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8.1

a. Yes, the reduction in the sales of the companys other products, referred to as erosion, and should be treated as

an incremental cash flow. These lost sales are included because they are a cost (a revenue reduction)

that the firm must bear if it chooses to produce the new product.

b. Yes, expenditures on plant and equipment should be treated as incremental cash flows. These are costs of the

new product line. However, if these expenditures have already occurred, they are sunk costs and are not

included as incremental cash flows.

c. No, the research and development costs should not be treated as incremental cash flows. The costs of research

and development undertaken on the product during the past 3 years are sunk costs and should not be included

in the evaluation of the project. Decisions made and costs incurred in the past cannot be changed. They

should not affect the decision to accept or reject the project.

d. Yes, the annual CCA expense should be treated as an incremental cash flow. CCA expense must be taken into

account when calculating the cash flows related to a given project. While CCA is not a cash expense that

directly affects cash flow, it decreases a firms net income and hence, lowers its tax bill for the year. Because

of this CCA tax shield, the firm has more cash on hand at the end of the year than it would have had without

expensing depreciation.

e.

No, dividend payments should not be treated as incremental cash flows. A firms decision to pay or not pay

dividends is independent of the decision to accept or reject any given investment project. For this reason, it is

not an incremental cash flow to a given project. Dividend policy is discussed in more detail in later chapters.

f.

Yes, the resale value of plant and equipment at the end of a projects life should be treated as an incremental

cash flow. The price at which the firm sells the equipment is a cash inflow, and any difference between the

book value of the equipment and its sale price will create gains or losses that result in either a tax credit or

liability.

g. Yes, salary and medical costs for production employees on leave should be treated as incremental cash flows.

The salaries of all personnel connected to the project must be included as costs of that project. Thus, the costs

of employees who are on leave for a portion of the project life must be included as costs of that project.

8.2

Since there is uncertainty surrounding the bonus payments, which Sundin might receive, you must use the

expected value of Sundins salary in the computation of the PV of his contract. The expected value of Sundins

salary is:

2

7

2

2

PV = $8,000,000 + $10,000,000 A12

.5% + [($3,000,000 A12.5% )/ 1.125 ] + 2,000,000 A12.5%

= $38,754,141.15

8-1

8.3

Product A:

t0

Revenues

Foregone rent

Expenditures

Restoration costs

EBT

Taxes at 40%

Net operating cash flow

Building Modifications tax shield

Capital investments

Tax shield on equipment

After tax cash flows

510,000.00

83,329.19

426,670.81

t1-14

300,000.00

60,000.00

150,000.00

90,000.00

36,000.00

54,000.00

3,200.00

t15

300,000.00

60,000.00

150,000.00

19,400.00

70,600.00

28,240.00

42,360.00

3,200.00

57,200.00

45,560.00

(1)

Building Modifications: The tax shield on these is Straightline and therefore can be included in the annual

cash flow calculations. The calculation of the annual tax shield is:

(120,000 / 15 ) x 0.40 = 3,200

(2)

CDT c 1 + 0.5k

x

k+d

1+ k

$390,000 x 0.20 x 0.40 1 + ( 0.5 x 0.15 )

=

x

= $83,329.19

0.15 + 0.20

1 + 0.15

14

15

NPV = 426,670 + 57,200 A15

% + 45,560/(1.15)

= $93,631.73

Product B

t0

Revenues

Foregone rent

Expenditures

Restoration costs

EBT

Taxes at 40%

Net operating cash flow

Building Modifications tax shield

Capital investments

Tax shield on equipment

After tax cash flows

650,000.00

98,285.71

551,714.29

t1-14

390,000.00

60,000.00

220,000.00

110,000.00

44,000.00

66,000.00

5,066.67

t15

390,000.00

60,000.00

220,000.00

110,000.00

0.00

0.00

0.00

5,066.67

71,066.67

5,066.67

(3) Building Modifications: The tax shield on these is Straightline and therefore can be included in the annual cash

flow calculations. The calculation of the annual tax shield is:

(190,000 / 15 ) x 0.40 = 5,066.67

Answers to EndofChapter Problems

8-2

CDTc 1 + 0.5k

x

k+d

1+ k

x

= $98,285.71

0.15 + 0.2

1 + 0.15

14

15

NPV = 551,714.29 + 71,066.67 A15

% + 5,066.67/(1.15)

= 144,272.22

Since both projects have negative NPVs, Victoria should continue to rent the building.

