Business High School

You have been asked by the president of the Farr Construction Company to evaluate the proposed acquisition of a new earth mover. The mover's basic price is $220,000, and it would cost another $30,000 to modify it for special use. Assume that the mover falls into the MACRS 5-year class, it would be sold after 4 years for $60,000, and it would require an increase in net operating working capital (spare parts inventory) of $10,000. The earth mover would have no effect on revenues, but it is expected to save the firm $52,000 per year in before-tax operating costs, mainly labor. The firm's marginal federal-plus-state tax rate is 25 percent and the project's cost of capital is 10 percent.

Evaluate the project using the NPV rule and the IRR rule.

Answers

Answer 1

To evaluate the project using the NPV rule and the IRR rule, we need to calculate the net cash flows for each year, discount them to their present value, and then apply the respective rules.

First, let's calculate the net cash flows:

Year 0:

Initial investment = -$220,000 (basic price) - $30,000 (modification cost) + $10,000 (increase in working capital) = -$240,000

Years 1-4:

Net cash flow = Savings in operating costs - Tax on savings

Net cash flow = $52,000 - ($52,000 * 0.25) = $39,000 (after-tax cash flow)

Year 5:

Net cash flow = Salvage value - Tax on salvage value

Net cash flow = $60,000 - ($60,000 - $30,000) * 0.25 = $45,000 (after-tax cash flow)

Now, let's calculate the present value of the net cash flows using the project's cost of capital of 10%:

PV (Year 0) = -$240,000 / (1 + 0.10)^0 = -$240,000

PV (Years 1-4) = $39,000 / (1 + 0.10)^1 + $39,000 / (1 + 0.10)^2 + $39,000 / (1 + 0.10)^3 + $39,000 / (1 + 0.10)^4 = $134,095.04

PV (Year 5) = $45,000 / (1 + 0.10)^5 = $28,598.74

Next, let's calculate the net present value (NPV) by summing up the present values of the net cash flows:

NPV = PV (Year 0) + PV (Years 1-4) + PV (Year 5) = -$240,000 + $134,095.04 + $28,598.74 = -$77,306.22

To evaluate the project using the IRR rule, we can use a financial calculator or spreadsheet to find the internal rate of return (IRR). The IRR is the discount rate that makes the NPV of the project equal to zero.

Using a financial calculator or spreadsheet, the IRR for this project is approximately 8.92%.

Based on the NPV rule, since the NPV is negative (-$77,306.22), the project would be considered unattractive. It does not generate sufficient returns to cover the initial investment and provide a positive net present value.

Based on the IRR rule, the project's IRR of 8.92% is lower than the cost of capital (10%). Therefore, the project would also be considered unattractive using the IRR rule.

Overall, based on both the NPV rule and the IRR rule, the proposed acquisition of the new earth mover would not be recommended.

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Related Questions

Earleton Manufacturing Company has $2 billion in sales and $471,500,000 in fixed assets. Currently, the company's fixed assets are operating at 85% of capacity.

What level of sales could Earleton have obtained if it had been operating at full capacity? Write out your answers completely. For example, 13 million should be entered as 13,000,000. Round your answer to the nearest dollar.
$

What is Earleton's target fixed assets/sales ratio? Do not round intermediate calculations. Round your answer to two decimal places.
%

If Earleton's sales increase 20%, how large of an increase in fixed assets will the company need to meet its target fixed assets/sales ratio? Write out your answer completely. Do not round intermediate calculations. Round your answer to the nearest dollar.
$

Answers

The Target fixed assets/sales ratio of Earleton's is 23.58% . The required increase in fixed assets is $242,454,000.

If Earleton Manufacturing Company is currently operating at 85% of capacity and has $2 billion in sales, to determine the level of sales it could have obtained if operating at full capacity, we can use the formula:

Full capacity sales = Current sales / Capacity utilization

Full capacity sales = $2,000,000,000 / 0.85 = $2,352,941,176 (rounded to the nearest dollar).

To calculate Earleton's target fixed assets/sales ratio, we divide the fixed assets by the sales and multiply by 100:

Target fixed assets/sales ratio = (Fixed assets / Sales) * 100

Target fixed assets/sales ratio = ($471,500,000 / $2,000,000,000) * 100 = 23.58% (rounded to two decimal places).

If Earleton's sales increase by 20%, we need to calculate the increase in fixed assets required to maintain the target fixed assets/sales ratio. First, we determine the new sales level:

New sales = Current sales + (Current sales * Sales increase)

New sales = $2,000,000,000 + ($2,000,000,000 * 0.20) = $2,400,000,000

Then, we calculate the required increase in fixed assets:

Required increase in fixed assets = (New sales * Target fixed assets/sales ratio) - Current fixed assets

Required increase in fixed assets = ($2,400,000,000 * 0.2358) - $471,500,000 = $242,454,000 (rounded to the nearest dollar).

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To address the eurozone crisis, the European Central Bank (ECB) adopted a negative interest rate policy in 2014. The ECB lowered its deposit rate to -0.1% that year to hold off deflation and move the economic bloc out of a prolonged recession. Today, the ECB deposit rate is - 0.5%, the lowest on record. In theory, negative rates would boost the economy by encouraging consumers and banks to take more risks through borrowing and lending money. Using the IS-LM framework, explain why traditional monetary policy fails in the presence of zero lower bounds, and how the negative interest rate policy may help the ECB to bring the economy out of recession. [20 marks]
MUST USE IS-LM MODEL TO EXPLAIN

Answers

The European Central Bank (ECB) adopted a negative interest rate policy to address the eurozone crisis. The ECB lowered its deposit rate to -0.1% that year to prevent deflation and bring the economic bloc out of a long-term recession.

In theory, negative interest rates would boost the economy by encouraging consumers and banks to take more risks through borrowing and lending money. Traditional monetary policy fails in the presence of zero lower bounds as the interest rates can't go lower. As a result, the central bank is unable to stimulate borrowing and lending in the economy.

When interest rates are already near zero, the effectiveness of monetary policy is severely restricted as it can no longer boost investment and consumption demand through interest rate cuts. Hence, conventional monetary policy becomes ineffective when interest rates hit zero and even quantitative easing (QE) has only limited effects. In this case, the negative interest rate policy may help the ECB bring the economy out of recession by lowering borrowing costs and increasing the availability of credit, thereby increasing investment and consumption.

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