Chapter 21: Chapter 21

City Hospital, a nonprofit organization, estimates that it can save 28,000 dollar a year in cash operating costs for the next 10 years if it buys a special-purpose eyetesting machine at a cost of 110,000 dollar. No terminal disposal value is expected. City Hospital's required rate of return is $14 \%$. Assume all cash flows occur at year-end except for initial investment amounts. City Hospital uses straight-line depreciation. 1\. Calculate the following for the special-purpose eye-testing machine: a. Net present value b. Payback period c. Internal rate of return Accrual accounting rate of return based on net initial investment e. Accrual accounting rate of return based on average investment 2\. What other factors should City Hospital consider in deciding whether to purchase the special-purpose eye-testing machine?

Laverty Clinic plans to purchase a new centrifuge machine for its New York facility. The machine costs 94,000 dollar and is expected to have a useful life of 6 years, with a terminal disposal value of 9,000 dollar. Savings in cash operating costs are expected to be 24,900 dollar per year. However, additional working capital is needed to keep the machine running efficiently. The working capital must continually be replaced, so an investment of 4,000 dollar needs to be maintained at all times, but this investment is fully recoverable (will be "cashed in") at the end of the useful life. Laverty Clinic's required rate of return is \(12 \%\). Ignore income taxes in your analysis. Assume all cash flows occur at year-end except for initial investment amounts. Laverty Clinic uses straight-line depreciation for its machines. 1\. Calculate net present value. 2\. Calculate internal rate of return. 3\. Calculate accrual accounting rate of return based on net initial investment. 4\. Calculate accrual accounting rate of return based on average investment. 5\. You have the authority to make the purchase decision. Why might you be reluctant to base your decision on the DCF methods?

What is the essence of the discounted cash flow methods?

Klein Dermatology is contemplating purchasing new laser therapy equipment. This new equipment would cost 300,000 dollar to purchase and 20,000 dollar for installation. Klein estimates that this new equipment would yield incremental margins of 98,000 dollar annually due to new client services but would require incremental cash maintenance costs of 10,000 dollar annually. Klein expects the life of this equipment to be 5 years and estimates a terminal disposal value of 20,000 dollar. Klein has a \(25 \%\) income tax rate and depreciates assets on a straight-line basis (to terminal value) for tax purposes. The required rate of return on investments is \(10 \%\) 1\. What is the expected increase in annual net income from investing in the improvements? 2\. Calculate the accrual accounting rate of return based on average investment. 3\. Is the project worth investing in from an NPV standpoint? 4\. Suppose the tax authorities are willing to let Klein depreciate the project down to zero over its useful life. If Klein plans to liquidate the project in 5 years, should it take this option? Quantify the impact of this choice on the NPV of the project.

If Manterd Sfantax formnation is an intfirnational manufacturer of fragrances for women. Management at Sentax is considering expanding the product line to men's fragrances. From the best estimates of the marketing and production managers, annual sales (all for cash) for this new line are 2,000,000 units at 100 dollar per unit; cash variable cost is 50 dollar per unit, and cash fixed costs are 18,000,000 dollar per year. The investment project requires 100,000,000 dollar of cash outflow and has a project life of 4 years. At the end of the 4-year useful life, there will be no terminal disposal value. Assume all cash flows occur at year-end except for initial investment amounts. Men's fragrance is a new market for Sentax, and management is concerned about the reliability of the estimates. The controller has proposed applying sensitivity analysis to selected factors. Ignore income taxes in your computations. Sentax's required rate of return on this project is \(16 \%\) 1\. Calculate the net present value of this investment proposal. 2\. Calculate the effect on the net present value of the following two changes in assumptions. (Treat each item independently of the other. a. \(20 \%\) reduction in the selling price b. \(20 \%\) increase in the variable cost per unit 3\. Discuss how management would use the data developed in requirements 1 and 2 in its consideration of the proposed capital investment.

Liam Mitchell, a manager of the Plate Division for the Harvest Manufacturing company, has the opportunity to expand the division by investing in additional machinery costing 495,000 dollar. He would depreciate the equipment using the straight-line method and expects it to have no residual value. It has a useful life of 9 years. The firm mandates a required after-tax rate of return of $14 \%$ on investments. Liam estimates annual net cash inflows for this investment of 130,000 dollar before taxes and an investment in working capital of 5,000 dollar that will be returned at the project's end. Harvest's tax rate is $30 \%$ 1\. Calculate the net present value of this investment. 2\. Calculate the accrual accounting rate of return based on net initial investment for this project. 3\. Should Liam accept the project? Will Liam accept the project if his bonus depends on achieving an accrual accounting rate of return of \(14 \% ?\) How can this conflict be resolved?

