Solutions Guide:

1.

We focus on free cash flows rather than accounting profits because these are the flows
that the firm receives and can reinvest. Only by examining cash flows are we able to
correctly analyze the timing of the benefit or cost. Also, we are only interested in these
cash flows on an after tax basis as only those flows are available to the shareholder. In
addition, it is only the incremental cash flows that interest us, because, looking at the
project from the point of the company as a whole, the incremental cash flows are the
marginal benefits from the project and, as such, are the increased value to the firm from
accepting the project.

2.

Although depreciation is not a cash flow item, it does affect the level of the differential
cash flows over the project's life because of its effect on taxes. Depreciation is an
expense item and, the more depreciation incurred, the larger are expenses. Thus,
accounting profits become lower and in turn, so do taxes which are a cash flow item.

3.

When evaluating a capital budgeting proposal, sunk costs are ignored. We are
interested in only the incremental after-tax cash flows, or free cash flows, to the
company as a whole. Regardless of the decision made on the investment at hand, the
sunk costs will have already occurred, which means these are not incremental cash
flows. Hence, they are irrelevant.

Solution to Integrative Problem, parts 4, 5, & 6.

Section I. Calculate the change in EBIT, Taxes, and Depreciation (this become an input in the calculation of Operating Cash Flow in Section II).
Year
0
1
2
3
4
Units Sold
70,000
120,000
140,000
80,000
Sale Price
$300
$300
$300
$300
Sales Revenue
Less: Variable Costs
Less: Fixed Costs
Equals: EBDIT
Less: Depreciation
Equals: EBIT
Taxes (@34%)

$21,000,000
12,600,000
$200,000
$8,200,000
$1,600,000
$6,600,000
$2,244,000

$36,000,000
21,600,000
$200,000
$14,200,000
$1,600,000
$12,600,000
$4,284,000

5
60,000
$260

272

$42,000,000
25,200,000
$200,000
$16,600,000
$1,600,000
$15,000,000
$5,100,000

$24,000,000
14,400,000
$200,000
$9,400,000
$1,600,000
$7,800,000
$2,652,000

$15,600,000
10,800,000
$200,000
$4,600,000
$1,600,000
$3,000,000
$1,020,000

Section II. Calculate Operating Cash Flow (this becomes an input in the calculation of Free Cash Flow in Section IV).
Operating Cash Flow:
EBIT
$6,600,000
$12,600,000
$15,000,000
Minus: Taxes
$2,244,000
$4,284,000
$5,100,000
Plus: Depreciation
$1,600,000
$1,600,000
$1,600,000
Equals: Operating Cash Flow
$5,956,000
$9,916,000
$11,500,000

$7,800,000
$2,652,000
$1,600,000
$6,748,000

$3,000,000
$1,020,000
$1,600,000
$3,580,000

$24,000,000

$15,600,000

$2,400,000
($1,800,000)

$1,560,000
$1,560,000
($2,400,000)

Section IV. Calculate Free Cash Flow (using information calculated in Sections II and III, in addition to the Change in Capital Spending).
Free Cash Flow:
Operating Cash Flow
$5,956,000
$9,916,000
$11,500,000
$6748,000
Minus: Change in Net Working Capital
$100,000
$2,000,000
$1,500,000
$600,000
($1,800,000)
Minus: Change in Capital Spending
$8,000,000
0
$0
0
0
Free Cash Flow:
($8,100,000)
$3,956,000
$8,416,000
$10,900,000
$8,548,000

$3,580,000
($2,400,000)
0
$5,980,000

Section III. Calculate the Net Working Capital (This becomes an input in the calculation of Free Cash Flows in Section IV).
Change In Net Working Capital:
Revenue:
$21,000,000
$36,000,000
$42,000,000
Initial Working Capital Requirement
$100,000
Net Working Capital Needs:
$2,100,000
$3,600,000
$4,200,000
Liquidation of Working Capital
Change in Working Capital:
$100,000
$2,000,000
$1,500,000
$600,000

NPV =
IRR =

$16,731,095.66
77%

7.

Cash flow diagram

$3,956,000
$5,980,000

$8,416,000

$10,900,000

$8,548,000

($8,100,000)
8.

NPV

= $16,731,095.66

9.

IRR

10.

Yes. This project should be accepted because the NPV 0. and the IRR required
rate of return.

11.

a.

77%

NPVA

NPVB

b.

