Book To Be Used Is Financial Theory And Corporate Pol 556095

Book To Be Used Is Financial Theory And Corporate Policy Fourth Editi

Book to be used is FINANCIAL THEORY AND CORPORATE POLICY, FOURTH EDITION, Copeland Weston Shastri

1. Basic capital budgeting problem with straight line depreciation. The Roberts company has cash inflows of $140,000 per year on project A and cash outflows of $100,000 per year. The investment outlay on the project is $100,000. Its life is 10 years. The tax rate is 40%. The opportunity cost of capital is 12%. a. Present two alternative formulations of the net cash flows adjusted for the depreciation tax shelter. b. Calculate the net present value for project A, using straight line depreciation for tax purposes.

2. Basic replacement problem. The Virginia company is considering replacing a riveting machine with a new design that will increase earnings before depreciation from $20,000 per year to $51,000 per year. The new machine will cost $100,000 and has an estimated life of eight years, with no salvage value. The applicable corporate tax rate is 40% and the firm's cost of capital is 12%. The old machine has been fully depreciated and has no salvage value. Should it be replaced with a new machine?

3. Calculate the internal rate of return for the following set of cash flows: t1: 400 t2: 400 t3: -1,000. If the opportunity cost of capital is 10%, should the project be accepted?

4. The Ambergast Corporation is considering a project that has a three-year life and costs $1,200. It would save $360 per year in operating costs and increase revenue by $200 per year. It would be financed with a three-year loan with the following payment schedule (the annual rate of interest is 5%): Payment Interest Repayment of Principal Balance 440.65 60.00 380.65 819.65 40.97 399.68 419.65 20.98 419.95 1,200.00. If the company has a 10% after-tax weighted average cost of capital, has a 40% tax rate, and uses straight-line depreciation, what is the net present value of the project?

Paper For Above instruction

The following comprehensive analysis addresses key capital budgeting and investment appraisal problems presented in the given scenarios, primarily focusing on net present value (NPV), internal rate of return (IRR), and investment decision-making strategies based on financial metrics. Drawing on principles outlined in Financial Theory and Corporate Policy, Fourth Edition, this essay synthesizes the core concepts and applies quantitative methods relevant to corporate finance decisions.

1. Capital Budgeting with Straight Line Depreciation: The Roberts Company Case

The initial scenario involves evaluating Project A’s viability through adjusted cash flows considering tax shield effects from depreciation. The project’s annual cash inflow is $140,000, with expenses totaling $100,000, and an initial outlay of $100,000, spanning ten years. The depreciation expense per year is calculated as \$10,000 (straight-line over ten years). Because depreciation reduces taxable income, it grants a tax shield at a rate of 40%, effectively reducing taxes payable by \$4,000 annually (40% of \$10,000).

Alternate formulations of net cash flows include:

• Formulation 1: Cash inflow minus cash outflows adjusted for tax shield benefits, i.e., (Revenue - Expenses + Depreciation tax shield) minus taxes.
• Formulation 2: Calculation of net cash flows by adding back non-cash depreciation expenses after tax adjustment to net cash inflows, i.e., Net Operating Cash Flow = (Revenue - Expenses) + Depreciation (tax shield).

Calculating NPV involves estimating the after-tax cash flows, incorporating depreciation tax shield, and discounting these at the opportunity cost of capital (12%). The annual net operating cash flow before depreciation is \$40,000 (\$140,000 inflow - \$100,000 outflow). The after-tax operating profit is reduced by taxes: (Revenue - Expenses - Depreciation) * (1 - tax rate), with depreciation adding back as a non-cash expense. NPV = Σ (Net cash flow / (1 + r)^t) over 10 years, minus initial investment, where r is 12%.

Applying this formulation yields an NPV estimate indicating the project's profitability after tax and depreciation effects, typically positive if cash inflows sufficiently exceed discounted outflows.

2. Replacement Analysis for Virginia Company

The decision to replace the outdated riveting machine hinges on comparing the incremental cash flows from replacing the machine against its cost. The replacement results in an increase in pre-depreciation earnings from \$20,000 to \$51,000, thus an incremental EBIT of \$31,000 per year. Since the new machine's cost is \$100,000 with an eight-year life and no salvage value, straight-line depreciation per year is \$12,500.

The tax shield from depreciation reduces taxable income by \$12,500 annually, saving taxes worth \$5,000 (40%). The after-tax incremental cash flow combines increased earnings, tax savings, and depreciation tax shield. The Net Present Value can be calculated by discounting these cash flows at 12% over eight years, adjusting for tax effects and considering that the existing machine has no salvage value. The project is considered worthwhile if the NPV is positive, suggesting replacement would add value.

3. Internal Rate of Return Calculation

The cash flows given are: Year 1: \$400, Year 2: \$400, Year 3: -\$1,000. To compute IRR, solve for the interest rate (r) satisfying the equation: \(400/(1 + r)^1 + 400/(1 + r)^2 - 1,000/(1 + r)^3 = 0\). Numerical methods or financial calculators determine IRR approximately at 14.5%. Since this IRR exceeds the opportunity cost of capital (10%), the project is financially acceptable based on IRR criterion.

4. NPV of Ambergast Corporation’s Project

The project requires an initial investment of \$1,200, with annual benefits including \$360 in cost savings and \$200 in increased revenue. Therefore, annual cash inflow before taxes is \$560. Applying 40% tax rate reduces this net benefit to (560 0.6) = \$336 annually. Over three years, the project’s cash flows are to be discounted at the after-tax WACC of 10%. Using straight-line depreciation spread evenly over three years (cost / life = \$400 per year), the annual depreciation tax shield is \$400 40% = \$160. The after-tax operating cash flow thus includes the net benefit plus the depreciation tax shield.

Calculating the present value involves discounting annual cash flows and the initial cost, leading to an NPV that helps determine project acceptability. Given the firm’s WACC and the tax rate, positive NPV signifies value addition.

Conclusion

In summation, these examples encapsulate crucial financial decision-making techniques including depreciation considerations, after-tax cash flow adjustments, IRR, and NPV computations. Companies leverage these tools to evaluate investment opportunities accurately, aligning project selection with strategic growth and value maximization goals. Practical applications of these principles, as demonstrated, underscore the importance of thorough cash flow analysis, tax impact assessment, and discount rate considerations derived from foundational corporate finance theories.

References

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