Brealey 5CE

Solutions to Chapter 9

A General Note: Many of the questions, for which solutions are provided below, require
only that the NPV or IRR or some other evaluation criterion be calculated. These
questions have not asked that you make a decision based on such criteria. In Chapter 7,
we discussed the decision rules when we use these criteria. For instance, a positive NPV
project should be accepted whereas a project with a negative NPV should be rejected.
These decision rules should generally be kept in mind while working on the solutions
below.

1. Net income = ($74 42 10) .35 ($74 42 10) = $22 $7.7 = $14.3 million

Revenues cash expenses taxes paid = $74 $42 $7.7 = $24.3 million
Net Profit + Deprec = $14.3 + $10 = $24.3 million
(Revenues cash expenses) (1 T) + T Deprec

= $32 .65 + .35 $10 = $24.3 million

2. a. NWC = Acct Receivable + Inventory Acct Payable

= $1,500 + $1,000 $2,000= $2,500

b. Cash flow = $36,000 $24,000 + $2,500 = $14,500

3. Net income = ($7 4 1) .40 ($7 4 1) = $2 $0.8 = $1.2 million

Revenues cash expenses taxes paid = $3 $0.8 = $2.2 million

Net Profit + Deprec = $1.2 + $1.0 = $2.2 million
(Revenues cash expenses) (1 T) + T Deprec
= $3 .60 + .40 $1 = $2.2 million

4. While depreciation is a non-cash expense, it still has an impact on net cash flow
because of its impact on taxes. Every dollar of depreciation reduces taxable income
by one dollar, and thus reduces taxes owed by $1 times the firms marginal tax rate.
In Canada, such tax savings can be generated by capital cost allowance (CCA)
which, for most assets, is computed using the written-down value method. CCA is
computed for asset classes rather than for individual assets. Also, in the first year of

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 the assets life, the half-year rule becomes applicable. The various unique features
of the declining balance CCA system make it quite different from straight-line
depreciation. Compared with straight-line depreciation, declining balance CCA will
move the tax benefits in time, and thus provide a different present value of the tax
shield, thereby altering the value of the project.

5. Gross revenues from new chip = 12 million $25 = $300 million

Cost of new chip = 12 million $8 = $96 million.

Lost sales of old chip = 7 million $20 = $140 million

Saved costs of old chip = 7 million $6 = $42 million.

Increase in cash flow = (300 96) (140 42) = $106 million

6. Revenue $160,000
Rental costs 35,000
Variable costs 45,000
Depreciation 10,000
Pretax profit 70,000
Taxes (35%) 24,500
Net income $45,500

7. a. Net Profit + Depreciation = $45,500 + $10,000 = $55,500

b. Revenue rental costs variable costs taxes

= $160,000 $35,000 $45,000 $24,500
= $55,500

c. (Revenue rental costs variable costs) (1.35) + .35 (Depreciation)

= ($160,000 $35,000 $45,000) .65 + .35 $10,000

= $52,000 + $3,500 = $55,500

8. Change in working capital = Accounts receivable Accounts payable

= ($4500 $1200) ($200 $600) = $3,700

Cash flow = $16,000 $9,000 $3,700 = $3,300

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9. Incremental cash flows are:

b. The cash that could have been realized by selling the art.

d. The reduction in taxes paid.

10. Capital investment: $1,000,000

CCAcalculation:
End of Year
Year UCC CCA (5%)
UCC
1 $1,000,000 $25,000 $975,000
2 975,000 48,750 926,250
3 926,250 46,313 879,937
4 879,937 43,997 835,940
5 835,940 41,797 794,143
6 794,143 39,707 754,436

Operating cash flows of the project for the next six years (figures in thousands of
dollars).

Year: 0 1 2 3 4 5 6
Capital Investment -1,000
Revenues 120 120 120 120 120 120
Operating Expenses:
Direct production
40 40 40 40 40 40
costs
Fixed maintenance 15 15 15 15 15
15
costs
Pre-tax Profits 65 65 65 65 65 65
Tax @35% 22.75 22.75 22.75 22.75 22.75 22.75
Operating Cash
Flow (excluding 42.25 42.25 42.25 42.25 42.25 42.25
CCA Tax Shield)
CCA Tax Shield
8.75 17.063 16.209 15.399 14.629 13.898
(CCA x 35%)
Total Cash Flow -1,000 51.000 59.313 58.459 57.649 56.879 56.148

11. a. CCA calculation for the first 3 years:

End of year
Year UCC CCA (30%)
UCC
1 $40,000 $6,000 $34,000
2 34,000 10,200 23,800
3 23,800 7,140 16,660

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 b. If the company has other assets in class 46 and the equipment is sold after 3
years, the adjusted cost of disposal is the sale price of $20,000. This amount is
then deducted from the UCC of asset class 46. If overall UCC remains
positive, we do not have to worry about CCA recapture. If, however, overall
UCC becomes negative, we consider CCA recapture. The firms after-tax
proceedsfrom the sale are $20,000 PV of CCA tax shield lost - (0.35 x
amount of CCA recapture, if applicable).

c. If no other assets exist in Class 46 and the equipment is sold after 3 years, the
adjusted cost of disposal is the sale price of $20,000. Subtracting this amount
from the UCC of asset class 46 ($16,660 - $20,000 = -$3,340), we arrive at a
negative balance, and thus recaptured depreciation. This amount is now added
back to taxable income and the UCC of the asset class becomes zero.

