Chapter 8

Capital Budgeting Cash Flows

Solutions to Problems
Note: The MACRS depreciation percentages used in the following problems appear in Chapter 3, Table 3.2. The percentages are rounded to the nearest integer for ease in calculation. For simplification, five-year-lived projects with 5 years of cash inflows are typically used throughout this chapter. Projects with usable lives equal to the number of years of cash inflows are also included in the end-of-chapter problems. It is important to recall from Chapter 3 that, under the Tax Reform Act of 1986, MACRS depreciation results in n + 1 years of depreciation for an n-year class asset. This means that in actual practice projects will typically have at least one year of cash flow beyond their recovery period. P8-1. LG 1: Classification of expenditures Basic a. b. c. d. e. f. g. h. P8-2. Operating expenditureease expires within one year Capital expenditurepatent rights exist for many years Capital expenditureresearch and development benefits last many years Operating expendituremarketable securities mature in under one year Capital expendituremachine will last over one year Capital expenditurebuilding tool will last over one year Capital expenditurebuilding will last for more than one year Operating expendituremarket changes require obtaining another report within a year

LG 2: Basic terminology Basic Situation A a. b. c. d. mutually exclusive unlimited ranking conventional Situation B mutually exclusive unlimited accept-reject nonconventional Situation C independent capital rationing ranking conventional (2&4)

nonconventional (1&3) P8-3. LG 3: Relevant cash flow pattern fundamentals Intermediate a.

Year Cash Flow

b.

c.

P8-4.

LG 3: Expansion versus replacement cash flows Intermediate a. Year Initial investment 1 2 3 4 5 b. Relevant Cash Flows ($28,000) 4,000 6,000 8,000 10,000 4,000

An expansion project is simply a replacement decision in which all cash flows from the old asset are zero.

P8-5.

LG 3: Sunk costs and opportunity costs Basic a. The $1,000,000 development costs should not be considered part of the decision to go ahead with the new production. This money has already been spent and cannot be retrieved so it is a sunk cost. The $250,000 sale price of the existing line is an opportunity cost. If Masters Golf Products does not proceed with the new line of clubs they will not receive the $250,000.

b.

Intermediate a. b. Sunk costThe funds for the tooling had already been expended and would not change, no matter whether the new technology would be acquired or not. Opportunity costThe development of the computer programs can be done without additional expenditures on the computers; however, the loss of the cash inflow from the leasing arrangement would be a lost opportunity to the firm. Opportunity costCovol will not have to spend any funds for floor space but the lost cash inflow from the rent would be a cost to the firm.

c.

d. Sunk costThe money for the storage facility has already been spent, and no matter what decision the company makes there is no incremental cash flow generated or lost from the storage building. e. Opportunity costForegoing the sale of the crane costs the firm $180,000 of potential cash inflows.

P8-6.

LG 3: Personal finance: Sunk and opportunity cash flows a. The sunk costs or cash outlays are expenditures that have been made in the past and have no effect on the cash flows relevant to a current situation. The cash outlays done before David and Ann decided to rent out their home would be classified as sunk costs. An opportunity cost or cash flow is one that can be realized from an alternative use of an existing asset. Here, David and Ann have decided to rent out their home, and all the costs associated with getting the home in rentable condition would be relevant. Sunk costs (cash flows): Replace water heater Replace dish washer Miscellaneous repairs and maintenance Opportunity costs cash flows: Rental income Advertising

b.

House paint and power wash P8-7. LG 4: Book value Basic Installed Cost $ 950,000 40,000 96,000 350,000 1,500,000 Accumulated Depreciation $ 674,500 13,200 79,680 70,000 1,170,000 Book Value $275,500 26,800 16,320 280,000 330,000

Asset A B C D E P8-8.