8.4

EPS = $700,000 / 315,000 = $2.22

NPVGO = ($1,300,000 + $2,100,000) / 315,000 = $2.54

Price = [EPS / r ] + NPVGO

= [$2.22 / 0.16] + $2.54

= $16.43

8.5

NPVA = $55,000+ $30,000 / 1.07619 + $18,000 / 1.076192 + $18,000 / 1.076193

= $55,000 + 27,876.10 +15,541.54 +14,441.25 = $2,858.91

NPVB = $60,000+ $10,000 / 1.13 + $25,000 / 1.132 + $40,000 / 1.133

= 60,000 + 8,849.55 + 19,578.66 + 27,722 = 3,849.76

Choose project A as it has the higher positive NPV.

8.6

8.7

= $1,190,476.19

a. The only mistake that Larry made was to discount at the riskfree rate of interest. The bankruptcy risk

adjustment to the cash flows was correct, but these should have been discounted by a riskadjusted rate. Given

that Larrys portfolio is undiversified (all of his money would be in the restaurant), he should have used a

higher discount rate. The deduction of the managerial wage was appropriate since the opportunity to earn that

amount elsewhere is Larrys opportunity cost of working in the restaurant.

ADD: Larry's calculation is : ( $35,715.93 / ( 0.02 - ( 0.065 ) ) / ( 1/1.02 4) = $388,188.24.

b. You should have chosen a higher discount rate and recomputed the value of the restaurant. For example, with a

discount rate of 10%, the value is ( $35,715.93 / ( 0.10 ( 0.065)) /(1/1.10 4) = $286,993.67. Notice that the

restaurants cash flows form a declining perpetuity.

8.8

The simplest approach to this problem is to discount the real cash flows. Since the revenues and costs are

growing perpetuities, the formula for computing the PV of such a stream can be used. The first year amounts of

8-3

the revenues and costs are stated in nominal terms. Since the growth rate and discount rate are real rates, adjust

the initial amounts. For revenues, labour costs and the other costs, those amounts are

$195,000 / 1.035, $100,000 / 1.035 and $27,000 / 1.035, respectively.

PV ( labour costs ) = ( $100,000 / 1.035 ) / ( 0.10 0.03 ) = $1,380,262.25

PV (other costs) = ( $27,000 / 1.035) / { 0.10 (0.01) } = $237,154.15

The lease payment is given in nominal terms and it should be discounted by the nominal rate which is

0.1385 = (1.035 1.10) 1.

Thus, the present value of the lease payments is $23,000 / 0.1385 = $166,928.14.

To find the NPV of BICCs toad ranch, deduct the present values of the costs from the present value of revenues.

Recall, the startup costs are negligible.

NPV

8.9

= $1,984,634.56

The analysis of the NPV of this project is most easily accomplished by separating the CCA costs from the project's

other cash flows. The CCA costs are in nominal terms. Those costs should be discounted at a riskless rate. The

riskless nominal rate is given. The revenues, labour costs and energy costs are given in real terms, so they are most

easily discounted using the real rate for risky cash flows. Remember, you can use different types of discount rates

(real vs. nominal) in a problem as long as you are careful to discount real cash flows with the real rate and nominal

cash flows with the nominal rate.

First, determine the net income from the revenues and expenses not including depreciation.

t =1

Revenues

Labor costs

Energy costs

EBT

Taxes 40%

Net Income

32,000.00

30,800.00

1,323.00

123.00

49.20

73.80

t =2

t =3

t =4

64,000.00

80,000.00

32,000.00

31,108.00

1,356.08

31,419.08

1,389.98

31,535.93

12,614.37

18,921.56

47,190.94

18,876.38

28,314.57

31,733.27

1,424.73

1,158.00

463.20

694.80

The NPV of the project is the present value of the net income in each year plus the present value of the CCA tax

shield.

