Fundamentals of Capital Budgeting: Replace Old Machine or Not

Fundamentals of Capital Budgeting: Replace Old Machine or Not

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. It will be depreciated on a straight-line basis over 10 years, after which it has no salvage value. You expect that the new machine will produce EBITDA (Earnings Before interest, taxes, depreciation, and amortization) of $40,000 per year for the next 10 years. The current machine is expected to produce EBITDA of $20,000 per year. The current machine is being depreciated on a straight-line basis over a useful life of 11 years, after which it will have no salvage value, so depreciation expense for the current machine is $10,000 per year. All other expenses of the two machines are identical. The market value today of the current machine is $50,000. Your company’s tax rate is 45%, and the opportunity cost of capital for this type of equipment is 10%. Is it profitable to replace the year-old machine?

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Fundamentals of Capital Budgeting: Percolated Fiber Free Cash Flow

Fundamentals of Capital Budgeting: Percolated Fiber Free Cash Flow in $1.50 only (Instant Download)

You are a manager at Percolated Fiber, which is considering expanding its operations in synthetic fiber 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.” You open the report and find the following estimates (in millions 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. The report concludes that because the project will increase earnings by $4.875 million per year for ten years, the project is worth $48.75 million. You think back to your halcyon days in finance class and realize there is more work to be done!

Multiple Choice Questions

Real estate economics - with depreciation

1.   A problem with the specific identification method is that

a.   inventories can be reported at actual costs.

b.   management can manipulate income.

c.   matching is not achieved.

d.   the lower of cost or market basis cannot be applied.

2.     In a period of increasing prices, which inventory flow assumption will result in the lowest amount of income tax expense?

a.   FIFO

b.   LIFO

c.   Average Cost Method

d.    Income tax expense for the period will be the same under all assumptions.

3.     When applying the lower of cost or market rule to inventory valuation, market generally means

a.   current replacement cost.

b.   original cost.

c.   resale value.

d.   original cost, less physical deterioration.

Mini Case: Will Leasing Fly at Continental?

Continental Airlines

CFM 3 Ch 21 Minicase Will Leasing Fly at Continental? in $28 only

  1. Calculate the net advantage to leasing, using the expected residual value and assuming Continental can use all the tax benefits of ownership with a tax rate of 40% and straight line depreciation to the expected residual value. Assume that Continental issues 80% secured debt and 20% unsecured debt to finance a purchase.

a) Calculate rt–the project cost of capital.

b) Calculate the expected lease residual value per aircraft.

c) Calculate the quarterly CFAT per aircraft under the leasing option.

      • Hint: It should be the same each quarter hroughout the term of the lease.
      • The lease payment is tax deductible.
      • Under the leasing option Continental forgoes the depreciation tax deduction.

      d) Calculate the NAL.

          • Assume quarterly compounding to match the lease payments.
          • Continental’s required return on the asset—r, is given.
          • Assume no incremental difference in operating expenses between the purchasing and leasing options.
          • Assume that the lessor claims the ITC.

          2.  Calculate the net advantage to leasing, assuming Continental cannot use any of the tax benefits of ownership and the residual value is (i) the expected residual value, (ii) $50 million, and (iii) $10 million

          Depreciation Calculation

          Depreciation Calculation

          Kleener Co. acquired a new delivery truck at the beginning of its current fiscal year. The truck cost $52,000 and has an estimated useful life of four years and an estimated salvage value of $8,000.

          Calculate deprecation expense for each year of the truck’s life using straight- line depreciation.

          Using straight- line depreciation method, what is the book value of the truck at the end of the third year of its life?

          Answer available.

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          Bach Company Paid

          Bach Company Paid in $6 only

          Bach Company paid $120,000 to purchase a machine on January 1, 2012. During 2014, a technological breakthrough resulted in the development of a new machine that costs $150,000. The old machine costs $50,000 per year to operate, but the new machine could be operated for only $18,000 per year. The new machine, which will be available for delivery on January 1, 2015, has an expected useful life of four years. The old machine is more durable and is expected to have a remaining useful life of four years. The current market value of the old machine is $40,000. The expected salvage value of both machines is zero.

