Solutions-Chapter8

Business, Finance, Economics, Accounting, Operations Management, Computer Science, Electrical Engineering, Mechanical Engineering, Civil Engineering, Chemical Engineering, Algebra, Precalculus, Statistics and Probabilty, Advanced Math, Physics, Chemistry, Biology, Nursing, Psychology, Certifications, Tests, Prep, and more.
Post Reply
answerhappygod
Site Admin
Posts: 899559
Joined: Mon Aug 02, 2021 8:13 am

Solutions-Chapter8

Post by answerhappygod »

Home Builder Supply, a retailer in the home improvement industry, currently operates seven retail outlets in Georgia and South Carolina. Management is contemplating building an eighth retail store across town from its most successful retail outlet. The company already owns the land for this store, which currently has an abandoned warehouse located on it. Last month, the marketing department spent $10,000 on market research to determine the extent of customer demand for the new store. Now Home Builder Supply must decide whether to build and open the new store.
Which of the following should be included as part of the incremental earnings for the proposed new retail store?
a. The cost of the land where the store will be located.
b. The cost of demolishing the abandoned warehouse and clearing the lot.
c. The loss of sales in the existing retail outlet, if customers who previously drove across town to shop at the existing outlet become customers of the new store instead.
d. The $10,000 in market research spent to evaluate customer demand.
e. Construction costs for the new store.
f. The value of the land if sold.
g. Interest expense on the debt borrowed to pay the construction costs.
a. No, this is a sunk cost and will not be included directly. (But see (f) below.)
b. Yes, this is a cost of opening the new store.
c. Yes, this loss of sales at the existing store should be deducted from the sales at the new store to determine the incremental increase in sales that opening the new store will generate for HBS.
d. No, this is a sunk cost.
e. This is a capital expenditure associated with opening the new store. These costs will, therefore, increase HBS’s depreciation expenses.
f. Yes, this is an opportunity cost of opening the new store. (By opening the new store, HBS forgoes the after-tax proceeds it could have earned by selling the property. This loss is equal to the sale price less the taxes owed on the capital gain from the sale, which is the difference between the sale price and the book value of the property. The book value equals the initial cost of the property less accumulated depreciation.)
g. While these financing costs will affect HBS’s actual earnings, for capital budgeting purposes we calculate the incremental earnings without including financing costs to determine the project’s unlevered net income.
8-6. Cellular Access, Inc. is a cellular telephone service provider that reported net income of $250 million for the most recent fiscal year. The firm had depreciation expenses of $100 million, capital expenditures of $200 million, and no interest expenses. Working capital increased by $10 million. Calculate the free cash flow for Cellular Access for the most recent fiscal year.
FCF = Unlevered Net Income + Depreciation – CapEx – Increase in NWC= 250 + 100 – 200 – 10 = $140 million.
8-9. Elmdale Enterprises is deciding whether to expand its production facilities. Although long- term cash flows are difficult to estimate, management has projected the following cash flows for the first two years (in millions of dollars):
a. What are the incremental earnings for this project for years 1 and 2?
b. What are the free cash flows for this project for the first two years?
a.
b.
7 8 9 10
Year 1 2
Incremental Earnings Forecast ($000s)
1 Sales 125.0 160.0
2 Costs of good sold and operating expenses other than depreciation (40.0) (60.0)
3 Depreciation (25.0) (36.0)
4 EBIT 60.0 64.0
5 Income tax at 35% (21.0) (22.4)
6 Unlevered Net Income 39.0 41.6
Free Cash Flow ($000s) 1 2
Plus: Depreciation 25.0 36.0
Less: Capital Expenditures (30.0) (40.0)
Less: Increases in NWC (5.0) (8.0)
Free Cash Flow 29.0 29.6

8-10. You are a manager at Percolated Fiber, which is considering expanding its operations in synthetic fiber manufacturing. Your boss comes into your office, drops a consultant’s report on your desk, and complains, “We owe these consultants $1 million for this report, and I am not sure their analysis makes sense. Before we spend the $25 million on new equipment needed for this project, look it over and give me your opinion.” You open the report and find the following estimates (in thousands of dollars):
All of the estimates in the report seem correct. You note that the consultants used straight-line depreciation for the new equipment that will be purchased today (year 0), which is what the accounting department recommended. The report concludes that because the project will increase earnings by $4.875 million per year for 10 years, the project is worth $48.75 million. You think back to your halcyon days in finance class and realize there is more work to be done!
First, you note that the consultants have not factored in the fact that the project will require $10 million in working capital upfront (year 0), which will be fully recovered in year 10. Next, you see they have attributed $2 million of selling, general and administrative expenses to the project, but you know that $1 million of this amount is overhead that will be incurred even if the project is not accepted. Finally, you know that accounting earnings are not the right thing to focus on!
a. Given the available information, what are the free cash flows in years 0 through 10 that should be used to evaluate the proposed project?
b. If the cost of capital for this project is 14%, what is your estimate of the value of the new project?
a. Free Cash Flows are:
= Net income
+ Overhead (after tax at 35%)
+ Depreciation
– Capex
– Inc. in NWC FCF
b. NPV 358.025
0 1
4,875 4,875
650 650 2,500 2,500
25,000
10,000
–35,000 8,025 8,025
1  18.025
9 10 4,875 4,875 650 650 2,500 2,500
–10000 8,025 18,025
1 
 9.56 .14 1.14  1.14
1
 9 10
2 ...
...

8-19. Bay Properties is considering starting a commercial real estate division. It has prepared the following four-year forecast of free cash flows for this division:
Assume cash flows after year 4 will grow at 3% per year, forever. If the cost of capital for this division is 14%, what is the continuation value in year 4 for cash flows after year 4? What is the value today of this division?
The expected cash flow in year 5 is 240,000 × 1.03 = 247,200. We can value the cash flows in year 5 and beyond as a growing perpetuity:
Continuation Value in Year 4 = 247,200/(0.14 – 0.03) = $2,247,273
We can then compute the value of the division by discounting the FCF in years 1 through 4, together with the continuation value:
185, 000 12, 000 99, 000 240, 000  2, 247, 273
NPV  1.14  1.142  1.143  1.144 $1,386,440
8-20. Your firm would like to evaluate a proposed new operating division. You have forecasted cash flows for this division for the next five years, and have estimated that the cost of capital is 12%. You would like to estimate a continuation value. You have made the following forecasts for the last year of your five-year forecasting horizon (in millions of dollars):
a. You forecast that future free cash flows after year 5 will grow at 2% per year, forever. Estimate the continuation value in year 5, using the perpetuity with growth formula.
a. FCFinyear6=110×1.02=112.2
Continuation Value in year 5 = 112.2 / (12% – 2%) = $1,122.
Join a community of subject matter experts. Register for FREE to view solutions, replies, and use search function. Request answer by replying!
Post Reply