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CapitalBudgetingCashFlows
Instructors Resources
Overview
Thischapterexpandsuponthecapitalbudgetingtechniquespresentedinthelastchapter(Chapter10).
Shareholderwealthmaximizationreliesuponselectionofprojectsthathavepositivenetpresentvalues.
Themostimportantanddifficultaspectofthecapitalbudgetingprocessisdevelopinggoodestimatesof
therelevantcashflows.Chapter11focusesonthebasicsofdeterminingrelevantaftertaxcashflowsofa
project,fromtheinitialcashoutlaytoannualcashstreamofcostsandbenefitsandterminalcashflow.It
alsodescribesthespecialconcernsfacingcapitalbudgetingforthemultinationalcompany.Thetext
highlightshowcapitalbudgetingwillbeacriticalaspectoftheprofessionallifeandpersonallifeof
studentsupongraduation.
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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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:
ExtendedPresentation:
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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Havingacommunistgovernmenthasanegativeaffectonforeigndirectinvestment(FDI).Asinall
investmentsabroad,FDIinChinaentailshightravelandcommunicationsexpenses.Thedifferencesof
politicalsystemandculturethatexistbetweenthecountryoftheinvestorandthehostcountrywillalso
causeproblemswithforeigndirectinvestmentinChina.Duetoitscontroloftheeconomy,thecommunist
partyhasmorecontroloveremployment,rawmaterials,andrepatriationofrevenuestoaparentfirmthan
foundinnoncommunistcountries.Thereisalsothechancethatacompanymayloseownershipofits
overseasoperationstoaChinesecompany.Hence,foreignfirmsoftenpartnerwithChinesefirmsintheir
developmentefforts,butthisrequirescoordinationandraisesthecostsofFDIinChina.
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.
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 ($28,000)
1 4,000
2 6,000
3 8,000
4 10,000
5 4,000
b. 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
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C 96,000 79,680 16,320
P118. Bookvalueandtaxesonsaleofassets
LG3,4;Intermediate
a. Bookvalue$80,000(0.71$80,000)
$23,200
b.
Capital Taxon Depreciation Taxon Total
SalePrice Gain CapitalGain Recovery Recovery Tax
$100,000 $20,000 $8,000 $56,800 $22,720 $30,720
23,200 0 0 0 0 0
P119. Taxcalculations
LG3,4;Intermediate
Currentbookvalue$200,000[(0.52($200,000)]$96,000
Taxoncapitalgain 8,000 0 0 0
Taxondepreciation
P1110. Changeinnetworkingcapitalcalculation
LG3;Basic
a.
CurrentAssets CurrentLiabilities
Cash $15,000 Accountspayable $90,000
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Accountsreceivable 150,000 Accruals 40,000
Inventory 10,000
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 $500,000
Lesssalespriceofoldmachine (200,000)
Plustaxonrecaptureofdepreciation 17,600
Initialinvestment $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
Capitalgain $25,000$20,000 $5,000
Taxonrecaptureddepreciation $14,200(0.40) $5,680
Taxoncapitalgain $5,000(0.40) 2,000
Totaltax $7,680
P1113. Initialinvestmentatvarioussaleprices
LG3,4;Intermediate
Aftertaxproceedsfromsale
ofoldasset
Proceedsfromsale
Bookvalueofexistingmachine$10,000[1(0.200.320.19)]$2,900
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*
TaxCalculations:
c. 0taxliability
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 $85,000
d. Costofnewroaster $130,000
Lessaftertaxproceedsfromsaleofoldroaster 28,440
Pluschangeinnetworkingcapital 85,000
Initialinvestment $186,560
P1115. Depreciation
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LG5;Basic
DepreciationSchedule
Year DepreciationExpense
1 $68,000 0.20 $13,600
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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
c.
(NPATdepreciation)
PBDTProfitsbeforedepreciationandtaxes
NPBTNetprofitsbeforetaxes
NPATNetprofitsaftertaxes
P1117. Personalfinance:Incrementaloperatingcashinflows
LG5;Challenge
RichardandLindaThomson
IncrementalOperatingCashFlows
ReplacementofJohnDeereRidingMower
Year1 Year2 Year3 Year4 Year5 Year6
Savingsfromnewandimprovedmower $500 $500 $500 $500 $500
Annualmaintenancecost 120 120 120 120 120 0
Depreciation *
360 576 342 216 216 90
Savings(loss)beforetaxes 20 (196) 38 164 164 (90)
Taxes(40%) 8 (78) 15 66 66 (36)
Savings(loss)aftertaxes 12 (118) 23 98 98 (54)
Depreciation 360 576 342 216 216 90
Incrementaloperatingcashflow $372 $458 $365 $314 $314 $36
MACRSDepreciationSchedule
*
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Year1 $1,800 20.0% $360
Year2 1,800 32.0% 576
Year3 1,800 19.0% 342
Year4 1,800 12.0% 216
Year5 1,800 12.0% 216
Year6 1,800 5.0% 90
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P1118. Incrementaloperatingcashinflowsexpensereduction
LG5;Intermediate
P1119. Incrementaloperatingcashinflows
LG5;Intermediate
a.