PV CCATS = ( 56,000 x 0.20 x 0.4 )/ ( 0.07+0.20 )] (1.035/1.07) = $16,049.84

NPV

8.10

= 56,000 70.96 + 17,494.04 + 25,171.55 593.92 + 16,049.84

= $2050.55

Initial expenses = $0.45 4,600,000 = $2,070,000

PV after tax = $9,200,000 (1 0.34) / (0.12 0.06) $$2,070,000 (1 0.34) / (0.12 0.04)

= $101,200,000 $22,770,000

= $78,430,000

8-4

8.11

The analysis of the NPV of this project is most easily accomplished by separating the CCA costs from the

project's other cash flows. The CCA costs are in nominal terms. Those costs should be discounted at a riskless

rate. The riskless nominal rate is given. The revenues and variable costs are given in nominal terms. The

revenues grow at the rate of 5% and the costs grow at the rate of 2.5%. Hence, they are discounted using the

nominal rate for risky cash flows.

First, determine the net income from the revenues and expenses not including CCA.

Revenue

Variable costs

Pretax earnings

Taxes at 34%

Net earnings

Factory Sale proceeds

Net cash flows

PV at 30%*

t =1

4,250,000.00

-375,000.00

3,875,000.00

1,317,500.00

2,557,500.00

t =2

4,462,500.00

-384,375.00

4,078,125.00

1,386,562.50

2,691,562.50

t =3

4,685,625.00

-393,984.38

4,291,640.63

1,459,157.81

2,832,482.81

t =4

4,919,906.25

-403,833.98

4,516,072.27

1,535,464.57

2,980,607.70

2,557,500.00

1,967,307.69

2,691,562.50

1,592,640.53

2,832,482.81

1,289,250.26

2,980,607.70

1,043,593.61

t =5

5,165,901.56

-413,929.83

4,751,971.73

1,615,670.39

3,136,301.34

825,000.00

3,136,301.34

844,697.14

The PV of the annual net operating cash flows using the nominal discount rate of 30% is $6,737,489.22

.

The NPV of the project is the present value of the net income in each year plus, the present value of the CCA tax

shield.

PV of CCA TS = Cd Tc / (k+d) [(1+.5k)/(1+k)] SdTc/(k+d) [1/(1+k)T ]

= ( $9,000,000 x 0.25 x 0.34 ) / ( 0.29 + 0.25 ) [ ( 1.145/1.29 )]

( $825,000 x 0.25 x .0.34 ) / ( 0.29 + 0.25 ) [( 1/1.295 )]

= $1,257,428.91 $36,352.19

= $1,221,076.75

Again, the CCA tax Shield is in nominal terms, so discount it using the nominal riskless rate.

NPV = $9,000,000 + $6,737,489.22 + $1,221,076.75 = $1,041,434.03

.

Note that International Buckeyes will continue the CCA pool by replacing the plant so there are no further tax

implications for the sale of the factory.

8.12

Let I be the maximum price the Majestic Mining Company should be willing to pay for the equipment. Examine

the incremental cash flows from purchasing the new equipment.

NPV = 0 = 12,000(1 0.40)

+

1.12

0.12

0.12 + 0.30

(6,000 0)(0.40)(0.30)

(1 + 0.12) 8 + (6,000 0)(1 + .12) 8 ( I 30,000)

0.12 + 0.30

I = $81,395.77

The maximum price Majestic should be willing to pay for the equipment is $81,395.77.

8.13

Note that in the problem they forgot the discount rate k-13%. Analyze the cash flows in real terms.

8-5

Headache Only:

Aftertax operating income = [ ( 6,000,000 x $5.25 ) ( 6,000,000 x $1.6 ) ] (1 0.34)

= $14,454,000

The CCA tax shield is in nominal terms, so discount it using the nominal rate.

Nominal discount rate = ( 1.14 x 1.04 ) 1 = 0.1856 or 18.56%

PV of CCA TS = ( 11,500,000 x 0.25 x 0.34)/( 0.1856 + 0.25)]( 1+0.5(0.1856)) / 1.1856) = $2,068,385.05

The headache pill equipment has no resale value.

