CHAPTER 6

Making Investment Decisions with the Net Present Value Rule

Answers to Practice Questions
1. See the table below. We begin with the cash flows given in the text, Table 6.6,
line 8, and utilize the following relationship from hapter !"
#eal cash flow $ nominal cash flow%&1 ' inflation rate(
t
)ere, the nominal rate is *+ percent, the expected inflation rate is 1+ percent,
and the real rate is given b, the following"
&1 ' r
nominal
( $ &1 ' r
real
( &1 ' inflation rate(
1.*+ $ &1 ' r
real
( &1.1+(
r
real
$ +.+-+- $ -.+-.
/s can be seen in the table, the 012 is unchanged &to within a rounding error(.
3ear + 3ear 1 3ear * 3ear ! 3ear 4 3ear 5 3ear 6 3ear 6
0et ash 7lows%0ominal 81*,6++ 81,484 *,-46 6,!*! 1+,5!4 -,-85 5,656 !,*6-
0et ash 7lows%#eal 81*,6++ 81,!4- *,4!6 4,651 6,1-5 6,*++ !,*5+ 1,668
012 of #eal ash 7lows &at -.+-.( $ 9!,8+4
*. 0o, this is not the correct procedure. The opportunit, cost of the land is its value
in its best use, so :r. 0orth should consider the 945,+++ value of the land as an
outla, in his 012 anal,sis of the funeral home.
!. ;nfortunatel,, there is no simple ad<ustment to the discount rate that will resolve the
issue of taxes. :athematicall,"
1.15
+.!5( %&1
1.1+

1 1

and
*
*
*
*
1.15
+.!5( &1 %
1.1+

46
4. =ven when capital budgeting calculations are done in real terms, an inflation
forecast is still re>uired because"
a. Some real flows depend on the inflation rate, e.g., real taxes and real
proceeds from collection of receivables? and,
b. #eal discount rates are often estimated b, starting with nominal rates and
@taAing outB inflation, using the relationship"
&1 ' r
nominal
( $ &1 ' r
real
( &1 ' inflation rate(
5. Cnvestment in worAing capital arises as a forecasting issue onl, because accrual
accounting recognizes sales when made, not when cash is received &and costs
when incurred, not when cash pa,ment is made(. Cf cash flow forecasts
recognize the exact timing of the cash flows, then there is no need to also include
investment in worAing capital.
6. Cf the 95+,+++ is expensed at the end of ,ear 1, the value of the tax shield is"
916,666
1.+5
95+,+++ +.!5

Cf the 95+,+++ expenditure is capitalized and then depreciated using a five8,ear

:/#S depreciation schedule, the value of the tax shield is"
915,!+6
1.+5
.+566
1.+5
.115*
1.+5
.115*
1.+5
.1-*
1.+5
.!*
1.+5
.*+
95+,+++D E+.!5
6 5 4 ! *

,
_

+ + + + +
Cf the cost can be expensed, then the tax shield is larger, so that the after8tax cost
is smaller.
6. a.
9!,81+
1.+8
*6,+++
,+++ 1++ 012
5
1 t
t
/
+

