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Chapter 11

Capital Budgeting Cash Flows

Instructors Resources
Overview
This chapter expands upon the capital budgeting techniques presented in the last chapter (Chapter 10).
Shareholder wealth maximization relies upon selection of projects that have positive net present values.
The most important and difficult aspect of the capital budgeting process is developing good estimates of
the relevant cash flows. Chapter 11 focuses on the basics of determining relevant after-tax cash flows of a
project, from the initial cash outlay to annual cash stream of costs and benefits and terminal cash flow. It
also describes the special concerns facing capital budgeting for the multinational company. The text
highlights how capital budgeting will be a critical aspect of the professional life and personal life of
students upon graduation.

Suggested Answer to Opener in Review Question


The chapter opener talked about ExxonMobils considerable investment in long-term projects and
the sometimes difficult task of having projects come in on budget. How are project cash flows
affected by budget overruns? In the capital budgeting process, how should financial managers
account for the potential of budget overruns?

It is critical to have the best estimate of project cash flows possible when making a project accept/reject
decision. Depending upon the scope of a project, financial managers may need to draw information from
many areas of a corporation including research and development, marketing, operations, human resources,
and within the various departments dealing with corporate finance. It may be possible to get some of the
information directly from the project managers if they have done some of the legwork already.

Budget overruns mean higher than expected costs, and therefore lower than expected cash flows. Lower
than expected cash flows mean lower than expected capital budgeting outcomes (e.g., lower NPVs, PIs,
IRRs, etc.). If financial managers do not adequately account for possible budget overruns in the capital
budgeting process they are unlikely to fully maximize firm value. Chapter 12 considers the uncertainty of
cash flows in more detail and discusses some of the methods used by financial managers to account for
the uncertainty of cash flows. In particular, ExxonMobil could generate a range or distribution of capital
budgeting outcomes for projects that have uncertain cash flows due to possible budget overruns. ExxonMobil
should calculate NPVs using cash flows that assume no budget overrun and a variety of possible budget
overruns and then calculate an expected average NPV where the weights reflect the probably of each
budget outcome.

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Chapter 11 Capital Budgeting Cash Flows 221

Answers to Review Questions


1. Capital budgeting projects should be evaluated using incremental after-tax cash flows, since after-tax
cash flows are what is available to the firm. When evaluating a project, concern is placed only on
added cash flows expected to result from its implementation. Expansion decisions can be treated
as replacement decisions in which all cash flows from the old assets are zero. Both expansion and
replacement decisions involve purchasing new assets. Replacement decisions are more complex
because incremental cash flows resulting from the replacement must be determined.

2. The three components of cash flow for any project are (1) initial investment, (2) operating cash flows,
and (3) terminal cash flows.

3. Sunk costs are costs that have already been incurred and thus the money has already been spent.
Opportunity costs are cash flows that could be realized from the next best alternative use of an owned
asset. Sunk costs are not relevant to the investment decision because they are not incremental. These
costs will not change no matter what the final accept/reject decision. Opportunity costs are a relevant
cost. These cash flows could be realized if the decision is made not to change the current asset
structure but to utilize the owned asset for this alternative purpose.

4. To minimize long-term currency risk, companies can finance a foreign investment in local capital
markets so that the projects revenues and costs are in the local currency rather than dollars.
Techniques such as currency futures, forwards, and options market instruments protect against short-
term currency risk. Financial and operating strategies that reduce political risk include structuring the
investment as a joint venture with a competent and well-connected local partner, and using debt
rather than equity financing, since debt service payments are legally enforceable claims while equity
returns such as dividends are not.

5. a. The cost of the new asset is the purchase price. (Outflow)


b. Installation costs are any added costs necessary to get an asset into operation. (Outflow)
c. Proceeds from sale of old asset are cash inflows resulting from the sale of an existing asset,
reduced by any removal costs. (Inflow)
d. Tax on sale of old asset is incurred when the replaced asset is sold due to recaptured depreciation,
capital gain, or capital loss. (May be an inflow or an outflow)
e. The change in net working capital is the difference between the change in current assets and the
change in current liabilities. (May be an inflow or an outflow)

6. The book value of an asset is its strict accounting value.


Book value installed cost of asset accumulated depreciation
Gains and losses in the sale of an asset may have tax consequences, and hence are both key forms of
taxable income. More specifically, taxable income may arise from (1) capital gain: portion of sale
price above initial purchase price, taxed at the ordinary rate; (2) recaptured depreciation: portion of
sale price in excess of book value that represents a recovery of previously taken depreciation, taxed at
the ordinary rate; and (3) loss on the sale of an asset: amount by which sale price is less than book
value, taxed at the ordinary rate and deducted from ordinary income if the asset is depreciable and
used in business. If the asset is not depreciable or is not used in business, it is also taxed at the
ordinary rate but is deductible only against capital gains.

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7. The asset may be sold (1) for more than its book value, (2) for the amount of its book value, or
(3) at a price below book value. In the first case, taxes arise from the amount by which the sale price
exceeded the book value. In the second case, no taxes would be required. In the third case, a tax
credit would occur.

8. The depreciable value of an asset is the installed cost of a new asset and is based on the depreciable
cost of the new project, including installation cost.

9. Depreciation is used to decrease the firms total tax liability and then is added back to net profits after
taxes to determine cash flow. Table 11.6 and Equation 3.4 (refer to the text) are equivalent ways of
expressing operating cash flows. The earnings before interest and taxes in Table 11.6 is the same as
the EBIT terminology in Equation 3.4. Both models then take out taxes and add back in depreciation.

10. To calculate incremental operating cash inflow for both the existing situation and the proposed
project, the depreciation on assets is added back to the after-tax profits to get the cash flows
associated with each alternative. The difference between the cash flows of the proposed and present
situation, the incremental after-tax cash flows, are the relevant operating cash flows used in
evaluating the proposed project.

