Cash Flow and Capital Budgeting

113

Chapter 8: Cash Flow and Capital Budgeting

Answers to questions
8-1.

Accounting numbers may not accurately reflect when revenues are received or when payments
are made. Net present value focuses on when money is actually received or paid and then
discounts these cash flows at an appropriate rate to find whether a project adds value to a
company. This emphasis recognizes that whatever accounting earnings a company has, it must
generate sufficient cash to pay its bills or it will not stay in business very long.

8-2.

No, even if the project is not adopted, the cost would still be incurred making it a sunk cost.

8-3.

No, this is an example of an opportunity cost.

8-4.

Depreciation reduces taxable income. The lower the taxable income, the lower the taxes paid,
which are a real cash outflow. Thus, depreciation creates a cash inflow through the lowering of a
real cash outflow.

8-5.

When constructing forecasts in nominal terms, each value that would be impacted by inflation
should be increased by the rate of inflation each year. To construct projections in real terms, all
values that would be inflated had they been in nominal terms should be in time zero dollars to
reflect real values.

8-6.

No, a negative change in net working capital is actually beneficial. It is a cash inflow in the sense
that it indicates proportionately more funding for current assets is coming from current liabilities.

8-7.

Interest expense should be ignored and should not be treated as a cash outflow. The discount rate
already captures the costs associated with financing a project, and deducting these costs from the
projects cash flows would be double counting.

8-8.

a.

Depreciation positively impacts cash flow. Depreciation reduces taxable income. The
lower the taxable income, the lower the taxes paid, which are a real cash outflow. Cash
flow from operations is net income with depreciation added back in. Higher depreciation
means higher cash flow.

b.

From a net present value perspective, the faster depreciation is taken the better. More
depreciation in the early years of a project means higher cash flows and higher net
present value for a project.

c. & d. Many companies use accelerated deprecation for cash flow/net present value purposes
and straight line depreciation for reporting purposes. This ensures that the depreciation
method used does not impact reported earnings per share; however, it does allow the
company to take maximum tax advantage of depreciation and reduce its tax bill.
8-9.

An increase in accounts payable is a cash inflow in the sense that the firm is asking its creditors to
finance more of its purchases. The creditor is providing non-interest bearing financing for the
firms working capital needs. The company is able to purchase more current assets since it has
less of a need to pay its creditors.

8-10.

Terminal value can be calculated using the growing perpetuity model, which states that terminal
value = CFt+1/(r g). Terminal value can also be calculated by multiplying the final years cash

114

Chapter 8
flow by a market multiple such as price-to-cash-flow ratio. One could also use an investments
book value or its expected liquidation value to estimate terminal value.

8-11.

If an investment is sold for more than its book value, then the firm has a capital gain on the
difference between market price and book value and must pay capital gains taxes on that
difference. The relevant cash flows are the market price of the investment sale minus the
additional taxes. If an asset is sold for less than book value, then the company can claim a tax
credit on the difference between the market price and the book value. This credit is the difference
between market value and book value times the tax rate. The relevant cash flows are the market
price of the asset plus the tax credit.

8-12.

Incremental cash flows matter because the project evaluator is looking at what will change if the
project is accepted. Any existing expenses that the company would pay whether or not it
accepted the project are not relevant to the decision at hand. The evaluator must look at what
changes will occur if a project is accepted.

8-13.

Sunk costs should not be included in a cash flow analysis. These are costs that have already been
paid. Accepting or rejecting the project will not impact these costs. These are not incremental to
the project. Opportunity costs are relevant. If a company accepts a project, it may have to forego
income from another, alternative use of a resource. If this is the case, then this opportunity cost is
relevant and should be included in the cash flow analysis.

8-14.

After one year, all of the out-of-pocket costs of the program, as well as one years lost wages, are
sunk costs. Therefore, the NPV of getting the degree is probably much higher.

8-15.

There are two ways to approach this problem. First, each company could estimate the cash value
of the stores that it is giving up. This is the cash price that the firm might obtain from another
buyer, and therefore represents the opportunity cost of this deal. This could be treated as the
initial cash outflow. Next, analysts would compare this cash outflow to the present value of cash
inflows generated by the stores it is acquiring to determine the overall NPV.
But what about the cash inflows that the company loses on the stores it gives up? Isnt that
another opportunity cost? The answer is, it depends. If analysts treat the opportunity cost of
selling the stores for cash as an initial outflow, then they should ignore subsequent cash inflows
from operating these stores. Thats because the company would not receive these cash inflows if
it sold the stores for cash. Therefore, the only other relevant future cash inflows are those from
the stores that the company acquires.
On the other hand, the company could approach the analysis by ignoring the opportunity to sell
their current stores for cash. In that case, the future cash inflows from these stores is the relevant
opportunity cost, so the project NPV would simply take the net cash flows from the stores that the
company receives and subtract those from the stores that it sells.

8-16.

False: You need an inflation forecast either way. If you are discounting real cash flows, you
need to estimate the inflation rate because you will have to use this rate to calculate the real value
of depreciation deductions which are fixed in nominal terms.

Cash Flow and Capital Budgeting

115

8-17.

The EAC method provides a present value per year. This means one can look at the yearly
contribution of an investment, rather than just the total investment. In other words, it might be
more profitable to take a project that provides a higher yearly NPV for fewer years, and then
reinvest again when that project ends than to take a longer-term project that provides a lower
NPV per year.

8-18.

Excess capacity is not free. It was originally accounted for when the project was first chosen
that size equipment that produced the excess capacity was included in those project cash flows. If
there truly is no use for excess capacity, now or in the future, for the original project, then a new
project could use that excess capacity at no additional charge to the project. However, if using
excess capacity for a new project means that the original project will have to add more capacity at
some time in the future, then this should be charged to the new project.

Answers to problems
8-1.

a.

