Comprehensive problem. The shrine corporation, a firm in the 34 percent marginal

Question

Comprehensive problem. The shrine corporation, a firm in the 34 percent marginal tax bracket with a 15 percent required rate of return or cost of capital, is considering a new project. The project involves the introduction of a new project. This project it's expected to last 5 years and then, because ths somewhat of a fad product, be terminated. Given the following information, determine the free cash flows associated with project, the projects net present value, the profitability index, and the internal rate of return. Apply the appropriate decision criteria. Cost of new plant and equipment. $6,900,000 Shipping and installation costs. $100,000 Unit sales Year Unit sold 1. 80,000 2. 100,000 3. 120,000 4. 70,000 5. 70,000 Sales price per unit. 250/unit in years 1-4/200/unit in year 5 Variable cost per unit. 130/units Working capital requirements There will be an initial working capital requirement of $100,000 just to get production started. For each year, the toal investment in net working capital will be equal to 10 percent of the dollar value of sales for that year. Thus, the investment in working capital will increase dring years 1-3, then decrease in year 4. Finally, all working capital is liquidated at the termination of project at the end of year 5 The deprecating method Use te simplified straight line method over 5 years. Assume that the plant and equipment will have no salvage value after 5 years

Explanation / Answer

it a should focus on cash flows rather than accounting profits because the firm can reinvest these cash flows. By examining cash flows, we are able to analyze the timing of either profits or cost. And we are only interested in cash flows on after-tax basis as those flows are available to the shareholder. In addition, it is the incremental cash flows that in which we are actually interested because incremental cash flows are benefits from the point of view of company and increase in value results in accepting the project. ============================================================================================================= Depreciation is considered non-cash flow item; it affects the differential cash flows over the life of the projects because it has effect on taxes. As depreciation is an expense, larger the expense, higher the depreciation. Hence accounting profits reduces and so taxes which are considered as an item of cash flow. ================================================================================= Sunk costs are ignored when evaluating capital budget. We are mainly interested in free cash flows for the company as whole. Irrespective of the decision on investment, the sunk costs have occurred which indicates that these are free cash flows. Hence, they are irrelevant. ============================================================================================ Project

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