FIN222 Week 8_T CH9: 7,9,13,16,18,19,22,25 (9 Questions, 10 parts)

P7 You have a depreciation expense of $500 000 and a tax rate of 30%. What is your depreciation tax
shield?

 The depreciation tax shield is equal to the depreciation expense multiplied by the tax rate.
 Depreciation tax shield= Depreciation expense  Tax Rate
= $500,000  0.3= = $150,000

 At a tax rate of 30% on a dollar of income, the total reduction in your taxes is $150,000.

P9

 Your projected income statement shows sales of $1million, cost of goods sold as $500000,
depreciation expense of $100000, and taxes of $150 000 due to a tax rate of 30%. What are your
projected earnings? What is your projected free cash flow?

Revenue 1,000,000
COGS -500,000
Depreciation -100,000
EBIT 400,000
Tax at 30% -120,000
Incremental Earnings 280,000
Add back depreciation +100,000
NWC NA
CapEx NA
FCF 380,000

P13

 Oakdale Enterprises is deciding whether to expand its production facilities.

 Although long-term cash flows are difficult to estimate, management has projected the following
cash flows for the first two years (in millions of dollars)
 Corporate Tax rate: 30%

a. What are the incremental earnings for this project for years 1 and 2?

b. What are the free cash flows for this project for the first two years?
1 Year 1 2
2 Revenue 125 160
3 Operating expenses (other than Depreciation) -40 -60
4 Depreciation -25 -36
EBIT 60 64
Tax at 30% -18 -19.2
Incremental Earnings 42 44.8
Add back depreciation +25 +36
5 NWC -2 -8
6 CapEx -30 -40
FCF 35 32.8

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**P 16

 One year ago, your company purchased a machine used in manufacturing for $110 000.
 You have learned that a new machine is available that offers many advantages; you can purchase
it for $150 000 today.
(a) Capital expenditure0=150,000
 It will be depreciated on a straight-line basis over 10 years and has no salvage value.
Depreciationnew= 150000/10=15000 (e)
 You expect that the new machine will produce a gross margin (revenue minus operating expenses
other than depreciation) of $40 000 per year for the next 10 years. Gross marginnew=40000 (c)
 The current machine is expected to produce a gross margin of $20 000 per year. The current
machine is being depreciated on a straight-line basis over a useful life of 11 years, and has no
salvage value, so depreciation expense for the current machine is $10 000 per year.
Depreciationold= 110000/11=10000 (f)
Gross marginold=20000 (d)

 The market value today of the current machine is $50 000. Your company’s tax rate is 30%,
MVold=50000,
BVold=? Cost –accumulated depreciation =110000-10000=100000
Made a capital loss of 50000 (BV>MV)
Tax saving on loss (=50000*0.3)
In Year 0, Cash inflow from sales of the old
= 50,000 + (50,000)*(0.3) = $65,000 (b)
 and the opportunity cost of capital for this type of equipment is 10%.
 Should your company replace its year-old machine?

Remember! What matters is INCREMENTAL Cash flows which arise from the adoption of the new
machine!

Year 0 Year 1-10

Revenue
Operating expenses (other than
Depreciation)
Gross profit(=margin) 20,000 (c)-(d)
Depreciation -5,000 (e)-(f)
EBIT 15,000
Tax at 30% -4,500
Incremental Earnings 10,500
Add back depreciation +5,000
NWC
CapEx -150,000 (a)
+65,000 (b)

FCF -85,000 15,500

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A form of the FCF of 15,500 for 10 years? Annuity!

15,500  1 
NPV  85, 000   1  $10, 240.79
0.10  1.1010 
NPV > 0 therefore replace the current machine with the new machine.

P18

 You have just completed a $20 000 feasibility study for a new coffee shop in some retail space you
own.
 You bought the space two years ago for $100 000, but if you sold it today, you would net $115 000
after taxes.
 Outfitting the space for a coffee shop would require a capital expenditure of $30 000 plus an initial
investment of $5000 in inventory.
 What is the correct initial cash flow for your analysis of the coffee shop opportunity?

 Identify the relevant incremental cash flows.

 The feasibility study is a sunk cost and so is irrelevant.

 CAPEX at Year 0 = Cost of the NEW = -$ 30,000

 Opportunity cost* = -$115,000

*The net amount you would receive if you sold the space today (=$115,000) is the amount you would have
to forego if you use the space for a coffee shop (i.e. an opportunity cost of using the space for a coffee
shop). So we recognise that as a cost (money you will lose).

 NWC = -$5,000

 FCF at year 0 = -$30,000 -$115,000 -$5,000 = -$150,000

Note: To properly represent the initial cash flow in your analysis, you need to ignore the sunk costs and
recognise the opportunity costs as well as the long-term investment (capital expenditures) and short-term
investments (increase in NWC).

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P19 You purchased a machine for $1 million three years ago and have been applying straight-line
depreciation to zero for a seven-year life.

 Your tax rate is 30%.

