Concept Questions

What are the three difficulties in determining incremental cash flows? Sunk costs. Opportunity costs Side effects. Define sunk costs, opportunity costs, and side effects. Sunk costs are costs that have already been incurred and that will not be affected by the decision whether to undertake the investment. Opportunity costs are costs incurred by the firm because, if it decides to undertake a project, it will forego other opportunities for using the assets. Side effects appear when a project negatively affects cash flows from other parts of the firm. What are the items leading to cash flow in any year? ash flow from operations !revenue"operating costs"ta#es$ plus cash flow of investment !cost of new machines % changes in net working capital % opportunity costs$. Why did we determine income when &'( )nalysis discounts cash flows, not income? *ecause we need to determine how much is paid out in ta#es. Why is working capital viewed as a cash outflow? *ecause increases in working capital must be funded by cash generated elsewhere in the firm. What is the difference between the nominal and the real interest rate? +he nominal interest rate is the real interest rate with a premium for inflation. What is the difference between nominal and real cash flows? ,eal cash flows are nominal cash flows adjusted for inflation. What is the e-uivalent annual cost method of capital budgeting? +he decision as to which of various mutually e#clusive machines to buy is based on the e-uivalent annual cost. +he .) is determined by dividing the net present value of costs by an annuity factor that has the same life as the machines. +he machine with the lowest .) should be ac-uired. an you list the assumptions that we must to use .) ? )ll machines do the same job. +hey have different operating costs and lives +he machine will be indefinitely replaced.

Questions And Problems

NPV and Capital Budgeting /.0 Which of the following cash flows should be treated as incremental cash flows when computing the &'( of an investment? a. +he reduction in the sales of the companys other products. b. +he e#penditure on plant and e-uipment. c. +he cost of research and development undertaken in connection with the product during the past three years. d. +he annual depreciation e#pense. e. Dividend payments. f. +he resale value of plant and e-uipment at the end of the projects life. g. Salary and medical costs for production employees on leave. Solutions a.1es, the reduction in the sales of the company2s other products is an incremental cash flow. 3nclude these lost sales because they are a cost !a revenue reduction$ which the firm must bear if it chooses to produce the new product. b.1es, the e#penditures on plant and e-uipment are incremental cash flows. +hese are direct costs of the new product line. c.&o, the research and development costs are not included. +he costs of research and development undertaken on the product during the past 4 years are sunk costs and should not be included in the

evaluation of the project. +he sunk costs must be borne whether or not the firm chooses to produce the new product5 thus, they should have no bearing on the acceptability of the project. d.1es, the annual depreciation charge is part of the incremental cash flows. +he depreciation charge is considered when computing the cash flows of the project. ,emember, though, that it is the depreciation ta# shield that is actually the cash flow. e.&o, the dividend payments are not incremental cash flows. Dividend payments are not a cost of the project. +he choice of whether or not to pay a dividend is a decision of the firm, which is separate from the decision of choosing investment projects. Dividend will be discussed thoroughly in a later chapter. f.1es, the resale value is an important cash flow at the end of the life of a project. 1et, be careful with the resale value of plant and e-uipment. +he price at which the firm sells the e-uipment is a cash inflow. 3f that price is different from the book value of the asset at the time of sale, ta# conse-uence will arise. ,emember that after an asset has been fully depreciated under current depreciation code, its book value is e-ual to 6ero. +he difference between the book value and the sale price creates losses or gains which in turn create a ta# credit or liability. g.1es, salary and medical costs for production employees on leave are incremental cash flows of the project. +he salaries of all personnel connected to the project must be included as costs of that project. +hus, the costs of employees who are on leave for a portion of the project life must be included as costs of that project. /.7 1our company currently produces and sells steel"shaft golf clubs. +he *oard of Directors wants you to look at introducing a new line of titanium bubble woods with graphite shaft. Which of the following costs are not relevant? 3. 8and you already own that will be used for the project and has a market value of 9/::,:::. 33. 94::,::: drop in sales of steel"shaft clubs if titanium woods with graphite shaft are introduced. 333. 97::,::: spent on ,esearch and Development last year on graphite shafts. a. 3 only b. 33 only c. 333 only d. 3 and 333 only e. 33 and 333 only /.4 +he *est ;anufacturing ompany is considering a new investment. <inancial projections for the investment are tabulated below. ! ash flows are in 9 thousands and the corporate ta# rate is 4= percent.$ 1ear : 1ear 0 1ear 7 1ear 4 1ear = Sales revenue /,::: /,::: /,::: /,::: Operating costs 7,::: 7,::: 7,::: 7,::: 3nvestment 0:,::: Depreciation 7,>:: 7,>:: 7,>:: 7,>:: &et working capital 7:: 7>: 4:: 7:: : !end of year$ a. ompute the incremental net income of the investment. b. ompute the incremental cash flows of the investment. c. Suppose the appropriate discount rate is 07 percent. What is the &'( of the project? Solutions 1ear : 1ear 0 1ear 7 1ear 4 1ear = !0$ Sales revenue " 9/,::: 9/,::: 9/,::: 9/,::: !7$ Operating costs " 7,::: 7,::: 7,::: 7,::: !4$ Depreciation " 7,>:: 7,>:: 7,>:: 7,>:: !=$ 3ncome before ta# " 7,>:: 7,>:: 7,>:: 7,>:: !>$ +a#es at 4=? " @>: @>: @>: @>: !A$ &et income : 0,A>: 0,A>: 0,A>: 0,A>: !/$ ash flow from : =,0>: =,0>: =,0>: =,0>: operation B!0$"!7$"!>$C !@$ 3nvestment "0:,::: " " " " !D$ hanges in net working "7:: ">: ">: 0:: 7:: capital !0:$ +otal cash flow from "0:,7:: ">: ">: 0:: 7:: investment

!00$ +otal cash flow "0:,7:: =,0:: =,0:: =,7>: =,4>: &et income Bfrom !A$CE : 0,A>: 0,A>: 0,A>: 0,A>: b. 3ncremental cash flow Bfrom !00$CE "0:,7:: =,0:: =,0:: =,7>: =,4>: c. &'( F "90:,7:: % 9=,0:: G 0.07 % 9=,0:: G 0.077 % 9=,7>: G 0.074 % 9=,4>: G 0.07=F 97,>0@./@ /.= )ccording to the <ebruary /, 0D@4, issue of +he Sporting &ews, the Hansas ity ,oyals designated hitter, Ial ;c,ae, signed a three"year contract in January 0D@4 with the following provisionsE 9=::,::: signing bonus. 97>:,::: salary per year for three years. 0: years of deferred payments of 907>,::: per year !these payments begin in year =$. Several bonus provisions that total as much as 9/>,::: per year for the three years of the contract. )ssume that ;c,ae has a A:"percent probability of receiving the bonuses each year, and that he signed the contract on January 0, 0D@4. !IintE Kse the e#pected bonuses as incremental cash flows.$ )ssume an effective annual interest rate of 07.4A percent, and ignore ta#es. ;c,aes salary and bonus are paid at the end of the year. What was the present value of this contract in January when ;c,ae signed it? Solutions Since there is uncertainty surrounding the bonus payments, which ;c,ae might receive, you must use the e#pected value of ;c,ae2s salary in the computation of the '( of his contract. +he e#pected value of ;c,ae2s salary in years one through three is 97>:,::: % :.A 9/>,::: % :.= 9: F 97D>,:::. '( F 9=::,::: % 97D>,::: B!0 " 0 G 0.074A4$ G :.074AC % L907>,::: G 0.074A4M B!0 " 0 G 0.074A0: G :.074AC F 90,>D=,@7>.A@ a. /.> *enson .nterprises, 3nc., is evaluating alternative uses for a three"story manufacturing and warehousing building that it has purchased for 977>,:::. +he company could continue to rent the building to the present occupants for 907,::: per year. +he present occupants have indicated an interest in staying in the building for at least another 0> years. )lternatively, the company could modify the e#isting structure to use for its own manufacturing and warehousing needs. *ensons production engineer feels the building could be adapted to handle one of two new product lines. +he cost and revenue data for the two product alternatives follow. 'roduct ) 'roduct * 3nitial cash outlay for building modifications 9 4A,::: 9 >=,::: 3nitial cash outlay for e-uipment 0==,::: 0A7,::: )nnual preta# cash revenues !generated for 0> years$ 0:>,::: 07/,>:: )nnual preta# cash e#penditures !generated for 0> years$ A:,::: />,::: +he building will be used for only 0> years for either product ) or product *. )fter 0> years, the building will be too small for efficient production of either product line. )t that time, *enson plans to rent the building to firms similar to the current occupants. +o rent the building again, *enson will need to restore the building to its present layout. +he estimated cash cost of restoring the building if product ) has been undertaken is 94,/>:5 if product * has been produced, the cash cost will be 97@,07>. +hese cash costs can be deducted for ta# purposes in the year the e#penditures occur. *enson will depreciate the original building shell !purchased for 977>,:::$ over a 4:"year life to 6ero, regardless of which alternative it chooses. +he building modifications and e-uipment purchases for either product are estimated to have a 0>"year life5 also, they can and will be depreciated on a straight"line basis. +he firms ta# rate is 4= percent, and its re-uired rate of return on such investments is 07 percent. <or simplicity, assume all cash flows for a given year occur at the end of the year. +he initial outlays for modifications and e-uipment will occur at t N :, and the restoration outlays will occur at the end of year 0>. )lso, *enson has other profitable ongoing operations that are sufficient to cover any losses. Which use of the building would you recommend to management? Solutions