Current net working capital = $30 million + $20 million + $45 million - $10 million
= $85 million
Future net working capital = $10 mill. + $20 mill. + $60 mill. - $40 mill. - $10 mill.
= $40 million

8-2.

b.

The change in net working capital is -$45 million (i.e. $40 million - $85 million)
indicating that the firm needs to supply less funding (i.e. its own cash) to support the
current assets. This is considered to be beneficial.

c.

Net working capital (just-in-time system) = $15 million + $20 million + $5 million - $10
million = $30 million. The change in net working capital becomes -$55 million making
this solution better than the inventory financing plan.

a.

The terminal value is: [$2.5 million * (1 + 4%)] [15% - 4%] = $23.64 million.

b.

The total value of the cash flows is: [$1.2 million (1 + 15%)] + [$1.4 million (1 +
15%)2] + [$1.7 million (1 + 15%)3] + [$2 million (1 + 15%)4] + [($2.5 million +
$23.64 million) (1 + 15%)5] = $17.36 million.

c.

The terminal value accounts for 67.7% of the total value of the cash flows ([$23.64
million (1 + 15%)5] $17.36 million).

8-3.

$51.5 million = price-to-cash-flow ratio * [$3.605 million (1 + 3%)]

Solving for the price-to-cash-flow ratio = $51.5 million [$3.605 million (1 + 3%)] = 14.714

8-4.

$69.3 million = [$4.2 million * (1 + g)] [14% - g]

Solving for the terminal growth rate g =
[$69.3 million * 14% - $4.2 million] [$69.3 million + $4.2 million] = 7.49%.
The growth rate is higher than 4.2% making the terminal value an over-estimation.
The terminal value using the 4.2% rate equates to: [$4.2 million * (1 + 4.2%)] [14% - 4.2%] =
$44.66 million. The price-to-cash-flow ratio equivalent is: $44.66 million $4.2 million = 10.62,
which is much lower than the original 16.5 ratio.

116
8-5.

Chapter 8
Initial NPV = -$10 million + [$5.6 million (1 + 12%)] + [$6.272 million (1 + 12%) 2] +
[$7.025 million (1 + 12%)3] = $5.00 million.
NPV for Year 3 cash flow = -$6 million + [$6.6 million (1 + 12%)] = -0.107 million. Because
the NPV is negative, the firm should not continue the project. Notice, the past performance of the
project (although successful) is not a factor in making this decision.

8-6.
Depreciation A/T ($)
3
7
20
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21

566,610
755,650
251,770
125,970
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0

242,930
416,330
297,330
212,330
151,810
151,810
151,810
75,650
0
0
0
0
0
0
0
0
0
0
0
0
0

PV of Depr. Tax Savings

63,750
122,740
113,560
105,060
97,070
89,760
83,130
76,840
75,820
75,820
75,820
75,820
75,820
75,820
75,820
75,820
75,820
75,820
75,820
75,820
38,250

Present Values ($)

a. 3
b. 7
c. 20
515,100
624,504.1
189,158.5
86,039.2
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0

220,845.5
57,954.55
344,074.4 101,438
223,388.4
85,319.31
145,024.2
71,757.39
942,62.07 60,272.83
856,92.79 50,667.18
779,02.53 42,658.83
352,91.28 35,846.43
0
32,155.08
0
29,231.89
0
26,574.45
0
24,158.59
0
21,962.35
0
19,965.78
0
18,150.71
0
16,500.64
0
15,000.58
0
13,636.89
0
12,397.18
0
11,270.16
0
5,168.74

$1,414,802 $1,226,481 $752,087.6

Cash Flow and Capital Budgeting

117

8-7.
End of Year
0
1
2
3
4
5
6

Depr. %

Depr.

0.2
0.32
0.192
0.1152
0.1152
0.0576

$2,312,000
3,699,200
2,219,520
1,331,712
1,331,712
665,856

PV Depr.

Depr. w/o Exp. PV Depr w/o Exp.

$680,000*
$2,064,286
$2,176,000
1,942,857
2,948,980
3,481,600
2,775,510
1,579,810
2,088,960
1,486,880
846,327.1
1,253,376
796,543.1
755,649.2
1,253,376
711,199.2
337,343.4
626,688
317,499.6
$8,532,396
$8,710,489

The present value of the write-offs when treating the installation cost as an initial expense is
$178,093 ($8,710,489 $8,532,396), greater than had the installation cost be included in the
depreciable base.
8-8.

a.

The company with the higher tax rate will receive more benefit from accelerated
depreciation than the company with the lower tax rate.

b.

If companies take larger deductions in the early years, then reported earnings would be
lower. Cash flows, however, would be higher because cash flows are earnings plus
depreciation. Project NPVs will be higher if a company accelerates its depreciation
expense. The stock market would react positively if a company were allowed to
accelerate its depreciation, and therefore lower its tax bill and increase its near term cash
flows.

8-9.
Year
1
2
3
4
5
6
Totals:

5-year MACRS %
20
32
19.2
11.52
11.52
5.76
100.00

Installed Cost Depreciation Amount

$4,000,000
$800,000
$4,000,000
$1,280,000
$4,000,000
$768,000
$4,000,000
$460,800
$4,000,000
$460,800
$4,000,000
$230,400
$4,000,000

Installed cost of equipment: $3,800,000 + $200,000 = $4,000,000

Year
1
2
3
4
5
6
Sales
$2,200,000 $2,200,000 $2,200,000 $2,200,000 $2,200,000 $2,200,000
Expenses (35%) 770,000
770,000
770,000
770,000
770,000
770,000
Depreciation
800,000 1,280,000
768,000
460,800
460,800
230,400
Taxable income
$630,000 $150,000 $662,000 $969,200 $969,200 $1,199,600
Taxes (40%)
252,000
60,000
264,800
387,680
387,680
479,840
Earnings
$378,000
$90,000 $397,200 $581,520 $581,520 $719,760
*

$2,000,000 0.34 = $680,000

118

Chapter 8
Inc. Opr. CFs
(Earn + Depr)

$1,178,000 $1,370,000 $1,165,200 $1,042,320 $1,042,320

a.

