A) Starbucks corporation has decided to replace an existing asset with a newer m
ID: 2670296 • Letter: A
Question
A) Starbucks corporation has decided to replace an existing asset with a newer model. The new asset will cost $70,000. The original asset, when purchased cost $10,000, was being depreciated under a straight line methodology, using a five-year recovery period, and has been depreciated for four full years. The existing asset can be sold for $8,000. If the assumed tax rate is 40 percent on ordinary income and capital gains, what is the initial investment?B) A Corp uses a cost of capital of 14% to evaluate average risk projects and adds/subtracts 2% points to evaluate projects of greater/lesser risk. Currently two mutually exclusive projects are under consideration. Both have a net cost of $240,000 and last four years. Project A, which is riskier than average, will produce cash flows of $97,000 each year. Project B, which is a less-than-average risk, will produce net cash flows of $196,000 in years 3 and 4 only. What should Corp. do?
Explanation / Answer
A). Old Asset cost $10000 & Life 5 Yrs. SO based on SLN, Dep pa = Cost of asset/life of asset = 10000/5 =2000 pa As 4 yrs have passed, BV of asset = Cost - Accu Dep = 10000-4*2000 = 2000 Sale price of old asset = 8000 SO Gain on Sale of old asset = Sale price - BV of Old asset = 8000-2000=6000 Less Tax 40% = 40%*6000 = 2400 --------------------------------------- SO net Gain on sale of old asset = 6000-2400 = 3600 Cost of new asset is 70000 SO Investment reqd is Cost of new asset - Net gain from sale of old asset = 70000-3600 ie SO Investment reqd in new asset is = 66400....................Ans B) Proj A is riskier. So Cost of capital is 14%+2% =16% NPVa = NPV(rate,CFs) + initial Inv = NPV(16%,97000,97000,97000,97000)-240000 ie NPVa = $31,423.52 ...(1) Proj B is Less than avge risk. So its cost of capital is 14%-2% =12% NPVb = CF0+PV(CF1+CF2+CF3+CF4) ie NPVb = -240000+ 0+0+196000*(1/(1+12%)^3 +1/(1+12%)^4) = $24,070.47 (2) From 1& 2 above, we see that NPVof Proj A is More than that of Proj B So Proj A is selected even though it is riskier.
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