012
F
$ 8Cnvestment ' 12&after8tax cash flow( ' 12&depreciation tax shield(

+

+
5
1 t
t
F
1.+8
.!5( + &1 *6,+++
1++,+++ 012
[ ]
1
]
1

+ + + + +
6 5 4 ! *
1.+8
+.+566
1.+8
+.115*
1.+8
+.115*
1.+8
+.1-*
1.+8
+.!*
1.+8
+.*+
1++,+++ +.!5
012
F
$ 894,1*6
46
/nother, perhaps more intuitive, wa, to do the ompan, F anal,sis is to
first calculate the cash flows at each point in time, and then compute the
present value of these cash flows"
t $ + t $ 1 t $ * t $ ! t $ 4 t $ 5 t $ 6
Cnvestment 1++,+++
ash Cn *6,+++ *6,+++ *6,+++ *6,+++ *6,+++
Gepreciation *+,+++ !*,+++ 1-,*++ 11,5*+ 11,5*+ 5,66+
Taxable Cncome 6,+++ 86,+++ 6,8++ 14,48+ 14,48+ 85,66+
Tax *,1++ 8*,1++ *,!8+ 5,+68 5,+68 8*,+16
ash 7low 81++,+++ *!,-++ *8,1++ *!,6*+ *+,-!* *+,-!* *,+16
012 &at 8.( $ 894,1*6
b. C##
/
$ -.4!.
C##
F
$ 6.!-.
=ffective tax rate $
!*.*. +.!**
+.+-4!
+.+6!-
1
8. /ssume the following"
a. The firm will manufacture widgets for at least 1+ ,ears.
b. There will be no inflation or technological change.
c. The 15 percent cost of capital is appropriate for all cash flows and is a
real, after8tax rate of return.
d. /ll operating cash flows occur at the end of the ,ear.
0ote" Since purchasing the lids can be considered a one8,ear Hpro<ect,I the two
pro<ects have a common chain life of 1+ ,ears.
ompute 012 for each pro<ect as follows"
012&purchase( $
91,!+4,88+
1.15
.!5( + &1 *++,+++( &*
1+
1 t
t