LG 4: Book value and taxes on sale of assets Intermediate a. b. Capital Gain $20,000 0 0 0 Tax on Capital Gain $8,000 0 0 0 Depreciatio n Recovery $56,800 32,800 0 (8,200) Tax on Recovery $22,720 13,120 0 (3,280) Total Tax $30,720 13,120 0 (3,280) Book value = $80,000 (0.71 $80,000) = $23,200

Sale Price $100,000 56,000 23,200 15,000

P8-9.

LG 4: Tax calculations Intermediate Current book value = $200,000 [(0.52 ($200,000)] = $96,000 (a) Capital gain Recaptured depreciation Tax on capital gain Tax on depreciation Recovery Total tax 41,600 $ 49,600 21,600 $21,600 0 $0 (6,400) ($6,400) $ 20,000 104,000 8,000 $ (b) 0 54,000 0 (c) $0 0 0 (d) $ 0 0

(16,000)

P8-10. LG 4: Change in net working capital calculation Basic a. Current Assets Cash Accounts receivable Inventory Net change +$15,0 00 +150,0 00 10, 000 $155,0 00 $130,0 00 Current Liabilities Accounts payable Accruals +$90,0 00 + 40, 000

Net working capital = current assets current liabilities NWC = $155,000 $130,000 NWC = $25,000 b. c. Analysis of the purchase of a new machine reveals an increase in net working capital. This increase should be treated as an initial outlay and is a cost of acquiring the new machine. Yes, in computing the terminal cash flow, the net working capital increase should be reversed.

P8-11. LG 4: Calculating initial investment Intermediate a. b. Book value = $325,000 (1 0.20 0.32) = $325,000 0.48 = $156,000 Sales price of old equipment Book value of old equipment Recapture of depreciation $200,000 156,000 $ 44,000

Taxes on recapture of depreciation = $44,000 0.40 = $17,600 After-tax proceeds = $200,000 $17,600 = $182,400 c. Cost of new machine Less sales price of old machine Plus tax on recapture of depreciation Initial investment P8-12. LG 4: Initial investmentbasic calculation Intermediate Installed cost of new asset = $ 500,000 (200,000) 17,600 $ 317,600

Cost of new asset + Installation costs Total installed cost (depreciable value) After-tax proceeds from sale of old asset = Proceeds from sale of old asset + Tax on sale of old asset Total after-tax proceeds-old asset Initial investment

$ 35,000 5,000 $40,000 ($25,000) 7,680 ($17,320) $22,680

Book value of existing machine = $20,000 (1 (0.20 + 0.32 + 0.19)) = $5,800 Recaptured depreciation = $20,000 $5,800 = $14,200 Capital gain Tax on capital gain Total tax = $25,000 $20,000 = $5,000 = $7,680 $5,680 = $5,000 (0.40) = 2,000 = Tax on recaptured depreciation = $14,200 (0.40)

P8-13. LG 4: Initial investment at various sale prices Intermediate (a) Installed cost of new asset: Cost of new asset + Installation cost Total installed-cost After-tax proceeds from sale of old asset Proceeds from sale of old asset + Tax on sale of old asset* Total after-tax proceeds Initial investment (11,000) 3,240 (7,760) $18,240 (7,000) 1,64 0 (5,360 ) $20,64 0 (2,900) 0 (2,90 0) $23,10 0 (1,500) (56 0) (2,06 0) $23,94 0 $24,000 2,000 26,000 $24,00 0 2,00 0 26,000 $24,00 0 2,00 0 26,000 $24,00 0 2,00 0 26,000 (b) (c) (d)

Book value of existing machine = $10,000 [1 (0.20 0.32 0.19)] = $2,900

*

Tax Calculations: a. Recaptured depreciation = $10,000 $2,900 = $7,100

Capital gain Tax on ordinary gain Tax on capital gain Total tax b. c. d.

