07 Relevant CF and NPV Analysis Test Bank Problems Solutions 2015.11.06 11.25

FNAN 301/303
Solutions to test bank problems relevant cash flows and NPV analysis
Some answers may be slightly different than provided solutions due to rounding
1. Golden Fleece Management is evaluating a 1-year project that would involve an initial
investment in equipment of $61,000 and an expected cash flow of $72,000 in 1 year. The project
has a cost of capital of 17.55 percent and an internal rate of return of 18.03 percent. If Golden
Fleece Management were to use $61,000 in cash from its bank account to purchase the
equipment, the net present value of the project would be $251. However, Golden Fleece
Management has no cash in its bank account, so using money from its account is not possible.
Therefore, the firm would need to borrow money to raise the $61,000. If Golden Fleece
Management were to borrow money to raise the $61,000, the interest rate on the loan would be
18.64 percent. Golden Fleece Management would receive $61,000 from the bank at the start of
the project and would pay $72,370 to the bank in 1 year. Which of the following assertions is
true?
A. If Golden Fleece Management borrows money to raise $61,000, then the NPV of the
project would be less than or equal to $250
B. If Golden Fleece Management borrows money to raise $61,000, then the NPV of the
project would be greater than $250 but less than $252
C. If Golden Fleece Management borrows money to raise $61,000, then the NPV of the
project would be equal to or greater than $252
D. If Golden Fleece Management borrows money to raise $61,000, then it is not clear
whether the NPV of the project would be less than or equal to $250, greater than $250 but
less than $252, or equal to or greater than $252
(Spring 2014, quiz 4, question 1)
(Spring 2015, final, question 15)
Answer: B. If Golden Fleece Management borrows money to raise $61,000, then the NPV of
the project would be greater than $250 but less than $252
The net present value of the project would be $251.
Projects should be evaluated solely on cash flows expected to be produced by assets. It does not
matter if funds are borrowed to pay for the project or whether new stock is issued or whether
the firm uses cash it already has. Ignore any and all cash flows associated with debt and equity
including debt-issuance proceeds, debt payments, equity-issuance proceeds, dividends, and
stock buybacks.
Therefore, the NPV computed based on the assumption that Golden Fleece Management
used $61,000 in cash that was in its bank account would be the same as the NPV computed
based on the assumption that Golden Fleece Management borrowed the $61,000.
Regardless of where the money for the project comes from, the NPV would be $251.
FNAN 301/303
2. Hailstorm Inc. is evaluating a 1-year project that would involve an initial investment in
equipment of $83,000 and an expected cash flow of $96,000 in 1 year. The project has a cost of
capital of 12.79 percent and an internal rate of return of 15.66 percent. If Hailstorm were to use
$83,000 in cash from its bank account to purchase the equipment, the net present value of the
project would be $2,114. However, Hailstorm has no cash in its bank account, so using money
from its account is not possible. Therefore, the firm would need to issue shares of common stock
to raise the $83,000. If Hailstorm were to issue stock to raise the $83,000, the expected return on
the stock would be 17.32 percent. Which of the following assertions is true?
A. If Hailstorm issues stock money to raise $83,000, then it is not clear whether the NPV of
the project would be less than or equal to $2,113, greater than $2,113 but less than
$2,115, or equal to or greater than $2,115
B. If Hailstorm issues stock money to raise $83,000, then the NPV of the project would be
less than or equal to $2,113
C. If Hailstorm issues stock money to raise $83,000, then the NPV of the project would be
greater than $2,113 but less than $2,115
D. If Hailstorm issues stock money to raise $83,000, then the NPV of the project would be
equal to or greater than $2,115
Answer: C. If Hailstorm issues stock money to raise $83,000, then the NPV of the project
would be greater than $2,113 but less than $2,115
The net present value of the project would be $2,114.
Projects should be evaluated solely on cash flows expected to be produced by assets. It does not
matter if funds are borrowed to pay for the project or whether new stock is issued or whether
the firm uses cash it already has. Ignore any and all cash flows associated with debt and equity
including debt-issuance proceeds, debt payments, equity-issuance proceeds, dividends, and
stock buybacks.
Therefore, the NPV computed based on the assumption that Hailstorm used $83,000 in
cash that was in its bank account would be the same as the NPV computed based on the
assumption that Hailstorm issues stock shares.
Regardless of where the money for the project comes from, the NPV would be $2,114.
FNAN 301/303
3. Buckeye Inc. operates coffee shops in Ohio. The firm is evaluating the Cleveland project,
which would involve opening a new coffee shop in Cleveland. During year 1, Buckeye would
have total revenue of $2,900,000 and total costs of $2,500,000 if it pursues the Cleveland project,
and the firm would have total revenue of $2,000,000 and total costs of $1,900,000 if it does not
pursue the Cleveland project. Depreciation taken by the firm would be $700,000 if the firm
pursues the project and $500,000 if the firm does not pursue the project. The tax rate is 35%.
What is the relevant net income for year 1 of the Cleveland project that Buckeye should use in its
NPV analysis of the Cleveland project?
In evaluating the Cleveland project, Buckeye should use incremental revenue, incremental
costs, and incremental depreciation, which is what those values would be with the project
minus what they would be without the project. The incremental effects reflect the effect of
the project, which is what is of interest.
Incremental revenue = revenue with project revenue without project
= $2,900,000 $2,000,000 = $900,000
Incremental costs = costs with project costs without project
= $2,500,000 $1,900,000 = $600,000
Incremental depreciation = depreciation with project depreciation without project
= $700,000 $500,000 = $200,000
Revenue
Costs
Annual depreciation
EBIT
Tax rate
Taxes paid
Net income = EBIT taxes
Year 1
900,000
600,000
200,000
100,000
0.35
35,000
65,000
Alternatively (can look at net income with project minus net income without project or can
compute net income from incremental revenue, costs, and depreciation)
With
Without in
Incremental in
in year 1
year 1
year 1
Revenue
2,900,000
2,000,000
900,000
Costs
2,500,000
1,900,000
600,000
Annual depreciation
700,000
500,000
200,000
= EBIT
-300,000
-400,000
100,000
Tax rate
0.35
0.35
0.35
= Taxes paid
-105,000
-140,000
35,000
-195,000
-260,000
65,000
FNAN 301/303
4. Gator Inc. operates coffee shops in Florida. The firm is evaluating the Miami project, which
would involve opening a new coffee shop in Miami. During year 3, Gator would have total
revenue of $2,900,000 and total costs of $1,200,000 if it pursues the Miami project, and the firm
would have total revenue of $2,000,000 and total costs of $1,300,000 if it does not pursue the
Miami project. Depreciation taken by the firm would be $700,000 if the firm pursues the project
and $500,000 if the firm does not pursue the project. The tax rate is 35%. What is the relevant
net income for year 3 of the Miami project that Gator should use in its NPV analysis of the
Miami project?
In evaluating the Miami project, Gator should use incremental revenue, incremental costs,
and incremental depreciation, which is what those values would be with the project minus
what they would be without the project. The incremental effects reflect the effect of the
project, which is what is of interest.
= $2,900,000 $2,000,000 = $900,000
= $1,200,000 $1,300,000 = -$100,000
= $700,000 $500,000 = $200,000
Revenue
Costs
Annual depreciation
EBIT
Tax rate
Taxes paid
Year 3
900,000
-100,000
200,000
800,000
0.35
280,000
520,000
With
Without in
Incremental in
in year 3
year 3
year 3
Revenue
2,900,000
2,000,000
900,000
Costs
1,200,000
1,300,000
-100,000
Annual depreciation
700,000
500,000
200,000
= EBIT
1,000,000
200,000
800,000
Tax rate
0.35
0.35
0.35
= Taxes paid
350,000
70,000
280,000
650,000
130,000
520,000
FNAN 301/303
5. Striped Potato is evaluating a project that would require the purchase of a piece of equipment
for $500,000 today. During year 1, the project is expected to have relevant revenue of $420,000,
relevant costs of $160,000, and relevant depreciation of $120,000. Striped Potato would need to
borrow $500,000 today to pay for the equipment and would need to make an interest payment of
$20,000 to the bank in 1 year. Relevant net income for the project in year 1 is expected to be
$95,000. What is the tax rate expected to be in year 1?
(Fall 2011, quiz 4, question 1)
(Fall 2012, final, question 14)
(Spring 2015, test 3, question 1)
The $20,000 interest payment is not included in the analysis. Projects should be evaluated
solely on cash flows expected to be produced by assets. It does not matter if funds are borrowed
to pay for the project or whether new stock is issued or whether the firm uses cash it already
has. Ignore any and all cash flows associated with debt and equity including debt-issuance
proceeds, debt payments, equity-issuance proceeds, dividends, and stock buybacks.
To solve:
1) Find expected taxable income
2) Find expected taxes paid
3) Find the expected tax rate
Taxable income = EBIT = revenues costs depreciation
420,000 160,000 120,000
= 140,000
Net income = taxable income taxes paid
95,000 = 140,000 taxes paid
So taxes paid = 140,000 95,000 = 45,000
Tables are useful for steps 1 and 2
Revenue
Costs
Annual depreciation
EBIT = taxable income
Taxes
Net income
Given
Year 1
420,000
160,000
120,000
Step 1
Year 1
420,000
160,000
120,000
140,000
95,000
95,000

