QUESTIONS FOR PRESENTATION

Group One

1 The Best Manufacturing Company is considering a new investment. Financial

projections for the investment are tabulated below. Cash flows are in $ thousands, and
the corporate tax rate is 34 percent. Assume all sales revenue is received in cash, all
operating costs and income taxes are paid in cash, and
all cash flows occur at the end of the year.

Year 0 Year 1 Year 2 Year 3 Year 4

Investment $10,000 - - - -
Sales Revenue - $7,000 $7,000 $7,000 $7,000
Operating Costs - 2,000 2,000 2,000 2,000
Depreciation - 2,500 2,500 2,500 2,500
Net Working 200 250 300 200 -
Capital
(end of year)

a. Compute the incremental net income of the investment in each year.

b. Compute the incremental cash flows of the investment in each year.
c.Suppose the appropriate discount rate is 12 percent. What is the NPV of the
project?

ANSWER:
a. Incremental net income of the investment in each year:
Year 0: -$10,000
Year 1: $7,000 - $2,000 - $2,500 = $2,500
Year 2: $7,000 - $2,000 - $2,500 = $2,500
Year 3: $7,000 - $2,000 - $2,500 = $2,500
Year 4: $7,000 - $2,000 - $2,500 = $2,500

b. Incremental cash flows of the investment in each year:

Year 0: -$10,000
 Year 1: $2,500 - $200 = $2,300
Year 2: $2,500 + $300 = $2,800
Year 3: $2,500 - $200 = $2,300
Year 4: $2,500 = $2,500
c. NPV of the project:
NPV = [($2,300 / (1 + 0.12)^1) + ($2,800 / (1 + 0.12)^2) + ($2,300 / (1 + 0.12)^3) +
($2,500 / (1 + 0.12)^4)] - $10,000 = $1,063.43

Group Two

1. According to the February 7, 2002, issue of The Sports Universe, the Seattle
Mariner’s designated runner, Andy Schneider, signed a three-year contract in January
2002 with the following provisions:

 $1,400,000 signing bonus

 $2,500,000 salary per year for three years
 10 years of deferred payments of $1,250,000 per year (these payments begin
in year 4)
 Several bonus provisions that total as much as $750,000 per year for the three
years of the contract

Assume that Schneider has a 60-percent probability of receiving the bonuses each
year, and that he signed the contract on January 1, 2002. Use the expected value of the
bonuses as incremental cash flows. Assume that expected cash flows are discounted at
12.36 percent. Ignore taxes. Schneider’s signing bonus was paid on January 1, 2002.
Schneider’s salary and bonuses other than the signing bonus are paid at the end of the
year. What was the present value of this contract in January when Schneider signed
it?

ANSWER
To calculate the present value of the contract, we need to find the present value of
each cash flow.
 1. Signing Bonus:
• $1,400,000 paid on January 1, 2002.
• The present value of the signing bonus is $1,400,000 / (1 + 0.1236)^0 =
$1,400,000.
2. Salary:
• $2,500,000 per year for three years, paid at the end of each year.
• The present value of salary for three years is $2,500,000 * (1 - 1 / (1 + 0.1236)^3) /
0.1236 = $7,068,670.
3. Deferred Payments:
• $1,250,000 per year for 10 years, starting from year 4.
• The present value of deferred payments is $1,250,000 * (1 - 1 / (1 + 0.1236)^10) /
0.1236 = $7,095,536.
4. Bonuses:
• $750,000 per year with 60% probability for three years, paid at the end of each
year.
• The expected value of bonuses is $750,000 * 0.6 = $450,000.
• The present value of bonuses is $450,000 * (1 - 1 / (1 + 0.1236)^3) / 0.1236 =
$1,255,007.
The total present value of the contract is $1,400,000 + $7,068,670 + $7,095,536 +
$1,255,007 = $16,818,213.