NPV

3

= $11,500,000 + $14,454,000 A14

% + $2,068,385.05

= $11,500,000 + $28,960,037.91 + $2,068,385.05

= $24,125,254.37

Aftertax operation income = [ (12,000,000 x $5.25) ( 12,000,000 x $1.90)] ( 1 0.34 )

= $26,532,000

Sale proceeds in nominal terms = $1,000,000 x (1.04)3 = $1,124,864

PV of CCA TS = [( 15,500,000 x 0.25 x 0.34) / ( 0.1856 + 0.25 ) ] ( 1+ 0.5(0.1856 ) / 1.1856 )

[( 1,124,864 x 0.25 x 0.34 ) / ( 0.1856 + 0.25 ) ] ( 1/1.18563 )

= $2,787,823.33 $131,709.31 = $2,656,114.01

NPV

3

3

= $15,500,000 + $26,532,000 A14

% + $1,000,000/1.14 + $2,656,114.01

= $15,500,000 + $61,597,541 + $674,971.5 + $2,656,114.01

= $49,428,626.47

8.14

t=0

$15,000

t=1

$7,350

t=2

$7,350

t=3

$7,350

t=4

$4,150

PV = $15,000 + $7,350 A83% + $4,150 / 1.084

= $15,000 + $18,941.67 + 3,050.37

= $36,992.04

The cycle is four years long, so use a fouryear annuity factor to compute the equivalent annual cost (EAC).

EAC = $36,992.04 / A84%

= $11,168.67

The present value of such a stream in perpetuity is

Answers to EndofChapter Problems

8-6

8.15

PV XX40 = $1,800 + $300 / 1+.066 + $300 / 1+.0662 + $300 / 1.0663

= $2,593.02

$2,593.02 = EAC 36.6% = EAC (2.6434)

EAC = $980.93

PV RH45 = $950 + $120 / 1.0857 + $120 / 1.08572 + $120 / 1.08573+ $120 / 1.08574 + $120 /1.08575

= $1,427.93

= EAC * 56.6% = EAC* 4.14406

EAC = $344.57

Choose RH45.

5

NPV = $500,000 + $120,000 A13

%

= -$77,932.24

5

EAC = -$77,932.24 / A13

% = - $22,157.27

8

NPV = $650,000 + $140,000 A13

%

= $21,827.84

8

EAC = $21,827.84 / A13

% = $4,548.63

Choose Mixer Y.

8.17

1)

In nominal terms you could receive, one year from now, aftertax $10,544 ($10,000 + 10,000 x 0.08

x0.68) which is $10,138.46 in real terms ( $10,544/1.04 ).

Real interest rate = ( 1.08 / 1.04 ) 1 = 0.0384 or 3.84%

2)

In nominal terms you would receive $10,408,000 aftertax ($10,000 + 10,000 x 0.06 x 0.68) but only

$10,203.92 in real terms.

Real interest rate = (1.06 / 1.02) 1 = 0.0392 or 3.92%

The second alternative is better since you would have more purchasing power at the end of the year. This

illustrates how inflation is a hidden tax.

8.18

PV of CCA TS = [ ( $145,000 x 0.25 x 0.38) / ( 0.135 +0.25 ) ] ( 1.0675 / 1.135)