At the time of sale, the present value of tax shields lost as a result of the sale is
calculated as:

16,660 0.30 0.35 1 0.5r

=
r 0.30 1 r , where r is the cost of

capital.

The firms after-tax proceeds from the sale are thus $20,000 (0.35 x 3,340)
PV of tax shields lost = $18,831 PV of CCA tax shields lost.

12. a. If the office space would have remained unused in the absence of the proposed
project, then the incremental cash outflow from allocating the space to the
project is effectively zero. The incremental cost of the space used should be
based on the cash flow given up by allocating the space to this project rather
than some other use.

b. One reasonable approach would be to assess a cost to the space equal to the
rental income that the firm could earn if it allowed another firm to use the
space. This is the opportunity cost of the space.

13. Cash flow = Net income + depreciation increase in NWC

1.2 = 1.2 + .5 NWC
NWC = $0.5 million

14. Cash flow = profit increase in inventory

= $10,000 $1,000 = $9,000

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15. NWC2009 = $32 + $25 $12 = $45 million

NWC2010 = $35 + $30 $25 = $40 million

Net working capital has decreased by $5 million.

16. Depreciation per year = $40/5 = $8 million

Current Book value of old equipment = $40 (3 $8) = $16 million

Sales price = $18 million

After-tax cash flow = $18 .35 ($18 $16) = $17.3 million

17. CCA calculation for the new capital investment (figures in thousands of dollars):

End of year
Year UCC CCA (25%)
UCC
1 $10,000 $1,250 $8,750
2 8,750 2,188 6,562
3 6,562 1,641 4,922
4 4,922 1,231 3,691
5 3,691 923 2,768

Since the project ends after 5 years, and the equipment is sold, the adjusted cost of
disposal is $4 million, which is deducted from the UCC asset class, that is 2.768 4
= -$1.232 million. This results in a negative balance and recaptured depreciation.
The after-tax cash flow from the sale = $4 million (.35 x $1.232) PV of CCA
tax shield lost. This equals $3.569 million PV of tax shields lost.

18. a. The UCC increases by $6,000 to the extent of the purchase of the new washer
but decreases by $2,000 to the extent of sale of the old washer. The net effect is
an UCC increase of $4,000. CCA calculations are as follows:

End of year
Year UCC CCA (30%)
UCC
1 $ 4,000 $ 600 $ 3,400
2 3,400 1,020 2,380
3 2,380 714 1,666
4 1,666 500 1,166
5 1,166 350 816
6 816 245 571

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 All dollar values should be interpreted as incremental results from making the
purchase.

First, we calculate operating cash flows excluding CCA tax shields.

Year: 16
Earnings from Savings (before CCA) 1,500
Tax (40%) 600
Cash Flow from Operations (excluding CCA) $900

Now we consider the effect of the CCA tax shield on Bottoms Ups cash
flows.

Year: 0 1 2 3 4 5 6
Capital Investment -6,000
After-tax Cash Flow from
0 900 900 900 900 900 900
Operations (excl. CCA)
Cash Flow from Sale of Old
2000 0 0 0 0 0 0
Equipment
Total Cash Flow (excl. CCA) -4,000 900 900 900 900 900 900
CCA Tax Shield (CCA x .4) 0 240 408 286 200 140 98
Total Project Cash Flow -4,000 1,140 1,308 1,186 1,100 1,040 998

b. The project NPV is calculated in two phases. First, we compute the total
present value of cash flows excluding the CCA tax shield:
PV = -4,000 + 900 x annuity factor(15%, 6 years) = -$594.4.
Second, we calculate the present value of the CCA tax shield:

CdTc 1 0.5r SdTc 1

PV of CCA tax shield = , where S = 0
r d 1 r d r 1 r t

4000 0.3 0.4 1 0.5 0.15

= 0.15 0.3 1 0.15 0

= $997.10

NPV = Total PV excluding CCA tax shields + PV of CCA tax shield

= -$594.40 + $997.10 = $402.7

c. Using straight-line depreciation, net cash flow at time 0 remains -$4,000, but
the net cash flow at times 1 through 6 becomes $1,300, which is calculated as
follows:

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Earnings before depreciation $1,500
Depreciation (6000/6 years) 1,000
Taxable income 500
Taxes (0.40) 200
Net Income 300
+ Depreciation 1,000
Operating Cash Flow $1,300

NPV = -4,000 + 1,300 x annuity factor (15%, 6 years) = $919.83

IRR = 23.21%

19. If the firm uses straight-line depreciation, the present value of the cost of buying,
net of the annual depreciation tax shield (which equals .40 1000 = 400), is:

6000 400 annuity factor(15%, 6 years) = 4486.21

The equivalent annual cost, EAC, is therefore determined by:

EAC 6-year annuity factor = 4486.21
EAC 3.7845 = 4486.21
EAC = $1185.42

Note: this is the equivalent annual cost of the new washer, and does not include any
of the washers benefits.

20. a. The year-wise CCA for the new grill, over its expected life, is as follows:

End of year
Year UCC CCA (30%)
UCC
1 $20,000 $3,000 $17,000
2 17,000 5,100 11,900
3 11,900 3,570 8,330

Operating cash flow contribution, excluding tax shields, for year 1 through 3
= Saving in energy expenses x (1 - .35) = $10,000 x (1 - .35) = $6,500. Now,
we must consider the effect of the CCA tax shield on the projects yearly cash
flows.

