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CH 11
CH 11
Section 11.1
1. Why do we care about incremental cash flows at the firm level when we evaluate a project?
We care about incremental cash flows at the firm level because they reflect the impact of the
project on the total cash flows that the firm produces. This is what the stockholders care about.
The difference between the present value of the expected cash flows from the firm with the
project and the present value of the expected cash flows from the firm without the project is
precisely what the NPV of a project is. Our NPV estimate will be incorrect if we do not account
2. Why is D&A first subtracted and then added back in FCF calculations?
By subtracting D&A, calculating the tax obligation, and then adding back D&A, we are
accounting for the fact that D&A is a noncash charge that reduces the firm’s tax obligation by the
product of D&A and the tax rate (D&A x t). If we did not do this, we would overstate the tax
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3. What types of investments should be included in FCF calculations?
All investments directly associated with the project should be included in FCF calculations. These
can include both investments in tangible and intangible assets. They can also include investments
in additions to working capital, such as for the credit a firm extends to its customers and
inventories.
Section 11.2
(1) Include cash flows and only cash flows in your calculations.
(2) Include the impact of the project on cash flows from other product lines.
(5) Include only after-tax cash flows in the cash flow calculations.
2. What is the difference between nominal and real dollars? Why is it important not to mix them in
an NPV analysis?
When most people talk about dollar amounts, they are referring to nominal dollars. Nominal
dollars do not take into account changes in purchasing power. Real dollars are dollar amounts that
are adjusted for changes in purchasing power. For example, 100 real dollars have the same
purchasing power whether they are received today or at some future date. It is important not to
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mix nominal and real dollars in an NPV analysis because the discount rate is either a nominal
rate, which is used to discount nominal dollars, or a real rate, which is used to discount real
dollars. Since the discount rate must be either a nominal rate or a real rate, if real and nominal
dollars are mixed in an NPV analysis, the NPV will be calculated incorrectly.
3. What is a progressive tax system? What is the difference between a firm’s marginal and average
tax rates?
A progressive tax system is one in which the marginal tax rate at low levels of income is lower
than the marginal tax rate at high levels of income. A firm’s marginal tax rate is the rate that it
pays on the last dollar earned while the average tax rate is the average rate paid on the firm’s total
4. How can FCF in the terminal year of a project’s life differ from FCF in the other years?
FCF in the terminal year can differ from FCF in other years in several ways. The terminal year
cash flows can include cash flows from the asset sales, including the actual proceeds from the
sales themselves and taxes due or received if there is a gain or loss on the sale. Terminal year
cash flows can also include cash flows associated with recovery of working capital.
5. Why is it important to understand that cash flow forecasts in an NPV analysis are expected
values?
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It is important to recognize that we are forecasting expected cash flows in an NPV analysis
because uncertainties regarding project cash flows that are unique to the project should be
Section 11.3
1. What is the difference between variable and fixed costs, and what are examples of each?
Variable costs vary directly with unit sales. Fixed costs do not vary with unit sales. For an
example of each, see the video game player scenario on page 379. Variable costs are those
associated with purchasing the components for the player, the labor required, and sales and
marketing. These costs will vary according to the number of units produced. Fixed costs are those
2. How are working capital items forecast? Why are accounts receivable typically forecast as a
percentage of revenue and accounts payable, and inventories as percentages of the cost of good
sold?
Working capital items are forecast using 1) cash and cash equivalents, 2) accounts receivable, 3)
Inventories are forecast as a percentage of the cost of goods sold because the COGS represent a
measure of the amount of money invested in inventories. Accounts payable are forecast this way
because the COGS is a measure of the amount of money actually owed to suppliers.
Section 11.4
1. When can we not simply compare the NPVs of two mutually exclusive projects?
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If we expect to replace at least one of the projects at the end of its life, we cannot simply compare
the NPVs. Doing so would ignore the subsequent investment(s). You can only directly compare
the NPVs of mutually exclusive projects under one condition—that is, if you expect to terminate
the project that is chosen (e.g., sell the lawn mower) on or before the end of the life of the shorter-
lived project.
We choose the harvest date that maximizes the NPV of the asset. To identify this date, we
compare the NPVs expected from harvesting the asset for each of the feasible harvest dates. The
best date to harvest the asset is the date that produces the largest NPV, once the NPVs for all of
the alternative harvest dates have been discounted to the same point in time.
3. Under what circumstance would you replace an old machine that is still operating with a new
one?
You should replace the old machine when the EAC of the new machine is lower than the EAC of
the old machine (if revenues are the same for both machines) or when the annualized cash inflow
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Self Study Problems
11.1 Explain why the announcement of a new investment is usually accompanied by a change in
Solution:
A firm’s investments cause changes in its future after-tax cash flows and stockholders are the
residual claimants (owners) of those cash flows. Therefore, the stock price should increase
when stockholders expect an investment to have a positive NPV, and decrease when it is
11.2 In calculating the NPV of a project, should we use all of the after-tax cash flows associated
with the project, or incremental after-tax cash flows from the project? Why?