$2,200,800 (1 .35) = $1,430,000 each year

b.

See Earnings line in table above.

c.

See Inc. Opr. CFs line in table above.

$950,160

8-10.
5-year MACRS % Installed Cost Depreciation
20
$72,000
$14,400.00
32
$72,000
$23,040.00
19.2
$72,000
$13,824.00
11.52
$72,000
$8,294.40
11.52
$72,000
$8,294.40
5.76
$72,000
$4,147.20
Total
$72,000
Year
0
Reduced expenses
Depreciation
Taxable income
Taxes (40%)
Earnings
Inc. Opr CFs (Earn + Depr)
8-11.

a.

1
$24,000
14,400
$9,600
3,840
$5,760
$20,160

2
$24,000
23,040
$960
384
$576
$23,616

3
$24,000
13,824
$10,176
4,070
$6,106
$19,930

4
$24,000
8,294.4
$15,706
6,282
$9,424
$17,718

5
$24,000
8,294.4
$15,706
6,282
$9,424
$17,718

6
0
4,147.2
$4,147
1,659
$2,488
$1,659

Operating Cash Flows

New Machine
Year
0
Sales
Expenses
Depreciation
Taxable income
Taxes (40%)
Earnings
Inc. Opr CFs (Earn + Depr)

1
2
3
4
5
6
$50,000 $51,000 $52,000 $53,000 $54,000
0
40,000 40,000 40,000 40,000 40,000
0
4,000
6,400
3,800
2,400
2,400
1,000
$6,000 $4,600 $8,200 $10,600 $11,600 $1,000
2,400
1,840
3,280
4,240
4,640
400
$3,600 $2,760 $4,920 $6,360 $6,960
$600
$7,600 $9,160 $8,720 $8,760 $9,360
$400

Cash Flow and Capital Budgeting

119

Old Machine
Year
0
Sales
Expenses
Depreciation
Taxable income
Taxes (40%)
Earnings
Inc. Opr CFs (Earn + Depr)
b.

1
2
3
4
5
$45,000 $45,000 $45,000 $45,000 $45,000
35,000 35,000 35,000 35,000 35,000
0
0
0
0
0
$10,000 $10,000 $10,000 $10,000 $10,000
4,000
4,000
4,000
4,000
4,000
$6,000 $6,000 $6,000 $6,000 $6,000
$6,000 $6,000 $6,000 $6,000 $6,000

6
0
0
0
0
0
0
0

Incremental operating cash flows

Year
New Machine
Old Machine
Difference

1
$7,600
6,000
$1,600

2
$9,160
6,000
$3,160

3
$8,720
6,000
$2,720

4
$8,760
6,000
$2,760

5
$9,360
6,000
$3,360

6
$400
0
$400

c.
$1,600

$3,160

$2,720

$2,760

$3,360

$400

End of Year
8-12.

Incremental operating cash flows

Year
2010
2011
2012
2013
2014
Change in sales
$2,000,000 $4,000,000 $6,000,000 $10,000,000 $14,000,000
Change in expenses
1,800,000 360,0000 540,0000 900,0000 12,600,000
(90%)
Advertising expense
3,000,000 3,000,000 3,000,000 3,000,000 3,000,000
Change in taxable income
$2,800,000 $2,600,000 $2,400,000 $2,000,000 $1,600,000
Taxes (40%)
1120000 1040000
960000
800000
640000
Incremental Opr. CFs
$1,680,000 $1,560,000 $1,440,000 $1,200,000 $960,000
The proposed campaign would not generate enough in new sales revenues to justify the additional
advertising expense.

8-13.

a.

Using the same dies and tools is not an incremental expense. This is a sunk cost and not
relevant to the project cash flows.

b.

The $17,000 is an opportunity cost and is relevant. If the firm accepts the project, it will

120

Chapter 8
forego $17,000 in leasing revenue. The firm is using some of its excess capacity that it
would have otherwise leased.

8-14.

c.

The $10,000 in floor space is an opportunity cost. The firm will forego $10,000 in
revenues in order to provide floor space for the new project.

d.

The storage space is a sunk cost and should not be charged to the new project. The
company has no other use for this space and it has already paid for the facility.

e.

Foregoing the sale of the crane is an opportunity cost. The $180,000 in lost equipment
sales revenue should be charged to the new project.

Sunk costs include:

a.
Research and development funds already spent
Relevant costs include:
b.
The impact on other products produced by the company. However, since it is expected
that the competition will erode sales if Blueberry does not do so itself, then a case could
be made that the firm should have included cannibalization of sales into its forecasts of
existing products when the decision was originally made to accept those projects.

8-15.

c.

Costs of ramping up production of the new device. This is incremental to the new
project.

d.

Increases in inventory and receivables that will occur because of the acceptance of the
new project.

a.
$30,50
0
$1,500

Cost of new oven

+ Installation costs

$32,00
0

Total installed cost

$22,00
0

Proceeds from Sale of old oven

Tax on sale of old oven
Sale price
Book value (1 .20 .32 .192) $20,000
Gain on sale of old oven
Tax rate
Tax on sale of old oven
After tax proceeds from sale of old oven
INITIAL CASH OUTFLOW

$22,00
0
$5,670
$16,24
0
.40
$6,496
($15,50
4)
$16,49
6

Cash Flow and Capital Budgeting

121

b.
5-year MACRS % Installed Cost Depreciation
20
32,000
$6,400.00
32
32,000
$10,240.00
19.2
32,000
$6,144.00
11.52
32,000
$3,686.40
11.52
32,000
$3,686.40
5.76
32,000
$1,843.20
Total
$32,000.00
New Oven
Year
1
2
3
4
5
6
Sales
$300,000 $300,000 $300,000 $300,000 $300,000
$0
Expenses
288,000 288,000 288,000 288,000 288,000
0
Depreciation
6,400
10,240
6,144
3,686
3,686
1,843
Taxable income
$5,600
$1,760
$5,856
$8,314
$8,314 $1,843
Taxes (40%)
2,240
704
2,342
3,325
3,325
737
Earnings
3,360
1,056
3,514
4,988
4,988 1,106
Inc. Opr. CFs (Earn + Depr)
$9,760 $11,296
$9,658
$8,674
$8,674
$737
5-year MACRS % Installed Cost Depreciation
20
$20,000
$4,000.00
32
$20,000
$6,400.00
19.2
$20,000
$3,840.00
11.52
$20,000
$2,304.00
11.52
$20,000
$2,304.00
5.76
$20,000
$1,152.00
Total
$20,000

Note that the first 3 years of

depreciation have already been taken
on the old oven.