The tax rate = taxes paid / taxable income
= 45,000 / 140,000
= 0.3214 = 32.14%
Step 2
Year 1
420,000
160,000
120,000
140,000
45,000
95,000
FNAN 301/303
6. What is the relevant net income for year 1 of the Kentucky project that Xavier should use in its
NPV analysis of the project? Xavier Inc. operates restaurants in Ohio. The firm is evaluating the
Kentucky project, which would involve opening a new restaurant in Kentucky. During year 1,
the Kentucky project is expected to have relevant revenue of $600,000, relevant variable costs of
$350,000, and relevant depreciation of $120,000. In addition, Xavier would have one source of
fixed costs associated with the Kentucky project. Yesterday, Xavier signed a deal with Wildcat
Marketing Corporation to develop an advertising campaign for use in Kentucky. The terms of
the deal required Xavier to pay $75,000 to Wildcat Design in 1 year from today. The tax rate is
40 percent.
Xavier must pay $75,000 in 1 year if they do the Kentucky project and $75,000 in 1 year if
they do not do the Kentucky project. The cost is sunk.
The incremental cost in 1 year would be $75,000 $75,000 = $0
Therefore, $0 should be included as a fixed cost for year 1 (which includes in 1 year) since
doing the Kentucky project would have no effect on fixed costs paid by the firm
Since total costs = fixed costs + variable costs, total costs = $0 + $350,000 = $350,000
Revenue
Costs
Annual depreciation
EBIT
Tax rate
Taxes paid
Year 1
600,000
350,000
120,000
130,000
0.40
52,000
78,000
FNAN 301/303
7. What is the relevant net income for year 1 of the Portland project that OreDuck should use in
its NPV analysis of the project? The tax rate is 50%. During year 1, the Portland project is
expected to have relevant revenue of $78,000, relevant variable costs of $26,000, and relevant
depreciation of $15,000. In addition, OreDuck would have one source of fixed costs associated
with the Portland project. Yesterday, OreDuck signed a deal with State Beaver Advertising to
develop a marketing campaign for use in Portland. The terms of the deal require OreDuck to pay
State Beaver either $30,000 in 1 year if the Portland project is pursued or $20,000 in 1 year if the
Portland project is not pursued.
The cost is partially sunk in 1 year

OreDuck must pay $30,000 in 1 year if it does the project and $20,000 in 1 year if it does
not do the project, so the incremental cost would be $30,000 $20,000 = $10,000.
Therefore, $10,000 of the fixed cost should be included in the cost of the project in 1 year
Since total costs = fixed costs + variable costs, total costs = $10,000 + $26,000 = $36,000
Revenue
Costs
Annual depreciation
EBIT
Tax rate
Taxes paid
Year 1
78,000
36,000
15,000
27,000
0.50
13,500
13,500
FNAN 301/303
8. What is the relevant net income for year 1 of the Eugene project that OreDuck should use in
its NPV analysis of the project? The tax rate is 50%. During year 1, the Eugene project is
with the Eugene project. Yesterday, OreDuck signed a deal with State Beaver Advertising to
develop a marketing campaign for use in Eugene. The terms of the deal require OreDuck to pay
State Beaver either $17,000 in 1 year if the Eugene project is pursued or $20,000 in 1 year if the
Eugene project is not pursued.
The cost is partially sunk in 1 year
OreDuck must pay $17,000 in 1 year if it does the project and $20,000 in 1 year if it does
not do the project, so the incremental cost would be $17,000 $20,000 = -$3,000.
Therefore, -$3,000 of the fixed cost should be included in the cost of the project in 1 year.
The fixed cost would be $3,000 lower as a result of pursuing the project
Since total costs = fixed costs + variable costs, total costs = -$3,000 + $26,000 = $23,000
Revenue
Costs
Annual depreciation
EBIT
Tax rate
Taxes paid
Year 1
78,000
23,000
15,000
40,000
0.50
20,000
20,000
FNAN 301/303
9. Patriot Theaters is evaluating the claw machine project. During year 1, the claw machine project is
depreciation of $0. In addition, Patriot Theaters would have one source of fixed costs associated with the
claw machine project. Yesterday, Patriot Theaters signed a deal with Ruby Marketing to develop a
marketing campaign for use in the project. The terms of the deal require Patriot Theaters to pay Ruby
Marketing either $15,000 in 1 year if the project is pursued or $20,000 in 1 year if the project is not
pursued. Relevant net income for the claw machine project in year 1 is expected to be $31,000. What is
the tax rate expected to be in year 1?
A. A rate less than 40.00% or a rate equal to or greater than 60.00%
B. A rate equal to or greater than 40.00% but less than 45.00%
C. A rate equal to or greater than 45.00% but less than 50.00%
D. A rate equal to or greater than 50.00% but less than 55.00%
E. A rate equal to or greater than 55.00% but less than 60.00%
The cost is partially sunk in 1 year. Patriot Theaters must pay $15,000 in 1 year if it does the project
and $20,000 in 1 year if it does not do the project, so the incremental cost would be $15,000 $20,000 = $5,000. Therefore, -$5,000 of the fixed cost should be included in the cost of the project in 1 year. Note
that the incremental effect of pursuing the project is to lower fixed costs.
Since total costs = fixed costs + variable costs, total costs = (-$5,000) + $35,000 = $30,000
To solve:
95,000 30,000 0 = 65,000
31,000 = 65,000 taxes paid
So taxes paid = 65,000 31,000 = 34,000
Tables are useful for steps 1 and 2
Revenue
Costs
Annual depreciation
Taxes
Net income
Given &
relevant costs
Year 1
95,000
30,000
0
31,000
Step 1
Step 2
Year 1
95,000
30,000
0
65,000
Year 1
95,000
30,000
0
65,000
34,000
31,000
31,000

= 34,000 / 65,000
= 0.523 = 52.3%
Answer: D, 52.3% is a rate equal to or greater than 50.00% but less than 55.00%
FNAN 301/303
10. Sliders operates 4 hamburger restaurants, all in malls. The firm is considering the diner
project. This project would involve opening a 5th restaurant, which would be a stand-alone
diner. The only two potentially relevant costs involve IT expenses, which would be variable, and
marketing expenses, which would be fixed. Without the diner project, each of the 4 Sliders
restaurants would be allocated annual IT expenses of $96,000 in 1 year. With the diner project,
each of the 5 restaurants that would exist would be allocated annual IT expenses of $74,000 in 1
year. Regarding marketing costs, Sliders just hired Rad Ads to develop a new marketing
campaign. The terms of the contract require a payment to Rad Ads of $17,000 in 1 year if the
diner project is not pursued or a payment to Rad Ads of $33,000 in 1 year if the project is
pursued. When determining the relevant annual net income of the diner project for 1 year from
now, what is the relevant amount of total costs that should be included in the analysis of the diner
project?
A. $2,000 (plus or minus $10)
B. $30,000 (plus or minus $10)
C. -$6,000 (plus or minus $10)
D. The relevant amount of total costs that the financial managers of Sliders should include in their
analysis of the diner project is not one of the answers listed above and is less than $200,000
E. The relevant amount of total costs that should be included in the analysis of the diner project
is equal to or greater than $200,000
Approach:
1) Find relevant IT costs, which are variable
2) Find relevant marketing costs, which are fixed
3) Find total costs
1) Find relevant IT costs, which are variable
The relevant annual IT costs for the diner project = incremental IT costs
Incremental IT expenses associated with the diner project
= (IT expenses of Sliders with the diner project) (IT expenses of Sliders without the diner project)
Total IT expenses of Sliders with the diner project = 5 $74,000 = $370,000
Total IT expenses of Sliders without the diner project = 4 $96,000 = $384,000
Incremental IT expenses associated with the diner project
= $370,000 $384,000 = -$14,000
2) Find relevant marketing costs, which are fixed
Marketing costs in 1 year are partially sunk
Sliders must pay $33,000 in 1 year if they do the project and $17,000 in 1 year if they do not do the
project, so the incremental cost would be $33,000 $17,000 = $16,000
3) Find total costs
Total costs = variable costs + fixed costs
= -$14,000 + $16,000 = $2,000
Answer: A. $2,000 (plus or minus $10)
10
FNAN 301/303
11. Yannis Yogurt currently owns 8 frozen yogurt stores and is considering the Arlington project,
which is a project that would involve opening a 9th store, which would be in Arlington. Without
the Arlington project, each of the currently owned stores would be allocated annual IT costs of
$71,000 for internal accounting. When determining the relevant net income for the Arlington
project, relevant IT costs of $45,000 would be included in the analysis of the Arlington project.
If each of the 9 stores that would be owned by the company with the Arlington project would be
allocated the same annual IT costs for internal accounting, then what IT costs would be allocated
to each store for internal accounting with the Arlington project?
To solve:
1) Find the total IT costs to the firm with the project
2) Find the IT costs that would be allocated to each store with the project
Incremental IT costs from project = total IT costs with the project total IT costs without the project
So
Total IT costs with the project = total IT costs without the project + incremental IT costs from project
Total IT costs of Yannis Yogurt without the Arlington project = 8 $71,000 = $568,000
Incremental IT costs associated with the Arlington project = $45,000
Total IT costs with the project = $568,000 + $45,000 = $613,000
2) Find the IT costs that would be allocated to each store with the project
IT costs per store with project = total IT costs with the project / number of stores with project
= $613,000 / 9
= $68,111
The IT costs that would be allocated to each store for internal accounting with the
Arlington project = $68,111
11
FNAN 301/303
12. Yannis Yogurt currently owns 9 frozen yogurt stores and is considering the Sterling project,
which is a project that would involve opening a 10th store, which would be in Sterling. With the
Sterling project, each of the stores owned by the company would be allocated annual IT costs of
$70,000 for internal accounting. When determining the relevant net income for the Sterling
project, relevant IT costs of $40,000 would be included in the analysis of the Sterling project. If
each of the 9 stores that are currently owned by the company would be allocated the same annual
IT costs for internal accounting, then what IT costs would be allocated to each store for internal
accounting without the Sterling project?
To solve:
2) Find the total IT costs to the firm without the project
3) Find the IT costs that would be allocated to each store without the project
IT costs per store with project = total IT costs with the project / number of stores with project
So $70,000 = total IT costs with the project / 10
So total IT costs with the project = 10 $70,000 = $700,000
2) Find the total IT costs to the firm without the project
Incremental IT costs from project = total IT costs with the project total IT costs without the project
So $40,000 = $700,000 total IT costs without the project

