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Chapter11

CapitalBudgetingCashFlows
Instructors Resources
Overview
Thischapterexpandsuponthecapitalbudgetingtechniquespresentedinthelastchapter(Chapter10).
Shareholderwealthmaximizationreliesuponselectionofprojectsthathavepositivenetpresentvalues.
Themostimportantanddifficultaspectofthecapitalbudgetingprocessisdevelopinggoodestimatesof
therelevantcashflows.Chapter11focusesonthebasicsofdeterminingrelevantaftertaxcashflowsofa
project,fromtheinitialcashoutlaytoannualcashstreamofcostsandbenefitsandterminalcashflow.It
alsodescribesthespecialconcernsfacingcapitalbudgetingforthemultinationalcompany.Thetext
highlightshowcapitalbudgetingwillbeacriticalaspectoftheprofessionallifeandpersonallifeof
studentsupongraduation.

Suggested Answer to Opener in Review Question

Chapter11CapitalBudgetingCashFlows221

ThechapteropenertalkedaboutExxonMobilsconsiderableinvestmentinlongtermprojectsand
thesometimesdifficulttaskofhavingprojectscomeinonbudget.Howareprojectcashflows
affectedbybudgetoverruns?Inthecapitalbudgetingprocess,howshouldfinancialmanagers
accountforthepotentialofbudgetoverruns?
Itiscriticaltohavethebestestimateofprojectcashflowspossiblewhenmakingaprojectaccept/reject
decision.Dependinguponthescopeofaproject,financialmanagersmayneedtodrawinformationfrom
manyareasofacorporationincludingresearchanddevelopment,marketing,operations,humanresources,
andwithinthevariousdepartmentsdealingwithcorporatefinance.Itmaybepossibletogetsomeofthe
informationdirectlyfromtheprojectmanagersiftheyhavedonesomeofthelegworkalready.
Budgetoverrunsmeanhigherthanexpectedcosts,andthereforelowerthanexpectedcashflows.Lower
thanexpectedcashflowsmeanlowerthanexpectedcapitalbudgetingoutcomes(e.g.,lowerNPVs,PIs,
IRRs,etc.).Iffinancialmanagersdonotadequatelyaccountforpossiblebudgetoverrunsinthecapital
budgetingprocesstheyareunlikelytofullymaximizefirmvalue.Chapter12considerstheuncertaintyof
cashflowsinmoredetailanddiscussessomeofthemethodsusedbyfinancialmanagerstoaccountfor
theuncertaintyofcashflows.Inparticular,ExxonMobilcouldgeneratearangeordistributionofcapital
budgetingoutcomesforprojectsthathaveuncertaincashflowsduetopossiblebudgetoverruns.ExxonMobil
shouldcalculateNPVsusingcashflowsthatassumenobudgetoverrunandavarietyofpossiblebudget
overrunsandthencalculateanexpectedaverageNPVwheretheweightsreflecttheprobablyofeach
budgetoutcome.

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Answers to Review Questions


1. Capitalbudgetingprojectsshouldbeevaluatedusingincrementalaftertaxcashflows,sinceaftertax
cashflowsarewhatisavailabletothefirm.Whenevaluatingaproject,concernisplacedonlyon
addedcashflowsexpectedtoresultfromitsimplementation.Expansiondecisionscanbetreated
asreplacementdecisionsinwhichallcashflowsfromtheoldassetsarezero.Bothexpansionand
replacementdecisionsinvolvepurchasingnewassets.Replacementdecisionsaremorecomplex
becauseincrementalcashflowsresultingfromthereplacementmustbedetermined.
2. Thethreecomponentsofcashflowforanyprojectare(1)initialinvestment,(2)operatingcashflows,
and(3)terminalcashflows.
3. Sunkcostsarecoststhathavealreadybeenincurredandthusthemoneyhasalreadybeenspent.
Opportunitycostsarecashflowsthatcouldberealizedfromthenextbestalternativeuseofanowned
asset.Sunkcostsarenotrelevanttotheinvestmentdecisionbecausetheyarenotincremental.These
costswillnotchangenomatterwhatthefinalaccept/rejectdecision.Opportunitycostsarearelevant
cost.Thesecashflowscouldberealizedifthedecisionismadenottochangethecurrentasset
structurebuttoutilizetheownedassetforthisalternativepurpose.
4. Tominimizelongtermcurrencyrisk,companiescanfinanceaforeigninvestmentinlocalcapital
marketssothattheprojectsrevenuesandcostsareinthelocalcurrencyratherthandollars.
Techniquessuchascurrencyfutures,forwards,andoptionsmarketinstrumentsprotectagainstshort
termcurrencyrisk.Financialandoperatingstrategiesthatreducepoliticalriskincludestructuringthe
investmentasajointventurewithacompetentandwellconnectedlocalpartner,andusingdebt
ratherthanequityfinancing,sincedebtservicepaymentsarelegallyenforceableclaimswhileequity
returnssuchasdividendsarenot.
5.

a.

Thecostofthenewassetisthepurchaseprice.(Outflow)

b. Installationcostsareanyaddedcostsnecessarytogetanassetintooperation.(Outflow)
c. Proceedsfromsaleofoldassetarecashinflowsresultingfromthesaleofanexistingasset,
reducedbyanyremovalcosts.(Inflow)
d. Taxonsaleofoldassetisincurredwhenthereplacedassetissoldduetorecaptureddepreciation,
capitalgain,orcapitalloss.(Maybeaninfloworanoutflow)
e. Thechangeinnetworkingcapitalisthedifferencebetweenthechangeincurrentassetsandthe
changeincurrentliabilities.(Maybeaninfloworanoutflow)
6. Thebookvalueofanassetisitsstrictaccountingvalue.
Bookvalueinstalledcostofassetaccumulateddepreciation
Gainsandlossesinthesaleofanassetmayhavetaxconsequences,andhencearebothkeyformsof
taxableincome.Morespecifically,taxableincomemayarisefrom(1)capitalgain:portionofsale
priceaboveinitialpurchaseprice,taxedattheordinaryrate;(2)recaptureddepreciation:portionof
salepriceinexcessofbookvaluethatrepresentsarecoveryofpreviouslytakendepreciation,taxedat
theordinaryrate;and(3)lossonthesaleofanasset:amountbywhichsalepriceislessthanbook
value,taxedattheordinaryrateanddeductedfromordinaryincomeiftheassetisdepreciableand
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usedinbusiness.Iftheassetisnotdepreciableorisnotusedinbusiness,itisalsotaxedatthe
ordinaryratebutisdeductibleonlyagainstcapitalgains.

