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Financial Analysis and Investment Decision Making Tutorial

This tutorial provides solutions to homework problems involving cash flows, operating and terminal values, salvage, depreciation adjustments, and profitability index for investment decisions.

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Financial Analysis and Investment Decision Making Tutorial

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  1. Net cash flows in Year 0: -$1,200,000 - $40,000 - $50,000 + $60,000 - ($90,400 - $60,000)(0.40) = -1,217,840 1: ($240,000)(0.60) + ($1,240,000)(0.3333)(0.40) = 309,317 2: ($240,000)(0.60) + ($1,240,000)(0.4445)(0.40) = 364,472 3: ($240,000)(0.60) + ($1,240,000)(0.1481)(0.40) = 217,458 4: ($240,000)(0.60) + ($1,240,000)(0.0741)(0.40) = 180,754 ($300,000)(0.60) + $50,000 = 230,000 Tutorial 7 Homework Solution

  2. Initial CF • Cost -1,200,000 • Installation -40,000 • NWC inc. -50,000 • Sale old asset +60,000 • Dep,n (90,400 – 60,000)(0.40) = +12,160 • - 1,217,840

  3. Operating CF 1: ($240,000)(0.60) + ($1,240,000)(0.3333)(0.40) = 309,317 2: ($240,000)(0.60) + ($1,240,000)(0.4445)(0.40) = 364,472 3: ($240,000)(0.60) + ($1,240,000)(0.1481)(0.40) = 217,458 4: ($240,000)(0.60) + ($1,240,000)(0.0741)(0.40) = 180,754 Terminal CF Salvage value 300,000 x 0.6 = 180,000 NWC recovered = 50,000

  4. Notes: • Salvage value is the amount the “new” asset can be sold for less tax because asset is fully written down for depreciation purposes • Depreciable value of the new asset is $1,240,000 (1,200,000 + 40,000) • Depreciation on old asset in its final year was $90,400, but the asset was worth just $60,000. Therefore there is a tax adjustment needed for the loss of $30,400 (i.e. 90,400 – 60,000)

  5. Text book Ch 12, problem # 3 (p.320) • Period Rockbuilt Bulldog Savings Bulldog truck • 0 ($74,000) ($59,000) ($15,000) • 1 (2,000) (3,000) 1,000 • 2 (2,000) (4,500) 2,500 • 3 (2,000) (6,000) 4,000 • 4 (2,000) (22,500) 20,500 • 5 (13,000) (9,000) (4,000) • 6 (4,000) (10,500) 6,500 • 7 (4,000) (12,000) 8,000 • 8 5,000* (8,500)** 13,500 • * $4,000 maintenance cost plus salvage value of $9,000. • ** $13,500 maintenance cost plus salvage value of $5,000.

  6. Tutorial 8 • 4. The Cardinal Machine Tool Company is considering the purchase of a new drill press to replace the one currently being used. • The present machine should last another seven years and have no salvage value. • The current drill press has a book value of $700 and can be sold for $400. • Cardinal pays $300 a year maintenance on the press. • The new drill press will cost $1,500 and is expected to last seven years, at which time it will be sold for $100. • The maintenance cost of the new machine is expected to be $150 a year. • Cardinal depreciates its assets on the straight-line basis and pays 40% taxes. • If its opportunity cost of funds is 10%, should it buy the new machine?

  7. Initial cost = $1,500 - $400 + ($700 - $400)(0.40) = $980 • Annual savings after tax = ($300 - $150)(0.60) = $90 • Change in depn = ($1,500 - $100)/7 - $700/7 = $100 per yr • Tax saving on depn change = ($100)(0.40) = $40 • NPV at 10%: • = ($90 + $40)(4.868) + ($100)(0.513) - $980 = -$295.86 • Since the NPV is negative, we would REJECT this project.

  8. Text book Ch 13, problem # 8 (p.348) • Selecting those projects with the highest profitability index values would indicate the following: • Project Amount PI NPV* • 1 $500,000 1.22 $110,000 • 3 350,000 1.20 70,000 • $850,000 $180,000 • * NPV = (Amount x PI) - Amount • = (500,000 x 1.22) – 500,000 = 110,000

  9. However, utilising “close to” full budgeting will be better. • Project Amount PI NPV • 1 $500,000 1.22 $110,000 • 4 450,000 1.18 81,000 • $950,000 $191,000

  10. b. No. The resort should accept all projects with a positive NPV. If capital is not available to finance them at the discount rate used, a higher discount rate should be used, which more adequately reflects the costs of financing.

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