CFA CFA Level 2 Schweser Exam 2 (Afternoon) – Q106

Schweser Exam 2 (Afternoon) – Q106

  • This topic has 15 replies, 4 voices, and was last updated Apr-17 by Alta12.
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  • Alta12
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    Replacement of equipment calculation

    Can someone explain why the Sal T of the old equipment was not taken into consideration when calculating TNCOF. I thought it was incremental Sal T for replacement projects. Schweser just basically used TNOCF Sal T of new equipment + NWC – t(Sal T – BV T).

    Thanks.

    Sophie Macon
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    Hi @alta12 – would you mind sharing an image or the full question? Not all of us have the reference book at hand

    Alta12
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    @Sophie. Thanks…here it is

    H Malfoy, CFA is an analyst with a major manufacturing firm. Currently he is evaluating the replacement of some production equipment. The old machine is still functional and could continue to serve in its current capacity for 3 more years. If the new equipment is purchased, the old equipment (which is fully depreciated) can be sold for $50,00. The new equipment will cost $400,000, including shipping and installation. If the new equipment is purchased, the company’s revenues will increase by $175,000 and costs by $25,000 for each year of the equipment’s 3 year life. There is no expected change in net working capital.

    The new machine will be depreciated using a 3 year MACRS schedule (note: 33% in first year, 45% in 2nd year, 15% in 3rd year and 7% in 4th year). At the end of the life of the new equipment i.e. 3 years, Malfoy expects that it can be sold for $10,000. The firm has a marginal tax rate of 40% and the cost of capital of the project is 20%. In calculation of tax liabilities, Malfoy assumes that the the firm is profitable, so any losses on this project can be offset against profits elsewhere in the firm. Malfoy calculates a project NPV of -$62,574.

    Q106. The combined after-tax operating CF and terminal year after tax non-operating CF in year 3 is closest to:
    A: $131,200
    B: $151,200
    C $152,200

    Answer: A

    vincentt
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    Hi @alta12 , I don’t have the book with me but this is the calculation.

    Year 3 cash flow = (S – C- D) (1 – tax) + D
    (175k – 25k – 60k ) (0.6) + 60k = 114k

    TNOCF = Sal + NWCInv – Tax (gains)
    where: gains = Sal – Book Value

    10k + 0 – 0.4( 10k – 28k) = 10k – (-7.2k)

    = 17.2k

    so, to get the answer requested:

    after-tax CF and terminal year after-tax CF = 114k + 17.2k = 131.2k

    If not mistaken, you must have got it wrong at the MACRS depreciation calculation.

    Book value for the new equipment at the end of year 3 is 400k * 7% as that’s the last portion of the deduction which should happen in year 4 or likewise you could get 7% by deducting the sum of all depreciation in the 3 years (33% + 45% + 15%) from 100%.

    Alta12
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    @vincentt But what about the incremental CF over the selling price of old equipment? I thought we need to take this into account for replacement project.

    vincentt
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    You would have sold your old equipment at time 0, that’s the whole point of this replacement project.
    They (new and old equipment) don’t run in parallel.

    And in case you are wondering what’s the calculation like for that.

    At time 0, you purchase the new equipment:

    FCInv + NWCInv (outlay so the sum of the 2 figures should be negative)

    and include the TNOCF of the old equipment = Sal + NWCInv – Tax (gains)

    When you merge the 2 calculations it should look like this:

    – FCInv + Sal_old – Tax (Sal_old – BV_old)

    *NWCInv would cross out each other since there’s no expected change in net working capital.

    Alta12
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    CFA notes p34 shows that for a replacement project TNOCF takes into consideration the incremental CF. TNOCF=Sal T+ NWC – T(Sal T – B T = ($200,000-100,000) + 80,000 – 0.3 = $150,000. It took the CF from the sale of the old equipment into consideration. Please help @ vincentt πŸ™

    vincentt
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    Hi @alta12 , I haven’t got the book with me as I’m in the office at the moment, maybe you could correct the typos you have in the calculation you posted above, especially where the brackets end and so on.

    Or is this a different question because 200k-100k+80k-0.3 isn’t equal to 150k?

    Alta12
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    Reference to p.35 CFA notes.

    “At the project termination, the new equipment is expected to be sold for $200,000, which constitutes an incremental cash flow of $100,000 over the $100,000 expected salvage price of the old equipment. Since the accounting salvage values for both the new and old equipment were zero, this gain is taxable at 30 percent. The company also recaptures its investment in net working capital. The terminal year after-tax non-operating cash flow is
    TNOCF=SalT +NWCInvβˆ’T(SalT βˆ’BT) =(200,000βˆ’100,000)+80,000βˆ’0.30
    [(200,000 βˆ’100,000)βˆ’(0 βˆ’0)] = $150,000

    vincentt
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    you are probably right regarding the Sal_T for TNOCF as its for the differences between both salvage value. That’s in CFAI, but in schweser notes they just use the Salvage value of the NEW equipment. Not too sure which is right now as I’ve checked both of their (CFAI and schweser) errata page, nothing there.

    vincentt
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    @diya did you notice this discrepancy? CFAI’s vs Schweser’s.

    Sarah
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    @vincentt and @Alta12 sorry for taking so long. I had to reread Schweser and read CFAI material to be able to comment.

    I don’t think there is a discrepancy between the material. Schweser points out on page 229:
    “Generally, we can classify incremental cash flows for capital projects as (1) initial investment outlay, (2) operating cash flow over the project’s life, and (3) terminal-year cash flow.”

    From this we can deduce that replacement projects is all about the incremental differences. On page 235 in Schweser there is a detailed example on replacement projects but note it says, “The printer is being depreciated using straight-line basis assuming a useful life of 15 years and no salvage value.

    Basically it isn’t a discrepancy rather Schweser has decided not to draw attention to the fact that we need to account for the old equipments salvage value since Schweser states that the old equipments salvage value is zero.

    For this particular question nowhere in the question does it indicate that the old equipment has a salvage value so we just need to worry about the new equipments salvage value.

    vincentt
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    I thought it specifically mentioned in the first paragraph “If the new equipment is purchased, the old equipment (which is fully depreciated) can be sold for $50,000.” so that would be the salvage value.

    Sarah
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    @vincentt ohh you are absolutely correct. Can’t believe I missed that! On oversight by Schweser?

    Thought most likely I am missing something.

    vincentt
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    @diya but i’m glad you pointed the one on page 235 which i clearly missed.

    Just cross checked with my exam prep notes and it is indeed to use any incremental/differences of both new and old for all 3 steps (outlay, cashflows, terminal value).

    Not too sure why nobody raised the error on exam 2 to schweser?

    Alta12
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    @diya @vincentt Thanks for looking into it. It appears to be a Schweser error! I can’t think of any other possibility.

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