2. Benson Enterprises is evaluating alternative uses for a three-story manufacturing and

warehousing building that it has purchased for $225,000. The company can continue
to rent the building to the present occupants for $12,000 per year. The present
occupants have indicated an interest in staying in the building for at least another 15
years. Alternatively, the company could modify the existing structure to use for its
own manufacturing and warehousing needs. Benson’s production engineer feels the
building could be adapted to handle one of two new product lines. The cost and
revenue data for the two product alternatives are as follows:

Product A Product B
Initial cash outlay for building modifications $36,000 $54,000
Initial cash outlay for equipment 144,000 162,000
 Annual pretax cash revenues (generated for 15 years) 105,000
127,500
Annual pretax expenditures (generated for 15 years) 60,000
75,000

The building will be used for only 15 years for either Product A or Product B. After
15 years, the building will be too small for efficient production of either product line.
At that time, Benson plans to rent the building to firms similar to the current
occupants. To rent the building again, Benson will need to restore the building to its
present layout. The estimated cash cost of restoring the building if Product A has been
undertaken is $3,750. If Product B has been manufactured, the cash cost will be
$28,125. These cash costs can be deducted for tax purposes in the year the
expenditures occur.
Benson will depreciate the original building shell (purchased for $225,000)
over a 30-year life to zero, regardless of which alternative it chooses. The building
modifications and equipment purchases for either product are estimated to have a 15-
year life. They will be depreciated by the straight-line method. The firm’s tax rate is
34 percent, and its required rate of return on such investments is 12 percent.
For simplicity, assume all cash flows occur at the end of the year. The initial
outlays for modifications and equipment will occur today (year 0), and the restoration
outlays will occur at the end of year 15. Benson has other profitable ongoing
operations that are sufficient to cover any losses. Which use of the building would
you recommend to management?

ANSWER
To determine the best use for the building, we can calculate the NPV for both product
alternatives and compare them.
Product A:
• Initial cash outlay for building modifications: $36,000
• Initial cash outlay for equipment: $144,000
• Total initial outlay: $36,000 + $144,000 = $180,000
• Annual pretax cash revenues: $105,000
• Annual pretax expenditures: $60,000
• Annual net income before taxes: $105,000 - $60,000 = $45,000
• Depreciation expense: ($36,000 + $144,000) / 15 = $12,800
• Taxable income: $45,000 - $12,800 = $32,200
• Tax expense: $32,200 * 34% = $10,948
• Net income after taxes: $32,200 - $10,948 = $21,252
• Incremental cash flows: $21,252 + $12,800 (depreciation) = $34,052
• NPV: $34,052 / (1 + 0.12)^1 + $34,052 / (1 + 0.12)^2 + ... + $34,052 / (1 + 0.12)^15 +
($105,000 * 15 - $60,000 * 15) / (1 + 0.12)^15 - $180,000 = $24,180
Product B:
• Initial cash outlay for building modifications: $54,000
• Initial cash outlay for equipment: $162,000
• Total initial outlay: $54,000 + $162,000 = $216,000
• Annual pretax cash revenues: $127,500
• Annual pretax expenditures: $75,000
• Annual net income before taxes: $127,500 - $75,000 = $52,500
• Depreciation expense: ($54,000 + $162,000) / 15 = $14,400
• Taxable income: $52,500 - $14,400 = $38,100
• Tax expense: $38,100 * 34% = $12,934
• Net income after taxes: $38,100 - $12,934 = $25,166
• Incremental cash flows: $25,166 + $14,400 (depreciation) = $39,566
• NPV: $39,566 / (1 + 0.12)^1 + $39,566 / (1 + 0.12)^2 + ... + $39,566 / (1 + 0.12)^15 +
($127,500 * 15 - $75,000 * 15) / (1 + 0.12)^15 - $216,000 = $33,510
Since the NPV of product B is higher than product A, it would be the recommended use for
the building to management.

Group Three

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

keyboards. The price of the machine will be $400,000 and its economic life is five
years. The machine will be fully depreciated by the straight-line method. The
machine will produce 10,000 keyboards each year. The price of each keyboard will be
$40 in the first year and will increase by 5 percent per year. The production cost per
 keyboard will be $20 in the first year and will increase by 10 percent per year. The
corporate tax rate for the company is 34 percent. If the appropriate discount rate is 15
percent, what is the NPV of the investment?