012&maAe( $

1+
1 t
t
1.15
.!5( + &1 *++,+++( &1.5+
!+,+++ 15+,+++
[ ] + + + + + +
5 4 ! * 1
1.15
+.+8-!
1.15
+.1*4-
1.15
+.164-
1.15
+.*44-
1.15
+.14*-
E 15+,+++ +.!5
91,118,!*8
1.15
!+,+++
D
1.15
+.+445
1.15
+.+8-!
1.15
+.+8-!
1+ 8 6 6
+ + +
Thus, the widget manufacturer should maAe the lids.
48
-. a. Capital Expenditure
1. Cf the spare warehouse space will be used now or in the future, then
the pro<ect should be credited with these benefits.
*. harge opportunit, cost of the land and building.
!. The salvage value at the end of the pro<ect should be included.
Research and Development
1. #esearch and development is a sunA cost.
Working Capital
1. Will additional inventories be re>uired as volume increasesJ
*. #ecover, of inventories at the end of the pro<ect should be
included.
!. Cs additional worAing capital re>uired due to changes in receivables,
pa,ables, etc.J
Revenues
1. #evenue forecasts assume prices &and >uantities( will be
unaffected b, competition, a common and critical mistaAe.
Operating Costs
1. /re percentage labor costs unaffected b, increase in volume in the
earl, ,earsJ
*. Wages generall, increase faster than inflation. Goes #eliable
expect continuing productivit, gains to offset thisJ
Overhead
1. Cs @overheadB trul, incrementalJ
Depreciation
1. Gepreciation is not a cash flow, but the /#S deprecation does
affect tax pa,ments.
*. /#S depreciation is fixed in nominal terms. The real value of the
depreciation tax shield is reduced b, inflation.
Interest
1. Ct is bad practice to deduct interest charges &or other pa,ments to
securit, holders(. 2alue the pro<ect as if it is all e>uit,8financed.
Taxes
1. See comments on /#S depreciation and interest.
*. Cf #eliable has profits on its remaining business, the tax loss should
not be carried forward.
Net Cash Flow
1. See comments on /#S depreciation and interest.
*. Giscount rate should reflect pro<ect characteristics? in general, it is
not e>uivalent to the compan,Is borrowing rate.
b. 1. 1otential use of warehouse.
* Kpportunit, cost of building.
!. Kther worAing capital items.
4. :ore realistic forecasts of revenues and costs.
5. ompan,Is abilit, to use tax shields.
6. Kpportunit, cost of capital.
4-
c. The table on the next page shows a sample 012 anal,sis for the pro<ect.
The anal,sis is based on the following assumptions"
1. Inlation" 1+ percent per ,ear.
*. Capital Expenditure! 98 million for machiner,? 95 million for marAet
value of factor,? 9*.4 million for warehouse extension &we assume
that it is eventuall, needed or that electric motor pro<ect and surplus
capacit, cannot be used in the interim(. We assume salvage value
of 9! million in real terms less tax at !5 percent.
!. Working Capital" We assume inventor, in ,ear t is -.1 percent of
expected revenues in ,ear &t ' 1(. We also assume that
receivables less pa,ables, in ,ear t, is e>ual to 5 percent of
revenues in ,ear t.
4. Depreciation Tax "hield" Fased on !5 percent tax rate and 58,ear
/#S class. This is a simplif,ing and probabl, inaccurate
assumption? i.e., not all the investment would fall in the 58,ear
class. /lso, the factor, is currentl, owned b, the compan, and
ma, alread, be partiall, depreciated. We assume the compan,
can use tax shields as the, arise.
5. Revenues" Sales of *,+++ motors in *+++, 4,+++ motors in *++1,
and 1+,+++ motors thereafter. The unit price is assumed to decline
from 94,+++ &real( to 9*,85+ when competition enters in *++*. The