Old Oven
Year
1
2
3
4
5
Sales
$270,000 $270,000 $270,000 $271,000 $270,000
Expenses
264,000 264,000 264,000 264,000 264,000
Depreciation
2,304
2,304
1,152
0
0
Taxable income
$3,696
$3,696
$6,848
$7,000
$6,000
Taxes (40%)
1,478
1,478
2,739
2,800
2,400
Earnings
$2,218
$2,218
$4,109
$4,200
$3,600
Inc. Opr. CFs (Earn + Depr)
$4,522
$4,522
$5,261
$4,200
$3,600
Incremental cash flows

6
0
0
0
0
0
0
0

122

Chapter 8

Year
New Oven
Old Oven
Difference

1
$9,760
4,522
$5,238

$16,496

2
$11,296
4,522
$6,774

3
$9,658
5,261
$4,397

4
$8,675
4,200
$4,474

5
$8,675
3,600
$5,074

c.
$5,238

$6,774

$4,397

$4,474

$5,074

$737

$16,496
End of Year
8-16.

a.
$210,00
0
$10,000

Cost of new washer

+ Installation cost

$220,00
0

Total Installed Cost

$140,00
0

Proceeds from sale of existing washer

Tax on sale of existing washer
Sale Price
Book Value (1 .20 .32) $140,000
Gain on sale of existing washer
Tax rate
Tax on sale of existing washer

$140,00
0
$57,600
$82,400
.40
$32,960
($107,0
40)

After tax proceeds from sale of existing washer

+ Initial working capital investment
Increase in current assets
Accounts receivable
+ Inventories

$80,000
60,000
$140,00
0

Total current assets increase

Increase in current liabilities
Accounts Payable
Total current liabilities increase
Initial working capital investment
INITIAL CASH OUTFLOW

$116,00
0
$116,00
0
$24,000
$136,96

6
$737
0
$737

Cash Flow and Capital Budgeting

123
0

b.

5-year MACRS %
20
32
19.2
11.52
11.52
5.76

Installed Cost Depreciation

$120,000
$24,000.00
$120,000
$38,400.00
$120,000
$23,040.00
$120,000
$13,824.00
$120,000
$13,824.00
$120,000
$6,912.00
Total
$120,000.00

Note that the first 3 years of

depreciation have already been taken
on the existing washer.

Existing Washer
Year
Sales Expenses (PBOT)
Depreciation
Taxable income
Taxes (40%)
Earnings
Inc. Opr CFs (Earn + Depr)

1
$52,000
23,040
$28,960
11,584
$17,376
$40,416

2
$48,000
13,824
$34,176
13,670
$20,506
$34,330

3
$44,000
13,824
$30,176
12,070
$18,106
$31,930

4
$40,000
6,912
$33,088
13,235
$19,853
$26,765

5
$36,000
0
$36,000
14,400
$21,600
$21,600

5-year MACRS % Installed Cost Depreciation

20
$220,000
$44,000.00
32
$220,000
$70,400.00
19.2
$220,000
$42,240.00
11.52
$220,000
$25,344.00
11.52
$220,000
$25,344.00
5.76
$220,000
$12,672.00
Total
$220,000.00
New Washer
Year
Machine cost
Sales-Expenses (PBDT)
Depreciation
Taxable income
Taxes (40%)
Earnings
Inc Opr. CFs (Earn + Depr)
+ Working capital recovery
+ Terminal value

$86,000

$86,000

$86,000

$86,000

$86,000

44,000
$42,000
16,800
$25,200
$69,200

70,400
$15,600
6,240
$9,360
$79,760

42,240
$43,760
17,504
$26,256
$68,496

25,344
$60,656
24,262
$36,394
$61,738

25,344
$60,656
24,262
$36,394
$61,738
$24,000
$39,869

124

Chapter 8
Cash flow
c.

$69,200

$79,760

$68,496

$61,738 $125,607

Terminal value of new washer in year 5

Sale Price
Book value
Gain on sale
Taxes (40%)
Terminal Value (sale price taxes)

$58,000
12,672
$45,328
18,131
$39,869

(year 6 depr)

Cash Flow and Capital Budgeting

125

Incremental cash flows

Year
0
New Washer
Existing Washer
Difference
$139,960
d.

1
$69,200
40,416
$28,784

2
$79,760
34,330
$45,430

3
$68,496
31,930
$36,566
$34,973

$28,784

$45,430

$36,566

4
$61,738
26,765
$34,973

5
$125,607
21,600
$104,007

$104,007
5

$136,960
End of Year
8-17.

a.
Cost of new ship
+ Installation
Total Installed Cost

Ship A
$40,000,0
00
$8,000,00
0
$48,000,0
00

Ship B
$54,000,0
00
$6,000,00
0
$60,000,0
00

(14,486,40
0)
$4,000,00
0
$37,513,6
00

(14,486,40
0)
$6,000,00
0
$51,513,6
00

$18,000,0
00

Proceeds from selling existing ship

Tax on sale of existing ship
Sale Price
Book Value
(1-.32-.20-.172) $32,000,000
Gain on sale of existing ship
Tax Rate

$18,000,0
00
$9,216,00
0
$8,784,00
0
.40

Tax on sale of existing ship

After tax proceeds from sale of existing ship
+ Initial Working Capital Investment
INITIAL CASH OUTFLOW
b. and c.

