SS8 Question i

Patrick Byden, CFA analyzes projects on behalf of large corporate clients for the firm Capital Ranking, Inc. (CRI). One of the firm’s clients has contracted CRI to help them determine whether to replace a shrink wrapping machine. Operating expenses from the current machine total 150,000 per year and the home office mandates an annual admin allocation of 25,000 for this division. Also, the client realizes that 20,000 per year in straight line depreciation from the existing shrink wrapping machine and determines a useful life of three more years. They could sell the machine today for 57,000, which is 3,000 less than book value. The client expect operating expenses on the new shrink-wrapping machine tot tal 75,000 per year, but the machine would require the firm to increase working capital by 5,000. The new machine will cost 450,000 and will have a useful life of three years, at which time they expect to sell it for 13,000, but would fully depreciate the machine over that period for book purposes. The client firm’s weighted average cost of capital is 10%, and their marginal income tax rate is 35%. ________________________ The initial investment outlay Byden would calculate for the client firm’s prospective project is closest to: a) 455,000 b) 398,000 c) 396,950

-450 for new machine + get 57 in sales value for old machine + 3 * .35 (Capital gains return on the old machine. BV is 3000 more than sale value. so 3000 loss). - 5 Increase in WC ---- -396.95 Choice C

450K + %K - (3)(0.35) - 57K = 396.95K = C??

Choice “c” is correct. Byden would calculate the following initial investment cash flows: Cash Outlay Cost of new machine $450,000 Add: Increase in working capital 5,000 Less: Sale of old machine (57,000) Less: Tax benefit of sale loss (1,050) (0.35 x $3,000 loss) Initial investment outlay $396,950 The initial investment outlay does not include the $25,000 administrative expense allocation because they are a sunk cost for the old machine or the new project. Choice “a” is incorrect. This choice fails to subtract the benefit from selling the machine ($57,000) and the tax benefit of the sale loss ($3,000 x 0.35 = $1,050). Choice “b” is incorrect. This choice fails to subtract the tax benefit of the sale loss ($3,000 x 0.35 = $1,050).