latter is the figure at which new entrantsI investment in the pro<ect
would have 012 $ +.
6. Operating Costs" We assume direct labor costs decline
progressivel, from 9*,5++ per unit in *+++, to 9*,*5+ in *++1 and
to 9*,+++ in real terms in *++* and after.
6. Other Costs" We assume true incremental costs are 1+ percent of
revenue.
8. Tax! !5 percent of revenue less costs.
-. Opportunit# Cost o Capital" /ssumed *+ percent.
5+
1ractice Luestion -
1--- *+++ *++1 *++* *++! *++4
apital =xpenditure &15,4++(
hanges in WorAing apital
Cnventories &8+1( &-61( &1,6-+( &!45( &!8+( &418(
#eceivables M 1a,ables &44+( &5*8( &-*-( &1-+( &*+-(
Gepreciation Tax Shield 1,+68 1,6*5 1,+!5 6*1 6*1
#evenues 8,8++ 1-,!6+ !6,-!4 41,6*6 45,-++
Kperating osts &5,5++( &1+,8-+( &*6,6*+( &*-,*8*( &!*,*1+(
Kther costs &88+( &1,-!6( &!,6-!( &4,16!( &4,5-+(
Tax &846( &*,*86( &*,6!*( &*,8-5( &!,185(
0et ash 7low &16,*+1( 1,*5+ !,654 4,65+ 5,4*8 5,-+-
*++5 *++6 *++6 *++8 *++- *+1+
apital =xpenditure 5,+58
hanges in WorAing apital
Cnventories &45-( &5+5( &556( &61*( 6,6*6
#eceivables M 1a,ables &**-( &*5*( &*68( &!+6( &!!6( !,6-6
Gepreciation Tax Shield !1+
#evenues 5+,48- 55,5!8 61,+-* 66,*+* 6!,-**
Kperating osts &!5,4!1( &!8,-64( &4*,86*( &46,15-( &51,865(
Kther costs &5,+4-( &5,554( &6,1+-( &6,6*+( &6,!-*(
Tax &!,5+!( &!,854( &4,*!-( &4,66!( &5,1*-(
0et ash 7low 6,1*8 6,!-- 6,+!8 6,64* *+,-65 !,6-6
012 &at *+.( $ 95,--1
51
1+. The table below shows the real cash flows. The 012 is computed using the real
rate, which is computed as follows"
&1 ' r
nominal
( $ &1 ' r
real
( &1 ' inflation rate(
1.+- $ &1 ' r
real
( &1.+!(
r
real
$ +.+58! $ 5.8!.
t $ + t $ 1 t $ * t $ ! t $ 4 t $ 5 t $ 6 t $ 6 t $ 8
Cnvestment 8!5,+++.+ 15,+++.+
Savings 6,41+.+ 6,41+.+ 6,41+.+ 6,41+.+ 6,41+.+ 6,41+.+ 6,41+.+ 6,41+.+
Cnsurance 81,*++.+ 81,*++.+ 81,*++.+ 81,*++.+ 81,*++.+ 81,*++.+ 81,*++.+ 81,*++.+
7uel 85*6.5 85*6.5 85*6.5 85*6.5 85*6.5 85*6.5 85*6.5 85*6.5
0et ash 7low 8!5,+++.+ 5,68!.5 5,68!.5 5,68!.5 5,68!.5 5,68!.5 5,68!.5 5,68!.5 *+,68!.5
012 &at 5.8!.( $ 91+,+64.-
11.
t $ + t $ 1 t $ * t $ ! t $ 4 t $ 5 t $ 6 t $ 6 t $ 8
Sales 4,*++.+ 4,41+.+ 4,6!+.5 4,86*.+ 5,1+5.1 5,!6+.4 5,6*8.4 5,-+-.8
:anufacturing osts !,68+.+ !,-6-.+ 4,166.5 4,!65.8 4,5-4.6 4,8*4.! 5,+65.6 5,!18.8
Gepreciation 1*+.+ 1*+.+ 1*+.+ 1*+.+ 1*+.+ 1*+.+ 1*+.+ 1*+.+
#ent 1++.+ 1+4.+ 1+8.* 11*.5 116.+ 1*1.6 1*6.5 1!1.6
=arnings Fefore Taxes *++.+ *16.+ *!4.- *5!.6 *6!.5 *-4.4 !16.! !!-.4
Taxes 6+.+ 66.+ 8*.* 88.8 -5.6 1+!.+ 11+.6 118.8
ash 7low
Kperations 18+.+ *4+.1 *5+.6 *61.8 *6!.5 *85.84 *-8.8 1,*46.4
WorAing apital !5+.+ 4*+.+ 441.+ 46!.1 486.* 51+.5 5!6.+ 56*.8 +.+
Cncrease in W.. !5+.+ 6+.+ *1.+ **.1 *!.* *4.! *5.5 *6.8 856*.8
#ent &after tax( 65.+ 66.6 6+.! 6!.1 66.+ 6-.1 8*.* 85.5
Cnitial Cnvestment 1,*++.+
Sale of 1lant 4++.+
Tax on Sale 56.+
0et ash 7low 81,55+.+ 18+.+ *4+.1 *5+.6 *61.8 *6!.5 *85.8 *-8.8 1,*46.4
012&at 1*.( $ 985.8
1*. 0ote" There are several different calculations of pre8tax profit and taxes given in
Section 6.*, based on different assumptions? the solution below is based on
Table 6.6 in the text.
See the table on the next page. With full usage of the tax losses, the 012 of the
tax pa,ments is 94,66-. With tax losses carried forward, the 012 of the tax
pa,ments is 95,641. Thus, with tax losses carried forward, the pro<ectIs 012
decreases b, 9-6*, so that the value to the compan, of using the deductions
immediatel, is 9-6*.

