Valuation case study

Topics: Depreciation, Stock, Stock market Pages: 21 (3529 words) Published: February 24, 2014
Finance 7A10
Solutions: End-of-Chapter questions

Chapter 7 (2nd Edition)
Questions are: 2, 9, 15

7-2. Kokomochi is considering the launch of an advertising campaign for its latest dessert product, the Mini Mochi Munch. Kokomochi plans to spend $5 million on TV, radio, and print advertising this year for the campaign. The ads are expected to boost sales of the Mini Mochi Munch by $9 million this year and by $7 million next year. In addition, the company expects that new consumers who try the Mini Mochi Munch will be more likely to try Kokomochi’s other products. As a result, sales of other products are expected to rise by $2 million each year.

Kokomochi’s gross profit margin for the Mini Mochi Munch is 35%, and its gross profit margin averages 25% for all other products. The company’s marginal corporate tax rate is 35% both this year and next year. What are the incremental earnings associated with the advertising campaign?

A
B
C
D
E
1

Year12
2
Incre
1
2
3
4
5
6
7
8
9
mental Earnings Forecast ($000s)
Sales of Mini Mochi Munch9,0007,000
Other Sales2,0002,000
Cost of Goods Sold(7,350)(6,050)
3

4

5

6

Gross Profit3,6502,950
Selling, General & Admin.(5,000)- Depreciation--
7

8

9

EBIT(1,350)2,950
Income tax at 35%473(1,033)
10

11

Unlevered Net Income(878)1,918

7-9. Elmdale Enterprises is deciding whether to expand its production facilities. Although long-term cash flows are difficult to estimate, management has projected the following cash flows for the first two years (in millions of dollars):

a. What are the incremental earnings for this project for years 1 and 2?

b. What are the free cash flows for this project for the first two years?

a.

Year1
2
Increm
ental Earnings Forecast ($000s)

1
Sales
125.0
160.0
2
Costs of good sold and operating expenses other than depreciation (40.0)
(60.0)
3
Depreciation
(25.0)
(36.0)
4
EBIT
Income tax at 35%
60.0
(21.0)
64.0
(22.4)
5

6
Unlevered Net Income
39.0
41.6
Free
Cash Flow ($000s)
1
2
7
Plus: Depreciation
25.0
36.0
8
Less: Capital Expenditures
(30.0)
(40.0)
9
Less: Increases in NWC
(5.0)
(8.0)
10
Free Cash Flow
29.0
29.6

b.
Free
Cash Flow ($000s)
1
2
7
Plus: Depreciation
25.0
36.0
8
Less: Capital Expenditures
(30.0)
(40.0)
9
Less: Increases in NWC
(5.0)
(8.0)
10
Free Cash Flow
29.0
29.6

7-15. Markov Manufacturing recently spent $15 million to purchase some equipment used in the manufacture of disk drives. The firm expects that this equipment will have a useful life of five years, and its marginal corporate tax rate is 35%. The company plans to use straight-line depreciation.

a. What is the annual depreciation expense associated with this equipment?

b. What is the annual depreciation tax shield?
c. Rather than straight-line depreciation, suppose Markov will use the MACRS depreciation method for five-year property. Calculate the depreciation tax shield each year for this equipment under this accelerated depreciation schedule.

d. If Markov has a choice between straight-line and MACRS depreciation schedules, and its marginal corporate tax rate is expected to remain constant, which should it choose? Why?

e. How might your answer to part (d) change if Markov anticipates that its marginal corporate tax rate will increase substantially over the next five years?

a. $15 million / 5 years = $3 million per year

b. $3 million × 35% = $1.05 million per year
c.

d. In both cases, its total depreciation tax shield is the same. But with MACRS, it receives the depreciation tax shields sooner—thus, MACRS depreciation leads to a higher NPV of Markov’s FCF.

e. If the tax rate will increase substantially, than Markov may be better off claiming higher depreciation expenses in later years, since the tax...
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