= $11,000 $10,000 = $1,000 = $7,100 (0.40) = $1,000 (0.40) = = $2,840 = 400 $3,240

Recaptured depreciation = $7,000 $2,900 = $4,100 Tax on ordinary gain 0 tax liability Loss on sale of existing asset = $1,500 $2,900 Tax benefit = $1,400 (0.40) = ($1,400) = $ 560 = $4,100 (0.40) = $1,640

P8-14. LG 4: Depreciation Basic Depreciation Schedule Year 1 2 3 4 5 6 Depreciation Expense $68,000 0.20 = $13,600 68,000 = 68,000 = 68,000 = 68,000 = 68,000 = 0.32 21,760 0.19 12,920 0.12 8,160 0.12 8,160 0.05 3,400

P8-15. LG 5: Incremental operating cash inflows Intermediate a. b. Year PBDT Depr. NPBT (1) $720,0 00 400,0 00 320,00 (2) $720,000 640,000 80,000 (3) $720,000 80,000 340,000 (4) $720,000 240,000 480,000 (5) $720,000 240,000 480,000 (6) $720,000 100,000 620,000 Incremental profits before depreciation and tax = $1,200,000 $480,000 = $720,000 each year

0 Tax NPAT 128,00 0 192,00 0 32,000 48,000 136,000 204,000 192,000 288,000 192,000 288,000 248,000 372,000

c. Cash flow (1) $592,000 (2) $688,000 (3) $584,000 (4) $528,000 (5) $528,000 (6) $472,000

(NPAT + depreciation) PBDT = Profits before depreciation and taxes NPBT = Net profits before taxes NPAT = Net profits after taxes

P8-16. LG5: Personal finance: Incremental operating cash inflows Richard and Linda Thomson Incremental Operating Cash Flows Replacement of John Deere Riding Mower Year 1 Year 2 Year 3 Year 4 Year 5 Savings from new and improved mower Annual maintenance cost Depreciation* Savings (loss) before taxes Taxes (40%) Savings (loss) after taxes Depreciation Incremental operating cash flow
*

Year 6 0 90 (90) (36) (54) 90 $ 36

$500 120 360 20 8 12 360 $372

$ 500 120 576 (196) (78) (118) 576 $ 458

$500 120 342 38 15 23 342 $365

$500 120 216 164 66 98 216 $314

$500 120 216 164 66 98 216 $314

MACRS Depreciation Schedule Year Year 1 Year 2 Year 3 Year 4

Base $1,800 1,800 1,800 1,800

MACRS 20.0% 32.0% 19.0% 12.0%

Depreciation $360 576 342 216

Year 5 Year 6

1,800 1,800

12.0% 5.0%

216 90

P8-17. LG 5: Incremental operating cash inflowsexpense reduction Intermediate Year Incremental expense savings Incremental profits before dep. and taxes* Depreciation Net profits before taxes Taxes Net profits after taxes Operating cash inflows**
*

(1)

(2)

(3)

(4)

(5)

(6)

$16,00 0 16,000 9,60 0 6,400 2,560 3,840 13,440

$16,000

$16,000

$16,000

$16,000

16,000 15,360

16,000 9,120

16,000 5,760

16,000 5,760

0 2,400

640 256 384 15,744

6,880 2,752 4,128 13,248

10,240 4,096 6,144 11,904

10,240 4,096 6,144 11,904

2,400 960 1,440 960

Incremental profits before depreciation and taxes will increase the same amount as the decrease in expenses. Net profits after taxes plus depreciation expense.

**

P8-18. LG 5: Incremental operating cash inflows Intermediate a.

Expenses (excluding depreciatio n and interest)

Year New Lathe 1 2

Reven ue

Profits before Depreciation and Taxes

Depreciation

Net Profits before Taxes

Taxes

Net Profits after Tax

Operati ng Cash Inflows

$40,00 0 41,000

$30,000 30,000

$10,000 11,000

$2,00 0 3,200

$8,000 7,800

$3,2 00 3,12

$4,80 0 4,680

$6,80 0 7,880

0 3 4 5 6 Old Lathe 15 $35,00 0 $25,000 $10,000 0 $10,00 0 $4,0 00 $6,00 0 $6,00 0 42,000 43,000 44,000 0 30,000 30,000 30,000 0 12,000 13,000 14,000 0 1,900 1,200 1,200 500 10,100 11,800 12,800 (500) 4,04 0 4,72 0 5,12 0 (200) 6,060 7,080 7,680 (300) 7,960 8,280 8,880 200

b.