5*
Tax ash 7lows
t $ + t $ 1 t $ * t $ ! t $ 4 t $ 5 t $ 6 t $ 6
1retax 1rofit 84,+++ 84,514 648 -,8+6 16,-4+ 11,56- 5,5!- 1,-4-
7ull usage of tax losses
Cmmediatel, &Table 6.6( 81,4++ 81,58+ *6* !,4!* 5,-*- 4,+5! 1,-!- 68*
012 at *+. 94,66-
Tax loss carr,8forward + + + 614 5,-*- 4,+5! 1,-!- 68*
012 &at *+.( $ 95,641
1!. &0ote" #ow numbers in the table below refer to the rows in Table 6.8.(
t $ + t $ 1 t $ * t $ ! t $ 4 t $ 5 t $ 6 t $ 6 t $ 8
1. apital investment 8!.5 81*.+
4. WorAing capital *.! 4.4 6.6 6.- 5.! !.* *.5 +.+ +.+
hange in W.. *.1 !.* 8+.6 81.6 8*.1 8+.6 8*.5 +.+
-. Gepreciation 11.- 11.- 11.- 11.- 11.- 11.- 11.- 11.-
1*. 1rofit after tax 85.8 !.- *5.+ *1.8 14.! 4.6 1.5 6.*
ash 7low 885.8 4.+ 1*.6 !6.6 !5.! *8.! 16.! 15.- 6.*
012 &at 11.+.( $ 915.6+
14. Cn order to solve this problem, we calculate the e>uivalent annual cost for each of
the two alternatives. &/ll cash flows are in thousands.(
$lternative % & "ell the new machine" Cf we sell the new machine, we receive the
cash flow from the sale, pa, taxes on the gain, and pa, the costs associated with
Aeeping the old machine. The present value of this alternative is"
5 4 ! *
1
1.1*
!+
1.1*
!+
1.1*
!+
1.1*
!+
1.1*
!+
*+ +(D .!5&5+ E+ 5+ 12
9-!.8+
1.1*
+( &5 +.!5
1.1*
5
5 5