Year: 1 2 3
Contribution from saving in
6,500 6,500 6,500
energy expenses
CCA Tax Shield (CCA x .35) 1,050 1,785 1,250
Total Operating Cash Flow 7,550 8,285 7,750

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 b. Total Cash Flow (0-3) = Operating CF + CF associated with investments.

At time 0, the CF from the investment is -$20,000. At the end of year 3, the
grill is sold for $5,000.

Therefore, total cash flows are:

Time Cash Flows ($)

0 -20,000
1 7,550
2 8,285
3 12,750 [=7,750 + 5,000]

c. First, we compute present value of cash flows excluding the CCA tax shield:
PV = -20,000 + 6,500 x annuity factor(12%, 3 years) + 5,000 x discount factor
(12%, 3 years) = -$829.3.
We next calculate the present value of the CCA tax shield:

PV of CCA tax shield:

CdTc 1 0.5r SdTc 1

=
r d 1 r d r 1 r t

20000 0.3 0.35 1 0.5 0.12 5000 0.3 0.35 1

= 0.12 0.3 1 0.12 0.3 0.12 1 0.12 3

= $3,842.41

NPV = Total PV excluding CCA tax shields + PV of CCA tax shield

= -$829.3 + $3, 842.41 = -$3,013.11

21. a. Initial investment = $50,000 + $8,000 for working capital (20% of 40,000)
= $58,000

b. CCA for the first 5 years of the plant and equipments life is as follows:

End of year
Year UCC CCA (25%)
UCC
1 $50,000 $6,250 $43,750
2 43,750 10,938 32,812
3 32,812 8,203 24,609

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 4 24,609 6,152 18,457
5 18,457 4,614 13,843

(Inthousandsofdollars)
Year: 0 1 2 3 4 5
Sales 40 30 20 10 0
Expenses 16 12 8 4 0
= Profit before tax 24 18 12 6 0
-tax @ 40% 9.6 7.2 4.8 2.4 0
= Operating Cash Flow
14.4 10.8 7.2 3.6 0
(excl. CCA tax shield)

For calculating project cash flows for each year, we will need to calculate the
tax savings generated from the CCA tax shield. We do this by multiplying
each years CCA by the firms tax rate (40% in this case).

(in thousands of dollars)

Year: 0 1 2 3 4 5
Capital investment -50.00
Initial investment in working
- 8.00
capital
Decrease in working capital
2.0 2.0 2.0 2.0
from previous year
Operating Cash Flow
14.4 10.8 7.2 3.6
(excluding CCA tax shield)
Total Cash Flow
- 58.00 16.4 12.8 9.2 5.6
(excluding CCA tax shield)
CCA tax shield (CCA x 0.40) 2.5 4.4 3.3 2.5
Total - 58.00 18.9 17.2 12.5 8.1

c. The project NPV is calculated in two phases. First, we calculate the present
value from cash flows excluding the CCA tax shield:

Year: 0 1 2 3 4
Total Cash Flow (excluding
(58) 16.40 12.80 9.20 5.60
CCA tax shield)
x Discount Factor (10%) 1.000 0.909 0.826 0.751 0.683
PV of total cash flow (excl.
(58) 14.91 10.57 6.91 3.83
CCA tax shield)*

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Total PV (excl. CCA tax
(21.78)
shield)

* Notice, you could also calculate this as follows, keeping in mind that there
could be some difference of result due to rounding errors.
16.4 12.8 9.2 5.6
58 2
3

1.1 (1.1) (1.1) (1.1) 4

We next calculate the present value of the CCA tax shield:

CdTc 1 0.5r SdTc 1

PV of CCA tax shield = , where S = 0
r d 1 r d r 1 r t

50000 0.25 0.4 1 0.5 0.10

= 0.10 0.25 1 0.10 0

= $13,636

NPV (in thousands of dollars) = Total PV excluding CCA tax shields + PV of

CCA tax shield

= -$21.78 + $13.64 = -$8.14

22. a. The present value of costs from buying is

$25,000 $5000/(1.10)5 = $21,895

The cost of leasing (assuming that lease payments come at the end of each
year) is

$5,000 annuity factor(10%, 5 years) = $18,954

Leasing is less expensive.

b. The maximum lease payment, L, would be chosen so that

L annuity factor(10%, 5 years) = $21,895
L = $5,776

23. The initial investment is $100,000 for the copier + $10,000 in working capital, for a
total outlay of $110,000.

Depreciation expense each year = ($100,000 $20,000)/5 = $16,000

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 The project saves $20,000 in annual labour costs, so its net operating cash flow
including the depreciation tax shield is:

$20,000 (1 .35) + .35 $16,000 = $18,600

In year 5, the copier is sold for $30,000, which generates net-of-tax proceeds of

$30,000 .35 $10,000 = $26,500

Note: tax is calculated on $10,000 which is the difference between the sale price of
$30,000 and current book value of $20,000

In addition, the working capital associated with the project is freed up, which releases
another $10,000 of cash. So non-operating cash flow in year 5 totals $36,500.

The NPV is thus

NPV = 110,000 + 18,600 annuity factor(8%, 5 years) + 36,500/(1.08)5

= 110,000 + 99,106 = $10,894

Because NPV is negative, Kinkys should not buy the new copier.