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7. Theassetmaybesold(1)formorethanitsbookvalue,(2)fortheamountofitsbookvalue,or
(3)atapricebelowbookvalue.Inthefirstcase,taxesarisefromtheamountbywhichthesaleprice
exceededthebookvalue.Inthesecondcase,notaxeswouldberequired.Inthethirdcase,atax
creditwouldoccur.
8. Thedepreciablevalueofanassetistheinstalledcostofanewassetandisbasedonthedepreciable
costofthenewproject,includinginstallationcost.
9. Depreciationisusedtodecreasethefirmstotaltaxliabilityandthenisaddedbacktonetprofitsafter
taxestodeterminecashflow.Table11.6andEquation3.4(refertothetext)areequivalentwaysof
expressingoperatingcashflows.TheearningsbeforeinterestandtaxesinTable11.6isthesameas
theEBITterminologyinEquation3.4.Bothmodelsthentakeouttaxesandaddbackindepreciation.
10. Tocalculateincrementaloperatingcashinflowforboththeexistingsituationandtheproposed
project,thedepreciationonassetsisaddedbacktotheaftertaxprofitstogetthecashflows
associatedwitheachalternative.Thedifferencebetweenthecashflowsoftheproposedandpresent
situation,theincrementalaftertaxcashflows,aretherelevantoperatingcashflowsusedin
evaluatingtheproposedproject.
11. Theterminalcashflowisthecashflowresultingfromterminationandliquidationofaprojectatthe
endofitseconomiclife.Theformofcalculatingterminalcashflowsisshownbelow:
TerminalCashFlowCalculation:
Aftertax
proceedsfrom
saleofnewasset

Aftertax
proceedsfrom
saleofoldasset

Proceedsfrom
saleofoldasset
Taxonsaleof
oldasset

Changein
networking
capital

Termina
lcash
flow

ExtendedPresentation:
Proceedsfrom
saleofnewasset
Taxonsaleof
newasset

Changein
networking
capital

Termina
lcash
flow

12. Therelevantcashflowsnecessaryforaconventionalcapitalbudgetingprojectaretheincremental
aftertaxcashflowsattributabletotheproposedproject:theinitialinvestment,theoperatingcash
inflows,andtheterminalcashflow.Theinitialinvestmentistheinitialoutlayrequired,takinginto
accounttheinstalledcostofthenewasset,proceedsfromthesaleoftheoldasset,taxonthesaleof
theoldasset,andanychangeinnetworkingcapital.Theoperatingcashinflowsaretheadditional
cashflowsreceivedasaresultofimplementingaproposal.Terminalcashflowrepresentstheafter
taxcashflowsexpectedtoresultfromtheliquidationoftheprojectattheendofitslife.Thesethree
componentsrepresentthepositiveornegativecashflowimpactifthefirmimplementstheproject,
andaredepictedinthefollowingdiagramforaprojectlasting5years.

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Suggested Answer to Global Focus Box:


Changes May Influence Future Investments in China
AlthoughChinahasbeenactivelycampaigningforforeigninvestment,howdoyouthinkhaving
acommunistgovernmentaffectsitsforeigninvestment?
Havingacommunistgovernmenthasanegativeaffectonforeigndirectinvestment(FDI).Asinall
investmentsabroad,FDIinChinaentailshightravelandcommunicationsexpenses.Thedifferencesof
politicalsystemandculturethatexistbetweenthecountryoftheinvestorandthehostcountrywillalso
causeproblemswithforeigndirectinvestmentinChina.Duetoitscontroloftheeconomy,thecommunist
partyhasmorecontroloveremployment,rawmaterials,andrepatriationofrevenuestoaparentfirmthan
foundinnoncommunistcountries.Thereisalsothechancethatacompanymayloseownershipofits
overseasoperationstoaChinesecompany.Hence,foreignfirmsoftenpartnerwithChinesefirmsintheir
developmentefforts,butthisrequirescoordinationandraisesthecostsofFDIinChina.

Suggested Answer to Focus on Ethics Box:


A Question of Accuracy
Whatwouldyouroptionsbewhenfacedwiththedemandsofanimperialchiefexecutiveofficer
(CEO)whoexpectsyoutomakeitwork?Brainstormseveraloptions.
ThereisachancethatyoumaybeworkingforanimperialCEOatsomepointinyourcareer.Thismay
bebychoiceorbychance.Whilethemakeitworkmandatemayseemlikeanordertodoanythingit
takestoaccomplishyourjob,youareundernoobligationtodoanythingunethicalorillegal.Ifthatisthe
onlywaytoaccomplishthejob,thebestapproachistoaskyoursuperiordirectly,Is(this)whatyouwant
metodo?

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Iftheansweristhatyoushouldbreakthelawordosomethingunethical,youmayhavethreeviableoptions
otherthandoingsomethingthatyoushouldnotdo.Oneoptionistoseektheguidanceofyourmentorif
youhaveoneinthecompany.Heorshemaybeabletointerveneonyourbehalf.Anotheroptionistotake
thematteroveryourbossshead(inthecaseofaCEO,thatwouldbetheboardofdirectors).Thethird
optionistoevaluateyourcareeroptions.Youmaybebetterservedworkingelsewhere.Realistically,by
offeringoppositiontoanimperialCEO,youmaybelimitingyourcareerinyourpresentcompany.
However,donotimmediatelyassumethatdowhateverittakesormakeitworkautomaticallyincludes
anythingunethicalorillegal.TheCEOmayjustbestatingthatmoreresourcesoreffortneedtobeputinto
solvingtheproblem.

Answers to Warm-Up Exercises


E111.

Categorizingafirmsexpenditures

Answer: Inthiscase,thetuitionreimbursementshouldbecategorizedasacapitalexpendituresincethe
outlayoffundsisexpectedtoproducebenefitsoveraperiodoftimegreaterthan1year.
E112.

Classificationofprojectcostsandcashflows

Answer: $3.5billionalreadyspentsunkcost(irrelevant)
$350millionincrementalcashoutflowrelevantcashflow
$15millionperyearcashinflowrelevantcashflow
$450millionforsatellitesopportunitycostandrelevantcashflow
E113.

Findingtheinitialinvestment

Answer: $20,000Purchasepriceofnewmachinery
$3,000Installationcosts
$4,500Aftertaxproceedsfromsaleofoldmachinery
$18,500Initialinvestment
E114.

Bookvalueandrecaptureddepreciation

Answer: Bookvalue$175,000$124,250$50,750
Recaptureddepreciation$110,000$50,750$59,250
E115.

Initialinvestment

Answer: Initialinvestmentpurchasepriceinstallationcostsaftertaxproceedsfromsaleofold
assetchangeinnetworkingcapital
$55,000$7,500$23,750$2,000$40,750

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Solutions to Problems
Note:TheMACRSdepreciationpercentagesusedinthefollowingproblemsappearinChapter4,
Table4.2.Thepercentagesareroundedtothenearestintegerforeaseincalculation.
Forsimplification,5yearlivedprojectswith5yearsofcashinflowsaretypicallyusedthroughoutthis
chapter.Projectswithusablelivesequaltothenumberofyearsofcashinflowsarealsoincludedinthe
endofchapterproblems.ItisimportanttorecallfromChapter4thatundertheTaxReformActof1986,
MACRSdepreciationresultsinn1yearsofdepreciationforannyearclassasset.Thismeansthatin
actualpracticeprojectswilltypicallyhaveatleastoneyearofcashflowbeyondtheirrecoveryperiod.
P111. Classificationofexpenditures
LG2;Basic
a.

