For Chapter 8, Know how to do this question.
8-24 LG 4, 5, 6: Integrative–Determining Relevant Cash Flows
Company replacing grinder. Existing grinder purchased 2 years ago for $60,000, depreciated using 5 year MACRS. Existing grinder has usable life of 5 more years.
New grinder costs $105,000, $5,000 installation cost. 5yr usable life, MACRS depreciation.
Existing grinder can be sold for $70,000.
If buy new grinder, working capital increases by $12,000.
At end of 5 years, existing grinder worth 0, new grinder could be sold for $29,000.
Firm in 40% tax bracket.
Profits before depreciation and taxes
Year New Existing Grinder
1 43,000 26,000
2 43,000 24,000
3 43,000 22,000
4 43,000 20,000
5 43,000 18,000
Questions
A. Calculate initial investment if replace grinder.
B. Determine incremental cash flows from replacing grinder.
C. Determine terminal cash flow at end of year 5 if replacing grinder.
D. Show all cash flows on a time line.
For Chapter 9, know the following:
Use the following for the next 6 questions.
Required Rate of Return is 7%.
Year Expected After Tax Net Cash Flow
0 (800)
1 100
2 200
3 300
4 100
5 200
6 300
1. What is the payback?
2. What is the discounted payback?
3. What is the NPV?
4. What is the IRR?
5. What is the Modified IRR?
6. What is the Profitability Ratio?
Also note, accept project if NPV>0, IRR>cost of capital, Profitability ratio > 1. Modified IRR > cost of capital. IRR assumes reinvestment occurs at projects rate of return, NPV and Modified IRR assume reinvestment occurs at firm’s cost of capital.
Chapter 11
For chapter 11, know how to do this question.
Firm is in 40% tax bracket.
Debt: Firm can raise unlimited amount of debt by selling $1000 par value 8% annual coupon 20 year bonds. To sell, $30 discount per bond will be given and firm must pay flotation costs of $30 per bond.
Preferred stock: Firm can sell 8% preferred stock at $95 per share. Cost of issuing stock is $5 per share.
Common Stock: Common stock is currently selling at $90 per share. Firm will pay $7 dividend per share next year. Dividends have been growing at 6% and is expected to continue. Stock must be underpriced by $7 to sell and flotation costs will be $5 per share.
Retained Earnings: Will have $100,000 available in the next year. When these earnings are exhausted, new common stock will be issued as the form of common stock equity financing.
A. Calculated specific cost of each source of financing.
B. Assume capital weights are 30% debt, 20% preferred stock, 50% equity.
(1) Calculate single break point associated with firms financial situation.(This occurs when retained earnings are used up.)
(2) Calculate weighted average cost of capital below break point calculated above.
(3) Calculate weighted average cost of capital above break point calculated above.
Chapter 8 answers
8-24 LG 4, 5, 6: Integrative–Determining Relevant Cash Flows
a. Initial investment:
Cost of new asset $105,000
+ Installation costs 5,000
Total cost of new asset $110,000
- After-tax proceeds from sale of old asset =
Proceeds from sale of old asset (70,000)
+ Tax on sale of old asset* 16,480
Total proceeds from sale of old asset (53,520)
+ Change in working capital 12,000
Initial investment $68,480
* Book value of old asset:
[1 - (.20 + .32)] x $60,000 = $28,800
$70,000 - $28,800 = $41,200 gain on sale of asset
$31,200 recaptured depreciation x .40 = $12,480
$10,000 capital gain x .40 = 4,000
Total tax of sale of asset = $16,480
b.
Calculation
of Operating Cash Inflows
Profits Before Operating
Depreciation Depre- Net Profits Net Profits Cash
New Grinder
1 $43,000 $22,000 $21,000 $ 8,400 $12,600 $34,600
2 43,000 35,200 7,800 3,120 4,680 39,880
3 43,000 20,900 22,100 8,840 13,260 34,160
4 43,000 13,200 29,800 11,920 17,880 31,080
5 43,000 13,200 29,800 11,920 17,880 31,080
6 --0- 5,500 -5,500 -2,200 -3,300 2,200
Existing Grinder
1 $26,000 $11,400 $14,600 $5,840 $ 8,760 $20,160
2 24,000 7,200 16,800 6,720 10,080 17,280
3 22,000 7,200 14,800 5,920 8,880 16,080
4 20,000 3,000 17,000 6,800 10,200 13,200
5 18,000 -0- 18,000 7,200 10,800 10,800
6 -0- -0- -0- -0- -0- -0-
Calculation
of Incremental Cash Inflows
Incremental Operating
1 $34,600 $20,160 $14,440
2 39,880 17,280 22,600
3 34,160 16,080 18,080
4 31,080 13,200 17,880
5 31,080 10,800 20,280
6 2,200 -0- 2,200
c. Terminal Cash Flow:
Proceeds from sale of new asset $29,000
- Tax on sale of new asset* ( 9,400)
Total proceeds from sale of new asset 19,600
- After-tax proceeds from sale of old asset =
Proceeds from sale of old asset 0
+ Tax on sale of old asset 0
Total proceeds from sale of old asset 0
+ Change in net working capital 12,000
Terminal cash flow $31,600
* Book value of asset at end of year 5 = $ 5,500
$29,000 - $5,500 = $23,500 recaptured depreciation
$23,500 x .40 = $ 9,400
d. Year 5 Relevant Cash Flow:
Terminal cash flow 31,600
Total inflow $51,880
0 1 2 3 4 5 6
-68,480 14,400 22,600 18,080 17,880 51,880 2,200
Chapter 9 answers
1. 4.5
2. 5.34 Discounted cash flows are 93.45, 174.68, 244.89, 76.28, 142.59, 199.90
3. 131.82
4. 11.65
5. 9.75 PV = -800, N = 6, FV = 1,398.41, PMT = 0, solve for I/Y. Remember, find fv of all cash flows for end of year 6. FV = 100(1.07)^5 + 200(1.07)^4 + 300(1.07)^3 + 100(1.07)^2 + 200(1.07) + 300
6. 1.1648
Chapter 11 answers
11-16 LG 2, 3, 4, 5: Calculation of Specific Costs, WACC, and WMCC
a. Debt: (approximate)
Plug numbers in your calculator
kd = 8.64%
ki = kd x (1 - t)
ki = 8.64% x (1 - .40)
ki = 5.1%
Preferred Stock:
Kp = D/N = 7.60/90 = 8.44%
Common Stock:
kn = Dj/Nn + g
ks = 7/78 + .06 = .1497 or 14.97%
Retained Earnings:
Kr = D1/P0 + g
= 7/90 + .06 = 13.78%
b. Breaking point = AFj/Wi
(1) BP common equity = 100,000/.5 = 200,000
Target Capital Cost of Weighted
Type of Capital Structure % Capital Source Cost
(2) WACC equal to or below $200,000 BP:
Preferred stock .20 8.4% 1.68%
Common stock equity .50 13.8% 6.90%
WACC = 10.11%
(3) WACC above $200,000 BP:
Preferred stock .20 8.4% 1.68%
Common stock equity .50 15.0% 7.50%
WACC = 10.71%