11. The terminal cash flow is the cash flow resulting from termination and liquidation of a project at the
end of its economic life. The form of calculating terminal cash flows is shown below:
Terminal Cash Flow Calculation:

After-tax After-tax Change in Terminal


proceeds from proceeds from net working = cash
sale of new asset sale of old asset capital flow

Extended Presentation:

Proceeds from Proceeds from Change in Terminal


sale of new asset sale of old asset net working cash
=
Tax on sale of Tax on sale of capital flow
new asset old asset

12. The relevant cash flows necessary for a conventional capital budgeting project are the incremental
after-tax cash flows attributable to the proposed project: the initial investment, the operating cash
inflows, and the terminal cash flow. The initial investment is the initial outlay required, taking into
account the installed cost of the new asset, proceeds from the sale of the old asset, tax on the sale of
the old asset, and any change in net working capital. The operating cash inflows are the additional
cash flows received as a result of implementing a proposal. Terminal cash flow represents the after-
tax cash flows expected to result from the liquidation of the project at the end of its life. These three
components represent the positive or negative cash flow impact if the firm implements the project,
and are depicted in the following diagram for a project lasting 5 years.

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Chapter 11 Capital Budgeting Cash Flows 223

Suggested Answer to Global Focus Box:


Changes May Influence Future Investments in China
Although China has been actively campaigning for foreign investment, how do you think having
a communist government affects its foreign investment?

Having a communist government has a negative affect on foreign direct investment (FDI). As in all
investments abroad, FDI in China entails high travel and communications expenses. The differences of
political system and culture that exist between the country of the investor and the host country will also
cause problems with foreign direct investment in China. Due to its control of the economy, the communist
party has more control over employment, raw materials, and repatriation of revenues to a parent firm than
found in non-communist countries. There is also the chance that a company may lose ownership of its
overseas operations to a Chinese company. Hence, foreign firms often partner with Chinese firms in their
development efforts, but this requires coordination and raises the costs of FDI in China.

Suggested Answer to Focus on Ethics Box:


A Question of Accuracy
What would your options be when faced with the demands of an imperial chief executive officer
(CEO) who expects you to make it work? Brainstorm several options.

There is a chance that you may be working for an imperial CEO at some point in your career. This may
be by choice or by chance. While the make it work mandate may seem like an order to do anything it
takes to accomplish your job, you are under no obligation to do anything unethical or illegal. If that is the
only way to accomplish the job, the best approach is to ask your superior directly, Is (this) what you want
me to do?

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If the answer is that you should break the law or do something unethical, you may have three viable options
other than doing something that you should not do. One option is to seek the guidance of your mentor if
you have one in the company. He or she may be able to intervene on your behalf. Another option is to take
the matter over your bosss head (in the case of a CEO, that would be the board of directors). The third
option is to evaluate your career options. You may be better served working elsewhere. Realistically, by
offering opposition to an imperial CEO, you may be limiting your career in your present company.

However, do not immediately assume that do whatever it takes or make it work automatically includes
anything unethical or illegal. The CEO may just be stating that more resources or effort need to be put into
solving the problem.

Answers to Warm-Up Exercises


E11-1. Categorizing a firms expenditures
Answer: In this case, the tuition reimbursement should be categorized as a capital expenditure since the
outlay of funds is expected to produce benefits over a period of time greater than 1 year.

E11-2. Classification of project costs and cash flows


Answer: $3.5 billion already spentsunk cost (irrelevant)
$350 million incremental cash outflowrelevant cash flow
$15 million per year cash inflowrelevant cash flow
$450 million for satellitesopportunity cost and relevant cash flow

E11-3. Finding the initial investment


Answer: $20,000 Purchase price of new machinery
$3,000 Installation costs
$4,500 After-tax proceeds from sale of old machinery
$18,500 Initial investment

E11-4. Book value and recaptured depreciation


Answer: Book value $175,000 $124, 250 $50,750
Recaptured depreciation $110,000 $50, 750 $59,250

E11-5. Initial investment


Answer: Initial investment purchase price installation costs after-tax proceeds from sale of old
asset change in net working capital
$55,000 $7,500 $23,750 $2,000 $40,750

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Chapter 11 Capital Budgeting Cash Flows 225

Solutions to Problems
Note: The MACRS depreciation percentages used in the following problems appear in Chapter 4,
Table 4.2. The percentages are rounded to the nearest integer for ease in calculation.

For simplification, 5-year-lived projects with 5 years of cash inflows are typically used throughout this
chapter. Projects with usable lives equal to the number of years of cash inflows are also included in the
end-of-chapter problems. It is important to recall from Chapter 4 that under the Tax Reform Act of 1986,
MACRS depreciation results in n 1 years of depreciation for an n-year class asset. This means that in
actual practice projects will typically have at least one year of cash flow beyond their recovery period.

P11-1. Classification of expenditures


LG 2; Basic
a. Operating expenditurelease expires within one year
b. Capital expenditurepatent rights exist for many years
c. Capital expenditureresearch and development benefits last many years
d. Operating expendituremarketable securities mature in under one year
e. Capital expendituremachine will last over one year
f. Capital expenditurebuilding tool will last over one year
g. Capital expenditurebuilding will last for more than one year
h. Operating expendituremarket changes require obtaining another report within a year
P11-2. Relevant cash flow and timeline depiction
LG 1, 2; Intermediate
a.
Year Cash Flow

This is a conventional cash flow pattern, where the cash inflows are of equal size, which is referred to
as an annuity.

b.

This is a conventional cash flow pattern, where the subsequent cash inflows vary, which is referred to
as a mixed stream.

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c.

This is a nonconventional cash flow pattern, which has several cash flow series of equal size, which is
referred to as an embedded annuity.

P11-3. Expansion versus replacement cash flows


LG 3; Intermediate
a.
Year Relevant Cash
Flows
Initial investment ($28,000)
1 4,000
2 6,000
3 8,000
4 10,000
5 4,000

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

P11-4. Sunk costs and opportunity costs


LG 2; Basic
a. The $1,000,000 development costs should not be considered part of the decision to go ahead
with the new production. This money has already been spent and cannot be retrieved so it is a
sunk cost.
b. The $250,000 sale price of the existing line is an opportunity cost. If Masters Golf Products
does not proceed with the new line of clubs they will not receive the $250,000.
c.

