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FINA 2201 Chapter Notes - Chapter 12: Sunk Costs, Cash Flow, Accelerated Depreciation

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lilacmule890
14 Mar 2016
School
Northeastern University
Department
Finance & Insurance
Course
FINA 2201
Professor
Sidi Boubker Drissi Messouak

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Document Summary

We will assume that investments in fixed assets and net operating working capital occur only at t=0. Once the project is completed the company sells the project"s fixed assets and inventory and receives cash: this can be thought of as a negative capital expenditure (cid:1) The price that company receives for a fixed asset at the end of the project is often referred to as its salvage value. The company will have to pay taxes if the asset"s salvage value exceeds its book value (cid:1) (cid:1) (cid:1) (cid:1) (cid:1) (cid:1) (cid:1) The company receives a tax credit if it sells its fixed asset for less than book value. Ideally cash flows should be dealt with on a daily basis: however this is not practical. For this reason we assume cash flows are incurred at the end of the year. Are cash flows that will occur if and only if some specific event occurs.

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Related Questions

Cochrane, Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of $2,670,000. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $2,340,000 in annual sales, with costs of $1,330,000. The project requires an initial investment in net working capital of $169,000, and the fixed asset will have a market value of $194,000 at the end of the project. Assume that the tax rate is 30 percent and the required return on the project is 6 percent. What are the net cash flows of the project for the years 0, 1, 2, and 3? What is the NPV of the project?

Cochrane, Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of $2.49 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $2,280,000 in annual sales, with costs of $1,270,000. The project requires an initial investment in net working capital of $163,000, and the fixed asset will have a market value of $188,000 at the end of the project. Assume that the tax rate is 30 percent and the required return on the project is 8 percent.

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PROBLEM #1: CAPITAL INVESTMENT ANALYSIS Arroyo Company is considering investing in a second manufacturing plant, due its recent growth in sales.

The proposed plant would require an initial cash investment of $600,000.

The plant would have a two-year life.

Forecasted cash revenues and cash costs are:

Cash revenues

Year 1: 235,000 units to be sold at $2.10 each

Year 2: 250,000 units to be sold at $2.25 each

Cash costs

Fixed costs: $120,000 in year #1 and $125,000 in year #2

Variable costs: $.25 per unit in year #1 and $.30 per unit in year #2

Additionally, the project will provide salvage value of $25,000 at the end of year #2. Arroyo Company requires a 10% return on investment.

Required: (Show all work and steps)

1. Calculate the net cash flows for year #1 and year #2. Include the salvage value as a cash receipt at the end of year #2.

2. Compute the present value of net cash flows. Should Arroyo invest in the project?

3. Now, suppose interest rates rise as the Federal Reserve Board raises interest rates to combat inflation. The company now requires a 12% return. Using net present value techniques recalculate the net present value of the project, using a discount rate of 12%. Should Arroyo invest in the project?

4. What do the results of this problem tell you about the effects of rising interest rates on capital investments?