CASE 1:
Damon Corporation, a sports equipment manufacturer, has a machine currently in use that was originally purchased 3 years ago for $120,000. The firm depreciates the machine under MACRS using a 5-year recovery period. Once removal and cleanup costs are taken into consideration, the expected net selling price for the present machine will be $70,000. Damon can buy a new machine for a net price of $160,000 (including installation costs of $15,000).
The proposed machine will be depreciated under MACRS using a 5-year recovery period. If the firm acquires the new machine its working capital needs will change: Accounts receivable will increase $15,000, inventory will increase $19,000, and accounts payable will increase $16,000.
Earnings before depreciation, interest, and taxes (EBDIT) for the present machine are expected to be $95,000 for each of the successive 5 years. For the proposed machine, the expected EBDIT for each of the next 5 years are $105,000, $110,000, $120,000, $120,000, and $120,000, respectively. The corporate tax rate (T) for the firm is 40%.
Damon expects to be able to liquidate the proposed machine at the end of its 5-year usable life for $24,000 (after paying removal and cleanup costs). The present machine is expected to net $8,000 upon liquidation at the end of same period. Damon expects to recover its net working capital investment upon termination of the project. The firm is subject to a tax rate of 40%.
REQUIRED:
Create a spreadsheet:
a) to calculate the initial investment.
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INITIAL INVESTENT
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New Machine
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120,000
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b) to prepare a depreciation schedule for both the proposed and the present machine. Both machines are depreciated under MACRS using a 5-year recovery period. Remember that the present machine has only 3 years of depreciation remaining.
c) to calculate the operating cash flows for Damon corporation for both the proposed and the present machine.
d) to calculate the terminal cash flow associated with the project.
Question Data:
Original purchase price 3 years ago $120,000
Net selling price of the existing machine $70,000
Cost of new machine (including installation costs) $160,000
Installation costs $15,000
Salvage value of new machine (after 5 years) $24,000
Salvage value of existing machine (after 5 years) $8,000
Changes to working capital:
Increase in accounts receivable $15,000
Increase in inventory $19,000
Increase in account payable $16,000
EBDIT for the present machine next 5 years $95,000
EBDIT for the proposed machine for next five years:
1 $105,000
2 $110,000
3 $120,000
4 $120,000
5 $120,000
Tax 40%
Depreciation MACRS 5-year recovery
MACRS 5-year Table
Recovery year Percentage recovery
1 20%
2 32%
3 19%
4 12%
5 12%
6 5%
CASE 2
Starstruck Company would like to determine its optimal capital structure. Several of its managers believe that the best method is to rely on the estimated earnings per share (EPS) of the firm because they believe that profits and stock price are closely related.
The financial managers have suggested another method that uses estimated required returns to estimate the share value of the firm. The following financial data are available.
Capital structure Estimated Estimated
debt ratio EPS required return
0% 1.75 11.40%
10% 1.9 11.80%
20% 2.25 12.50%
30% 2.55 13.25%
40% 3.18 18.00%
50% 3.06 19.00%
60% 3.1 25.00%
REQUIRED:
a) Based on the given financial data, create a spreadsheet to calculate the estimated share values associated with the seven alternative capital structures.
b) Use Excel to graph the relationship between capital structure and the estimated EPS of the firm. What is the optimal debt ratio?
c) Use Excel to graph the relationship between capital structure and the estimated share value of the firm. What is the optimal debt ratio?
d) Do both methods lead to the same optimal capital structure? Which method do you favor? Explain.
e) What is the major difference between the EPS and share value methods?