BuyFindarrow_forward

Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937

Solutions

Chapter
Section
BuyFindarrow_forward

Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937
Textbook Problem
528 views

SCENARIO ANALYSIS Your firm, Agrico Products, is considering a tractor that would have a cost of $36,000, would increase pretax operating cash flows before taking account of depreciation by $12,000 per year, and would be depreciated on a straight-line basis to zero over 5 years at the rate of $7,200 per year beginning the first year. (Thus, annual cash flows would be $12,000 before taxes plus the tax savings that result from $7,200 of depreciation.) The managers disagree about whether the tractor would last 5 years. The controller insists that she knows of tractors that have lasted only 4 years. The treasurer agrees with the controller, but he argues that most tractors do give 5 years of service. The service manager then states that some last for as long as 8 years.

Given this discussion, the CFO asks you to prepare a scenario analysis to determine the importance of the tractor's life on the NPV. Use a 40% marginal federal-plus-state tax rate, a zero salvage value, and a 10% WACC. Assuming each of the indicated lives has the same probability of occurring (probability = 1/3), what is the tractor's expected NPV? (Hint: Use the 5-year straight-line depreciation for all analyses, and ignore the MACRS half-year convention for this problem.)

Summary Introduction

To prepare: Scenario analysis and tractor’s expected NPV.

Introduction:

Scenario Analysis:

Under this analysis, the management considers the different alternatives outcome to analyze the future events. It is the method in which the analyst estimates the expected future value after a period of time.

Net present Value (NPV):

NPV is the technique of capital budgeting.  It is used to decide whether to accept or reject a project. If the project has positive NPV then accept the project, if the NPV is negative then reject the project.

Explanation

Given information:

Tractor cost is $36,000.

It increase the pretax operating cash flows by $12,000 per year.

Straight line method of depreciation follows

Life is 5 years and depreciation is $7,200 per year

Controller thinks that the life of tractor is 4 years

Tax rate 40%

Weighted average cost of capital is 10%

Prepare table that shows the calculation of expected NPV.

Life of tractor

(Years)

Probability of outcome (A)

NPV

($)

(B)

Expected NPV

(C)

(A)×(B)

50.3336,76812,133.44
40.3324,8648205.12
80.3466,33622,554.24

Table (1)

Where the life of tractor is 5 years

Formula to calculate net present value is,

Net present value= Present value of cash inflowPresent value of cash outflow

Substitute $72,768 for present value of cash inflow and $36,000 for present value of cash outflow.

Net present value=$72,768$36,000=$36,768

Where the life of tractor is 4 years

Formula to calculate net present value is,

Net present value= Present value of cash inflowPresent value of cash outflow

Substitute $60,864 for present value of cash inflow and $36,000 for present value of cash outflow.

Net present value=$60,864$36,000=$24,864

Where the life of tractor is 8 years

Formula to calculate net present value is,

Net present value= Present value of cash inflowPresent value of cash outflow

Substitute $102,336 for present value of cash inflow and $36,000 for present value of cash outflow

Still sussing out bartleby?

Check out a sample textbook solution.

See a sample solution

The Solution to Your Study Problems

Bartleby provides explanations to thousands of textbook problems written by our experts, many with advanced degrees!

Get Started

Additional Business Solutions

Find more solutions based on key concepts

Show solutions add

Explain how absolute advantage and comparative advantage differ.

Principles of Microeconomics (MindTap Course List)