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1. Project cash flows and NPV. The managers of Classic Autos Incorporated plan to manufacture
classic Thunderbirds (1957 replicas). The necessary foundry equipment will cost a total of
$4,000,000 and will be depreciated using a five-year MACRS life (depreciation rates: 0.20,
0.32, 0.192, 0.1152, 0.1152). Projected sales in annual units for the next five years are 300 per
year. If sales price is $27,000 per car, variable costs are $18,000 per car, and fixed costs are
$1,200,000 annually, what is the annual operating cash flow if the tax rate is 30%? The
equipment is sold for salvage for $500,000 at the end of year five. What is the after-tax cash
flow of the salvage? Net working capital increases by $600,000 at the beginning of the project
(Year 0) and is reduced back to its original level in the final year. What is the incremental cash
flow of the project? Using a discount rate of 12% for the project, determine whether the project
be accepted or rejected with the NPV decision model?

ANSWER
Annual depreciation of foundry equipment is:
Year One, $4,000,000×0.20 = $800,000
Year Two, $4,000,000×0.32 = $1,280,000
Year Three, $4,000,000×0.192 = $768,000
Year Four, $4,000,000×0.1152 = $460,800
Year Five, $4,000,000×0.1152 = $460,800
Operating Cash Flows are:
Annual Sales, 300×$27,000 = $8,100,000
Annual COGS, 300×$18,000 = $5,400,000
In thousands (rounded)
Year 1 Year 2 Year 3 Year 4 Year 5
Sales Revenue $8,100 $8,100 $8,100 $8,100 $8,100
-COGS $5,400 $5,400 $5,400 $5,400 $5,400
-FixedCosts $1,200 $1,200 $1,200 $1,200 $1,200
-Depreciation $800 $1,280 $ 768 $ 461 $ 461
EBIT $ 700 $ 220 $ 732 $1,039 $1,039
-Taxes(30%) $ 210 $ 66 $ 220 $ 312 $ 312
NetIncome $ 490 $ 154 $ 512 $ 727 $ 727
+Depreciation $ 800 $1,280 $ 768 $ 461 $ 461
OperatingCashFlows $1,290 $1,434 $1,280 $1,188 $1,188

The equipment is sold for salvage for $500,000 at the end of year five. It has a book value of
$4,000,000 – $800,000 – $1,280,000 – $768,000 – $460,800 – $460,800 = $230,400
Gain on Sale is $500,000 – $230,400 = $269,600
Tax on Gain is $269,600×0.30 = $80,880
And after-tax cash flow on disposal is $500,000 – $80,880 = $419,120.
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Incremental Cash Flows for Project (Answer in Thousands, $000)

Account/Activity Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Investment -$4,000
NWC -$ 600 $ 600
OCF $1,290 $1,434 $1,280 $1,188 $1,188
Salvage Value $ 419
Total Cash Flows -$4,600 $1,290 $1,434 $1,280 $1,188 $2,207
(Incremental)
NPV @ 12% = -$4,600 + $1,290/1.12 + $1,434/1.122 + $1,280/1.123 + $1,188/1.124 +
$2,207/1.125 = -$4,600 + 1,152 + 1,143 + $911 + $755 + $1,252 = $613.345
Accept the project because NPV is positive $613,345 (with rounding to nearest thousand).

2. Ashman Motors is currently an all-equity firm. It has two million shares outstanding, selling
for $43 per share. The company has a beta of 1.1, with the current risk-free rate at 3% and the
market premium at 8%. The tax rate is 35% for the company. Ashman has decided to sell $43
million of bonds and retire half its stock. The bonds will have a yield to maturity of 9%. The
beta of the company will rise to 1.3 with the new debt. What was the adjusted WACC of
Ashman Motors before selling bonds? What is the new WACC of Ashman Motors after
selling the bonds and retiring the stock with the proceeds from the sale of the bonds? Hint:
The weight of equity before selling the bond is 100%.

ANSWER
Before the sale of bonds the weighted average cost of capital is the cost of equity.
Re = 3% + 1.1 (8%) = 11.8% and this is the adjusted WACC.
After the sale of bonds the new cost of equity is:
Re = 3% + 1.3 (8%) = 13.4%
If Bonds sell for $43 million the firm can retire 1 million shares, $43,000,000 / $43 = 1,000,000
The market value of equity is now $43 × 1,000,000 = $43,000,000
The market value of debt is $43,000,000
E/V = $43,000,000 / ($43,000,000 + $43,000,000) = 0.5
D/V = $43,000,000 / ($43,000,000 + $43,000,000) = 0.5
Adjusted WACC = 0.5 × 13.4% + 0.5 × 9% × (1 – 0.35) = 6.7% + 2.925% = 9.625%

3. Define the following terms briefly:

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Sunk costs
Synergy gain
Flotation costs
Banker’s acceptance
Commercial paper

4. What would be the probable effect of each of the following on a firm’s cash
position?
a. A new advertising campaign that results in more rapidly rising sales.
b. A delay in the payment of the firm’s accounts payable.
c. A decision to offer a more liberal credit policy (to the firm’s customers).
d. A decision to hold larger inventories in an attempt to reduce the probability of
being out of stock.

Answer:
a. A new advertising campaign that results in more rapidly rising sales—An immediate
cash outflow that will be followed later by cash inflows as sales are made and money
is collected.
b. A delay in the payment of the firm’s accounts payable—A reduction in planned cash
expenditures but no change in the firm’s cash balance.
c. Offering a more liberal credit policy (to the firm’s customers)—As credit sales are
made cash will not flow in as rapidly as before so there will be a reduction in the
firm’s cash balance.
d. Holding larger inventories in an attempt to reduce the probability of being out of
stock—this requires a cash outflow to acquire the additional inventory (unless trade
credit can be arranged, thus a reduction in the firm’s cash balance.

BONUS: (Calculating the discounted payback period) Gio’s Restaurants is considering a project
with the following expected cash flows:

If the project’s appropriate discount is 12 percent, what is the project’s discounted payback
period?
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Gio’s Restaurant is considering a project whose cash flows are shown in the second column of
the table below:

12% cumulative
discounted
t CFt PV(CFt) cash flows
0 ($150,000,000) ($150,000,000) ($150,000,000)
1 $90,000,000 $80,357,143 ($69,642,857)
2 $70,000,000 $55,803,571 ($13,839,286)
3 $90,000,000 $64,060,222 $50,220,937
4 $100,000,000 $63,551,808

A payback method adds cash flows from different periods together, looking for the
number of periods it takes to recoup the initial cash outflow. In Gio’s case, we need to
find out how many years’ worth of cash flows equal $150 million. In addition, we will
be discounting the future years’ cash flows before we add them.
Years’ 1 and 2 have cash flows that total $136,160,714 in discounted value, so that we
have only ($150,000,000 $136,160,714) $13,839,286 left to recoup in year 3. Year
3’s total discounted cash flow is $64,060,222, so we won’t need the full year’s worth of t
$13,839,286
3 cash flows. Instead, we will need only ( $64,060,222 ) 22% of year 3’s cash flows. Thus,
Gio’s discounted payback period is 2.22 years.