Q.1 Cushing Corporation is considering the purchase of a new grading machine to replace the existing one. The existing machine was purchased 3 years ago at an installed cost of $20,000; it was being depreciated under MACRS using a 5-year recovery period. (See Table 3.2 on page 100 for the applicable depreciation percentages.) The existing machine is expected to have a usable life of at least 5 more years. The new machine costs $35,000 and requires $5,000 in installation costs; it will be depreciated using a 5-year recovery period under MACRS. The existing machine can currently be sold for $25,000 without incurring any removal or cleanup costs. The firm pays 40% taxes on both ordinary income and capital gains. Calculate the initial investment associated with the proposed purchase of a new grading machine.
Q.2 Miller Corporation is considering replacing a machine. The replacement will reduce operating expenses (that is, increase revenues) by $16,000 per year for each of the 5 years the new machine is expected to last. Although the old machine has zero book value, it can be used for 5 more years. The depreciable value of the new machine is $48,000. The firm will depreciate the machine under MACRS using a 5-year recovery period (see Table 3.2 on page 100 for the applicable depreciation percentages) and is subject to a 40% tax rate on ordinary income. Estimate the incremental operating cash inflows generated by the replacement. (Note: Be sure to consider the depreciation in year 6.)
Q.3 Hook Industries is considering the replacement of one of its old drill presses. Three alternative replacement presses are under consideration. The relevant cash flows associated with each are shown in the following table. The firm's cost of capital is 15%.
|
|
Press A
|
Press B
|
Press C
|
|
Initial investment (CF0)
|
$85,000
|
$60.000
|
$130,000
|
|
Year(t)
|
|
Cash inflow. (CFt).
|
|
| 1 |
518.000
|
S12,000
|
550.000
|
| 2 |
18,000
|
14,000
|
30,000
|
| 3 |
18.000
|
16.000
|
20.000
|
| 4 |
18,000
|
18,000
|
20,000
|
| 5 |
18,000
|
20,000
|
20,000
|
| 6 |
18,000
|
25,000
|
30,000
|
|
7
|
18,000
|
-
|
40,000
|
| 8 |
18,000
|
-
|
50,000
|
a. Calculate the net present value (NPV) of each press.
b. Using NPV, evaluate the acceptability of each press.
c. Rank the presses from best to worst using NPV.
Q.4 Equity Lighting Corp. wishes to explore the effect on its cost of capital of the rate at which the company pays taxes. The firm wishes to maintain a capital structure of 30% debt, 10% preferred stock, and 60% common stock. The cost of financing with retained earnings is 14%, the cost of preferred stock financing is 9%, and the before-tax cost of debt financing is 11%. Calculate the weighted average cost of capital (WACC) given the tax rate assumptions in parts a to c.
a. Tax rate_40%
b. Tax rate_35%
c. Tax rate_25%
d. Describe the relationship between changes in the rate of taxation and the weighted average cost of capital.