Solution:
We should use incremental cash flows of the project. Incremental cash flows reflect the
amount by which the firm’s total cash flows will change if the project is adopted. In other
words, incremental cash flows represent the net difference in cash revenues, costs, and
investment outlays (in net working capital and capital expenditures) at the firm level with and
without the project, which is precisely what the stockholders care about.
11.3 You are considering opening another restaurant in the TexasBurgers chain. The new
restaurant will have annual revenue of $300,000 and operating expenses of $150,000. The
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annual depreciation and amortization for the assets used in the restaurant will equal $50,000.
assets used in the restaurant, but no additions to working capital will be required. The
marginal tax rate will be 40 percent. Calculate the incremental annual free cash flow for the
project
Solution:
11.4 Sunglass Heaven, Inc., is launching a new store in a shopping mall in Houston. The annual
revenue of the store depends on the weather conditions in the summer in Houston. The annual
revenue will be $240,000 in a sizzling summer, with probability of 0.3; $80,000 in a cool
summer, with probability of 0.2; and $150,000 in a normal summer, with probability of 0.5.
Solution:
11.5 Sprigg Lane Manufacturing, Inc., needs to purchase a new central air-conditioning system for
a plant. There are two choices. The first system costs $50,000 and is expected to last 10 years,
and the second system costs $72,000 and is expected to last 15 years. Assume that the
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opportunity cost of capital is 10 percent. Which air-conditioning system should Sprigg Lane
purchase?
Solution:
11.1 Do you agree or disagree with the following statement given the techniques discussed in this
chapter? We can calculate future cash flows precisely and obtain an exact value for the NPV
of an investment.
The statement is not true. Given the nature of the real business world, it is almost certain that
the cash flows generated by a project will differ from the forecasts used to decide whether to
proceed with the project. However, techniques discussed in this chapter provide an important
and useful framework that helps minimize errors and ensures that forecasts are internally
consistent.
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11.2 What are the differences between cash flows used in capital budgeting calculations and past
accounting earnings?
Cash flows used in capital budgeting calculations are forward looking; they are incremental
after-tax cash flows based on forecast. Accounting earnings are backward looking; they
represent a record of past performance and may not accurately reflect cash flows.
11.3 Suppose that FRA Corporation already has divisions in both Dallas and Houston. FRA is now
considering setting up a third division in Austin. This expansion will require one senior
manager from Dallas and one from Houston to relocate to Austin. Ignore relocation expenses.
The annual compensations of existing senior managers are not incremental to the new
investment and therefore are not relevant for capital budgeting analysis. This is consistent
with our Rule 1 for incremental cash flow calculations: Include cash flows and only cash
flows; do not include allocated costs unless they reflect cash flows.
11.4 MusicHeaven,Inc., is a producer of MP3 players which currently have either 20 gigabytes or
30 gigabytes of storage. Now the company is considering launching a new production line
making mini MP3 players with 5 gigabytes of storage. Analysts forecast that your company
will be able to sell 1 million such mini MP3 players if the investment is taken. In making the
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investment decision, discuss what the company should consider other than the sales of the
The company’s launch of the new mini MP3 players may reduce its current sales of MP3
players of bigger storage. This impact has to be considered. This is consistent with our Rule 2
for incremental cash flow calculations: Include the impact of the project on cash flows from
11.5 QualityLiving Trust is a real estate investment company that builds and remodels apartment
its possession into luxury apartment buildings in San Jose. The company bought those
buildings eight months ago. How should the market value of the buildings be treated in
Although the buildings are not currently in use, the company can sell them at their market
value rather than remodel them into apartments. Therefore, the market value of the buildings
is the opportunity cost of the project and should be considered as cash outflow in the
investment decision. This is consistent with our Rule 3 for incremental cash flow calculations:
11.6 High-End Fashions, Inc., bought a production line of ankle-length skirts last year at a cost of
$500,000. This year, however, miniskirts are in and ankle-length skirts are completely out of
fashion. High-End has the option to rebuild the production line and use it to produce
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miniskirts, with an annual operating cost of $300,000 and expected revenue of $700,000. How
should the company treat the cost of $500,000 of the old production line in evaluating the
rebuilding plan?
The cost of the old production line occurred in the past. It cannot be changed whether or not
the company rebuilds it into the miniskirt production line. Therefore, High-End should not
consider the cost of $500,000. This is consistent with our Rule 4 for incremental cash flow
11.7 How is the MACRS depreciation method under IRS rules different from the straight-line
depreciation allowed under GAAP rules? What is the implication of incremental after-tax
depreciation, Modified Accelerated Cost Recovery System (MACRS), has been used for U.S.
that it enables a firm to deduct depreciation changes sooner, thereby realizing the tax saving
11.8 Explain the difference between marginal and average tax rates, and identify which of these
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The marginal tax rate is the rate paid on the next dollar earned. The average tax rate is the
dollar value of total taxes paid divided by total income. The marginal tax rate is the
appropriate rate to use in capital budgeting analysis because this is the tax rate that will be
11.9 Under what circumstances will the sale of an asset result in taxable gain? How do you
estimate the taxes or benefits associated with the sale of an asset?
