Answer the case studies I have Uploaded and post the solution of all the case studies in a SINGLE WORD DOCUMENT.
The Case study starts with “Excel Master It! Problem” so you know that is the case study you solve – so no need to solve any question before the “Excel Master It! Problem”.
Let’s take Case 1 for example, the Case you solve is CASH FLOWS AT WARF COMPUTERS, INC.
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25. Net Fixed Assets and Depreciation On the balance sheet, the net fixed assets (NFA) account is equal
to the gross fixed assets (FA) account, which records the acquisition cost of fixed assets, minus the
accumulated depreciation (AD) account, which records the total depreciation taken by the firm against
its fixed assets. Using the fact that NFA = FA − AD, show that the expression given in the chapter for
net capital spending, NFAend− NFAbeg+ D (where D is the depreciation expense during the year), is
equivalent to FAend− FAbeg.
26. Tax Rates Refer to the corporate marginal tax rate information in Table 2.3.
1. Why do you think the marginal tax rate jumps up from 34 percent to 39 percent at a taxable
income of $100,001, and then falls back to a 34 percent marginal rate at a taxable income of
$335,001?
2. Compute the average tax rate for a corporation with exactly $335,001 in taxable income. Does
this confirm your explanation in part (a)? What is the average tax rate for a corporation with
exactly $18,333,334? Is the same thing happening here?
3. The 39 percent and 38 percent tax rates both represent what is called a tax “bubble.” Suppose
the government wanted to lower the upper threshold of the 39 percent marginal tax bracket from
$335,000 to $200,000. What would the new 39 percent bubble rate have to be?
Excel Master It! Problem
Using Excel to find the marginal tax rate can be accomplished using the VLOOKUP function. However,
calculating the total tax bill is a little more difficult. Below we have shown a copy of the IRS tax table for an
individual for 2015 (the income thresholds are indexed to inflation and change through time).
If taxable income is over –But not over –The tax is:
$ 0 $ 9,22510% of the amount over $0
9,226 37,450$922.50 plus 15% of the amount over $9,225
37,451 90,750$5,126.25 plus 25% of the amount over $37,450
90,751 189,300$18,481.25 plus 28% of the amount over $90,750
189,301 411,500$46,075.25 plus 33% of the amount over $189,300
411,501 413,200$119,402.25 plus 35% of the amount over $411,500
413,201 $119,996.25 plus 39.6% of the amount over $413,200
In reading this table, the marginal tax rate for taxable income less than $9,225 is 10 percent. If the taxable
income is between $9,226 and $37,450, the tax bill is $922.50 plus the marginal taxes. The marginal taxes
are calculated as the taxable income minus $9,225 times the marginal tax rate of 15 percent.
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1. Create a tax table for corporate taxes similar to the individual tax table shown above.
2. For a given taxable income, what is the marginal tax rate?
3. For a given taxable income, what is the total tax bill?
4. For a given taxable income, what is the average tax rate?
Mini Case
CASH FLOWS AT WARF COMPUTERS, INC.
Warf Computers, Inc., was founded 15 years ago by Nick Warf, a computer programmer. The small initial
investment to start the company was made by Nick and his friends. Over the years, this same group has
supplied the limited additional investment needed by the company in the form of both equity and short- and
long-term debt. Recently the company has developed a virtual keyboard (VK). The VK uses sophisticated
artificial intelligence algorithms that allow the user to speak naturally and have the computer input the text,
correct spelling and grammatical errors, and format the document according to preset user guidelines. The
VK even suggests alternative phrasing and sentence structure, and it provides detailed stylistic diagnostics.
Based on a proprietary, very advanced software/hardware hybrid technology, the system is a full generation
beyond what is currently on the market. To introduce the VK, the company will require significant outside
investment.
Nick has made the decision to seek this outside financing in the form of new equity investments and bank
loans. Naturally, new investors and the banks will require a detailed financial analysis. Your employer,
Angus Jones & Partners, LLC, has asked you to examine the financial statements provided by Nick. Here are
the balance sheets for the two most recent years and the most recent income statement:
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Nick has also provided the following information: During the year the company raised $228,000 in new
long-term debt and retired $197,000 in long-term debt. The company also sold $15,000 in new stock and
repurchased $66,000 in stock. The company purchased $1,482,000 in fixed assets and sold $429,000 in fixed
assets.