 If you sell the machine right now (after three years of depreciation) for $700,000, what is your
incremental cash flow from selling the machine?

o At time -3, an annual depreciation could be calculated as $1,000,000/7=$142,857.14.

o The machine is 3 years old therefore book value can be calculated as
Cost - Accumulated depreciation = $1,000,000 – 3*$142,857.14 = $571,428.58
o Market Value(Sales Price)= $700,000 > Book Value = $571,428.58
o Therefore, you made a gain of $128,571.42 (=700,000- 571,428.58). So you will have to pay 30% tax on
the gain.
o After-tax cash flows from selling the machine =
Sales Price – Tax paid on gain = $700,000 – ($128,571.42*0.3)
= $661,428.6
P22
 Home Builder Supply, a retailer in the home improvement industry, currently operates seven
retail outlets in New South Wales.
 Management is contemplating building an eighth retail store across town from its most successful
retail outlet.
 The company already owns the land for this store, which currently has an abandoned warehouse
located on it. Last month, the marketing department spent $10 000 on market research to
determine the extent of customer demand for the new store.
 Now Home Builder Supply must decide whether to build and open the new store.
Which of the following should be included as part of the incremental earnings for the proposed new retail
store?
a. The original purchase price of the land where the store will be located.
No, this is a sunk cost.
If not going ahead, the cost is still there? Then Sunk cost!
b. The cost of demolishing the abandoned warehouse and clearing the land.
Yes, this is a cost of opening the new store. If not going ahead, the cost won’t be incurred.
c. The loss of sales in the existing retail outlet, if customers who previously drove across town to shop at
the existing outlet become customers of the new store instead.
Yes, this loss of sales at the existing store should be deducted from the sales at the new store to
determine the incremental increase in sales that opening the new store will generate for HBS.
d. The $10 000 in market research spent to evaluate customer demand.
No, this is a sunk cost.
If not going ahead, the cost is still there? Then Sunk cost!

e. Construction costs for the new store.

Yes. This is a capital expenditure associated with opening the new store. These costs will therefore
increase HBS’s depreciation expenses.
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f. The value of the land if sold.
Yes, this is an opportunity cost of opening the new store. (By opening the new store, HBS forgoes the
after-tax proceeds it could have earned by selling the land. The after-tax proceeds will be either
Sales price – (capital gain)*(tax rate) or
Sales price + (capital loss)*(tax rate)
g. Interest expense on the debt borrowed to pay the construction costs.
No. For capital budgeting purposes we calculate the incremental earnings without including
financing costs to determine the project’s unlevered net profit. In capital budgeting, the cost of
borrowing is felt though the WACC which incorporates the cost of debt.

P 25

 You are a manager at Percolated Fibre, which is considering expanding its operations in synthetic
fibre manufacturing.
 Your boss comes into your office, drops a consultant’s report on your desk and complains, ‘We
owe these consultants $1 million for this report, and I am not sure their analysis makes sense.
Before we spend the $25 million on new equipment needed for this project, look it over and give
me your opinion’.
Capital expenditure0 = 25mil
 You open the report and find the following estimates (in thousands of dollars)
 All of the estimates in the report seem correct.
 You note that the consultants used straight-line depreciation for the new equipment that will be
purchased today (year 0), which is what the accounting department recommended.
 They also calculated the depreciation assuming no salvage value for the equipment, which is the
company’s assumption in this case.
 The report concludes that because the project will increase earnings by $4.875 million per year for
10 years, the project is worth $48.75 million. You think back to your glory days in finance class
and realise there is more work to be done!
 First, you note that the consultants have not factored in the fact that the project will require $10
million in working capital up-front (year 0), which will be fully recovered in year 10.
 NWC of 10mil would need to be part of the cost in Year0 which is to be reversed in Year 10.
 Next, you see they have attributed $2 million of selling, general and administrative expenses to the
project, but you know that $1 million of this amount is overhead that will be incurred even if the
project is not accepted.
 Fixed overhead amount of 1 mil is a sunk cost (Not incremental). Therefore 1million*(1-tax
rate) would need to be added back.
 Finally, you know that accounting earnings are not the right thing to focus on!

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 a. Given the available information, what are the free cash flows in years 0 to 10 that should be used
to evaluate the proposed project? Let’s add necessary steps to arrive at the FCF!

1 Year 0 1 2 … 9 10

2 Sales revenue 30 000 30 000 30 000 30 000

3 Cost of goods sold 18 000 18 000 18 000 18 000

4 Gross Profit 12 000 12 000 12 000 12 000

5 Sales, general and 2 000 2 000 2 000 2 000

administrative
expenses
6 Depreciation 2 500 2 500 2 500 2 500
7 Net operating profit 7 500 7 500 7 500 7 500
8 Income tax 2 250 2 250 2 250 2 250
9 Net profit 5 250 5 250 5 250 5 250
Add back after-tax +700 +700 +700 +700
overhead cost
Add back deprecation +2,500 +2,500 +2,500 +2,500
CapEx -25,000
NWC -10,000 +10,000
FCF -35,000 8,450 8,450 8,450 8,450 18,450

b. If the cost of capital for this project is 14%, what is your estimate of the value of the new project?

8, 450, 000  1  18, 450, 000

NPV  35, 000, 000   1  
0.14  1.149  1.1410
 $11,773, 615.31

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