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12-1 a. Cash flow, which is the relevant financial variable, represents the
actual flow of cash. Accounting income, on the other hand, reports
accounting data as defined by Generally Accepted Accounting
Principles (GAAP).
b. Incremental cash flows are those cash flows that arise solely from
the asset that is being evaluated. For example, assume an existing
machine generates revenues of $1,000 per year and expenses of $600
per year. A machine being considered as a replacement would generate
revenues of $1,000 per year and expenses of $400 per year. On an
incremental basis, the new machine would not increase revenues at
all, but would decrease expenses by $200 per year. Thus, the annual
incremental cash flow is a before-tax savings of $200. A sunk cost
is one that has already occurred and is not affected by the capital
project decision. Sunk costs are not relevant to capital budgeting
decisions. Within the context of this chapter, an opportunity cost
is a cash flow which a firm must forgo to accept a project. For
example, if the project requires the use of a building which could
otherwise be sold, the market value of the building is an opportunity
cost of the project.
d. Salvage value is the market value of an asset after its useful life.
Salvage values and their tax effects must be included in project cash
flow estimation.
The Dryden Press items and derived items copyright © 1999 by The Dryden Press Answers and Solutions: 12 - 1
would be replicated 5 times and the 5-year project replicated 3
times; thus, both projects would terminate in 15 years.
i. The real rate of return (k r), or, for that matter the real cost of
capital, contains no adjustment for expected inflation. If net cash
flows from a project do not include inflation adjustments, then the
cash flows should be discounted at the real cost of capital. In a
similar manner, the IRR resulting from real net cash flows should be
compared with the real cost of capital. Conversely, the nominal rate
of return (kn) does include an inflation adjustment (premium). Thus
if nominal rates of return are used in the capital budgeting process,
the net cash flows must also be nominal.
12-2 Only cash can be spent or reinvested, and since accounting profits do
not represent cash, they are of less fundamental importance than cash
flows for investment analysis. Recall that in the stock valuation
chapters we focused on dividends and free cash flows, which represent
cash flows, rather than on earnings per share, which represent
accounting profits.
12-3 Since the cost of capital includes a premium for expected inflation,
failure to adjust cash flows means that the denominator, but not the
numerator, rises with inflation, and this lowers the calculated NPV.
Answers and Solutions: 12 - 2 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
12-4 Generally, the failure to employ common life analysis in such situations
will bias the NPV against the shorter project because it "gets no
credit" for profits beyond its initial life, even though it could
possibly be "renewed" and thus provide additional NPV.
12-5 a. Because the firm has depreciated the asset to a book value which is
less than its salvage value; that is, the firm has taken excess
depreciation. Thus, the firm must declare this excess as income and
pay ordinary taxes on it. This is called "recapture of
depreciation."
CF = (R - C)(1 - T) + TD.
12-6 Capital budgeting analysis should only include those cash flows which will be
affected by the decision. Sunk costs are unrecoverable and cannot be changed, so
they have no bearing on the capital budgeting decision. Opportunity costs
represent the cash flows the firm gives up by investing in this project rather than its
next best alternative, and externalities are the cash flows (both positive and
negative) to other projects that result from the firm taking on this project. These
cash flows occur only because the firm took on the capital budgeting project;
therefore, they must be included in the analysis.
The Dryden Press items and derived items copyright © 1999 by The Dryden Press Answers and Solutions: 12 - 3
12-7 When a firm takes on a new capital budgeting project, it typically must
increase its investment in receivables and inventories, over and above
the increase in payables and accruals, thus increasing its net working
capital. Since this increase must be financed, it is included as an
outflow in Year 0 of the analysis. At the end of the project’s life,
inventories are depleted and receivables are collected. Thus, there is
a decrease in NWC, which is treated as an inflow in the final year of
the project’s life.
