Exam 10: Project Cash Flows and Risk

The two cardinal rules which financial analysts follow to avoid capital budgeting errors are: (1) capital budgeting decisions must be based on accounting income, and (2) only incremental cash flows are relevant to accept/reject decisions.

Stanton Inc.is considering the purchase of a new machine which will reduce manufacturing costs by R5,000 annually and increase earnings before depreciation and taxes by R6,000 annually.Stanton will use the MACRS method to depreciate the machine, and it expects to sell the machine at the end of its 5-year operating life for R10,000 before taxes.Stanton's marginal tax rate is 40 percent, and it uses a 9 percent required rate of return to evaluate projects of this type.If the machine's cost is R40,000, what is the project's NPV?

Alabama Pulp Company (APC) can control its environmental pollution using either "Project Old Tech" or "Project New Tech." Both will do the job, but the actual costs involved with Project New Tech, which uses unproved, new state-of-the-art technology, could be much higher than the expected cost levels.The cash outflows associated with Project Old Tech, which uses standard proven technology, are less risky--they are about as uncertain as the cash flows associated with an average project.APC's required rate of return for average risk projects normally is set at 12 percent, and the company adds 3 percent for high risk projects but subtracts 3 percent for low risk projects.The two projects in question meet the criteria for high and average risk, but the financial manager is concerned about applying the normal rule to such cost-only projects.You must decide which project to recommend, and you should recommend the one with the lower PV of costs.What is the PV of costs of the better project?