Question

1) A firm believes it can generate an additional $2,000,000 per year in revenues for the next 5 years if it purchases a new piece of equipment for $1,000,000. The firm does not expect to be able to sell the new equipment when it is finished using it (after 5 years). Variable costs are expected to be 48% of revenue annually. Assuming the firm uses straight-line depreciation and its marginal tax rate is 25%, what are the incremental annual operating cash flows of this acquisition?

2) A firm believes it can generate an additional $4,000,000 per year in revenues for the next 10 years if it replaces existing equipment that is no longer usable with new equipment that costs $6,500,000. The existing equipment has a book value of $50,000 and a market value of $20,000. The firm expects to be able to sell the new equipment when it is finished using it (after 10 years) for $100,000. Variable costs are expected to be 54% of revenue annually. The additional sales will require an initial investment in net working capital of $400,000, which is expected to be recovered at the end of the project (after 10 years). Assume the firm uses straight-line depreciation, its marginal tax rate is 25%, and the discount rate for the project is 14%.

a) How much value will this new equipment create for the firm?

b) At what discount rate will this project break even?

c) Should the firm purchase the new equipment? Be sure to justify your recommendation.

d) How would your analysis change if the firm believes the project is more risky than initially expected? Be specific.

Answer 1

1.
Straight line depreciation = Original Value /Useful Life
= $1,000,000 / 5 = $200,000

Additional Revenues	$   2,000,000
Variable Costs	$       960,000
Depreciation	$       200,000
Income before taxes	$       840,000
Income tax @25%	$       210,000
Net Income	$       630,000
Depreciation	$       200,000
Incremental Cash flows	$       830,000

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