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Angus has asked you to prepare the financial statement of cash flows and the accounting statement of cash
flows. He has also asked you to answer the following questions:
1. How would you describe Warf Computers’ cash flows?
2. Which cash flow statement more accurately describes the cash flows at the company?
3. In light of your previous answers, comment on Nick’s expansion plans.
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Assuming that all debt is constant, show that EFN can be written as:
EFN = −PM(S)b + [A − PM(S)b] × g
Hint: Asset needs will equal A × g. The addition to retained earnings will equal PM(S) b × (1 + g).
28. Sustainable Growth Rate Based on the results in Problem 27, show that the internal and sustainable
growth rates can be calculated as shown in Equations 3.24 and 3.25. (Hint: For the internal growth
rate, set EFN equal to zero and solve for g.)
29. Sustainable Growth Rate In the chapter, we discussed one calculation of the sustainable growth rate
as:
In practice, probably the most commonly used calculation of the sustainable growth rate is ROE × b.
This equation is identical to the sustainable growth rate equation presented in the chapter if the ROE is
calculated using the beginning of period equity. Derive this equation from the equation presented in the
chapter.
30. Sustainable Growth Rate Use the sustainable growth rate equations from the previous problem to
answer the following questions. I Am Myself, Inc., had total assets of $410,000 and equity of
$230,000 at the beginning of the year. At the end of the year, the company had total assets of
$460,000. During the year the company sold no new equity. Net income for the year was $75,000 and
dividends were $32,000. What is the sustainable growth rate for the company? What is the sustainable
growth rate if you calculate ROE based on the beginning of period equity?
Excel Master It! Problem
Financial planning can be more complex than the percentage of sales approach indicates. Often, the
assumptions behind the percentage of sales approach may be too simple. A more sophisticated model allows
important items to vary without being a strict percentage of sales.
Consider a new model in which depreciation is calculated as a percentage of beginning fixed assets, and
interest expense depends directly on the amount of debt. Debt is still the plug variable. Note that since
depreciation and interest now do not necessarily vary directly with sales, the profit margin is no longer
constant. Also, for the same reason, taxes and dividends will no longer be a fixed percentage of sales. The
parameter estimates used in the new model are:
Cost percentage = Costs / Sales
Depreciation rate = Depreciation / Beginning fixed assets
Interest rate = Interest paid / Total debt
Tax rate = Taxes / Net income
Payout ratio = Dividends / Net income
Capital intensity ratio = Fixed assets / Sales
Fixed assets ratio = Fixed assets / Total assets
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The model parameters can be determined by whatever methods the company deems appropriate. For
example, they might be based on average values for the last several years, industry standards, subjective
estimates, or even company targets. Alternatively, sophisticated statistical techniques can be used to estimate
them.
The Loftis Company is preparing its pro forma financial statements for the next year using this model. The
abbreviated financial statements are presented below.
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1. Calculate each of the parameters necessary to construct the pro forma balance sheet.
2. Construct the pro forma balance sheet. What is the total debt necessary to balance the pro forma
balance sheet?
3. In this financial planning model, show that it is possible to solve algebraically for the amount of new
borrowing.
Mini Case
RATIOS AND FINANCIAL PLANNING AT EAST COAST YACHTS
Dan Ervin was recently hired by East Coast Yachts to assist the company with its short-term financial
planning and also to evaluate the company’s financial performance. Dan graduated from college five years
ago with a finance degree, and he has been employed in the treasury department of a Fortune 500 company
since then.
East Coast Yachts was founded 10 years ago by Larissa Warren. The company’s operations are located near
Hilton Head Island, South Carolina, and the company is structured as an LLC. The company has
manufactured custom midsize, high-performance yachts for clients over this period, and its products have
received high reviews for safety and reliability. The company’s yachts have also recently received the highest
award for customer satisfaction. The yachts are primarily purchased by wealthy individuals for pleasure use.
Occasionally, a yacht is manufactured for purchase by a company for business purposes.
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The custom yacht industry is fragmented, with a number of manufacturers. As with any industry, there are
market leaders, but the diverse nature of the industry ensures that no manufacturer dominates the market.