\((\mathrm{CMA},\) adapted) The Kuhl Brothers own a frozen custard ice cream shop. The brothers currently are using a machine that has been in use for the last 4 years. \(0 n\) January \(1,2017,\) the \(\mathrm{Kuhl}\) Brothers are considering buying a new machine to make their frozen custard. The Kuhl Brothers have two options: (1) continue using the old freezing machine or (2) sell the old machine and purchase a new freezing machine. The seller of the new machine is not interested in a tradein of Kuhl's old machine. The following information has been obtained: The Kuhl Brothers are subject to a \(25 \%\) income tax rate. Any gain or loss on the sale of machines is treated as an ordinary tax item and will affect the taxes paid by the Kuhl Brothers in the year in which it occurs. The Kuhl Brothers have an after-tax required rate of return of \(8 \%\). Assume all cash flows occur at year-end except for initial investment amounts. 1\. The Kuhl Brothers ask you whether they should buy the new machine. To help in your analysis, calculate the following: a. One-time after-tax cash effect of disposing of the old machine on January 1,2017 b. Annual recurring after-tax cash operating savings from using the new machine (variable and fixed) c. Cash tax savings due to differences in annual depreciation of the old machine and the new machine d. Difference in after-tax cash flow from terminal disposal of new machine and old machine 2\. Use your calculations in requirement 1 and the net present value method to determine whether the Kuhl Brothers should continue to use the old machine or acquire the new machine. 3\. How much more or less would the recurring after-tax cash operating savings of the new machine need to be for the Kuhl Brothers to earn exactly the \(8 \%\) after-tax required rate of return? Assume that all other data about the investment do not change.

Johnny Buster owns Entertainment World, a place that combines fast food, innovative beverages, and arcade games. Worried about the shifting tastes of younger audiences, Johnny contemplates bringing in new simulators and virtual reality games to maintain customer interest. As part of this overhaul, Johnny is also looking at replacing his old Guitar Hero equipment with a Rock Band Pro machine. The Guitar Hero setup was purchased for 25,200 dollar and has accumulated depreciation of 23,000 dollar, with a current trade-in value of 2,700 dollar.It currently costs Johnny 600 dollar per month in utilities and another 5,000 dollar a year in maintenance to run the Guitar Hero equipment. Johnny feels that the equipment could be kept in service for another 11 years, after which it would have no salvage value. The Rock Band Pro machine is more energy efficient and durable. It would reduce the utilities costs by \(30 \%\) and cut the maintenance cost in half. The Rock Band Pro costs 49,000 dollar and has an expected disposal value of 5,000 at the end of its useful life of 11 years. Johnny charges an entrance fee of 5 dollar per hour for customers to play an unlimited number of games. He does not believe that replacing Guitar Hero with Rock Band Pro will have an impact on this charge or materially change the number of customers who will visit Entertainment World. 1\. Johnny wants to evaluate the Rock Band Pro purchase using capital budgeting techniques. To help him, read through the problem and separate the cash flows into four groups: (1) net initial investment cash flows, (2) cash flow savings from operations, (3) cash flows from terminal disposal of investment, and (4) cash flows not relevant to the capital budgeting problem. 2\. Assuming a tax rate of \(40 \%\), a required rate of return of \(8 \%\), and straight-line depreciation over the remaining useful life of equipment, should Johnny purchase Rock Band Pro?

Fancy Foods is considering replacing all 12 of its meat scales with new, digital ones. The old scales are fully depreciated and have no disposal value. The new scales cost 120,000 dollar (in total). Because the new scales are more efficient and more accurate than the old scales, Fancy Foods will have annual incremental cash savings from using the new scales in the amount of 30,000 dollar per year. The scales have a 6 -year useful life and no terminal disposal value and are depreciated using the straight-line method. Fancy Foods requires a \(6 \%\) real rate of return. 1\. Given the preceding information, what is the net present value of the new scales? Ignore taxes. 2\. Assume the 30,000 dollar cost savings are in current real dollars and the inflation rate is \(4 \% .\) Recalculate the NPV of the project. 3\. Based on your answers to requirements 1 and 2 , should Fancy Foods buy the new meat scales? 4\. Now assume that the company's tax rate is \(25 \%\). Calculate the NPV of the project assuming no inflation. 5\. Again assuming that the company faces a \(25 \%\) tax rate, calculate the NPV of the project under an inflation rate of \(4 \%\) 6\. Based on your answers to requirements 4 and 5 , should Fancy Foods buy the new meat scales?

How can sensitivity analysis be incorporated in DCF analysis?