FINC206
Tutorial 3 – Questions
Students are required to turn in their HW solutions for Questions 1, 2, 3.
Questions marked with a * will be covered in tutorial class. Remaining questions are for
practice purpose.
1. Explain the following with examples
a. Opportunity cost
b. Sunk Cost
c. Salvage Value
d. Nominal versus Real cash flow
2*.
The Best Manufacturing Company is considering a new investment. Financial projections for
the investment are tabulated here. 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. All net working capital is recovered at the end of the
project.
Year 0 Year 1 Year 2 Year 3 Year 4
Investment $24,000
Sales revenue $12,500 $13,000 $13,500 $10,500
Operating costs 2,700 2,800 2,900 2,100
Depreciation 6,000 6,000 6,000 6,000
Net working capital spending 300 350 400 300 ?
a. Compute the incremental earnings after tax of the investment for each year.
b. Compute the incremental cash flows of the investment each year.
c. Suppose the appropriate discount rate is 12 percent. What is the NPV of the project?
3*.
Consider the following cash flows on two mutually exclusive projects:
Year Project A Project B
0 –$50,000 –$65,000
1 30,000 29,000
2 25,000 38,000
3 20,000 41,000
The cash flows of project A are expressed in real terms, whereas those of project B are
expressed in nominal terms. The appropriate nominal discount rate is 13 percent and the
inflation rate is 4 percent. Which project should you choose?
4*.
Pilot Plus Pens is deciding when to replace its old machine. The machine’s current salvage
value is $2.2 million. Its current book value is $1.4 million. If not sold, the old machine will
require maintenance costs of $845,000 at the end of the year for next five years. Depreciation
on the old machine is $280,000 per year. At the end of five years, it will have a salvage value
of $120,000 and a book value of $0. A replacement machine costs $4.3 million now and
requires maintenance costs of $330,000 at the end of each year during its economic life of 5
years. At the end of the five years, the new machine will have a salvage value of $800,000. It
will be fully depreciated by the straight-line method. In five years a replacement machine will
cost $3,200,000. Pilot will need to purchase this machine regardless of what choice it makes
today. The corporate tax is 40 percent and the appropriate discount rate is 8 percent. The
company is assumed to earn sufficient revenues to generate tax shields from depreciation.
Should Pilot plus Pens replace the old machine now or at the end of five years?
5.
Suppose we are thinking of replacing an old computer with a new one. The old one cost us
$450,000; the new one will cost $580,000. The new machine will be depreciated straight-line
to zero over its five-year life. It will probably be worth about $130,000 after five years.
The old computer is being depreciated at a rate of $90,000 per year. It will be completely
written off in three years. If we don’t replace it now, we will have to replace it in two years.
We can sell it now for $230,000; in two years it will probably be worth $60,000. The new
machine will save us $85,000 per year in operating costs. The tax rate is 38 percent, and the
discount rate is 14 percent.
Suppose we recognize that if we don’t replace the computer now, we will be replacing it in
two years. Should we replace it now or should we wait? (Hint: What we effectively have here
is a decision either to “invest” in the old computer – by not selling it - or to invest in the new
one. Notice that two investments have unequal lives).