+o evaluate *enson2s alternatives, compute the after"ta# net cash flows !)G+"& <$. <irst, note that the building left and depreciation are not incremental and should not be included in the analysis of these two alternatives. 'roduct )E ,evenues "<oregone rent ".#penditures "DepreciationO .arnings before ta#es "+a#es !4=?$ &et income %Depreciation apital investment )G+"& < tF: t F 0 " 0= 90:>,::: 07,::: A:,::: 07,::: 970,::: /,0=: 904,@A: 07,::: 97>,@A: t F 0> 90:>,::: 07,::: A4,/>: 07,::: 90/,7>: >,@A> 900,4@> 07,::: 974,4@>

OO

"90@:,::: "90@:,:::

ODepreciation F !90==,::: % 94A,:::$ G 0> F 907,::: OO ash e#penditures % ,estoration costs &'() F "90@:,::: % 97>,@A: :.07 % 974,4@> G 0.070> F "90@:,::: % 97>,@A: !A.A7@7$ % 974,4@> G 0.070> F "9=,477.=: +he cash flows in year 0 " 0= could have been computed using the simplification demonstrated in the te#t. )G+"& < F ,evenue !0 " +$ " .#penses !0 " +$ % Depreciation !+$ F 90:>,::: !:.AA$ " 9/7,::: !:.AA$ % 907,::: !:.4=$F 97>,@A: +he cash flows for the final year could have been computed by adjusting for the after"ta# value of the restoration costs. 97>,@A: " 94,/>: !:.AA$ F 974,4@> 'roduct *E ,evenues "<oregone rent ".#penditures "DepreciationO .arnings before ta#es "+a#es !4=?$ &et income %Depreciation apital investment )G+"& < tF: t F 0 " 0= 907/,>:: 07,::: />,::: 0=,=:: 97A,0:: @,@/= 90/,77A 0=,=:: 940,A7A t F 0> 907/,>:: 07,::: 0:4,07> 0=,=:: "97,:7> "A@D "90,44A 0=,=:: 904,:A=

0=

OO

"970A,::: "970A,:::

ODepreciation F !90A7,::: % 9>=,:::$ G 0> F 90=,=:: OO ash e#penditures % ,estoration costs &'(* F "970A,::: % 940,A7A :.07 % 904,:A= G 0.070> F "970A,::: % 940,A7A !A.A7@7$ % 904,:A= G 0.070> F "94,D@D.@: +he cash flows in year 0 " 0= could have been computed using the simplification demonstrated the te#t. )G+"& < F ,evenue !0 " +$ " .#penses !0 " +$ % Depreciation !+$ F 907/,>:: !:.AA$ " 9@/,::: !:.AA$ % 90=,=:: !:.4=$ F 940,A7A +he cash flows for the final year could have been computed by adjusting for the after"ta# value of the restoration costs. 940,A7A " 97@,07> !:.AA$ F 904,:A=

0=

*enson should continue to rent the building. /.A Samsung 3nternational has rice fields in alifornia that are e#pected to produce average annual profits of 9@::,::: in real terms forever. Samsung has no depreciable assets and is an all"e-uity firm with 7::,::: shares outstanding. +he appropriate discount rate for its stock is 07 percent. Samsung has an investment opportunity with a gross present value of 90 million. +he investment re-uires a 9=::,::: outlay now. Samsung has no other investment opportunities. )ssume that all cash flows are received at the end of each year. What is the price per share of Samsung? Solutions .'S F 9@::,::: G 7::,::: F 9= &'(PO F !"9=::,::: % 90,:::,:::$ G 7::,::: F 94 'rice F .'S G r % &'(PO F 9= G :.07 % 94 F94A.44 /./ Dickinson *rothers, 3nc., is considering investing in a machine to produce computer keyboards. +he price of the machine will be 9=::,::: and its economic life five years. +he machine will be fully depreciated by the straight"line method. +he machine will produce 0:,::: units of keyboards each year. +he price of the keyboard will be 9=: in the first year, and it will increase at > percent per year. +he production cost per unit of the keyboard will be 97: in the first year, and it will increase at 0: percent per year. +he corporate ta# rate for the company is 4= percent. 3f the appropriate discount rate is 0> percent, what is the &'( of the investment? Solutions 1ear : 1ear 0 1ear 7 1ear 4 1ear = 1ear > Sales revenue 9=::,::: 9=7:,::: 9==0,::: 9=A4,:>: 9=@A,7:: Operating costs 7::,::: 77:,::: 7=7,::: 7AA,7:: 7D7,@7: Depreciation @:,::: @:,::: @:,::: @:,::: @:,::: 3ncome before ta# 07:,::: 07:,::: 00D,::: 00A,@>: 004,4@: +a#es at 4=? =:,@:: =:,@:: =:,=A: 4D,/7D 4@,>=D &et income /D,7:: /D,7:: /@,>=: //,070 /=,@40 ash flow from 0>D,7:: 0>D,7:: 0>@,>=: 0>/,070 0>=,@40 operation !Sales ,evenue Q Operating osts Q +a#es$ 3nvestment "9=::,::: &'( F "9=::,:::% 90>D,7:: G 0.0> % 90>D,7:: G 0.0>7 % 90>@,>=: G 0.0>4 % 90>/,070 G 0.0>= % 90>=,@40 G 0.0>> F 907D,@A@.7D /.@ Scott 3nvestors, 3nc., is considering the purchase of a 9>::,::: computer that has an economic life of five years. +he computer will be depreciated based on the system enacted by the +a# ,eform )ct of 0D@A. !See +able /.4 for the depreciation schedules.$ +he market value of the computer will be 90::,::: in five years. +he use of the computer will save five office employees whose annual salaries are 907:,:::. 3t also contributes to lower net working capital by 90::,::: when they buy the computer. +he net working capital will be recovered at the end of the period. +he corporate ta# rate is 4= percent. 3s it worthwhile to buy the computer if the appropriate discount rate is 07 percent? Solutions 1ear : 1ear 0 1ear 7 1ear 4 1ear = 1ear > 0. )nnual Salary Savings 907:,::: 907:,::: 907:,::: 907:,::: 907:,::: 7. Depreciation 0::,::: 0A:,::: DA,::: >/,A:: >/,A:: 4. +a#able 3ncome 7:,::: "=:,::: 7=,::: A7,=:: A7,=:: =. +a#es A,@:: "04,A:: @,0A: 70,70A 70,70A >. Operating ash <low 004,7:: 044,A:: 000,@=: D@,/@= D@,/@= !line 0"=$ A. &et working capital 90::,::: "0::,::: /. 3nvestment 9>::,::: />,/D7O

@.