The sale of an asset results in a taxable gain when the selling price of the asset exceeds its
book value.
Tax on the sale of an asset = (Selling price of asset – Book value of asset) × t
11.10 When two mutually exclusive projects have different lives, how can an analyst determine
When we choose from mutually exclusive projects with different lives, instead of electing the
project with higher NPV or lower net present value of costs, we should choose the project
with higher Equivalent Annual Revenue or lower Equivalent Annual Cost. The underlying
assumption is that we will continue to operate with the same equivalent annual revenue or
11.11 What is the opportunity cost of using an existing asset? Give an example of the opportunity
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The opportunity cost of using an existing asset in a project is the present value of the change
in the firm’s cash flows that is attributed to the fact that this asset is being used in the project.
For example, by using the excess capacity of a machine, you may accelerate the wear-and-
tear of the machine and hence will need to replace it sooner. The present value of the added
11.12 You are providing financial advice to a shrimp farmer who will be harvesting his last crop of
farm-raised shrimp. His current shrimp crop is very young and will therefore grow and
become more valuable as their weight increases. Describe how you would determine the
Assuming that the price of shrimp is directly (and linearly) related to the weight of the
shrimp, then the optimal point in time to harvest the shrimp would be where the rate of weight
increase is no longer greater than the opportunity cost of capital for the shrimp farmer.
Alternatively, the appropriate time is when the value increase of the shrimp is no longer
BASIC
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11.1 Calculating project cash flows: Why do we use forecasted incremental after-tax cash flows
LO 1
Solution:
Accounting earnings can differ from cash flows for a number of reasons, making accounting
earnings an unreliable measure of the costs and benefits of a project. For example, ease of
manipulating earnings components such as accounts receivable and depreciation may result in
distorted estimation of capital budgeting; using forecasted cash flows eliminates such
possibilities. In addition, because there is time value of money, cash flows better reflect the
11.2 The FCF calculation: How do we calculate incremental after-tax free cash flow from the
LO 2
Solution:
We need to adjust for the depreciation and amortization tax shield, capital expenditures, and
11.3 The FCF calculation: How do we adjust for depreciation when we calculate incremental after-
tax cash flow from EBITDA? What is the intuition for the adjustment?
LO 2
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Solution:
There are two ways to adjust for depreciation: (1) subtract depreciation from EBITDA,
multiply it by (1 – tax rate), and then add depreciation back; (2) add the tax shield from
depreciation (depreciation multiplied by tax rate) to revenue. These two methods yield the
same results. The intuition is that although depreciation itself is not a cash flow inflow or
outflow, increase in depreciation will result in a decrease in taxable income. This saving on
11.4 Nominal versus real cash flows: What is the difference between nominal and real dollars?
Which rate of return should we use to discount each type of these cash flows in the future?
LO 2
Solution:
Nominal dollars are dollars stated as we usually think of them, without any adjustment for
changes in purchasing power over time. Real dollars are dollars stated so that their purchasing
power remains constant. We should use nominal rate of return to discount future nominal
dollars and real rate of return to discount future real dollars. By doing this, we will get
11.5 Taxes and depreciation: What is the difference between the average tax rate and the
marginal tax rate? Which one should we use in calculating the incremental after-tax cash
flows?
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LO 2
Solution:
In a progressive tax system, the marginal tax rate is different from the average tax rate. The
average tax rate is the total amount of tax divided by total amount of money earned, while the
marginal tax rate is the rate paid on the last dollar earned. Since a firm already pays taxes, the
appropriate tax rate used for the firm’s new project is the tax rate that the firm will pay on any
additional profits that are earned because the project is adopted. Therefore, we use the
11.6 Computing terminal-year FCF: Healthy Potions, Inc., a pharmaceutical company, bought a
machine that produces pain-reliever medicine at a cost of $2 million five years ago.. The
machine has been depreciated over the past five years, and the current book value is
$800,000. The company decides to sell the machine now at its market price of $1 million. The
marginal tax rate is 30 percent. What are the relevant cash flows? How do they change if the
LO 1
Solution:
The relevant cash flows include the sale price of the machine, as well as the tax on the capital
gain:
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When the market price of the machine is changed to $600,000, the relevant cash flows
11.7 Cash flows from operations: What are variable costs and fixed costs? What are some
examples of each? How are these costs estimated in forecasting operating expenses?
LO 1
Solution:
Variable costs vary directly with unit sales, while fixed costs do not. Variable costs are those
associated with purchasing the components for the player, the labor required, and sales and
marketing. These costs will vary according to the number of units produced. Fixed costs are those
11.8 Cash flows from operations: When forecasting operating expenses, explain the difference
between a fixed cost and a variable cost.
