Zelda Haggerty was recently promoted to project manager at Verban Automation, a maker of industrial machinery. Haggerty’s first task as project manager is to analyze capital-spending proposals.

The first project under review is a proposal for a new factory. Verban wants to build the plant on land it already owns in India. Below are details included on a fact sheet regarding the factory project:

§ The initial outlay to the builder would be $85 million for the building. Verban would spend another $20 million on specialized equipment in the first year.

§ The factory would open up new markets for Verban’s products. Production should begin July 1 of the second year.

§ Verban’s tax rate is 34 percent.

§ Verban expects the factory to generate $205 million in annual sales starting in the third year, with half of that amount in the second year.

§ At the end of the sixth year, Verban expects the market value and the book value of the building to be worth $35 million, and the market value and the book value of the equipment to be worth $3.25 million.

§ Fixed operating costs are expected to be $65 million a year once the factory starts production.

§ Variable operating costs should be 40 percent of sales.

§ Verban uses straight-line depreciation.

§ New inventories are likely to boost working capital by $7.5 million in the first year of production.

§ Verban’s cost of capital for the factory project is 14.3 percent.

Verban’s chief of operations, Max Jenkins, attached a note containing some of his thoughts about the project. His comments are listed below:

§ Comment 1: “We spent $5 million up front on an exclusive, 10-year maintenance contract for all of our equipment in Asia two years ago, before an earlier project was canceled. Your budget should reflect that.”

§ Comment 2: “Some Asian clients are likely to switch over to the equipment from the new factory. They account for about $5 million a year in sales for the U.S. division. Your budget should reflect that.”

§ Comment 3: “I expect variable costs to take a one-time hit in Year 1, as we should plan for about $1.5 million in installation expense for the manufacturing equipment.”

§ Comment 4: “We bought the land allocated for this factory for $30 million in 1998. That money is long spent, so don’t worry about including it in the budget analysis.”

Haggerty is unimpressed with the advice she received from Jenkins and calculates cash flows and net present values using numbers from the fact sheet without taking any of the advice. She assumes all inflows and outflows take place at the end of the year.

Verban is also considering upgrading two smaller, outdated factories, projects for which the cost of capital is 14.3 percent. Both of the remodeled factories would have a three-year life and cash flows as follows:

Initial outlayYear 1Year 2Year 3

-$30 million$15 million$17 million$28 million

Verban is willing to pursue the new factory or the renovations, but not both projects. Haggerty decides which project makes the most sense and prepares models and recommendations for Verban’s executives. Haggerty is concerned that her budgeting calculations do not accurately affect inflation, so she attempts to tweak her models to reflect the 2.5 percent inflation expected annually over the next five years.

Part 5)

In Year 2 of the new factory project, cash flows will be closest to:

A) $15.61 million.

B) $19.35 million.

C) $23.32 million.

D) $23.11 million.

Zelda Haggerty was recently promoted to project manager at Verban Automation, a maker of industrial machinery. Haggerty’s first task as project manager is to analyze capital-spending proposals.

The first project under review is a proposal for a new factory. Verban wants to build the plant on land it already owns in India. Below are details included on a fact sheet regarding the factory project:

§ The initial outlay to the builder would be $85 million for the building. Verban would spend another $20 million on specialized equipment in the first year.

§ The factory would open up new markets for Verban’s products. Production should begin July 1 of the second year.

§ Verban’s tax rate is 34 percent.

§ Verban expects the factory to generate $205 million in annual sales starting in the third year, with half of that amount in the second year.

§ At the end of the sixth year, Verban expects the market value and the book value of the building to be worth $35 million, and the market value and the book value of the equipment to be worth $3.25 million.

§ Fixed operating costs are expected to be $65 million a year once the factory starts production.

§ Variable operating costs should be 40 percent of sales.

§ Verban uses straight-line depreciation.

§ New inventories are likely to boost working capital by $7.5 million in the first year of production.

§ Verban’s cost of capital for the factory project is 14.3 percent.