So total IT costs without the project = $700,000 $40,000 = $660,000
3) Find the IT costs that would be allocated to each store without the project
IT costs per store without project = total IT costs without the project / number of stores without project
= $660,000 / 9
= $73,333
The IT costs that would be allocated to each store for internal accounting without the
Sterling project = $73,333
12
FNAN 301/303
13. The PowerCore Fitness Company operates 3 gyms: one in Vienna, one in Fairfax, and one in
Reston. The firm is considering the Arlington project. This project would involve opening a 4th
gym, which would be in Arlington. Without the Arlington project, the Vienna gym would be
allocated annual IT costs of $80,000, the Fairfax gym would be allocated annual IT costs of
$100,000, and the Reston gym would be allocated annual IT costs of $40,000. With the
Arlington project, the Vienna gym would be allocated annual IT costs of $70,000, the Fairfax
gym would be allocated annual IT costs of $90,000, the Reston gym would be allocated annual
IT costs of $20,000, and the Arlington project would be allocated annual IT costs of $50,000.
When determining the relevant net income for the Arlington project, how much in annual IT
costs should the financial managers of PowerCore Fitness include in their analysis of the
Arlington project?
The relevant annual IT costs for the Arlington project = incremental IT costs
Incremental IT expenses associated with the Arlington project
= (IT expenses of PowerCore Fitness with the Arlington project) (IT expenses of
PowerCore Fitness without the Arlington project)
Total IT expenses of PowerCore Fitness with the Arlington project
= $70,000 + $90,000 + $20,000 + $50,000 = $230,000
Total IT expenses of PowerCore Fitness without the Arlington project
= $80,000 + $100,000 + $40,000 = $220,000
Incremental IT expenses associated with the Arlington project
= $230,000 $220,000
= $10,000
Pursuing the Arlington project would increase IT costs by $10,000 (from $220,000 to
$230,000), so managers of PowerCore Fitness would include $10,000 of IT costs in their
analysis of the Arlington project
13
FNAN 301/303
14. Purple Pelican operates a chain of restaurants and is considering adding a new hamburger to
its menu for 1 year called the Triple-Beef-Triple-Cheese Extravaganza. The firm expects sales of
the new hamburger to be $2,000,000 and associated costs from the meat, cheese, and buns used
to make the new hamburger would be $1,000,000. The firm believes that sales of the DoubleBeef-Double-Cheese Celebration, a hamburger that is currently offered by the firm, would be
$240,000 less with the addition of the new triple burger, and that costs associated with the
Double-Beef-Double-Cheese Celebration to be $100,000 less with the addition of the new triple
burger. Finally, Purple Pelican believes that the new hamburger would increase traffic to its
restaurants, which would increase expected sales of french fries, drinks, and other items by
$300,000 more than it would be without the addition of the new triple burger, and increase costs
by $200,000 more than it would be without the addition of the new triple burger. What is the
relevant net income in year 1 that Purple Pelican should use to analyze the Triple-Beef-TripleCheese Extravaganza project? The tax rate is 25 percent, the cost of capital is 10 percent, and
there is no relevant depreciation.
The relevant net income depends on incremental revenues and incremental costs. In order
to determine these in this case, side effects must be taken into account.
Relevant revenue for the new hamburger =
Sales of new hamburger + effect on sales of old hamburger + effect on sales from change in
traffic to restaurants
= 2,000,000 240,000 + 300,000 = $2,060,000
Relevant costs for the new hamburger =
Costs associated with new hamburger + effect on costs of old hamburger + effect on costs
from change in traffic to restaurants
Relevant costs for the new hamburger = 1,000,000 100,000 + 200,000 = $1,100,000
Revenue
Costs
Annual depreciation
EBIT
Tax rate
Taxes paid
Year 1
2,060,000
1,100,000
0
960,000
0.25
240,000
720,000
Note that the cost of capital is not relevant
14
FNAN 301/303
15. Waters Edge Resorts is evaluating a project that would require an initial investment in
equipment of $500,000 and that is expected to last for 6 years. MACRS depreciation would be
used where the depreciation rates in years 1, 2, 3, and 4 are 30.0%, 45.0%, 15.0%, and 10.0%,
respectively. For each year of the project, Waters Edge Resorts expects relevant, incremental
annual revenue associated with the project to be $650,000 and relevant, incremental annual costs
associated with the project to be $470,000. The tax rate is 50 percent. What is (X plus Y) if X is
the relevant operating cash flow (OCF) associated with the project expected in year 2 of the
project and Y is the relevant OCF associated with the project expected in year 4 of the project?
MACRS rate
Initial investment
Annual depreciation
Year 2
.450
500,000
225,000
Year 4
.100
500,000
50,000
Revenue
Costs
Annual depreciation
EBIT
Tax rate
Taxes paid
Net income = EBIT taxes paid
OCF = net income + depreciation
650,000
470,000
225,000
-45,000
0.50
-22,500
-22,500
202,500
650,000
470,000
50,000
130,000
0.50
65,000
65,000
115,000
OCF in year 2 + OCF in year 4 = 202,500 + 115,000 = 317,500
15
FNAN 301/303
16. Based on the following information, what is the relevant operating cash flow (OCF)
associated with the project expected to be in year 3? The project would require an initial
investment in equipment of $100,000 that would be depreciated using MACRS where the
depreciation rates in years 1, 2, 3, and 4 are 33.0%, 44.0%, 15.0%, and 8.0%, respectively. At
the end of the project in 3 years, the equipment would be sold for an expected after-tax cash flow
of $60,000. In year 3 of the project, relevant, incremental revenue associated with the project
would be $80,000 and relevant, incremental costs associated with the project would be $30,000.
The tax rate is 30 percent.
The expected cash flow from capital spending is not relevant for OCF
MACRS rate
Initial investment
Annual depreciation
Year 3
0.150
100,000
15,000
Revenues
Costs
Annual depreciation
EBIT
Tax rate
Taxes paid
80,000
30,000
15,000
35,000
0.30
10,500
24,500
39,500
16
FNAN 301/303
17. What is the operating cash flow (OCF) for year 3 of the Portland project that OreDuck should
use in its NPV analysis of the project? The tax rate is 40%. During year 3, the Portland project
is expected to have relevant revenue of $83,000; relevant variable costs of $26,000; and relevant
with the Portland project. Yesterday, OreDuck signed a deal with State Beaver Advertising to
develop a marketing campaign for use in Portland. The terms of the deal require OreDuck to pay
State Beaver either $45,000 in 3 years if the project is pursued or $21,000 in 3 years if the
project is not pursued. Finally, the equipment purchased for the project would be sold in 3 years
for an expected after-tax cash flow of $10,000.
The sale of the equipment is considered under cash flow from capital spending, not
operating cash flows. Therefore, it is not relevant for answering the question.
The cost is partially sunk in 3 years
OreDuck must pay $45,000 in 3 years if it does the project and $21,000 in 3 years if it does
not do the project, so the incremental cost would be $45,000 $21,000 = $24,000.
Therefore, $24,000 of the fixed cost should be included in the cost of the project in 3 years
Since total costs = fixed costs + variable costs, total costs = $24,000 + $26,000 = $50,000
=
+
=
Revenue
Costs
Annual depreciation
EBIT
Tax rate
Taxes paid
Annual depreciation
OCF
Year 3
83,000
50,000
17,000
16,000
0.40
6,400
9,600
17,000
26,600
17
FNAN 301/303
18. Two Friends Inc. is considering project A. The table presents expected financial figures for
year 1 for Two Friends if it pursues project A and for Two Friends if it does not pursue project A.
The tax rate is 40 percent. What is the operating cash flow (OCF) for year 1 that Two Friends
should use to analyze the net present value of project A?
Expected financial figures for year 1
Two Friends with Project A
Two Friends without Project A
Revenue
800,000
450,000
Costs
200,000
150,000
Depreciation
300,000
200,000
Interest paid to bank
150,000
100,000
Recall that incremental cash flows are used to analyze the NPV of a project
Incremental cash flows can be computed from incremental inputs
An incremental input is the value of an input for the entire firm with the project minus the value of
that input for the entire firm without the project
Therefore, relevant OCF can be found from incremental revenues, expenses, and depreciation
Note that interest paid to the bank is not relevant for an NPV analysis of a potential project, so no
interest expenses are included in the analysis
Two Friends
with
Project A
800,000
200,000
300,000
Revenue
Costs
Annual depreciation
=
EBIT
Tax rate
=
Taxes paid
Relevant OCF for project A = incremental OCF = $220,000
Two Friends
without
Project A
450,000
150,000
200,000
Incremental effect of
Project A
(with without)
350,000
50,000
100,000
200,000
0.40
80,000
120,000
220,000
Another approach is to compute the OCF for the firm with the project and without the project and
find with minus without:
Two Friends
Two Friends
with
without
Project A
Project A
Revenue
800,000
450,000
Costs
200,000
150,000
Annual depreciation
300,000
200,000
=
EBIT
300,000
100,000
Tax rate
0.40
0.40
=
Taxes paid
120,000
40,000
180,000
60,000
480,000
260,000
Incremental OCF = OCF with project A OCF without project A = 480,000 260,000 = 220,000
18
FNAN 301/303
19. Scarlet Inc. operates coffee shops in Ohio. The firm is evaluating the Cleveland project, which would
involve opening a new coffee shop in Cleveland. During year 1, Scarlet would have total revenue of
$2,900,000 and total costs of $1,500,000 if it pursues the Cleveland project, and the firm would have total
revenue of $2,500,000 and total costs of $1,900,000 if it does not pursue the Cleveland project.
Depreciation taken by the firm would be $700,000 if the firm pursues the project and $500,000 if the firm
does not pursue the project. The tax rate is 35%. What is the relevant operating cash flow (OCF) for year
1 of the Cleveland project that Scarlet should use in its NPV analysis of the Cleveland project?
In evaluating the Cleveland project, Scarlet should use incremental revenue, incremental costs,
and incremental depreciation, which is what those values would be with the project minus what
they would be without the project. The incremental effects reflect the effect of the project,
which is what is of interest.
= $2,900,000 $2,500,000 = $400,000
= $1,500,000 $1,900,000 = -$400,000
= $700,000 $500,000 = $200,000
=
+
=
Revenue
Costs
Annual depreciation
EBIT
Tax rate
Taxes paid
Annual depreciation
OCF
Year 1
400,000
-400,000
200,000
600,000
0.35
210,000
390,000
200,000
590,000
With
Without in
Incremental in
in year 1
year 1
year 1
Revenue
2,900,000
2,500,000
400,000
Costs
1,500,000
1,900,000
-400,000
Annual depreciation
700,000
500,000
200,000
= EBIT
700,000
100,000
600,000
Tax rate
0.35
0.35
0.35
= Taxes paid
245,000
35,000
210,000
455,000
65,000
390,000
OCF = net income + dep
1,155,000
565,000
590,000
19
FNAN 301/303
20. Spotted Potato is evaluating project A, which would require the purchase of a piece of equipment for
$600,000. During year 1, project A is expected to have relevant revenue of $310,000, relevant costs of
$100,000, and some depreciation. Spotted Potato would need to borrow $600,000 for the equipment and
would need to make an interest payment of $60,000 to the bank in year 1. Relevant net income for project
A in year 1 is expected to be $90,000 and operating cash flows for project A in year 1 are expected to be
$170,000. Straight-line depreciation would be used. What is the tax rate expected to be in year 1?
The $60,000 interest payment is not included in the analysis. Projects should be evaluated solely on cash
flows expected to be produced by assets. It does not matter if funds are borrowed to pay for the project or
whether new stock is issued or whether the firm uses cash it already has. Ignore any and all cash flows
associated with debt and equity including debt-issuance proceeds, debt payments, equity-issuance proceeds,
dividends, and stock buybacks.
The fact that straight-line depreciation is used is not relevant. The depreciation expense can be found from
OCF = net income + depreciation.
To solve:
1) Find expected depreciation in year 1
1) Find expected depreciation in year 1
170,000 = 90,000 + depreciation
Depreciation = 170,000 90,000 = 80,000
310,000 100,000 80,000 = 130,000
90,000 = 130,000 taxes paid
So taxes paid = 130,000 90,000 = 40,000
Tables are useful for steps 1, 2, and 3
=
+
=
Revenue
Costs
Annual depreciation
Taxes
Net income
Annual depreciation
OCF
Given
Year 1
310,000
100,000
Step 1
Year 1
310,000
100,000
Step 2
Year 1
310,000
100,000
80,000
130,000
90,000
90,000
80,000
170,000
90,000
80,000
170,000
170,000

