Ch 12-1 Tuesday, April 17, 2007 Soln.

1. Truman industries is considering an expansion. The necessary equipment would be

purchased for $9 million, and it would also an additional $3 million investment in
working capital. The tax rate is 40 percent.
a. what is the initial investment outlay?
b. The company spent and expensed $50,000 on research related to the project last year.
Would this change your answer? Explain.
c. The company plans to use a building it owns but is not now using to house the project.
The building could be sold for $ 1 million after taxes and real estate commissions. How
could that affect your answer?
a. Equipment
$ 9,000,000
NOWC Investment
3,000,000
Initial investment outlay
$12,000,000
b. No, last years $50,000 expenditure is considered a sunk cost and
does not represent
an incremental cash flow. Hence, it should not be included in the
analysis.
c. The potential sale of the building represents an opportunity cost of
conducting the project in that building. Therefore, the possible after-tax
sale price must be charged against the project as a cost.
2. Eisenhower communications is trying to estimate the first-year net
operating cash flow (at year 1) for a proposed project. The financial
staff has collected the following information on the project:
Sales revenue
$10 million
Operating costs (excluding depreciation)
$ 7 million
Depreciation
$ 2 million
Interest expense
$ 2 million
The company has a 40 percent tax rate, and its WACC is 10 percent
a. What is the projects operating cash flow for the first year?
b. If this project would cannibalize other projects by $1 million of
cash flow before taxes per year. How would this change your
answer to part a?
c. Ignore part b. if the TR dropped to 30%, how would that change
your answer to part a?

a.
b. b. The cannibalization of existing sales needs to be considered in
this analysis on an
after-tax basis, because the cannibalized sales represent sales revenue
the firm would
realize without the new project but would lose if the new project is
accepted. Thus,
the after-tax effect would be to reduce the firms operating cash flow
by $1,000,000(1
T) = $1,000,000(0.6) = $600,000. Thus, the firms OCF would now be
$2,000,000
rather than $2,600,000.
c.

3. Huang Industries is considering a proposed project whose estimated

NPV is $12 million. This estimate assumes that economic conditions
will be average, however the CFO realizes that conditions could be
better or worse, so she performed a scenario analysis and obtained
these results:
Economic scenario
Prob. Of outcome
Recession
0.05
$70
Below average
0.20
mil
Average
0.50
$12
Above average
0.20
$20
Boom
0.05
$30
Calculate the projects expected NPV, Std. deviation, and CV

NPV
mil
$25
mil
mil
mil

4. Kennedy air services is now in the final year of a project. The equipment originally
cost $20 million, of which 80% has been depreciated. Kennedy can sell the used
equipment today for $5 mil and its TR is 40%. What is the equipments after-tax net
salvage value?