The competition in the market, as well as the product cost, ensures that attention to detail is a necessity. For
instance, East Coast Yachts will spend 80 to 100 hours on hand-buffing the stainless steel stem-iron, which is
the metal cap on the yacht’s bow that conceivably could collide with a dock or another boat.
To get Dan started with his analyses, Larissa has provided the following financial statements. Dan has
gathered the industry ratios for the yacht manufacturing industry.
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1. Calculate all of the ratios listed in the industry table for East Coast Yachts.
2. Compare the performance of East Coast Yachts to the industry as a whole. For each ratio, comment on
why it might be viewed as positive or negative relative to the industry. Suppose you create an
inventory ratio calculated as inventory divided by current liabilities. How do you interpret this ratio?
How does East Coast Yachts compare to the industry average?
3. Calculate the sustainable growth rate of East Coast Yachts. Calculate external funds needed (EFN) and
prepare pro forma income statements and balance sheets assuming growth at precisely this rate.
Recalculate the ratios in the previous question. What do you observe?
4. As a practical matter, East Coast Yachts is unlikely to be willing to raise external equity capital, in part
because the owners don’t want to dilute their existing ownership and control positions. However, East
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Coast Yachts is planning for a growth rate of 20 percent next year. What are your conclusions and
recommendations about the feasibility of East Coast’s expansion plans?
5. Most assets can be increased as a percentage of sales. For instance, cash can be increased by any
amount. However, fixed assets often must be increased in specific amounts because it is impossible, as
a practical matter, to buy part of a new plant or machine. In this case a company has a “staircase” or
“lumpy” fixed cost structure. Assume that East Coast Yachts is currently producing at 100 percent of
capacity. As a result, to expand production, the company must set up an entirely new line at a cost of
$25 million. Calculate the new EFN with this assumption. What does this imply about capacity
utilization for East Coast Yachts next year?
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73. Present Value of a Growing Perpetuity What is the equation for the present value of a growing
perpetuity with a payment of C one period from today if the payments grow by C each period?
74. Rule of 72 A useful rule of thumb for the time it takes an investment to double with discrete
compounding is the “Rule of 72.” To use the Rule of 72, you simply divide 72 by the interest rate to
determine the number of periods it takes for a value today to double. For example, if the interest rate is
6 percent, the Rule of 72 says it will take 72/6 = 12 years to double. This is approximately equal to the
actual answer of 11.90 years. The Rule of 72 can also be applied to determine what interest rate is
needed to double money in a specified period. This is a useful approximation for many interest rates
and periods. At what rate is the Rule of 72 exact?
75. Rule of 69.3 A corollary to the Rule of 72 is the Rule of 69.3. The Rule of 69.3 is exactly correct
except for rounding when interest rates are compounded continuously. Prove the Rule of 69.3 for
continuously compounded interest.
Excel Master It! Problem
Excel is a great tool for solving problems, but with many time value of money problems, you may still need
to draw a time line. For example, consider a classic retirement problem. A friend is celebrating her birthday
and wants to start saving for her anticipated retirement. She has the following years to retirement and
retirement spending goals:
Years until retirement 30
Amount to withdraw each year $90,000
Years to withdraw in retirement 20
Interest rate 8%
Because your friend is planning ahead, the first withdrawal will not take place until one year after she retires.
She wants to make equal annual deposits into her account for her retirement fund.
1. If she starts making these deposits in one year and makes her last deposit on the day she retires, what
amount must she deposit annually to be able to make the desired withdrawals in retirement?
2. Suppose your friend has just inherited a large sum of money. Rather than making equal annual
payments, she has decided to make one lump sum deposit today to cover her retirement needs. What
amount does she have to deposit today?
3. Suppose your friend’s employer will contribute to the account each year as part of the company’s
profit sharing plan. In addition, your friend expects a distribution from a family trust several years
from now. What amount must she deposit annually now to be able to make the desired withdrawals in
retirement? The details are:
Employer’s annual contribution $ 1,500
Years until trust fund distribution 20
Amount of trust fund distribution$25,000
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Mini Case
THE MBA DECISION
Ben Bates graduated from college six years ago with a finance undergraduate degree. Although he is
satisfied with his current job, his goal is to become an investment banker. He feels that an MBA degree
would allow him to achieve this goal. After examining schools, he has narrowed his choice to either Wilton
University or Mount Perry College. Although internships are encouraged by both schools, to get class credit
for the internship, no salary can be paid. Other than internships, neither school will allow its students to work
while enrolled in its MBA program.