LO 3
Solution:
Fixed costs are operating expenses that do not vary with the number of units sold, while
variable costs vary directly with the number of units sold.
11.9 Investment cash flows: Zippy Corporation just purchased computing equipment for $20,000.
The equipment will be depreciated using a five-year MACRS depreciation schedule. If the
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equipment is sold at the end of its fourth year for $12,000, what are the after-tax proceeds
from the sale, assuming the marginal tax rate is 35%.
LO 2
Solution:
The 5-year depreciation schedule allows us to depreciate 20 percent of the value of the
equipment in year 1, 32 percent in year two, 19.20 percent in year 3, and 11.52 percent in year
four after the purchase. The associated depreciation charges in years 1 through 4 in order are
$4,000, $6,400, $ 3,840, and $2,304 respectively. Total depreciation at the end of year 4
$16,544, so the book value of the equipment when sold is $3,456. Since the equipment is sold
for $12,000 the tax on the sale of the asset is equal to ($12,000-$3,456) × 0.35 = $2,990.40.
11.10 Investment cash flows: Six Twelve is considering opening up a new convenience store in
downtown New York City. The expected annual revenue is $800,000. To estimate the increase
in working capital, analysts estimate the ratio of cash and cash-equivalents to revenue to be
0.03, and the ratio of receivables, inventories, and payables to revenue to be 0.05, 0.10, and
0.04, respectively in the same industry. What is the incremental cash flow related to working
LO 2
Solution:
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Cash flow related to working capital in year0 = $(800,000) × (0.03 + 0.05 +.10 - .04) = $
(($112,000)
11.11 Investment cash flows: Keswick Supply Company wants to set up a division that provides
copy and fax services to businesses. Customers will be given 20 days to pay for such services.
The annual revenue of the division is estimated to be $25,000. Assuming that the customers
take the full 20 days to pay, what is the incremental cash flow related to working capital when
LO 2
Solution:
Alternatively, the average daily credit sale = $25,000 / 365 = $68.49, and it takes 20 days, on
Therefore, the incremental cash flow related to working capital when the store is opened:
11.12 Expected cash flows: Define expected cash flows and explain why this concept is important
in evaluating projects.
LO 2
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Solution:
Expected cash flows are probability-weighted averages of the future cash flows generated by
a project under alternative scenarios. In the real business world there are a lot of uncertainties.
Future cash flows may vary across different states of the world. It is not possible to estimate a
unique number of cash flow for all states. We can estimate the expected cash flows across
different states and use that as an estimation of future cash flows. The cash flows that are
discounted in an NPV analysis are the expected incremental cash flows the project will
produce.
11.13 Projects with different lives: Explain the concept of equivalent annual cost and how it is
LO 4
Solution:
The equivalent annual cost (EAC) is the annualized cost of an investment stated in nominal
dollars. In other words, it is the annual payment from an annuity with a life equal to that of a
project that has the same NPV as the project. Since it is a measure of the annual cost or cash
inflow from a project, the EAC for one project can be compared directly with the EAC from
11.14. Replace an existing asset: Explain how we decide the optimal time to replace an existing
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LO 4
Solution:
The optimal time to replace an existing asset with a new one is if the benefits of replacing the
INTERMEDIATE
11.15 Nominal versus real cash flows: You are buying a sofa. You will pay $200 today and make
three consecutive annual payments of $300 in the future. The real rate of return is 10 percent,
and the expected inflation rate is 4 percent. What is the actual price of the sofa?
LO 2
Solution:
Real annual payments are: 300 / (1 + 4%) = 288.46, 300 / (1 + 4%)2 = 277.37, and
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Note that we get identical results as long as we are consistent in using nominal or real cash
11.16 Nominal versus real cash flows: You are graduating in two years. You want to invest your
current savings of $5,000 in bonds and use the proceeds to purchase a new car when you
graduate and start to work. You can invest the money in either Bond A, a two-year bond with
percent real interest above the inflation rate (assume this bond makes annual interest
payments). The inflation rate over the next two years is expected to be 1.5 percent. Assume
that both bonds are default free and have the same market price. Which bond should you
invest in?
LO 2
Solution:
The nominal interest rate is 3 percent for bond A, and (1 + 1%) × (1 +1.5%) –1 = 2.52% for
11.17 Marginal and average tax rates: Given the U.S. Corporate Tax Rate Schedule in Exhibit
11.6, what is the marginal tax rate and average tax rate of a corporation that generates a
Solution:
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The total tax payable is 3,400,000 + (12,000,000-10,000,000) ×35% = $4,100,000 Therefore
LO 1
11.18 Investment cash flows: Healthy Potions, Inc., is considering investing in a new production
line for eye drops. Other than investing in the equipment, the company needs to increase its
cash and cash equivalents by $10,000, increase the level of inventory by $30,000, increase
accounts receivable by $25,000, and increase accounts payable by $5,000 at the beginning of
the investment. Healthy Potions will recover these changes in working capital at the end of the
project 10 years later. Assume the appropriate discount rate to be 12 percent. What are the PV
LO 1
Solution:
The relevant cash flow related to working capital at the beginning of the project is:
The present value of relevant cash flow related to working capital at the end of the project is:
11.19 Cash flows from operations: Given the soaring price of gasoline, Ford is considering
introducing a new production line of gas-electric hybrid sedans. The expected annual unit
sales of the hybrid cars is 30,000; the price is $22,000 per car. Variable costs of production are
$10,000 per car. The fixed overhead including salary of top executives is $80 million per year.
