,000,000 project that resulted in a

negative $1,000 NPV. Which of the following factors might make you reconsider the

decision to reject the investment?

1. The person who forecasted the cash flows is very optimistic when making forecast.
2. The price of the investment might increase.
3. The cost of capital is expected to increase.
4. The period over which the asset is depreciated could be decreased.

63. What are the four reasons a company will make operating investments and how does management know what investments to select?

64. Explain how performance evaluation based on accrual accounting may lead to investment decisions that are not in the best interests of the firm.

65. Explain why both the timing and quantity of cash flows are significant in determining net present value.

66. After computing a net present value that indicated that the return would be in excess of the cost of capital, you presented an investment proposal to the CFO of your company. The CFO notices that you assumed that the cost of the asset would be written off evenly over its economic life. She comments that the firm often uses accelerated depreciation (a method under which more depreciation is recorded in the early years of an asset’s life and less later). How will this change in depreciation methods affect the net present value? Explain.

67. Depreciation expense taken on plant assets does not directly decrease cash. However, depreciation does provide a tax shield. Explain the concept of a tax shield as it relates to depreciation expense.

68. What constitutes sensitivity analysis when using net present value as a tool for selecting investment decisions?

69. Why should qualitative factors be considered in the capital budgeting process?

70. Gfeller Brothers had earnings before interest of $1,650,000 for its most recent year-end. Total debt amounted to $10,600,000 and total assets were $19,800,000. The debt carried an interest rate of 9 percent, while stockholders were demanding an 18 percent rate of return. Ignoring income taxes, determine the firm’s cost of capital.

Answers:

Cost of Capital for Gfeller Brothers is 13.2 percent.

71. Barton Inc. had assets of $15,350,000 and owners’ equity of $4,975,000 at December 31, 2010. Their net income for the year was $750,000 and their interest expense for the year was $830,000. Given the amount of leverage of the firm, the stockholders demanded a 17 percent rate of return. Given this information what is the firm’s cost of capital?

Answers:

Total Debt: $15,350,000 – $4975,000 = $10,375,000

Interest on Debt: $830,000/$10,375,000 = 8%

Cost of Capital for Gfeller Brothers is 10.9 percent.

72. Champion Contractors had earnings before interest of $3,500,000 for its most recent year-end. Total debt amounted to $5,000,000 and total stockholders’ equity was $20,000,000. The debt carried an interest rate of 7 percent, while stockholders were demanding an 15 percent rate of return. Ignoring income taxes, determine the firm’s cost of capital.

Answers:

Cost of Capital for Champion Contractors is 13.4 percent.

73. Weimer Systems, Inc. is considering the purchase of a new machine that will cost the company $350,700. The machine is estimated to have an 8-year life and no salvage value. The machine is expected to generate $81,500 of net cash inflows each year over its useful life. Weimer’s cost of capital is 15 percent. Ignoring income taxes, determine the maximum price Weimer should pay for this machine. What is the net-present-value of the investment in the machine? Should Weimer purchase the machine?

Answers:

$81,500 (PV of annuity: n = 7; i =15%; c = 1) = $365,716

Maximum price to pay = $365,716

Net-present-value = $365,716 – $350,700 = $15,016

Weimer should purchase the machine.

74. Huntel Systems, Inc. is considering the purchase of a new machine that will cost the company $309,700. The machine is estimated to have a 7-year life and no salvage value. The machine is expected to generate $61,500 of net cash inflows each year over its useful life. Huntel’s cost of capital is 12 percent. Ignoring income taxes, determine the maximum price Huntel should pay for this machine. What is the net present value of the investment in the machine? Should Huntel purchase the machine?

Answers:

$61,500 (PV of annuity: n = 7; i =12%; c = 1) = $280,674

Maximum price to pay = $280,674

Net-present-value = $280,674 – $309,700 = $(29,026)

Huntel should not purchase the machine.

75. Standard Corporation is considering the purchase of a new truck that will cost the company $48,780. The truck is estimated to have a 5-year life and no salvage value. The truck is expected to save the company $13,532 of operating costs per year over its useful life. Standard’s cost of capital is 12 percent. Ignoring income taxes, determine the net present value of the truck. Should Standard purchase the truck?

76. Mendocino Company is contemplating the acquisition of a new copier that will cost the company $10,900. The copier is expected to last 6 years, after which it will be discarded. Mendocino’s cost of capital is 9 percent, and the copier is expected to reduce annual cash expenditures by the following amounts:

Ignoring income taxes, determine the net-present-value of the investment in the copier. Should Mendocino purchase the copier?

Answers:

Year 1 FV = $3,000 n = 1, i = 9% PV = $2,752

Year 2 FV = 2,800 n = 2, i = 9% PV = 2,357

Year 3 FV = 2,300 n = 3, i = 9% PV = 1,776

Year 4 FV = 1,900 n = 4, i = 9% PV = 1,346

Year 5 FV = 1,400 n = 5, i = 9% PV = 910

Year 6 FV = 800 n = 6, I = 9% PV = 477

Maximum price to pay for a 9% return $9,618

Net-present value = $9,618 – $10,900 = $(1,282)

Mendocino should not purchase the copier because given the projected cash flow this investment will not generate the 9% return required.

