1. Sydney Air services is now in the final year of a project. The equipment orig
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Question
1. Sydney Air services is now in the final year of a project. The equipment originally cost $15 of which $12 has been depreciated. Sydney can sell the used equipment today for $5 and its marginal tax rate is 50%. What is the equipment’s net salvage value?
a. $1
b. $2
c. $3
d. $4
2. You have been hired as a financial consultant by BUBBA Corporation. BUBBA is considering investing in a new machine to produce dog biscuits. BUBBA has provided you with the following information.
Base price of machine is $50,000.
Machine modification cost for special use by BUBBA is $15,000.
BUBBA has a 30% average tax rate. BUBBA has a 35% marginal tax rate.
The machine falls into the MACRS 3-year class.
BUBBA will use the machine for 3 years and then plans sell it for $15,000 at the end of year 3.
The machine is expected to increase earnings before depreciation by $35,000 a year for the life of the machine.
BUBBA has a weighted average cost of capital of 11%.
Assume that the NPV under the above assumptions is $16,456.
Which of the following is true if the machine is expected to increase earnings by $40,000 per year instead of $35,000 per year?
a. The NPV will become smaller and the project should be accepted
b. The NPV will become smaller and the project should be rejected
c. The NPV will become larger and the project should be rejected
d. The NPV will become larger and the project should be accepted
3. If the incremental revenue for a project is the same for the life of the project, why is it that the cash flows vary?
a. Constant depreciation expense
b. Constant interest expense
c. Variable depreciation expense
d. Variable interest expense
Explanation / Answer
1. Equipment’s net salvage value = Selling price of equipment - Tax on profit on sale of equipment
Tax on profit on sale of equipment is computed as under:
Selling price of equipment = $5
Net Book Value of equipment as on the date of sale = $3 ($15 orignial cost - $12 depreciation till date)
Profit on sale of equipment = $5 - $3 = $2
Tax on profit on sale of equipment = $2 * 50% = $1
Equipment’s net salvage value = $5 - $1 = $4
Correct answer d
2. Since earnings are in the nature of positive cash flows, an increase in earnings imply an increase in cash flows.
NPV under the base case (considering earnings of $35,000 per year) is positive, hence the project is accepted.
If earnings increase from $35,000 per year to $40,000, this will increase the cash flows are correspondingly increase the NPV.
The project will be accepted even then.
Correct answer - d
3. Depreciation is a tax deductible expense, however interest is not considered in the calculation of operating cash flows.
Variable depreciation will lead to variable savings in tax due to depreciation, and hence variable cash flows.
As mentioned earlier, interest expense is ignored in discounted cash flow technique.
Correct answer - c
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