P11-5. Sunk costs and opportunity costs


LG 2; Intermediate
a. Sunk costThe funds for the tooling had already been expended and would not change, no
matter whether the new technology would be acquired or not.
b. Opportunity costThe development of the computer programs can be done without
additional expenditures on the computers; however, the loss of the cash inflow from the
leasing arrangement would be a lost opportunity to the firm.

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Chapter 11 Capital Budgeting Cash Flows 227

c. Opportunity costCovol will not have to spend any funds for floor space but the lost cash
inflow from the rent would be a cost to the firm.
d. Sunk costThe money for the storage facility has already been spent, and no matter what
decision the company makes there is no incremental cash flow generated or lost from the
storage building.
e. Opportunity costForgoing the sale of the crane costs the firm $180,000 of potential cash
inflows.
P11-6. Personal finance: Sunk and opportunity cash flows
LG 2; Intermediate
a. The sunk costs or cash outlays are expenditures that have been made in the past and have no
effect on the cash flows relevant to a current situation. The cash outlays done before David
and Ann decided to rent out their home would be classified as sunk costs. An opportunity
cost or cash flow is one that can be realized from an alternative use of an existing asset.
Here, David and Ann have decided to rent out their home, and all the costs associated with
getting the home in rentable condition would be relevant.
b. Sunk costs (cash flows):
Replace water heater
Replace dish washer
Miscellaneous repairs and maintenance
Opportunity costs cash flows:
Rental income
Advertising
House paint and power wash
P11-7. Book value
LG 3; Basic

Installed Accumulated Book


Asset Cost Depreciation Value
A $ 950,000 $ 674,500 $275,500
B 40,000 13,200 26,800
C 96,000 79,680 16,320
D 350,000 70,000 280,000
E 1,500,000 1,170,000 330,000

P11-8. Book value and taxes on sale of assets


LG 3, 4; Intermediate
a. Book value $80,000 (0.71 $80,000)
$23,200
b.
Capital Tax on Depreciation Tax on Total
Sale Price Gain Capital Gain Recovery Recovery Tax
$100,000 $20,000 $8,000 $56,800 $22,720 $30,720
56,000 0 0 32,800 13,120 13,120
23,200 0 0 0 0 0
15,000 0 0 (8,200) (3,280) (3,280)

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P11-9. Tax calculations


LG 3, 4; Intermediate
Current book value $200,000 [(0.52 ($200,000)] $96,000
(a) (b) (c) (d)
Capital gain $ 20,000 $0 $0 $0
Recaptured depreciation 104,000 54,000 0 (16,000)
Tax on capital gain 8,000 0 0 0
Tax on depreciation
Recovery 41,600 21,600 0 (6,400)
Total tax $ 49,600 $21,600 $0 ($6,400)

P11-10. Change in net working capital calculation


LG 3; Basic
a.
Current Assets Current Liabilities
Cash $15,000 Accounts payable $90,000
Accounts receivable 150,000 Accruals 40,000
Inventory 10,000
Net change $155,000 $130,000

Net working capital current assets current liabilities


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

P11-11. Calculating initial investment


LG 3, 4; Intermediate
a. Book value $325,000 (1 0.20 0.32) $325,000 0.48 $156,000
b. Sales price of old equipment $200,000
Book value of old equipment 156,000
Recapture of depreciation $ 44,000
Taxes on recapture of depreciation $44,000 0.40 $17,600
After-tax proceeds $200,000 $17,600 $182,400
c. Cost of new machine $ 500,000
Less sales price of old machine (200,000)
Plus tax on recapture of depreciation 17,600
Initial investment $ 317,600

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P11-12. Initial investmentbasic calculation


LG 3, 4; Intermediate
Installed cost of new asset
Cost of new asset $ 35,000
Installation costs 5,000
Total installed cost (depreciable value) $40,000
After-tax proceeds from sale of old asset
Proceeds from sale of old asset ($25,000)
Tax on sale of old asset 7,680
Total after-tax proceedsold asset ($17,320)
Initial investment $22,680
Book value of existing machine $20,000 (1 (0.20 0.32 0.19)) $5,800
Recaptured depreciation $20,000 $5,800 $14,200
Capital gain $25,000 $20,000 $5,000
Tax on recaptured depreciation $14,200 (0.40) $5,680
Tax on capital gain $5,000 (0.40) 2,000
Total tax $7,680

P11-13. Initial investment at various sale prices


LG 3, 4; Intermediate
(a) (b) (c) (d)
Installed cost of new asset:
Cost of new asset $24,000 $24,000 $24,000 $24,000
Installation cost 2,000 2,000 2,000 2,000
Total installed cost 26,000 26,000 26,000 26,000
After-tax proceeds from sale
of old asset
Proceeds from sale
of old asset (11,000) (7,000) (2,900) (1,500)
Tax on sale of old asset* 3,240 1,640 0 (560)
Total after-tax proceeds (7,760) (5,360) (2,900) (2,060)
Initial investment $18,240 $20,640 $23,100 $23,940

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


*
Tax Calculations:
a. Recaptured depreciation $10,000 $2,900 $7,100
Capital gain $11,000 $10,000 $1,000
Tax on ordinary gain $7,100 (0.40) $2,840
Tax on capital gain $1,000 (0.40) 400
Total tax $3,240
b. Recaptured depreciation $7,000 $2,900 $4,100
Tax on ordinary gain $4,100 (0.40) $1,640
c. 0 tax liability

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d. Loss on sale of existing asset $1,500 $2,900 ($1,400)


