Question

1. A new project has an intial cost of $350,000 with an expected life of 7 years. The project is expected to have earnings before depreciation and taxes of $125,000 per year. If the projected is being depreciated over a 4-year term and the firm's tax rate is 40%, calculate the cashflows of the project over its estimated life. 2. Texas Tires is considering replacing an old machine with a new, more efficient, one. The new machine will cost $1.2 million. The old machine originally cost $665,000 4 years ago and was being depreciated straight line over a 7 year life. The old machine can now be sold for $312,000. The firm has a 30 % tax rate. Calculate the initial outlay on the new machine. 3. BBC is looking to acquire ZZP Co. This investment will cost $2.3 million and is expected to give BBC returns of $680,000 yearly for the next 11 years. ZZP has a beta of 2.1. The current Treasury bond rate is 3.9% while the stock market return is 14.5%. Calculate the risk-adjusted discount rate for ZZP and the risk-adjusted NPV. Should BBC acquire ZZP? State your reasons.

Answer 1

Question 1:

Calculation of Cash Flows of the project
Particulars	0	1	2	3	4	5	6	7
Initial Investment
Initial Cost (A)	-350000
Operating Cash Flows
Earnings Before depreciation and taxes (B)		125000	125000	125000	125000	125000	125000	125000
Depreciation (C ) $350,000 / 4 years		87500	87500	87500	87500	0	0	0
Profit Before Tax (D = B-C)		37500	37500	37500	37500	125000	125000	125000
Tax @40% (E = D*40%)		15000	15000	15000	15000	50000	50000	50000
Profit After Tax (F = D-E)		22500	22500	22500	22500	75000	75000	75000
Add back Depreciation (G = C)		87500	87500	87500	87500	0	0	0
Net Operating Cash flows (H = F+G)		110000	110000	110000	110000	75000	75000	75000
Project Cash Flows (I = A+H)	-350000	110000	110000	110000	110000	75000	75000	75000

Question 2:

Cost of Old Machine = $665,000

Book value of Old machine = Cost of old machine * Remainig life / total useful life

= $665,000 * 3 years / 7 years = $285,000

Tax on sale of old machine = (Sale value - Book value) * tax rate

= ($312,000 - $285,000) * 30% = $8,100

After tax sale value of old machine = Sale value - tax on profit

= $312,000 - $8,100

= $303,900

Initial outlay of the new machine = New mchine cost - after tax sale value of old machine

= $1,200,000 - $303,900

= $896,100

Therefore, initial outlay on new machine is $896,100

Question 3:

rf = Treasury bond rate = 3.9%

rm = stock market return = 14.5%

beta = 2.1

Risk adjusted discount rate = rf + beta * (rm-rf)

= 3.9% + 2.1 * (14.5% - 3.9%)

= 3.9% + 22.26%

= 26.16%

Therefore, risk adjusted discount rate is 26.16%

Calculation of NPV of the Project
Year	Cash Flows	Discount [email protected]%	Discounted Cash Flows
A	B	C = 1/(1+26.16%)^A	D = B*C
0	-2300000	1	-2300000
1	680000	0.792644261	538998.0977
2	680000	0.628284925	427233.7489
3	680000	0.49800644	338644.3793
4	680000	0.394741947	268424.5239
5	680000	0.312889939	212765.1584
6	680000	0.248010414	168647.0818
7	680000	0.196584032	133677.1416
8	680000	0.155821205	105958.4191
9	680000	0.123510784	83987.33286
10	680000	0.097900114	66572.07741
11	680000	0.077599963	52767.97512
NPV of the Project	-97675.93609
Risk adjusted NPV of the project is $97,675.94
BBC should not acquire ZZP since NPV of the project is negative