Cash Flows And Sunken Costs Calculation Exercises

11-2. (Relevant cash flows) Captins’ Cereal is considering introducing a variation of its current
breakfast cereal, Crunch Stuff. The new cereal will be similar to the old with the exception that it
will contain sugarcoated marshmallows shaped in the form of stars and will be called Crunch
Stuff n’ Stars. It is estimated that the sales for the new cereal will be $25 million; however, 20
percent of those sales will be former Crunch Stuff customers who have switched to Crunch Stuff
n’ Stars but who would not have switched if the new product had not been introduced. What is
the relevant sales level to consider when deciding whether to introduce Crunch Stuff n’ Stars?
11-3. (Consideration of sunk and opportunity costs) Hewlett-Packard has designed a new type of
printer that produces professional-quality photos. These new printers took 2 years to develop,
with research and development running at $10 million after taxes over that period. Now all that’s
left is an investment of $22 million after taxes in new production equipment. It is expected that
this new product line will bring in free cash flows of $5 million per year for each of the next 10
years. In addition, if Hewlett-Packard goes ahead with the new line of printers, the current
production facility for the old printers that are to be replaced with this new line could be sold to a
competitor, generating $3 million after taxes.
1. How should the $10 million of research and development be treated?
2. How should the $3 million from the sale of the existing production facility for the old
printers be treated?
3. Given the information above, what are the cash flows associated with the new printers?
11-4. (Capital gains tax) The J. Harris Corporation is considering selling one of its old assembly
machines. The machine, purchased for $30,000 5 years ago, had an expected life of 10 years and
an expected salvage value of zero. Assume Harris uses simplified straight-line depreciation
(depreciation of $3,000 per year) and could sell this old machine for $35,000. Also assume
Harris has a 21 percent marginal tax rate.
1. What would be the taxes associated with this sale?
2. If the old machine were sold for $25,000, what would be the taxes associated with this
sale?
3. If the old machine were sold for $15,000, what would be the taxes associated with this
sale?
4. If the old machine were sold for $12,000, what would be the taxes associated with this
sale?
11-6. (Calculating free cash flows) Spartan Stores is expanding operations with the introduction
of a new distribution center. Not only will sales increase but investment in inventory will decline
due to increased efficiencies in getting inventory to showrooms. As a result of this new
distribution center, Spartan expects a change in EBIT of $900,000. Although inventory is
expected to drop from $90,000 to $70,000, accounts receivables are expected to climb as a result
of increased credit sales from $80,000 to $110,000. In addition, accounts payable are expected to
increase from $65,000 to $80,000. This project will also produce $300,000 of bonus depreciation
in year 1, and Spartan Stores is in the 21 percent marginal tax rate. What is the project’s free cash
flow in year 1?