Ben currently works at the money management firm of Dewey and Louis. His annual salary at the firm is
$65,000 per year, and his salary is expected to increase at 3 percent per year until retirement. He is currently
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28 years old and expects to work for 40 more years. His current job includes a fully paid health insurance
plan, and his current average tax rate is 26 percent. Ben has a savings account with enough money to cover
the entire cost of his MBA program.
The Ritter College of Business at Wilton University is one of the top MBA programs in the country. The
MBA degree requires two years of full-time enrollment at the university. The annual tuition is $70,000,
payable at the beginning of each school year. Books and other supplies are estimated to cost $3,000 per year.
Ben expects that after graduation from Wilton, he will receive a job offer for about $110,000 per year, with a
$20,000 signing bonus. The salary at this job will increase at 4 percent per year. Because of the higher salary,
his average income tax rate will increase to 31 percent.
The Bradley School of Business at Mount Perry College began its MBA program 16 years ago. The Bradley
School is smaller and less well known than the Ritter College. Bradley offers an accelerated, one-year
program, with a tuition cost of $85,000 to be paid upon matriculation. Books and other supplies for the
program are expected to cost $4,500. Ben thinks that he will receive an offer of $92,000 per year upon
graduation, with an $18,000 signing bonus. The salary at this job will increase at 3.5 percent per year. His
average tax rate at this level of income will be 29 percent.
Both schools offer a health insurance plan that will cost $3,000 per year, payable at the beginning of the year.
Ben also estimates that room and board expenses will cost $2,000 more per year at both schools than his
current expenses, payable at the beginning of each year. The appropriate discount rate is 6.3 percent.
1. How does Ben’s age affect his decision to get an MBA?
2. What other, perhaps nonquantifiable factors affect Ben’s decision to get an MBA?
3. Assuming all salaries are paid at the end of each year, what is the best option for Ben—from a strictly
financial standpoint?
4. Ben believes that the appropriate analysis is to calculate the future value of each option. How would
you evaluate this statement?
5. What initial salary would Ben need to receive to make him indifferent between attending Wilton
University and staying in his current position?
6. Suppose, instead of being able to pay cash for his MBA, Ben must borrow the money. The current
borrowing rate is 5.4 percent. How would this affect his decision?
Appendix 4A
Net Present Value: First Principles of Finance
To access the appendix for this chapter, please logon to Connect for this title.
Appendix 4B
Using Financial Calculators
To access the appendix for this chapter, please logon to Connect for this title.
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2. Suppose that the two streams are combined into one project, called C. What is the IRR of Project
C?
3. What is the correct IRR rule for Project C?
27. Calculating Incremental Cash Flows Darin Clay, the CFO of MakeMoney.com, has to decide
between the following two projects:
YearProject MillionProject Billion
0 −$1,200 −$Io
1 Io + 160 Io + 400
2 960 1,200
3 1,200 1,600
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The expected rate of return for either of the two projects is 12 percent. What is the range of initial
investment (Io) for which Project Billion is more financially attractive than Project Million?
28. Problems with IRR McKeekin Corp. has a project with the following cash flows:
YearCash Flow
0 $20,000
1 −26,000
2 13,000
What is the IRR of the project? What is happening here?
Excel Master It! Problem
As you have already seen, Excel does not have a function to calculate the payback period. We have shown
three ways to calculate the payback period, but there are numerous other methods as well. The cash flows for
a project are shown below. You need to calculate the payback period using two different methods:
1. Calculate the payback period in a table. The first three columns of the table will be the year, the cash
flow for that year, and the cumulative cash flow. The fourth column will show the whole year for the
payback. In other words, if the payback period is 3 plus years, this column will have a 3, otherwise it
will be a zero. The next column will calculate the fractional part of the payback period, or else it will
display zero. The last column will add the previous two columns and display the final payback period
calculation. You should also have a cell that displays the final payback period by itself, and a cell that
returns the correct accept or reject decision based on the payback criteria.
2. Write a nested IF statement that calculates the payback period using only the project cash flow column.
The IF statement should return a value of “Never” if the project has no payback period. In contrast to
the example we showed previously, the nested IF function should test for the payback period starting
with shorter payback periods and working towards longer payback periods. Another cell should
display the correct accept or reject decision based on the payback criteria.
