Tutorial Problem Set 6

Problem 1

Down Under Boomerang Inc., is considering a new 3-year expansion that requires an
initial fixed asset investment of $1.42 million. The fixed asset will be depreciated straight-
line to zero over its 3-year tax life, after which it will be worthless. The project is estimated
to generate $1.09 million in annual sales, with costs of $475,000. The tax rate is 25% and
the required rate of return is 12 percent. What is the project’s NPV?

Problem 2

Calligraphy Pens is deciding when to replace its old machine. The machine’s current
salvage value is $2.8 million. Its current book value is $1.6 million. If not sold, the old
machine will require maintenance costs of $855,000 at the end of the year for the next
five years. Depreciation on the old machine is $320,000 per year. At the end of five years,
it will have a salvage value of $140,000 and a book value of $0. A replacement machine
costs $4.5 million now and requires maintenance costs of $350,000 at the end of each
year during its economic life of five years. At the end of five years, the new machine will
have a salvage value of $900,000. It will be fully depreciated by the straight-line method.
In five years, a replacement machine will cost $3,400,000. The company will need to
purchase this machine regardless of what choice it makes today. The corporate tax rate
is 21 percent and the appropriate discount rate is 8 percent. The company is assumed to
earn sufficient revenues to generate tax shields from depreciation. Should the company
replace the old machine now or at the end of five years?

Problem 3

Dickinson Brothers, Inc., is considering investing in a machine to produce computer

keyboards. The price of the new machine will be $1.2 million, and its economic life is five
years. The machine will be fully depreciated by the straight-line method. The machine will
produce 25,000 keyboards each year. The price of each keyboard will be $47 in the first
year and will increase by 3 percent per year. The production cost per keyboard will be
$17 in the first year and will increase by 4 percent per year. The project will have an
annual fixed cost of $235,000 and require an immediate investment of $200,000 in net
working capital. The corporate tax rate for the company is 21 percent. If the appropriate
discount rate is 11 percent, what is the NPV of the investment?

Problem 4

Your company has been approached to bid on a contract to sell 18,000 voice recognition
(VR) computer keyboards per year for four years. Due to technological improvements,
beyond that time they will be outdated and no sales will be possible. The equipment
necessary for the production will cost $3.6 million and will be depreciated on a straight-
line basis to zero salvage value. Production will require an investment in net working
capital of $125,000 to be returned at the end of the project, and the equipment can be
sold for $250,000 at the end of production. Fixed costs are $775,000 per year and variable
costs are $43 per unit. In addition to the contract, you feel your company can sell 4,000,
12,000, 14,000, and 17,000 additional units to companies in other countries over the next
4 years, respectively, at a price of $135. This price is fixed. The tax rate is 24 percent,
and the required return is 13 percent. Additionally, the president of the company will
undertake the project only if it has an NPV of $100,000. What bid price should you set for
the contract?