Calculation of incremental cash inflows Year New Lathe Old Lathe Incremental Cash Flows $800 1,880 1,960 2,280 2,880 200

1 2 3 4 5 6 c.

$6,800 7,880 7,960 8,280 8,880 200

$6,000 6,000 6,000 6,000 6,000 0

P8-19. LG 6: Terminal cash flowsvarious lives and sale prices Challenge a. After-tax proceeds from sale of new asset= 3-year* Proceeds from sale of proposed asset Tax on sale of proposed asset* Total after-tax proceeds-new + Change in net working capital Terminal cash flow
*

5-year* $10,000 + 16,880 $9,600 + 30,000 $39,600

7-year* $10,000 400 $ 6,000 + 30,000 $36,000 4,000

$10,000 $26,880 + 30,000 $56,880

1.

Book value of asset = [1 (0.20 + 0.32 + 0.19)] $180,000 = $52,200 Proceeds from sale = $10,000 $10,000 $52,200 = ($42,200) loss

$42,200 (0.40) 2. = $9,000 $10,000 $9,000 $1,000 (0.40) 3. $10,000 $0 $10,000 (0.40)

= $16,880 tax benefit Book value of asset = [1 (0.20 + 0.32 + 0.19 + 0.12 + 0.12)] $180,000 = $1,000 recaptured depreciation = $400 tax liability = $10,000 recaptured depreciation = $4,000 tax liability

Book value of asset = $0

b. If the usable life is less than the normal recovery period, the asset has not been depreciated fully and a tax benefit may be taken on the loss; therefore, the terminal cash flow is higher. c. (1) After-tax proceeds from sale of new asset = Proceeds from sale of new asset + Tax on sale of proposed asset* + Change in net working capital Terminal cash flow
*

(2) $170,000 (64,400) + 30,000 $135,600

$ 9,000 0 + 30,000 $39,000

1. 2.

Book value of the asset = $180,000 0.05 = $9,000; no taxes are due Tax = ($170,000 $9,000) 0.4 = $64,400.

d. The higher the sale price, the higher the terminal cash flow. P8-20. LG 6: Terminal cash flowreplacement decision Challenge After-tax proceeds from sale of new asset = Proceeds from sale of new machine Tax on sale of new machine
l

$75,000 (14,360) $60,640 (15,000) 6,000 (9,000) 25,000 $76,640

Total after-tax proceeds-new asset After-tax proceeds from sale of old asset Proceeds from sale of old machine + Tax on sale of old machine2 Total after-tax proceeds-old asset + Change in net working capital Terminal cash flow
l

Book value of new machine at end of year.4: [1 (0.20 + 0.32 + 0.19 + 0.12) ($230,000)] = $39,100 $75,000 $39,100 $35,900 (0.40) = $35,900 recaptured depreciation = $14,360 tax liability

Book value of old machine at end of year 4: $0

$15,000 $0 $15,000 (0.40)

= $15,000 recaptured depreciation = $6,000 tax benefit

P8-21. LG 4, 5, 6: Relevant cash flows for a marketing campaign Challenge Marcus Tube Calculation of Relevant Cash Flow ($000) Calculation of Net Profits after Taxes and Operating Cash Flow: with Marketing Campaign 2010 Sales CGS (@ 80%) Gross profit Less: Less: Operating expenses General and administrative (10% of sales) Marketing campaign Depreciation Total operating expenses Net profit before taxes Less: Taxes 40% Net profit after taxes +Depreciation Operating CF $ 840 5 00 $ 1,340 $ 870 5 00 $ 1,370 $ 900 5 00 $ 1,400 $ 960 5 00 $ 1,460 $ 1,020 500 $ 1,520 $ 1,400 5 60 $ 1,450 5 80 $ 1,500 6 00 $ 1,600 6 40 $ 1,700 680 2,700 2,750 2,800 2,900 3,000 $20,5 00 16,4 00 $ 4,100 2011 $21,0 00 16,8 00 $ 4,200 2012 $21,5 00 17,2 00 $ 4,300 2013 $22,5 00 18,00 0 $ 4,500 2014 $23,50 0 18,800 $ 4,700