Expenses Net
(excluding Profitsbefore Profits Net Operating
depreciation Depreciation Depre before Profits Cash
Year Revenue andinterest) andTaxes ciation Taxes Taxes afterTax Inflows
NewLathe
OldLathe
b. Calculationofincrementalcashinflows
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6 200 0 200
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c.
P1120. Determiningincrementaloperatingcashflows
LG5;Intermediate
Year
1 2 3 4 5 6
Revenues:(000)
P1121. Terminalcashflowsvariouslivesandsaleprices
LG6;Challenge
a.
Aftertaxproceedsfromsaleofnewasset 3Year* 5Year* 7Year*
Proceedsfromsaleofproposedasset $10,000 $10,000 $10,000
Taxonsaleofproposedasset* 16,880 400 4,000
Totalaftertaxproceedsnew $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) $16,880taxbenefit
2. Bookvalueofasset [1(0.200.320.190.120.12)]$180,000$9,000
$10,000$9,000 $1,000recaptureddepreciation
$1,000(0.40) $400taxliability
3. Bookvalueofasset $0
$10,000$0 $10,000recaptureddepreciation
$10,000(0.40) $4,000taxliability
b. Iftheusablelifeislessthanthenormalrecoveryperiod,theassethasnotbeendepreciated
fullyandataxbenefitmaybetakenontheloss;therefore,theterminalcashflowishigher.
c.
(1) (2)
Aftertaxproceedsfromsaleofnewasset
Proceedsfromsaleofnewasset $9,000 $170,000
Taxonsaleofproposedasset *
0 (64,400)
Changeinnetworkingcapital 30,000 30,000
Terminalcashflow $39,000 $135,600
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 (15,000)
Taxonsaleofoldmachine 2
6,000
Totalaftertaxproceedsoldasset (9,000)
Changeinnetworkingcapital 25,000
Terminalcashflow $76,640
1
Bookvalueofnewmachineatendofyear4:
[1(0.200.320.190.12)($230,000)] $39,100
$75,000$39,100 $35,900recaptureddepreciation
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$35,900(0.40) $14,360taxliability
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
Less:Less:Operatingexpenses
Generaland
administrative
(10%ofsales) $2,050 $2,100 $2,150 $2,250 $2,350
Totaloperating
Netprofit
Netprofit
WithoutMarketingCampaign
Years20132017
Netprofitaftertaxes $900
Depreciation 500
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Operatingcashflow $1,400
RelevantCashFlow
($000)
WithMarketing WithoutMarketing Incremental
Year Campaign Campaign CashFlow
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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 2,000
Totaltaxonsaleofasset $16,200
b.
CalculationofOperatingCashFlow
Year (1) (2) (3) (4) (5) (6)
OldMachine
NewMachine
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Incremental
Aftertax
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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 4,000
Totaltaxofsaleofasset $16,480
b.
CalculationofOperatingCashInflows
Profitsbefore Operating
Depreciation NetProfits NetProfits Cash
Year andTaxes Depreciation beforeTaxes Taxes afterTaxes Inflows
NewGrinder
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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
CalculationofIncrementalCashInflows
IncrementalOperating
Year NewGrinder ExistingGrinder CashFlow
1 $34,600 $20,160 $14,440
6 2,200 0 2,200
c. Terminalcashflow:
Aftertaxproceedsfromsaleofnewasset
Proceedsfromsaleofnewasset $29,000
Taxonsaleofnewasset *
(9,400)
Totalproceedsfromsaleofnewasset 19,600
Aftertaxproceedsfromsaleofoldasset
Proceedsfromsaleofoldasset 0
Taxonsaleofoldasset 0
Totalproceedsfromsaleofoldasset 0
Changeinnetworkingcapital 12,000
Terminalcashflow $31,600
*
Bookvalueofassetatendofyear5 $5,500
$29,000$5,500 $23,500 recaptureddepreciation
$23,5000.40 $9,400
d. Year5relevantcashflow:
Operatingcashflow $20,280
Terminalcashflow 31,600
Totalinflow $51,880
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P1126. Personalfinance:Determiningrelevantcashflowsforacashbudget
LG3,4,5,6;Challenge
JanandDeana
CashFlowBudget
PurchaseofBoat
a. Initialinvestment
Totalcostofnewboat $(70,000)
Add:Taxes(6.5%) (4,550)
Initialinvestment $(74,550)
b. Operatingcashflows Year1 Year2 Year3 Year4
Maint.&repair 12monthsat$800 $(9,600) $(9,600) $(9,600) $(9,600)
Dockingfees 12monthsat$500 $(6,000) $(6,000) $(6,000) $(6,000)
Operatingcashflows $(15,600) $(15,600) $(15,600) $(15,600)
c. Terminalcashflowendofyear4
Proceedsfromthesaleofboat $40,000
d. Summaryofcashflows CashFlow
Yearzero $(74,550)
Endofyear1 $(15,600)
Endofyear2 $(15,600)
Endofyear3 $(15,600)
Endofyear4 $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 A B
Installedcostofnewasset
Costofnewasset $40,000 $54,000
Aftertaxproceedsfromsaleofoldasset
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Proceedsfromsaleofoldasset (18,000) (18,000)
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b.