24.
Year: 0 1 2 3 4 5
Sales revenue 33,000 38,500 44,000 55,000 55,000
Less: cost 19,500 22,750 26,000 32,500 32,500
Profit before tax 13,500 15,750 18,000 22,500 22,500
Tax (35 percent) 4,725 5,513 6,300 7,875 7,875
Cash flow from
operations 8,775 10,237 11,700 14,625 14,625
(excluding CCA) (A)
Net working capital
6,600 7,700 8,800 11,000 11,000 0
requirement
Investment in net
6,600 1,100 1,100 2,200 0 -11,000
working capital
Investment in plant and
25,000
equipment
Investment cash flow (B) 31,600 1,100 1,100 2,200 0 -11,000
Total cash flow
-31,600 7,675 9,137 9,500 14,625 25,625
(excluding CCA)(A B)
Present value of total 7,675 9,137 9,500 14,625 25,625
cash flow (excluding -31,600 (1.15) 2 (1.15) 3 (1.15) 4 (1.15) 5
(1.15)
CCA)
Present value (excluding -31,600 6,674 6,909 6,246 8,362 12,740

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CCA)
= 9,331

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 Present value of CCA Tax Shield (PVTS), given a zero salvage value:

25,000 0.15 0.35 1 (0.5 0.15)

0.15 0.15 1 0.15

= $4,090

NPV = $9,331 + $4,090 = $13,421

25. Find the equivalent annual cost of each alternative.

Quick and Dirty Do-It-Right

Operating Cost $ 1 million $ 1 million
Investment $ 10 million $ 12 million
Project Life 5 years 8 years
PV CCA tax shield $ 2.37 million $ 2.84 million
Net Capital Cost * $ 7.63 million $ 9.16 million
EAC of Net Capital $2.12 million $1.84 million
Cost **

Computation:

PV of CCA tax shield for Quick and Dirty:

10 0.3 0.35 1 (0.5 0.12)

0.12 0.3 1 0.12

1.05 1.06
2.37
0.42 1.12

PV of CCA tax shield for Do-It Right:

12 0.3 0.35 1 (0.5 0.12)

0.12 0.3 1 0.12
1.26 1.06
2.84
0.42 1.12

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 EAC for Quick and Dirty:

$7.63m = Annuity (3.605)

7.63
Annuity = $2.12 m
3.605

EAC for Do-It-Right:

$9.16m = Annuity (4.968)

9.16
Annuity = $1.84m
4.968

Since the operating costs are the same, the project with the lower EAC is cheaper.
This is Do-It-Right.

* Investment PV of CCA tax shield

** Annuity discounted at 12%; number of years = project life

26.
All figures in thousands of dollars
0 1 2 3 4
Net working capital $220 $300 $140 $ 50 $0

Investment in NWC 220 80 160 90 50

Investment in Plant & eq 200 0 0 0 0
Cash flow from $420 $ 80 +$160 +$ 90 +$ 50
investment activity (A)

All figures in thousands of dollars

0 1 2 3 4

Revenue $880 $1200 $560 $200

Cost 550 750 350 125
Pretax profit (excluding CCA) 330.00 450.00 210.00 75.00
Taxes (35%) 115.50 157.50 73.50 26.25
Operating cash flow $214.50 $292.50 $136.50 $ 48.75
(excluding CCA tax shield) (B)

Total CF $420 $134.50 $452.50 $226.50 $98.75

(excluding CCA tax shield) (A+B)

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Present Value of CCA Tax Shield (PVTS):

200 0.25 0.35 1 (0.5 0.20)

0.20 0.25 1 .20

17.5 1.1
$35.65
0.45 1.2

NPV (in thousands of dollars):

= PVTS + PV TOTAL CF (excluding CCA tax shield)

134.5 452.5 226.5 98.75

= 35.65 420
1.2 (1.2) 2 (1.2) 3 (1.2) 4

= 35.65 420 + 112.08 + 314.24 + 131.08 + 47.62

= $ 220.67

27. All figures are on an incremental basis

Labour savings $125,000

Cost to run lathe 35,000
Net Savings (excluding CCA) 90,000
Taxes (35%) 31,500
After tax savings (excluding CCA) $58,500

PV of CCA tax shield (PVTS):

=
1,000,000 0.25 0.35 1 (0.5 0.10) 100,000 0.25 0.35 1
10
0.10 0.25 1 0.10 0.25 0.10 (1 0.10)

87,500 1.05 8,750

= 0.3855
0.35 1.10 0.35

= 238,636.36 9,637.50

= $ 228,998.86

NPV = 1,000,000 + 228,998.86 + 58,500 annuity factor (10%, 10 years)

+ 100,000/(1.10)10
= -$372,987.71

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28.

You can access information on CCA asset classes and rates on commonly used assets by
going to the following link on Revenue Canadas website:

http://www.cra-arc.gc.ca/tx/bsnss/tpcs/slprtnr/rprtng/cptl/clsss-eng.html

As of October 30, 2010 this site has a table with 15 listed asset classes. The minimum
eligible CCA rate is 4 percent and the maximum eligible rate is 100 percent. Thirteen of
the 15 asset classes have declining balance CCA rates while asset Class 13 (leasehold
interest) and asset Class 14 (patents, franchises, concessions or licenses for a limited
period) involve straight-line computations. Notice that these classes include assets for
which the cost to a business may not be a onetime initial outlay but rather a fixed
recurring periodic cost over their economic life (such as, on leasehold interests). The
CCA on such items is also computed as a fixed charge on a straight line basis.