+otal ash <low

"9=::,::: 9004,7::

9044,A::

9000,@=:

9D@,/@=

9/=,>/A

O/>,/D7 F 90::,::: " :.4= !90::,::: " 97@,@::$ &'( F "9=::,:::% 9004,7:: G 0.07 % 9044,A:: G 0.077 % 9000,@=: G 0.074 % 9D@,/@= G 0.07= % 9/=,>/A G 0.07> F "9/,/77.>7 /.D +he Pap is considering buying an on"line cash register software from 3*; so that it can effectively deal with its retail sales. +he software package costs 9/>:,::: and will be depreciated down to 6ero using the straight"line method over its five"year economic life. +he marketing department predicts that sales will be 9A::,::: per year for the ne#t three years, after which the market will cease to e#ist. ost of goods sold and operating e#penses are predicted to be 7> percent of sales. )fter three years the software can be sold for 9=:,:::. +he Pap also needs to add net working capital of 97>,::: immediately. +his additional net working capital will be recovered in full at the end of the project life. +he corporate ta# rate for Pap is 4> percent and the re-uired rate of return on it is 0/ percent. What is the &'( of the new software? Solutions tF: ,evenues " .#penses " Depreciation .arnings *efore +a#es " +a#es !4>?$ &et 3ncome % Depreciation apital 3nvestment Working apital apital 8oss )G+"& < t F 0" 7 9A::,::: 0>:,::: 0>:,::: 94::,::: 0:>,::: 90D>,::: 0>:,::: tF4 9A::,::: 0>:,::: 0>:,::: 94::,::: 0:>,::: 90D>,::: 0>:,::: % 9=:,::: % 97>,::: " 97A:,::: 90>:,:::

" 9/>:,::: " 7>,::: " 9//>,::: 94=>,:::

+he capital loss reflects 94::,::: in book value of the asset less the sale of 9 =:,:::. +he cash flows in year 0"7 could have been calculated by )G+ " & < F ,evenue !0 " +$ " .#penses !0 " +$ % Depreciation !:.4>$ F 9A::,::: !:.A>$ " 90>:,::: !:.A>$ % 90>:,:::!:.4>$F 94=>,::: &'( F " 9//>,::: % 94=>,::: :.0/ % 90>:,::: G !0.0/$ 4 F " 904=.==>.=> /.0: .tonic 3nc. is considering an investment of 97>:,::: in an asset with an economic life of five years. +he firm estimates that the nominal annual cash revenues and e#penses will be 97::,::: and 9>:,:::, respectively. *oth revenues and e#penses are e#pected to grow at 4 percent per year as that of the e#pected annual inflation. .tonic will use straight"line method to depreciate its asset to 6ero over the economic life. +he salvage value of the asset is estimated to be 94:,::: in nominal terms at the end of five years. +he one" time &W investment of 90:,::: is re-uired immediately. <urther, the nominal discount rate for all cash flows is 0> percent. )ll corporate cash flows are subject to a 4> percent ta# rate. )ll cash flows, e#cept the initial investment and the &W , occur at the end of the year. What is the project2s total nominal cash flow from assets in year >? Solutions ) G + Q & < F 97::,::: !0.:4$> !0 " :.4>$ " 9>:,::: !0.:4$> !0 Q :.4>$ % 9>:,::: !:.4>$ %94:,::: !0 " :.4>$ % 90:,::: F 90@=,:47./ /.00 ommercial ,eal .state, 3nc., is considering the purchase of a 9= million building to lease. +he economic life of the building will be 7: years. )ssume that the building will be fully depreciated by the straight"line method and its market value in 7: years will be 6ero. +he company e#pects that annual lease payments will increase at 4 percent per year. +he appropriate discount rate for cash flows of lease payments

is 04 percent, while the discount rate for depreciation is D percent. +he corporate ta# rate is 4= percent. What is the least ommercial ,eal .state should ask for the first"year lease? )ssume that the annual lease payment starts right after the signature of the lease contract. Solutions +his is an annuity due !or annuity in advance$ problem. '( of lease revenue after ta# F :.AA 8 B0 G !:.04 " :.:4$ " L0 G !:.04 " :.:4$M !0.:4 G 0.04$ 7:C!0.04$F A.7@D:= 8 Where 8 F the first year lease payment. '( of depreciation ta# shield for annual depreciation of 97::,:::F :.4= 97::,::: :.:D F 9A7:,/=0.00 Solve the e-uationE &'( F "9=,:::,::: % A.7@D:= 8 % 9A7:,/=0.00 F : 8 F 9>4/,47>.:@ /.07 ,oyal Dutch 'etroleum is considering going into a new project, which is typical for the firm. ) capital tool re-uired for the project costs 97 million. +he marketing department predicts that sales will be 90.7 million per year for the ne#t four years, after which the market will cease to e#ist. +he tool, a five"year class capital tool, will be depreciated down to 6ero using the straight"line method. ost of goods sold and operating e#penses are predicted to be 7> percent of sales. )fter four years the tool can be sold for 90>:,:::. ,oyal Dutch also needs to add net working capital of 90::,::: immediately. +his additional capital will be received in full at the end of the project life. +he ta# rate for ,oyal Dutch is 4> percent. +he re-uired rate of return on ,oyal Dutch is 0A.>> percent. Solutions tF: tF0Q4 tF= ,evenues 90,7::,::: 90,7::,::: " .#penses 4::,::: 4::,::: " Depreciation =::,::: =::,::: .arnings *efore +a#es 9>::,::: 9>::,::: " +a#es !4>?$ 0/>,::: 0/>,::: &et 3ncome 947>,::: 947>,::: % Depreciation =::,::: =::,::: apital 3nvestment " 97,:::,::: %90>:,::: &W " 0::,::: %90::,::: apital 8oss " 97>:,::: )G+Q& < "97,0::,::: 9/7>,::: 9/7>,::: &'( F " 97,0::,::: % 9/7>,::: F " 9D4,4D0
= : .0A>>

7:

apital *udgeting with 3nflation /.04 onsider the following cash flows on two mutually e#clusive projects. 1ear 'roject ) 'roject * : N9=:,::: N9>:,::: 0 7:,::: 0:,::: 7 0>,::: 7:,::: 4 0>,::: =:,::: ash flows of project ) are e#pressed in real terms while those of project * are e#pressed in nominal terms. +he appropriate nominal discount rate is 0> percent, and the inflation is = percent. Which project should you choose? Solutions ,eal interest rate F !0.0> G 0.:=$ " 0 F 0:.>@? &'() F "9=:,:::% 97:,::: G 0.0:>@ % 90>,::: G 0.0:>@7 % 90>,::: G 0.0:>@4F 90,==A./A &'(* F "9>:,:::% 90:,::: G 0.0> % 97:,::: G 0.0>7 % 9=:,::: G 0.0>4F 900D.0/ hoose project ). /.0= Sanders .nterprises, 3nc., has been considering the purchase of a new manufacturing facility for 907:,:::. +he facility is to be depreciated on a seven"year basis. 3t is e#pected to have no value after seven

years. Operating revenues from the facility are e#pected to be 9>:,::: in the first year. +he revenues are e#pected to increase at the inflation rate of > percent. 'roduction costs in the first year are 97:,:::, and they are e#pected to increase at / percent per year. +he real discount rate for risky cash flows is 0= percent, while the nominal riskless interest rate is 0: percent. +he corporate ta# rate is 4= percent. Should the company accept the suggestion? Solutions )fter"ta# revenues F L9>:,::: !0 " :.4=$ G 0.:>M F 904=,//>.7D
/ / :.0= F 940,=7@.>/ :.0=

)ssume production costs grow at a nominal rate of /? a year, the real growth rate of the production costs F B!0 % /?$ G !0 % >?$C " 0 F 0.D:>? )fter"ta# e#penses F "L97:,::: !0 " :.4=$ G 0.:>M L0 G !:.0= " :.:0D:>$M B0 " !0.:0D:> G 0.0=$/CF "9>A,>4>.7= Depreciation ta# shield Bfrom table /.>C F 907:,::: :.4= :./70=F 97D,=44.07 &'( F "907:,::: % 904=,//>.7D " 9>A,>4>.7= % 97D,=44.07F "907,47A.@4 Do not accept the suggestion. /.0> 'hillips 3ndustries runs a small manufacturing operation. <or this year, it e#pects to have real net cash flows of 907:,:::. 'hillips is an ongoing operation, but it e#pects competitive pressures to erode its !inflation"adjusted$ net cash flows at A percent per year. +he appropriate real discount rate for 'hillips is 00 percent. )ll net cash flows are received at year"end. What is the present value of the net cash flows from 'hillipss operations? Solutions '( F 907:,::: G L:.00 " !":.:A$M F 9/:>,@@7.4> /.0A Iarry Pultekin, a small restaurant ownerGmanager, is contemplating the purchase of a larger restaurant from its owner who is retiring. Pultekin would finance the purchase by selling his e#isting small restaurant, taking a second mortgage on his house, selling the stocks and bonds that he owns, and, if necessary, taking out a bank loan. *ecause Pultekin would have almost all of his wealth in the restaurant, he wants a careful analysis of how much he should be willing to pay for the business. +he present owner of the larger restaurant has supplied the following information about the restaurant from the past five years. 1ear Pross ,evenue 'rofit N> 9@/>,::: 9 A7,::: N= @@4,::: 7@,::: N4 @7@,::: =,=:: N7 D40,::: DA,::: 8ast DD@,::: 0:4,::: )s with many small businesses, the larger restaurant is structured as a Subchapter S corporation. +his structure gives the owner the advantage of limited liability, but the preta# profits flow directly through to the owner, without any corporate ta# deducted. +he preceding figures have not been adjusted for changes in the price level. +here is general agreement that the average profits for the past five years are representative of what can be e#pected in the future, after adjusting for inflation. Pultekin is of the opinion that he could earn at least 94,::: in current dollars per month as a hired manager. Pultekin feels he should subtract this amount from profits when analy6ing the venture. <urthermore, he is aware of statistics showing that for restaurants of this si6e, appro#imately A percent of owners go out of business each year. Pultekin has done some preliminary work to value the business. Iis analysis is as followsE 'rice"8evel 'rofits 3mputed ;anagerial &et 1ear 'rofits <actor !current dollars$ Wage 'rofits N> 9 A7,::: 0.7@ 9 /D,=:: 94A,::: 9 =4,=:: N= 7@,::: 0.0@ 44,::: 4A,::: N4,::: N4 =,=:: 0.:D =,@:: 4A,::: N40,7::