8-7

NPV

= $33,651.38

6

= $145,000 + $38,440 A13

.5% + $33,651.38

= $145,000 + $151,549.87 + $33,651.38

= $40,201.25

8.19

t=0

-$180,000.00

-$42,500.00

Investment

Net working capital

Revenue

Variable costs

Fixed costs

EBIT

Taxes at 40%

Net income

After tax cash flows

t=1-4

t=5

$42,500.00

$420,000.00

-$285,000.00

-30,000.00

105,000.00

42,000.00

63,000.00

$420,000.00

-$285,000.00

-30,000.00

105,000.00

42,000.00

63,000.00

63,000.00

105,500.00

-222,500.00

= $40,301.98

4

5

NPV = $222,500 + $63,000 A16

.5% + $105,500/1.165 + $40,301.98

= $222,500 + $174,540.33 + $49,161.24 + $40,302

= $41,503.55

8.20

t=0

Investment

t=1

t=2

t=3

t=4

t=5

-1,000,000.00

Sale of asset

500,000.00

Working capital

-225,000.00

225,000.00

Cost savings

440,000.00

440,000.00

440,000.00

440,000.00

440,000.00

CCA at 25%

-125,000.00

-218,750.00

-164,062.50

-123,046.88

-92,285.16

EBIT

315,000.00

221,250.00

275,937.50

316,953.13

347,714.84

Taxes at 34%

107,100.00

75,225.00

93,818.75

107,764.06

118,223.05

NI

207,900.00

146,025.00

182,118.75

209,189.06

229,491.80

125,000.00

218,750.00

164,062.50

123,046.88

92,285.16

332,900.00

364,775.00

346,181.25

332,235.94

321,776.95

332,900.00

364,775.00

346,181.25

332,235.94

1,046,776.9

5

-1,225,000.00

8-8

+ 1,046,776.9/(1+IRR)5 = 0

IRR = 0.2267 or 22.67%

= $15,558.32

6

61,200 15,607.19 = PMT 13

%

PMT = $11,417.41

Cost savings must exceed $19,351.55 ($11,417.41/0.59)

b. PV of CCATS = [ ( 61,200 x 0.25 x 0.41) / ( 0.13 + 0.25 ) ] ( 1.065/1.13 )

[( 19,000 x 0.25 x 0.41) / ( 0.13 + 0.25 ) ] [ 1/1.136)

= 15,558.32 2,461.36 = $13,096.69

6

6

61,200 $13,096.69 = PMT 13

% + 19,000/(1.13)

PMT = $9,750.28

8.22

Operating Cash flow (years 1 8 ):= [ (10,000) (10,130 8,200) 12,000,000 ] (1 0.40) = $4,380,000

9,000,000 x 0.05 x 0.40) 1.08 4,000,000 x 0.05 x 0.40)

8

+

1.16

(1 + 0.16)

0.16 + 0.05

0.16 + 0.05

+

(1 + 0.16) 8

0.16 + 0.20

0.16 + 0.20

1.16

10,300,000 10,000,000

+

+

= 20,491,906.22

1.16 8

1.16 8

The net present value is negative, so they should not produce the robots.

8-9

8.23

340,000

(1 + 0.13) 7

7

+

1.13

(1 + 0.13)

0

.

13

+

0

.

25

0

.

13

+

0

.

25

= - 2,404,112.61

7

EACA = 2,404,112. 61 / A13

% = 543,595.83

420,000

(1 + 0.13) 9

+

(1 + 0.13) 9

0.13 + 0.25

0.13 + 0.25

1.13

= - 3,019,319.50

9

EAC B = 3,019,319. 50 / A13

% = 588,371.48

8-10

To analyze this project, we must calculate the incremental cash flows generated by the project. Since

net working capital is built up ahead of sales, the initial cash flow depends in part on this cash

outflow. So, we will begin by calculating sales. Each year, the company will sell 600,000 tons under

contract, and the rest on the spot market. The total sales revenue is the price per ton under contract

times 600,000 tons, plus the spot market sales times the spot market price. The sales per year will be:

Contract

Spot

Total

Year 1

$20,400,000

2,000,000

$22,400,000

Year 2

$20,400,000

5,000,000

$25,400,000

Year 3

$20,400,000

8,400,000

$28,800,000

Year 4

$20,400,000

5,600,000

$26,000,000

The current aftertax value of the land is an opportunity cost. The initial outlay for net working

capital is the percentage required net working capital times Year 1 sales, or:

Initial net working capital = .05($22,400,000) = $1,120,000

So, the cash flow today is:

Equipment

Land

NWC

Total

$30,000,000

5,000,000

1,120,000

$36,120,000

Now we can calculate the OCF each year. The OCF is:

Year 1

Sales

Var. costs

Fixed costs

CCA.

EBT

Tax - 38%

Net income

+ Dep.