+
The e>uivalent annual cost for the five8,ear period is computed as follows"
12
1
$ =/
1
Eannuit, factor, 5 time periods, 1*.D
8-!.8+ $ =/
1
E!.6+5D
=/
1
$ 8*6.+*, or an e>uivalent annual cost of 9*6,+*+
5!
$lternative ' & "ell the old machine" Cf we sell the old machine, we receive the
cash flow from the sale, pa, taxes on the gain, and pa, the costs associated with
Aeeping the new machine. The present value of this alternative is"
5 4 ! *
*
1.1*
*+
1.1*
*+
1.1*
*+
1.1*
*+
1.1*
*+
+(D E+.!5&*5 *5 12
1+ - 8 6 6 5
1.1*
!+
1.1*
!+
1.1*
!+
1.1*
!+
1.1*
!+
1.1*
*+

91*6.51
1.1*
+( &5 .!5 +

1.1*
5
1+ 1+

+
The e>uivalent annual cost for the ten8,ear period is computed as follows"
12
*
$ =/
*
Eannuit, factor, 1+ time periods, 1*.D
81*6.51 $ =/
*
E5.65+D
=/
*
$ 8**.56, or an e>uivalent annual cost of 9**,56+
Thus, the least expensive alternative is to sell the old machine because this
alternative has the lowest e>uivalent annual cost.
Kne Ae, assumption underl,ing this result is that, whenever the machines have
to be replaced, the replacement will be a machine that is as efficient to operate
as the new machine being replaced.
15. The current copiers have net cost cash flows as follows"
3ear
Fefore8
Tax
ash 7low /fter8Tax ash 7low
0et ash
7low
1 8*,+++ &8*,+++ .65( ' &.!5 .+8-! *+,+++( 8664.-
* 8*,+++ &8*,+++ .65( ' &.!5 .+8-! *+,+++( 8664.-
! 88,+++ &88,+++ .65( ' &.!5 .+8-! *+,+++( 84,564.-
4 88,+++ &88,+++ .65( ' &.!5 .+445 *+,+++( 84,888.5
5 88,+++ &88,+++ .65( 85,*++.+
6 88,+++ &88,+++ .65( 85,*++.+
These cash flows have a present value, discounted at 6 percent, of 8915,856.
;sing the annuit, factor for 6 time periods at 6 percent &4.666(, we find an
e>uivalent annual cost of 9!,!*6. Therefore, the copiers should be replaced
onl, when the e>uivalent annual cost of the replacements is less than 9!,!*6.
54
When purchased, the new copiers will have net cost cash flows as follows"
3ear
Fefore8
Tax
ash 7low /fter8Tax ash 7low
0et ash
7low
+ 8*5,+++ 8*5,+++ 8*5,+++.+
1 81,+++ &81,+++ .65( ' &.!5 .14*- *5,+++( 6++.+
* 81,+++ &81,+++ .65( ' &.!5 .*44- *5,+++( 1,4-!.+
! 81,+++ &81,+++ .65( ' &.!5 .164- *5,+++( 88+.+
4 81,+++ &81,+++ .65( ' &.!5 .1*4- *5,+++( 44!.+
5 81,+++ &81,+++ .65( ' &.!5 .+8-! *5,+++( 1!1.+
6 81,+++ &81,+++ .65( ' &.!5 .+8-! *5,+++( 1!1.+
6 81,+++ &81,+++ .65( ' &.!5 .+8-! *5,+++( 1!1.+
8 81,+++ &81,+++ .65( ' &.!5 .+445 *5,+++( 8*61.+
These cash flows have a present value, discounted at 6 percent, of 89*1,-6-.
The decision to replace must also taAe into account the resale value of the
machine, as well as the associated tax on the resulting gain &or loss(. onsider
three cases"
a. The booA &depreciated( value of the existing copiers is now 96,*48. Cf the
existing copiers are replaced now, then the present value of the cash flows
is"
8*1,-6- ' 8,+++ M E+.!5 &8,+++ M 6,*48(D $ 8914,58*
;sing the annuit, factor for 8 time periods at 6 percent &5.-61(, we find
that the e>uivalent annual cost is 9*,44*.
b. Two ,ears from now, the booA &depreciated( value of the existing copiers
will be 9*,666. Cf the existing copiers are replaced two ,ears from now,
then the present value of the cash flows is"
&8664.-%1.+6
1
( ' &8664.-%1.+6
*
( ' &8*1,-6-%1.+6
*
( '
N!,5++ M E+.!5 &!,5++ M *,666(DO%1.+6
*
$ 8916,6+4
;sing the annuit, factor for 1+ time periods at 6 percent &6.+*4(, we find
that the e>uivalent annual cost is 9*,5+6.
c. Six ,ears from now, both the booA value and the resale value of the
existing copiers will be zero. Cf the existing copiers are replaced six ,ears
from now, then the present value of the cash flows is"