$3,513,60
0

126

Chapter 8

Ship A
5-year MACRS %
20
32
19.2
11.52
11.52
5.76

Installed Cost
$48,000,000
$48,000,000
$48,000,000
$48,000,000
$48,000,000
$48,000,000
Total

Depreciation
$9,600,000.00
$15,360,000.00
$9,216,000.00
$5,529,600.00
$5,529,600.00
$2,764,800.00
$48,000,000

Ship A
Year
1
2
3
4
5
Sales Expenses (PBDT) $21,000,000 $21,000,000 $21,000,000 $21,000,000 $21,000,000
Depreciation
9,600,000 15,360,000 9,216,000 5,529,600 5,529,600
Taxable income
$11,400,000 $5,640,000 $11,784,000 $15,470,400 $15,470,400
Taxes (40%)
4,560,000 2,256,000 4,713,600 6,188,160 6,188,160
Earnings
$6,840,000 $3,384,000 $7,070,400 $9,282,240 $9,282,240
Inc Opr. CFs (Earn + Depr) 16,440,000 18,744,000 16,286,400 14,811,840 14,811,840
Working Capital Recovery
$4,000,000
Terminal value
$8,305,920
Cash flow
$16,440,000 $18,744,000 $16,286,400 $14,811,840 $27,117,760
Terminal value of Ship A in year 5
Sale Price
$12,000,000
Book value
2,764,800
Gain on sale
$9,235,200
Taxes (40%)
3,694,080
Terminal Value (sale price taxes) $8,305,920

(Year 6 Depr)

Ship B
5-year MACRS %
20
32
19.2
11.52
11.52
5.76

Year
Sales-Expenses

Installed Cost
$60,000,000
$60,000,000
$60,000,000
$60,000,000
$60,000,000
$60,000,000
Total
0

Depreciation
$12,000,000.00
$19,200,000.00
$11,520,000.00
$6,912,000.00
$6,912,000.00
$3,456,000.00
$60,000,000

1
2
3
4
5
$22,000,000 $24,000,000 $26,000,000 $26,000,000 $26,000,000

Cash Flow and Capital Budgeting

Depreciation
Taxable income
Taxes (40%)
Earnings
Inc Opr. CFs (Earn + Depr)
Working Capital Recovery
Terminal value
Cash flow

127
12,000,000 19,200,000 11,520,000 6,912,000 6,912,000
$10,000,000 $4,800,000 $14,480,000 $19,088,000 $19,088,000
4,000,000 1,920,000 5,792,000 7,635,200 7,635,200
6,000,000 2,880,000 8,688,000 11,452,800 11,452,800
18,000,000 22,080,000 20,208,000 18,364,800 18,364,800
$6,000,000
$13,382,400
$18,000,000 $22,080,000 $20,208,000 $18,364,800 $37,747,200

Terminal value of Ship B in year 5

Sale price
$20,000,000
Book value
3,456,000 (Year 6 Depr.)
Gain on sale
$16,544,000
Taxes (40%)
6,617,600
Terminal Value (sale price taxes) $13,382,400
Existing Ship
5-year MACRS % Installed Cost
Depreciation
20
$32,000,000 $6,400,000.00
$10,240,000.0
32
$32,000,000
0
19.2
$32,000,000 $6,144,000.00
11.52
$32,000,000 $3,686,400.00
11.52
$32,000,000 $3,686,400.00
5.76
$32,000,000 $1,843,200.00
Total
$32,000,000

Note that the first 3 years of

depreciation have been taken on
the existing ship

Year
0
1
2
3
4
5
Sales Expenses (PBDT) $14,000,000 $14,000,000 $14,000,000 $14,000,000 $14,000,000
Depreciation
3,686,400 3,686,400 1,843,200
0
0
Taxable income
$10,313,600 $10,313,600 $12,156,800 $14,000,000 $14,000,000
Taxes (40%)
4,125,440 4,125,440 4,862,720 5,600,000 5,600,000
Earnings
$6,188,160 $6,188,160 $7,294,080 $8,400,000 $8,400,000
Inc Opr. CFs (Earn + Depr) $9,874,560 $9,874,560 $9,137,280 $8,400,000 $8,400,000
Terminal value
$600,000
Cash flow
$9,874,560 $9,874,560 $9,137,280 $8,400,000 $9,000,000
Terminal value of existing ship in year 5
Sale price
Book value
Gain on sale
Taxes (40%)
Terminal value

$1,000,000
0
$1,000,000
$400,000
$600,000

(Fully depreciated)

128

Chapter 8

Incremental cash flows

Year
0
1
2
3
4
5
Ship A
$16,440,000 $18,744,000 $16,286,400 $14,811,840 $27,117,760
Existing Ship
9,874,560 9,874,560 9,137,280 8,400,000 9,000,000
Difference
$37,513,600 $6,565,440 $8,869,440 $7,149,120 $6,411,840 $18,117,760
Incremental cash flows
Year
0
1
2
3
4
5
Ship B
$18,000,000 $22,080,000 $20,208,000 $18,364,800 $37,747,200
Old Ship
9,874,560 9,874,560 9,137,280 8,400,000 9,000,000
Difference $51,513,600 $8,125,440 $12,205,440 $11,070,720 $9,964,800 $28,747,200
d.

Time lines

Ship A
$6,565,440

$8,869,440

$7,149,120

$37,513,600

$6,411,840 $18,117,600
4

End of Year

Ship B
$8,125,440 $12,205,440 $11,070,720 $9,964,800 $28,747,200
0

$51,513,600

End of Year

8-18.
Year
0
1
2
3
4
5
Network Cost
$500,000
Operating Cash Flows
$125,000 $125,000 $125,000 $125,000 $125,000
*
Donate old computer
$20,000
Cash flows
$480,000 $125,000 $125,000 $125,000 $125,000 $125,000
NPV at 10%
$6,151.65

Loss = sale price book value = 0 $50,000 = $50,000

Tax benefit from loss = $50,000 x .40 = $20,000

Cash Flow and Capital Budgeting

129

The NPV is negative. The new system should not be installed.