          Required:
          a.
          Calculate the total avoidable costs in keeping the old machine and buy a new machine.

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          Depreciation Question on Atlas Inc.

          Depreciation Question on Atlas Inc. in $6 only

          Annual depreciation expense on a building purchased by Atlas Inc. a few years ago (using the straight-line method) is $10,000. The cost of the building was $200,000. The current book value of the equipment (January 1, 2013) is $170,000. At the time of purchase, the asset was estimated to have a zero salvage value. On January 1, 2013, the company decided to reduce the original useful life by 25% and to establish a salvage value of $10,000. The firm also decided double-declining-balance depreciation was more appropriate. Ignore tax effects.

          Required:

          (1.) Record the journal entry, if any, to report the accounting change.

          (2.) Record the annual depreciation for 2013.

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          Bandera Corporation Straight-line Depreciation

          Bandera Corporation Straight-line Depreciation in $4 onlyBandera Corporation

          Bandera Corporation has been using the straight-line depreciation method to depreciate some office equipment that was acquired at the beginning of 2012. At the beginning of 2015, Pinnacle decided to change to the sum-of-the-years’-digits method. The equipment cost $150,000 and is expected to have no salvage value. The estimated useful life of the equipment is five years. The tax rate is 35%.

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          Plant Assets of Jimenez Company

          At December 31, 2008, Jimenez Company reported the following as plant assets.

          SOMF Asset Patterns

          Land              $4,000,000

          Buildings       $28,500,000

          Less: Accumulated depreciation-buildings        12,100,000    16,400,000

          Equipment    48,000,000

          Less: Accumulated depreciation-equipment      5,000,000      43,000,000

          Total plant assets                       $63,400,000

          During 2009, the following selected cash transactions occurred.

          April 1 Purchased land for $2,130,000.

          May 1 Sold equipment that cost $780,000 when purchased on January 1, 2005. The equipment was sold for $450,000.

          Cost of Capital Mini Case: Cascade Water Company

          English: Cost-Volume-Profit diagram, decomposi...

          Source Book : Corporate Finance: Linking Theory to What Companies Do By John Graham, Scott B. Smart, William L. Megginson

          Chapter 9: Cost of Capital and Project Risk

          Mini Case

          Cascade Water Company (CWC) currently has 30,000,000 shares of common stock out- standing that trade at a price of $42 per share. CWC also has 500,000 bonds outstanding that currently trade at $923.38 each. CWC has no preferred stock outstanding and has an equity beta of 2.639. The risk-free rate is 3.5%, and the market is expected to return 12.52%. The firm’s bonds have a 20-year life, a $1,000 par value, a 10% coupon rate and pay interest semi-annually.

          CWC is considering adding to its product mix a “healthy” bottled water geared toward children. The initial outlay for the project is expected to be $3,000,000, which will be depreciated using the straight-line method to a zero salvage value, and sales are expected to be 1,250,000 units per year at a price of $1.25 per unit. Variable costs are estimated to be $0.24 per unit, and fixed costs of the project are estimated at $200,000 per year. The project is expected to have a 3-year life and a terminal value (excluding the operating cash flows in year 3) of $500,000. CWC has a 34% marginal tax rate. For the purposes of this project, working capital effects will be ignored. Bottled water targeted at children is expected to have different risk characteristics from the firm’s current products. Therefore, CWC has decided to use the “pure play” approach to evaluate this project. After researching the market, CWC managed to find two pure-play firms. The specifics for those two firms are:

          Question on Elimination Entry etc

          Historical financial statement

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          At the end of the year 2003, a parent sold equipment to a wholly owned subsidiary for $32,000. The equipment cost the parent $100,000 and, at the date of the inter company sale, had accumulated depreciation of $60,000 and a four-year remaining life. Both the subsidiary and the parent use straight line depreciation and assume no salvage value. The subsidiary plans to depreciate the asset over the equipment’s remaining four-year life.

          Required:

          A) Prepare the elimination entry or entries required on the consolidation work papers used to prepare a complete set of financial statements for the years 2003 and 2004.

          B) Compute the amounts that would appear in the year 2005 consolidated balance sheet for the equipment and related accumulated depreciation.

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