815,856' &8*1,-6-%1.+6
6
( $ 89!+,4-6
;sing the annuit, factor for 14 time periods at 6 percent &8.645(, we find
that the e>uivalent annual cost is 9!,486.
The copiers should be replaced immediatel,.
55
16. a.
3ear 1 3ear * 3ear ! 3ear 4 3ear 5 3ear 6 3ear 6 3ear 8 3ear - 3ear 1+ 3ear 11
:/#S
1ercent
1+.++.18.++.14.4+. 11.5*. -.**. 6.!6. 6.55. 6.55. 6.55. 6.55. !.*-.
:/#S
Gepr.
4+.++ 6*.++ 56.6+ 46.+8 !6.88 *-.48 *6.*+ *6.*+ *6.*+ *6.*+ 1!.16
Tax
Shield
15.6+ *8.+8 **.46 16.-6 14.!8 11.5+ 1+.** 1+.** 1+.** 1+.** 5.1!
1resent 2alue &at 6.( $ 9114.56 million
The e>uivalent annual cost of the depreciation tax shield is computed b,
dividing the present value of the tax shield b, the annuit, factor for *5
,ears at 6."
=>uivalent annual cost $ 9114.56 milliion%11.654 $ 9-.8! million
The e>uivalent annual cost of the capital investment is"
9!4.! million M 9-.8! million $ 9*4.46 million
b. The extra cost per gallon &after tax( is"
9*4.46 million%-++ million gallons $ 9+.+*6* per gallon
The pre8tax charge $ 9+.+*6*%+.65 $ 9+.+418 per gallon
16. Since the growth in value of (oth timber and land is less than the cost of capital after
,ear 8, it must pa, to cut b, that time. The table below shows that 12 is
maximized if ,ou cut in ,ear 8. Therefore, if we cut in ,ear 8, the 012 of the offer
is" 914+,+++ M 1+-,-++ $ 9!+,1++
3ear 1 3ear * 3ear ! 3ear 4 3ear 5
7uture 2alue" Timber 48.! 58.* 6+.* 84.6 -6.8
Pand 5* .+ 54 .1 56 .* 58 .5 6+ .8
Total 1++.! 11*.! 1*6.4 14!.* 158.6
1resent 2alue" -*.+ -4.5 -6.6 1+1.4 1+!.1
3ear 6 3ear 6 3ear 8 3ear -
7uture 2alue" Timber 11*.- 1!+.! 15+.5 16*.6
Pand 6! .! 65 .8 68 .4 61 .*
Total 166.* 1-6.1 *18.- *!!.-
1resent 2alue" 1+5.1 1+6.! 1+-.- 1+6.6
56
18. a.
! *
/
1.+6
1+,+++
1.+6
1+,+++
1.+6
1+,+++
4+,+++ 12 + + +
12
/
$ 966,6!+ &0ote that this is a cost.(
4 ! *
F
1.+6
8,+++
1.+6
8,+++
1.+6
8,+++
1.+6
8,+++
5+,+++ 12 + + + +
12
F
$ 966,6*1 &0ote that this is a cost.(
=>uivalent annual cost &=/( is found b,"
12
/
$ =/
/
Eannuit, factor, 6., ! time periodsD
66,6!+ $ =/
/
*.66!
=/
/
$ 9*4,-64 per ,ear rental
12
F
$ =/
F
Eannuit, factor, 6., 4 time periodsD
66,6*1 $ =/
F
!.465
=/
F
$ 9**,4!+ per ,ear rental
b. /nnual rental is 9*4,-64 for :achine / and 9**,4!+ for :achine F.
Forstal should bu, :achine F.
c. The pa,ments would increase b, 8 percent per ,ear. 7or example, for
:achine /, rent for the first ,ear would be 9*4,-64? rent for the second
,ear would be &9*4,-64 1.+8( $ 9*6,-61? etc.
1-. Fecause the cost of a new machine now decreases b, 1+ percent per ,ear, the rent
on such a machine also decreases b, 1+ percent per ,ear. Therefore"
! *
/
1.+6
6,*-+
1.+6
8,1++
1.+6
-,+++
4+,+++ 12 + + +
12
/
$ 961,8*+ &0ote that this is a cost.(
4 ! *
F
1.+6
5,*4-
1.+6
5,8!*
1.+6
6,48+
1.+6
6,*++
5+,+++ 12 + + + +
12
F
$ 961,61! &0ote that this is a cost.(
56
=>uivalent annual cost &=/( is found as follows"
12
/
$ =/
/
Eannuit, factor, 6., ! time periodsD
61,8*+ $ =/
/
*.66!
=/
/
$ 9*!,1*8, a reduction of 6.!5.
12
F
$ =/
F
Eannuit, factor, 6., 4 time periodsD
61,61! $ =/
F
!.465
=/
F
$ 9*+,668, a reduction of 6.86.
*+. With a 68,ear life, the e>uivalent annual cost &at 8 percent( of a new <et is"
&91,1++,+++%4.6*!( $ 9*!6,-41. Cf the <et is replaced at the end of ,ear ! rather
than ,ear 4, the compan, will incur an incremental cost of 9*!6,-41 in ,ear 4.
The present value of this cost is"
9*!6,-41%1.+8
4
$ 9164,8-4
The present value of the savings is"
The president should allow wider use of the present <et because the present
value of the savings is greater than the present value of the cost.
58
9*+6,168
1.+8
8+,+++
!
1 t
t