N7 DA,::: 0.:= DD,@:: 4A,::: A4,@:: 8ast 0:4,::: 0.:: 0:4,::: 4A,::: A/,::: +he average profits for the past five years, e#pressed in current dollars, are 97@,:::. Ksing this average profit figure, Pultekin produced the following figures. +hese figures are in current dollars. .#pected 'rofits ,isk" ,eal if *usiness 'robability )djusted Discount 'resent 1ear ontinues of ont.O 'rofits <actor 7? (alue &e#t 97@,::: 0.::: 97@,::: :.D@: 97/,=:: N7 7@,::: :.D=: 7A,4:: :.DA0 7>,4:: N4 7@,::: :.@@= 7=,/:: :.D=7 74,4:: N= 7@,::: :.@40 74,4:: :.D7= 70,>:: ...... ...... ...... O'robability of the business continuing. +he probability of failing in any year is A percent. +hat probability compounds over the years. *ased on these calculations, Pultekin has calculated that the value of the restaurant is 94>:,:::. a. )ssume that there is indeed a A percent per year probability of going out of business. Do you agree with Pultekins assessment of the restaurant? 3n your answer, consider his treatment of inflation, his deduction of the managerial wage of 94,::: per month, and the manner in which he assessed risk. b. What present value would you place on the revenue stream5 in other words, how much would you advise Pultekin that he should be willing to pay for the restaurant? /.0A a. +he only mistake that Pultekin made was to discount at the risk"free rate of interest. +he bankruptcy risk adjustment to the cash flows was correct, but these should have been discounted by a risk" adjusted rate. Piven that Pultekin2s portfolio is un"diversified !all of his money would be in the restaurant$, he should have used a higher discount rate. +he deduction of the managerial wage was appropriate since the opportunity to earn that amount elsewhere is Pultekin2s opportunity cost of working in the restaurant. b. 1ou should have chosen a higher discount rate and recomputed the value of the restaurant. <or e#ample, with a discount rate of 0:?, the value is 97@,::: G B:.0: " !":.:A$C F 90/>,:::. &otice that the restaurant2s cash flows form a growing !actually declining$ perpetuity. /.0/ +he *iological 3nsect ontrol orporation !*3 $ has hired you as a consultant to evaluate the &'( of their proposed toad ranch. *3 plans to breed toads and sell them as ecologically desirable insect" control mechanisms. +hey anticipate that the business will continue in perpetuity. <ollowing negligible start"up costs, *3 will incur the following nominal cash flows at the end of the year. ,evenues 90>:,::: 8abor costs @:,::: Other costs =:,::: +he company will lease machinery from a firm for 97:,::: per year. !+he lease payment starts at the end of year 0.$ +he payments of the lease are fi#ed in nominal terms. Sales will increase at > percent per year in real terms. 8abor costs will increase at 4 percent per year in real terms. Other costs will decrease at 0 percent per year in real terms. +he rate of inflation is e#pected to be A percent per year. +he real rate of discount for revenues and costs is 0: percent. +he lease payments are risk"free5 therefore, they must be discounted at the risk"free rate. +he real risk"free rate is / percent. +here are no ta#es. )ll cash flows occur at year"end. What is the &'( of *3 s proposed toad ranch today? Solutions +he simplest approach to this problem is to discount the real cash flows. Since the revenues and costs are growing perpetuities, the formula for computing the '( of such a stream can be used. +he first year amounts of the revenues and costs are stated in nominal terms. Since the growth rate and discount rate are real rates, adjust the initial amounts. <or revenues, labor costs and the other costs, those amounts are 90>:,::: G 0.:A, 9@:,::: G 0.:A and 9=:,::: G 0.:A, respectively. '( !revenue$ F !90>:,::: G 0.:A$ G !:.0: " :.:>$ F 97,@4:,0@D '( !labor costs$ F !9@:,::: G 0.:A$ G !:.0: " :.:4$ F 90,:/@,0A/

'( !other costs$ F !9=:,::: G 0.:A$ G L:.0: " !":.:0$M F 94=4,:>4 +he lease payment is given in nominal terms and it should be discounted by the nominal rate which is :.04=7 BF !0.:/ 0.:A$ " 0C. +hus, the present value of the lease payments is 97:,::: G :.04=7 F 90=D,:40. +he lease payments are constant in nominal terms, but not in real terms. +his can be seen that by computing the real value of the first few lease payments. 1ear &ominal ,eal 0 97:,::: 97:,::: G 0.:A F 90@,@A@ 7 97:,::: 97:,::: G 0.:A7 F 90/,@:: 4 97:,::: 97:,::: G 0.:A4 F 90A,/D7 +he real payments form a declining perpetuity. 1ou can apply the growing perpetuity formula to compute their '( in real terms, but be careful about which growth rate you use. +he growth rate is not A? as the inflation rate would imply. +he growth rate is !0 G 0.:A$ " 0 F ":.:>AA. Ksing this growth rate, the '( of the real lease payments is 90@,@A@ G B:.:/ " !":.:>AA$C F 90=D,:4A. 1ou can use either method for computing the '( of the lease payments, but you are wise to use whichever method is easiest and most straight"forward. 3n this case, it would be easy to use the wrong growth rate or the wrong initial cash flow in the calculation of the real nominal flows. &ote, both methods must give you the same amount in '( terms. !+he difference in this case is due to rounding.$ +o find the &'( of *3 2s toad ranch, add the present values of the revenues and the costs. ,ecall, the start"up costs are negligible. &'( F 97,@4:,0@D " 90,:/@,0A/ " 94=4,:>4 " 90=D,:40F 90,7>D,D4@. /.0@ Sony 3nternational has an investment opportunity to produce a new stereo color +(. +he re-uired investment on January 0 of this year is 947 million. +he firm will depreciate the investment to 6ero using the straight"line method. +he firm is in the 4="percent ta# bracket. +he price of the product on January 0 will be 9=:: per unit. +hat price will stay constant in real terms. 8abor costs will be 90> per hour on January 0. +hey will increase at 7 percent per year in real terms. .nergy costs will be 9> per physical unit on January 05 they will increase at 4 percent per year in real terms. +he inflation rate is > percent. ,evenues are received and costs are paid at year"end. 1ear 0 1ear 7 1ear 4 1ear = 'hysical production, in units 0::,::: 7::,::: 7::,::: 0>:,::: 8abor input, in hours 7,:::,::: 7,:::,::: 7,:::,::: 7,:::,::: .nergy input, physical units 7::,::: 7::,::: 7::,::: 7::,::: +he riskless nominal discount rate is = percent. +he real discount rate for costs and revenues is @ percent. alculate the &'( of this project. Solutions 1ear 0 1ear 7 1ear 4 1ear = ,evenues =:,:::,::: @:,:::,::: @:,:::,::: A:,:::,::: 8abor osts 4:,A::,::: 40,707,::: 40,@4A,7=: 47,=/7,DA> .nergy osts 0,:4:,::: 0,:A:,D:: 0,:D7,/7/ 0,07>,>:D !,evenues" osts$ @,4/:,::: =/,/7/,0:: =/,:/0,:44 7A,=:0,>7A )fter"ta# !,evenues" osts$ >,>7=,7:: 40,=DD,@@A 40,:AA,@@7 0/,=7>,::/ &'( F "947,:::,::: % !9>,>7=,7::G0.:@ % 940,=DD,@@AG0.:@7 % 940,:AA,@@7G0.:@4 % 90/,=7>,::/G0.:@=$ % 9@,:::,:::!4=?$ :.:= F 9=4,=A=,0@4 where 9@,:::,::: is the amount of depreciation each year. /.0D Sparkling Water, 3nc., sells 7 million bottles of drinking water each year. .ach bottle sells at 97.> in real terms and costs per bottle are 9:./ in real terms. Sales income and costs occur at year"end. Sales income is e#pected to rise at a real rate of / percent annually, while real costs are e#pected to rise at > percent annually. +he relevant, real discount rate is 0: percent. +he corporate ta# rate is 4= percent. What is Sparkling worth today? Solutions 3nitial revenues F 97.> 7,:::,:::F 9>,:::,::: 3nitial e#penses F 9:./ 7,:::,:::F 90,=::,::: '( after ta# F 9>,:::,::: !0 " :.4=$ G !:.0: " :.:/$ " 90,=::,::: !0 " :.4=$ G !:.0: " :.:>$