29.
Rogers Communication ($ million)

2009 2008 2007

Net capital expenditure. 1,015 2,025 1,023
Net Capital Expenditure to sales 8.7 % 17.9 % 10.1 %
Sales & net capital expenditure to total assets 74.9 % 78.2 % 72.7 %
Change in non-cash working capital items related to PP&E (55) 40 (20)

Note: Calculations were done as follows:

Capital expenditure = change in gross Physical Plant &Equipment (PP&E) from year to year.
For example, capital expenditure for 2007 = PP&E for 2007 minus PP&E for 2006.
Net capital expenditure (net Cap.Expd.) = capital expenditure after tax sales of fixed assets.

30. If the savings are permanent, it is worth $250,000 to the firm. It can take $250,000
out of the project now without ever having to replace it. So the most the firm should
be willing to pay is $250,000.

31.ProjectEvaluation
Assumptions
Plant and Equipment 100,000.00
Start up cost before tax 25,000.00
Start up cost after tax 16,500.00
# of years 5
Sales revenue year 1 60,000.00
Growth in sales: 1-4 5%
Year 5 -5%
Depreciation 20,000.00
Operating Exp 10,000.00

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Tax rate 34%
Cost of capital 12%
1 2 3 4 5
Sales 60,000.00 63,000.00 66,150.00 69,457.50 65,984.63
Operating cost - 10,000.00 - 10,500.00 - 11,025.00 - 11,576.25 - 10,997.44
Operating cash flow before tax 50,000.00 52,500.00 55,125.00 57,881.25 54,987.19
Taxes - 17,000.00 - 17,850.00 - 18,742.50 - 19,679.63 - 18,695.64
Operating cash flow (after tax) 33,000.00 34,650.00 36,382.50 38,201.63 36,291.54
Depreciation tax shield 6,800.00 6,800.00 6,800.00 6,800.00 6,800.00
Salvage value
Total Cash Flow 39,800.00 41,450.00 43,182.50 45,001.63 43,091.55

(a)
i) Note: Cash flow at year 0 includes initial investment after tax [100,000+ (25,000 *(1-.34)]
Cumulative cash
Year Cash flow flow
0 - 116,500.00 - 116,500.00
1 39,800.00 -76,700.00
2 41,450.00 -35,250.00
3 43,182.50 7,932.50
4 45,001.63 52,934.13
5 43,091.55 96,025.68
Payback Period = 35,250.00
2
43,182.50
= 2.82 years

Discount Payback
Discount Factor PV of cash flow Cumulative
Year Cash flow (12%) 12 % cash flow
0 - 116,500.00 1.000 - 116,500.00 - 116,500.00
1 39,800.00 0.893 35,541.40 - 80,958.60
2 41,450.00 0.797 33,035.65 - 47,922.95
3 43,182.50 0.712 30,745.94 -17,177.01
4 45,001.63 0.636 28,621.03 11,444.02
5 43,091.55 0.567 24,432.91 35,876.93

Discounted Payback period = 3 17,177.01

28,621.03
= 3.6 years

NPV = $35,876.93

IRR = 23.57 %

Profitability Index = 35,876.93 0.31
116,500

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b). Using NPV and IRR decision rule the project should accepted. It has a positive
NPV of $35,876.93 and an IRR of 23.57 % which is higher that the cost of capital
rate.

(c) i)
CdTc 1 0.5r SdTc 1
PV tax shield with zero salvage value = , where S = 0
r d 1 r d r 1 r t
100,000 0.25 0.34 1 (0.5 0.12)

0.12 0.25 1 0.12
8,500 1.06
$21,742.28
0.37 1.12

NPV including CCA tax shield = $35,876.93 + $21,742.48 = $57,619.21

(ii)

1 2 3 4 5
Sales 60,000.00 63,000.00 66,150.00 69,457.50 65,984.63
Operating cost - 10,000.00 - 10,500.00 - 11,025.00 - 11,576.25 - 10,997.44
Operating cash flow before tax 50,000.00 52,500.00 55,125.00 57,881.25 54,987.19
Taxes - 17,000.00 - 17,850.00 - 18,742.50 - 19,679.63 - 18,695.64
Operating cash flow (after tax) 33,000.00 34,650.00 36,382.50 38,201.63 36,291.55
Depreciation tax shield 6,800.00 6,800.00 6,800.00 6,800.00 6,800.00
Salvage value 10,000.00
Total Cash Flow 39,800.00 41,450.00 43,182.50 45,001.63 53,091.55

Cumulative cash
Year Cash flow Discount Factor (12%) PV of cash flow 12 % flow
0 - 116,500.00 1.000 - 116,500.00 - 116,500.00
1 39,800.00 0.893 35,541.40 - 80,958.60
2 41,450.00 0.797 33,035.65 -47,922.95
3 43,182.50 0.712 30,745.94 -17,177.01
4 45,001.63 0.636 28,621.03 11,444.02
5 53,091.55 0.567 30,102.91 41,546.93
NPV 41,546.93

CdTc 1 0.5r SdTc 1

PV of CCA tax shield with salvage value =
r d 1 r d r 1 r t

=
100,000 0.25 0.34 1 (0.5 0.12) 10,000 0.25 0.34 1
5
0.12 0.25 1 0.12 0.25 0.12 (1 0.12)

= $20,438.73

NPV including CCA tax shield = $41,546.93 + $20,438.73 = $61,985.66

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32. All cash flows are in millions of dollars. Sales price of machinery in year 5 is
shown on an after-tax basis in year 5 as a positive cash flow on the capital
investment line.