$ 2,050 150 5 00

$ 2,100 150 5 00

$ 2,150 150 5 00

$ 2,250 150 5 00

$ 2,350 150 500

Without Marketing Campaign Years 20072011 Net profit after taxes + Depreciation Operating cash flow $ 900 5 00 $1,4 00

Relevant Cash Flow ($000) With Marketing Campaign Without Marketing Campaign $1,400 1,400 1,400 1,400 1,400 Incremen tal Cash Flow $(60) (30) 0 60 120

Year

2010 2011 2012 2013 2014

$1,340 1,370 1,400 1,460 1,520

P8-22. LG 4, 5: Relevant cash flowsno terminal value Challenge a. Installed cost of new asset Cost of new asset + Installation costs Total cost of new asset After-tax proceeds from sale of old asset Proceeds from sale of old asset + Tax on sale of old asset* Total proceeds, sale of old asset Initial investment
*

$76,000 4,000 $80,000 (55,000) 16,200 (38,800) $41,200

= $14,500 = $40,500 gain on asset =

Book value of old machine: [1 (0.20 + 0.32 + 0.19)] $50,000 $55,000 $14,500 $5,000 capital gain 0.40 Total tax on sale of asset

$35,500 recaptured depreciation 0.40 = $14,200 2,000 = $16,200

b. Calculation of Operating Cash Flow Year Old Machine PBDT Depreciation NPBT Taxes NPAT Depreciation Cash flow New Machine PBDT Depreciation NPBT Taxes NPAT $30,000 16,000 $14,000 5,600 $ 8,400 $30,000 25,600 $ 4,400 1,760 $ 2,640 $30,000 15,200 $14,800 5,920 $ 8,880 $30,000 9,600 $20,400 8,160 $12,240 $30,000 9,600 $20,400 8,160 $12,240 $ 0 4,000 $4,000 1,600 $2,400 $14,000 6,000 $ 8,000 3,200 $ 4,800 6,000 $10,800 $16,000 6,000 $10,000 4,000 $ 6,000 6,000 $12,000 $20,000 2,500 $17,500 7,000 $10,500 2,500 $13,000 $18,000 0 $18,000 7,200 $10,800 0 $10,800 $14,000 0 $14,000 5,600 $ 8,400 0 $ 8,400 $ $ $ 0 0 0 0 0 0 0 (1) (2) (3) (4) (5) (6)

Depreciation Cash flow Incremental After-tax Cash flows

16,000 $24,400

25,600 $28,240

15,200 $24,080

9,600 $21,840

9,600 $21,840

4,000 $1,600

$13,600

$16,240

$11,080

$11,040

$13,440

$1,600

c.

P8-23. LG 4, 5, 6: Integrativedetermining relevant cash flows Challenge a. Initial investment: Installed cost of new asset = Cost of new asset + Installation costs Total cost of new asset After-tax proceeds from sale of old asset = Proceeds from sale of old asset + Tax on sale of old asset* Total proceeds from sale of old asset + Change in working capital Initial investment
*

$105,000 5,000 $110,000 (70,000) 16,480 (53,520) 12,000 $ 68,480

$28,800 = 4,000 $12,480

Book value of old asset:

[1 (0.20 + 0.32)] $60,000 = $31,200 recaptured depreciation 0.40 $10,000 capital gain 0.40 Total tax of sale of asset =