Challenge )uestions
1. a.
3ear + 3ear 1 3ear * 3ear ! 3ear 4 3ear 5 3ear 6 3ear 6
1re8Tax 7lows 814,+++.+ 8!,+64.+ !,*+-.+ -,655.+ 16,46!.+ 14,+!8.+ 6,6-6.+ !,444.+
C## $ !!.!.
1ost8Tax 7lows 81*,6++.+ 81,6!+.+ *,!81.+ 6,*+5.+ 1+,685.+ 1+,1!6.+ 6,11+.+ !,444.+
C## $ *6.8.
=ffective Tax #ate $ 1-.5.
b. Cf the depreciation rate is accelerated, this has no effect on the pretax C##,
but it increases the after8tax C##. Therefore, the numerator decreases
and the effective tax rate decreases.
Cf the inflation rate increases, we would expect pretax cash flows to
increase at the inflation rate, while after tax cash flows increase at a
slower rate. /fter tax cash flows increase at a slower rate than the
inflation rate because depreciation expense does not increase with
inflation. Therefore, the numerator of T
=
becomes proportionatel, larger
than the denominator and the effective tax rate increases.
c.

=
T ( T &1 1

( T C&1
C

( T C&1

( T C&1

( T C&1
( T &1
( T C&1

T
1
]
1

1
]
1

)ence, if the up8front investment is deductible for tax purposes, then the
effective tax rate is e>ual to the statutor, tax rate.
*. a. With a real rate of 6 percent and an inflation rate of 5 percent, the nominal
rate, r, is determined as follows"
&1 ' r( $ &1 ' +.+6( &1 ' +.+5(
r $ +.11! $ 11.!.
7or a three8,ear annuit, at 11.! percent, the annuit, factor &using the
annuit, formula from hapter !( is *.4!1+? for a two8,ear annuit,, the
annuit, factor is 1.6+56.
7or a three8,ear annuit, with a present value of 9*8.!6, the nominal
annuit, is" &9*8.!6%*.4!1+( $ 911.66
7or a two8,ear annuit, with a present value of 9*1.++, the nominal annuit,
is" &9*1.++%1.6+56( $ 91*.!1
5-
These nominal annuities are not realistic estimates of e>uivalent annual
costs because the appropriate rental cost &i.e., the e>uivalent annual cost(
must taAe into account the effects of inflation.
b. With a real rate of 6 percent and an inflation rate of *5 percent, the
nominal rate, r, is determined as follows"
&1 ' r( $ &1 ' +.+6( &1 ' +.*5(
r $ +.!*5 $ !*.5.
7or a three8,ear annuit, at !*.5 percent, the annuit, factor &using the
annuit, formula from hapter !( is 1.654*? for a two8,ear annuit,, the
annuit, factor is 1.!*4!.
7or a three8,ear annuit, with a present value of 9*8.!6, the nominal
annuit, is" &9*8.!6%1.654*( $ 916.16
7or a two8,ear annuit, with a present value of 9*1.++, the nominal annuit,
is" &9*1.++%1.!*4!( $ 915.86
With an inflation rate of 5 percent, :achine / has the lower nominal
annual cost &911.66 compared to 91*.!1(. With inflation at *5 percent,
:achine F has the lower nominal annual cost &915.86 compared to
916.16(. Thus it is clear that inflation has a significant impact on the
calculation of e>uivalent annual cost, and hence, the warning in the text to
do these calculations in real terms. The ranAings change because, at the
higher inflation rate, the machine with the longer life &here, :achine /( is
affected more.
!. a. The cash outflow in 1eriod + becomes 891+,4*6,+++ and
012 $ 95,6-!,684. The format is advantageous since it recognizes
additional cash flows created b, the tax8deductibilit, of depreciation.
)owever, it ma, also be disadvantageous because several assumptions
are made here. We are assuming"
1. The tax rate remains constant.
*. The depreciation method remains constant.
!. The compan,Is abilit, to generate taxable income continues so the
tax shield can be used.
b. Since the cash flows are relativel, safe, the, should probabl, be discounted
at an after8tax borrowing or lending rate.
c. The discount rate for the other cash flows should not change since it must
represent the opportunit, cost of funds in a pro<ect of similar risA.
6+