Question and Problem

NPV and Capital Budgeting

7.1 which of the following cash flows should be treated as incremental cash flow when computing the
NPV of an investment ?

a. the reduction in the sales of the company’s other products.

b. the expenditure on plant and equipment.
c. the cost of the research and development undertaken in connection with the product during the
past three years.
d. the annual depreciation expanse.
e. dividend payments.
f. The resale value of plant and equipment at the end of the project’s life.
g. salary and medical cost for production employees on leave.
h.

7.2 the best manufacturing company is considering a new investment. Financial projections for the
investment are tabulated below. (cash flows are in $ thousand and the corporate tax rate is 34 percent.)

Year 0 year 1 year 2 year 3 year 4

Sales revenue 7.000 7.000 7.000 7.000
Operating cost 2.000 2.000 2.000 2.000
Investment 10.000
Depreciation 2.500 2.500 2.500 2.500
New working capital 200 250 300 200 0
(End of year)

a. Compute the incremental net income of the investment.

b. Compute the incremental cash flow of the investment.
c. Suppose the appropriate discount rate is 12 percent. What is the NPV of the project?

7.3 according to the February 7, 1983 issue of the sporting news, The Khansas City Royals’ designated
hitter, Hal McRae, signed a three-year contract in January 1983 with the following provisions:

 $400.000 signing bonus

 $250.000 salary per year for three years
 10 years of deferred payments of $125.000 per year ( these payments begin in year 4).
 Several bonus provisions that total as much as $75.000 per year for three years of the contract.

Assume that McRae has a 60-percent probability of receiving the bonuses each year, and that he
signed the contact on January 1. 1983. (Hint: Use the expected bonuses as incremental cash flows.)
Assume an effective annual interest rate of 12.36 percent, and ignore taxes. McRae salary and
bonus are paid at the end of the year. What was the percent value of this contract in January when
McRae signed it ?
7.4 Benson Enterprises, Inc. is evaluating alternative uses for a three story manufacturing and
warehousing building that is has purchased for $225.000. the company could continue to rent the
building to the present occupants for $12.000 per year. The present occupants have indicated an
interest in staying in the building for at least another 15 years. Alternatively, the company could
modify the existing structure to use for its own manufacturing and warehousing needs. Benson’s
production engineer feels the building could be adapted to handle one of two new product lines.
The cost and revenue data for the two product alternatives follow :

Product A Product B

Initial cash outlay for building modifications $ 36.000 $54.000

Initial cash outlay for equipment 144.000 162.000
Annual pretax cash revenues (generated for 15 years) 105.000 127.500
Annual pretax cash expenditures (generated for 15 years) 60.000 75.000

The building will be used for only 15years for either product A or product B. after 15 years, the
building will be too small for efficient production of either product line. At the time, Benson Plans to
rent the building to firms similar to the currents occupants. To rent the building again, Benson will
need to restore the building to its present layout. The estimated cash cost of restoring the building if
product A has been undertaken is $3.750; if product B has been produced, the cash cost will be
$25.125. these cash cost can be deducted for tax purposes in the year the expenditures occur.
Benson will depreciate the original building shell (purchased for $225.000) over a 30-year life to
zero, regardless of which alternative it chooses. The building modifications and equipment
purchases for either product are estimated to have a 25-year life; also, they can and will be
depreciated on a straight-line basis. The firm’s tax rate is 34 percent. And its required rate of return
on such investments is 12 percent.
For simplicity assume all cash flow for a given year occur at the end of the year. The initial
outlays for modifications and equipment will occur at t=0, and the restoration outlays will occur at
the end of year 15. Also, Benson has other profitable ongoing operations that are sufficient to cover
any losses.
Which use of the building would you recommended to management ?