F 900:,:::,::: " 90@,=@:,:::F 9D0,>7:,::: /.7: 3nternational *uckeyes is building a factory that can make 0 million buckeyes a year for five years. +he factory costs 9A million. 3n year 0, each buckeye will sell for 94.0> in nominal terms. +he price will rise > percent each year in real terms. During the first year variable costs will be 9:.7A7> per buckeye in nominal terms and will rise by 7 percent each year in real terms. 3nternational *uckeyes will depreciate the value of the factory to 6ero over the five years by use of the straight"line method. 3nternational *uckeyes e#pects to be able to sell the factory for 9A4@,0=:./@ at the end of year > !or 9>::,::: in real terms$. +he nominal discount rate for risky cash flows is 7: percent. +he nominal discount rate for riskless cash flows is 00 percent. +he rate of inflation is > percent. ash flows, e#cept the initial investment, occur at the end of the year. +he corporate ta# rate is 4= percent5 capital gains are also ta#ed at 4= percent. What is the net present value of this project? Solutions +he analysis of the &'( of this project is most easily accomplished by separating the depreciation costs from the project2s other cash flows. +hose costs should be discounted at a riskless rate. +he riskless nominal rate is given. +he revenues and variable costs are given in nominal terms, but their growth rates are real growth rates. Ience, they are most easily discounted using the real rate for risky cash flows. ,emember that you can use different types of discount rates !real vs. nominal$ in a problem as long as you are careful to discount real cash flows with the real rate and nominal cash flows with the nominal rate. <irst, determine the net income from the revenues and e#penses not including depreciation. &ote that the nominal price of a buckeye during the first year was 94.0>. +he inflation rate during the period was >?. +herefore, the real price of a buckeye was 94.:: BF 4.0> G 0.:>C. Similarly, the nominal variable cost for a buckeye was 9:.7A7>5 the real variable cost is 9:.7> BF 9:.7A7> G 0.:>C. ,evenue " (ariable cost 're"ta# earnings " +a#es !4=?$ &et income )fter"ta# saleO tF0 94,:::,::: 7>:,::: 7,/>:,::: D4>,::: 0,@0>,::: 0,@0>,::: tF7 94,0>:,::: 7>>,::: 7,@D>,::: D@=,4:: 0,D0:,/:: 0,D0:,/:: tF4 94,4:/,>:: 7A:,0:: 4,:=/,=:: 0,:4A,00A 7,:00,7@= 7,:00,7@= tF= 94,=/7,@/> 7A>,4:7 4,7:/,>/4 0,:D:,>/> 7,00A,DD@ 7,00A,DD@ tF> 94,A=A,>0D 7/:,A:@ 4,4/>,D00 0,0=/,@0: 7,77@,0:0 44:,::: 7,>>@,0:0

O)fter"ta# proceeds F 9>::,::: :.AAF 944:,::: Since these cash flows are in real terms, you must use the real discount rate to find the '( of the flows. ,eal discount rate F 0.7: G 0.:> " 0 F :.0=7D F 0=.7D? +he '( of the annual net incomes using the real discount rate of 0=.7D? is 9A,D>:,A/4. !&oteE )lthough the actual real discount rule is 0=.7@>/0=4..., we round to 0=.7D to computational conventional.$ +he &'( of the project is the present value of the net income in each year plus the present value of the depreciation ta# shield. +he depreciation per yearE 9A,:::,::: G > F 90,7::,::: +he depreciation ta# shield per yearE 90,7::,::: :.4= F 9=:@,::: )gain, the depreciation ta# shield is in nominal terms, so discount it using the nominal riskless rate. &'( F "9A,:::,::: % 9A,D>:,A/4 % 9=:@,:::

> :.00 F 97,=>@,A::

/.70 ;ajestic ;ining ompany !;; $ is negotiating for the purchase of a new piece of e-uipment for their current operations. ;; wants to know the ma#imum price that it should be willing to pay for the e-uipment. +hat is, how high must the price be for the e-uipment to have an &'( of 6ero? 1ou are given the following factsE a. +he new e-uipment would replace e#isting e-uipment that has a current market value of 97:,:::. b. +he new e-uipment would not affect revenues, but before"ta# operating costs would be reduced by 90:,::: per year for eight years. +hese savings in cost would occur at year"end.

c. +he old e-uipment is now five years old. 3t is e#pected to last for another eight years, and it is e#pected to have no resale value at the end of those eight years. 3t was purchased for 9=:,::: and is being depreciated to 6ero on a straight"line basis over 0: years. d. +he new e-uipment will be depreciated to 6ero using straight"line depreciation over five years. ;; e#pects to be able to sell the e-uipment for 9>,::: at the end of eight years. +he proceeds from this sale would be subject to ta#es at the ordinary corporate income ta# rate of 4= percent. e. ;; has profitable ongoing operations. f. +he appropriate discount rate is @ percent. Solutions 8et 3 be the ma#imum price the ;ajestic ;ining ompany should be willing to pay for the e-uipment. .#amine the incremental cash flows from purchasing the new e-uipment. 3ncremental :E ost of the new e-uipment "3 Sale of the old e-uipment 97:,::: +a# effect of the saleO : +otal 97:,::: " 3 O+a# savings F + !*ook value " Sale price$ F :.4= !97:,::: " 97:,:::$F 9: *ook value F ost " )ccumulated depreciation F 9=:,::: " >!9=:,::: G 0:$ F 97:,::: 3ncremental 0 " > E )fter"ta# savingsE 90:,::: :.AA F 9A,A:: Depreciation ta# shieldE B3 G > " 9=,:::C :.4= 3ncremental A " @ E )fter"ta# savingsE 90:,::: :.AA F 9A,A:: Depreciation ta# shieldOE 9: O)t the end of year five, both pieces of e-uipment have been fully depreciated. +hus, ;ajestic ;ining will no longer get a depreciation ta# shield. )dditional cash flows in t F @E Sale of e-uipment 9>,::: +a# effectO "0,/:: +otal 94,4:: O+a# savings F + !*ook value " Sale price$ F :.4= !9: " 9>,:::$ F "90,/:: *ook valueE Since the e-uipment was depreciated to a 6ero value over five years, its book value is 6ero at the end of year eight. &'( F "3 % 97:,::: % 9A,A::

@ :.:@ >

% B3 G > " 9=,:::C !:.4=$ :.:@ % 94,4:: G 0.:@@ F "3 % 97:,::: % 9A,A:: !>./=AA$ % B3 G > " 9=,:::C !:.4=$ !4.DD7/$ % 94,4:: G 0.:@@F 9: :./7@> 3 F 9>=,7@:.4/>4 3 F 9/=,>0: /.77 )fter e#tensive medical and marketing research, 'ill, 3nc., believes it can penetrate the pain reliever market. 3t can follow one of two strategies. +he first is to manufacture a medication aimed at relieving headache pain. +he second strategy is to make a pill designed to relieve headache and arthritis pain. *oth products would be introduced at a price of 9= per package in real terms. +he broader remedy would probably sell 0: million packages a year. +his is twice the sales rate for the headache"only medication. ash costs of production in the first year are e#pected to be 90.>: per package in real terms for the headache"only brand.

