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Corporate Finance Exercises

The document contains sample problems and solutions for calculating cash flow, payback period, internal rate of return, and net present value. Problem 12-1 shows how to calculate cash flow for a corporation given earnings before depreciation and taxes, depreciation, tax rate, and earnings after taxes. Problem 12-3 demonstrates calculating payback periods for two alternative investments to determine which has the faster payback. Problem 12-7 uses a financial table to calculate the internal rate of return for an investment. Problem 12-11 uses the net present value method to determine if an investment should be undertaken given the project's cash inflows, outflows, and cost of capital.

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Jefferson Sarmiento
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96 views6 pages

Corporate Finance Exercises

The document contains sample problems and solutions for calculating cash flow, payback period, internal rate of return, and net present value. Problem 12-1 shows how to calculate cash flow for a corporation given earnings before depreciation and taxes, depreciation, tax rate, and earnings after taxes. Problem 12-3 demonstrates calculating payback periods for two alternative investments to determine which has the faster payback. Problem 12-7 uses a financial table to calculate the internal rate of return for an investment. Problem 12-11 uses the net present value method to determine if an investment should be undertaken given the project's cash inflows, outflows, and cost of capital.

Uploaded by

Jefferson Sarmiento
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Chapter 12

Problems
12-1. Assume a corporation has earnings before depreciation and taxes of $100,000,
and depreciation of $50,000, and that it has a 30 percent tax bracket. Compute
its cash flow using the format below.

Earnings before depreciation and taxes


Depreciation
Earnings before taxes
Taxes @ 30%
Earnings after taxes
Depreciation
Cash flow

Solution:

Earnings before depreciation and taxes $100,000


Depreciation – 50,000
Earnings before taxes 50,000
Taxes @ 30% 15,000
Earnings after taxes 35,000
Depreciation + 50,000
Cash flow $ 85,000

12-3. Assume a $50,000 investment and the following cash flows for two alternatives.

Year Investment A Investment B


1 ............ $10,000 $20,000
2 ............ 11,000 25,000
3 ............ 13,000 15,000
4 ............ 16,000
5 ............ 30,000

Which alternative would you select under the payback method?

Solution:
Payback for Investment A Payback for Investment B
$50,000 – $10,000 1 year $50,000 – $20,000 1 year
40,000 – 11,000 2 years 30,000 – 25,000 2 years
29,000 – 13,000 3 years 5,000/15,000 .33 years
16,000 – 16,000 4 years

Payback Investment A = 4.00 years


Payback Investment B = 2.33 years
Investment B would be selected because of the faster
payback.

12-7. You buy a new piece of equipment for $11,778, and you receive a cash inflow
of $2,000 per year for 10 years. What is the internal rate of return?

Solution:

Appendix D

$11,778
PVIFA = = 5.889
$2, 000

IRR = 11%

For n = 10, we find 5.889 under the 11% column.

12-11. Hamilton Control Systems will invest $90,000 in a temporary project that will
generate the following cash inflows for the next three years.

Year Cash Flow


1 ....................................... $23,000
2 ....................................... 38,000
3 ....................................... 60,000

The firm will be required to spend $15,000 to close down the project at the end
of the three years. If the cost of capital is 10 percent, should the investment be
undertaken? Use the net present value method.
undertaken? Use the net present value method.

Solution:
Hamilton Control Systems

Present Value of inflows

Year Cash Flow * PVIF at 10% Present Value


1 $23,000 .909 $20,907
2 38,000 .826 31,388
3 60,000 .751 45,060
$97,355

Present Value of outflows

0 $90,000 1.000 $ 90,000


3 15,000 .751 11,265
$101,265

Present Value of inflows $ 97,355


Present Value of outflows 101,265
Net present value ($ 3,910)

12-22. The Summit Petroleum Corporation will purchase an asset that qualifies for
three-year MACRS depreciation. The cost is $80,000 and the asset will provide
the following stream of earnings before depreciation and taxes for the next four
years:

Year 1 ............................... $36,000


Year 2 ............................... 40,000
Year 3 ............................... 31,000
Year 4 ............................... 19,000

The firm is in a 35 percent tax bracket and has an 11 percent cost of capital.
Should it purchase the asset? Use the net present value method.

Solution:
Summit Petroleum Corporation
First determine annual depreciation.

Percentage
Depreciation Depreciation Annual
Year Base (Table 12-9) Depreciation
1 $80,000 .333 $26,640
2 80,000 .445 35,600
3 80,000 .148 11,840
4 80,000 .074 5,920
$80,000

Then determine the annual cash flow.

1 2 3 4
EBDT $36,000 $40,000 $31,000 $19,000
–D 26,640 35,600 11,840 5,920
EBT 9,360 4,400 19,160 13,080
T (35%) 3,276 1,540 6,706 4,578
EAT 6,084 2,860 12,454 8,502
+D 26,640 35,600 11,840 5,920
Cash
Flow $32,724 $38,460 $24,294 $14,422

Then determine the net present value.

Cash Flow
Year (inflows) PVIF at 11% Present Value
1 $32,724 .901 $29,484
2 38,460 .812 31,230
3 24,294 .731 17,759
4 14,422 .659 9,504

Present value of inflows $87,977


Present value of outflows 80,000
Net present value $ 7,977

The asset should be purchased based on the new present


value.

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