Year Cash Flow
0 −$250,000
1 41,000
2 48,000
3 63,000
4 79,000
5 88,000
6 64,000
7 41,000
Required payback: 5
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Mini Case
BULLOCK GOLD MINING
Seth Bullock, the owner of Bullock Gold Mining, is evaluating a new gold mine in South Dakota. Dan
Dority, the company’s geologist, has just finished his analysis of the mine site. He has estimated that the
mine would be productive for eight years, after which the gold would be completely mined. Dan has taken an
estimate of the gold deposits to Alma Garrett, the company’s financial officer. Alma has been asked by Seth
to perform an analysis of the new mine and present her recommendation on whether the company should
open the new mine.
Alma has used the estimates provided by Dan to determine the revenues that could be expected from the
mine. She has also projected the expense of opening the mine and the annual operating expenses. If the
company opens the mine, it will cost $850 million today, and it will have a cash outflow of $75 million nine
years from today in costs associated with closing the mine and reclaiming the area surrounding it. The
expected cash flows each year from the mine are shown in the following table. Bullock Mining has a 12
percent required return on all of its gold mines.
Year Cash Flow
0 −$850,000,000
1 170,000,000
2 190,000,000
3 205,000,000
4 265,000,000
5 235,000,000
6 170,000,000
7 160,000,000
8 105,000,000
9 −75,000,000
1. Construct a spreadsheet to calculate the payback period, internal rate of return, modified internal rate
of return, and net present value of the proposed mine.
2. Based on your analysis, should the company open the mine?
3. Bonus question: Most spreadsheets do not have a built-in formula to calculate the payback period.
Write a VBA script that calculates the payback period for a project.
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year in real terms. The inflation rate is 5 percent per year. Revenues are received and costs are paid at
year-end. Refer to the following table for the production schedule:
Year 1 Year 2 Year 3 Year 4
Physical production, in units 155,000 175,000 190,000 170,000
Labor input, in hours 1,120,0001,200,0001,360,0001,280,000
Energy input, physical units 210,000 225,000 255,000 240,000
The real discount rate for the project is 4 percent. Calculate the NPV of this project.
37. Project Analysis and Inflation After extensive medical and marketing research, Pill, Inc., believes it
can penetrate the pain reliever market. It is considering two alternative products. The first is a
medication for headache pain. The second is a pill for headache and arthritis pain. Both products
would be introduced at a price of $7.75 per package in real terms. The headache-only medication is
projected to sell 3.2 million packages a year, whereas the headache and arthritis remedy would sell 4.9
million packages a year. Cash costs of production in the first year are expected to be $3.80 per package
in real terms for the headache-only brand. Production costs are expected to be $4.35 in real terms for
the headache and arthritis pill. All prices and costs are expected to rise at the general inflation rate of 3
percent.
Either product requires further investment. The headache-only pill could be produced using equipment
costing $25 million. That equipment would last three years and have no resale value. The machinery
required to produce the broader remedy would cost $34 million and last three years. The firm expects
that equipment to have a $1 million resale value (in real terms) at the end of Year 3.
Pill, Inc., uses straight-line depreciation. The firm faces a corporate tax rate of 34 percent and believes
that the appropriate real discount rate is 7 percent. Which pain reliever should the firm produce?
38. Calculating Project NPV J. Smythe, Inc., manufactures fine furniture. The company is deciding
whether to introduce a new mahogany dining room table set. The set will sell for $6,100, including a
set of eight chairs. The company feels that sales will be 1,900, 2,250, 2,700, 2,450, and 2,300 sets per
year for the next five years, respectively. Variable costs will amount to 37 percent of sales, and fixed
costs are $2.25 million per year. The new tables will require inventory amounting to 10 percent of
sales, produced and stockpiled in the year prior to sales. It is believed that the addition of the new table
will cause a loss of 250 tables per year of the oak tables the company produces. These tables sell for
$4,500 and have variable costs of 40 percent of sales. The inventory for this oak table is also 10
percent of sales. The sales of the oak table will continue indefinitely. J. Smythe currently has excess
production capacity. If the company buys the necessary equipment today, it will cost $19 million.