'roduction costs are e#pected to be 90./: in real terms for the more general pill. )ll prices and costs are e#pected to rise at the general inflation rate of > percent. .ither strategy would re-uire further investment in plant. +he headache"only pill could be produced using e-uipment that would cost 90:.7 million, last three years, and have no resale value. +he machinery re-uired to produce the broader remedy would cost 907 million and last three years. )t this time the firm would be able to sell it for 90 million !in real terms$. +he production machinery would need to be replaced every three years, at constant real costs. Suppose that for both projects the firm will use straight"line depreciation. +he firm faces a corporate ta# rate of 4= percent. +he firm believes the appropriate real discount rate is 04 percent. apital gains are ta#ed at the ordinary corporate ta# rate of 4= percent. Which pain reliever should the firm produce? Solutions Ieadache only )fter"ta# operating income F B!9= >,:::,:::$ " !90.>: >,:::,:::$C !0 " :.4=$F 9@,7>:,::: Depreciation ta# shield tF0 tF7 tF4 &ominal depreciation 94,=::,::: 94,=::,::: 94,=::,::: ,eal depreciation 4,74@,:D> 4,:@4,D:: 7,D4/,:=@ +a# shields !,eal$ 0,0::,D>7 0,:=@,>7A DD@,>DA F "90:,7::,::: % 9@,7>:,::: :.04 % 90,0::,D>7 G 0.04 % 90,:=@,>7A G 0.047 % 9DD@,>DA G 0.044F 900,/A/,:4: Ieadache and )rthritis )fter"ta# operating income F B!9= 0:,:::,:::$ " !90./: 0:,:::,:::$C !0 " :.4=$F 90>,0@:,::: &'( Depreciation ta# shield &ominal depreciation ,eal depreciation +a# shields !,eal$ tF0 9=,:::,::: 4,@:D,>7= 0,7D>,74@ tF7 9=,:::,::: 4,A7@,00@ 0,744,>A: tF4 9=,:::,::: 4,=>>,4>: 0,0/=,@0D

)fter"ta# cash flow from sale of machinery F 90,:::,::: !0".4=$ F 9AA:,:::. &'( F "907,:::,::: % 90>,0@:,::: :.04 % 90,7D>,74@ G 0.04 % 90,744,>A: G 0.047 % 90,0/=,@0D G 0.044 % 9AA:,::: G 0.044 F 97/,77A,7:= +he firm should choose to manufacture Ieadache and )rthritis. /.74 ) machine that lasts four years has the following net cash outflows. 907,::: is the cost of purchasing the machine, and 9A,::: is the annual year"end operating cost. )t the end of four years, the machine is sold for 97,:::5 thus, the cash flow at year =, =, is only 9=,:::. : 0 7 4 = 907,::: 9A,::: 9A,::: 9A,::: 9=,::: +he cost of capital is A percent. What is the present value of the costs of operating a series of such machines in perpetuity? Solutions )ssume the ta# rate is 6ero. tF: 907,::: tF0 9A,::: tF7 9A,::: tF4 9A,::: tF= 9=,::: 907,::: tF> 9A,::: tFA 9A,::: ... ...

+he present value of one cycle isE '( F 907,::: % 9A,::: :.:A % 9=,::: G 0.:A= F 907,::: % 9A,::: !7.A/4:$ % 9=,::: G 0.:A=F 940,7:A.4/ +he cycle is four years long, so use a four year annuity factor to compute the e-uivalent annual cost !.) $. .) F 940,7:A.4/ G
= : .:A

F 940,7:A.4/ G 4.=A>0F 9D,::A +he present value of such a stream in perpetuity is 9D,::A G :.:A F 90>:,0:: /.7= ) machine costs 9A:,::: and re-uires 9>,::: maintenance for each year of its three"year life. )fter three years, this machine will be replaced. )ssume a ta# rate of 4= percent and a discount rate of 0= percent. 3f the machine is depreciated with a three"year straight"line without a salvage value, what is the e-uivalent annual cost !.) $? Solutions '( of cash outflows '( F 9A:,::: % !0 " :.4=$ 9>,::: F 9>0,@/=.7D F .) ! :.0= $ .) F 977,4=4.@D /.7> Knited Iealthcare, 3nc. needs a new admitting system, which costs 9A:,::: and re-uires 97,::: in maintenance for each year of its five"year life. +he system will be depreciated straight"line down to 6ero without salvage value at the end of five years. )ssume a ta# rate of 4> percent and an annual discount rate of 0@ percent. What is the e-uivalent annual cost of this admitting system? Solutions '( of cash outflows '( F 9A:,::: % !0 " :.4>$ 97,:::
> > :.0@ " !:.4>$ 907,::: :.0@ > F 9>:,D40.7:F .) ! :.0@ $ 4 4 :.0= " !:.4=$ 97:,::: :.0=

.) F 90A,7@A.A/ /.7A )viara Polf )cademy is evaluating different golf practice e-uipment. +he easy as piee-uipment costs 9=>,:::, has a three"year life, and costs 9>,::: per year to operate. +he relevant discount rate is 07 percent. )ssume that the straight"line depreciation down to 6ero is used. <urthermore, it has a salvage value of 90:,:::. +he relevant ta# rate is 4= percent. What is the .) of this e-uipment? Solutions '( of cash outflows '( F 9=>,::: % !0 " :.4=$ 9>,::: F 977,:4:.00
4 4 :.07 " !:.4=$ 90>,::: :.07 " 90:,::: G !0.07$ 4

F .) ! :.07 $ .) F 9D,0/7.77 ,eplacement with Kne-ual 8ives /.7/ Office )utomation, 3nc., is obliged to choose between two copiers, RR=: or ,I=>. RR=: costs less than ,I=>, but its economic life is shorter. +he costs and maintenance e#penses of these two copiers are given as follows. +hese cash flows are e#pressed in real terms. opier 1ear : 1ear 0 1ear 7 1ear 4 1ear = 1ear > RR=: 9/:: 90:: 90:: 90:: ,I=> D:: 00: 00: 00: 900: 900: +he inflation rate is > percent and the nominal discount rate is 0= percent. )ssume that revenues are the same regardless of the copier, and that whichever copier the company chooses, it will buy the model forever. Which copier should the company choose? 3gnore ta#es and depreciation. Solutions ,eal discount rate F !0.0= G 0.:>$ " 0 F @.>/? '( of cash outflow from RR=: F 9/:: % 90:: G 0.:@>/ % 90:: G 0.:@>/7 % 90:: G 0.:@>/4 F 9D>>.:@
:.:@>/ F !7.>>:@7$ .) F .) .) F 94/=.=7

'( of cash outflow from ,I=> F 9D:: % 900: G 0.:@>/ % 900: G 0.:@>/7 % 900: G 0.:@>/4 % 900: G 0.:@>/= % 900: G 0.:@>/> F 90,447.A@ F .) !

> :.:@>/ $ F !4.D44==$ .)

.) F 944@.@0 hoose ,I=>. /.7@ <iber Plasses must choose between two kinds of facilities. <acility 3 costs 97.0 million and its economic life is seven years. +he maintenance costs for facility 3 are 9A:,::: per year. <acility 33 costs 97.@ million and it lasts 0: years. +he annual maintenance costs for facility 33 are 90::,::: per year. *oth facilities are fully depreciated by the straight"line method. +he facilities will have no values after their economic lives. +he corporate ta# rate is 4= percent. ,evenues from the facilities are the same. +he company is assumed to earn a sufficient amount of revenues to generate ta# shields from depreciation. 3f the appropriate discount rate is 0: percent, which facility should <iber Plasses choose? Solutions <acility 3 )fter"ta# maintenance costs F !0 " :.4=$ 9A:,::: Depreciation ta# shield

/ :.0: F 90D7,/@D.4D

F !:.4=$ 94::,::: :.0: F 9=DA,>/@./7 '( of cash outflow F 97,0::,::: % 90D7,/@D.4D " 9=DA,>/@./7 F 90,/DA,70:.A/ .) F .) ! :.0: $ F 94A@,D>0.>>

<acility 33 )fter"ta# maintenance costs F !0 " :.4=$ 90::,::: Depreciation ta# shield

0: :.0: F 9=:>,>=0.=4

F !:.4=$ 97@:,::: :.0: F 9>@=,DA7./D '( of cash outflow F 97,@::,::: % 9=:>,>=0.=4 " 9>@=,DA7./D F 97,A7:,>/@.A= .) F .) ! :.0: $ F 9=7A,=@/.00

0:

0:

hoose facility 3. /.7D 'ilot 'lus 'ens is considering when to replace its old machine. +he replacement costs 94 million now and re-uires maintenance costs of 9>::,::: at the end of each year during the economic life of five years. )t the end of five years the new machine would have a salvage value of 9>::,:::. 3t will be fully depreciated by the straight"line method. +he corporate ta# rate is 4= percent and the appropriate discount rate is 07 percent. ;aintenance cost, salvage value, depreciation, and book value of the e#isting machine are given as follows. *ook (alue 1ear ;aintenance Salvage Depreciation !end of year$ : 9 =::,::: 97,:::,::: 97::,::: 90,:::,::: 0 0,>::,::: 0,7::,::: 7::,::: @::,::: 7 0,>::,::: @::,::: 7::,::: A::,:::

4 7,:::,::: A::,::: 7::,::: =::,::: = 7,:::,::: =::,::: 7::,::: 7::,::: +he company is assumed to earn a sufficient amount of revenues to generate ta# shields from depreciation. When should the company replace the machine? Solutions &ew ;achine '( of cash outflow F 94,:::,::: % !0 " :.4=$ 9>::,::: " !:.4=$ 9A::,::: F 94,7AA,D>:.D=

> :.07

> :.07 " 9>::,::: !0 " :.4=$ G 0.07>

.)