Cash flow calculations are as follows:

YEAR: 0 1 2 3 4 5
Sales (traps) 0.00 0.50 0.60 1.00 1.00 0.60
Revenue 0.00 2.00 2.40 4.00 4.00 2.40
Working capital 0.20 0.24 0.40 0.40 0.24 0.00
Change in Wk Cap 0.20 0.04 0.16 0.00 0.16 0.24

Revenue 0.00 2.0000 2.400 4.000 4.000 2.400

Expense 0.00 0.7500 0.900 1.500 1.500 0.900
Depreciation 0.00 1.2000 1.200 1.200 1.200 1.200
Pretax profit 0.00 0.0500 0.300 1.300 1.300 0.300
Tax 0.00 0.0175 0.105 0.455 0.455 0.105
After-tax profit 0.00 0.0325 0.195 0.845 0.845 0.195
CF from operations 0.00 1.2325 1.3950 2.0450 2.0450 1.3950

Cash flow
CF: capital investments 6.00 0.0000 0.0000 0.0000 0.0000 0.3250
CF from wk cap 0.20 0.0400 0.1600 0.0000 0.1600 0.2400
CF from operations 0.00 1.2325 1.3950 2.0450 2.0450 1.3950
Total 6.20 1.1925 1.2350 2.0450 2.2050 1.9600
PV @ 12% 6.20 1.0647 0.9845 1.4556 1.4013 1.1122

Net present value 0.1817

33. If working capital requirements were only one-half of those in the previous problem,
then the working capital cash flow forecasts would change as follows:

Year 0 1 2 3 4 5
Original forecast .20 .04 .16 0.0 .16 .24
Revised forecast .10 .02 .08 0.0 .08 .12
Change in cash flow +.10 +.02 +.08 0.0 .08 .12

The PV of the change in the cash flow stream at a discount rate of 12% is $.0627
million.

34. a. Annual depreciation is (115 15)/5 = $20 million.

Book value at the time of sale is $115 (2 $20) = $75 million

Sales price = $80 million, so net-of-tax proceeds from the sale are:

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 $80 (.35 $5) = $78.25 million

Therefore, the net cash outlay at time 0 is $150 $78.25 = $71.75 million

b. The project saves $10 million in expenses, and increases sales by $25 million.
The new machine would entail depreciation of $50 million per year. Therefore,
including the depreciation tax shield, operating cash flow increases by

$35 (1 .35) + .35 $50 = $40.25 million per year

c. NPV = 71.75 + 40.25 annuity factor(12%, 3 years) = $24.92 million.

To find IRR, set the PV of the annuity to $71.75 and solve for the discount rate
to find that IRR = 31.33%.

d. All figures in $ millions

After-tax annual operating cash flows:
$35 (1 0.35) = $ 22.75 million

PV of after-tax operating cash flows:

$35 (1 0.35) annuity factor (12%, 3) = $54.64

Net cash outlay at time 0:

$150 $80 = $70 million

PV of net salvage value of new modem pool:

1
($30 $15) $10.68
(1.12) 3

PV of CCA tax shield:

70 0.3 0.35 1 (0.5 0.12) 15 0.3 0.35 1

0.12 0.3 (1.12) 3
0.12 0.3 1 0.12

7.35 1.06 1.575 1

0.42 1.12 0.42 1.404928

16.56 2.67 $13.89

NPV 70 54.64 10.68 13.89 $9.21 million

35. Project evaluation

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Note: 1. The 1-year feasibility study is a sunk cost and should not be considered.

2. Price/volume increase factor = (1+ inflation)*(1+ unit sales increase)

= (1.015)*(1.04)= 1.0556
For example to find sale revenue in year 2, we multiply year 1 revenue by the
price/volume factor.

T1 T2 T3 T4 T5 T6
Sales Revenue 255,000 269,178 284,144 299,942 316,619 334,223
Less:
Variable cost 16,000 16,889.6 17,828.7 18,819.9 19,866.3 20,970.9
Fixed cost 40,000 40,000 40,000 40,000 40,000 40,000

EBIT 199,000 212,288.4 226,315.3 241,122.1 256,758.7 273,252.1

Less: Taxes35 % 69,650 74,300.9 79,210.4 84,392.7 89,865.5 95,638.2

Net Income 129,350 137,987.5 147,104.9 156,729.4 166,893.2 177,613.9

T0 T1 T2 T3 T4 T5 T6
Net Working Capital 40,000 44,000 48,400 53,240 58,564 64,420 70,862

Change in NWC 4,000 4,400 4,840 5,324 5,856 6,442

T0 T1 T2 T3 T4 T5 T6
Investment: Land 150,000
Building 350,000
Equipment 250,000
Net working Capital 40,000
(790,000)
NWC (4,000) (4,400) (4,840) (5,324) (5,856) (6,442)
Net Income (Excluding
CCA tax shield) 129,350 137,987.5 147,104.9 156,729.4 166,893.2 177,613.9
Salvage Value: Building 300,000
Equipment 125,000