Tax benefit $ 1,400 (0.40) $ 560

P11-14. Calculating initial investment


LG 3, 4; Challenge
a. Book value ($60,000 0.31) $18,600
b. Sales price of old equipment $35,000
Book value of old equipment 18,600
Recapture of depreciation $16,400
Taxes on recapture of depreciation $16,400 0.40 $6,560
Sale price of old roaster $35,000
Tax on recapture of depreciation (6,560)
After-tax proceeds from sale of old roaster $28,440
c. Changes in current asset accounts
Inventory $ 50,000
Accounts receivable 70,000
Net change $ 120,000
Changes in current liability accounts
Accruals $ (20,000)
Accounts payable 40,000
Notes payable 15,000
Net change $ 35,000
Change in net working capital $ 85,000
d. Cost of new roaster $130,000
Less after-tax proceeds from sale of old roaster 28,440
Plus change in net working capital 85,000
Initial investment $186,560
P11-15. Depreciation
LG 5; Basic
Depreciation Schedule
Year Depreciation Expense
1 $68,000 0.20 $13,600
2 68,000 0.32 21,760
3 68,000 0.19 12,920
4 68,000 0.12 8,160
5 68,000 0.12 8,160
6 68,000 0.05 3,400

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P11-16. Incremental operating cash inflows


LG 5; Intermediate
a. Incremental profits before depreciation and tax $1,200,000 $480,000
$720,000 each year
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 (1) (2) (3) (4) (5) (6)
flow $592,000 $688,000 $584,000 $528,000 $528,000 $472,000

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

P11-17. Personal finance: Incremental operating cash inflows


LG 5; Challenge
Richard and Linda Thomson
Incremental Operating Cash Flows
Replacement of John Deere Riding Mower
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Savings from new and improved mower $500 $ 500 $500 $500 $500
Annual maintenance cost 120 120 120 120 120 0
*
Depreciation 360 576 342 216 216 90
Savings (loss) before taxes 20 (196) 38 164 164 (90)
Taxes (40%) 8 (78) 15 66 66 (36)
Savings (loss) after taxes 12 (118) 23 98 98 (54)
Depreciation 360 576 342 216 216 90
Incremental operating cash flow $372 $ 458 $365 $314 $314 $ 36

*
MACRS Depreciation Schedule
Year Base MACRS Depreciation
Year 1 $1,800 20.0% $360
Year 2 1,800 32.0% 576
Year 3 1,800 19.0% 342
Year 4 1,800 12.0% 216
Year 5 1,800 12.0% 216
Year 6 1,800 5.0% 90

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P11-18. Incremental operating cash inflowsexpense reduction


LG 5; Intermediate
Year (1) (2) (3) (4) (5) (6)
Incremental
expense savings $16,000 $16,000 $16,000 $16,000 $16,000 $0
Incremental profits
before dep. and taxes* 16,000 16,000 16,000 16,000 16,000 0
Depreciation 9,600 15,360 9,120 5,760 5,760 2,400
Net profits
before taxes 6,400 640 6,880 10,240 10,240 2,400
Taxes 2,560 256 2,752 4,096 4,096 960
Net profits
after taxes 3,840 384 4,128 6,144 6,144 1,440
Operating cash
inflows** 13,440 15,744 13,248 11,904 11,904 960
*
Incremental profits before depreciation and taxes will increase the same amount as the decrease in expenses.
**
Net profits after taxes plus depreciation expense.

P11-19. Incremental operating cash inflows


LG 5; Intermediate
a.

Expenses Net
(excluding Profits before Profits Net Operating
depreciation Depreciation Depre- before Profits Cash
Year Revenue and interest) and Taxes ciation Taxes Taxes after Tax Inflows
New Lathe
1 $40,000 $30,000 $10,000 $2,000 $8,000 $3,200 $4,800 $6,800
2 41,000 30,000 11,000 3,200 7,800 3,120 4,680 7,880
3 42,000 30,000 12,000 1,900 10,100 4,040 6,060 7,960
4 43,000 30,000 13,000 1,200 11,800 4,720 7,080 8,280
5 44,000 30,000 14,000 1,200 12,800 5,120 7,680 8,880
6 0 0 0 500 (500) (200) (300) 200
Old Lathe
15 $35,000 $25,000 $10,000 0 $10,000 $4,000 $6,000 $6,000

b. Calculation of incremental cash inflows

Year New Lathe Old Lathe Incremental Cash Flows


1 $6,800 $6,000 $800
2 7,880 6,000 1,880
3 7,960 6,000 1,960
4 8,280 6,000 2,280
5 8,880 6,000 2,880
6 200 0 200

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Chapter 11 Capital Budgeting Cash Flows 233

c.

P11-20. Determining incremental operating cash flows


LG 5; Intermediate

Year
1 2 3 4 5 6
Revenues: (000)
New buses $1,850 $1,850 $1,830 $1,825 $1,815 $1,800
Old buses 1,800 1,800 1,790 1,785 1,775 1,750
Incremental revenue $50 $50 $40 $40 $40 $50
Expenses: (000)
New buses $460 $460 $468 $472 $485 $500
Old buses 500 510 520 520 530 535
Incremental expense $ (40) $ (50) $ (52) $ (48) $ (45) $ (35)
Depreciation: (000)
New buses $ 600 $ 960 $ 570 $ 360 $ 360 $ 150
Old buses 324 135 0 0 0 0
Incremental depr. $276 $825 $570 $360 $360 $150
Incremental depr. tax
savings @40% 110 330 228 144 144 60
Net Incremental Cash Flows
Cash flows: (000)
Revenues $50 $50 $40 $40 $40 $50
Expenses 40 50 52 48 45 35
Less taxes @40% (36) (40) (37) (35) (34) (34)
Depr. tax savings 110 330 228 144 144 60
Net operating cash
inflows $164 $390 $283 $197 $195 $111

P11-21. Terminal cash flowsvarious lives and sale prices


LG 6; Challenge
a.
After-tax proceeds from sale of new asset 3-Year* 5-Year* 7-Year*
Proceeds from sale of proposed asset $10,000 $10,000 $10,000
Tax on sale of proposed asset *
16,880 400 4,000
Total after-tax proceedsnew $26,880 $9,600 $ 6,000
Change in net working capital 30,000 30,000 30,000
Terminal cash flow $56,880 $39,600 $36,000