F .) ! :.07 $ F !4.A:=/@$ .) F 9D:A,7@4.D@

>

Old ;achine !0$ 3f replace in year 0. Opportunity cost of selling !after"ta#$ F 97,:::,::: " :.4= !97,:::,::: " 90,:::,:::$ F 90,AA:,::: )fter"ta# maintenance cost !'resent value$ F 9=::,::: !0 " :.4=$ G 0.07 F 974>,/0=.7D '( of salvage value after ta# F L90,7::,::: " :.4= !90,7::,::: " 9@::,:::$M G 0.07 F 9D>:,::: '( of depreciation ta# shield F :.4= 97::,::: G 0.07 F 9A:,/0=.7D +hus, '( of cash outflow F 90,AA:,::: % 974>,/0=.7D " 9D>:,::: " 9A:,/0=.7D F 9@@>,::: +hus, '( in year 0 F 9DD0,7:: S .) of new machine. ,eplace right now. O We can check whether '( of old machine in year 7 has still higher cash outflow than .) of new machine. !7$ 1ear 7 '( in year 0 F L90,7::,::: " :.4= !90,7::,::: " 9@::,:::$M % 90,>::,::: !0 " :.4=$ G 0.07 " L9@::,::: " :.4= !9@::,::: " 9A::,:::$M G 0.07 " :.4= 97::,::: G 0.07 F 90,744,A=7.@> +hus, '( in year 7 F 90,744,A=7.@> 0.07 F 90,4@0,A@:.:: .ven much greater than the cost in !0$. ,eplace right now. /.4: Pold Star 3ndustries is in need of computers. +hey have narrowed the choices to the S)8 >::: and the D.+ 0:::. +hey would need 0: S)8s. .ach S)8 costs 94,/>: and re-uires 9>:: of maintenance each year. )t the end of the computers eight"year life Pold Star e#pects to be able to sell each one for 9>::. On the other hand, Pold Star could buy eight D.+s. D.+s cost 9>,7>: each and each machine re-uires 9/:: of maintenance every year.

+hey last for si# years and have a resale value of 9A:: for each one. Whichever model Pold Star chooses, it will buy that model forever. 3gnore ta# effects, and assume that maintenance costs occur at year"end. Which model should they buy if the appropriate discount rate is 00 percent? Solutions 0: S)8s '( F 94,/>: 0: % !9>:: 0:$ F 9A0,:A:.D@ F .) ! :.00 $ F 900,@A>.=4 F 9>,7>: @ % !9/:: @$ F 9A4,07=./= F .) ! :.00 $ .) F 90=,D70.70 Pold star should buy 0: S)8s. /.40 *1O Kniversity is faced with the decision of which word processor to purchase for its typing pool. 3t can buy 0: *ang word processors which cost 9@,::: each and have estimated annual, year"end maintenance costs of 97,::: per machine. +he *ang word processors will be replaced at the end of year = and have no value at that time. )lternatively, *1O could buy 00 3OK word processors to accomplish the same work. +he 3OK word processors would need to be replaced after three years. +hey cost only 9>,::: each, but annual, year"end maintenance costs will be 97,>:: per machine. ) reasonable forecast is that each 3OK word processor will have a resale value of 9>:: at the end of three years. +he university2s opportunity cost of funds for this type of investment is 0= percent. *ecause the university is a nonprofit institution, it does not pay ta#es. 3t is anticipated that whichever manufacturer is chosen now will be the supplier of future machines. Would you recommend purchasing 0: *ang word processors or 00 3OK machines? Solutions +o evaluate the word processors, compute their e-uivalent annual costs !.) $. *ang '(!costs$ F !0: 9@,:::$ % !0: 97,:::$ F 9@:,::: % 97:,::: !7.D04/$ F 904@,7/= .) F 904@,7/= G 7.D04/ F 9=/,=>A 3OK '(!costs$ F !00 9>,:::$ % !00 97,>::$ " !00 9>::$ G 0.0=4 F 9>>,::: % 97/,>:: !7.470A$ " 9>,>:: G 0.0=4 F 900>,047 .)
= : .0=

@ :.00 " !9>:: 0:$ G 0.00@

.) @ D.+s '(

A :.00 " !9A:: @$ G 0.00A

4 :.0=

F 900>,047 G 7.470A F 9=D,>D7 *1O should purchase the *ang word processors. /.47 Station WJR+ is considering the replacement of its old, fully depreciated sound mi#er. +wo new models are available. ;i#er R has a cost of 9=::,:::, a five"year e#pected life, and after"ta# cash flow savings of 907:,::: per year. ;i#er 1 has a cost of 9A::,:::, an eight"year life, and after"ta# cash flow savings of 904:,::: per year. &o new technological developments are e#pected. +he cost of capital is 00 percent. Should WJR+ replace the old mi#er with R or 1?

Solutions ;i#er R &'( F "9=::,::: % 907:,::: :.00 F 9=4,>:/.A=

>

.) F 9=4,>:/.A= G ;i#er 1 &'(

> :.00 F 900,//0.@@ @

F "9A::,::: % 904:,::: :.00 F 9A@,DD>.DA

.) F 9A@,DD>.DA G :.00 F 904,=:/.4/ hoose ;i#er 1. /.44 Haul onstruction must choose between two pieces of e-uipment. +amper ) costs 9A::,::: and it will last five years. +his tamper will re-uire 900:,::: of maintenance each year. +amper * costs 9/>:,:::, but it will last seven years. ;aintenance costs for +amper * are 9D:,::: per year. Haul incurs all maintenance costs at the end of the year. +he appropriate discount rate for Haul onstruction is 07 percent. a. Which machine should Haul purchase? b. What assumptions are you making in your analysis for part !a$? Solutions a. +amper ) '( F 9A::,::: % 900:,::: F 9DDA,>7>.4@ .) F 9DDA,>7>.4@ G F 97/A,==>.@= +amper * '( F 9/>:,::: % 9D:,::: F 90,0A:,/4@.:D .) F 90,0A:,/4@.:D G

> :.07

> :.07

/ :.07

/ :.07

F 97>=,44@.4: hoose +amper *. b. +he two assumptions behind replacement chains areE 0. +he time hori6on is long. 7. ,eplacement at the end of each cycle is possible. /.4= 'hilben 'harmaceutics must decide when to replace its autoclave. 'hilben s current autoclave will re-uire increasing amounts of maintenance each year. +he resale value of the e-uipment falls every year. +he following table presents this data. 1ear ;aintenance osts ,esale (alue +oday 9 : 9D:: 0 7:: @>: 7 7/> //> 4 47> /:: = =>: A:: > >:: >:: 'hilben can purchase a new autoclave for 94,:::. +he new e-uipment will have an economic life of si# years. )t the end of each of those years, the e-uipment will re-uire 97: of maintenance. 'hilben e#pects to be able to sell the machine for 90,7:: at the end of si# years. )ssume that 'hilben will pay no ta#es. +he appropriate discount rate for this decision is 0: percent. When should 'hilben replace its current machine? Solutions <irst compute the e-uivalent annual cost !.) $ of the new machine.