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However, the introduction of the hybrid sedan will decrease Ford’s sales of regular sedans by
10,000 cars per year; the regular sedans have a unit price of $20,000 and unit variable cost of
$12,000, and fixed costs of $250,000 per year. Depreciation costs of the production plant are
$50,000 per year. The marginal tax rate is 40 percent. What is the incremental annual cash
LO 1
Solution:
Step Two: Op Exp: $10,000 × 30,000 machines = $300,000,000, plus lost net revenue from
$380,000,000
Step Four: Plug information into the text book template as below.
ΔNR 660,000,000
- ΔOpEx -380,000,000
= ΔEBITDA 280,000,000
- ΔD&A -50,000
= ΔEBIT 279,950,000
x (1-t) 0.60
= ΔNOPAT 167,970,000
+ ΔD&A 50,000
= ΔCFO 168,020,000
- ΔCapEx 0
- ΔAWC 0
= ΔFCF 168,020,000
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((22,000-10,000) ×30,000-(20,000-12,000) ×10,000) ×(1-0.4) + 50,000 ×0.4 =
168,020,000
Note that the fixed costs are not included in the incremental cash flows calculations, since
11.20 FCF and NPV for a project: Archers Daniels Midland Company is considering buying a
new farm that it plans to operate for 10 years. The farm will require an initial investment of
$12 million. This investment will consist of $2 million for land and $10 million for trucks and
other equipment. The land, all trucks, and all other equipment is expected to be sold at the end
of 10 years for a price of $5 million, $2 million above book value. The farm is expected to
produce revenue of $2 million each year, and annual cash flow from operations equals $1.8
million. The marginal tax rate is 35 percent, and the appropriate discount rate is 10 percent.
LO 1
Solution:
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Sale price of asset = $5,000,000
11.21 Projects with different lives: You are trying to choose between purchasing one of two
machines for a factory. Machine A costs $15,000 to purchase and has a three-year life.
Machine B costs $17,700 to purchase but has a four year life. Regardless of which machine
you purchase, it will have to be replaced at the end of its operating life. Which machine
should you choose? Assume a marginal tax rate of 35% and a discount rate of 15%.
LO 4
Solution
Since the machines have difference purchase costs and different operating lives, you should
choose the machine that has the lowest equivalent annual cost (EAC).
You should choose machine B because it has the lowest equivalent annual cost.
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11.22 Projects with different lives: You are starting a family pizza parlor and need to buy a
motorcycle for delivery orders. You have two models in mind. Model A costs $9,000 and is
expected to run for six years; model B is more expensive, with a price of $14,000 and an
expected life of 10 years. The annual maintenance costs are $800 for model A and $700 for
model B. Assume that the opportunity cost of capital is 10 percent. Which one should you
buy?
LO 4
Solution:
You need first calculate the NPV of costs for each of the motorcycles:
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11.23 When to harvest an asset: Predator LLC, a leveraged buyout specialist, recently bought a
company and wants to determine the optimal time to sell it. The partner in charge of this
investment has estimated the after-tax cash flows at different times as follows: $700,000 if
sold one year later; $1,000,000 if sold two years later; $1,200,000 if sold three years later; and
$1,300,000 if sold four years later. The opportunity cost of capital is 12 percent. When should
LO 5
Solution:
11.24 Replace an existing asset: Bell Mountain Vineyards is considering updating its current
manual accounting system with a high-end electronic system. While the new accounting
system would save the company money, the cost of the system continues to decline. The Bell
Mountain’s opportunity cost of capital is 10 percent, and the costs and values of investments
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0 $5,000 $7,000
1 4,500 7,000
2 4,000 7,000
3 3,600 7,000
4 3,300 7,000
5 3,100 7,000
LO 4
Solution:
11.25 Replace an existing asset: You have a 1993 Nissan that is expected to run for another three
years, but you are considering buying a new Hyundai before the Nissan wears out. You will
donate the Nissan to Goodwill when you buy the new car. The annual maintenance cost is
$1,500 per year for the Nissan and $200 for the Hyundai. The price of your favorite Hyundai
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model is $18,000, and it is expected to run for 15 years. Your opportunity cost of capital is 3
percent. Ignore taxes. When should you buy the new Hyundai?
LO 4
Solution:
Since the EAC of the new car is $1,707.8 and exceeds that of the Nissan( $1,500), you should
drive the 1993 Nissan for three more years and then buy a new Hyundai.