Verban’s chief of operations, Max Jenkins, attached a note containing some of his thoughts about the project. His comments are listed below:

§ Comment 1: “We spent $5 million up front on an exclusive, 10-year maintenance contract for all of our equipment in Asia two years ago, before an earlier project was canceled. Your budget should reflect that.”

§ Comment 2: “Some Asian clients are likely to switch over to the equipment from the new factory. They account for about $5 million a year in sales for the U.S. division. Your budget should reflect that.”

§ Comment 3: “I expect variable costs to take a one-time hit in Year 1, as we should plan for about $1.5 million in installation expense for the manufacturing equipment.”

§ Comment 4: “We bought the land allocated for this factory for $30 million in 1998. That money is long spent, so don’t worry about including it in the budget analysis.”

Haggerty is unimpressed with the advice she received from Jenkins and calculates cash flows and net present values using numbers from the fact sheet without taking any of the advice. She assumes all inflows and outflows take place at the end of the year.

Verban is also considering upgrading two smaller, outdated factories, projects for which the cost of capital is 14.3 percent. Both of the remodeled factories would have a three-year life and cash flows as follows:

Initial outlayYear 1Year 2Year 3

-$30 million$15 million$17 million$28 million

Verban is willing to pursue the new factory or the renovations, but not both projects. Haggerty decides which project makes the most sense and prepares models and recommendations for Verban’s executives. Haggerty is concerned that her budgeting calculations do not accurately affect inflation, so she attempts to tweak her models to reflect the 2.5 percent inflation expected annually over the next five years.

Part 2)

In the last year of the new factory project, cash flows will be closest to:

A) $95.71 million.

B) $91.74 million.

C) $90.21 million.

D) $88.00 million.

Zelda Haggerty was recently promoted to project manager at Verban Automation, a maker of industrial machinery. Haggerty’s first task as project manager is to analyze capital-spending proposals.

The first project under review is a proposal for a new factory. Verban wants to build the plant on land it already owns in India. Below are details included on a fact sheet regarding the factory project:

§ The initial outlay to the builder would be $85 million for the building. Verban would spend another $20 million on specialized equipment in the first year.

§ The factory would open up new markets for Verban’s products. Production should begin July 1 of the second year.

§ Verban’s tax rate is 34 percent.

§ Verban expects the factory to generate $205 million in annual sales starting in the third year, with half of that amount in the second year.

§ At the end of the sixth year, Verban expects the market value and the book value of the building to be worth $35 million, and the market value and the book value of the equipment to be worth $3.25 million.

§ Fixed operating costs are expected to be $65 million a year once the factory starts production.

§ Variable operating costs should be 40 percent of sales.

§ Verban uses straight-line depreciation.

§ New inventories are likely to boost working capital by $7.5 million in the first year of production.

§ Verban’s cost of capital for the factory project is 14.3 percent.

Verban’s chief of operations, Max Jenkins, attached a note containing some of his thoughts about the project. His comments are listed below:

§ Comment 1: “We spent $5 million up front on an exclusive, 10-year maintenance contract for all of our equipment in Asia two years ago, before an earlier project was canceled. Your budget should reflect that.”

§ Comment 2: “Some Asian clients are likely to switch over to the equipment from the new factory. They account for about $5 million a year in sales for the U.S. division. Your budget should reflect that.”

§ Comment 3: “I expect variable costs to take a one-time hit in Year 1, as we should plan for about $1.5 million in installation expense for the manufacturing equipment.”

§ Comment 4: “We bought the land allocated for this factory for $30 million in 1998. That money is long spent, so don’t worry about including it in the budget analysis.”

Haggerty is unimpressed with the advice she received from Jenkins and calculates cash flows and net present values using numbers from the fact sheet without taking any of the advice. She assumes all inflows and outflows take place at the end of the year.

Verban is also considering upgrading two smaller, outdated factories, projects for which the cost of capital is 14.3 percent. Both of the remodeled factories would have a three-year life and cash flows as follows:

Initial outlayYear 1Year 2Year 3

-$30 million$15 million$17 million$28 million

Verban is willing to pursue the new factory or the renovations, but not both projects. Haggerty decides which project makes the most sense and prepares models and recommendations for Verban’s executives. Haggerty is concerned that her budgeting calculations do not accurately affect inflation, so she attempts to tweak her models to reflect the 2.5 percent inflation expected annually over the next five years.