Answers and Solutions: 12 - 4 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
0 10% 1 2 10
├───────────┼───────────┼────── ··· ─────┤
-40,000 9,000 9,000 9,000
With a financial calculator, input the appropriate cash flows into the cash flow
register, input I = 10, and then solve for NPV = $15,301.
12-5 1. Net investment at t = 0:
2. After-tax
Year Earnings T(ΔDep) Annual CFt
1 $16,200 $ 6,600 $22,800
2 16,200 10,560 26,760
3 16,200 6,270 22,470
4 16,200 3,960 20,160
5 16,200 3,630 19,830
6 16,200 1,980 18,180
7 16,200 0 16,200
8 16,200 0 16,200
Notes:
Dep Dep
Year Rate Basis Depreciation
1 0.20 $82,500 $16,500
2 0.32 82,500 26,400
3 0.19 82,500 15,675
4 0.12 82,500 9,900
5 0.11 82,500 9,075
6 0.06 82,500 4,950
7-8 0.00 82,500 0
0 12% 1 2 3 4 5 6 7 8
├──────┼──────┼──────┼──────┼──────┼──────┼──────┼──────┤
-82,500 22,800 26,760 22,470 20,160 19,830 18,180 16,200 16,200
With a financial calculator, input the appropriate cash flows into the cash flow
register, input I = 12, and then solve for NPV = $22,329.
The NPV of the investment is positive; therefore, the new machine should be
bought.
12-6 Plane A: Expected life = 5 years; Cost = $100 million; NCF = $30 million; COC =
12%.
Plane B: Expected life = 10 years; Cost = $132 million; NCF = $25 million; COC =
12%.
0 12% 1 2 3 4 5 6 7 8 9 10
A: ├─────┼─────┼─────┼─────┼─────┼─────┼─────┼─────┼─────┼─────┤
-100 30 30 30 30 30 30 30 30 30 30
-100
-70
Install
Enter these values into the cash flow register: CF 0 = -100; Equation
CF1-4 = 30;Editor
CF5 =and double-
-70; CF6-
10 = 30. Then enter I = 12, and press the NPV key to get
click here to view equation.
0 12% 1 2 3 4 5 6 7 8 9 10
B: ├─────┼─────┼─────┼─────┼─────┼─────┼─────┼─────┼─────┼─────┤
-132 25 25 25 25 25 25 25 25 25 25
Enter these cash flows into the cash flow register, along with the interest rate, and
press the NPV key to get NPV B = 9.256 $9.26 million.
Project A is the better project and will increase the company's value by $12.76
million.
12-7 0 10% 1 2 3 4 5 6 7 8
A: ├─────┼─────┼─────┼─────┼─────┼─────┼─────┼─────┤
-10 4 4 4 4 4 4 4 4
-10
-6
0 10% 1 2 3 4 5 6 7 8
B: ├─────┼─────┼─────┼─────┼─────┼─────┼─────┼─────┤
-15 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5
Enter these cash flows into the cash flow register, along with the
interest rate, and press the NPV key to get NPV B = $3.672 $3.67
million.
Machine A is the better project and will increase the company's value
by $4.51 million.
The problem could also be worked using the equivalent annual annuity
method (EAA); using a calculator, we find EAA A as follows: N = 4, I =
10, PV = -2.679, FV = 0, and then solve for PMT = $0.845 million. We
find EAAB as Install Equation Editor
follows: N = and8, double-
I = 10, PV = -3.672, FV = 0, and then
solve for click here to view equation. million. Thus, the EAA approach
results in the same decision. Machine A should be chosen since it has
the higher EAA.
Price ($108,000)
Modification (12,500)
Increase in NWC (5,500)
Cash outlay for new machine ($126,000)
Notes:
PV @ 10% = $674,311
Install Equation
With Editor and double-
a financial calculator,Install Equationthe
input Editorfollowing:
and double- CF 0 = 0,
click here to view equation. = 0, click here to view equation. = 1360000, CF3
Install680000,
= Equation Editor
CF4and double-
= 340000, Install
CF5Equation
= Editor and double-
-170000, CF6 = -510000,
click here to view equation. = 4, click here to view equation. = -680000, CF11
= 510000, and I = 10 to solve for NPV = $674,310.51.
