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Chapter 8: Net Present Value and Capital Budgeting

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%

= $8,000,000 + $16,790,123.46 + $10,605,993 + $3,358,024.91


= $38,754,141.15

Answers to EndofChapter Problems

8-1

8.3

Tax Shield Approach


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)

PV of CCA Tax Shield on the Equipment :

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

(4) PV of CCA Tax Shield on the Equipment:

CDTc 1 + 0.5k
x
k+d
1+ k

$460,000 x 0.2 x 0.4 1 + (0.5 x 0.15)


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

The price will rise by the NPVGO per share


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

Real interest rate = (1.13 / 1.05) 1 = 0.07619 or 7.619%


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

PV = $250,000 / { 0.13 ( 0.08 )}


= $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

Answers to EndofChapter Problems

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 ( revenue ) = ( $195,000 / 1.035 ) / ( 0.10 0.05 ) = $3,768,115.94


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

= $3,768,115.94 $1,380,262.25 $237,154.15 $166,928.14


= $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 $73.80/1.04 + $18,921.56/1.042 + $28,314.57/1.043 $694.80/1.044+$16,049.84


= 56,000 70.96 + 17,494.04 + 25,171.55 593.92 + 16,049.84
= $2050.55

Initial revenues = $2.00 4,600,000 = $9,200,000


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

Answers to EndofChapter Problems

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.

1 (1 + 0.12) 8 ( I 30,000)(0.40)(0.30) 1.06


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.

Answers to EndofChapter Problems

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

Headache and Arthritis:


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

The firm should choose to manufacture Headache and Arthritis.


8.14

Assume the tax rate is zero.


t=0
$15,000

t=1
$7,350

t=2
$7,350

t=3
$7,350

t=4
$4,150

The present value of one cycle is:


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

$11,168.67 / 0.08 = $139,608.31


8.15

Real discount rate = ( 1.13 / 1.06) 1 = 0.066 or 6.6%


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.

8.16 Mixer X Cost Savings


5
NPV = $500,000 + $120,000 A13
%
= -$77,932.24
5
EAC = -$77,932.24 / A13
% = - $22,157.27

Mixer Y Cost Savings


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

Aftertax savings = $62,000 x (1 0.38) = $38,440


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

Answers to EndofChapter Problems

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

PV of CCA TS = [ ( $180,000 x 0.25 x 0.40) / ( 0.165 + 0.25 ) ] ( 1.0825 / 1.165 )


= $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

Since the NPV is positive, it is a good project.


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

Add back CCA

125,000.00

218,750.00

164,062.50

123,046.88

92,285.16

Cash flow from operations

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

Total cash flows

-1,225,000.00

Answers to EndofChapter Problems

8-8

Set NPV = - 1,225,000 + 332,900/(1+IRR) + 364,775/(1+IRR)2 + 346,181.25/(1+IRR)3 + 332,235.94/(1+IRR)4


+ 1,046,776.9/(1+IRR)5 = 0
IRR = 0.2267 or 22.67%

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


= $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

Cost savings must exceed $16,525.91 ($9,750.28/ 0.59)


8.22

We ignore the cost of the marketing study since it is not incremental.


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

NPV = 2,500,000 30,000,000 9,000,000 10,000,000 1,400,000 (1 0.4) + 4,380,000 A168 %


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

30,000,000 x 0.20 x 0.40) 1.08 3,800,000 x 0.20 x 0.40)


+

(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.

Answers to EndofChapter Problems

8-9

8.23

NPV A = 3,000,000 + 80,000 (1 0.38) A137 % +

340,000
(1 + 0.13) 7

3,000,000 x 0.25 x 0.38) 1.065 340,000 x 0.25 x 0.38)


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

NPV B = 3,800,000 + 69,000 (1 0.38) A139 % +

420,000
(1 + 0.13) 9

3,800,000 x 0.25 x 0.38) 1.065 42,000 x 0.25 x 0.38)


+

(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

Choose equipment A as its EAC is lower.

Answers to EndofChapter Problems

8-10

Mini Case # 1 Beaver Mining Company


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:

Answers to EndofChapter Problems

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

So, the net present value for the project is:


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.

Answers to EndofChapter Problems

8-12

Mini Case # 2 Goodweek Tires, Inc.


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

Total tires sold in market


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

Answers to EndofChapter Problems

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

Answers to EndofChapter Problems

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.

Answers to EndofChapter Problems

8-15