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*
1. Book value of asset [1 (0.20 0.32 0.19)] $180,000 $52,200
Proceeds from sale $10,000
$10,000 $52,200 ($42,200) loss
$42,200 (0.40) $16,880 tax benefit
2. Book value of asset [1 (0.20 0.32 0.19 0.12 0.12)] $180,000 $9,000
$10,000 $9,000 $1,000 recaptured depreciation
$1,000 (0.40) $400 tax liability
3. Book value of asset $0
$10,000 $0 $10,000 recaptured depreciation
$10,000 (0.40) $4,000 tax liability
b. If the usable life is less than the normal recovery period, the asset has not been depreciated
fully and a tax benefit may be taken on the loss; therefore, the terminal cash flow is higher.
c.
(1) (2)
After-tax proceeds from sale of new asset
Proceeds from sale of new asset $ 9,000 $170,000
Tax on sale of proposed asset *
0 (64,400)
Change in net working capital 30,000 30,000
Terminal cash flow $39,000 $135,600
1. Book value of the asset $180,000 0.05 $9,000; no taxes are due
2. Tax ($170,000 $9,000) 0.4 $64,400.
d. The higher the sale price, the higher the terminal cash flow.
P11-22. Terminal cash flowreplacement decision
LG 6; Challenge
After-tax proceeds from sale of new asset
Proceeds from sale of new machine $75,000
Tax on sale of new machine l
(14,360)
Total after-tax proceedsnew asset $60,640
After-tax proceeds from sale of old asset
Proceeds from sale of old machine (15,000)
Tax on sale of old machine 2
6,000
Total after-tax proceedsold asset (9,000)
Change in net working capital 25,000
Terminal cash flow $76,640
1
Book value of new machine at end of year 4:
[1 (0.20 0.32 0.19 0.12) ($230,000)] $39,100
$75,000 $39,100 $35,900 recaptured depreciation
$35,900 (0.40) $14,360 tax liability
2
Book value of old machine at end of year 4:
$0
$15,000 $0 $15,000 recaptured depreciation
$15,000 (0.40) $6,000 tax benefit

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Chapter 11 Capital Budgeting Cash Flows 235

P11-23. Relevant cash flows for a marketing campaign


LG 3, 4, 5, 6; Challenge
Marcus Tube
Calculation of Relevant Cash Flow
($000)
Calculation of Net Profits after Taxes and Operating Cash Flow:
with Marketing Campaign
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
Gross profit $ 4,100 $ 4,200 $ 4,300 $ 4,500 $ 4,700
Less: Less: Operating expenses
General and
administrative
(10% of sales) $ 2,050 $ 2,100 $ 2,150 $ 2,250 $ 2,350
Marketing campaign 150 150 150 150 150
Depreciation 500 500 500 500 500
Total operating
expenses 2,700 2,750 2,800 2,900 3,000
Net profit
before taxes $ 1,400 $ 1,450 $ 1,500 $ 1,600 $ 1,700
Less: Taxes 40% 560 580 600 640 680
Net profit
after taxes $ 840 $ 870 $ 900 $ 960 $ 1,020
Depreciation 500 500 500 500 500
Operating CF $ 1,340 $ 1,370 $ 1,400 $ 1,460 $ 1,520

Without Marketing Campaign


Years 20132017
Net profit after taxes $ 900
Depreciation 500
Operating cash flow $1,400

Relevant Cash Flow


($000)
With Marketing Without Marketing Incremental
Year Campaign Campaign Cash Flow
2013 $1,340 $1,400 $(60)
2014 1,370 1,400 (30)
2015 1,400 1,400 0
2016 1,460 1,400 60
2017 1,520 1,400 120

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P11-24. Relevant cash flowsno terminal value


LG 3, 4, 5; Challenge
a. Installed cost of new asset
Cost of new asset $76,000
Installation costs 4,000
Total cost of new asset $80,000
After-tax proceeds from sale of old asset
Proceeds from sale of old asset (55,000)
Tax on sale of old asset *
16,200
Total proceeds, sale of old asset (38,800)
Initial investment $41,200
*
Book value of old machine:
[1 (0.20 0.32 0.19)] $50,000 $14,500
$55,000 $14,500 $40,500 gain on asset
$35,500 recaptured depreciation 0.40 $14,200
$5,000 capital gain 0.40 2,000
Total tax on sale of asset $16,200

b.
Calculation of Operating Cash Flow
Year (1) (2) (3) (4) (5) (6)
Old Machine
PBDT $14,000 $16,000 $20,000 $18,000 $14,000 $0
Depreciation 6,000 6,000 2,500 0 0 0
NPBT $ 8,000 $10,000 $17,500 $18,000 $14,000 0
Taxes 3,200 4,000 7,000 7,200 5,600 0
NPAT $ 4,800 $ 6,000 $10,500 $10,800 $ 8,400 $0
Depreciation 6,000 6,000 2,500 0 0 0
Cash flow $10,800 $12,000 $13,000 $10,800 $ 8,400 $0
New Machine
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
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
Cash flow $24,400 $28,240 $24,080 $21,840 $21,840 $1,600

Incremental
After-tax
cash flows $13,600 $16,240 $11,080 $11,040 $13,440 $1,600

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Chapter 11 Capital Budgeting Cash Flows 237

c.

P11-25. Integrativedetermining relevant cash flows


LG 3, 4, 5, 6; Challenge
a. Initial investment:
Installed cost of new asset
Cost of new asset $105,000
Installation costs 5,000
Total cost of new asset $110,000
After-tax proceeds from sale of old asset
Proceeds from sale of old asset (70,000)
Tax on sale of old asset *
16,480
Total proceeds from sale of old asset (53,520)
Change in working capital 12,000
Initial investment $ 68,480
*
Book value of old asset:
[1 (0.20 0.32)] $60,000 $28,800
$70,000 $28,800 $41,200 gain on sale of asset
$31,200 recaptured depreciation 0.40 $12,480
$10,000 capital gain 0.40 4,000
Total tax of sale of asset $16,480
b.
Calculation of Operating Cash Inflows
Profits before Operating
Depreciation Net Profits Net Profits Cash
Year and Taxes Depreciation before Taxes Taxes after Taxes Inflows
New Grinder
1 $43,000 $22,000 $21,000 $8,400 $12,600 $34,600
2 43,000 35,200 7,800 3,120 4,680 39,880
3 43,000 20,900 22,100 8,840 13,260 34,160
4 43,000 13,200 29,800 11,920 17,880 31,080
5 43,000 13,200 29,800 11,920 17,880 31,080
6 0 5,500 5,500 2,200 3,300 2,200
Existing Grinder
1 $26,000 $11,400 $14,600 $5,840 $8,760 $20,160
2 24,000 7,200 16,800 6,720 10,080 17,280
3 22,000 7,200 14,800 5,920 8,880 16,080
4 20,000 3,000 17,000 6,800 10,200 13,200
5 18,000 0 18,000 7,200 10,800 10,800
6 0 0 0 0 0 0