Operatingexpenditureleaseexpireswithinoneyear

b.

Capitalexpenditurepatentrightsexistformanyyears

c.

Capitalexpenditureresearchanddevelopmentbenefitslastmanyyears

d.

Operatingexpendituremarketablesecuritiesmatureinunderoneyear

e.

Capitalexpendituremachinewilllastoveroneyear

f.

Capitalexpenditurebuildingtoolwilllastoveroneyear

g.

Capitalexpenditurebuildingwilllastformorethanoneyear

h.

Operatingexpendituremarketchangesrequireobtaininganotherreportwithinayear

P112. Relevantcashflowandtimelinedepiction
LG1,2;Intermediate
a.
Year

Cash Flow

Thisisaconventionalcashflowpattern,wherethecashinflowsareofequalsize,whichisreferredto
asanannuity.

b.

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Thisisaconventionalcashflowpattern,wherethesubsequentcashinflowsvary,whichisreferredto
asamixedstream.

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c.

Thisisanonconventionalcashflowpattern,whichhasseveralcashflowseriesofequalsize,whichis
referredtoasanembeddedannuity.

P113. Expansionversusreplacementcashflows
LG3;Intermediate
a.
Year

RelevantCashFlows

Initialinvestment

b.

($28,000)
1

4,000

6,000

8,000

10,000

4,000

Anexpansionprojectissimplyareplacementdecisioninwhichallcashflowsfromtheold
assetarezero.

P114. Sunkcostsandopportunitycosts
LG2;Basic
a.

The$1,000,000developmentcostsshouldnotbeconsideredpartofthedecisiontogoahead
withthenewproduction.Thismoneyhasalreadybeenspentandcannotberetrievedsoitisa
sunkcost.

b.

The$250,000salepriceoftheexistinglineisanopportunitycost.IfMastersGolfProducts
doesnotproceedwiththenewlineofclubstheywillnotreceivethe$250,000.

c.

P115. Sunkcostsandopportunitycosts
LG2;Intermediate

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a.

SunkcostThefundsforthetoolinghadalreadybeenexpendedandwouldnotchange,no
matterwhetherthenewtechnologywouldbeacquiredornot.

b.

OpportunitycostThedevelopmentofthecomputerprogramscanbedonewithout
additionalexpendituresonthecomputers;however,thelossofthecashinflowfromthe
leasingarrangementwouldbealostopportunitytothefirm.

c.

OpportunitycostCovolwillnothavetospendanyfundsforfloorspacebutthelostcash
inflowfromtherentwouldbeacosttothefirm.

d.

SunkcostThemoneyforthestoragefacilityhasalreadybeenspent,andnomatterwhat
decisionthecompanymakesthereisnoincrementalcashflowgeneratedorlostfromthe
storagebuilding.

e.

OpportunitycostForgoingthesaleofthecranecoststhefirm$180,000ofpotentialcash
inflows.

P116. Personalfinance:Sunkandopportunitycashflows
LG2;Intermediate
a.

Thesunkcostsorcashoutlaysareexpendituresthathavebeenmadeinthepastandhaveno
effectonthecashflowsrelevanttoacurrentsituation.ThecashoutlaysdonebeforeDavid
andAnndecidedtorentouttheirhomewouldbeclassifiedassunkcosts.Anopportunity
costorcashflowisonethatcanberealizedfromanalternativeuseofanexistingasset.
Here,DavidandAnnhavedecidedtorentouttheirhome,andallthecostsassociatedwith
gettingthehomeinrentableconditionwouldberelevant.

b.

Sunkcosts(cashflows):
Replacewaterheater
Replacedishwasher
Miscellaneousrepairsandmaintenance
Opportunitycostscashflows:
Rentalincome
Advertising
Housepaintandpowerwash

P117. Bookvalue
LG3;Basic
Installed
Cost

Accumulated
Depreciation

Book
Value

$950,000

$674,500

$275,500

40,000

13,200

26,800

Asset

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96,000

79,680

16,320

350,000

70,000

280,000

1,500,000

1,170,000

330,000

P118. Bookvalueandtaxesonsaleofassets
LG3,4;Intermediate
a.

Bookvalue$80,000(0.71$80,000)
$23,200

b.
SalePrice

Capital
Gain

Taxon
CapitalGain

Depreciation
Recovery

Taxon
Recovery

Total
Tax

$100,000

$20,000

$8,000

$56,800

$22,720

$30,720

56,000

32,800

13,120

13,120

23,200

15,000

(8,200)

(3,280)

(3,280)

P119. Taxcalculations
LG3,4;Intermediate
Currentbookvalue$200,000[(0.52($200,000)]$96,000
(a)

(b)

(c)

(d)

Capitalgain

$20,000

$0

$0

Recaptureddepreciation

104,000

54,000

8,000

41,600

21,600

(6,400)

$49,600

$21,600

$0

($6,400)

Taxoncapitalgain

$0
(16,000)

Taxondepreciation
Recovery
Totaltax

P1110. Changeinnetworkingcapitalcalculation
LG3;Basic
a.
CurrentAssets
Cash

CurrentLiabilities
$15,000

Accountspayable

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$90,000

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Accountsreceivable

150,000

Inventory

10,000

Netchange

$155,000

$130,000

Accruals

40,000

Networkingcapitalcurrentassetscurrentliabilities
NWC$155,000$130,000
NWC$25,000
b.

Analysisofthepurchaseofanewmachinerevealsanincreaseinnetworkingcapital.This
increaseshouldbetreatedasaninitialoutlayandisacostofacquiringthenewmachine.

c.

Yes,incomputingtheterminalcashflow,thenetworkingcapitalincreaseshouldbe
reversed.

P1111. Calculatinginitialinvestment
LG3,4;Intermediate
a.

Bookvalue$325,000(10.200.32)$325,0000.48$156,000

b.

Salespriceofoldequipment

$200,000

Bookvalueofoldequipment

156,000

Recaptureofdepreciation

$44,000

Taxesonrecaptureofdepreciation$44,0000.40$17,600
Aftertaxproceeds$200,000$17,600$182,400
c.