Therefore, the value of the firm would increase by $674,311, each
year, if it elected to use standard MACRS depreciation rates.
Price ($70,000)
Modification (15,000)
Change in NWC (4,000)
_______
($89,000)
b. The operating cash flows follow:
*
Tax on SV = ($30,000 - $5,950)(0.4) = $9,620.
Price ($150,000)
SV (old machine) 65,000
Tax effect (3,400)
________
Initial outlay ($ 88,400)
d.
0 15% 1 2 3 4 5
├────────┼────────┼────────┼────────┼────────┤
(88,400) 46,770 52,890 37,590 33,510 29,940
(10,000)
______
19,940
Enter cash flows into cash flow register, I = 15, and then solve for
NPV = $46,051.19 $46,051.
Therefore, the firm should replace the old machine.
12-12 a. Using a financial calculator, input the following: CF 0 = -190000,
CF1 = 87000, Nj = 3, and I = 14 to solve for NPV190-3 = $11,981.99
$11,982 (for 3 years).
EAA(360-6) $5,723:
0 14% 3 6 9
├───────────┼───────────┼───────────┤
───────────────── 11,982
0 6 7 8 9
├─── ··· ────┼──────────┼──────────┼──────────┤
-360,000 98,300 98,300 98,300
──────────┘ │ │ 180,000
─────────────────────┘ │ │
────────────────────────────────┘ │
───────────────────────────────────────────┘
The firm should operate the truck for 3 years, NPV3 = $1,307.
b. No. Abandonment possibilities could only raise NPV and IRR. The
value of the firm is maximized by abandoning the project after Year
3.
(1 + kr)(1 + i) = 1.15
(1 + kr)(1.06) = 1.15
kr = 0.0849
$21,780
-$150,000 + _______ = $106,537.
0.0849
After adjusting for expected inflation, we see that the project has a
positive NPV and should be accepted. This demonstrates the bias that
inflation can induce into the capital budgeting process: Inflation
is already reflected in the denominator (the cost of capital), so it
must also be reflected in the numerator.
b. If part of the costs were fixed, and hence did not rise with
inflation, then sales revenues would rise faster than total costs.
However, when the plant wears out and must be replaced, inflation
Price ($180,000)
Modification (25,000)
Change in NWC (7,500)
________
($212,500)
h. When the base price of the machine is increased to $200,000, the NPV
is ($52). You would be indifferent to the project at a machine cost
of $199,928 (rounded to $199,900).
f. (1) If the expected life of the old machine decreases, the new
machine will look better as cash flows attributable to the new
machine would increase. On the other hand, a serious
complication arises: the two projects now have unequal lives,
and an estimate must be made about the action to be taken when
the old machine is scrapped. Will it be replaced, and at what
cost and with what savings?
(2) The higher capital cost should be used in the analysis, and
this would reduce the NPV of the new machine.
g. NPV = $15,296. The NPV is positive, although its NPV is less than
the other machine's NPV of $31,789. Thus, the new supplier's machine
should not be bought in place of the other supplier's bottling
machine because the alternative machine's NPV is $31,789 - $15,296 =
$16,493 less than the original machine being considered.
Real WACC:
0 1 2 3
_________ ______ ______ ______
($18,800) $5,100a $5,100 $5,100
2,482b 3,384 1,128
_______ ______ ______ ______
($18,800) $7,582 $8,484 $6,228
a
(R - VC - FC)(1 - T) = ($30,000 - $15,000 - $6,500)(0.60) = $5,100.
b
(Dep)(T) = $6,204(0.4) = $2,482.
When calculating the NPV based upon real cash flows, the firm's real
WACC should be utilized. If the nominal WACC were used, the discount
rate would include an inflation premium, while the cash flows would
not. The calculation would bias NPV downward.