8-19.

a. and b.
Year
1
2
3
4
5
Units sales
20,000
25,000
30,000
36,000
41,400
Price/unit
$250
$260
$260
$245
$240
Revenue
$5,000,000 $6,500,000 $7,800,000 $8,820,000 $9,936,000
Variable cost ($135/unit)
2,700,000 3,375,000 4,050,000 4,860,000 5,589,000
Depreciation ($10 million 5) 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000
Net income
$300,000 $1,125,000 $1,750,000 $1,960,000 $2,347,000
After-tax income
198,000
742,500 1,155,000 1,293,600 1,549,020
[net income (1 .34)]
+ Depreciation
2,000,000 2,000,000 2,000,000 2,000,000 2,000,000
Operating CF
$2,198,000 $2,742,500 $3,155,000 $3,293,600 $3,549,020
*
Working capital
700,000 200,000 180,000
330,000
750,000
Cash flow
$1,498,000 $2,542,500 $2,975,000 $3,623,600 $4,299,020
c. and d.
1

NPV at
10%

NPV at
15%

Year End
$1,361,818 $2,101,240 $2,235,162 $2,474,968 $2,669,353 $842,541 $-609,607
PV @ 10%
Mid year
$1,428,287 $2,203,799 $2,344,257 $2,595,768 $2,799,641 $1,371,752 $70,074
PV @ 10%
Difference with mid year discounting $329,211 $679,681
8-20.

a.
Net Income
+ Depreciation
in Current assets
in Gross final assets
+ Accounts Payable
Cash Flow
b.

2010
$10,65
0
12,000
3,500
33,000
6,000
$
7,940

2011
$16,33
5
18,000
9,875
53,500
6,750
$
22,290

($ in thousands)
2012
2013
$22,44
$27,72
0
0
24,000
28,800
9,825
7,800
59,500
57,200
6,750
5,400
$
$
16,135
3,080

Cash flow 2015 = 1.05 $8,976 = $9,424.80

g = 5% r = 15%

PV2014 =

CF2015
$9,424.80
=
= $94,248
r g
.15 .05

*
*

Year-to-year change in investment in A/R and inventories

2014
$32,07
6
32,400
5,850
53,700
4,050
$8,976

130

Chapter 8

c.
End of Year
2010
2011
2012
2013
2014

Cash
Flow
$
7,940

22,290

16,135
3,080
8,976

PV of CF beyond
2014

Total Cash
Flow
$7,940
22,290
16,135
3,080
103,224

94,248

PV Total Cash Flow @15% at the end of 2009 = $15,192

d.

Fusion Chips

Income Statement
Sales (+10%)
COGS (1.45)
Gross Profit (0.55)
Oper Expenses
Depreciation
PreTax Income
Taxes (0.34)
Net Income
+ Depreciation
Current Assets*
Gross Fixed Assets
+ Accts. Pay (+30%)
Cash Flow
e.

2010
$110,000
60,500
$49,500
13,200
12,000
$24,300
8,262
$16,038
12,000
3,100
33,000
10,050
$1,988

2011
$165,000
90,750
$74,250
18,975
18,000
$37,275
12,674
$24,601
18,000
9,750
53,500
8,775
$11,874

($ thousands)
2012
$220,000
121,000
$99,000
24,200
24,000
$50,800
17,272
$33,528
24,000
9,750
59,500
8,775
$2,947

2013
$264,000
145,200
$118,800
27,720
28,800
$62,280
21,175
$41,105
28,800
7,800
57,200
7,020
$11,925

Cash Flow 2015 = 1.05 $25,338 = $26,604.90

g = 5% r = 15%

PV2014 =

CF2015
$26,604.90
=
= $266,049
r g
.15 .05

f.
End of Year Cash Flow
2010
2011
*

$1,988

11,874

Reflects reduction of cash balances to $0

PV of CF beyond
2014

Total Cash
Flow
$1,988
11,874

2014
$297,000
163,350
$133,650
29,700
32,400
$71,550
24,327
$47,273
32,400
5,850
53,700
5,265
$25,338

Cash Flow and Capital Budgeting

2012
2013
2014

131

2,947
11,925
25,338

2,947
11,925
291,387

266,049

P.V. Total Cash Flow @15% at end of 2009 = $142,502

g.

Fusion Chips

Cash Flows from Technology Integration ($ thousands)

2010

2011
$20,000
6,250
$13,750
4,675
$9,075
6,250
$15,325

PBDT
Depr. ($50K/8)
PBT
Tax (0.34)
PAT
+ Depr.
Cash Flow (Opr.)
Invest in FA
50,000
Invest in NWC
3,000
+ Proceeds Sale of FA
+ Tax Savings from Sale*
+ Recovery of NWC
Project CF
$53,000

$15,325

2012
$30,000
6,250
$23,750
8,075
$15,675
6,250
$21,925

$21,925

2013
$15,000
6,250
$8,750
2,975
$5,775
6,250
$12,025

$12,025

2014
$15,000
6,250
$8,750
2,975
$5,775
6,250
$12,025

2015
$15,000
6,250
$8,750
2,975
$5,775
6,250
$12,025

$12,025

1,000
6,035
3,000
$22,060

NPV of Project CF @ 15 % at end of 2009 = $2,654

Maximum Price ($ thousands)
P.V. Total Cash Flow (from part f)
+NPV of Tech. Integ. Project
Maximum Price
8-21.

$142,502
2,654
$145,156

a.

NPV at 11% = 32.96 million

b.

Terminal value as of year 6 =

$8.25 million
= $75 million. New NPV = $7.13
0.11

million
c.