OCF

Year 2

Year 3

Year 4

22,400,000

-8,450,000

-2,500,000

-3,750,000

7,700,000

2,926,000

4,774,000

3,750,000

25,400,000

-9,425,000

-2,500,000

-6,562,500

6,912,500

2,626,750

4,285,750

6,562,500

28,800,000

-10,530,000

-2,500,000

-4,921,875

10,848,125

4,122,288

6,725,838

4,921,875

26,000,000

-9,620,000

-2,500,000

-3,691,406

10,188,594

3,871,666

6,316,928

3,691,406

8,524,000

10,848,250

11,647,713

10,008,334

Year 5

Year 6

-4,000,000

-6,000,000

-4,000,000

-1,520,000

-2,480,000

-6,000,000

-2,280,000

-3,720,000

-2,480,000

-3,720,000

Years 5 and 6 are of particular interest. Year 5 has an expense of $4 million to reclaim the land, and it is the only expense

for the year. Taxes that year are a credit, an assumption given in the case. In Year 6, the charitable donation of the land is

an expense, again resulting in a tax credit. The land does have an opportunity cost, but no information on the aftertax

salvage value of the land is provided. The implicit assumption in this calculation is that the aftertax salvage value of the

land in

Year 6 is equal to the $6 million charitable expense.

Next, we need to calculate the net working capital cash flow each year. NWC is 5 percent of next

years sales, so the NWC requirement each year is:

8-11

Beg. NWC

End NWC

NWC CF

Year 1

$1,120,000

1,270,000

$150,000

Year 2

$1,270,000 $

1,440,000

$170,000

Year 3

1,440,000

1,300,000

$140,000

Year 4

$1,300,000

0

$1,300,000

The last cash flow we need to account for is the salvage value. The fact that the company is keeping

the equipment for another project is irrelevant. The aftertax salvage value of the equipment should

be used as the cost of equipment for the new project. In other words, the equipment could be sold

after this project. Keeping the equipment is an opportunity cost associated with that project. The

undepreciated capital cost (UCC) of the equipment is the original cost, minus the accumulated depreciation, or:

UCC - Opening

30,000,000

26,250,000

19,687,500

14,765,625

CCA

3,750,000

6,562,500

4,921,875

3,691,406

UCC-Closing

26,250,000

19,687,500

14,765,625

11,074,219

Since the market value of the equipment is $18 million and the UCC at year 4 is 11,074,219,

it incurs a recapture tax liability of:

Recapture tax liability on sale of equipment = ($18,000,000 11,074,219)(0.38) = $2,631,796.88

And the aftertax salvage value of the equipment is:

Aftertax salvage value = $18,000,000 $2,631,796.88

Aftertax salvage value = $15,368,203.13

So, the net cash flows each year, including the operating cash flow, net working capital, and aftertax

salvage value, are:

Time

0

1

2

3

4

5

6

Cash flow

8,374,000 - 150,000 =

10,678,250 170,000 =

11,787,713 + 140,000 =

25,556,537 +1,300,000 + 15,368,203.13 =

$36,120,000

8,224,000

10,508,250

11,927,713

42,224,740.13

2,480,000

3,720,000

NPV = $36,120,000 + $8,224,000/1.12 + $10,508,250/1.122 + $11,927,713/1.123

+ $42,224,740.13/1.124 $2,480,000/1.125 $3,720,000/1.126

NPV = $11,632,580

In the final analysis, the company should accept the project since the NPV is positive.

8-12

The cash flow to start the project is the $120 million equipment cost and the $10 million required for

net working capital, yielding a total cash outflow today of $130 million. The research and

development costs and the marketing test are sunk costs.

We can calculate the future cash flows on a nominal basis or a real basis. Since the depreciation is

given in nominal values, we will calculate the cash flows in nominal terms. The same solution can be

found using real cash flows. Since the price and variable costs increase by 1 percent, and the

inflation rate is 3.5 percent, the nominal growth in both variables is:

(1 + R) = (1 + r)(1 + h)

R = [(1.01)(1.0325)] 1

R = 0.0428 or 4.28%

To analyze this project, we must calculate the incremental cash flows generated by the project. We

will calculate the real cash flows, although using nominal cash flows will result in the same NPV.