11.26 Replace an existing asset: Assume that you are considering replacing your old Nissan with a
new Hyundai, as in the previous problem. However, the annual maintenance cost of the old
Nissan increases as time goes by. It is $1,200 in the first year, $1,500 in the second year, and
$1,800 in the third year. When should you replace it with the new Hyundai in this case?
LO 4
Solution:
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The EAC of the Hyundai remains at $1,707.80, as calculated above.
Comparing this amount with the annual maintenance costs of the Nissan and you will see that
in year 2 it is cheaper to drive the Nissan, but in year 3 it is cheaper to drive the Hyundai.
Therefore, the optimal time to replace the old car is at the end of year 2.
11.27 When to harvest an existing asset: Anaconda Manufacturing Company currently own a mine
that is known to contain a known amount of gold. Since Anaconda does not have any gold-
mining expertise, the company plans to sell the entire mine and base the selling price on a
fixed multiple of the spot price for gold at the time of the sale. Analysts at Anaconda have
forecast the price spot for gold and have determined that the price will increase by 14 percent,
12 percent, 9 percent, and 6 percent during the next one, two, three, and four years,
respectively. If Anaconda’s opportunity cost of capital is 10 percent, what is the optimal time
LO 5
Solution:
The rate of gold price appreciation is greater than the opportunity cost of capital for the next
two years and then it drops below the opportunity cost of capital. Therefore, Anaconda should
sell the gold at the beginning of the third year (or at the end of the second year).
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11.28 Replace an existing asset: You are thinking about delivering pizzas in your spare time. Since
you must use your own car to deliver the pizzas, you will wear out your current car one year earlier,
which is one year from today, than if you did not take on the delivery job. You estimate that when
you purchase a new car, regardless of when that occurs, you will pay $20,000 for the car and it will
last you five years. If your opportunity cost of capital is 7 percent, what is the opportunity cost of
LO 4
Solution:
Therefore, the opportunity cost of wearing out your car a year earlier is
ADVANCED
11.29 You are the CFO of SlimBody, Inc., a retailer of the exercise machine Slimbody6® and
related accessories. Your firm is considering opening up a new store in Los Angeles. The
store will have a life of 20 years. It will generate annual sales of 5,000 exercise machines, and
the price of each machine is $2,500. The annual sales of accessories will be $600,000, and the
operating expenses of running the store, including labor and rent, will amount to 50 percent of
the revenues from the exercise machines. The initial investment in the store will equal $30
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million and will be fully depreciated on a straight-line basis over the 20-year life of the store.
Your firm will need to invest $2 million in additional working capital immediately, and
recover it at the end of the investment. Your firm’s marginal tax rate is 30 percent. The
opportunity cost of opening up the store is 10 percent. What are the incremental cash flows
from this project at the beginning of the project as well as in years 1-19 and 20? Should you
approve it?
LO 1
Solution:
Yrs 1-19 Yr 20
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You should approve the project since it has a positive NPV.
Alternative Solution:
Incremental cash flows in year 0 is:
FCF0 = -$30,000,000-$2,000,000= -$32,000,000
Annual incremental cash flows through the life of the investment are:
FCFt = ($2,500 ×$2,500+$600,000) × (1-0.3)+0.3 ×$1,500,000 = $5,245,000
Additional incremental cash flows at the end of the project are:
$2,000,000
Therefore the NPV of the project is:
11.30 Merton Shovel Corporation has decided to bid for a contract to supply shovels to the
Honduran Army. The Honduran Army intends to buy 1000 shovels per year for the next three
years. To supply these shovels, Merton will have to acquire manufacturing equipment at a
cost of $150,000. This equipment will be depreciated on a straight-line basis over its five-
year lifetime. At the end of the third year Merton can sell the equipment for exactly its book
value ($60,000). Additional fixed costs will be $36,000 per year and variable costs will be
$3.00 per shovel. An additional investment of $25,000 in net working capital will be required
when the project is initiated. This investment will be recovered at the end of the third year.
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Merton Shovel has a 35% marginal tax rate and a 17% required rate of return on the project.
What is the lowest possible per shove bid price that Merton can submit for the contract?
