(i). Why do we focus on cash flows rather than accounting profits in making capital- budgeting decisions?
(ii). Briefly compare and contrast the three discounted-cash-flow criteria (NPV, PI, and IRR). What are the advantages and disadvantages of the use of each of these methods?
Hippo Trucks Ltd is considering the purchase of a new production machine for $200 000. The purchase of this machine will result in an increase in earnings before interest and taxes of $50 000 per year. To operate this machine properly, workers would have to go through a brief training session that would cost $5000 after tax, In addition, it would cost $5000 after tax to install the machine properly. Also, because this machine is extremely efficient, its purchase would necessitate an increase in inventory of $20 000. The machine has an expected life of 10 years after which it will have no salvage value. Finally, to purchase the new machine, it appears that the firm would have to borrow $100 000 at 8% interest from its local bank, resulting in additional interest payments of $8000 per year, assume straight-line depreciation and that the machine is being depreciated down to zero, a 30% marginal tax rate, and required rate of return of 10%.
(i). What is the initial outlay associated with the project?
(ii). What are the annual after-tax cash flows associated with this project for years 1 to 9?
(iii). What is the terminal cash flow in year 10? (What is the annual after-tax cash flow in year 10 plus any additional cash flows associated with termination of the project?)
(iv). What is the NPV of the project? Should it be accepted?
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