Question

Financial Management

Chapter 11 Case

1. CompU is looking at starting a major advertising campaign to further expand their business. Based on preliminary estimates, the advertising campaign will cost $100,000 and will increase revenue by $80,000 per year for the next 5 years. The increased expenses excluding depreciation will be $35,000 per year. Inventory will increase by $25,000, accounts receivable will increase by $20,000, accounts payable will increase by $20,000, and accruals will increase by $15,000. The company is in the 40% tax bracket. The ad campaign will be capitalized and depreciated using a 5-year MACRS recovery schedule.

1. Calculate the initial investment associated with the advertising campaign.
2. Calculate the annual operating cash flows for the project.

2. CellU, a subsidiary of CompU, is looking to replace one of the machines they use to manufacture cell phones with a new, more efficient model. The current machine cost $7,500, is three years old, and is depreciated using the MACRS 3-year recovery period. The current machine could be sold now for $1,000, but at the end of 3 years it would be worthless. The cost of the new machine is $11,500, installation costs are $500, and would require an increase in net working capital of $1,000. The expected life of the new machine is 3 years, is depreciated using the MACRS 3-year recovery period, and will reduce annual labor expenses from $10,000 to $4,000. At the end of the project the firm will be able to sell the new machine for $3,000 and recover their investment in net working capital. The firm has a marginal tax rate of 40 percent.

1. Calculate the initial investment of the new machine.
2. Calculate the annual incremental operating cash flows for the new machine.
3. Calculate the terminal value of the new machine.

Answer 1

	CompU:
a)	Cost of the advertisement campaign	100000
	Increase in NWC = 25000+20000-20000-15000 =	10000
	Initial investment	110000
b)		0	1	2	3	4	5
	Incremental revenue		80000	80000	80000	80000	80000
	Incremental expenses other than depn		35000	35000	35000	35000	35000
	Depreciation		20000	32000	19200	11520	11520	5760
	Incremental NOI		25000	13000	25800	33480	33480
	Tax at 40%		10000	5200	10320	13392	13392
	Incremental NOPAT		15000	7800	15480	20088	20088
	Add: Depreciation		20000	32000	19200	11520	11520
	Incremental Annual OCF		35000	39800	34680	31608	31608
	CellU:
a)	Cost of the new machine+Installation costs		12000
	Sale value of the old machine	1000
	Book value of the old machine = 7500*7.41% =	556
	Gain on sale	444
	Tax on gain at 40%	178
	After tax sale value of old machine = 1000-178 =		822
	Net cash outflow for the new machine		11178
	Add: Investment in NWC		1000
	Initial investment for the replacement		12178
b)	Savings in labor expenses		6000	6000	6000
	Incremental depreciation:
	Depreciation on the new machine		4000	5334	1777	889		12000
	Depreciation on the old machine		556	0	0
	Incremental depreciation		3444	5334	1777
	Incremental NOI		2556	666	4223
	Tax at 40%		1022	266	1689
	Incremental NOPAT		1534	400	2534
	Add: Incremental depreciation		3444	5334	1777
	Incremental OCF		4978	5734	4311
c)	Salvage value	3000
	Book value = 12000*7.41% =	889
	Gain on sale	2111
	Tax on gain at 40%	844
	Terminal value of the old equipment = 3000-844 =	2156