Now, since these are nominal cash flows, the NPV can be found using
ANSWER: WE HAVE FIVE CASH FLOWS, AS FOLLOWS:
Mini Case: 12 - 20 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
B. 1. CONSTRUCT INCREMENTAL OPERATING CASH FLOW STATEMENTS FOR
THE PROJECT’S 4 YEARS OF OPERATIONS.
ANSWER: GET THE DEPRECIATION RATES FROM TABLE 12-2 IN THE BOOK. NOTE THAT
BECAUSE OF THE ½ YEAR CONVENTION, A 3-YEAR PROJECT IS DEPRECIATED
OVER 4 CALENDAR YEARS:
HERE ARE THE ANNUAL OPERATING CASH FLOWS (IN THOUSANDS OF DOLLARS):
1 2 3 4
NET REVENUES $125 $125 $125 $125
DEPRECIATION 79 108 36 17
BEFORE-TAX INCOME $ 46 $ 17 $ 89 $108
TAXES (40%) 18 7 36 43
NET INCOME $ 28 $ 10 $ 53 $ 65
PLUS DEPRECIATION 79 108 36 17
NET OPERATING CF $107 $118 $ 89 $ 82
The Dryden Press items and derived items copyright © 1999 by The Dryden Press Mini Case: 12 - 21
B. 2. DOES YOUR CASH FLOW STATEMENT INCLUDE ANY FINANCIAL FLOWS
SUCH AS INTEREST EXPENSE OR DIVIDENDS? WHY OR WHY NOT?
ANSWER: THE CASH FLOW STATEMENT SHOULD NOT INCLUDE INTEREST EXPENSE OR
DIVIDENDS. THE RETURN REQUIRED BY THE INVESTORS FURNISHING THE
CAPITAL IS ALREADY ACCOUNTED FOR WHEN WE APPLY THE 10 PERCENT COST OF
CAPITAL DISCOUNT RATE, HENCE INCLUDING FINANCING FLOWS WOULD BE
"DOUBLE COUNTING." PUT ANOTHER WAY, IF WE DEDUCTED CAPITAL COSTS IN
THE TABLE, AND THUS REDUCED THE BOTTOM LINE CASH FLOWS, AND THEN
DISCOUNTED THOSE CFs BY THE COST OF CAPITAL, WE WOULD, IN EFFECT, BE
ANSWER: IF THE PLANT SPACE COULD BE LEASED OUT TO ANOTHER FIRM, THEN IF
CROCKETT ACCEPTS THIS PROJECT, IT WOULD FOREGO THE OPPORTUNITY TO
RECEIVE $25,000 IN ANNUAL CASH FLOWS. THIS REPRESENTS AN OPPORTUNITY
COST TO THE PROJECT, AND IT SHOULD BE INCLUDED IN THE ANALYSIS. NOTE
THAT THE OPPORTUNITY COST CASH FLOW MUST BE NET OF TAXES, SO IT WOULD
BE A $25,000(1 - T) = $25,000(0.6) = $15,000 ANNUAL OUTFLOW.
Mini Case: 12 - 22 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
C. 3. FINALLY, ASSUME THAT THE NEW PRODUCT LINE IS EXPECTED TO
DECREASE SALES OF THE FIRM’S OTHER LINES BY $50,000 PER YEAR. SHOULD
THIS BE CONSIDERED IN THE ANALYSIS? IF SO, HOW?
The Dryden Press items and derived items copyright © 1999 by The Dryden Press Mini Case: 12 - 23
D. DISREGARD THE ASSUMPTIONS IN PART C. WHAT IS CROCKETT’S
NET INVESTMENT OUTLAY ON THIS PROJECT? WHAT IS THE NET NONOPERATING CASH
FLOW AT THE TIME THE PROJECT IS TERMINATED? BASED ON THESE CASH FLOWS,
WHAT ARE THE PROJECT’S NPV, IRR, MIRR, AND PAYBACK? DO THESE INDICATORS
SUGGEST THAT THE PROJECT SHOULD BE UNDERTAKEN?