LO 1
Solution
11.31 Rocky Mountain Lumber, Inc., is considering purchasing a new wood saw that costs $50,000.
The saw will generate revenues of $100,000 per year for five years. The cost of materials and
labor needed to generate these revenues will total $60,000 per year, and other cash expenses
will be $10,000 per year. The machine is expected to sell for $1,000 at the end of its five-year
life and will be depreciated on a straight-line basis over five years to zero. Rocky Mountain’s
tax rate is 34 percent, and its opportunity cost of capital is 10 percent. Should the company
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LO 1
Solution:
Yrs 1-4 Yr 5
Alternatively:
The annual operating cash flows from year 1 to 5 are:
($100,000-$60,000-$10,000) ×1-0.34) + 0.34 ×10,000=$23,200
The after-tax terminal value in year 5 is:
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$1,000 - (0.34)($1,000-$0) = $660
Therefore, NPV of investment is:
11.32 A beauty product company is developing a new fragrance named Happy Forever. There is a
probability of 0.5 that consumers will love Happy Forever, and in this case, annual sales will
be 1 million bottles; a probability of 0.4 that consumers will find the smell acceptable and
annual sales will be 200,000 bottles; and a probability of 0.1 that consumers will find the
smell weird and annual sales will be only 50,000 bottles. The selling price is $38, and the
variable cost is $8 per bottle. There is a fixed production cost of $1 million per year, and
depreciation will be $1.2 million. Assume that the marginal tax rate is 40 percent. What are
the expected annual incremental cash flows from the new fragrance?
LO 1
Solution:
Step One: Expected sales units: (0.5) ×1,000,000 + (0.4) ×200,000 + (0.1) ×50,000 =
585,000 units
Step Two: ΔNR: 585,000 units × $38 = $22,230,000
Step Three: ΔOpExp: 585,000 units x $8 + $1,000,000 = $5,680,000
Step Four: ΔD&A: $1,200,000
Step Five: Plug into the text book template as below.
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ΔNR 22,230,000
- ΔOpEx -5,680,000
= ΔEBITDA 16,550,000
- ΔD&A -1,200,000
= ΔEBIT 15,350,000
x (1-t) 0.60
= ΔNOPAT 9,210,000
+ ΔD&A 1,200,000
= ΔCFO 10,410,000
- ΔCapEx 0
- ΔAWC 0
= ΔFCF 10,410,000
11.33 Great Fit, Inc., is a company that makes clothing. The company has a product line that
produces women’s tops of regular sizes. The same machine could be used to produce petite
sizes as well. However, the life of the machines will be reduced from four more years to two
more years if the petite size production is added. The cost of identical machines with a life of
eight years is $2 million. Assume the opportunity cost of capital is 8 percent. What is the
LO 4
Solution:
The opportunity cost is the incremental costs of the machine in year 3 and year 4 if petite
sizes are in production. The EAC of the machine is:
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The present value of such cost in year 3 and year 4 is:
11.34 Biotech Partners LLC has been farming a new strain of radioactive-material-eating bacteria
that the electrical utility industry can use to help dispose of its nuclear waste. Two opposing
effects are affecting Biotech’s decision of when to harvest the bacteria. The bacteria are
currently growing at a 22 percent annual rate, but due to known competition from other top
firms, Biotech analysts estimate that the price for the bacteria will fluctuate according to the
scale below. If the opportunity cost of capital is 10 percent, then when should Biotech harvest
1 5%
2 -2
3 -8
4 -10
5 -15
6 -25
LO 5
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Solution:
Change in revenue:
Since the change in revenue is higher for the first two years, Biotech should sell its bacteria
colony at the beginning of the third year or at the end of the second year.
11.35 ACME manufacturing is considering replacing an existing production line with a new line
that has a greater output capacity and operates with less labor than the existing line. The new
line would cost $1 million, have a five-year life, and would be depreciated using MACRS
over three years. At the end of five years, the new line could be sold as scrap for $200,000 (in
year 5 dollars). Because the new line is more automated, it would require fewer operators,
resulting in a saving of $40,000 per year before tax and unadjusted for inflation (in today’s
dollars). Additional sales with the new machine are expected to result in additional net cash
inflows, before tax, of $60,000 per year (in today’s dollars). If ACME invests in the new line,
a one-time investment of $10,000 in additional working capital will be required. The tax rate
is 35 percent, the opportunity cost of capital is 10 percent, and the annual rate of inflation is 3
40
LO 1
Solution:
0 1 2 3 4 5
(Revenue -
11.36 The alternative to investing in the new production line in Problem 11.31 is to overhaul the
existing line, which currently has both a book value and a salvage value of $0. It would cost
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$300,000 to overhaul the existing line, but this expenditure would extend its useful life to five
years. The line would have a $0 salvage value at the end of five years. The overhaul outlay
would be capitalized and depreciated using MACRS over three years. Should ACME replace
LO 1
0 1 2 3 4 5
(Revenue -
Op Ex)(1-t)
minus Add WC
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Renovating the old line is less costly.
CFA Problems
11.37. FITCO is considering the purchase of new equipment. The equipment costs $350,000, and an
additional $110,000 is needed to install it. The equipment will be depreciated straight-line to
zero over a five-year life. The equipment will generate additional annual revenues of
$265,000, and it will have annual cash operating expenses of $83,000. The equipment will be
sold for $85,000 after five years. An inventory investment of $73,000 is required during the
life of the investment. FITCO is in the 40 percent tax bracket and its cost of capital is 10
percent. What is the project NPV?
a. $47,818
b. $63,658
c. $80,189
d. $97,449
Solution:
d is correct.