Part 6)

Haggerty is using the replacement-chain method, depending only on data from the new factory fact sheet and the cash-flow estimate for the remodeling projects. Which strategy should Haggerty recommend, and what is the difference between that project’s NPV and that of the other project?

Project NPV difference

A) New Factory $1.09 million

B) Remodeling $3.69 million

C) New Factory $1.24 million

D) Remodeling $11.20 million

Zelda Haggerty was recently promoted to project manager at Verban Automation, a maker of industrial machinery. Haggerty’s first task as project manager is to analyze capital-spending proposals.

The first project under review is a proposal for a new factory. Verban wants to build the plant on land it already owns in India. Below are details included on a fact sheet regarding the factory project:

§ The initial outlay to the builder would be $85 million for the building. Verban would spend another $20 million on specialized equipment in the first year.

§ The factory would open up new markets for Verban’s products. Production should begin July 1 of the second year.

§ Verban’s tax rate is 34 percent.

§ Verban expects the factory to generate $205 million in annual sales starting in the third year, with half of that amount in the second year.

§ At the end of the sixth year, Verban expects the market value and the book value of the building to be worth $35 million, and the market value and the book value of the equipment to be worth $3.25 million.

§ Fixed operating costs are expected to be $65 million a year once the factory starts production.

§ Variable operating costs should be 40 percent of sales.

§ Verban uses straight-line depreciation.

§ New inventories are likely to boost working capital by $7.5 million in the first year of production.

§ Verban’s cost of capital for the factory project is 14.3 percent.

Verban’s chief of operations, Max Jenkins, attached a note containing some of his thoughts about the project. His comments are listed below:

§ Comment 1: “We spent $5 million up front on an exclusive, 10-year maintenance contract for all of our equipment in Asia two years ago, before an earlier project was canceled. Your budget should reflect that.”

§ Comment 2: “Some Asian clients are likely to switch over to the equipment from the new factory. They account for about $5 million a year in sales for the U.S. division. Your budget should reflect that.”

§ Comment 3: “I expect variable costs to take a one-time hit in Year 1, as we should plan for about $1.5 million in installation expense for the manufacturing equipment.”

§ Comment 4: “We bought the land allocated for this factory for $30 million in 1998. That money is long spent, so don’t worry about including it in the budget analysis.”

Haggerty is unimpressed with the advice she received from Jenkins and calculates cash flows and net present values using numbers from the fact sheet without taking any of the advice. She assumes all inflows and outflows take place at the end of the year.

Verban is also considering upgrading two smaller, outdated factories, projects for which the cost of capital is 14.3 percent. Both of the remodeled factories would have a three-year life and cash flows as follows:

Initial outlayYear 1Year 2Year 3

-$30 million$15 million$17 million$28 million

Verban is willing to pursue the new factory or the renovations, but not both projects. Haggerty decides which project makes the most sense and prepares models and recommendations for Verban’s executives. Haggerty is concerned that her budgeting calculations do not accurately affect inflation, so she attempts to tweak her models to reflect the 2.5 percent inflation expected annually over the next five years.

Part 3)

Which of the following statements about the effect of inflation on the capital-budgeting process is mostaccurate?

Statement 1: Inflation is reflected in the WACC, but future cash flows should still be adjusted when calculating the NPV.

Statement 2: Inflation will cause the WACC to decrease.

Statement 3: Inflation tends to exert upward pressure on the NPV.

Statement 4: Because the IRR does not depend on the WACC, inflation has no effect on it.

A) Statement 1 only.

B) Statements 2 and 3.

C) Statements 3 and 4.

D) Statements 1 and 2.

Zelda Haggerty was recently promoted to project manager at Verban Automation, a maker of industrial machinery. Haggerty’s first task as project manager is to analyze capital-spending proposals.

The first project under review is a proposal for a new factory. Verban wants to build the plant on land it already owns in India. Below are details included on a fact sheet regarding the factory project:

§ The initial outlay to the builder would be $85 million for the building. Verban would spend another $20 million on specialized equipment in the first year.