Terminal value as of year 6 =

New NPV = $17.03 million

d.

8.25 million 1.02

= $93.50 million.
0.11 0.02

Terminal value = 10 $8.25 million = $82.5 million. New NPV = $11.15 million

*
*

1,000 sale price 18,750 book value = 17,750 Loss; Tax savings = $17,750 .34 = $6,035

132

Chapter 8

8-22.

a.
Year
0
Initial cost
$1,200,000
After tax CF

$500,000

$400,000

$300,000

$200,000

$100,000

NPV at 12% = -$37,313.50

The project is not acceptable at 12% because the NPV is negative.
b.

Real values of cash flows

Year
0
1
2
3
4
5
Initial cost
$1,200,000
After tax CF
$485,436.89 $377,038.36 $274,542.50 $177,697.41 $86,260.88
(1 + Nominal rate) = (1 + inflation rate)(1 + real rate)
1.12 = (1.03)(1+real rate)
Real rate =
c.

1.12
1 = 8.738%
1.03

NPV at 8.738% = -$37,316.65

The project is rejected whether real rates and real cash flows or nominal rates and
nominal cash flows are used.

8-23.
a.

0
Initial Cost
$4 million
After Tax CF
0

$1.25 million $1.25 million $1.25 million $1.25 million

NPV @ 10.25% = $-59,017

b.
Initial Cost
Real A/T CF

0
$4 million
0

$1,190,476

$1,133,787

$1,079,787

$1,028,378

(1 + Nominal rate) = (1 + inflation rate) (1 + real rate)

1.1025 = (1 + real rate)
Real rate =

1.1025
1 = 5.00%
1.05

NPV @ 5.00% = $59.017

The projects NPV is the same when real cash flows are discounted at the real interest rate as is
the case when the nominal cash flows are discounted at the nominal interest rate.
8-24.

Aircraft cash flows:

Year

Cash Inflow

Consumer project cash flows:

Year

Cash Inflow

Cash Flow and Capital Budgeting

1
2
3
4
5

133

$10 million
$20 million
$20 million
$30 million
$40 million

1
2
3
4
5

$10 million
$12 million
$14 million
$20 million
$25 million

Discount the first projects cash flows at the nominal rate of return = (1.05)(1.08) 1 = 1.134 1
or 13.4% and you get an NPV of $2,557,333. Discount the second projects cash flows at the real
rate of return of 8% and you get an NPV of $7,376,153.
Both projects have positive NPVs, but the second project has the higher NPV and should be
accepted.
8-25.

a. and b.
Year
0
Computer A $50,000

1
$7,000

2
$7,000

3
$7,000

4
$7,000

5
$7,000

6
$7,000

NPV at 12% = $21,220.15

EAC = NPV/PV factor annuity, 12%, 6 years = $5,161.29
Year
Computer B

0
$35,000

1
$5,500

2
$12,000

3
$16,000

4
$23,000

NPV at 12% = $5,482.44

EAC = NPV/PV factor annuity, 12%, 4 years = $1,805.00
Year
Computer C

0
$60,000

1
$18,000

2
$18,000

3
$18,000

4
$18,000

5
$18,000

NPV at 12% = $4,885.97

EAC = NPV/PV factor annuity, 12%, 5 years = $1,355.42
c.

8-26.

Computer A is unacceptable due to its negative NPV and Computer B provides a greater
positive NPV, both in an absolute sense and in terms of providing the most NPV per year
on an EAC basis than Computer C. Therefore, the firm should acquire Computer B.

a. and b.
Year
Project X

0
$156,000

1
$34,000

2
$50,000

3
$66,000

4
$82,000

NPV at 14% = $5,396.64

EAC = NPV/PV factor annuity, 14%, 4 years = $1,852.15
Year
Project Y

0
$104,000

1
$56,000

2
$56,000

NPV at 14% = $11,787.01

EAC = NPV/PV factor annuity, 14%, 2 years = $7,158.13
Year

134

Chapter 8
Project Z $132,000 $30,000 $30,000 $30,000 $30,000 $30,000 $30,000 $30,000 $30,000
NPV at 14% = $7,165.92
EAC = NPV/PV factor annuity, 14%, 8 years = $1,544.76
Rank Descending Order Based on NPV: Project Z, Project X, Project Y
Rank Descending Order Based on EAC: Project X, Project Z, Project Y
c.

Project Y has a negative NPV and EAC and is therefore unacceptable. Project Z has the
highest absolute NPV, but Project X provides the greatest EAC. Project Z should be
accepted if these projects involve a lifetime purchase, but if these projects are to be
replaced continuously over time, then Project X should be accepted.

8-27.
Present Value (cost/yd)
EAC @13%

Low Cost
$22
$5.51

High Cost
$28
$5.46

The 9-year, higher grade carpet provides a lower EAC (NPV of cost per year) and therefore is
preferred.
8-28.
a.

PV of costs = $40,000 +

$1,500
$1,500 $3,500
+ ... +

= $51,130
1
1.09
1.0915
1.0915

Equivalent Annual Cost (EAC) for 15 years at 9% = $6,343

b.

PV of costs = $7,000 +

$2,500 $5,500

= $4,248
1.091
1.091

One year later this equals $4,630 (1.09 $4,248). The opportunity cost is the lost $7,000
the firm would get if it sells the old truck right away. The firm pays that cost, plus $2,500
in maintenance cost one year later, but it does get the salvage value of $5,500 at the end of
year 1.
c.

The cost (in year 1 dollars) of using the old truck one more year is $4,630. The cost (in
year 1 dollars) of replacing the old truck now is $6,343, so the firm should not replace the
old truck immediately.

d.

PV of costs = $5,500 +

$3,600 $3,700

= 5,408
1.091
1.091

Cost in end-of-year 2 dollars = $5,408(1.09)1 = $5,895

The end-of-year 2 cost of keeping the old truck in service through year 2 of $5,895 is still
less than the EAC of $6,343 for the new truck, so do not replace the truck at the end of
year 1.
e.