= 40,000 / 130,000
20
Step 3
Year 1
310,000
100,000
80,000
130,000
40,000
90,000
80,000
170,000
FNAN 301/303
= 0.308 = 30.8%21. Spotted Potato is evaluating a project that would require the purchase of a piece
of equipment for $500,000 today. During year 1, the project is expected to have relevant revenue of
$420,000, relevant costs of $160,000, and relevant depreciation of $120,000. Spotted Potato would
need to borrow $500,000 today for the equipment and would need to make an interest payment of
$50,000 to the bank in 1 year. Relevant operating cash flow for the project in year 1 is expected to be
$200,000. What is the tax rate expected to be in year 1?
The $50,000 interest payment is not included in the analysis. Projects should be evaluated solely on
cash flows expected to be produced by assets. It does not matter if funds are borrowed to pay for
the project or whether new stock is issued or whether the firm uses cash it already has. Ignore any
and all cash flows associated with debt and equity including debt-issuance proceeds, debt payments,
equity-issuance proceeds, dividends, and stock buybacks.
To solve:
1) Find expected net income
1) Find expected net income
So net income = OCF depreciation = 200,000 120,000 = 80,000
420,000 160,000 120,000 = 140,000
80,000 = 140,000 taxes paid
So taxes paid = 140,000 80,000 = 60,000
Tables are useful for steps 1, 2 and 3
=
+
=
Revenue
Costs
Annual depreciation
Taxes
Net income
Depreciation
OCF
Given
Year 1
420,000
160,000
120,000
Step 1
Year 1
420,000
160,000
120,000
120,000
200,000
80,000
120,000
200,000

