FINANCE-Capital Budgeting – Tax Effects

QUESTION

1. Capital
Budgeting – Tax Effects
You are analyzing a project with a life of 5 years, which
requires an initial investment in equipment and machinery of $10 million. The
equipment is expected to have a 5-year lifetime and no salvage value and to be
depreciated straight line. The project is expected to generate revenues of $ 5
million each year for the 5 years and have operating expenses (not including
depreciation) amounting to 30% of revenues. The tax rate is 40%, and the cost
of capital is 11%.
a. Estimate the after-tax operating
cash flow each year on this project.
b. Estimate the net present value
for this project.
c. How
much of the net present value can be attributed to the tax benefits accruing
from depreciation?
d. Assume
that the firm that takes this project is losing money currently, and expects to
continue losing money for the first 3 years. Estimate the net present value of
this project.

2. Capital Budgeting – Project Evaluation
You have been given the following information on a project:

It has a 5-year lifetime
The initial investment in the
project equipment is $25 million, and will be depreciated straight line,
to a salvage value of $10 million at the end of the fifth year.
The initial investment in
working capital is $2million. Working capital will grow in line with sales;
working capital level is assumed to be 10% of sales.
The revenues are expected to be
$20 million next year and to grow 10% a year after that for the remaining
4 years.
The cost of goods sold,
excluding depreciation, is expected to be 50% of revenues.
The machine can be sold at the
end of the project for $10million.
Assume that 90% of working
capital is recovered.
The tax rate is 40%.
Firm cost of capital is 12%

a)
Should the firm accept this project?

b)
The managers are concerned about the
assumptions provided by their sales, marketing and production departments and
have asked you to perform a scenario analysis for the following
conditions:

Pessimistic

Optimistic

Revenue growth

8%

12%

Cost of Goods Sold

54% of revenues

48% of revenues

3. Replacement
Decision
REFI Ltd. is considering replacing its machine with a more
efficient model.
Replacement Machine

11,500
RO

Cost

8 years

Economic
Life

1,000 RO

Annual
Maintenance (paid at end of year)

2,000 RO

Can
sell at end of life

Current Machine

Selling
Price RO

Annual
Maintenance RO
(paid
at end of year)

Time

4,000

0

2,500

1,000

1

1,500

2,000

2

1,000

3,000

3

0

4,000

4

Assume tax rate is zero. When is it optimal to replace the current
machine?

4. Growth
option – NPV
Parker Inc. is evaluating a new
project (called Project Alpha) that would cost $9 million at t = 0. There is a 50% chance that the project will
be hugely successful and generate annual after-tax cash flows of $6 million
during Years 1, 2, and 3. However, there
is a 50% chance that the project will be less successful and generate only $1
million for each of the 3 years. If the
project is hugely successful, it will open the door to another investment
(called Project Beta) that would require a $10 million outlay at the end of
Year 2. This new investment would then
be sold to another company at a price of $20 million at the end of Year 3. The project’s WACC is 10%.
What is the
project’s expected NPV after taking this growth option into account?

ANSWER:

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