PV of costs = $3,700 +

$4,500
= $7,828
1.091

Cost in end-of-year 3 dollars = $7,828 (1.09) = $8,533

Cash Flow and Capital Budgeting

135

At this point, the end-of-year 3 cost of keeping the old truck through the end of year 3 of
$8,533 is greater than the EAC of $6,343 for the new truck, so the firm is better off
buying the new truck at the end of year 2.
8-29.

NPV = $250,000 +

$250,000 $250,000 $5,000,000 $5,000,000

+

+
= $232,872
1.121
1.122
1.121
1.123

Since the NPV is negative, the firm should not take on the subcontracting job.

$232,872 = x +

x
x
+
1
1.12 1.122

$232,872
x
x
x
= $207,921 =
+
+
1
2
1.12
1.12
1.12
1.123
x = $86,568
$250,000 + $86,568 = $336,568

NPV = $336,568 +

$336,568 $336,568 $5,000,000 $5,000,000

+

+
=0
1.121
1.122
1.121
1.123

The minimum acceptable cash flow per year is $336,568.

8-30.

Thomson One Business School Edition

8-31.

Thomson One Business School Edition

8-32.

Thomson One Business School Edition

Cash Flow and Capital Budgeting

113

Answers to mini-case
The firm should undertake the microwave dryer project based upon NPV and IRR analysis.
Year 1
235,000
$257.23

Year 2
270,250
$264.66

Year 3
310,788
$272.31

$60,447,875
$1,028,900
$102.89
$24,179,150
$25,208,050
$35,239,825
$(5,000,000)
$30,239,825
$10,281,541
$19,958,285
$24,958,285

$71,524,041
$1,058,635
$105.86
$28,609,617
$29,668,252
$41,855,790
$(5,000,000)
$36,855,790
$12,530,968
$24,324,821
$29,324,821

$6,044,788

Inventory
Accounts Payable

Expected Unit Sales

Expected Unit Price
Expected Revenue
Fixed Costs
Variable Costs/unit
Variable Costs
Total Expenses
Net CF before depreciation and taxes
Depreciation
Income before taxes
Taxes
Net Income
Cash Flows

Year 5
285,925
$288.27

Year 6
228,740
$296.61

Year 7
182,992
$305.18

Year 8
146,393
$314.00

Year 9
117,115
$323.07

Year 10
93,692
$332.41

$84,629,749
$1,089,230
$108.92
$33,851,900
$34,941,129
$49,688,620
$(5,000,000)
$44,688,620
$15,194,131
$29,494,489
$34,494,489

Year 4
357,406
$280.18
$100,136,88
1
$1,120,709
$112.07
$40,054,752
$41,175,461
$58,961,420
$(5,000,000)
$53,961,420
$18,346,883
$35,614,537
$40,614,537

$82,424,670
$1,153,097
$115.31
$32,969,868
$34,122,965
$48,301,705
$(5,000,000)
$43,301,705
$14,722,580
$28,579,125
$33,579,125

$67,845,394
$1,186,421
$118.64
$27,138,158
$28,324,579
$39,520,815
$(5,000,000)
$34,520,815
$11,737,077
$22,783,738
$27,783,738

$55,844,901
$1,220,709
$122.07
$22,337,960
$23,558,669
$32,286,231
$(5,000,000)
$27,286,231
$9,277,319
$18,008,913
$23,008,913

$45,967,055
$1,255,988
$125.60
$18,386,822
$19,642,809
$26,324,245
$(5,000,000)
$21,324,245
$7,250,243
$14,074,002
$19,074,002

$37,836,402
$1,292,286
$129.23
$15,134,561
$16,426,846
$21,409,556
$(5,000,000)
$16,409,556
$5,579,249
$10,830,307
$15,830,307

$31,143,899
$1,329,633
$132.96
$12,457,560
$13,787,192
$17,356,707
$(5,000,000)
$12,356,707
$4,201,280
$8,155,427
$13,155,427

$7,152,404

$8,462,975

$10,013,688

$8,242,467

$6,784,539

$5,584,490

$4,596,705

$3,783,640

$3,114,390

$21,156,756

$25,033,414

$29,620,412

$35,047,908

$28,848,634

$23,745,888

$19,545,715

$16,088,469

$13,242,741

$10,900,365

$10,578,378

$12,516,707

$14,810,206

$17,523,954

$14,424,317

$11,872,944

$9,772,858

$8,044,235

$6,621,370

$5,450,182

$16,623,166

$19,669,111

$23,273,181

$27,537,642

$22,666,784

$18,657,483

$15,357,348

$12,640,940

$10,405,011

$8,564,572

Change in Working Capital

Accounts Receivable

Net WC
Change in WC
Net Cash Flows

$16,623,166

$3,045,946

$3,604,070

$4,264,461

$(4,870,858)

$(4,009,301)

$(3,300,136)

$(2,716,408)

$(2,235,929)

$(1,840,438)

$8,335,119

$26,278,875

$30,890,419

$36,350,076

$38,449,983

$31,793,039

$26,309,048

$21,790,410

$18,066,236

$14,995,865

$14,995,865
$206,942,93
5
$221,938,80
0

After Year 10 the cash flows are expected to rise at a rate 3.5% a year. The value of these flows in year 10 is:
($14,995,865 * 1.035) (.11 0.035) = $206,942,935.
Net Cash Flows

$8,335,119

$26,278,875

$30,890,419

$36,350,076

$38,449,983

$31,793,039

$26,309,048

$21,790,410

$18,066,236

$8,335,119

$26,278,875

$30,890,419

$36,350,076

$38,449,983

$31,793,039

$26,309,048

$21,790,410

$18,066,236

Value of constantly growing CFs

Total

The initial outlay is $50,000,000. The resulting NPV is $172,538,770.91 with an IRR of 48.55%.