Practice Problem Set-5
Practice Problem Set – 5
( The following problems are from Corporate Finance by Ross, Westerfield, and Jaffe –
Tenth edition, McGraw-Hill / Irwin – ISBN 978-0-07-803477-0 )
1. Howell Petroleum is considering a new project that complements its existing business.
The machine required for the project costs $ 3.8 million. The marketing department
predicts that sales related to the project will be $ 2.5 million per year for the next four
years, after which the market will cease to exist. The machine will be depreciated down to zero over its four-year economic life using the straight-line method. Cost of goods sold and operating expenses related to the project are predicted to be 25 percent of sales.
Howell also needs to add net working capital of $ 150,000 immediately. The additional net working capital will be recovered in full at the end of the project’s life. The corporate tax rate is 35 percent. The required rate of return for Howell is 16 percent. Should Howell proceed with the project ?
2. Scott Investors, Inc., is considering the purchase of a $ 360,000 computer with an
economic life of five years. The computer will be fully depreciated over five years using the straight-line method. The market value of the computer will be $ 60,000 in five years.
The computer will replace five office employees whose combined annual salaries are
$ 105,000. The machine will also immediately lower the firm’s required net working
capital by $ 80,000. This amount of net working capital will need to be replaced once the machine is sold. The corporate tax rate is 34 percent. Is it worthwhile to buy the
computer if the appropriate discount rate is 12 percent ?
3. A firm is considering an investment in a new machine with a price of $ 18 million to
replace its existing machine. The current machine has a book value of $ 6 million and a market value of $ 4.5 million. The new machine is expected to have a four-year life, and the old machine has four years left in which it can be used. If the firm replaces the old
machine with the new machine, it expects to save $ 6.7 million in operating costs each
year over the next four years. Both machines will have no salvage value in four years.
If the firm purchases the new machine, it will also need an investment of $ 250,000 in
net working capital. The required return on the investment is 10 percent, and the tax rate is 39 percent. Assume straight-line depreciation. What are the NPV and IRR of the
decision to replace the old machine ?
4. Pilot Plus Pens is deciding when to replace its old machine. The machine’s current
salvage value is $ 2.2 million. Its current book value is $ 1.4 million. If not sold, the old
machine will require maintenance costs of $ 845,000 at the end of the year for the next five years. Depreciation on the old machine is $ 280,000 per year. At the end of five
years, it will have a salvage value of $ 120,000 and a book value of $ 0. A replacement machine costs $ 4.3 million now and requires maintenance costs of $ 330,000 at the end of each year during its economic life of five years. At the end of the five years, the new
machine will have a salvage value of $ 800,000. It will be fully depreciated by the
straight-line method. In five years a replacement machine will cost $ 3,200,000. Pilot will need to purchase this machine regardless of what choice it makes today. The corporate tax rate is 40 percent and the appropriate discount rate is 8 percent. The company is
assumed to earn sufficient revenues to generate tax shields from depreciation. Should
Pilot Plus Pens replace the old machine now or at the end of five years ?
5. Vandalay Industries is considering the purchase of a new machine for the production of
latex. Machine A costs $ 2,900,000 and will last for six years. Variable costs are 35
percent of sales, and fixed costs are $ 195,000 per year. Machine B costs $ 5,700,000
and will last for nine years. Variable costs for this machine are 30 percent and fixed
costs are $ 165,000 per year. The sales for each machine will be $ 12 million per year.
The required return is 10 percent and the tax rate is 35 percent. Both machines will be
depreciated on a straight-line basis. If the company plans to replace the machine when it wears out on a perpetual basis, which machine should you choose ?