You are given the following information Garcia Paper. Use this information for t
ID: 1170688 • Letter: Y
Question
You are given the following information Garcia Paper. Use this information for the next four questions, numbers 25, 26, 27 and 28. Garcia Paper is deciding whether to build a new plant. The proposed project would have an upfront cost (at t = 0) of $30 million. The project's cost can be depreciated on a straight-line basis over three years. Consequently, the depreciation expense will be $10 million in each of the first three years, t = 1, 2, and 3. Even though the project is depreciated over three years, the project has an economic life of five years.
The project is expected to increase the company's sales by $20 million. Sales will remain at this higher level for each year of the project (t = 1, 2, 3, 4, and 5). The operating costs, not including depreciation, equal 60 percent of the increase in annual sales. The project's interest expense is $5 million per year and the company's tax rate is 40 percent. The company is very profitable, so any accounting losses on this project can be used to reduce the company's overall tax burden. The project does not require any additions to net operating working capital. The company estimates that the project's after-tax salvage value at t = 5 will be $1.2 million. The project is of average risk, and, therefore, the CFO has decided to discount the operating cash flows at the company's overall weighted average cost of capital of 10 percent. However, the salvage value is more uncertain, so the CFO has decided to discount it at 12 percent.
25. Refer to Garcia Paper. What is the operating cash flows in year 1? a. $2.4 million b. $3.2 million c. $4.8 million d. $6.0 million e. $8.8 million
26. Refer to Garcia Paper. What is the operating cash flows in year 5? a. $2.4 million b. $3.2 million c. $4.8 million d. $6.0 million e. $8.8 million
27. Refer to Garcia Paper. What is the present value of the project’s after-tax salvage value? a. $0.4272 million b. $0.6809 million c. $0.7451 million d. $1.2 million e. $2.4 million
28. Refer to Garcia Paper. What is the net present value (NPV) of the entire proposed project? a. $11.86 million b. $14.39 million c. -$26.04 million d. -$12.55 million e. -$ 1.18 million
Explanation / Answer
Operating cash flow in year -1
operating cash flow in year 4 & 5
1-
sales
20
1-
sales
20
operating cost-60%
12
operating cost-60%
12
depreciation
10
depreciation
0
Operating profit
-2
Operating profit
8
less tax-40%
-0.8
less tax-40%
3.2
net operating income
-1.2
net operating income
4.8
add depreciation
10
add depreciation
0
net operating cash flow
8.8
net operating cash flow
4.8
Answer is E
8.8
Operating cash flow in year-5
2-
sales
20
operating cost-60%
12
depreciation
0
Operating profit
8
less tax-40%
3.2
net operating income
4.8
add depreciation
0
net operating cash flow
4.8
Answer is C
4.8
3-
present value of after tax salvage value
after tax salvage value/(1+r)^n = 1.2/(1.12)^5
0.6809
4-
Year
operating cash flow
present value of cash flow = operting cash flow/(1+r)^n r = 10%
0
-30
-30
1
8.8
8
2
8.8
7.272727
3
8.8
6.61157
4
4.8
3.278465
5
4.8
2.980422
Net present value without salvage value
-1.85682
add present value of salvage value
0.6809
Net present value
-1.18
Operating cash flow in year -1
operating cash flow in year 4 & 5
1-
sales
20
1-
sales
20
operating cost-60%
12
operating cost-60%
12
depreciation
10
depreciation
0
Operating profit
-2
Operating profit
8
less tax-40%
-0.8
less tax-40%
3.2
net operating income
-1.2
net operating income
4.8
add depreciation
10
add depreciation
0
net operating cash flow
8.8
net operating cash flow
4.8
Answer is E
8.8
Operating cash flow in year-5
2-
sales
20
operating cost-60%
12
depreciation
0
Operating profit
8
less tax-40%
3.2
net operating income
4.8
add depreciation
0
net operating cash flow
4.8
Answer is C
4.8
3-
present value of after tax salvage value
after tax salvage value/(1+r)^n = 1.2/(1.12)^5
0.6809
4-
Year
operating cash flow
present value of cash flow = operting cash flow/(1+r)^n r = 10%
0
-30
-30
1
8.8
8
2
8.8
7.272727
3
8.8
6.61157
4
4.8
3.278465
5
4.8
2.980422
Net present value without salvage value
-1.85682
add present value of salvage value
0.6809
Net present value
-1.18
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