   Chapter 12, Problem 18P Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

Solutions

Chapter
Section Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

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 depredated 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? (1-lint: Use the 5-year straight-line depredation 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) 5 0.33 36,768 12,133.44 4 0.33 24,864 8205.12 8 0.34 66,336 22,554.24 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

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