1. A bicycle manufacturer currently produces 364,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $2.20 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct in-house production costs are estimated to be only $1.50 per chain. The necessary machinery would cost $275,000 and would be obsolete after ten years. This investment could be depreciated to zero for tax purposes using a ten-year straight-line depreciation schedule. The plant manager estimates that the operation would require additional working capital of $23,000 but argues that this sum can be ignored since it is recoverable at the end of the ten years. Expected proceeds from scrapping the machinery after ten years are $20,625.
If the company pays tax at a rate of 35% and the opportunity cost of capital is 15%, what is the net present value of the decision to produce the chains in-house instead of purchasing them from the supplier?
2. One year ago, your company purchased a machine used in manufacturing for $110,000. You have learned that a new machine is available that offers many advantages; you can purchase it for $150,000 today. It will be depreciated on a straight-line basis over ten years, after which it has no salvage value. You expect that the new machine will contribute EBITDA (earnings before interest, taxes, depreciation, and amortization) of $35,000 per year for the next ten years. The current machine is expected to produce EBITDA of $24,000 per year. The current machine is being depreciated on a straight-line basis over a useful life of 11 years, after which it will have no salvage value, so depreciation expense for the current machine is $10,000 per year. The current machine can be sold today for a market value of $50,000. Your company's tax rate is 35%, and the opportunity cost of capital for this type of equipment is 12%. Is it profitable to replace the year-old machine?
3. Markov Manufacturing recently spent $16 million to purchase some equipment used in the manufacture of dsk drives. The firm expects that this equipment will have a useful life of five years, and its marginal corporate tax rate is 37%. The company plans to use stain-line depreciation.
a. What is the annual depreciation expense associated with this equipment?
b. What is the annual depreciation tax shield?
c. Rather than stain-line depreciation, suppose Markov will use the MACRS depreciation methodfor five-year property. Calculate the depreciation tax shield each year for this equipment under this accelerated depreciation schedule.
d. If Markov has a choice between straight-line and MACRS depreciation schedules, anO its marginal corporate tax rate is expected to remain constant, which should it choose? Why?
e. How might your answer to part (d) change if Markov anticipates that its marginal corporate tax rate will charge substantially over the next five years?
4. You are evaluating the HomeNet project under the following assumptions: Sales of 50,000 units in year 1 increasing by 50,000 units per year over the life of the project, a year 1 sales price of $260/unit, decreasing by 11% annually and a year 1 cost of S120 unit decreasing by 20% annually. In addition, new tax laws allow you to depreciate the equipment, costing $7.5 million, over three years using straight-line depreciation. Research and development expenditures total $15 million in year 0 and selling, general, and administrative expenses are $2.8 million per year (assuming there is no cannibalization).
Also assume HomeNet will have no incremental cash or inventory requirements (products will be shipped directly from the contract manufacturer to customers). However, receivables related to HomeNet are expected to account for 15% of annual sales, and payables are expected to be 15% of the annual cost of goods sold. Under these assumptions the unlevered net income, net working capital requirements and free cash flow. Using the FCF projections given:
a. Calculate the NPV of the HomeNet project assuming a cost of capital of 10%, 12% and 14%.
b. What is the IRR of the project in this case?
5. What does the phrase limited liability mean in a corporate context?
Owners' liability is limited to the amount they invested in the firm.
Stockholders are not responsible for any encumbrances of the firm; in particular, they cannot be required to pay back any debts incurred by the firm.
Owners' liability is limited to fifty percent of the amount they invested in the firm.
Stockholders are not responsible for any encumbrances of the firm beyond fifty percent of the amount they invested in the firm; in particular, they cannot be required to pay back any debts incurred by the firm.