Question

Commercial Hydronics Incorporation is considering an asset replacement project of replacing a control device. This old control device has been fully depreciated but can be sold for $5,000. The new control device, which is more automated, will cost $22,000. The new device’s installation and shipping costs will total $12,000. The new device will be depreciated on a straight-line basis over its 2-year economic life to an estimated salvage value of $0. The actual salvage value of this device at the end of 2-year period (That is, the market value of the device at the end of 2-year period) is estimated to be $3,000. If the replacement project is accepted, Commercial Hydronics will require an initial working capital investment of $3,000 (that is, adding $3,000 initially to its net working capital). During the 1st year of operations, Commercial Hydronics expects its annual revenue to increase from $65,000 to $85,000. After the 1st year, revenues from the replacement are expected to increase at a rate of $2,200 a year for the remainder of the project life. Commercial Hydronics' incremental operating costs associated with the replacement project are expected to decrease from $20,000 to $12,000 during the 1st year and increase at a rate of $2500 for the remainder of the project life. Commercial Hydronics expects that it will have to add about $2,000 to its net working capital in year 1, and nothing in year 2. At the end of the project, the total accumulated net working capital required by the project will be recovered. Commercial Hydronics has a marginal tax rate of 35%.

What is the net operating cash flow at the end of year 2?

Question options:

$31,785

$30,905

$30,230

$35,210

Using the profitability index, which of the following mutually exclusive projects should be accepted?

Project A: NPV = $6,000; NINV = $50,000

Project B: NPV = $10,000; NINV = $120,000

Project C: NPV = $8,000; NINV = $80,000

Question options:

All projects should be accepted.

B

C

A

Answer 1

1)

Depreciation = (22,000 +12,000 ) / 2 years = 17,000

after tax salvage value = 3000*(1 - tax)

= 3000*(1 - 0.35)

= 1950

Recovey of workingcapital  in year 2 (NWC) = 3000 +2000 = 5000

increase in revenue (in 2nd year) = 85000 + 2200 - 65000 = 22,200

Decrease in operating costs = 20,000 - (12000+2500) = 5500

Net operating cash flow in year 2 =

(increase in revenue + Decrease in operating costs - depreciation)*(1-tax) + depreciation + salvage value + NWC

= (22,200 + 5500 -17,000 )*(1 - 0.35) + 17000 + 1950 + 5000

= $30,905

2)

PI = (NINV + NPV) / NINV

A = 56,000 / 50,000 = 1.12

B = 130,000 / 120,000 = 1.08

C = 88,000 / 80,000 = 1.1

Since mutually exclusive the project with HIGH PI ratio should be selected

Answer is A