PRICE ($200,000)
FREIGHT & INSTALLATION (40,000)
CHANGE IN NET WORKING CAPITAL (20,000)*
($260,000)
• FINALLY, SELLING THE CURRENT MACHINE NOW MEANS THAT THE FIRM WILL
NOT RECEIVE THE SALVAGE VALUE AT THE END OF THE OLD MACHINE'S
ORIGINAL LIFE. THUS, THE OLD ASSET'S ORIGINAL EXPECTED SALVAGE
VALUE, NET OF TAXES AND AT THE OLD EXPECTED END-OF-LIFE, IS AN
OUTFLOW IF THE REPLACEMENT PROJECT IS ACCEPTED.
F. EXPLAIN WHAT IS MEANT BY CASH FLOW ESTIMATION BIAS. WHAT
ARE SOME STEPS THAT CROCKETT’S MANAGEMENT COULD TAKE TO ELIMINATE THE
INCENTIVES FOR BIAS IN THE DECISION PROCESS?
ANSWER: CASH FLOW ESTIMATION BIAS IS THE TENDENCY ON THE PART OF MANAGERS TO
BE OVERLY OPTIMISTIC WHEN ESTIMATING A PROJECT'S CASH FLOWS.
COMPANIES SHOULD ROUTINELY COMPARE THE CASH FLOW ESTIMATES SUBMITTED
IN THE PROJECT EVALUATION PROCESS WITH THOSE ACTUALLY REALIZED,
REWARD THOSE MANAGERS WHO ARE DOING A GOOD JOB, AND PENALIZE THOSE
WHO ARE NOT. (HOWEVER, THE CASH FLOWS ARE MUCH HARDER TO ESTIMATE IN
SOME LINES OF BUSINESS THAN IN OTHER LINES, AND THIS MUST BE TAKEN
INTO CONSIDERATION IN THE EVALUATION PROCESS.) WHEN THERE IS
EVIDENCE THAT CASH FLOW BIAS IS PRESENT, THE PROJECT'S CASH FLOW
ESTIMATES SHOULD BE LOWERED, OR THE COST OF CAPITAL SHOULD BE RAISED,
IN ORDER TO OFFSET THE BIAS.
ANSWER: IT APPEARS THAT THE CASH FLOW ESTIMATES ARE REAL, THAT IS, THEY ARE
STATED IN YEAR 0 (OR YEAR 1) DOLLARS, BECAUSE THE CASH REVENUES AND
COSTS ARE CONSTANT OVER THE 4-YEAR PERIOD EVEN THOUGH INFLATION IS
EXPECTED TO AVERAGE 5 PERCENT.
kds , HOWEVER, THE 10 PERCENT COST OF CAPITAL ESTIMATE IS A NOMINAL COST
BECAUSE THE ESTIMATES OFANDWHICH MAKE UP THE FIRM'S WACC, INCLUDE
INVESTORS' INFLATION PREMIUMS. SINCE AN INFLATION PREMIUM IS
INCLUDED IN THE DENOMINATOR (THE DISCOUNT RATE), BUT INFLATION IS NOT
CONSIDERED IN THE NUMERATOR (THE CASH FLOWS), THE CALCULATED NPV IS
BIASED DOWNWARD. THE BEST SOLUTION TO THE PROBLEM IS TO RECAST THE
CASH FLOW ESTIMATES TO INCLUDE THE IMPACT OF INFLATION OVER TIME.
USING A SPREADSHEET PROGRAM, THIS ADJUSTMENT IS AS EASY AS IT IS
NECESSARY.