= 60,000 / 140,000
= 0.4286 = 42.86%
21
Step 2
Year 1
420,000
160,000
120,000
140,000
60,000
80,000
120,000
200,000
Step 3
Year 1
420,000
160,000
120,000
140,000
60,000
80,000
120,000
200,000
FNAN 301/303
22. For project A, the cash flow effect from the change in net working capital is expected to be
$500 at time 2 and the level of net working capital is expected to be $800 at time 2. What is the
level of current liabilities for project A expected to be at time 1 if the level of current assets for
project A is expected to be $1,900 at time 1?
Recall that:
1) Cash flow effects from changes in NWC = -NWC
2) The change in NWC equals NWC at a point in time minus NWC at the previous point in time, so
NWCt = NWCt NWCt-1 and in this case: NWC2 = NWC2 NWC1
3) Net working capital (NWC) is measured as current assets (CA) minus current liabilities (CL), so
NWC = CA CL
To solve:
1) Find NWC from the cash flow effects from changes in NWC
2) Find NWC1 from NWC2 and NWC2
3) Find CL1 from NWC1 and CA1
Cash flow effects from changes in NWC = -NWC
500 = -NWC2
So NWC2 = -500
Since the cash flow effect from the change in net working capital is expected to be $500 at time 2,
then the change in NWC at time 2 is expected to be -$500, which means that NWC is expected to
decline by $500 from time 1 to time 2
NWC2 = NWC2 NWC1
-500 = 800 NWC1
So NWC1 = 800 + 500 = 1,300
NWC is expected to be $1,300 at time 1 and $800 at time 2, which means that it is expected to
NWC1 = CA1 CL1
1,300 = 1,900 CL1
So CL1 = 1,900 1,300 = 600
Given
CA
CL
NWC
NWC
CF NWC
1
1,900
Step 1
2
800
500
1
1,900
Step 2
Step 3
1
1,900
800
-500
500
1,300
800
-500
500
22
1
1,900
600
1,300
2
800
-500
500
FNAN 301/303
23. For project A, the cash flow effect from the change in net working capital is expected to be -$500 at
time 2 and the level of net working capital is expected to be $800 at time 2. What is the level of current
assets for project A expected to be at time 1 if the level of current liabilities for project A is expected to be
$1,900 at time 1?
Recall that:
NWC = CA CL
To solve:
-500 = -NWC2
So NWC2 = 500
Since the cash flow effect from the change in net working capital is expected to be -$500 at time 2,
then the change in NWC at time 2 is expected to be $500, which means that NWC is expected to
increase by $500 from time 1 to time 2
NWC2 = NWC2 NWC1
500 = 800 NWC1
So NWC1 = 800 500 = 300
NWC is expected to be $300 at time 1 and $800 at time 2, which means that it is expected to increase
by $500 from time 1 to time 2
3) Find CA1 from NWC1 and CL1
NWC1 = CA1 CL1
300 = CA1 1,900
So CA1 = 300 + 1,900 = 2,200
Given
1
CA
CL
NWC
NWC
CF NWC
Step 1
2
1,900
Step 2
2
1,900
800
-500
800
500
-500
23
1
1,900
300
Step 3
2
800
500
-500
1
2,200
1,900
300
2
800
500
-500
FNAN 301/303
24. For project A, the cash flow effect from the change in net working capital is expected to be -$400 at
liabilities for project A expected to be at time 2 if the level of current assets for project A is expected to be
$2,500 at time 2?
Recall that:
NWC = CA CL
To solve:
-400 = -NWC2
So NWC2 = 400
Since the cash flow effect from the change in net working capital is expected to be -$400 at time 2,
then the change in NWC at time 2 is expected to be $400, which means that NWC is expected to
NWC2 = NWC2 NWC1
400 = NWC2 700
So NWC2 = 400 + 700 = 1,100
NWC is expected to be $700 at time 1 and $1,100 at time 2, which means that it is expected to
NWC2 = CA2 CL2
1,100 = 2,500 CL2
So CL2 = 2,500 1,100 = 1,400
Given
1
CA
CL
NWC
NWC
CF NWC
Step 1
2
2,500
700
Step 2
2
2,500
700
-400
400
-400
24
Step 3
2
2,500
700
1,100
400
-400
700
2
2,500
1,400
1,100
400
-400
FNAN 301/303
25. For project A, the cash flow effect from the change in net working capital is expected to be $400 at
assets for project A expected to be at time 2 if the level of current liabilities for project A is expected to be
$2,500 at time 2?
Recall that:
NWC = CA CL
To solve:
400 = -NWC2
So NWC2 = -400
Since the cash flow effect from the change in net working capital is expected to be $400 at time 2,
then the change in NWC at time 2 is expected to be -$400, which means that NWC is expected to
NWC2 = NWC2 NWC1
-400 = NWC2 700
So NWC2 = -400 + 700 = 300
NWC is expected to be $700 at time 1 and $300 at time 2, which means that it is expected to decline
by $400 from time 1 to time 2
NWC2 = CA2 CL2
300 = CA2 2,500
So CA2 = 2,500 + 300 = 2,800
Given
1
CA
CL
NWC
NWC
CF NWC
Step 1
2
2,500
700
Step 2
2
2,500
700
400
1
700
-400
400
25
Step 3
2
2,500
300
-400
400
1
700
2
2,800
2,500
300
-400
400
FNAN 301/303
26. For project A, the cash flow effect from the change in net working capital is expected to be $400 at
time 2, the level of net working capital is expected to be $700 at time 0, and the level of net working
capital is expected to be $900 at time 2. What is the cash flow effect from the change in net working
capital expected to be at time 1?
To solve
1) Find NWC at time 2
4) Find CF effect from NWC at time 1
Timeline helps identify what we know and what we want to know and how we can get there
0
1
2
NWC
700
900
NWC
CF effect from NWC
400
Cash flow effects from NWC = -NWC
Therefore, CF effect from NWC2 = -NWC2 = 400
So NWC2 = -400
0
NWC
700
NWC
CF effect from NWC
2
900
-400
400
0
700
1
1,300
2
900
-400
400
0
700
1
1,300
600
2
900
-400
400
1
1,300
600
-600
2
900
-400
400

NWC2 = NWC2 NWC1
-400 = 900 NWC1
So NWC1 = 900 + 400 = 1,300
NWC
NWC
CF effect from NWC
NWC1 = NWC1 NWC0
= 1,300 700
= 600
NWC
NWC
CF effect from NWC

CF effect from NWC1 = -NWC1 = -600
NWC
NWC
CF effect from NWC
0
700
26
FNAN 301/303
27
FNAN 301/303
27. For project A, the change in net working capital is expected to be $800 at time 0, the cash flow effect from the
change in net working capital is expected to be -$100 at time 1, and the level of net working capital is expected to be
$600 at time 2. What is the cash flow effect from the change in net working capital expected to be at time 2?
To solve
Timeline helps identify what we know and what we want to know and how we can get there
0
1
NWC
NWC
800
CF effect from NWC
-100
2
600

NWC0 = NWC0
NWC
NWC
CF effect from NWC
0
800
800
2
600
-100

CF effect from NWC1 = -NWC1 = -100
NWC1 = 100
NWC
NWC
CF effect from NWC
0
800
800
2
600
100
-100

NWC1 = NWC1 NWC0
100 = NWC1 800
NWC1 = 100 + 800 = 900
NWC
NWC
CF effect from NWC
0
800
800
1
900
100
-100
2
600
0
800
800
1
900
100
-100
2
600
-300
0
800
800
1
900
100
-100
2
600
-300
300

NWC2 = NWC2 NWC1= 600 900 = -300
NWC
NWC
CF effect from NWC
CF effect from NWC2 = -NWC2 = 300
NWC
NWC
CF effect from NWC
28
FNAN 301/303
28. What is the expected after-tax cash flow from selling a piece of equipment if TwoPlus
purchases the equipment today for $1,600,000, the tax rate is 30%, the equipment is sold in 3
years for $400,000, and MACRS depreciation is used where the depreciation rates in years 1, 2,
3, 4, and 5 are 40.0%, 30.0%, 15.0%, 10.0%, and 5.0%, respectively?
CF from asset sale = sales price of asset taxes paid on sale of asset
Taxes paid = (sales price of asset book value of asset) tax rate = taxable gain tax rate
Book value = initial price of asset accumulated depreciation
Accumulated depreciation equals depreciation in year 1 + depreciation in year 2 +
depreciation in year 3
Depreciation in year 1 = 40.0% 1,600,000 = 640,000
Accumulated depreciation = 640,000 + 480,000 + 240,000 = 1,360,000
Book value = 1,600,000 1,360,000 = 240,000
Taxes paid on sale of asset = (400,000 240,000) 0.30 = 160,000 0.30 = 48,000
CF from asset sale = 400,000 48,000 = 352,000
29
FNAN 301/303
29. Today, Probst Corporation purchased a piece of equipment for $540,000 that will be
depreciated to $60,000 over 12 years using straight-line depreciation. What would the after-tax
cash flow be from the equipment sale if the equipment is sold in 5 years for $100,000 and the tax
rate is 25 percent?
CF from asset sale = sale price of asset taxes paid on sale of asset
Taxes paid = (sale price of asset book value of asset) corporate tax rate
Depreciation = (investment amount asset is depreciated to) / useful life
Depreciation = [($540,000 $60,000) / 12] = [$480,000 / 12] = $40,000 per year
Accumulated depreciation over the next 5 years = 5 $40,000 = $200,000
Book value = $540,000 $200,000 = $340,000
Sale price of asset = $100,000
Taxes paid = ($100,000 $340,000) 0.25 = (-$240,000) 0.25 = -$60,000
So, after-tax CF from sale = $100,000 (-$60,000) = $160,000
30
FNAN 301/303
30. Today, Rock Star Parties Inc. purchased a piece of equipment for $100,000 that is expected to
be sold in 2 years for $75,000. The tax rate is 40%. X is the after-tax cash flow to Rock Star
Parties from selling the equipment in 2 years if it is depreciated to $10,000 over 4 years using
straight-line depreciation. Y is the after-tax cash flow to Rock Star Parties from selling the
equipment in 2 years if it is depreciated with MACRS depreciation where the depreciation rates
in years 1, 2, 3, and 4 are 34.0%, 44.0%, 14.0%, and 8.0%, respectively. What is X plus Y?
Taxes paid = (sale price of asset book value of asset) corporate tax rate
Accumulated depreciation equals depreciation in year 1 + depreciation in year 2
X: Straight Line
Depreciation = [(100,000 10,000) / 4] = [90,000 / 4] = 22,500 per year
Accumulated depreciation over the next 2 years = 2 22,500 = 45,000
Book value = 100,000 45,000 = 55,000
Sale price of asset = 75,000
Taxes paid = (75,000 55,000) 0.40 = (20,000) 0.40 = 8,000
So, after-tax CF from sale = 75,000 8,000 = 67,000
Y: MACRS
Depreciation in year 1 = 34.0% 100,000 = 34,000
Depreciation in year 2 = 44.0% 100,000 = 44,000
Accumulated depreciation = 34,000 + 44,000 = 78,000
Book value = 100,000 78,000 = 22,000
Taxes paid on sale of asset = (75,000 22,000) 0.40 = 53,000 0.40 = 21,200
X + Y = 67,000 + 53,800 = 120,800
31
FNAN 301/303
31. Today, Temple Inc. purchased a piece of equipment for $200,000 that will be depreciated to
$56,000 over 8 years using straight-line depreciation. What would the after-tax cash flow be
from the equipment sale if the equipment is sold in 10 years for $82,000, and the tax rate is 40
percent?
**It is important to remember that depreciation can only be taken over the depreciable life
of the asset. In this case, the depreciable life is 8 years, so depreciation can only be taken
for 8 years. In years 9 and 10, no depreciation can be taken.
Taxes paid on sale of asset = (sale price of asset book value of asset) corporate tax rate
Depreciation = ($200,000 $56,000) / 8 = $18,000 per year for years 1 through 8
Depreciation = $0 per year for years 9 and 10
Accumulated depreciation over the 10 years = 8 $18,000 = $144,000
Book value = $200,000 $144,000 = $56,000
Sale price of asset = $82,000
Taxes paid = ($82,000 $56,000) 0.40
= $26,000 0.40
= $10,400
So, after-tax CF from sale = $82,000 ($10,400) = $71,600
32
FNAN 301/303
32. Donovan Corporation sells passes to sporting events in Philadelphia and is evaluating the DC
project, which would involve selling passes with the Donovan logo in DC for 2 years, starting
today. Based on the following information, what is the net present value of the DC project? The
project would involve an initial investment in equipment of $1,000,000 today. Cash flows from
capital spending would be $0 in year 1 and $50,000 in year 2. To finance the project, Donovan
would borrow $1,000,000. The firm would receive $1,000,000 from the bank today and would
pay the bank $1,100,000 in 2 years (consisting of a $100,000 interest payment and a $1,000,000
principal payment). There would be no loan payments in 1 year. Operating cash flows are
expected to be $700,000 in year 1 and $700,000 in year 2. The tax rate is 50 percent. The cost
of capital is 14.7 percent.
The information on the loan proceeds and payments is irrelevant since we ignore all cash
flows associated with financing a project. The capital budgeting decision (whether or not to
do the project) is evaluated separately from the financing project. How money is raised
should not influence the decision of whether or not to pursue a project.
Year
0
1
2
OCF
0
700,000
700,000
+ Cash flows from NWC
0
0
0
+ CF from capital spending
-1,000,000
0
50,000
+ Terminal value
0
0
0
= Relevant CF
-1,000,000
700,000
750,000
NPV = -1,000,000 + [700,000 / (1.147)] + [750,000 / (1.147)2] = 180,366
33
FNAN 301/303
npv(14.7,-1000000,{700000,750000}) 180,36633. Based on the following information,