Costofnewmachine
Lesssalespriceofoldmachine
Plustaxonrecaptureofdepreciation
Initialinvestment

$500,000
(200,000)
17,600
$317,600

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P1112.Initialinvestmentbasiccalculation
LG3,4;Intermediate
Installedcostofnewasset
Costofnewasset

$35,000

Installationcosts

5,000

Totalinstalledcost(depreciablevalue)

$40,000

Aftertaxproceedsfromsaleofoldasset
Proceedsfromsaleofoldasset

($25,000)

Taxonsaleofoldasset

7,680

Totalaftertaxproceedsoldasset

($17,320)

Initialinvestment

$22,680

Bookvalueofexistingmachine $20,000(1(0.200.320.19))$5,800
Recaptureddepreciation $20,000$5,800 $14,200
$25,000$20,000 $5,000

Capitalgain

Taxonrecaptureddepreciation $14,200(0.40) $5,680


Taxoncapitalgain

$5,000(0.40) 2,000

Totaltax

$7,680

P1113. Initialinvestmentatvarioussaleprices
LG3,4;Intermediate
(a)

(b)

(c)

(d)

$24,000

$24,000

$24,000

$24,000

Installationcost

2,000

2,000

2,000

2,000

Totalinstalledcost

26,000

26,000

26,000

26,000

(11,000)

(7,000)

(2,900)

(1,500)

3,240

1,640

(560)

(7,760)

(5,360)

(2,900)

(2,060)

$20,640

$23,100

Installedcostofnewasset:
Costofnewasset

Aftertaxproceedsfromsale
ofoldasset
Proceedsfromsale
ofoldasset
Taxonsaleofoldasset*
Totalaftertaxproceeds
Initialinvestment

$18,240

$23,940

Bookvalueofexistingmachine$10,000[1(0.200.320.19)]$2,900
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*

TaxCalculations:
a.

b.

Recaptureddepreciation $10,000$2,900

$7,100

Capitalgain

$11,000$10,000 $1,000

Taxonordinarygain

$7,100(0.40)

$2,840

Taxoncapitalgain

$1,000(0.40)

Totaltax

$3,240

Recaptureddepreciation $7,000$2,900
Taxonordinarygain

400

$4,100(0.40)

c.

0taxliability

d.

Lossonsaleofexistingasset

$4,100
$1,640

$1,500$2,900

$1,400(0.40)

Taxbenefit

($1,400)
$560

P1114. Calculatinginitialinvestment
LG3,4;Challenge
a.

Bookvalue($60,0000.31)$18,600

b.

Salespriceofoldequipment

$35,000

Bookvalueofoldequipment

18,600

Recaptureofdepreciation

$16,400

Taxesonrecaptureofdepreciation$16,4000.40$6,560
Salepriceofoldroaster

$35,000

Taxonrecaptureofdepreciation

(6,560)

Aftertaxproceedsfromsaleofoldroaster $28,440
c.

Changesincurrentassetaccounts
Inventory

$50,000

Accountsreceivable

70,000

Netchange

$120,000

Changesincurrentliabilityaccounts
Accruals $(20,000)
Accountspayable 40,000
Notespayable 15,000
Netchange

$35,000

Changeinnetworkingcapital
d.

Costofnewroaster
Lessaftertaxproceedsfromsaleofoldroaster
Pluschangeinnetworkingcapital
Initialinvestment

$85,000
$130,000
28,440
85,000
$186,560

P1115. Depreciation
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LG5;Basic
DepreciationSchedule
Year

DepreciationExpense

$68,000 0.20 $13,600

2
3
4
5
6

68,000
68,000
68,000
68,000
68,000

0.32 21,760
0.19 12,920
0.12 8,160
0.12 8,160
0.05 3,400

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P1116. Incrementaloperatingcashinflows
LG5;Intermediate
a.

Incrementalprofitsbeforedepreciationandtax $1,200,000$480,000
$720,000eachyear

b.
Year

(1)

(2)

(3)

(4)

(5)

(6)

PBDT

$720,000

$720,000

$720,000

$720,000

$720,000

$720,000

Depr.

400,000

640,000

380,000

240,000

240,000

100,000

NPBT

320,000

80,000

340,000

480,000

480,000

620,000

Tax

128,000

32,000

136,000

192,000

192,000

248,000

NPAT

192,000

48,000

204,000

288,000

288,000

372,000

c.
Cash
flow

(1)
$592,000

(2)
$688,000

(3)
$584,000

(4)
$528,000

(5)
$528,000

(6)
$472,000

(NPATdepreciation)
PBDTProfitsbeforedepreciationandtaxes
NPBTNetprofitsbeforetaxes
NPATNetprofitsaftertaxes
P1117. Personalfinance:Incrementaloperatingcashinflows
LG5;Challenge
RichardandLindaThomson
IncrementalOperatingCashFlows
ReplacementofJohnDeereRidingMower
Year1 Year2 Year3 Year4 Year5
Savingsfromnewandimprovedmower
$500
$500
$500
$500
$500
Annualmaintenancecost
120
120
120
120
120
*
Depreciation
360
576
342
216
216
Savings(loss)beforetaxes
20
(196)
38
164
164
Taxes(40%)
8
(78)
15
66
66
Savings(loss)aftertaxes
12
(118)
23
98
98
Depreciation
360
576
342
216
216
Incrementaloperatingcashflow
$372
$458
$365
$314
$314
MACRSDepreciationSchedule
Year
Base
MACRS
*

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Depreciation

Year6

0
90
(90)
(36)
(54)
90
$36

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Year1
Year2
Year3
Year4
Year5
Year6

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

20.0%
32.0%
19.0%
12.0%
12.0%
5.0%

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$360
576
342
216
216
90

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P1118. Incrementaloperatingcashinflowsexpensereduction
LG5;Intermediate
Year

(1)

Incremental
expensesavings
Incrementalprofits
beforedep.andtaxes*
Depreciation
Netprofits
beforetaxes
Taxes
Netprofits
aftertaxes
Operatingcash
inflows**
*

(2)

(3)

(4)

(5)

(6)

$16,000

$16,000

$16,000

$16,000

$16,000

$0

16,000
9,600

16,000
15,360

16,000
9,120

16,000
5,760

16,000
5,760

0
2,400

6,400
2,560

640
256

6,880
2,752

10,240
4,096

10,240
4,096

2,400
960

3,840

384

4,128

6,144

6,144

1,440

13,440

15,744

13,248

11,904

11,904

960

Incrementalprofitsbeforedepreciationandtaxeswillincreasethesameamountasthedecreaseinexpenses.

**

Netprofitsaftertaxesplusdepreciationexpense.

P1119. Incrementaloperatingcashinflows
LG5;Intermediate
a.
Expenses
(excluding Profitsbefore
depreciation Depreciation
Revenue andinterest)
andTaxes

Year

Depre
ciation

Net
Profits
before
Taxes

Taxes

Net
Operating
Profits
Cash
afterTax Inflows

NewLathe
1

$40,000

$30,000

$10,000

$2,000

$8,000 $3,200

$4,800

$6,800

41,000

30,000

11,000

3,200

7,800

3,120

4,680

7,880

42,000

30,000

12,000

1,900

10,100

4,040

6,060

7,960

43,000

30,000

13,000

1,200

11,800

4,720

7,080

8,280

44,000

30,000

14,000

1,200

12,800

5,120

7,680

8,880

500

$35,000

$25,000

$10,000

(500)

(200)

(300)

200

OldLathe
15

b.

$10,000

$4,000

Calculationofincrementalcashinflows

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$6,000

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Year

NewLathe

OldLathe

IncrementalCashFlows

$6,800

$6,000

$800

7,880

6,000

1,880

7,960

6,000

1,960

8,280

6,000

2,280

8,880

6,000

2,880

200

200

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c.

