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Use the following in-class exercise (I copied from the slide 4 of Lecture Note 7) to answer all questions in this test.

• As the finance manager of a company, you are presented with the following project. The company is considering the purchase of a new piece of equipment which would cost $200,000. This equipment will have a five-year useful life and have a salvage value of $0 at the end of the five-year period. It is estimated that (baseline assumptions):

the new equipment will be able to produce 10,000 shelves per year.

the incremental overhead for running the equipment will be $20,000 per year.

they can sell the shelves for $25 each.

the cost of sales is $15 per shelf.

Net Working Capital requirements for the project are as follows:

Year 0 = $10,000

Year 1 = $15,000

Year 2 = $17,000

Year 3 = $15,000

Year 4 = $10,000

The company has a 30% marginal tax rate and a cost of capital of 15%.

Would you accept this project (support your answer with NPV)?

• You can find the excel answer for the baseline assumptions in the lecture 7 folder (file name 2. In-class exercise - DCF analysis).
  • We used a very similar exercise in lecture 6 (the only difference is the salvage value). You find the video on how to solve that exercise in the lecture 6 folder (Capital Budgeting in-class exercise solution).

Questions:

1. What is the net effect of Year 1 depreciation on Year 1 free cash flow ?

$40,000
	B.	-$40,000
	C.	0
	D.	$12,000

Under the baseline assumptions (that is, no interest expense), what is accounting break-even of quantity sold per year?

Under the baseline assumptions, the economic break-even of quantity sold is 9,095.17 per year (see the file Economic Break-even to the slide 4 example in the lecture 7 folder). If you sell 7,000 units per year, what are the signs of unlevered net income and the NPV?

I. positive NPV

II. negative NPV

III. positive net income

IV. negative net income

Reset your assumptions to the baseline assumptions. If you decide to place the equipment in an idle warehouse which could be rented out for $5,000 per year. What is the new NPV? Should you still take the project

$21,232; Yes

B.

$18,189; Yes

C.

$9,499; Yes

D.

Negative NPV; No

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