ANSWERS:

The NPV of the investment can be calculated as follows:

Year 1:
Revenue: 10,000 * $40 = $400,000
Cost: 10,000 * $20 = $200,000
Profit before tax: $400,000 - $200,000 = $200,000
Tax: $200,000 * 34% = $68,000
Profit after tax: $200,000 - $68,000 = $132,000
Discounted profit after tax: $132,000 / (1 + 0.15)^1 = $112,935

Year 2:
Revenue: 10,000 * $40 * 1.05 = $42,000
Cost: 10,000 * $20 * 1.10 = $22,000
Profit before tax: $420,000 - $220,000 = $200,000
Tax: $200,000 * 34% = $68,000
Profit after tax: $200,000 - $68,000 = $132,000
Discounted profit after tax: $132,000 / (1 + 0.15)^2 = $106,145
Year 3 TO 5: Repeat the same calculation as year 2

Depreciation: $400,000 / 5 = $80,000

Tax savings from depreciation: $80,000 * 34% = $27,200
Discounted tax savings: $27,200 / (1 + 0.15)^1 + $27,200 / (1 + 0.15)^2 + $27,200 / (1 +
0.15)^3 + $27,200 / (1 + 0.15)^4 + $27,200 / (1 + 0.15)^5 = $144,907
NPV: $112,935 + $106,145 + ... + $106,145 + $80,000 - $400,000 + $144,907 = $69,741.
So, the NPV of the investment is $69,741.

2. Scott Investors, Inc., is considering the purchase of a $500,000 computer with an

economic life of five years. The computer will be fully depreciated over five years
using the straight-line method. The market value of the computer will be $100,000 in
 five years. The computer will replace five office employees whose combined annual
salaries are $120,000. The machine will also immediately lower the firm’s required
net working capital by $100,000. This amount of net working capital will need to be
replaced once the machine is sold. The corporate tax rate is 34 percent. Is it
worthwhile to buy the computer if the appropriate discount rate is 12 percent?

ANSWER

The NPV of the investment can be calculated as follows:

Year 1:
Depreciation: $500,000 / 5 = $100,000
Tax savings from depreciation: $100,000 * 34% = $34,000
Discounted tax savings: $34,000 / (1 + 0.12)^1 = $30,357
Year 2-5: Repeat the same calculation for tax savings as year 1

Tax savings over 5 years: $30,357 + $27,067 + $24,112 + $21,450 + $19,053 =

$121,939
Savings from employee salaries: 5 * $120,000 = $600,000
Discounted savings from employee salaries: $600,000 / (1 + 0.12)^1 + $600,000 / (1
+ 0.12)^2 + $600,000 / (1 + 0.12)^3 + $600,000 / (1 + 0.12)^4 + $600,000 / (1 +
0.12)^5 = $2,582,933
Reduction in net working capital: $100,000
Replacement of net working capital: $100,000 / (1 + 0.12)^5 = $61,764
NPV: $121,939 + $2,582,933 - $500,000 - $61,764 = $2,644,108
So, the NPV of the investment is $2,644,108, which is positive. Therefore, it is
worthwhile to buy the computer if the discount rate is 12 percent.

Group Four

1. The Gap is considering buying cash register software from Microsoft so that it can
more effectively deal with its retail sales. The software package costs $750,000 and
will be depreciated down to zero using the straight-line method over its five-year
economic life. The marketing department predicts that sales will be $600,000 per year
for the next three years, after which the market will cease to exist. Cost of goods sold
 and operating expenses are predicted to be 25 percent of sales. After three years the
software can be sold for $40,000. The Gap also needs to add net working capital of
$25,000 immediately. The additional net working capital will be recovered in full at
the end of the project life. The corporate tax rate for the Gap is 35 percent and the
required rate of return relevant to the project is 17 percent. What is the NPV of the
new software?

ANSWER
The NPV of the new software can be calculated as follows:
Year 1:
Depreciation: $750,000 / 5 = $150,000
Tax savings from depreciation: $150,000 * 35% = $52,500
Discounted tax savings: $52,500 / (1 + 0.17)^1 = $44,254
Operating expenses: $600,000 * 25% = $150,000
Sales: $600,000
Profit before taxes: $600,000 - $150,000 = $450,000
Taxes: $450,000 * 35% = $157,500
Discounted taxes: $157,500 / (1 + 0.17)^1 = $132,187
Year 2-3: Repeat the same calculation as year 1

Tax savings over 3 years: $44,254 + $37,568 + $32,071 = $113,893

NPV of discounted profits after tax: $132,187 + $132,187 + $132,187 = $396,561
Additional net working capital: $25,000
Recovery of net working capital: $25,000 / (1 + 0.17)^3 = $18,652
Sale of software: $40,000
NPV: $396,561 - $25,000 + $18,652 + $40,000 - $750,000 = $-299,787
So, the NPV of the new software is -$299,787, which is negative. Therefore, The Gap
should not buy the cash register software from Microsoft based on the NPV.