P1120. Determiningincrementaloperatingcashflows
LG5;Intermediate
Year
1

$1,850
1,800
$50

$1,830
1,790
$40

$1,825
1,785
$40

$1,815
1,775
$40

$1,800
1,750
$50

$460
510
$(50)

$468
520
$(52)

$472
520
$(48)

$485
530
$(45)

$500
535
$(35)

$960
135
$825

$570
0
$570

$360
0
$360

$360
0
$360

$150
0
$150

330

228

144

144

60

$50
40
(36)
110

$50
50
(40)
330

$40
52
(37)
228

$40
48
(35)
144

$40
45
(34)
144

$50
35
(34)
60

$164

$390

$283

$197

$195

Revenues:(000)
Newbuses
$1,850
Oldbuses
1,800
Incrementalrevenue
$50
Expenses:(000)
Newbuses
$460
Oldbuses
500
Incrementalexpense $(40)
Depreciation:(000)
Newbuses
$600
Oldbuses
324
Incrementaldepr.
$276
Incrementaldepr.tax
savings@40%
110
NetIncrementalCashFlows
Cashflows:(000)
Revenues
Expenses
Lesstaxes@40%
Depr.taxsavings
Netoperatingcash
inflows

$111

P1121. Terminalcashflowsvariouslivesandsaleprices
LG6;Challenge
a.
Aftertaxproceedsfromsaleofnewasset 3Year*
Proceedsfromsaleofproposedasset
Taxonsaleofproposedasset*
Totalaftertaxproceedsnew

5Year*

7Year*

$10,000

$10,000

$10,000

16,880

400

4,000

$26,880

$9,600

$6,000

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Changeinnetworkingcapital

30,000

30,000

30,000

Terminalcashflow

$56,880

$39,600

$36,000

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*

1.

Bookvalueofasset [1(0.200.320.19)]$180,000$52,200
Proceedsfromsale $10,000
$10,000$52,200 ($42,200)loss
$42,200(0.40)

2.

3.

$16,880taxbenefit

Bookvalueofasset [1(0.200.320.190.120.12)]$180,000$9,000
$10,000$9,000

$1,000recaptureddepreciation

$1,000(0.40)

$400taxliability

Bookvalueofasset $0
$10,000$0

$10,000recaptureddepreciation

$10,000(0.40)

$4,000taxliability

b. Iftheusablelifeislessthanthenormalrecoveryperiod,theassethasnotbeendepreciated
fullyandataxbenefitmaybetakenontheloss;therefore,theterminalcashflowishigher.
c.
(1)

(2)

$9,000

$170,000

Aftertaxproceedsfromsaleofnewasset
Proceedsfromsaleofnewasset
Taxonsaleofproposedasset

Changeinnetworkingcapital

30,000

30,000

$39,000

$135,600

Terminalcashflow

(64,400)

1.

Bookvalueoftheasset$180,0000.05$9,000;notaxesaredue

2.

Tax($170,000$9,000)0.4$64,400.

d. Thehigherthesaleprice,thehighertheterminalcashflow.
P1122. Terminalcashflowreplacementdecision
LG6;Challenge
Aftertaxproceedsfromsaleofnewasset
Proceedsfromsaleofnewmachine

$75,000

Taxonsaleofnewmachinel

(14,360)

Totalaftertaxproceedsnewasset

$60,640

Aftertaxproceedsfromsaleofoldasset
Proceedsfromsaleofoldmachine
Taxonsaleofoldmachine

(15,000)
6,000

Totalaftertaxproceedsoldasset
Changeinnetworkingcapital

25,000

Terminalcashflow
1

(9,000)
$76,640

Bookvalueofnewmachineatendofyear4:
[1(0.200.320.190.12)($230,000)] $39,100
$75,000$39,100

$35,900recaptureddepreciation
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$14,360taxliability

$35,900(0.40)
2

Bookvalueofoldmachineatendofyear4:
$0
$15,000$0

$15,000recaptureddepreciation

$15,000(0.40)

$6,000taxbenefit

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P1123. Relevantcashflowsforamarketingcampaign
LG3,4,5,6;Challenge
MarcusTube
CalculationofRelevantCashFlow
($000)
CalculationofNetProfitsafterTaxesandOperatingCashFlow:
withMarketingCampaign
2013

2014

2015

2016

2017

Sales

$20,500

$21,000

$21,500

$22,500

$23,500

CGS(@80%)

16,400

16,800

17,200

18,000

18,800

Grossprofit

$4,100

$4,200

$4,300

$4,500

$4,700

$2,050

$2,100

$2,150

$2,250

$2,350

Marketingcampaign

150

150

150

150

150

Depreciation

500

500

500

500

500

2,700

2,750

2,800

2,900

3,000

$1,400

$1,450

$1,500

$1,600

$1,700

560

580

600

640

680

$840

$870

$900

$960

$1,020

500

500

500

500

500

$1,340

$1,370

$1,400

$1,460

$1,520

Less:Less:Operatingexpenses
Generaland
administrative
(10%ofsales)

Totaloperating
expenses
Netprofit
beforetaxes
Less:Taxes40%
Netprofit
aftertaxes
Depreciation
OperatingCF

WithoutMarketingCampaign
Years20132017
Netprofitaftertaxes
Depreciation

$900
500

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Operatingcashflow

$1,400

RelevantCashFlow
($000)
Year

WithMarketing
Campaign

WithoutMarketing Incremental
Campaign
CashFlow

2013

$1,340

$1,400

$(60)

2014

1,370

1,400

(30)

2015

1,400

1,400

2016

1,460

1,400

60

2017

1,520

1,400

120

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P1124. Relevantcashflowsnoterminalvalue
LG3,4,5;Challenge
a.

Installedcostofnewasset
Costofnewasset

$76,000

Installationcosts

4,000

Totalcostofnewasset

$80,000

Aftertaxproceedsfromsaleofoldasset
Proceedsfromsaleofoldasset

(55,000)

Taxonsaleofoldasset*

16,200

Totalproceeds,saleofoldasset

(38,800)

Initialinvestment
*

$41,200

Bookvalueofoldmachine:

[1(0.200.320.19)]$50,000

$14,500

$55,000$14,500

$40,500 gainonasset

$35,500recaptureddepreciation0.40

$14,200

$5,000capitalgain0.40

Totaltaxonsaleofasset

$16,200

2,000

b.
CalculationofOperatingCashFlow
Year

(1)

(2)

(3)

(4)

(5)

(6)

$14,000

$16,000

$20,000

$18,000

$14,000

$0

6,000

6,000

2,500

NPBT

$8,000

$10,000

$17,500

$18,000

$14,000

Taxes

3,200

4,000

7,000

7,200

5,600

NPAT

$4,800

$6,000

$10,500

$10,800

$8,400

$0

6,000

6,000

2,500

$10,800

$12,000

$13,000

$10,800

$8,400

$0

PBDT

$30,000

$30,000

$30,000

$30,000

$30,000

$0

Depreciation

16,000

25,600

15,200

9,600

9,600

4,000

NPBT

$14,000

$4,400

$14,800

$20,400

$20,400

$4,000

OldMachine
PBDT
Depreciation

Depreciation
Cashflow
NewMachine

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Taxes

5,600

1,760

5,920

8,160

8,160

1,600

NPAT

$8,400

$2,640

$8,880

$12,240

$12,240

$2,400

Depreciation

16,000

25,600

15,200

9,600

9,600

4,000

Cashflow

$24,400

$28,240

$24,080

$21,840

$21,840

$1,600

$13,600

$16,240

$11,080

$11,040

$13,440

$1,600

Incremental
Aftertax
cashflows

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c.

