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Managerial Finance

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Chapter 11 Questions 

(11-2)  Operating cash flows, rather than accounting profits, are used in project analysis. What is

the basis for this emphasis on cash flows as opposed to net income?

(11-4)  Explain why sunk costs should not be included in a capital budgeting analysis but

opportunity costs and externalities should be included.

(11-5)  Explain how net operating working capital is recovered at the end of a project’s life and

why it is included in a capital budgeting analysis.

(11-7)  Why are interest charges not deducted when a project’s cash flows are calculated for use in

a capital budgeting analysis?

(11-8)  Most firms generate cash inflows every day, not just once at the end of the year. In capital

budgeting, should we recognize this fact by estimating daily project cash flows and then

using them in the analysis? If we do not, will this bias our results? If it does, would the

NPV be biased up or down? Explain.

(11-11)  In theory, market risk should be the only “relevant” risk. However, companies focus as

much on stand-alone risk as on market risk. What are the reasons for the focus on stand-

alone risk?

Chapter 11 Problems

(11-3)  Allen Air Lines must liquidate some equipment that is being replaced. The equipment

originally cost $12 million, of which 75% has been depreciated. The used equipment can

be sold today for $4 million, and its tax rate is 40%. What is the equipment’s after-tax net

salvage value?

(11-4)  Although the Chen Company’s milling machine is old, it is still in relatively good working

order and would last for another 10 years. It is inefficient compared to modern standards,

though, and so the company is considering replacing it. The new milling machine, at a

cost of $110,000 delivered and installed, would also last for 10 years and would produce

after-tax cash flows (labor savings and depreciation tax savings) of $19,000 per year. It

would have zero salvage value at the end of its life. The firm’s WACC is 10%, and its

marginal tax rate is 35%. Should Chen buy the new machine?

(11-6)  The Campbell Company is considering adding a robotic paint sprayer to its

production line. The sprayer’s base price is $1,080,000, and it would cost another

$22,500 to install it. The machine falls into the MACRS 3-year class, and it would be

sold after 3 years for $605,000. The MACRS rates for the first three years are 0.3333,

0.4445, and 0.1481. The machine would require an increase in net working capital

(inventory) of $15,500. The sprayer would not change revenues, but it is expected to

save the firm $380,000 per year in before-tax operating costs, mainly labor.

Campbell’s marginal tax rate is 35%.

a. What is the Year 0 net cash flow?

b. What are the net operating cash flows in Years 1, 2, and 3?

c. What is the additional Year-3 cash flow (i.e., the after-tax salvage and the return of

working capital)?

d. Based on your IRR analysis, if the project’s cost of capital is 12%, should the machine be purchased?

Chapter 12 Problems

(12-1)  Broussard Skateboard’s sales are expected to increase by 15% from $8 million in

2013 to $9.2 million in 2014. Its assets totaled $5 million at the end of 2013.

Broussard is already at full capacity, so its assets must grow at the same rate as

projected sales. At the end of 2013, current liabilities were $1.4 million, consisting

of $450,000 of accounts payable, $500,000 of notes payable, and $450,000 of

accruals. The after-tax profit margin is forecasted to be 6%, and the forecasted

payout ratio is 40%. Use the AFN equation to forecast Broussard’s additional funds

needed for the coming year.

(12-8)  Stevens Textiles’s 2013 financial statements are shown here:

Balance Sheet as of December 31, 2013 (Thousands of Dollars)

Cash                                         $  1,080          Accounts payable                          $  4,320

Receivables                                 6,480          Accruals                                               2,880

Inventories                                  9,000          Line of credit                                             0

Total current assets               $16,560         Notes payable                                   2,100

Net fixed assets                         12,600        Total current liabilities                 $  9,300

                                                                          Mortgage bonds                               3,500

                                                                          Common stock                                  3,500

                                                   ______         Retained earnings                            12,860

   Total assets                           $29,160            Total liabilities and equity        $ 29,160

Income Statement for December 31, 2013 (Thousands of Dollars)

Sales                                                                $36,000

Operating costs                                               32,440

Earnings before interest and taxes           $  3,560

Interest                                                                   460

Pre-tax earnings                                              $ 3,100

Taxes (40%)                                                         1,240

Net income                                                       $ 1,860

Dividends (45%)                                                  $  837

Addition to retained earnings                       $ 1,023

a. Suppose 2014 sales are projected to increase by 15% over 2013 sales. Use the

forecasted financial statement method to forecast a balance sheet and income

statement for December 31, 2014. The interest rate on all debt is 10%, and cash

earns no interest income. Assume that all additional debt in the form of a line of

credit is added at the end of the year, which means that you should base the

forecasted interest expense on the balance of debt at the beginning of the year. Use

the forecasted income statement to determine the addition to retained earnings.

Assume that the company was operating at full capacity in 2013, that it cannot sell

off any of its fixed assets, and that any required financing will be borrowed as

notes payable. Also, assume that assets, spontaneous liabilities, and operating costs

are expected to increase by the same percentage as sales. Determine the additional

funds needed.

b. What is the resulting total forecasted amount of the line of credit?