Capital budgeting

Instructions

Write brief answers to the questions below. Note that bullet points are fine. Don’t worry about grammar or writing a finely crafted essay—just note the main points that apply to that question.

1. Why not use earnings vs. free cash flows to find the value of a project or company? Why use incremental cash flows?
2. When working capital needs decrease, we add to free cash flow. Why?
3. What is the purpose of sensitivity analysis?

Work the problems in Excel; submit your Excel worksheet/workbook as your answer in Canvas. Do NOT hardcode your numbers. If we click on a cell in your worksheet, we should be able to see the formulas that you used in your calculations.

4. Siclan Company Problem

The Siclan Company is considering opening a new office. The company owns the building and would sell it for $74,000 after taxes if it does not open the new office. The building has been depreciated down to a zero book value. The equipment that would be used in the building costs $69,000. The equipment that would be used has a three-year tax life, depreciated straight-line, with zero scrap value. (If the company tried to sell the equipment at the end of Year 3, it would receive zero sales proceeds). (There will be no new revenues after the end of Year 3.) No new working capital is required.

Cost of Capital = 15%

Due to opening the office and using the equipment, additional annual revenues = $100,000

Additional annual operating cost, excluding depreciation = $20,000

Tax rate = 30%

1. What is the required cash outflow associated with the acquisition of a new machine at t = 0?

1. What is the project’s NPV?

5. Depreciation methods

Sam is evaluating a capital budgeting project that should last for four years. The project requires $700,000 of equipment. He is unsure what depreciation method to use in her analysis, straight-line or the three-year MACRS accelerated method. Under straight-line depreciation, the cost of the equipment would be depreciated evenly over its four-year life (ignore the half-year convention for the straight-line method). The applicable MACRS depreciation rates are 33.33, 44.45, 14.81 and 7.41 percent. Assume that both straight-line and MACRS depreciation expenses begin in Year 1.

The company’s required return on capital is 10%and its tax rate is 40%.

1. What would the depreciation expense be each year under each method?
2. Calculate the PV of the depreciation tax shield for both straight-line and MACRS. Which depreciation method produces the higher value? By how much?