T0 T1 T2 T3 T4 T5 T6
Total Cash flow
(excluding CCA tax shield) (790,000) 125,350 133,587.5 142,264.9 151,405.4 161,037.2 596,171.9

Discount Factor (12%) 1.000 .8929 .7972 .7118 .6355 .5674 .5066
PV excluding CCA tax
shield (790,000) 111,925 106,495.9 101,264.1 96,218.13 91,372.5 302,020.7
Total PV (excluding
CCA tax shields) 19,296.33

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PV of CCA tax shield:
Building =
350,000 0.04 0.35 1 (0.5 0.12) 300,000 0.04 0.35 1
6
0.12 0.04 1 0.12 0.12 .04 (1 0.12)

4,900 1.06 4,200

= 0.50663
0.16 1.12 0.16
= $15,685.34

Manufacturing Equipment

250,000 0.25 0.35 1 (0.5 0.12) 125,000 0.25 0.35 1

= 6
0.12 0.25 1 0.12 0.25 0.12 (1 0.12)

21,875 1.06 10,937.5

= 0.50663
0.37 1.12 0.37
= (59,121.62 x .94643) 14,976.39
= $ 40,978.08

NPV = 19,296.33 + 15,685.34 + 40,978.08

= $ 75,959.75
Since the project has a positive net present value we should go ahead with it.

36.
Assumptions
Plant and Equipment 160,000.00
Building 40,000.00
Number useful life (yrs) 8
Sales revenue year 1 60,000.00
Growth in sales: 1-3 0
Growth in sales: 4-6 10 %
Growth in sales: 6-8 -5%
Depreciation P&E 20,000.00
Building 5,000.00
Operating Exp 15,000.00
Tax rate 34%
Cost of capital 12%

1 2 3 4 5 6 7 8
Sales 60,000 60,000 60,000 66,000 72,600 79,860 75,867 72,074
Operating cost -15,000 - 15,000 -15,000 -16,500 -18,150 -19,965 -18,967 -18,018
Operating cash flow
before tax 45,000 45,000 45,000 49,500 54,450 59,895 56,900 54,055
Taxes -15,300 - 15,300 -15,300 -16,830 -18,513 -20,364 -19,346 -18,379
Operating cash flow
(after tax) 29,700 29,700 29,700 32,670 35,937 39,531 37,554 35,676

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Dep. tax shield: P&E 6,800 6,800 6,800 6,800 6,800 6,800 6,800 6,800
Building 1,700 1,700 1,700 1,700 1,700 1,700 1,700 1,700
Total Cash Flow 38,200 38,200 38,200 41,170 44,437 48,031 46,054 44,176

(a)
Years Cash flow Discount Factor (12%) PV of CF (12 %) Cumulative cash flow
0 - 200,000.00 1.00000 - 200,000.00 - 200,000.00
1 38,200.00 0.89286 34,107.14 - 165,892.86
2 38,200.00 0.79719 30,452.81 - 135,440.05
3 38,200.00 0.71178 27,190.01 - 108,250.04
4 41,170.00 0.63552 26,164.28 - 82,085.76
5 44,437.00 0.56743 25,214.75 - 56,871.01
6 48,030.70 0.50663 24,333.85 - 32,537.16
7 46,054.17 0.45235 20,832.57 - 11,704.59
8 44,176.46 0.40388 17,842.13 6,137.54
NPV 6,137.54

Based on the positive NPV Virtual Printing should accept the finance managers
recommendations.
(b) The technique used in part (a) is the net present value decision rule. Accordingly,
accept projects with positive NPV because the total present value of future cash flows is
greater than the initial cost.

(c)i)
Years Cash flow Cumulative cash flow
0 - 200,000.00 - 200,000.00
1 38,200.00 - 161,800.00
2 38,200.00 - 123,600.00
3 38,200.00 - 85,400.00
4 41,170.00 - 44,230.00
5 44,437.00 207.00
6 48,030.70 48,237.70
7 46,054.17 94,291.87
8 44,176.46 138,468.33
Payback period = 4 + (44,203/44437) = 4.995 years

(ii)
11,704.59
Discounted payback = 7 7.66 years
17,842.13
Advantage for payback period It is relatively easy to use.
Disadvantage for payback period Does not take into consideration the time value of
money. This method also ignores cash flows beyond the payback period.

Advantage of discounted payback- this method considers time value of money, unlike
payback period. Also, if the projects meet the cutoff, it must have a positive NPV.

Disadvantage of discounted payback It does not consider cash flows beyond the
payback period and therefore, it may incorrectly reject positive NPV projects. Also, it is

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not easier to use than NPV rule because both projected cash flow and discount rate must
be determined.

(d) IRR = 12.84

(e)

Discount Factor PV of cash flow Cumulative cash

Years Cash flow (12%) (12% ) flow
0 - 200,000.00 1.000 - 200,000.00 - 200,000.00
1 38,200.00 0.89286 34,107.14 - 165,892.86
2 38,200.00 0.79719 30,452.81 - 135,440.05
3 38,200.00 0.71178 27,190.01 - 108,250.04
4 41,170.00 0.63552 26,164.28 - 82,085.76
5 44,437.00 0.56743 25,214.75 - 56,871.01
6 48,030.70 0.50663 24,333.85 - 32,537.16
7 46,054.17 0.45235 20,832.57 - 11,704.59
8 54,176.46 0.40388 21,880.96 10,176.37
10,176.37