P1125. Integrativedeterminingrelevantcashflows
LG3,4,5,6;Challenge
a.

Initialinvestment:
Installedcostofnewasset
Costofnewasset

$105,000

Installationcosts

5,000

Totalcostofnewasset

$110,000

Aftertaxproceedsfromsaleofoldasset
Proceedsfromsaleofoldasset

(70,000)

Taxonsaleofoldasset

16,480

Totalproceedsfromsaleofoldasset

(53,520)

Changeinworkingcapital

12,000

Initialinvestment
*

$68,480

Bookvalueofoldasset:
[1(0.200.32)]$60,000

$28,800

$70,000$28,800$41,200gainonsaleofasset
$31,200recaptureddepreciation0.40 $12,480
$10,000capitalgain0.40

Totaltaxofsaleofasset

$16,480

4,000

b.

Year

CalculationofOperatingCashInflows
Profitsbefore
Depreciation
NetProfits
NetProfits
andTaxes Depreciation beforeTaxes Taxes afterTaxes

Operating
Cash
Inflows

NewGrinder
1
$43,000
2
43,000
3
43,000
4
43,000
5
43,000
6
0
ExistingGrinder
1
$26,000
2
24,000
3
22,000

$22,000
35,200
20,900
13,200
13,200
5,500

$21,000
7,800
22,100
29,800
29,800
5,500

$8,400
3,120
8,840
11,920
11,920
2,200

$12,600
4,680
13,260
17,880
17,880
3,300

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

$11,400
7,200
7,200

$14,600
16,800
14,800

$5,840
6,720
5,920

$8,760
10,080
8,880

$20,160
17,280
16,080

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4
5
6

20,000
18,000
0

3,000
0
0

17,000
18,000
0

6,800
7,200
0

10,200
10,800
0

CalculationofIncrementalCashInflows
Year

c.

IncrementalOperating
NewGrinder ExistingGrinder
CashFlow

$34,600

$20,160

$14,440

39,880

17,280

22,600

34,160

16,080

18,080

31,080

13,200

17,880

31,080

10,800

20,280

2,200

2,200

Terminalcashflow:
Aftertaxproceedsfromsaleofnewasset
Proceedsfromsaleofnewasset
Taxonsaleofnewasset

$29,000
(9,400)

Totalproceedsfromsaleofnewasset

19,600

Aftertaxproceedsfromsaleofoldasset
Proceedsfromsaleofoldasset

Taxonsaleofoldasset

Totalproceedsfromsaleofoldasset
Changeinnetworkingcapital

12,000

Terminalcashflow
*

d.

0
$31,600

Bookvalueofassetatendofyear5 $5,500
$29,000$5,500

$23,500 recaptureddepreciation

$23,5000.40

$9,400

Year5relevantcashflow:
Operatingcashflow

$20,280

Terminalcashflow

31,600

Totalinflow

$51,880

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10,800
0

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P1126. Personalfinance:Determiningrelevantcashflowsforacashbudget
LG3,4,5,6;Challenge
JanandDeana
CashFlowBudget
PurchaseofBoat
a. Initialinvestment
Totalcostofnewboat
Add:Taxes(6.5%)
Initialinvestment

$(70,000)
(4,550)
$(74,550)

b. Operatingcashflows
Maint.&repair
12monthsat$800
Dockingfees
12monthsat$500
Operatingcashflows

Year1
$(9,600)
$(6,000)
$(15,600)

Year2
$(9,600)
$(6,000)
$(15,600)

Year3
$(9,600)
$(6,000)
$(15,600)

c. Terminalcashflowendofyear4
Proceedsfromthesaleofboat
d. Summaryofcashflows
Yearzero
Endofyear1
Endofyear2
Endofyear3
Endofyear4

Year4
$(9,600)
$(6,000)
$(15,600)
$40,000

CashFlow
$(74,550)
$(15,600)
$(15,600)
$(15,600)
$24,400

e. Theownershipoftheboatisvirtuallyjustanannualoutflowofmoney.Acrossthefouryears,
$96,950willbespentinexcessoftheanticipatedsalespriceinyear4.Overthesametime
period,thedisposableincomeisonly$96,000.Consequently,ifthecostsexceedtheexpected
disposableincome.Ifcashflowswereadjustedfortheirtiming,andnotingthattheproceeds
fromthesaleofthenewboatcomesinfirstattheendofyear4,JanandDeanaareina
positionwheretheywillhavetoincreasetheirdisposableincomeinordertoaccommodate
boatownership.Ifaloanisneeded,themonthlyinterestpaymentwouldbeanotherburden.
However,thereisnoattemptheretomeasuresatisfactionofownership.
P1127. Integrativedeterminingrelevantcashflows
LG3,4,5,6;Challenge
a.
InitialInvestment
Installedcostofnewasset
Costofnewasset

$40,000

$54,000

Installationcosts

8,000

6,000

Totalproceeds,saleofnewasset

48,000

60,000

Aftertaxproceedsfromsaleofoldasset

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Proceedsfromsaleofoldasset
Taxonsaleofoldasset*
Totalproceeds,saleofoldasset
Changeinworkingcapital
Initialinvestment
*

Bookvalueofoldasset:

(18,000)

(18,000)

3,488

3,488

(14,512)

(14,512)

4,000

6,000

$37,488

$51,48
8

[1(0.200.320.19)]($32,000)$9,280

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b.
CalculationofOperatingCashInflows
Profits
before
Depreciation
andTaxes

Depre
ciation

NetProfits
before
Taxes

Taxes

$21,000

$9,600

$11,400

$4,560

$6,840

$16,440

21,000

15,360

5,640

2,256

3,384

18,744

21,000

9,120

11,880

4,752

7,128

16,248

21,000

5,760

15,240

6,096

9,144

14,904

21,000

5,760

15,240

6,096

9,144

14,904

2,400

2,400

960

1,440

960

$22,000

$12,000

$10,000

$4,000

$6,000

18,000

24,000

19,200

4,800

1,920

2,880

22,080

26,000

11,400

14,600

5,840

8,760

20,160

26,000

7,200

18,800

7,520

11,280

18,480

26,000

7,200

18,800

7,520

11,280

18,480

3,000

3,000

1,200

1,800

1,200

$14,000

$3,840

$10,160

$4,064

$6,096

$9,936

14,000

3,840

10,160

4,064

6,096

9,936

14,000

1,600

12,400

4,960

7,440

9,040

14,000

14,000

5,600

8,400

8,400

14,000

14,000

5,600

8,400

8,400

Year

NetProfits Operating
after
Cash
Taxes
Inflows

HoistA

HoistB

ExistingHoist

CalculationofIncrementalCashInflows
Incremental
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CashFlow

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Year

HoistA

HoistB

ExistingHoist

HoistA

HoistB

$16,440

$18,000

$9,936

$6,504

$8,064

18,744

22,080

9,936

8,808

12,144

16,248

20,160

9,040

7,208

11,120

14,904

18,480

8,400

6,504

10,080

14,904

18,480

8,400

6,504

10,080

960

1,200

960

1,200

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c.

