MGFB10H3 Study Guide - Final Guide: Sunk Costs, Net Present Value, Opportunity Cost

Applying GAAP to Record Assets

Complete both sections 1 and 2.

1. Recording Assets

A. Smith Company has developed a computerized machine to assist in the production of appliances. It is anticipated that the machine will do well in the marketplace; however, the company lacks the necessary capital to produce the machine. Roseline Rowland, secretary-treasurer of Smith Company, has offered to transfer land to the company to be used as collateral for a bank loan. In exchange for the land transfer, Roseline will receive a five-year employment contract and a percentage of any profits earned from sales of the new machine. The title to the land is to be transferred unconditionally. If Smith defaults on the employment contract, a lump sum cash settlement for lost wages will be paid to Roseline. The land transfer may be a good business move, but it raises a number of questionable accounting issues. Smith’s controller has given you the task of writing a detailed report that summarizes the options available in accounting for the land transfer. Your report should outline the arguments both for and against recording the land as an asset on Smith’s books. Also, discuss how the land should be valued if it is recorded as an asset.

B. Two college students, Elizabeth Stephens and Rachel Marcus, organized Concept, Inc. Elizabeth and Rachel both used the internet extensively while in high school and became very proficient web surfers. Elizabeth has a special ability for designing web- based games that challenge the reasoning power of players. Rachel saw great potential in marketing Elizabeth’s products to other web users, and so the two began Concept. Sales have exceeded expectations, and they have added 10 employees to their company to design additional products, debug new programs, and produce and distribute the final software products. Because of its growing size, increased capital is needed for the company. The partners decide to apply for a $100,000 loan to support the growing cost of research. As part of the documentation to obtain the loan, the bank asks for audited financial statements for the past year. The company hired Timothy Pressly, CPA, to prepare the statements. Concept had produced a preliminary income statement that reported net income of $35,000. After reviewing the statement, Pressly indicates that the company actually had a $10,000 loss for the year. The major difference relates to $45,000 of wage and material costs that Concept had capitalized as an intangible asset, but that Pressly determined should be expensed.

The partners are confused because they thought they were applying the matching principle. Pressly allowed capitalization of the equipment but not the web development costs. The partners are worried that the loss calculated is unjustified and that they will not be profitable under “Pressly’s requirements.” What major issues are involved in this case? Which position best reflects GAAP?

2. Asset Write-Downs

Professor Linda DeAngelo (1988) found evidence suggesting that when management of a company is ousted under fire, the new management tends to take an earnings “bath” after gaining control. A “bath” is a large reduction in earnings due to asset write-downs, reorganization charges, discontinuance of segments, and other extraordinary charges.

What reasons could new management of a company have for wanting to “take a bath” in its first year?

Your well-written paper must be 2 to 3 pages in length.

Matrix Printers, Inc. is considering entering the laser printing business. An entirely new plant will be needed which will cost $1,500,000. Land for the plant will cost an additional $250,000. Both of these costs will be incurred immediately. The plant will be depreciated straight line over its 15 year life. (Remember the rule about depreciating land.) In addition to these costs an investment of $100,000 will be needed for working capital. The plant will generate sales of $300,000 per year and have associated expenses of $175,000. The firms marginal tax rate is 34%. The plant will be sold in 15 years for $700,000. What is the NPV of making this investment if the required rate of return is 16%. Should they make the investment?

International Soup Company is considering replacing a canning machine. The old machine is being depreciated by the straight-line method over a 10-year recovery period from a depreciable cost basis of $120,000. The old machine has 5 years of remaining usable live, at which time its salvage value is expected to be zero, and it can be sold now for $40,000. This machine has a current book value of $60,000.

The purchase price of the new machine is $250,000 and it will have shipping and installation costs of $12,500. It has a 5-year life and an expected salvage value of $25,000. Annual savings of electricity, labor and materials from use of the new machine are estimated at $40,000. The new machine will require an additional inventory of spare parts of $30,000. The company is in a 40 percent tax bracket, and its cost of capital is 16 percent. The machine will be depreciated straight line over its five-year life. What should the firm do? Show your work.