what is the net present value of the flier project, which is a 3-year project where Dispersion
Corporation would spread fliers all over Fairfax? The project would involve an initial
investment in equipment of $240,000 today. Cash flows from capital spending would be $0 in
year 1, $0 in year 2, and $35,000 in year 3. Operating cash flows are expected to be $150,000
in year 1, $100,000 in year 2, and -$30,000 in year 3. The cash flow effects from the change in
net working capital are expected to be -$10,000 at time 0; -$20,000 in 1 year; $15,000 in year
2, and $15,000 in year 3. The tax rate is 35 percent. The cost of capital is 7.1 percent.
Year
0
1
2
3
OCF
0
150,000
100,000
-30,000
-10,000
-20,000
15,000
15,000
-240,000
0
0
35,000
+ Terminal value
0
0
0
0
= Relevant CF
-250,000
130,000
115,000
20,000
2
NPV = -250,000 + [130,000 / (1.071)] + [115,000 / (1.071) ] + [20,000 / (1.071)3] = -12,080
npv(7.1,-250000,{130000,115000,20000}) -12,080
34
FNAN 301/303
34. Chaotic Corporation is considering a project that would last for 3 years and have a cost of
capital of 10.0 percent. The relevant level of net working capital for the project is expected to be
$10,000 immediately (at year 0); $30,000 in 1 year; $20,000 in 2 years; and $0 in 3 years.
Relevant expected operating cash flows and cash flows from capital spending in years 0, 1, 2,
and 3 are presented in the following table. What is the net present value of this project?
Year 0
Year 1
Year 2
Year 3
Operating cash flows
$0
$50,000
$50,000
$50,000
Cash flows from capital spending
-$100,000
$0
$0
$10,000
Relevant cash flows in a given year = OCF + CF effects from NWC + CF from capital
spending + terminal value
In this problem, terminal value = 0
Therefore, relevant cash flows in a given year = OCF + CF effects from NWC + CF from
capital spending
We are given OCF and CF from capital spending. We are given NWC for each point in
time (years 0, 1, 2, and 3) and must compute NWC as NWC at the end of a period minus
NWC at the start of the period and the cash flow effects from NWC as NWC.
Year
OCF
NWC
NWC = NWC at end of period minus NWC
at start of period (except NWC0 = NWC0)
Rel CF (OCF + CF NWC + CF cap spend)
0
0
10,000
10,000
-10,000
-100,000
-110,000
npv(10.0,-110000,{30000,60000,80000}) 26,965
35
1
50,000
30,000
2
50,000
20,000
30k 10k = 20k 30k =

20,000
-10,000
-20,000
0
30,000
10,000
0
60,000
3
50,000
0
0 20k =
-20,000
20,000
10,000
80,000
FNAN 301/303
35. What is the net present value of a project that would involve an initial investment of
$135,000 for new equipment that would be sold for an after-tax cash flow of $25,000 at the end
of the project in 2 years? The cost of capital for the project is 18.2 percent and the tax rate is 40
percent. Finally, the project involves the following additional expectations:
Year 0
Year 1
Year 2
Operating cash flows
$0
$80,000
$80,000
Change in net working capital
$40,000
$10,000
-$50,000
Note that the tax rate is not necessary, since all relevant figures are given on an after-tax basis.
Also, note that the change in NWC is given not the level and not the cash flow effects. To
get CF effects, the sign needs to be flipped.
OCF and CF from capital spending are given for the relevant years. Note that OCF = $0 in
year 0 and CF from capital spending = $0 in year 1. Also, CF from capital spending =
-$135,000 in year 0 and $25,000 in 2 years. Terminal value = $0 for all years.
The changes in NWC at different points in time are given, so the CF effect from the change
in NWC must be found. Note that the change in NWC is given, not the level.
Year
0
1
2
NWC
40,000
10,000
-50,000
Cash flow effect from NWC
-40,000
-10,000
50,000
Put it all together
Year
0
1
OCF
0
80,000
+ Cash flow effect from NWC
-40,000
-10,000
-135,000
0
+ Terminal value
0
0
= Relevant CF
-175,000
70,000
NPV = -175,000 + [70,000/(1.182)1] + [155,000/(1.182)2] = -4,836
npv(18.2,-175000,{70000,155000}) -4,836
36
2
80,000
50,000
25,000
0
155,000
FNAN 301/303
36. Vermont Technology is considering a project that would last for 3 years and have a cost of
capital of 21.0 percent. The relevant level of net working capital for the project is expected to be
$2,000 immediately (at year 0); $5,000 in 1 year; $15,000 in 2 years; and $0 in 3 years. Relevant
expected revenue, costs, depreciation, and cash flows from capital spending in years 0, 1, 2, and
3 are presented in the following table. The tax rate is 50 percent. What is the net present value
of this project?
Year 0
Year 1
Year 2
Year 3
Revenue
$0
$12,000
$12,000
$12,000
Costs
$0
$4,000
$4,000
$4,000
Depreciation
$0
$2,000
$2,000
$2,000
-$7,000
$0
$0
$4,000
In this problem, terminal value = 0
Therefore, relevant cash flows in a given year = OCF + CF effects from NWC + CF from
capital spending. We are given CF from capital spending. We can compute OCF from
revenue, costs, depreciation, and the tax rate. We are given NWC for each point in time
(years 0, 1, 2, and 3) and must compute NWC as NWC at the end of a period minus NWC
at the start of the period and the cash flow effects from NWC as NWC.
Year
Revenue
Costs
Depreciation
EBIT = revenues costs depreciation
tax rate
Taxes = tax rate EBIT
net inc
0
2,000
1
12,000
4,000
2,000
6,000
0.50
3,000
3,000
5,000
2
12,000
4,000
2,000
6,000
0.50
3,000
3,000
5,000
3
12,000
4,000
2,000
6,000
0.50
3,000
3,000
5,000
15,000
15k 5k =
10,000
-10,000
0
0 15k =
-15,000
15,000
0
-5,000
4,000
24,000
NWC
NWC = NWC at end of period minus NWC
at start of period (except NWC0 = NWC0)
2,000
-2,000
5,000
5k 2k =
3,000
-3,000