CalculationofOperatingCashInflows
Profits
before NetProfits NetProfits Operating
Depreciation Depre before after Cash
Year andTaxes ciation Taxes Taxes Taxes Inflows
HoistA
HoistB
1 $22,000 $12,000 $10,000 $4,000 $6,000 18,000
ExistingHoist
1 $14,000 $3,840 $10,160 $4,064 $6,096 $9,936
6 0 0 0 0 0 0
CalculationofIncrementalCashInflows
Incremental CashFlow
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Year HoistA HoistB ExistingHoist HoistA HoistB
1 $16,440 $18,000 $9,936 $6,504 $8,064
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c. Terminalcashflow:
(A) (B)
Aftertaxproceedsformsaleofnewasset
Proceedsfromsaleofnewasset $12,000 $20,000
Taxonsaleofnewassetl (3,840) (6,800)
Totalproceedsnewasset 8,160 13,200
Aftertaxproceedsfromsaleofoldasset
Proceedsfromsaleofoldasset (1,000) (1,000)
Taxonsaleofoldasset2 400 400
Totalproceedsoldasset (600) (600)
Changeinnetworkingcapital 4,000 6,000
Terminalcashflow $11,560 $18,600
1
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 $6,800tax
2
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.
CalculationofOperatingCashFlows
NetProfits NetProfits Cash
Year Revenues Expenses Depreciation beforeTaxes Taxes afterTaxes 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. 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 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
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$2,439,289
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$656,000 $761,600 $647,200 $585,600 $585,600 $44,000
$0 $1,480,000
(1 IRR) (1 IRR) (1 IRR) (1 IRR) (1 IRR) (1 IRR)6
1 2 3 4 5
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 (185,000)
Taxonsaleofexistingmachine *
(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 NetProfits Cash
Year OperatingCosts Depreciation beforeTaxes Taxes afterTaxes 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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ExistingMachine
NetProfits NetProfits Cash
Year Depreciation beforeTaxes Taxes afterTaxes 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
IncrementalOperatingCashFlows
Year NewMachine ExistingMachine IncrementalCashFlow
1 $318,000 $60,800 $257,200
5 274,800 0 274,800
6 27,000 0 27,000
Terminalcashflow:
Aftertaxproceedsfromsaleofnewasset
Proceedsfromsaleofnewasset $200,000
Taxonsaleofnewasset *
(53,000)
Totalproceedssaleofnewasset $147,000
Aftertaxproceedsfromsaleofoldasset 0
Changeinnetworkingcapital 25,000
Terminalcashflow $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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$257,200 $344,400 $274,200 $258,800 $446,800
$0 $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.
a. InitialInvestment:
Alternative1 Alternative2
Installedcostofnewasset
Costofasset $90,000 $100,000
Installationcosts 0 10,000
Totalproceeds,saleofnewasset 90,000 110,000
Aftertaxproceedsfromsaleofoldasset
Proceedsfromsaleofoldasset 0 (20,000)
Taxonsaleofoldasset* 0 8,000
Totalproceeds,saleofoldasset 0 (12,000)
Changeinworkingcapital 15,000 22,000
Initialinvestment $105,000 $120,000
*
Bookvalueofoldasset 0
$20,000$0 $20,000recaptureddepreciation
$20,000(0.40) $8,000tax
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b.
CalculationofOperatingCashInflows
Profitsbefore Operating
Depreciation Depre NetProfits NetProfits Cash
Year andTaxes ciation beforeTaxes Taxes afterTaxes Inflows
Alternative1
Alternative2
CalculationofIncrementalCashInflows
IncrementalCashFlow
Year Alternative1 Alternative2 Existing Alt.1 Alt.2
1 $126,300 $150,100 $100,000 $26,300 $50,100
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c. TerminalCashFlow:
Alternative1 Alternative2
Aftertaxproceedsfrom
saleofnewasset
Proceedsfromsaleofnewasset $8,000 $25,000
Taxonsaleofnewasset* (1,400) (7,800)
Totalproceeds,saleofnewasset 6,600 17,200
Aftertaxproceedsfromsaleofoldasset
Proceedsfromsaleofoldasset (2,000) (2,000)
Taxonsaleofoldasset** 800 800
Totalproceeds,saleofoldasset (1,200) (1,200)
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
Alternative2
Year5relevantcashflow: Operatingcashflow: $15,940
Terminalcashflow 38,000
Totalcashinflow $53,940
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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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