$70,000 $28,800 = $41,200 gain on sale of asset

= $16,480

b. Calculation of Operating Cash Inflows Profits before Depreciatio n and Taxes Operati ng Cash Inflows

Year

Depreciatio n

Net Profits before Taxes

Taxe s

Net Profits after Taxes

New Grinder 1 2 3 $43,00 0 43,000 43,000 $22,000 35,200 20,900 $21,000 7,800 22,100 $8,4 00 3,12 0 8,84 $12,600 4,680 13,260 $34,600 39,880 34,160

4 5 6

43,000 43,000 0

13,200 13,200 5,500

29,800 29,800 5,500

0 11,9 20 11,9 20 2,2 00 $5,8 40 6,72 0 5,92 0 6,80 0 7,20 0 0

17,880 17,880 3,300

31,080 31,080 2,200

Existing Grinder 1 2 3 4 5 6 $26,00 0 24,000 22,000 20,000 18,000 0 $11,400 7,200 7,200 3,000 0 0 $14,600 16,800 14,800 17,000 18,000 0 $ 8,760 10,080 8,880 10,200 10,800 0 $20,160 17,280 16,080 13,200 10,800 0

Calculation of Incremental Cash Inflows Incremental Operating Cash Flow $14,440 22,600 18,080 17,880 20,280 2,200

Year 1 2 3 4 5 6 c.

New Grinder $34,600 39,880 34,160 31,080 31,080 2,200

Existing Grinder $20,160 17,280 16,080 13,200 10,800 0

Terminal cash flow: After-tax proceeds from sale of new asset = Proceeds from sale of new asset Tax on sale of new asset* Total proceeds from sale of new asset After-tax proceeds from sale of old asset = Proceeds from sale of old asset + Tax on sale of old asset Total proceeds from sale of old asset + Change in net working capital Terminal cash flow
*

$29,000 (9,400) 19,600 0 0 0 12,000 $31,600

Book value of asset at end of year 5 = $5,500 $29,000 $5,500 $23,500 0.40 = $23,500 recaptured depreciation = $9,400

d.

Year 5 relevant cash flow: Operating cash flow Terminal cash flow Total inflow $20,280 31,600 $51,880

P8-24. LG 4, 5,6: Personal finance: Determining relevant cash flows for a cash budget Jan and Deana Cash Flow Budget Purchase of Boat a. Initial investment Total cost of new boat Add: Taxes (6.5%) Initial investment b. Operating cash flows Maint. & repair 12 months at $800 Docking fees 12 months at $500 Operating cash flows c. Terminal cash flowend of Year 4 Proceeds from the sale of boat d. Summary of cash flows Year zero End of Year 1 End of Year 2 End of Year 3 End of Year 4 Cash Flow $(74,550) $(15,600) $(15,600) $(15,600) $ 24,400

$ (70,000) (4,550) $ (74,550) Year 1 $ (9,600) $ (6,000) $ (15,600) Year 2 $ (9,600) $ (6,000) $(15,600) Year 3 $ (9,600) $ (6,000) $(15,600) Year 4 $ (9,600) $ (6,000) $(15,600)

$ 40,000

e. The ownership of the boat is virtually just an annual outflow of money. Across the four years, $96,950 will be spent in excess of the anticipated sales price in Year 4. Over the same time period, the disposable income is only $96,000. Consequently, if the costs exceed the expected disposable income. If cash flows were adjusted for their timing, and noting that the proceeds from the sale of the new boat comes in first at the end of Year 4, Jan and Deana are in a position where they will have to increase their disposable income in order to accommodate boat ownership. If a loan is needed, the monthly interest payment would be another burden. However, there is no attempt here to measure satisfaction of ownership. P8-25. Ethics problem Intermediate The likely explanation is that loan officers and bank credit analysts are often more preoccupied with a firms ability to repay the loan and how soon rather than internal rate of return of the project or its discounted cash flow. Another reason is maybe that owners or managers of small businesses may not have sufficient skills to conduct the more tedious financial analysis.