However, the excess production capacity means the company can produce the new table without
buying the new equipment. The company controller has said that the current excess capacity will end
in two years with current production. This means that if the company uses the current excess capacity
for the new table, it will be forced to spend the $19 million in two years to accommodate the increased
sales of its current products. In five years, the new equipment will have a market value of $3.1 million
if purchased today, and $4.7 million if purchased in two years. The equipment is depreciated on a
seven-year MACRS schedule. The company has a tax rate of 40 percent, and the required return for
the project is 11 percent.
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1. Should J. Smythe undertake the new project?
2. Can you perform an IRR analysis on this project? How many IRRs would you expect to find?
3. How would you interpret the profitability index?
Excel Master It!Problem
For this Master It! assignment, refer to the Goodweek Tires, Inc., case at the end of this chapter. For your
convenience, we have entered the relevant values such as the price and variable costs in the case on the next
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page. For this project, answer the following questions:
1. What is the profitability index of the project?
2. What is the IRR of the project?
3. At what OEM price would Goodweek Tires be indifferent to accepting the project? Assume the
replacement market price is constant.
4. At what level of variable costs per unit would Goodweek Tires be indifferent to accepting the project?
Mini Cases
BETHESDA MINING COMPANY
Bethesda Mining is a midsized coal mining company with 20 mines located in Ohio, Pennsylvania, West
Virginia, and Kentucky. The company operates deep mines as well as strip mines. Most of the coal mined is
sold under contract, with excess production sold on the spot market.
The coal mining industry, especially high-sulfur coal operations such as Bethesda, has been hard-hit by
environmental regulations. Recently, however, a combination of increased demand for coal and new
pollution reduction technologies has led to an improved market demand for high-sulfur coal. Bethesda has
just been approached by Mid-Ohio Electric Company with a request to supply coal for its electric generators
for the next four years. Bethesda Mining does not have enough excess capacity at its existing mines to
guarantee the contract. The company is considering opening a strip mine in Ohio on 5,000 acres of land
purchased 10 years ago for $4 million. Based on a recent appraisal, the company feels it could receive $6.5
million on an aftertax basis if it sold the land today.
Strip mining is a process where the layers of topsoil above a coal vein are removed and the exposed coal is
removed. Some time ago, the company would simply remove the coal and leave the land in an unusable
condition. Changes in mining regulations now force a company to reclaim the land; that is, when the mining
is completed, the land must be restored to near its original condition. The land can then be used for other
purposes. Because it is currently operating at full capacity, Bethesda will need to purchase additional
necessary equipment, which will cost $95 million. The equipment will be depreciated on a seven-year
MACRS schedule. The contract runs for only four years. At that time the coal from the site will be entirely
mined. The company feels that the equipment can be sold for 60 percent of its initial purchase price in four
years. However, Bethesda plans to open another strip mine at that time and will use the equipment at the new
mine.
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The contract calls for the delivery of 500,000 tons of coal per year at a price of $86 per ton. Bethesda Mining
feels that coal production will be 620,000 tons, 680,000 tons, 730,000 tons, and 590,000 tons, respectively,
over the next four years. The excess production will be sold in the spot market at an average of $77 per ton.
Variable costs amount to $31 per ton, and fixed costs are $4,100,000 per year. The mine will require a net
working capital investment of 5 percent of sales. The NWC will be built up in the year prior to the sales.
Bethesda will be responsible for reclaiming the land at termination of the mining. This will occur in Year 5.
The company uses an outside company for reclamation of all the company’s strip mines. It is estimated the
cost of reclamation will be $2.7 million. In order to get the necessary permits for the strip mine, the company
agreed to donate the land after reclamation to the state for use as a public park and recreation area. This will
occur in Year 6 and result in a charitable expense deduction of $6 million. Bethesda faces a 38 percent tax
rate and has a 12 percent required return on new strip mine projects. Assume that a loss in any year will
result in a tax credit.
You have been approached by the president of the company with a request to analyze the project. Calculate
the payback period, profitability index, net present value, and internal rate of return for the new strip mine.
Should Bethesda Mining take the contract and open the mine?
GOODWEEK TIRES, INC.