PIA

PIB

c.

$240,000
(1 0.10)1

- $195,000

$218,182 - $195,000

$23,182

$1,650,000
(1 0.10)1

- $1,200,000

$1,500,000 - $1,200,000

$300,000

$218,182
$195,000

1.1189

$1,500,000
$1,200,000

1.25

$195,000

= $240,000 [PVIFIRR %,1 yr]

A

0.8125

= PVIFIRR %,1 yr
A

Thus, IRRA = 23%

$1,200,000 = $1,650,000 [PVIFIRR %,1 yr]
B
0.7273

= [PVIFIRR %,1 yr]

B

Thus, IRRB = 37.5%

12.

d.

If there is no capital rationing, project B should be accepted because it has

a larger net present value. If there is a capital constraint, the problem then
focuses on what can be done with the additional $1,005,000 freed up if
project A is chosen. If Caledonia can earn more on project A, plus the
project financed with the additional $1,005,000, than it can on project B,
then project A and the marginal project should be accepted.

a.

Payback A = 3.125 years

Payback B = 4.5 years
B assumes even cash flow throughout year 5.

b.

NPVA

$32,000

t 1

(1 0.11) t

- $100,000

= $32,000 (3.696) - $100,000

= $118,272 - $100,000
= $18,272
NPVB

$200,000
(1 0.11)5

- $100,000

= $200,000 (0.593) - $100,000

= $118,600 - $100,000
= $18,600
c.

$100,000

= $32,000 [PVIFAIRR %,5 yrs]

A

3.125

= PVIFAIRR %,5 yrs

A

Thus, IRRA = 18.03%

$100,000

= $200,000 [PVIFIRR %,5 yrs]

B

.50

= PVIFIRR %,5 yrs

B

Thus IRRB is just under 15% (14.87%).

13.

d.

The conflicting rankings are caused by the differing reinvestment

assumptions made by the NPV and IRR decision criteria. The NPV
criterion assume that cash flows over the life of the project can be
reinvested at the required rate of return or cost of capital, while the IRR
criterion implicitly assumes that the cash flows over the life of the project
can be reinvested at the internal rate of return.

e.

Project B should be taken because it has the largest NPV. The NPV
criterion is preferred because it makes the most acceptable assumption for
the wealth maximizing firm.

a.

Payback A = 1.5385 years

Payback B = 3.0769 years

b.

NPVA

$65,000

t 1

(1 0.14) t

- $100,000

= $65,000 (2.322) - $100,000

= $150,930 - $100,000
= $50,930
NPVB

$32,500

t 1

(1 0.14) t

- $100,000

= $32,500 (4.946) - $100,000

= $160,745 - $100,000
= $60,745
c.

$100,000

= $65,000 [PVIFAIRR %,3 yrs]

A

Thus, IRRA = over 40% (42.57%)

$100,000

= $32,500 [PVIFAIRR %,9 yrs]

B

Thus, IRRB = 29%

d.

These projects are not comparable because future profitable investment

proposals are affected by the decision currently being made. If project A
is taken, at its termination the firm could replace the machine and receive
additional benefits while acceptance of project B would exclude this
possibility.

e.

Using 3 replacement chains, project A's cash flows would become:

Year
0
1
2
3
4
5
6
7
8
9
NPVA

Cash flow
-$100,000
65,000
65,000
-35,000
65,000
65,000
- 35,000
65,000
65,000
65,000

$100,000
(1 0.14)

$65,000

t 1

(1 0.14) t

- $100,000 -

$100,000
(1 0.14) 6

= $65,000(4.946) - $100,000 - $100,000 (0.675)

- $100,000 (0.456)
= $321,490 - $100,000 - $67,500 - $45,600
= $108,390
The replacement chain analysis indicated that project A should be selected as the
replacement chain associated with it has a larger NPV than project B.
Project A's EAA:
Step 1: Calculate the project's NPV (from part b):
NPVA

= $50,930

Step 2: Calculate the EAA:

EAAA = NPV / PVIFA14%, 3 yr.
= $50,930/ 2.322
= $21,934
Project B's EAA:
Step 1: Calculate the project's NPV (from part b):
NPVB

= $60,745

Step 2: Calculate the EAA:

EAAB

= NPV / PVIFA14%, 9 yr.

= $60,745 / 4.946
= $12,282
Project A should be selected because it has a higher EAA.