Terminalcashflow:
(A)

(B)

$12,000

$20,000

Aftertaxproceedsformsaleofnewasset
Proceedsfromsaleofnewasset
Taxonsaleofnewassetl
Totalproceedsnewasset

(3,840)

(6,800)

8,160

13,200

(1,000)

(1,000)

400

400

(600)

(600)

Aftertaxproceedsfromsaleofoldasset
Proceedsfromsaleofoldasset
Taxonsaleofoldasset2
Totalproceedsoldasset
Changeinnetworkingcapital
Terminalcashflow
1

4,000

6,000

$11,560

$18,600

BookvalueofHoistAatendofyear5$2,400
$12,000$2,400 $9,600recaptureddepreciation
$9,6000.40

$3,840tax

BookvalueofHoistBatendofyear5$3,000
$20,000$3,000 $17,000recaptureddepreciation
$17,0000.40
2

$6,800tax

Bookvalueofexistinghoistatendofyear5$0
$1,000$0

$1,000recaptureddepreciation

$1,0000.40

$400tax

Year5relevantcashflowHoistA:
Operatingcashflow

$6,504

Terminalcashflow

11,560

Totalinflow

$18,064

Year5relevantcashflowHoistB:
Operatingcashflow

$10,080

Terminalcashflow

18,600

Totalinflow

$28,680

d.

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P1128. Integrativecompleteinvestmentdecision
LG1,2,3,4,5,6;Challenge
a.

Initialinvestment:
Installedcostofnewpress
Costofnewpress

$2,200,000

Aftertaxproceedsfromsaleofoldasset
Proceedsfromsaleofexistingpress

(1,200,000)

Taxesonsaleofexistingpress*

480,000

Totalaftertaxproceedsfromsale

(720,000)

Initialinvestment
$1,480,000
*

Bookvalue$0
$1,200,000$0$1,200,000incomefromsaleofexistingpress
$1,200,000incomefromsale(0.40)$480,000

b.

Year Revenues

CalculationofOperatingCashFlows
NetProfits
Expenses Depreciation beforeTaxes
Taxes

NetProfits
afterTaxes

1
2
3
4
5
6

$800,000
800,000
800,000
800,000
800,000
0

$216,000
57,600
229,200
321,600
321,600
66,000

$1,600,000
1,600,000
1,600,000
1,600,000
1,600,000
0

c.

$440,000
704,000
418,000
264,000
264,000
110,000

$360,000
96,000
382,000
536,000
536,000
110,000

$144,000
38,400
152,800
214,400
214,400
44,000

Paybackperiod2years($62,400$647,200)2.1years

d. PVofcashinflows:
CF0$1,480,000,CF1$656,000,CF2$761,600,CF3$647,200,
CF4$585,600,CF5585,600,CF6$44,000
SetI11
SolveforNPV$959,152
Year
1
2
3
4
5
6

CF

PVIF11%,n

$656,000
761,600
647,200
585,600
585,600
44,000

0.901
0.812
0.731
0.659
0.593
0.535

PV
$591,056
618,419
473,103
385,910
347,261
23,540

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Cash
Flow
$656,000
761,600
647,200
585,600
585,600
44,000

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$2,439,289

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$0

$656,000 $761,600 $647,200 $585,600 $585,600


$44,000

$1,480,000
1
2
3
4
5
(1 IRR) (1 IRR) (1 IRR) (1 IRR) (1 IRR) (1 IRR)6
IRR35%
Calculatorsolution:35.04%
e.

TheNPVisapositive$959,289andtheIRRof35%iswellabovethecostofcapitalof11%.
Basedonbothdecisioncriteria,theprojectshouldbeaccepted.

P1129. Integrativeinvestmentdecision
LG1,2,3,4,5,6;Challenge
a.

Initialinvestment:
Installedcostofnewasset
Costofthenewmachine

$1,200,000

Installationcosts

150,000

Totalcostofnewmachine

$1,350,000

Aftertaxproceedsfromsaleofoldasset
Proceedsfromsaleofexistingmachine
Taxonsaleofexistingmachine

(185,000)
(79,600)

Totalaftertaxproceedsfromsale

(264,600)

Increaseinnetworkingcapital

25,000

Initialinvestment

$1,110,400

Bookvalue$384,000
$185,000$384,000$199,000lossfromsaleofexistingpress
$199,000lossfromsale(0.40)$79,600

CalculationofOperatingCashFlows
NewMachine
Reductionin
NetProfits
Year OperatingCosts Depreciation beforeTaxes Taxes
1
2
3
4
5
6

$350,000
350,000
350,000
350,000
350,000
0

$270,000
432,000
256,500
162,000
162,000
67,500

$80,000
82,000
93,500
188,000
188,000
67,500

$32,000
32,800
37,400
75,200
75,200
27,000

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NetProfits
afterTaxes
$48,000
49,200
56,100
112,800
112,800
40,500

Cash
Flow
$318,000
382,800
312,600
274,800
274,800
27,000

297Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition

Year
1
2
3
4
5
6

ExistingMachine
NetProfits
beforeTaxes
Taxes

Depreciation

$152,000
96,000
96,000
40,000
0
0

$152,000
96,000
96,000
40,000
0
0

Year

NetProfits
afterTaxes

$60,800
38,400
38,400
16,000
0
0

$91,200
57,600
57,600
24,000
0
0

IncrementalOperatingCashFlows
NewMachine
ExistingMachine IncrementalCashFlow

$318,000

$60,800

$257,200

382,800

38,400

344,400

312,600

38,400

274,200

274,800

16,000

258,800

274,800

274,800

27,000

27,000

Terminalcashflow:
Aftertaxproceedsfromsaleofnewasset
Proceedsfromsaleofnewasset
Taxonsaleofnewasset

$200,000
(53,000)

Totalproceedssaleofnewasset

$147,000

Aftertaxproceedsfromsaleofoldasset

Changeinnetworkingcapital
Terminalcashflow

25,000
$172,000

Bookvalueofnewmachineattheendofyear5is$67,500
200,000$67,500$132,500incomefromsaleofoldmachine
132,5000.40$53,000taxliability

b. CF0$1,110,400,CF1257,200,CF2$344,400,CF3$274,200,
CF4$258,800,CF5$274,800172,000$446,800
SetI9%
SolveforNPV=$100,900.39

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Cash
Flow
$60,800
38,400
38,400
16,000
0
0

299Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition

$0

$257,200 $344,400 $274,200 $258,800 $446,800

$1,110,400
(1 IRR)1 (1 IRR) 2 (1 IRR)3 (1 IRR) 4 (1 IRR)5

c.
IRR12.2%
Calculatorsolution:12.24%
d. SincetheNPV0andtheIRRcostofcapital,thenewmachineshouldbepurchased.
e.