§ The factory would open up new markets for Verban’s products. Production should begin July 1 of the second year.

§ Verban’s tax rate is 34 percent.

§ Verban expects the factory to generate $205 million in annual sales starting in the third year, with half of that amount in the second year.

§ At the end of the sixth year, Verban expects the market value and the book value of the building to be worth $35 million, and the market value and the book value of the equipment to be worth $3.25 million.

§ Fixed operating costs are expected to be $65 million a year once the factory starts production.

§ Variable operating costs should be 40 percent of sales.

§ Verban uses straight-line depreciation.

§ New inventories are likely to boost working capital by $7.5 million in the first year of production.

§ Verban’s cost of capital for the factory project is 14.3 percent.

Verban’s chief of operations, Max Jenkins, attached a note containing some of his thoughts about the project. His comments are listed below:

§ Comment 1: “We spent $5 million up front on an exclusive, 10-year maintenance contract for all of our equipment in Asia two years ago, before an earlier project was canceled. Your budget should reflect that.”

§ Comment 2: “Some Asian clients are likely to switch over to the equipment from the new factory. They account for about $5 million a year in sales for the U.S. division. Your budget should reflect that.”

§ Comment 3: “I expect variable costs to take a one-time hit in Year 1, as we should plan for about $1.5 million in installation expense for the manufacturing equipment.”

§ Comment 4: “We bought the land allocated for this factory for $30 million in 1998. That money is long spent, so don’t worry about including it in the budget analysis.”

Haggerty is unimpressed with the advice she received from Jenkins and calculates cash flows and net present values using numbers from the fact sheet without taking any of the advice. She assumes all inflows and outflows take place at the end of the year.

Verban is also considering upgrading two smaller, outdated factories, projects for which the cost of capital is 14.3 percent. Both of the remodeled factories would have a three-year life and cash flows as follows:

Initial outlayYear 1Year 2Year 3

-$30 million$15 million$17 million$28 million

Verban is willing to pursue the new factory or the renovations, but not both projects. Haggerty decides which project makes the most sense and prepares models and recommendations for Verban’s executives. Haggerty is concerned that her budgeting calculations do not accurately affect inflation, so she attempts to tweak her models to reflect the 2.5 percent inflation expected annually over the next five years.

Part 4)

Jenkins advice is correct with respect to:

A) Comments 1 and 2.

B) Comment 4, but incorrect with respect to Comment 1.

C) Comments 3 and 4, but incorrect with respect to Comment 2.

D) Comment 2, but incorrect with respect to Comment 4.

Computer question NSJCT is considering a project that requires initial investment of €150,000 in new machinery. The project will be shut down at the end of four years. The following is the projected cash flow from the project: Year 1 2 3 4 Sales €120,000 €120,000 €140,000 €140,000 Operating expenses €40,000 €40,000 €50,000 €50,000 The firm can raise funds at 8% and its tax rate is 45%. In Lesson 5 when depreciation was first introduced, it was mentioned that the different methods of depreciation for tax purposes will result in different tax shields. In this exercise, you will examine the effects of this difference. In part (a) you will calculate the after-tax cash flows that would occur if straight-line depreciation were an allowable expense for tax purposes. You will compare this to the cash flows in part (b) where a declining balance method is used. You will use the same worksheet for both parts. a. Assume that the proposed machinery is to be depreciated over four years on a straight-line basis, with no salvage value at the end of the four years. For this part, assume that the depreciation expense can be deducted from income to calculate the net tax for NSJCT. Use Excel file I-FN1L6Q1 to compute the net present value and the internal rate of return for this project over four years. b. Assume depreciation for tax purposes is to be taken using the declining-balance method at the rate of 20% for capital cost allowance. For this part, assume the machinery will have a salvage value of €30,000 at the end of year 4, and that the asset class to which it belongs will not be left empty by the sale of the machinery at that time, and that the half year rule does not apply to the salvage value. Use Excel file I-FN1L6Q1 to compute the net present value and the internal rate of return for this project. Also compute the net cash flow from this project for each of the four years. Compare the results from parts (a) and (b) and comment on the difference.