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After extensive research and development, Goodweek Tires, Inc., has recently developed a new tire, the
SuperTread, and must decide whether to make the investment necessary to produce and market it. The tire
would be ideal for drivers doing a large amount of wet weather and off-road driving in addition to normal
freeway usage. The research and development costs so far have totaled about $10 million. The SuperTread
would be put on the market beginning this year, and Goodweek expects it to stay on the market for a total of
four years. Test marketing costing $5 million has shown that there is a significant market for a SuperTread-
type tire.
As a financial analyst at Goodweek Tires, you have been asked by your CFO, Adam Smith, to evaluate the
SuperTread project and provide a recommendation on whether to go ahead with the investment. Except for
the initial investment that will occur immediately, assume all cash flows will occur at year-end.
Goodweek must initially invest $160 million in production equipment to make the SuperTread. This
equipment can be sold for $65 million at the end of four years. Goodweek intends to sell the SuperTread to
two distinct markets:
1. The original equipment manufacturer (OEM) market: The OEM market consists primarily of the large
automobile companies (like General Motors) that buy tires for new cars. In the OEM market, the
SuperTread is expected to sell for $41 per tire. The variable cost to produce each tire is $29.
2. The replacement market: The replacement market consists of all tires purchased after the automobile
has left the factory. This market allows higher margins; Goodweek expects to sell the SuperTread for
$62 per tire there. Variable costs are the same as in the OEM market.
Goodweek Tires intends to raise prices at 1 percent above the inflation rate; variable costs will also increase
at 1 percent above the inflation rate. In addition, the SuperTread project will incur $43 million in marketing
and general administration costs the first year. This cost is expected to increase at the inflation rate in the
subsequent years.
Goodweek’s corporate tax rate is 40 percent. Annual inflation is expected to remain constant at 3.25 percent.
The company uses a 13.4 percent discount rate to evaluate new product decisions. Automotive industry
analysts expect automobile manufacturers to produce 6.2 million new cars this year and production to grow
at 2.5 percent per year thereafter. Each new car needs four tires (the spare tires are undersized and are in a
different category). Goodweek Tires expects the SuperTread to capture 11 percent of the OEM market.
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Industry analysts estimate that the replacement tire market size will be 32 million tires this year and that it
will grow at 2 percent annually. Goodweek expects the SuperTread to capture an 8 percent market share.
The appropriate depreciation schedule for the equipment is the seven-year MACRS depreciation schedule.
The immediate initial working capital requirement is $9 million. Thereafter, the net working capital
requirements will be 15 percent of sales. What are the NPV, payback period, discounted payback period,
IRR, and PI on this project?
In view of the above cash flow statement, it is clearly visible that Warf computers has positive cash flows from operating activities which can be considered as healthy for any organisation. It has negative cash flow in investment activities which is due to purchase of new fixed asset which is a sign of expansion plan of Warf Computers. Again it has negative cash flow from financing activities which means it has more of outflow than inflow. This is mainly owing to payment of dividend to shareholders and interest to long term debt. It has received long term debt of $ 175,000 and sold stock worth $ 12,000 and paid long term debt of $ 151,000 and buyback stock worth $ 48,000. Overall it has reduced its long term funding by $12,000 (175000+12000 – 151000 – 48000). So there is no significant raising of capital as far as financing activity is concerned. Hence we can come to a conclusion that although Warf computers has bought new fixed assets, it is not necessarily towards expansion as there is no rise in capital funds. Although it might be possible that Warf computers is planning an expansion from the funds raised by its own operations.
In view of the above cash flow statement, it is clearly visible that Warf computers has positive cash flows from operating activities which can be considered as healthy for any organisation. It has negative cash flow in investment activities which is due to purchase of new fixed asset which is a sign of expansion plan of Warf Computers. Again it has negative cash flow from financing activities which means it has more of outflow than inflow. This is mainly owing to payment of dividend to shareholders and interest to long term debt. It has received long term debt of $ 175,000 and sold stock worth $ 12,000 and paid long term debt of $ 151,000 and buyback stock worth $ 48,000. Overall it has reduced its long term funding by $12,000 (175000+12000 – 151000 – 48000). So there is no significant raising of capital as far as financing activity is concerned. Hence we can come to a conclusion that although Warf computers has bought new fixed assets, it is not necessarily towards expansion as there is no rise in capital funds. Although it might be possible that Warf computers is planning an expansion from the funds raised by its own operations.