The sales of new automobiles will grow by 2 percent per year, and there are four tires per car.

Since the company expects to capture 11 percent of the market, the number of tires sold in the OEM

market will be:

Year 1

Automobiles sold

Tires for automobiles sold

SuperTread tires sold

2,000,000

8,000,000

960,000

Year 2

Year 3

Year 4

2,040,000

8,160,000

979,200

2,080,800

8,323,200

998,784

2,122,416

8,489,664

1,018,760

The number of tires sold in the replacement market will grow at 2 percent per year, and Goodweek

will capture 8 percent of the market. So, the number of tires sold in the replacement market will be:

Year 1

SuperTread tires sold

14,000,000

1,050,000

Year 2

14,280,000

1,071,000

Year 3

14,565,600

1,092,420

Year 4

14,856,912

1,114,268

The tires will be sold in each market at a different price. The price will increase each year at the

inflation rate, so the price each year will be:

OEM

Replacement

Year 1

Year 2

Year 3

Year 4

$36

$37.54

$39.15

$40.82

$59

$61.53

$64.16

$66.90

8-13

Multiplying the number of tires sold in each market by the respective price in that market, the

revenue each year will be:

Year 1

OEM market

Replacement market

Total

$34,560,000

$61,950,000

$96,510,000

Year 2

$36,759,951

$65,893,489

$102,653,441

Year 3

Year 4

$39,099,943

$70,088,005

$109,187,948

$41,588,889

$74,549,527

$116,138,416

Now we can calculate the incremental cash flows each year. We will calculate the nominal cash

flows. Doing so, we find:

Revenue

Variable costs

Mkt. and general costs

CCA

EBT

Tax-39%

Net income

Add CCA

OCF

Year 1

Year 2

96,510,000 102,653,441

-36,180,000 -38,472,003

-25,000,000 -25,812,500

-15,000,000 -26,250,000

20,330,000

12,118,938

7,928,700

4,726,386

12,401,300

7,392,552

15,000,000

26,250,000

27,401,300

33,642,552

Year 3

109,187,948

-40,909,204

-26,651,406

-19,687,500

21,939,838

8,556,537

13,383,301

19,687,500

33,070,801

Year 4

116,138,416

-43,500,802

-27,517,577

-14,765,625

30,354,412

11,838,220

18,516,191

14,765,625

33,281,816

Net working capital is a percentage of sales, so the net working capital requirements will change

every year. The net working capital cash flows will be:

Beginning

Ending

NWC cash flow

11,000,000

14,476,500

3,476,500

14,476,500

15,398,016

921,516

15,398,016

16,378,192

980,176

16,378,192

16,378,192

8-14

The undepreciated cost of capital of the equipment is the original cost minus the accumulated depreciation.

The undepreciated capital cost (UCC) of the equipment is the original cost, minus the accumulated depreciation, or:

UCC - Opening

120,000,000

105,000,000

78,750,000

59,062,500

CCA

15,000,000

26,250,000

19,687,500

14,765,625

UCC- Closing

105,000,000

78,750,000

59,062,500

44,296,875

Since the market value of the equipment is $51 million, the equipment is sold at a gain to book

value, so the sale will incur the taxes of:

Recapture tax on sale of equipment = ($51,000,000 44,296,875)(0.39) = $2,614,219

And the aftertax salvage value of the equipment is:

Aftertax salvage value = $51,000,000 $2,614,219

Aftertax salvage value = $48,385,781

So, the net cash flows each year, including the operating cash flow, net working capital, and aftertax

salvage value, are:

Time

Cash flow

0

$130,000,000

1

23,924,800

2

32,721,036

3

32,090,625

4

98,045,789

So, the capital budgeting analysis for the project is:

NPV = $13,000,000 + $23,924,800/(1.16) + $32,721,036/(1.16)2 + $32,090,625/(1.16)3+ $98,045,789/(1.15)4

NPV = $10,349,191

In the final analysis, the company should reject the project since the NPV is negative.

8-15

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