2. Commercial Real Estate, Inc., is considering the purchase of a $4 million building.

The company will enter into a long-term lease to commercial tenants, with payments
made annually. The building will be fully depreciated over 20 years via the straight-
line method. In addition, the market value of the building will be zero at that time.
The annual lease payments will increase at 3 percent per year. The appropriate
 discount rate for all cash flows is 12 percent. The corporate tax rate is 34 percent.
What is the least amount of money that Commercial Real Estate should ask for the
first-year lease payment? Assume that the first lease payment is made immediately
after the signing of the contract.
ANSWER
The least amount of money that Commercial Real Estate should ask for the first-year
lease payment can be calculated as follows:
Depreciation: $4 million / 20 years = $200,000
Tax savings from depreciation: $200,000 * 34% = $68,000
Discounted tax savings: $68,000 / (1 + 0.12)^1 = $59,486
Discounted operating profits: $59,486
In the second year, the lease payment will increase by 3 percent, or $0.03 * lease
payment in year 1.
Discounted operating profits in year 2: $59,486 + ($0.03 * lease payment in year 1) *
(1 / (1 + 0.12)^2)
By repeating this calculation for each year, we can find the present value of all
lease payments over 20 years.
Let's call the first-year lease payment "L".
NPV of discounted lease payments: L / (1 + 0.12)^1 + (1.03L) / (1 + 0.12)^2 + ... +
(1.03^19 * L) / (1 + 0.12)^20 = $4 million - $200,000 + $59,486
So, the least amount of money that Commercial Real Estate should ask for the first-
year lease payment (L) is the value that makes the NPV equal to zero. This value can
be found through trial and error or by using a financial calculator.

3. Royal Dutch Petroleum is considering a new project that complements its existing
business. The machine required for the project costs $2 million. The marketing
department predicts that sales related to the project will be $1.2 million per year for
the next four years, after which the market will cease to exist. The machine will be
depreciated down to zero over its 5-year economic life using the straight-line method.
Cost of goods sold and operating expenses related to the project are predicted to be 25
percent of sales. After four years the machine can be sold for $150,000. Royal Dutch
also needs to add net working capital of $100,000 immediately. The additional net
working capital will be recovered in full at the end of the project’s life. The corporate
 tax rate 35 percent. The required rate of return for Royal Dutch Petroleum is 16.55
percent. Should Royal Dutch proceed with the project?
ANSWER
To determine whether Royal Dutch should proceed with the project, we need to
calculate its net present value (NPV).
Depreciation: $2 million / 5 years = $400,000
Tax savings from depreciation: $400,000 * 35% = $140,000
Discounted tax savings: $140,000 / (1 + 0.1655)^1 = $117,896
First-year operating profits: $1.2 million - $1.2 million * 25% = $900,000
Taxable income: $900,000 - $400,000 = $500,000
Taxes: $500,000 * 35% = $175,000
After-tax operating profit: $500,000 - $175,000 + $117,896 = $443,896
Discounted operating profit: $443,896 / (1 + 0.1655)^1 = $375,632
In the second year, operating profits will be the same as in the first year, and the
discounted operating profit will be:
Discounted operating profit in year 2: $375,632 / (1 + 0.1655)^2 = $317,579
By repeating this calculation for each year, we can find the present value of all cash
flows related to the project over 4 years.
NPV: -$2 million + $375,632 + $317,579 + ... + $150,000 / (1 + 0.1655)^4 - $100,000
=?
If the NPV is positive, Royal Dutch should proceed with the project, as it will generate a
positive return. If the NPV is negative, the project will not generate a positive return and
Royal Dutch should not proceed with it.