15 May QuestionDiscussion Questions12-1.What are the important administrative c
Question
Discussion Questions
| 12-1. | What are the important administrative considerations in the capital budgeting process? | |
| 12-3. | What are the weaknesses of the payback method? | |
| 12-5. | What does the term mutually exclusive investments mean? | |
| 12-6. | How does the modified internal rate of return include concepts from both the traditional internal rate of return and the net present value methods? | |
| 12-7. | If a corporation has projects that will earn more than the cost of capital, should it ration capital? | |
| 12-8. | What is the net present value profile? What three points should be determined to graph the profile? | |
| 12-9. | How does an asset’s ADR (asset depreciation range) relate to its MACRS category? | |
Problems
1. Assume a corporation has earnings before depreciation and taxes of $90,000, depreciation of $40,000, and that it is in a 30 percent tax bracket. Compute its cash flow using the format below.
Earnings before depreciation and taxes _____
Depreciation _____
Earnings before taxes _____
Taxes @ 30% _____
Earnings after taxes _____
Depreciation _____
Cash flow _____
2. a. In problem 1, how much would cash flow be if there were only $10,000 in depreciation? All other factors are the same.
b. How much cash flow is lost due to the reduced depreciation between problems
1 and 2a?
3. Assume a firm has earnings before depreciation and taxes of $200,000 and no depreciation. It is in a 40 percent tax bracket.
a. Compute its cash flow.
b. Assume it has $200,000 in depreciation. Recompute its cash flow.
c. How large a cash flow benefit did the depreciation provide?
4. Bob Cole, the president of a New York Stock Exchange-listed firm, is very short term oriented and interested in the immediate consequences of his decisions. Assume a project that will provide an increase of $3 million in cash flow because of favorable tax consequences, but carries a three-cent decline in earning per share because of a write-off against first quarter earnings. What decision might Mr. Cole make?
5. Assume a $100,000 investment and the following cash flows for two alternatives.
| Year | Investment A | Investment B |
| 1 | $30,000 | $40,000 |
| 2 | 50,000 | 30,000 |
| 3 | 20,000 | 15,000 |
| 4 | 60,000 | 15,000 |
| 5 | — | 50,000 |
Which of the two alternatives would you select under the payback method?
6. Assume a $40,000 investment and the following cash flows for two alternatives.
| Year | Investment X | Investment Y |
| 1 | $ 6,000 | $15,000 |
| 2 | 8,000 | 20,000 |
| 3 | 9,000 | 10,000 |
| 4 | 17,000 | — |
| 5 | 20,000 | — |
Which of the alternatives would you select under the payback method?
7. Referring back to problem 6, if the inflow in the fifth year for Investment X were $20,000,000 instead of $20,000, would your answer change under the payback method?
8. The Short-Line Railroad is considering a $100,000 investment in either of two companies. The cash flows are as follows:
| Year | Electric Co. | Water Works |
| 1……………… | $70,000 | $15,000 |
| 2……………… | 15,000 | 15,000 |
| 3……………… | 15,000 | 70,000 |
| 4-10…………. | 10,000 | 10,000 |
a. Using the payback method, what will the decision be?
b. Explain why the answer in part a can be misleading.
9. X-treme Vitamin Company is considering two investments, both of which cost $10,000. The cash flows are as follows:
| Year | Project A | Project B |
| 1………………. | $12,000 | $10,000 |
| 2………………. | 8,000 | 6,000 |
| 3………………. | 6,000 | 16,000 |
a. Which of the two projects should be chosen based on the payback method?
b. Which of the two projects should be chosen based on the net present value method? Assume a cost of capital of 10 percent.
c. Should a firm normally have more confidence in answer a or answer b?
10. You buy a new piece of equipment for $16,980, and you receive a cash inflow of $3,000 per year for 12 years. What is the internal rate of return?
11. Warner Business Products is considering the purchase of a new machine at a cost of $11,070. The machine will provide $2,000 per year in cash flow for eight years. Warner’s cost of capital is 13 percent. Using the internal rate of return method, evaluate this project and indicate whether it should be undertaken.
12. Elgin Restaurant Supplies is analyzing the purchase of manufacturing equipment that will cost $20,000. The annual cash inflows for the next three years will be:
| Year | Cash Flow |
| 1……………. | $10,000 |
| 2……………. | 9,000 |
| 3……………. | 6,500 |
a. Determine the internal rate of return using interpolation.
b. With a cost of capital of 12 percent, should the machine be purchased?
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