I. IN AN
UNRELATED ANALYSIS, JOAN WAS ASKED TO CHOOSE
EXPECTED
BETWEEN THE FOLLOWING TWO MUTUALLY NET CASH
EXCLUSIVE FLOWS
PROJECTS:
YEAR PROJECT S PROJECT L
0 ($100,000) ($100,000)
1 60,000 33,500
2 60,000 33,500
3 -- 33,500
4 -- 33,500
ANSWER: THE SIMPLE REPLACEMENT CHAIN APPROACH ASSUMES THAT THE PROJECTS WILL
BE REPLICATED OUT TO A COMMON LIFE. SINCE PROJECT S HAS A 2-YEAR
LIFE AND L HAS A 4-YEAR LIFE, THE SHORTEST COMMON LIFE IS 4 YEARS.
PROJECT L'S COMMON LIFE NPV IS ITS RAW NPV:
ANSWER: THE EQUIVALENT ANNUAL ANNUITY (EAA) APPROACH FINDS THE CONSTANT
ANNUITY PAYMENT (EAA) WHOSE PRESENT VALUE IS EQUAL TO THE PROJECT'S
RAW NPV OVER ITS ORIGINAL LIFE:
PROJECT S'S RAW NPV IS $4,132. TO FIND THE ANNUITY PAYMENT (EAA)
USING A CALCULATOR, ENTER N = 2, I = 10, PV = -4132, FV = 0, AND
SOLVE FOR PMT = $2,380.82 $2,381. THUS, A 2-YEAR ANNUITY OF $2,381
PER YEAR, WHEN DISCOUNTED AT 10 PERCENT, IS EQUIVALENT TO PROJECT S'S
RAW NPV OF $4,132.
USING THE SAME PROCEDURE, WE FIND THAT A 4-YEAR ANNUITY OF $1,953
IS EQUIVALENT TO PROJECT L'S NPV OF $6,190: ENTER N = 4, I =10, PV =
-6190, FV = 0, AND SOLVE FOR PMT = $1,952.76 $1,953.
IF EACH PROJECT WERE REPLICATED CONTINUOUSLY, WE WOULD HAVE A
CONTINUOUS STRING OF EAA CASH FLOWS, AND, OVER ANY COMMON LIFE, THE
PROJECT WITH THE HIGHER EAA WOULD HAVE THE HIGHER VALUE. SINCE EAA S
> EAAL, THE EAA APPROACH INDICATES THAT PROJECT S SHOULD BE SELECTED.
NOTE THAT THE REPLACEMENT CHAIN AND EAA APPROACHES ALWAYS LEAD TO THE
SAME DECISION. THEREFORE, EITHER CAN BE USED--WE USE WHICHEVER IS
EASIEST TO USE AND EXPLAIN TO DECISION MAKERS IN THE PROBLEM AT HAND.
WITH THIS CHANGE, THE COMMON LIFE NPV OF PROJECT S IS LESS THAN THAT
FOR PROJECT L, AND HENCE PROJECT L SHOULD BE CHOSEN.
J. CROCKETT IS ALSO CONSIDERING ANOTHER PROJECT WHICH HAS A
INITIAL
PHYSICAL LIFE OF 3 YEARS; THAT INVESTMENT
IS, THE MACHINERY WILLEND-OF-YEAR
BE TOTALLY WORN OUT
AND OPERATING NET ABANDONMENT
AFTER 3 YEARS. HOWEVER,
YEAR IF THE PROJECT WERE ABANDONED PRIOR
CASH FLOWS VALUETO THE END OF
3 YEARS, THE MACHINERY WOULD HAVE A POSITIVE SALVAGE (OR ABANDONMENT)
0 ($5,000) $5,000
VALUE. HERE ARE THE PROJECT’S ESTIMATED CASH FLOWS:
1 2,100 3,100
2 2,000 2,000
3 1,750 0
ANSWER: HERE ARE THE TIME LINES FOR THE 3 ALTERNATIVE LIVES:
NO ABANDONMENT:
NPV = $123.
ABANDON AFTER 2 YEARS:
NPV = $215.
ABANDON AFTER 1 YEAR:
NPV = $273.