You have been asked by the president of your company to evaluate the proposed acquisition of a new special-purpose truck. The truck’s basic price is $50,000 and it will cost another $10,000 to modify it for special use by your firm. The truck falls into a five-year depreciation class and will be depreciated to zero over the five-year period. The truck is actually expected to be sold for $20,000 after three years when the project is ended. Use of the truck will require an increase in net working capital of $2,000 (spare parts). The truck will have no effect on revenue, but it is expected to save the firm $22,000 per year in before-tax operating costs, mainly labor. The firms marginal tax rate is 40 percent and the required rate of return on the project is 13 percent. What should you do?

Blue Note Jazz Productions has decided to cash in on the country craze by starting a subsidiary that will promote concerts by "Country Jazz" artists for the next three years. The country music boom is expected to subside by this time and the subsidiary will be folded. Blue Note expects that average ticket prices will be $35 and that ticket sales for the three years will be 300,000 tickets per year. Fixed cost each year are expected to be $3,000,000 and variable costs are expected to be 25% of sales. The subsidiary will need $4,000,000 in new equipment to start up and requires a $300,000 investment in working capital. The $4,000,000 in equipment will be depreciated straight-line over five years to a zero salvage value, but will be sold at the end of three years for an estimated $1,500,000. The firm's marginal tax rate is 40%. What is the NPV of this new investment if the firm's required rate of return is 12%? What is the IRR? Should the project be accepted?

F1 Q6-Q10

Please show all workings/give explanations

Note: Questions 6 – 10 are based on the same mega problem. For convenience

we have included the entire set of information in every question. For purposes

of the questions that follow, assume that changes in working capital are

negligible and capex and depreciation are of the same magnitude and therefore

cancel each other. This is the assumption we made in most of the videos to

focus on valuation effects of borrowing and taxes and to figure out the key differences between alternative valuation methods.

XYZ, Inc.’s revenues have been $500,000 and total costs have been $250,000;

both costs and revenues are expected to remain the same in perpetuity. XYZ,

Inc. is an all equity firm (i.e., it has no debt) and has 125,000 shares outstanding.

The market knows that the company has no other investment (or growth)

opportunities. XYZ, Inc. currently pays out all its earnings as dividends (100%

payout) and is expected to do so forever. The dividends on the basis of last

year’s earnings have just been paid out. If the appropriate discount rate for XYZ,

Inc. is 7.50%, For this question, assume taxes are zero. (Enter the number with up to two decimals but without any $ or comma sign.)

Q6 What is the price per share of XYZ, Inc.?

Q7 What is the price-to-earnings ratio?

XYZ, Inc.’s revenues have been $500,000 and total costs have been $250,000;

both costs and revenues are expected to remain the same in perpetuity. XYZ,

Inc. is an all equity firm (i.e., it has no debt) and has 125,000 shares outstanding.

The market knows that the company has no other investment (or growth)

opportunities. XYZ, Inc. currently pays out all its earnings as dividends (100%

payout) and is expected to do so forever. The dividends on the basis of last

year’s earnings have just been paid out. The appropriate discount rate for XYZ,

Inc. is 7.50%. The CEO of XYZ, Inc. has a very exciting plan to make her company

look more attractive to investors. She suggests to her CFO that if the firm issues

$2.50M debt in perpetuity with a return of 5%, and uses this debt to repurchase

some of the shares of the company, it will make the firm more attractive to

acquirers. The CFO is skeptical of the CEO’s plan and argues with her about the

logic behind it. Frustrated with her CFO’s argumentative stance, the CEO finally

simply states: “I do not have to convince you, Gautam, especially since my plan

is fool proof. My debt-based strategy will make our company attractive to any

acquirer because it will lower our price-earnings ratio and, consequently, make

them offer us a lot more money for our assets than they would otherwise.” Is

the CEO correct in believing that the price-earnings ratio of XYZ, Inc. will drop?

For this question, assume taxes are zero.

Q8 Is the CEO correct in believing that the price-earnings ratio of XYZ, Inc. will drop?

Yes

No

It depends

Q9 What will be the new price-earnings ratio of XYZ?

Q10 What will the value of the firm be?

3,000,000

2,333,333

3,333,333

None of the above