Rel CF (OCF + CF NWC + CF cap spend)
-7,000
-9,000
0
2,000
npv(21.0,-9000,{2000,-5000,24000}) 2,785
37
FNAN 301/303
37. DreamView sells large, high-definition televisions and is evaluating the 2-year radio project.
The radio project would involve buying equipment for $600,000 that would be depreciated to $0
over 2 years using straight-line depreciation. Cash flows from capital spending would be $0 in
year 1 and $10,000 in year 2. To finance the project, DreamView would borrow $600,000. The
firm would receive $600,000 from the bank today and would pay the bank $0 in 1 year and
$720,000 in 2 years (consisting of a $120,000 interest payment and a $600,000 principal
payment). Relevant annual revenues are expected to be $900,000 in year 1 and year 2. Relevant
annual costs are expected to be $450,000 in year 1 and $200,000 in year 2. The tax rate is 50
percent. The cost of capital is 17.6 percent. What is the net present value of the radio project?
The information on the loan proceeds and payments is irrelevant since we ignore all cash flows
associated with financing a project. The capital budgeting decision (whether or not to do the
project) is evaluated separately from the financing project. How money is raised should not
influence the decision of whether or not to pursue a project.
Depreciation in year 1 and in year 2 = 600,000 / 2 = 300,000
Revenues
Costs
Annual depreciation
EBIT
Tax rate
Taxes paid
OCF = NI + depreciation
Year
1
900,000
450,000
300,000
150,000
0.50
75,000
75,000
375,000
0
0
0
0
0
0.50
0
0
0
Year
0
1
OCF
0
375,000
0
0
-600,000
0
+ Terminal value
0
0
= Relevant CF
-600,000
375,000
NPV = -600,000 + [375,000 / (1.176)] + [510,000 / (1.176) 2] = 87,648
38
2
900,000
200,000
300,000
400,000
0.50
200,000
200,000
500,000
2
500,000
0
10,000
0
510,000
FNAN 301/303
npv(17.6,-600000,{375000,510000}) 87,64838. Sleepy Opera Inc. is considering a project that would last
for 2 years. The project would involve an initial investment of $640,000 for new equipment that would be sold for
an expected price of $430,000 at the end of the project in 2 years. The equipment would be depreciated to zero over
4 years using straight-line depreciation. In years 1 and 2, relevant annual revenue for the project is expected to be
$510,000 per year and relevant annual costs for the project are expected to be $270,000 per year. The tax rate is 40
percent and the cost of capital for the project is 13.0 percent. What is the net present value of the project?
A. An amount less than -$100,000
B. An amount equal to or greater than -$100,000 but less than $0
C. An amount equal to or greater than $0 but less than $11,000
D. An amount equal to or greater than $11,000 but less than $22,000
E. An amount equal to or greater than $22,000
In a given year, the relevant cash flow for a project = operating cash flow + cash flow effects from changes in
net working capital + cash flow from capital spending + terminal value
In this case, cash flow effects from changes in net working capital and terminal value are zero in each year.
Therefore, to get relevant cash flow is each year, we need to find operating cash flow and cash flow from capital spending.
Annual SL depreciation = (investment amount asset is depreciated to) / depreciable life
= (640,000 0) / 4 = 160,000 per year for 4 years
OCF
Year
0
1
2
Revenues
0
510,000
510,000
Costs
0
270,000
270,000
Annual depreciation
0
160,000
160,000
EBIT (revs costs depreciation)
0
80,000
80,000
Tax rate
0.40
0.40
0.40
Taxes paid
0
32,000
32,000
0
48,000
48,000
OCF = Net income + depreciation
0
208,000
208,000
CF from asset sale: CF from asset sale = sales price of asset taxes paid on sale of asset
Taxes paid on sale of asset = taxable gain on sale of asset tax rate
Taxable gain on sale of asset = (sales price of asset book value of asset)
Accumulated depreciation = 0 + 160,000 + 160,000 = 320,000
Book value = 640,000 320,000 = 320,000
Taxable gain on asset sale = 430,000 320,000 = 110,000
Taxes paid on sale of asset = 110,000 .40 = 44,000
Relevant CF
OCF
Cash flow effects from NWC
CF from capital spending
Terminal value
Relevant CF
npv(13.0,-640000,{208000,594000}) 9,260
0
0
0
-640,000
0
-640,000
39
Year
1
208,000
0
0
0
208,000
2
208,000
0
386,000
0
594,000
FNAN 301/303
Answer: C, $9,260 is an amount equal to or greater than $0 but less than $11,00039. Rocky Mountain Cavers
provides cave exploration tours in Colorado. The firm is considering the Canada project, which would
involve expanding into Canada. The project, which would last for 2 years, would involve an initial
investment of $470,000 for new equipment that would be sold for an after-tax cash flow of $20,000 at the
end of the project in 2 years. The equipment would be depreciated to zero over 2 years using straight-line
depreciation. Rocky Mountain management expects annual revenue from Canada caving to be $700,000
in the first year and $900,000 in the second year. Management expects annual variable costs from Canada
caving to be $500,000 in the first year and $600,000 in the second year. Finally, the firm has one fixed
cost. Yesterday, Rocky Mountain Cavers signed a $100,000 deal with Great White Marketing to develop
an advertising campaign for use in Canada. The terms of the deal require Rocky Mountain Cavers to pay
Great White Marketing $100,000 in one year from today. The tax rate is 40 percent and the cost of capital
for the Canada project is 14.2 percent. What is the net present value of the Canada project?
Despite the fact that the $100,000 payment will take place in the future, the $100,000 payment to
Great White Marketing in one year is also a sunk cost. The company must pay it regardless of
whether it expands into Canada or not. Therefore, the payment to Great White Marketing is not
relevant to the analysis of whether to pursue the Canada project. Therefore, for this project:
Relevant costs = relevant fixed costs + relevant variable costs = relevant variable costs in each year
The initial investment is $470,000

The investment is depreciated to $0 over 2 years
Annual depreciation in years 1 and 2 is ($470,000 $0) / 2 = $235,000
NPV based on overview
Revenues
Costs
Annual depreciation
EBIT (revs costs depreciation)
Tax rate
Taxes paid
0
0
0
0
0
0.40
0
0
0
Year
1
700,000
500,000
235,000
-35,000
0.40
-14,000
-21,000
214,000
2
900,000
600,000
235,000
65,000
0.40
26,000
39,000
274,000
0
0
0
-470,000
0
-470,000
Year
1
214,000
0
0
0
214,000
2
274,000
0
20,000
0
294,000
OCF
Cash flow effects from NWC
Terminal value
Relevant CF
npv(14.2,-470000,{214000,294000}) -57,178
Note: answers may differ somewhat due to rounding
40
FNAN 301/303
40. Business Monkey Inc. is evaluating a 3-year project that would involve buying a new piece
of equipment for $3,600,000 today. The equipment would be depreciated straight-line to $0 over
2 years. In 3 years, the equipment would be hauled away for an after-tax cash flow of $0. In
each of the 3 years of the project, relevant revenues are expected to be $3,000,000 and relevant
costs are expected to be $1,000,000. The tax rate is 50% and the cost of capital for the project is
15%. What is the NPV of the project?
The initial investment is $3,600,000
Annual depreciation in years 1 and 2 is ($3,600,000 $0) / 2 = $1,800,000
Annual depreciation in years 3 is $0 since the equipment is depreciated over 2 years
There is no information about NWC or terminal values, so their effect on expected cash
flows can be assumed to be zero and only OCF and cash flow from capital spending need to
be computed for each year
Year
Revenues
Costs
Annual depreciation
EBIT
Tax rate
Taxes paid
0
0
0
0
0
0.50
0
0
0
1
3,000,000
1,000,000
1,800,000
200,000
0.50
100,000
100,000
1,900,000
2
3,000,000
1,000,000
1,800,000
200,000
0.50
100,000
100,000
1,900,000
3
3,000,000
1,000,000
0
2,000,000
0.50
1,000,000
1,000,000
1,000,000
2
1,900,000
0
0
0
1,900,000
3
1,000,000
0
0
0
1,000,000
Year
OCF
+ Cash flow effect from NWC
+ Terminal value
= Relevant CF
0
0
0
-3,600,000
0
-3,600,000
1
1,900,000
0
0
0
1,900,000
NPV = -3,600,000 + [1,900,000/(1.15)1] + [1,900,000/(1.15)2] + [1,000,000/(1.15)3] = 146,363

npv(15,-3600000,{1900000,1900000,1000000}) 146,363
Business Monkey should pursue the project since NPV > 0
41
FNAN 301/303
41. What is the NPV of the mall project? The project would require an initial investment in
equipment of $950,000 and would last for either 3 years or 4 years (the date when the project
ends will not be known until it happens and that will be when the equipment stops working in
either 3 years from today or 4 years from today). Annual operating cash flows of $500,000 per
year are expected each year until the project ends in either 3 years or 4 years. In 1 year, the
project is expected to have an after-tax terminal value of $900,000. The cost of capital for this
project is 15.4 percent.
There is a terminal value in 1 year, so we only need to examine cash flow components for
up to 1 year. The terminal value in 1 year reflects all subsequent expected cash flows (for
years 2, 3, and 4, taking into account the likelihood of the equipment stopping to work in 3
years or in 4 years).
All the information needed to find the NPV of the project is given.
Year
OCF
+ Terminal value
= Relevant CF
0
0
0
-950,000
0
-950,000
NPV = -950,000 + (1,400,000 / 1.154) = 263,172

npv(15.4,-950000,{1400000}) 263,172
42
1
500,000
0
0
900,000
1,400,000
FNAN 301/303
42. Tripp Industries is considering buying a new, high efficiency recycling system. The new
system would be purchased today for $7,800. It would be depreciated straight-line to $1,000
over 2 years. In 2 years, the system would be sold and the after-tax cash flow from capital
spending in year 2 would be $1,200. The system is expected to reduce costs by $2,800 in year 1
and by $8,700 in year 2. If the tax rate is 50% and the cost of capital is 7.2%, what is the net
present value of the new recycling system project?
The investment is depreciated to $1,000 over 2 years
Annual depreciation in years 1 and 2 is ($7,800 $1,000) / 2 = $3,400
flows can be assumed to be zero and only OCF and CF from capital spending need to be
computed for each year
Revenues
- Costs
- Annual depreciation
= EBIT (revs - costs - depreciation)
Tax rate
= Taxes
OCF
+ CF effects from NWC
+ Terminal value
= Relevant CF
0
0
0
0
0
0.50
0
0
0
Year
1
0
-2,800
3,400
-600
0.50
-300
-300
3,100
2
0
-8,700
3,400
5,300
0.50
2,650
2,650
6,050
0
0
-7,800
0
-7,800
3,100
0
0
0
3,100
6,050
0
1,200
0
7,250
NPV = -7,800 + [3,100/(1.072)1] + [7,250/(1.072)2] = 1,400.62

