Practice Exercises

1. Marie's Fashions is considering a project that will require $28,000 in net working capital and $87,000 in fixed assets. The project is expected to produce annual sales of $75,000 with associated costs of $57,000. The project has a 5-year life. The company uses straight-line depreciation to a zero book value over the life of the project. The tax rate is 30 percent. What is the operating cash flow for this project?

a. OCF = ($75,000 - $57,000)(1 - 0.30) + ($87,000/5)(0.30) = $17,820

2. The Pancake House has sales of $1,642,000, depreciation of $27,000, and net working capital of $218,000. The firm has a tax rate of 35 percent and a profit margin of 6 percent. The firm has no interest expense. What is the amount of the operating cash flow?

a. OCF = ($1,642,000 0.06) + $27,000 = $125,520

3. A proposed expansion project is expected to increase sales of JL Ticker's Store by $35,000 and increase cash expenses by $21,000. The project will cost $24,000 and be depreciated using straight-line depreciation to a zero book value over the 4-year life of the project. The store has a marginal tax rate of 30 percent. What is the operating cash flow of the project using the tax shield approach?

a. OCF = ($35,000 - $21,000) (1 - 0.30) + ($24,000/4) (0.30) = $11,600

4. Bruno's Lunch Counter is expanding and expects operating cash flows of $26,000 a year for 4 years as a result. This expansion requires $39,000 in new fixed assets. These assets will be worthless at the end of the project. In addition, the project requires $3,000 of net working capital throughout the life of the project. What is the net present value of this expansion project at a required rate of return of 16 percent?a.

5. Jasper Metals is considering installing a new molding machine which is expected to produce operating cash flows of $73,000 a year for 7 years. At the beginning of the project, inventory will decrease by $16,000, accounts receivables will increase by $21,000, and accounts payable will increase by $15,000. All net working capital will be recovered at the end of the project. The initial cost of the molding machine is $249,000. The equipment will be depreciated straight-line to a zero book value over the life of the project. The equipment will be salvaged at the end of the project creating a $48,000 aftertax cash flow. At the end of the project, net working capital will return to its normal level. What is the net present value of this project given a required return of 14.5 percent?a. CF0 = -$249,000 + $16,000 - $21,000 + $15,000 = -$239,000C07 = $73,000 + $48,000 - $16,000 + $21,000 - $15,000 = $111,000

6. Gateway Communications is considering a project with an initial fixed asset cost of $2.46 million which will be depreciated straight-line to a zero book value over the 10-year life of the project. At the end of the project the equipment will be sold for an estimated $300,000. The project will not directly produce any sales but will reduce operating costs by $725,000 a year. The tax rate is 35 percent. The project will require $45,000 of inventory which will be recouped when the project ends. Should this project be implemented if the firm requires a 14 percent rate of return? Why or why not?a. Initial cash flow = -$2,460,000 - $45,000 = -$2,505,000OCF = $725,000(1 - 0.35) + ($2,460,000/10)(0.35) = $557,350Final cash flow = $45,000 + $300,000 (1 - 0.35) = $240,000

Yes positive NPV of $466,940.57

7. Samuelson Electronics has a required payback period of three years for all of its projects. Currently, the firm is analyzing two independent projects. Project A has an expected payback period of 2.8 years and a net present value of $6,800. Project B has an expected payback period of 3.1 years with a net present value of $28,400. Which projects should be accepted based on the payback decision rule?a. Project A shorter payback

8. The Green Fiddle is considering a project that will produce sales of $87,000 a year for the next 4 years. The profit margin is estimated at 6 percent. The project will cost $90,000 and will be depreciated straight-line to a book value of zero over the life of the project. The firm has a required accounting return of 11 percent. This project should be _____ because the AAR is _____ percenta.

9. Motor City Productions sells original automotive art on a prepaid basis as each piece is uniquely designed to the customer's specifications. For one project, the cash flows are estimated as follows.

Based on the internal rate of return (IRR), should this project be accepted if the required return is 9 percent?a. $5,500 $5,900/(1 + IRR) = 0; IRR = 7.27 percent Accept

10. A project that provides annual cash flows of $12,600 for 12 years costs $67,150 today. At what rate would you be indifferent between accepting the project and rejecting it?a. The IRR of 15.40%

11. Jerilu Markets has a beta of 1.09. The risk-free rate of return is 2.75 percent and the market rate of return is 9.80 percent. What is the risk premium on this stock?a. Risk premium = 1.09 (0.098 - 0.0275) = 7.68 percent

12. .The common stock of Jensen Shipping has an expected return of 16.3 percent. The return on the market is 10.8 percent and the risk-free rate of return is 3.8 percent. What is the beta of this stock?a. E(r) = 0.163 = 0.038 + (0.108 - 0.038); = 1.79