Problem 2 A firm is considering renewing its equipment to meet increaseddemand f

Question

Problem 2

A firm is considering renewing its equipment to meet increaseddemand for its product. The cost of equipment modifications is $1.9million plus $100,000 in installation costs. The firm willdepreciate the equipment modifications under MACRS, using a 5-yearrecovery period. Additional sales revenue from the renewal shouldamount to $1.2 million per year, and additional operating expensesand other costs (excluding depreciation and interest) will amountto 40% of the additional sales. The firm is subject to a tax rateof 40%. For each of the next 6 years.

a. Determine earnings before depreciation, interest, and taxesthat will result from the renewal?  

b. Determine net operating profits after taxes that willresult   from the renewal?

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Problem 2 A firm is considering renewing its equipment to meet increaseddemand for its product. The cost of equipment modifications is dollar1.9million plus dollar100,000 in installation costs. The firm willdepreciate the equipment modifications under MACRS, using a 5-yearrecovery period. Additional sales revenue from the renewal shouldamount to dollar1.2 million per year, and additional operating expensesand other costs (excluding depreciation and interest) will amountto 40percent of the additional sales. The firm is subject to a tax rateof 40percent. For each of the next 6 years. a. Determine earnings before depreciation, interest, and taxesthat will result from the renewal? b. Determine net operating profits after taxes that willresult from the renewal? c. Determine cash flows that will result from therenewal? See Example 7.5 in Text Below: Determining Free Cash Flow and NPV As discussed in Chapter 2, earnings are an accounting measure of the firm^'s performance. They do not represent real profits: The firm cannot use its earnings to buy goods, pay employees, fund new investments, or pay dividends to shareholders. To do those things, a firm needs cash. Thus, to evaluate a capital budgeting decision, we must determine its consequences for the firm^'s available cash. The incremental effect of a project on the firm^'s available cash is the project^'s free cash flow. In this section, we forecast the free cash flow of the HomeNet project using the earn-ings forecasts we developed in Section 7.1. We then use this forecast to calculate the NPV of the project.

Explanation / Answer

(1200000 X 40%)

($320000 X40%)

A. Revenue $1,200,000 Operating ($480,000)

(1200000 X 40%)

expense EBDIT $720,000 B Total cost of equipment Cost of Equipment $1,900,000 Add: Installation cost $100,000 total Cost of equipment $2,000,000 Depreciation expense $2000000 X 20% (double-declining) (MACRS) for 1 year             = $400,000 1st year Revenue $1,200,000 Operating ($480,000) expense Depreciation ($400,000) Net operating profit before $320,000 Tax Tax 40% ($128,000)

($320000 X40%)

Net operating $192,000 profit after Tax C Free cash flow = Net profit + Depreciation- Capital expenditure Free cash flow = $192000 + $400000 - $100000 Free cash flow = $492,000

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