npv(7.2,-7800,{3100,7250}) 1,400.62
43
FNAN 301/303
43. The Merry Monkey Company is thinking about buying a new banana peeling machine that
would cost $60,000 today and be used for 2 years. The machine would be depreciated to zero
over 3 years using straight-line depreciation and the machine would be sold in 2 years for an
after-tax cash flow of $22,000. With the machine, the company would save $25,000 per year in
peeling expenses. The tax rate is 20%, and the cost of capital is 12.5%. What is the NPV of the
banana peeling machine project?
flows can be assumed to be zero and only OCF and CF from capital spending need to be
computed for each year
Annual depreciation in years 1 through 3 is ($60,000 $0) / 3 = $20,000
Revenues
Costs
Annual depreciation
= EBIT
Tax rate
= Taxes paid
0
0
0
0
0
0.20
0
0
0
Year
1
0
-25,000
20,000
5,000
0.20
1,000
4,000
24,000
Year
0
1
OCF
0
24,000
Cash flow effect from NWC
0
0
-60,000
0
Terminal value
0
0
Relevant CF
-60,000
24,000
1
2
NPV = -60,000 + [24,000/(1.125) ] + [46,000/(1.125) ] = -2,321
npv(12.5,-60000,{24000,46,000}) -2,321
44
2
0
-25,000
20,000
5,000
0.20
1,000
4,000
24,000
2
24,000
0
22,000
0
46,000
FNAN 301/303
NPV < 0, so the company should not buy the banana peeling machine44. Riverton Silver is
considering buying a new, high efficiency extraction system. The new system would be
purchased today for $56,000. It would be depreciated straight-line to $0 over 2 years. In 2
years, the system would be sold for an after-tax cash flow of $3,000. Without the system, costs
are expected to be $100,000 in 1 year and $120,000 in 2 years. With the system, costs are
expected to be $80,000 in 1 year and $40,000 in 2 years. If the tax rate is 40% and the cost of
capital is 14.3%, what is the net present value of the new extraction system project?
Annual depreciation in years 1 and 2 is ($56,000 $0) / 2 = $28,000
Relevantcosts=costswiththeprojectcostswithoutproject
Inyear1,relevantcosts=$80,000$100,000=$20,000
Inyear1,costsareexpectedtobe$20,000lowerwiththesystem
Inyear2,relevantcosts=$40,000$120,000=$80,000
Inyear2,costsareexpectedtobe$80,000lowerwiththesystem
Revenues
- Costs
- Annual depreciation
= EBIT (revs - costs - depreciation)
Tax rate
= Taxes paid
OCF
+ CF effects from NWC
+ Terminal value
= Relevant CF
0
0
0
0
0
0.40
0
0
0
Year
1
0
-20,000
28,000
-8,000
0.40
-3,200
-4,800
23,200
2
0
-80,000
28,000
52,000
0.40
20,800
31,200
59,200
0
0
-56,000
0
-56,000
23,200
0
0
0
23,200
59,200
0
3,000
0
62,200
NPV = -56,000 + [23,200/(1.143)1] + [62,200/(1.143)2] = 11,907

npv(14.3,-56000,{23200,62200}) 11,907
45
FNAN 301/303
45.TheWashingtonFootballCorporationownsafootballteaminWashington,DC.The
objectiveofitsmanagersistomaximizeshareholdervalue.Thefirmisevaluatingthestadium
project,whichinvolvesbuildinganewstadiuminFairfaxCounty.Whichassertionistrue,
basedontheinformationgiveninthequestionandthefollowingtableontheproject?
BasecaseNPV(basedonfinalestimatesandexpectations)
$215,000
Valuecreatediftheteamloses11gamesaseason(basedonscenarioanalysis)
$3,400,000
Valuecreatedifworstcasetaxesoccur(basedonsensitivityanalysis)
$1,700,000
Valuecreatedifbestcasetaxesoccur(basedonsensitivityanalysis)
$450,000
Probabilitythatprojectwillcreatemorethan$0ofvalue(basedonsimulationanalysis)
16.1%
A. WashingtonFootballshouldbeindifferentbetweenacceptingandrejectingthestadium
project
B. WashingtonFootballshouldacceptthestadiumproject
C. WashingtonFootballshouldrejectthestadiumproject
D. ItisnotclearwhetherWashingtonFootballshouldacceptorrejectthestadiumproject,
becausetheinformationthatisprovidediscontradictorywithrespecttoansweringthe
question
E. ItisnotclearwhetherWashingtonFootballshouldacceptorrejectthestadiumproject,
becausethecostofcapitalisnotgiven
(Fall2009,quiz4,question6)
Answer:B.WashingtonFootballshouldacceptthestadiumproject
RecallthatyoushouldcomputeabasecaseNPVbasedonfinalestimates,pursuethe
projectwhenthatbasecaseNPVispositive,andrejecttheprojectwhenthatbasecase
NPVisnegative.In this case, the base-case NPV based on final estimates and expectations
is positive, so Washington Football should accept the project.
Ifawhatifanalysisindicatesthattheamountofvaluecreatedwouldbenegative,butthe
basecaseNPVbasedonexpectationsispositive,thenpursuetheproject.Ifawhatif
analysisindicatesthattheamountofvaluecreatedwouldbepositive,butthebasecase
NPVbasedonexpectationsisnegative,thendonotpursuetheproject.
46
FNAN 301/303
46.TheWashingtonFootballCorporationownsafootballteaminWashington,DC.The
objectiveofitsmanagersistomaximizeshareholdervalue.Thefirmisevaluatingthestadium
project,whichinvolvesbuildinganewstadiuminFairfaxCounty.Whichassertionistrue,
basedontheinformationgiveninthequestionandthefollowingtableontheproject?
BasecaseNPV(basedonfinalestimatesandexpectations)
$130,000
Valuecreatediftheteamwins11gamesaseason(basedonscenarioanalysis)
$2,700,000
Valuecreatedifworstcasetaxesoccur(basedonsensitivityanalysis)
$650,000
Valuecreatedifbestcasetaxesoccur(basedonsensitivityanalysis)
$2,900,000
Probabilitythatprojectwillcreatemorethan$0ofvalue(basedonsimulationanalysis)
82.7%
A. WashingtonFootballshouldbeindifferentbetweenacceptingandrejectingthestadium
project
B. WashingtonFootballshouldacceptthestadiumproject
C. WashingtonFootballshouldrejectthestadiumproject
D. ItisnotclearwhetherWashingtonFootballshouldacceptorrejectthestadiumproject,
becausetheinformationthatisprovidediscontradictorywithrespecttoansweringthe
question
E. ItisnotclearwhetherWashingtonFootballshouldacceptorrejectthestadiumproject,
becausethecostofcapitalisnotgiven
(Fall2009,quiz4,question6)
Answer:C.WashingtonFootballshouldrejectthestadiumproject
RecallthatyoushouldcomputeabasecaseNPVbasedonfinalestimates,pursuethe
projectwhenthatbasecaseNPVispositive,andrejecttheprojectwhenthatbasecase
NPVisnegative.In this case, the base-case NPV based on final estimates and expectations
is negative, so Washington Football should reject the project.
Ifawhatifanalysisindicatesthattheamountofvaluecreatedwouldbenegative,butthe
basecaseNPVbasedonexpectationsispositive,thenpursuetheproject.Ifawhatif
analysisindicatesthattheamountofvaluecreatedwouldbepositive,butthebasecase
NPVbasedonexpectationsisnegative,thendonotpursuetheproject.
47

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FNAN 301/303

3) Find the expected tax rate

The cost is partially sunk in 1 year

3) Find the expected tax rate

So $40,000 = $700,000 total IT costs without the project

Note that the cost of capital is not relevant

OCF in year 2 + OCF in year 4 = 202,500 + 115,000 = 317,500

OCF = net income + depreciation

4) Find the expected tax rate

4) Find the expected tax rate

2) Find NWC at time 1

4) Find CF effect from NWC at time 1

1) Find NWC at time 0

2) Find NWC at time 1

3) Find NWC at time 1

4) Find NWC at time 2

npv(14.7,-1000000,{700000,750000}) 180,36633. Based on the following information,

30k 10k = 20k 30k =

Cash flows from capital spending

(Fall 2013, final, question 15)

(Fall 2014, final, question 15)

The initial investment is $470,000

NPV = -3,600,000 + [1,900,000/(1.15)1] + [1,900,000/(1.15)2] + [1,000,000/(1.15)3] = 146,363

NPV = -950,000 + (1,400,000 / 1.154) = 263,172

NPV = -7,800 + [3,100/(1.072)1] + [7,250/(1.072)2] = 1,400.62

NPV = -56,000 + [23,200/(1.143)1] + [62,200/(1.143)2] = 11,907

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