'(!costs$ F 94,::: % 97: :.0: " 90,7:: G 0.0:A F 94,::: % 97: !=.4>>4$ " 90,7:: G 0.0:A F 97,=0: .) F 97,=0: G =.4>>4F 9>>4 ompute the cost of keeping the old autoclave for an additional year. +hose costs include the foregone resale value for the previous year and maintenance for the current year. +he costs are reduced by the resale value at the end of the current year. '( of keeping the old autoclave through year oneE '( F 9D:: % 97:: G 0.0: " 9@>: G 0.0: F 94:D +he value of these costs at the end of year one isE 94:D 0.0: F 94=: 3t is cheaper to operate the old autoclave than to purchase the new one. ost at the end of year one of keeping the old autoclave through year twoE '( F 9@>: % 97/> G 0.0: " 9//> G 0.0:F 94D> +he value of these costs at the end of year two isE94D> 0.0: F 9=4> 3t is cheaper to operate the old autoclave than to purchase the new one. ost at the end of year two of keeping the old autoclave through year threeE '( F 9//> % 947> G 0.0: " 9/:: G 0.0:F 9=4= +he value of these costs at the end of year three isE9=4= 0.0: F 9=// 3t is cheaper to operate the old autoclave than to purchase the new one. ost at the end of year three of keeping the old autoclave through year fourE '( F 9/:: % 9=>: G 0.0: " 9A:: G 0.0:F 9>A= +he value of these costs at the end of year four isE9>A= 0.0: F 9A7: 3t would be cheaper to purchase the new autoclave than to operate the old one in year four. Ience, 'hilben should purchase the new machine at the end of year three. +o be certain that future costs of the old autoclave do not make it more economical to operate, you should compute the annual cost of each of the additional years. ost at the end of year four of keeping the old autoclave through year fiveE '( F 9A:: % 9>:: G 0.0: " 9>:: G 0.0:F 9A:: +he value of these costs at the end of year five isE 9A:: 0.0: F 9AA: +he decision to replace after year three was correct. /.4> ! hallenge$ ) firm considers an investment of 97@,:::,::: !purchase price$ in new e-uipment to replace old e-uipment that has a book value of 907,:::,::: !market value of 97:,:::,:::$. 3f the firm replaces the old e-uipment with the new e-uipment, it e#pects to save 90/,>::,::: in preta# cash flow !net savings$ savings the first year and an additional 07 percent !more than the previous year$ per year for each of the following three years !total of four years$. +he old e-uipment has a four"year remaining life, being written off on a straight"line depreciation basis with no e#pected salvage value. +he new e-uipment will be depreciated under the ;) ,S system !which uses a double"declining balance approach, the half"year convention in year 0, and the option to switch to straight"line when it is beneficial$ using a three"year life. 3n addition, it is assumed that replacement of the old e-uipment with the new e-uipment would re-uire an increase in working capital of 9>,:::,:::, which would not be recovered until the end of the four"year investment. 3f the relevant ta# rates is =: percent, findE a. +he net investment !time : cash flow$. b. +he after"ta# cash flow for each period. c. +he internal rate of return, the net present value, and the profitability inde#. Solutions &et 'resent (alue 3,, '3 94i,DA@,07@ @:? 7.D/ /A.D=?

&ew .-uipment &ew .-uip. (alue Kseful 8ife

7@,:::,::: 4

Old .-uipment *ook (alue ;arket (alue 3ncrease in Working ap Prowth Dep.Gyr !old$ +a# ,ate Discount rate 4,:::,::: =:? 0:?

07,:::,::: 7:,:::,::: >,:::,::: 07?

1ear 0 7 4 =

Depreciation D,444,444 07,===,=== =,0=@,0=@ 7,:/=,:/= Ialf"year convention in first year5 switch to straight in year 4 'urchase &ew .-uip. Sell Old .-uip. +a# on Old .-uip. hange in WG 're"ta# < Savings Depreciation !old$ Depreciation !new$ +a#able 3ncome +a#es &et 3ncome Depreciation )dd"back ash <low !after"ta#$

*alance 0@,AAA,AA/ A,777,777 7,:/=,:/= :

: 0 !7@,:::,:::$ 7:,:::,::: !4,7::,:::$ !>,:::,:::$

>,:::,::: 70,D>7,::: 7=,>@A,7=: 4,:::,::: 4,:::,::: !=,0=@,0=@$ !7,:/=,:/=$ 7:,@:4,@>7 7>,>07,0AA !@,470,>=0$ !0:,7:=,@AA$ 07,=@7,400 0>,4:/,4:: 0,0=@,0=@ !D7>,D7A$ 04,A4:,=>D 0D,4@0,4/=

0/,>::,::: 0D,A::,::: 4,:::,::: 4,:::,::: !D,444,444$ !07,===,===$ 00,0AA,AA/ 0:,0>>,>>A !=,=AA,AA/$ !=,:A7,777$ A,/::,::: A,:D4,444 A,444,444 D,===,=== "0A,7::,::: 04,:44,444 0>,>4/,//@

Mini Case: Goodweek Tires !nc"

)ssumptions ''T. 3nvestment Kseful life of ''T. 3nvestment !years$ Salvage (alue of ''T. 3nvestment )nnual Depreciation .#pense !/ year ;) ,S$ 1ear 0 7 4 8ast year of project > A / @ = 07:,:::,::: / A:,:::,::: ;) ,S ? 0=.7D? 7=.=D? 0/.=D? 07.=D? @.D4? @.D4? @.D4? =.=>? Depreciation 0/,0=@,::: 7D,4@@,::: 7:,D@@,::: 0=,D@@,::: 0:,/0A,::: 0:,/0A,::: 0:,/0A,::: >,4=:,::: .nding *ook (alue 0:7,@>7,::: /4,=A=,::: >7,=/A,::: 4/,=@@,::: 7A,//7,::: 0A,:>A,::: >,4=:,::: : 4A.:: >D.:: 0@.::

Super+read priceGunit in O.; market !year 0$ Super+read priceGunit in ,eplacement market !year 0$ Super+read costGunit !year 0$

1ear 0 marketing and admin costs )nnual inflation rate orporate +a# rate *eta !0G7=GD/ (alueline$ ,f !4: year K.S. +reasury *ond$ ,m !ST' >:: 4: year average$ ,e !from )';$ ,eF ,f% eB ,; " ,f C F :.:>> % 0.4B :.04> " :.:>> C F 0>.D:? 1ear 0 O.; ;arket for Super+read !7 million new cars # = tiresGcar$ O.; ;arket growth Super+read share of O.; market 1ear 0 ,eplacement ;arket for Super+read ,eplacement ;arket growth Super+read share of ,eplacement market

7>,:::,::: 4.7>? =:.::? 0.4: >.>:? 04.>:? 0>.D:?

@,:::,::: 7.>:? 00.::? 0=,:::,::: 7.::? @.::?

1ear Sales O.; ;arket Knits 'rice +otal O.; ;arket ,eplacement ;arket Knits 'rice +otal ,eplacement ;arket +otal Sales (ariable osts Knits !O.; % ,eplacement$ ost +otal (ariable osts SPT) Depreciation .*3+ 3nterest +a# !=:?$ &et 3ncome

@@:,::: 4A.:: 40,A@:,::: 0,07:,::: >D.:: AA,:@:,::: D/,/A:,::: 7,:::,::: 0@.:: 4A,:::,::: 7>,:::,::: 0/,0=@,::: 0D,A07,::: : /,@==,@:: 00,/A/,7::

D:7,::: 4/.>4 44,@>7,:A: 0,0=7,=:: A0.>0 /:,7AA,0A@ 0:=,00@,77@ 7,:==,=:: 0@.// 4@,4A4,0AA 7>,@07,>:: 7D,4@@,::: 0:,>>=,>A7 : =,770,@7> A,447,/4/

D7=,>>: 4D.04 4A,0/4,:=7 0,0A>,7=@ A=.07 /=,/0/,>4: 00:,@D:,>/7 7,:@D,/D@ 0D.>A =:,@@0,ADD 7A,A>0,=:A 7:,D@@,::: 77,4AD,=AA : @,D=/,/@A 04,=70,A@:

D=/,AA= =:./D 4@,A>4,0>A 0,0@@,>>4 AA.@> /D,=>:,@@> 00@,0:=,:=0 7,04A,70/ 7:.4D =4,>A>,@40 7/,>0/,>// 0=,D@@,::: 47,:47,A44 : 07,@04,:>4 0D,70D,>@:

.*3+ % Dep " +a#es 8essE hange in &W 8essE aptial Spending < from )ssetsE Discounted < from )ssets

7@,D0>,7:: 00,:::,::: 4,AA=,::: 07:,:::,::: !040,:::,:::$ 7>,7>0,7:: 70,/@/,:>@ 07>,>>A,47A !040,:::,:::$ 9! >,==4,A/=$

4>,/7:,/4/ D>4,/4= 4=,/A/,::4 7>,@@7,0>7

4=,=:D,A@: 0,:0>,@>7 44,4D4,@7@ 70,==D,=4/

4=,7:/,>@: !0A,A44,>@A$ !>:,DD>,7::$ 0:0,@4A,4AA >A,=4/,A/D

+otal Discounted < from )ssets 8essE 3nvestment &et 'resent (alue

,esults

'ayback Discounted 'ayback )), 3,, &'( '3

4.4/ years S= never pays back 0A.=7? 0=.77? 9 !>,==4,A/=$ :.DA