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Calculation of Incremental Cash Inflows


Incremental Operating
Year New Grinder Existing Grinder Cash Flow
1 $34,600 $20,160 $14,440
2 39,880 17,280 22,600
3 34,160 16,080 18,080
4 31,080 13,200 17,880
5 31,080 10,800 20,280
6 2,200 0 2,200

c. Terminal cash flow:


After-tax proceeds from sale of new asset
Proceeds from sale of new asset $29,000
Tax on sale of new asset *
(9,400)
Total proceeds from sale of new asset 19,600
After-tax proceeds from sale of old asset
Proceeds from sale of old asset 0
Tax on sale of old asset 0
Total proceeds from sale of old asset 0
Change in net working capital 12,000
Terminal cash flow $31,600
*
Book value of asset at end of year 5 $5,500
$29,000 $5,500 $23,500 recaptured depreciation
$23,500 0.40 $9,400

d. Year 5 relevant cash flow:


Operating cash flow $20,280
Terminal cash flow 31,600
Total inflow $51,880

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Chapter 11 Capital Budgeting Cash Flows 239

P11-26. Personal finance: Determining relevant cash flows for a cash budget
LG 3, 4, 5, 6; Challenge
Jan and Deana
Cash Flow Budget
Purchase of Boat
a. Initial investment
Total cost of new boat $(70,000)
Add: Taxes (6.5%) (4,550)
Initial investment $(74,550)
b. Operating cash flows Year 1 Year 2 Year 3 Year 4
Maint. & repair 12 months at $800 $(9,600) $(9,600) $(9,600) $(9,600)
Docking fees 12 months at $500 $(6,000) $(6,000) $(6,000) $(6,000)
Operating cash flows $(15,600) $(15,600) $(15,600) $(15,600)
c. Terminal cash flowend of year 4
Proceeds from the sale of boat $40,000
d. Summary of cash flows Cash Flow
Year zero $(74,550)
End of year 1 $(15,600)
End of year 2 $(15,600)
End of year 3 $(15,600)
End of year 4 $24,400
e. The ownership of the boat is virtually just an annual outflow of money. Across the four years,
$96,950 will be spent in excess of the anticipated sales price in year 4. Over the same time
period, the disposable income is only $96,000. Consequently, if the costs exceed the expected
disposable income. If cash flows were adjusted for their timing, and noting that the proceeds
from the sale of the new boat comes in first at the end of year 4, Jan and Deana are in a
position where they will have to increase their disposable income in order to accommodate
boat ownership. If a loan is needed, the monthly interest payment would be another burden.
However, there is no attempt here to measure satisfaction of ownership.

P11-27. Integrativedetermining relevant cash flows


LG 3, 4, 5, 6; Challenge
a.
Initial Investment A B
Installed cost of new asset
Cost of new asset $ 40,000 $ 54,000
Installation costs 8,000 6,000
Total proceeds, sale of new asset 48,000 60,000
After-tax proceeds from sale of old asset
Proceeds from sale of old asset (18,000) (18,000)
Tax on sale of old asset * 3,488 3,488
Total proceeds, sale of old asset (14,512) (14,512)
Change in working capital 4,000 6,000
Initial investment $37,488 $51,488
*
Book value of old asset: [1 (0.20 0.32 0.19)] ($32,000) $9,280

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b.
Calculation of Operating Cash Inflows
Profits
before Net Profits Net Profits Operating
Depreciation Depre- before after Cash
Year and Taxes ciation Taxes Taxes Taxes Inflows
Hoist A
1 $21,000 $9,600 $11,400 $4,560 $6,840 $16,440
2 21,000 15,360 5,640 2,256 3,384 18,744
3 21,000 9,120 11,880 4,752 7,128 16,248
4 21,000 5,760 15,240 6,096 9,144 14,904
5 21,000 5,760 15,240 6,096 9,144 14,904
6 0 2,400 2,400 960 1,440 960
Hoist B
1 $22,000 $12,000 $10,000 $4,000 $6,000 18,000
2 24,000 19,200 4,800 1,920 2,880 22,080
3 26,000 11,400 14,600 5,840 8,760 20,160
4 26,000 7,200 18,800 7,520 11,280 18,480
5 26,000 7,200 18,800 7,520 11,280 18,480
6 0 3,000 3,000 1,200 1,800 1,200
Existing Hoist
1 $14,000 $3,840 $10,160 $4,064 $6,096 $9,936
2 14,000 3,840 10,160 4,064 6,096 9,936
3 14,000 1,600 12,400 4,960 7,440 9,040
4 14,000 0 14,000 5,600 8,400 8,400
5 14,000 0 14,000 5,600 8,400 8,400
6 0 0 0 0 0 0

Calculation of Incremental Cash Inflows


Incremental Cash Flow
Year Hoist A Hoist B Existing Hoist Hoist A Hoist B
1 $16,440 $18,000 $9,936 $6,504 $8,064
2 18,744 22,080 9,936 8,808 12,144
3 16,248 20,160 9,040 7,208 11,120
4 14,904 18,480 8,400 6,504 10,080
5 14,904 18,480 8,400 6,504 10,080
6 960 1,200 0 960 1,200

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Chapter 11 Capital Budgeting Cash Flows 241

c. Terminal cash flow:


(A) (B)
After-tax proceeds form sale of new asset
Proceeds from sale of new asset $12,000 $20,000
Tax on sale of new assetl (3,840) (6,800)
Total proceedsnew asset 8,160 13,200
After-tax proceeds from sale of old asset
Proceeds from sale of old asset (1,000) (1,000)
Tax on sale of old asset2 400 400
Total proceedsold asset (600) (600)
Change in net working capital 4,000 6,000
Terminal cash flow $11,560 $18,600
1
Book value of Hoist A at end of year 5 $2,400
$12,000 $2,400 $9,600 recaptured depreciation
$9,600 0.40 $3,840 tax
Book value of Hoist B at end of year 5 $3,000
$20,000 $3,000 $17,000 recaptured depreciation
$17,000 0.40 $6,800 tax
2
Book value of existing hoist at end of year 5 $0
$1,000 $0 $1,000 recaptured depreciation
$1,000 0.40 $400 tax
Year 5 relevant cash flowHoist A:
Operating cash flow $ 6,504
Terminal cash flow 11,560
Total inflow $18,064
Year 5 relevant cash flowHoist B:
Operating cash flow $10,080
Terminal cash flow 18,600
Total inflow $28,680
d.

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P11-28. Integrativecomplete investment decision


LG 1, 2, 3, 4, 5, 6; Challenge
a. Initial investment:
Installed cost of new press
Cost of new press $2,200,000
After-tax proceeds from sale of old asset
Proceeds from sale of existing press (1,200,000)
Taxes on sale of existing press* 480,000
Total after-tax proceeds from sale (720,000)
Initial investment
$1,480,000
*
Book value $0
$1,200,000 $0 $1,200,000 income from sale of existing press
$1,200,000 income from sale (0.40) $480,000
b.

Calculation of Operating Cash Flows


Net Profits Net Profits Cash
Year Revenues Expenses Depreciation before Taxes Taxes after Taxes Flow
1 $1,600,000 $800,000 $440,000 $360,000 $144,000 $216,000 $656,000
2 1,600,000 800,000 704,000 96,000 38,400 57,600 761,600
3 1,600,000 800,000 418,000 382,000 152,800 229,200 647,200
4 1,600,000 800,000 264,000 536,000 214,400 321,600 585,600
5 1,600,000 800,000 264,000 536,000 214,400 321,600 585,600
6 0 0 110,000 110,000 44,000 66,000 44,000

c. Payback period 2 years ($62,400 $647,200) 2.1 years

d. PV of cash inflows:
CF0 $1,480,000, CF1 $656,000, CF2 $761,600, CF3 $647,200,
CF4 $585,600, CF5 585,600, CF6 $44,000
Set I 11
Solve for NPV $959,152

Year CF PVIF11%,n PV
1 $656,000 0.901 $ 591,056
2 761,600 0.812 618,419
3 647,200 0.731 473,103
4 585,600 0.659 385,910
5 585,600 0.593 347,261
6 44,000 0.535 23,540
$2,439,289

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Chapter 11 Capital Budgeting Cash Flows 243

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


$0 $1,480,000
(1 IRR)1 (1 IRR)2 (1 IRR)3 (1 IRR)4 (1 IRR)5 (1 IRR)6
IRR 35%
Calculator solution: 35.04%
e. The NPV is a positive $959,289 and the IRR of 35% is well above the cost of capital of 11%.
Based on both decision criteria, the project should be accepted.

P11-29. Integrativeinvestment decision


LG 1, 2, 3, 4, 5, 6; Challenge
a. Initial investment:
Installed cost of new asset
Cost of the new machine $1,200,000
Installation costs 150,000
Total cost of new machine $1,350,000
After-tax proceeds from sale of old asset
Proceeds from sale of existing machine (185,000)
Tax on sale of existing machine* (79,600)
Total after-tax proceeds from sale (264,600)
Increase in net working capital 25,000
Initial investment $1,110,400
Book value $384,000
*

$185,000 $384,000 $199,000 loss from sale of existing press


$199,000 loss from sale(0.40) $79,600

Calculation of Operating Cash Flows


New Machine
Reduction in Net Profits Net Profits Cash
Year Operating Costs Depreciation before Taxes Taxes after Taxes Flow
1 $350,000 $270,000 $80,000 $32,000 $48,000 $318,000
2 350,000 432,000 82,000 32,800 49,200 382,800
3 350,000 256,500 93,500 37,400 56,100 312,600
4 350,000 162,000 188,000 75,200 112,800 274,800
5 350,000 162,000 188,000 75,200 112,800 274,800
6 0 67,500 67,500 27,000 40,500 27,000

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Existing Machine
Net Profits Net Profits Cash
Year Depreciation before Taxes Taxes after Taxes Flow
1 $152,000 $152,000 $60,800 $91,200 $60,800
2 96,000 96,000 38,400 57,600 38,400
3 96,000 96,000 38,400 57,600 38,400
4 40,000 40,000 16,000 24,000 16,000
5 0 0 0 0 0
6 0 0 0 0 0

Incremental Operating Cash Flows


Year New Machine Existing Machine Incremental Cash Flow
1 $318,000 $60,800 $257,200
2 382,800 38,400 344,400
3 312,600 38,400 274,200
4 274,800 16,000 258,800
5 274,800 0 274,800
6 27,000 0 27,000

Terminal cash flow:


After-tax proceeds from sale of new asset
Proceeds from sale of new asset $200,000
Tax on sale of new asset* (53,000)
Total proceedssale of new asset $147,000
After-tax proceeds from sale of old asset 0
Change in net working capital 25,000
Terminal cash flow $172,000
*
Book value of new machine at the end of year 5 is $67,500
200,000 $67,500 $132,500 income from sale of old machine
132,500 0.40 $53,000 tax liability
b. CF0 $1,110,400, CF1 257,200, CF2 $344,400, CF3 $274,200,
CF4 $258,800, CF5 $274,800 172,000 $446,800
Set I 9%
Solve for NPV = $100,900.39
$257,200 $344,400 $274,200 $258,800 $446,800
c. $0 $1,110,400
(1 IRR)1 (1 IRR)2 (1 IRR)3 (1 IRR)4 (1 IRR)5
IRR 12.2%
Calculator solution: 12.24%
d. Since the NPV 0 and the IRR cost of capital, the new machine should be purchased.
e. 12.24%. The criterion is that the IRR must equal or exceed the cost of capital; therefore,
12.24% is the lowest acceptable IRR.

