**Cash flow**

*(LO12-2)*

2. Assume a corporation has earnings before depreciation and taxes of $100,000, depreciation of $40,000, and a 40 percent tax bracket.

*a.* Compute its cash flow using the following format:

Earnings before depreciation and taxes | _________ |

Depreciation | _________ |

Earnings before taxes | _________ |

Taxes @ 40% | _________ |

Earnings after taxes | _________ |

Depreciation | _________ |

*b.* Compute the cash flow for the company if depreciation is only $20,000.

*c.* How much cash flow is lost due to the reduced depreciation from $40,000 to $20,000?

**Cash flow**

*(LO12-2)*

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3. Assume a firm has earnings before depreciation and taxes of $200,000 and no depreciation. It is in a 40 percent tax bracket.

*a.* Compute its cash flow.

*b.* Assume it has $200,000 in depreciation. Recompute its cash flow.

*c.* How large a cash flow benefit did the depreciation provide?

**Cash flow**

*(LO12-2)*

4. Assume a firm has earnings before depreciation and taxes of $440,000 and depreciation of $140,000.

*a.* If it is in a 35 percent tax bracket, compute its cash flow.

*b.* If it is in a 20 percent tax bracket, compute its cash flow.

**Cash flow versus earnings**

*(LO12-2)*

5. Al Quick, the president of a New York Stock Exchange–listed firm, is very short-term oriented and interested in the immediate consequences of his decisions. Assume a project that will provide an increase of $2 million in cash flow because of favorable tax consequences, but carries a two-cent decline in earnings per share because of a write-off against first-quarter earnings. What decision might Mr. Quick make?

**Payback method**

*(LO12-3)*

6. Assume a $250,000 investment and the following cash flows for two products:

Year |
Product X |
Product Y |

1 | $90,000 | $50,000 |

2 | 90,000 | 80,000 |

3 | 60,000 | 60,000 |

4 | 20,000 | 70,000 |

Which alternatives would you select under the payback method?

**Payback method**

*(LO12-3)*

7. Assume a $40,000 investment and the following cash flows for two alternatives:

Year |
Investment X |
Investment Y |

1 | $ 6,000 | $15,000 |

2 | 8,000 | 20,000 |

3 | 9,000 | 10,000 |

4 | 17,000 | __ |

5 | 20,000 | __ |

Which of the alternatives would you select under the payback method?

**Payback method**

*(LO12-3)*

8. Assume a $90,000 investment and the following cash flows for two alternatives:

Year |
Investment A |
Investment B |

1 | $25,000 | $40,000 |

2 | 30,000 | 40,000 |

3 | 25,000 | 28,000 |

4 | 19,000 | __ |

5 | 25,000 | __ |

*a.* Calculate the payback for investments A and B.

*b.* If the inflow in the fifth year for Investment A was $25,000,000 instead of $25,000, would your answer change under the payback method?

**Payback method**

*(LO12-3)*

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9. The Short-Line Railroad is considering a $140,000 investment in either of two companies. The cash flows are as follows:

Year |
Electric Co. |
Water Works |

1 | $85,000 | $30,000 |

2 | 25,000 | 25,000 |

3 | 30,000 | 85,000 |

4–10 | 10,000 | 10,000 |

*a.* Using the payback method, what will the decision be?

*b.* Explain why the answer in part *a* can be misleading.

**Payback and net present value**

*(LO12-3 & 12-4)*

10. X-treme Vitamin Company is considering two investments, both of which cost $10,000. The cash flows are as follows:

Year |
Project A |
Project B |

1 | $12,000 | $10,000 |

2 | 8,000 | 6,000 |

3 | 6,000 | 16,000 |

*a.* Which of the two projects should be chosen based on the payback method?

*b.* Which of the two projects should be chosen based on the net present value method? Assume a cost of capital of 10 percent.

*c.* Should a firm normally have more confidence in answer *a* or answer *b*?

**Internal rate of return**

*(LO12-4)*

11. You buy a new piece of equipment for $16,230, and you receive a cash inflow of $2,500 per year for 12 years. What is the internal rate of return?

**Internal rate of return**

*(LO12-4)*

12. King’s Department Store is contemplating the purchase of a new machine at a cost of $22,802. The machine will provide $3,500 per year in cash flow for nine years. King’s has a cost of capital of 10 percent. Using the internal rate of return method, evaluate this project and indicate whether it should be undertaken.

**Internal rate of return**

*(LO12-4)*

13. Home Security Systems is analyzing the purchase of manufacturing equipment that will cost $50,000. The annual cash inflows for the next three years will be:

Year |
Cash Flow |

1 | $25,000 |

2 | 23,000 |

3 | 18,000 |

*a.* Determine the internal rate of return.

*b.* With a cost of capital of 18 percent, should the machine be purchased?

**Net present value method**

*(LO12-4)*

14. Aerospace Dynamics will invest $110,000 in a project that will produce the following cash flows. The cost of capital is 11 percent. Should the project be undertaken? (Note that the fourth year’s cash flow is negative.)

Page 410

Year |
Cash Flow |

1 | $36,000 |

2 | 44,000 |

3 | 38,000 |

4 | (44,000) |

5 | 81,000 |

**Net present value method**

*(LO12-4)*

15. The Horizon Company will invest $60,000 in a temporary project that will generate the following cash inflows for the next three years.

Year |
Cash Flow |

1 | $15,000 |

2 | 25,000 |

3 | 40,000 |

The firm will also be required to spend $10,000 to close down the project at the end of the three years. If the cost of capital is 10 percent, should the investment be undertaken?

**Net present value method**

*(LO12-4)*

16. Skyline Corp. will invest $130,000 in a project that will not begin to produce returns until after the third year. From the end of the third year until the end of the 12th year (10 periods), the annual cash flow will be $34,000. If the cost of capital is 12 percent, should this project be undertaken?

**Intermediate Problems**

**Net present value and internal rate of return methods**

*(LO12-4)*

17. The Hudson Corporation makes an investment of $24,000 that provides the following cash flow:

Year |
Cash Flow |

1 | $13,000 |

2 | 13,000 |

3 | 4,000 |

*a.* What is the net present value at an 8 percent discount rate?

*b.* What is the internal rate of return?

*c.* In this problem, would you make the same decision under both parts *a* and *b?*

**Net present value and internal rate of return methods**

*(LO12-4)*

18. The Pan American Bottling Co. is considering the purchase of a new machine that would increase the speed of bottling and save money. The net cost of this machine is $60,000. The annual cash flows have the following projections:

Year |
Cash Flow |

1 | $23,000 |

2 | 26,000 |

3 | 29,000 |

4 | 15,000 |

5 | 8,000 |

Page 411

*a.* If the cost of capital is 13 percent, what is the net present value of selecting a new machine?

*b.* What is the internal rate of return?

*c.* Should the project be accepted? Why?

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