77. Late in 2010, the Spencer K Corporation has projected the pretax cash flows shown below for a dabblemaster that cost $460,000. If Spencer K Corp’s tax rate is 40 percent and its cost of capital is 14 percent. The projected cash flows and depreciation for the dabblemaster are described as follows:

Required:

(A.) Calculate the net present value of the dabblemaster given the pretax cash flows and depreciation described earlier and indicate whether you would recommend purchasing the assets.

(B.) If Spencer K Corp used straight-line depreciation of $94,000 per year for 5 years, would your answer be the same?

Answers:

Tax Shields for the alternative depreciation methods:

Accelerated Depreciation

2011 $180,000 × 0.40 = $72,000

2012 160,000 × 0.40 = 64,000

2013 130,000 × 0.40 = 52,000

Straight-Line Depreciation

$94,000 × 0.40 = $37,600 per year for 5 years

Net Pretax Cash Flows

Present Value given

Cost of Capital (i) = 14%

Given this information Spencer K should buy the dabblemaster.

Impact of Straight-Line Depreciation on Decision

Present Value given

Cost of Capital (i) = 14%

Straight-line depreciation reduced the amount of the net present value creating a negative NPV and, therefore, Spencer K Corp should not acquire the dabblemaster if they use straight-line depreciation and the other cash flows remain the same.

78. At the end of 2010, Bezdek Corporation is planning to buy a new machine for $70,000. The new machine has a useful life of 7 years and is expected to have a salvage value of $5,000. The pretax cash flow and the depreciation for tax purposes are described below. Bezdek’s tax rate is 30 percent and its cost of capital is 15 percent.

Required:

(A) Calculate the net present value for the new machine.

(B) Should Bezdek buy the new machine?

Answers:

(A) After-Tax

Year After-Tax Cash Inflow Tax Shield Cash Flow

2011 (21,500)(1 – 0.3) = 15,050 (20,000)(0.3) = 6,000 $21,050

2012 (25,000)(1 – 0.3) = 17,500 (16,000)(0.3) = 4,800 22,300

2013 (22,000)(1 – 0.3) = 15,400 (14,000)(0.3) = 4,200 19,600

2014 (20,000)(1 – 0.3) = 14,000 (8,000)(0.3) = 2,400 16,400

2015 (19,000)(1 – 0.3) = 13,300 (6,000)(0.3) = 1,800 15,100

2016 (17,500)(1 – 0.3) = 12,250 (4,000)(0.3) = 1,200 13,450

2017 (16,000)(1 – 0.3) = 11,200 (2,000)(0.3) = 600 11,800

Cash from sale of old equipment

Cash from sale $5,000

Book Value 70,000 – 70,000 0__

Gain on Sale $5,000

Gain on Sale $5,000 × Tax Rate 0.4 = Tax on Gain $2,000

Cash from sale $5,000 – Tax on Gain $2,000 =

After-tax cash from disposal of salvage $3,000

Cost of Capital i = 15% (Based on Table Value)

(b.) Bezdek Corporation should buy the new machine because the positive net present value means that it will generate a rate of return that will exceed Bezdek’s 15% cost of capital.

79. The Psychic Cookie Company is considering the purchase of a new machine to produce fortune cookies in January 2010. The fortune cookie machine will cost $270,000 and Psychic’s management expects it to last 6 years. If it purchases the new machine it will sell its old machine with a book value of $20,000 for $25,000 cash. At the end of 6 years the new machine is expected to have no salvage value. Depreciation each year on the fortune cookie machine will be $45,000 and Psychic’s tax rate is 30%. The Pretax cash flows expected from the machine at the end of the following year are:

Required:

(A.) Calculate the net present of the new machine if the cost of capital is 15 percent.

(B.) Indicate whether Psychic should buy the new machine, and explain the basis for your decision (do not use positive or negative NPV as an explanation):

Answers:

After-tax cash flows from depreciation tax shield: ($45,000 × 0.3) = $13,500 per year for 6 years.

After-tax cash flow from the sale of the old machine:

After-Tax

Present Value based on Cost of Capital (i) = 15% (Based on Calculator)

1. Psychic Cookie should buy the new machine because it will generate a rate of return greater than the 15 percent cost of capital. The positive net present value indicates this relationship.

80. The Katrina Corp is considering the purchase of a new machine that produces hurricane proof windows in January 2010. The window machine will cost $300,000 and Katrina’s management expects it to last 6 years. At the end of six years, the new machine is expected to have a zero book value but could be sold for $25,000. Depreciation each year on the window machine will be $50,000 and Katrina’s tax rate is 30 percent. The Pretax cash flows expected from the machine are as follows:

Required:

(A.) Calculate the net present value of the new machine if the cost of capital is 15 percent.

(B.) Indicate whether Katrina should buy the new machine and explain the basis for your decision (do not use positive or negative NPV as an explanation):

Answers:

After-tax cash flows from depreciation tax shield: ($50,000 x 0.3) = $15,000 per year for 6 years.

After-tax cash flow from sale of machine at the end of 6 years:

After-Tax

Present Value based on Cost of Capital (i) = 15% (Based on Calculator)

(B.) Katrina Corporation should not buy the new machine because it will generate a rate of return less than the 15 percent cost of capital. The negative net present value indicates this relationship.