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Chapter 11 Capital Budgeting Cash Flows 245

P11-30. Ethics problem


LG 2; Intermediate
The person who came up with the idea for a new investment may have an selfish interest in seeing
the project approved, or may simply be emotionally vested in the project. In either case, this individual
may have an incentive to make overly optimistic cash flow projections. It is best to have an objective
third party be responsible for cash flow projections.

Case
Case studies are available on www.myfinancelab.com.

Developing Relevant Cash Flows for Clark Upholstery Companys Machine


Renewal or Replacement Decision
Clark Upholstery is faced with a decision to either renew its major piece of machinery or to replace the
machine. The case tests the students understanding of the concepts of initial investment and relevant cash
flows.
a. Initial Investment:
Alternative 1 Alternative 2
Installed cost of new asset
Cost of asset $90,000 $100,000
Installation costs 0 10,000
Total proceeds, sale of new asset 90,000 110,000
After-tax proceeds from sale of old asset
Proceeds from sale of old asset 0 (20,000)
Tax on sale of old asset *
0 8,000
Total proceeds, sale of old asset 0 (12,000)
Change in working capital 15,000 22,000
Initial investment $105,000 $120,000
*
Book value of old asset 0
$20,000 $0 $20,000 recaptured depreciation
$20,000 (0.40) $8,000 tax

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b.
Calculation of Operating Cash Inflows
Profits before Operating
Depreciation Depre- Net Profits Net Profits Cash
Year and Taxes ciation before Taxes Taxes after Taxes Inflows
Alternative 1
1 $198,500 $18,000 $180,500 $72,200 $108,300 $126,300
2 290,800 28,800 262,000 104,800 157,200 186,000
3 381,900 17,100 364,800 145,920 218,880 235,980
4 481,900 10,800 471,100 188,440 282,660 293,460
5 581,900 10,800 571,100 228,440 342,660 353,460
6 0 4,500 4,500 1,800 2,700 1,800
Alternative 2
1 $235,500 $22,000 $213,500 $85,400 $128,100 $150,100
2 335,200 35,200 300,000 120,000 180,000 215,200
3 385,100 20,900 364,200 145,680 218,520 239,420
4 435,100 13,200 421,900 168,760 253,140 266,340
5 551,100 13,200 537,900 215,160 322,740 335,940
6 0 5,500 5,500 2,200 3,300 2,200

Calculation of Incremental Cash Inflows


Incremental Cash Flow
Year Alternative 1 Alternative 2 Existing Alt. 1 Alt. 2
1 $126,300 $150,100 $100,000 $26,300 $50,100
2 186,000 215,200 150,000 36,000 65,200
3 235,980 239,420 200,000 35,980 39,420
4 293,460 266,340 250,000 43,460 16,340
5 353,460 335,940 320,000 33,460 15,940
6 1,800 2,200 0 1,800 2,200

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Chapter 11 Capital Budgeting Cash Flows 247

c. Terminal Cash Flow:


Alternative 1 Alternative 2
After-tax proceeds from
sale of new asset
Proceeds from sale of new asset $8,000 $25,000
Tax on sale of new asset* (1,400) (7,800)
Total proceeds, sale of new asset 6,600 17,200
After-tax proceeds from sale of old asset
Proceeds from sale of old asset (2,000) (2,000)
Tax on sale of old asset** 800 800
Total proceeds, sale of old asset (1,200) (1,200)
Change in working capital 15,000 22,000
Terminal cash flow $20,400 $38,000
*
Book value of Alternative 1 at end of year 5: $4,500
$8,000 $4,500 $3,500 recaptured depreciation
$3,500 (0.40) $1,400 tax
Book value of Alternative 2 at end of year 5: $5,500
$25,000 $5,500 $19,500 recaptured depreciation
$19,500 (0.40) $7,800 tax
**
Book value of old asset at end of year 5: $0
$2,000 $0 $2,000 recaptured depreciation
$2,000 (0.40) $800 tax

Alternative 1
Year 5 relevant cash flow: Operating cash flow: $33,460
Terminal cash flow 20,400
Total cash inflow $53,860
Alternative 2
Year 5 relevant cash flow: Operating cash flow: $15,940
Terminal cash flow 38,000
Total cash inflow $53,940

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d. Alternative 1

e. Alternative 2 appears to be slightly better because it has the larger incremental cash flow amounts
in the early years. Assuming a 9% discount rate, the NPV of Alternative 1 is $43,005.50, while the
NPV of Alternative 2 is $57,913.27. The IRR of Alternative 2, 27.77%, is also higher than the IRR
of Alternative 1, which is 22.04%.

Spreadsheet Exercise
The answer to Chapter 11s Damon Corporation spreadsheet problem is located on the Instructors
Resource Center at www.pearsonhighered.com/irc under the Instructors Manual.

Group Exercise
Group exercises are available on www.myfinancelab.com.

Capital investment is revisited in this chapter. A long-term investment project will be detailed across this
and the following two chapters. Students are warned that while this chapters exercise is apparently brief,
the work is vital to the work in the following chapters.

The first task is to design two mutually exclusive investment projects. The design should focus on why
these investments should each be undertaken. After establishing the why for each project, the process
of rigorous numerical analysis is begun. Cash flows are to be estimated and students should be encouraged
to use simple round numbers when estimating the initial investment and operating/terminal cash flows. All
numbers should be organized on an annual basis. Each group is asked to design a timeline with a minimum
of 5 years for each projects numbers. The most feasible estimates will run from 510 years.

A payback period, net present value, and internal rate of return are estimated for both projects. If the
projects have different sizes, it may be possible for the smaller project to have a higher internal rate of
return but a lower net present value. Giving groups a variety of discount rates to use in the analysis also
adds to the richness of the project.

2012 Pearson Education, Inc. Publishing as Prentice Hall