CdTc 1 0.5r SdTc 1

PV tax shield Building = , where S = 0
r d 1 r d r 1 r t
10,000 0.04 0.34 1 (0.5 0.12)

0.12 0.04 1 0.12
= $804.46

CdTc 1 0.5r SdTc 1

PV tax shield P&E with salvage value =
rd 1 r d r 1 r t

160,000 0.25 0.34 1 (0.5 0.12) 10,000 0.25 0.34 1

= 8
0.12 0.25 1 0.12 0.25 0.12 (1 0.12)

= 34,787.64 927.72 = $33,859.92

PV tax shield building = $804.46

Total NPV with salvage value = 33,859.92 + 804.46+ 10,176.37 = $ 44,840.75

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Solution to Minicase for Chapter 9

The spreadsheet on the next page shows the cash flows associated with the project. Lines
1 11 match the data given in Table 9.11 except for the substitution of CCA. Line 8,
capital investment, shows the initial investment of $1.5 million in refurbishing the plant
and buying the new machinery.

When the project is shut down after 5 years, the machinery and plant will be worthless.
But they will not be fully depreciated and will continue to generate CCA tax shields
assuming that Sheetbend has other assets in the respective asset classes. The present
value of the CCA tax shields on the refurbished plant and new machinery are entered in
lines 14 and 15, respectively.

The working capital requirement is 10 percent of sales, or $300,000. This means, the
investment in working capital (line 9) initially is $300,000, but in Year 5, when the
project is shut down, the investment in working capital is recouped.

If the project goes ahead, the land cannot be sold until the end of year 5. If the land is
sold for $600,000 (as Mr. Tar assumes it can be), the taxable gain on the sale is .5 x
$590,000 = $295,000, since the land is carried on the books at $10,000. Therefore, the
cash flow from the sale of the land, net of tax at 35%, is $496750.

The net present value of the project, which accounts for the present value of the total cash
flows (Line 13) and the present value for CCA tax shield of the refurbished plant (Line
14) and the new machinery (Line 15), at a 12% discount rate, is $683,480 (Line 16).

If the land can be sold for $1.5 million immediately, the after-tax proceeds will be

1,500,000 .35 x .5(1,500,000 10,000) = $1,239,250

So it appears that immediate sale is the better option.

However, Mr. Tar may want to reconsider the estimate of the selling price of the land in 5
years. If it can be sold today for $1,500,000 and the inflation rate is 4%, then perhaps it
makes more sense to assume it can be sold in 5 years for 1,500,000 1.045 = $1,824,979.
In that case, the forecasted after-tax proceeds of the sale of the land in 5 years rises to
$1,507,357, which is $1,010,607 higher than the original estimate of $496,750; the
present value of the proceeds from the sale of the land increases by $1,010,607/1.125 =
$573,445. Therefore, under this assumption, the present value of the project increases
from the original estimate of $683,480 to a new value of $1,256,925 and in this case the
project is more valuable than the proceeds from selling the land immediately. The extent
to which the project is now more valuable is $1,256,925 $1,239,250 = $17,675.

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Dollarfiguresinthousands,exceptpriceperyard.
Year 0 1 2 3 4 5
1. Yards sold 100.00 100.00 100.00 100.00 100.00
2. Price per yard 30.00 30.00 30.00 30.00 30.00
3. Revenue 3000.00 3000.00 3000.00 3000.00 3000.00
4. Cost of goods sold 2100.00 2184.00 2271.36 2362.21 2456.70
5. Operating cash flow (excluding CCA) 900.00 816.00 728.64 637.79 543.30
6. Tax at 35% 315.00 285.60 255.02 223.23 190.16
7. Cash flow from operations after-tax (excluding 585.00 530.40 473.62 414.56 353.14
CCA)
8. Capital investment 1500.00
9. Investment in working capital 300.00 300.00
10. Sale of land (after tax) 496.75
11. Total cash flow 1800.00 585.00 530.40 473.62 414.56 1149.89
12. PV of total cash flow (excluding CCA) 1800.00 522.32 422.83 337.11 263.45 652.45
13. Total present value of the cash flows (excluding 398.16
CCA) (A)
14. PV of CCA tax shield on refurbished plant1 (B) 48.71
15. PV of CCA tax shield of new machinery1 (C) 236.61
16. Net present value (A) + (B) + (C) 683.48

1. The calculations for the CCA tax shields are as follows:

PV of the CCA tax shield on the refurbished plant:

CdTc 1 0.5r SdTc 1

= , where S = 0
r d 1 r d r 1 r t

500000 0.05 0.35 1 (0.5 0.12)

0.12 0.05 1 0.12

8750 1.06
$48,713.24
0.17 1.12

PV of the CCA tax shield of the new machinery:

1000000 0.30 0.35 1 (0.5 0.12)

0.12 0.30 1 0.12

105000 1.06
$236,607.14
0.42 1.12

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(We compare the NPV of the project to the value of an immediate sale of the land. This
treats the problem as two competing mutually exclusive investments: sell the land now
versus pursue the project. The investment with higher NPV is selected. Alternatively, we
could treat the after-tax cash flow that can be realized from the sale of the land as an
opportunity cost at time 0 if the project is pursued. In that case, the NPV of the project
would be reduced by the initial cash flow given up by not selling the land. Under this
approach, the decision rule is to pursue the project if NPV is positive, accounting for that
opportunity cost. This approach would result in the same decision as the one we have
presented.)

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