Outlay = FCInv + NWCInv – Sal0 + T × (Sal0 – B0)
Outlay = (350,000 + 110,000) + 73,000 – 0 + 0 = $533,000
The installed cost is $350,000 + $110,000 = $460,000, so the annual
depreciation is $460,000/5 = $92,000. The annual after-tax operating
cash flow for Years 1–5 is
CF = (S – C – D)(1 – T) + D = (265,000 – 83,000 – 92,000)(1 – 0.40) + 92,000
CF = $146,000
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TNOCF = $124,000
The NPV is
5
146, 000 124, 000
NPV 533, 000 t
t 1 1.10 1.105 = $97,449
11.38. After estimating a project’s NPV, the analyst is advised that the fixed capital outlay will be
revised upward by $100,000. The fixed capital outlay is depreciated straight-line over an
eight-year life. The tax rate is 40 percent and the required rate of return is 10 percent. No
changes in cash operating revenues, cash operating expenses, or salvage value are expected.
What is the effect on the project NPV?
a. $100,000 decrease
b. $73,325 decrease
C. $59,988 decrease
d. No change
Solution:
B is correct. The additional annual depreciation is $100,000/8 = $12,500. The
depreciation tax savings is 0.40 ($12,500) = $5,000. The change in project NPV is
8
5, 000
100, 000 100, 000 26, 675 $73,325
t 1 (1.10)t
11.39. When assembling the cash flows to calculate an NPV or IRR, the project’s after-tax interest
expenses should be subtracted from the cash flows for
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b. the IRR calculation, but not the NPV calculation.
c. both the NPV calculation and the IRR calculation.
d. neither the NPV calculation nor the IRR calculation.
Solution:
D is correct. Financing costs are not subtracted from the cash flows for either the NPV or the
IRR. The effects of financing costs are captured in the discount rate used.
11.1 You purchased 100 shares of stocks of an oil company, Texas Energy, Inc., at $50 per share.
The company has 1 million shares outstanding. Ten days later, Texas Energy announced an
investment in an oil field in east Texas. The probability of the investment being successful and
generating NPV of $10 million is 0.2; the probability of the investment will be a failure and
generate a negative NPV of negative $1 million is 0.8. How would you expect the stock price
Solution:
The expected change in the stock price should be equal to the expected NPV of the project
divided by the number of shares outstanding. The expected NPV of the project is 0.2
$1.2/share
Stock price of Texas Energy, Inc., will increase by $1.20 upon the announcement of the
investment.
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11.2 A chemical company is considering buying a magic fan for its plant. The magic fan is
expected to work forever and to help cool the machines in the plant and hence reduce their
maintenance costs by $4,000 per year. The cost of the fan is $30,000. The appropriate
discount rate is 10 percent, and the marginal tax rate is 40 percent. Should the company buy
Solution:
The after-tax saving of maintenance costs is: $4,000 × (1 – 40%) / 10% = $24,000, which is
less than the cost. Therefore the company should not buy the fan. If one fails to take into
consideration the tax effect on maintenance costs, the opposite conclusion will be made.
Therefore it is important to remember our Rule 5 for incremental cash flow calculations:
11.3 Hogvertz Elvin Catering (HEC) is considering switching from its old food maker to a new
Wonder Food Maker. Both food makers will remain useful for the next ten years, but the new
option will generate a depreciation expense of $5,000 per year while the old food maker will
generate a depreciation expense of $4,000 per year. What is the after-tax cash flow effect from
deprecation of switching to the new food maker for HEC if the firm’s marginal tax rate is 40
Solution:
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Without the benefit of other information required in the cash flow calculation table, we must
isolate the cash flow effect of depreciation for a firm. We therefore find that we have a
deduction of D&A above the tax calculation line and an addition of D&A below the tax
calculation line. This means that the net yearly after-tax effect of depreciation and
Usin
g that result, we find that the net yearly effect of depreciation and amortization of cash flow
is:
and so the present value of the total after-tax cash flow effect from depreciation can be found
as follows:
11.4 The Long-Term Financing Company has identified an alternative project that is similar to a
project currently under consideration in all respects except one. That is, the new project will
reduce the need for working capital by $10,000 during the 30-year life of the project. The
firm’s cost of capital is 18 percent, and the marginal corporate tax rate for the firm is 34
percent. What is the after-tax present value of this new alternative project?
Solution:
Because working capital has no effect on the income statement of the firm, there are no tax
effects from the two cash flows associated with the working capital change. Therefore, the
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$10,000 – $10,000 × (1.18)-30 = $10,000 – ($10,000) × 0.006975 = $9,930.25
11.5 Choice Masters must choose between two projects of unequal lives. Project 1 has a NPV of
$50,000 and will be viable for five years. The discount rate for project 1 and project 2 is 10
percent. Project 2 will be viable for seven years. In order for Choice Master to be indifferent
between the two projects, what must the NPV of project 2 be?
Solution:
which means that project 2 must also generate cash flow of $13,189.87 per year for seven
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