12.24%.ThecriterionisthattheIRRmustequalorexceedthecostofcapital;therefore,
12.24%isthelowestacceptableIRR.

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P1130. Ethicsproblem
LG2;Intermediate
Thepersonwhocameupwiththeideaforanewinvestmentmayhaveanselfishinterestinseeing
theprojectapproved,ormaysimplybeemotionallyvestedintheproject.Ineithercase,thisindividual
mayhaveanincentivetomakeoverlyoptimisticcashflowprojections.Itisbesttohaveanobjective
thirdpartyberesponsibleforcashflowprojections.

Case
Casestudiesareavailableonwww.myfinancelab.com.

Developing Relevant Cash Flows for Clark Upholstery Companys Machine


Renewal or Replacement Decision
ClarkUpholsteryisfacedwithadecisiontoeitherrenewitsmajorpieceofmachineryortoreplacethe
machine.Thecaseteststhestudentsunderstandingoftheconceptsofinitialinvestmentandrelevantcash
flows.
a.

InitialInvestment:
Alternative1

Alternative2

$90,000

$100,000

10,000

90,000

110,000

Installedcostofnewasset
Costofasset
Installationcosts
Totalproceeds,saleofnewasset
Aftertaxproceedsfromsaleofoldasset
Proceedsfromsaleofoldasset

(20,000)

Taxonsaleofoldasset*

8,000

(12,000)

Totalproceeds,saleofoldasset
Changeinworkingcapital
Initialinvestment
*

15,000

22,000

$105,000

$120,000

Bookvalueofoldasset 0
$20,000$0

$20,000recaptureddepreciation

$20,000(0.40)

$8,000tax

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b.
CalculationofOperatingCashInflows
Profitsbefore
Depreciation
andTaxes

Year

Depre
ciation

NetProfits
beforeTaxes Taxes

Operating
NetProfits
Cash
afterTaxes Inflows

Alternative1
1

$198,500

$18,000

$180,500

$72,200 $108,300

$126,300

290,800

28,800

262,000

104,800

157,200

186,000

381,900

17,100

364,800

145,920

218,880

235,980

481,900

10,800

471,100

188,440

282,660

293,460

581,900

10,800

571,100

228,440

342,660

353,460

4,500

4,500

1,800

2,700

1,800

$235,500

$22,000

$213,500

$85,400 $128,100

$150,100

335,200

35,200

300,000

120,000

180,000

215,200

385,100

20,900

364,200

145,680

218,520

239,420

435,100

13,200

421,900

168,760

253,140

266,340

551,100

13,200

537,900

215,160

322,740

335,940

5,500

5,500

2,200

3,300

2,200

Alternative2

CalculationofIncrementalCashInflows
IncrementalCashFlow
Year

Alternative1

Alternative2

Existing

Alt.1

Alt.2

$126,300

$150,100

$100,000

$26,300

$50,100

186,000

215,200

150,000

36,000

65,200

235,980

239,420

200,000

35,980

39,420

293,460

266,340

250,000

43,460

16,340

353,460

335,940

320,000

33,460

15,940

1,800

2,200

1,800

2,200

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c.

TerminalCashFlow:
Alternative1

Alternative2

Aftertaxproceedsfrom
saleofnewasset
Proceedsfromsaleofnewasset

$8,000

Taxonsaleofnewasset*
Totalproceeds,saleofnewasset

$25,000

(1,400)

(7,800)

6,600

17,200

(2,000)

(2,000)

800

800

(1,200)

(1,200)

Aftertaxproceedsfromsaleofoldasset
Proceedsfromsaleofoldasset
Taxonsaleofoldasset**
Totalproceeds,saleofoldasset
Changeinworkingcapital

15,000

22,000

Terminalcashflow

$20,400

$38,000

BookvalueofAlternative1atendofyear5: $4,500
$8,000$4,500 $3,500recaptureddepreciation
$3,500(0.40)

$1,400tax

BookvalueofAlternative2atendofyear5: $5,500
$25,000$5,500 $19,500recaptureddepreciation
$19,500(0.40) $7,800tax
**

Bookvalueofoldassetatendofyear5:$0
$2,000$0

$2,000recaptureddepreciation

$2,000(0.40)

$800tax

Alternative1
Year5relevantcashflow:

Operatingcashflow:

$33,460

Terminalcashflow

20,400

Totalcashinflow

$53,860

Operatingcashflow:

$15,940

Terminalcashflow

38,000

Totalcashinflow

$53,940

Alternative2
Year5relevantcashflow:

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d.

Alternative1

e.

Alternative2appearstobeslightlybetterbecauseithasthelargerincrementalcashflowamounts
intheearlyyears.Assuminga9%discountrate,theNPVofAlternative1is$43,005.50,whilethe
NPVofAlternative2is$57,913.27.TheIRRofAlternative2,27.77%,isalsohigherthantheIRR
ofAlternative1,whichis22.04%.

Spreadsheet Exercise
TheanswertoChapter11sDamonCorporationspreadsheetproblemislocatedontheInstructors
ResourceCenteratwww.pearsonhighered.com/ircundertheInstructorsManual.

Group Exercise
Groupexercisesareavailableonwww.myfinancelab.com.
Capitalinvestmentisrevisitedinthischapter.Alongterminvestmentprojectwillbedetailedacrossthis
andthefollowingtwochapters.Studentsarewarnedthatwhilethischaptersexerciseisapparentlybrief,
theworkisvitaltotheworkinthefollowingchapters.
Thefirsttaskistodesigntwomutuallyexclusiveinvestmentprojects.Thedesignshouldfocusonwhy
theseinvestmentsshouldeachbeundertaken.Afterestablishingthewhyforeachproject,theprocess
ofrigorousnumericalanalysisisbegun.Cashflowsaretobeestimatedandstudentsshouldbeencouraged
tousesimpleroundnumberswhenestimatingtheinitialinvestmentandoperating/terminalcashflows.All
numbersshouldbeorganizedonanannualbasis.Eachgroupisaskedtodesignatimelinewithaminimum
of5yearsforeachprojectsnumbers.Themostfeasibleestimateswillrunfrom510years.
Apaybackperiod,netpresentvalue,andinternalrateofreturnareestimatedforbothprojects.Ifthe
projectshavedifferentsizes,itmaybepossibleforthesmallerprojecttohaveahigherinternalrateof
returnbutalowernetpresentvalue.Givinggroupsavarietyofdiscountratestouseintheanalysisalso
addstotherichnessoftheproject.

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