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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 Aftertax Changein Termina


proceedsfrom proceedsfrom networking = lcash
saleofnewasset saleofoldasset capital flow

ExtendedPresentation:

Proceedsfrom Proceedsfrom Changein Termina


saleofnewasset saleofoldasset networking lcash
=
Taxonsaleof Taxonsaleof capital flow
newasset oldasset

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 ($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

Installed Accumulated Book


Asset Cost Depreciation Value
A $950,000 $674,500 $275,500

B 40,000 13,200 26,800

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C 96,000 79,680 16,320

D 350,000 70,000 280,000

E 1,500,000 1,170,000 330,000

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

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)

P119. Taxcalculations
LG3,4;Intermediate

Currentbookvalue$200,000[(0.52($200,000)]$96,000

(a) (b) (c) (d)


Capitalgain $20,000 $0 $0 $0

Recaptureddepreciation 104,000 54,000 0 (16,000)

Taxoncapitalgain 8,000 0 0 0

Taxondepreciation

Recovery 41,600 21,600 0 (6,400)

Totaltax $49,600 $21,600 $0 ($6,400)

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

Netchange $155,000 $130,000

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

(a) (b) (c) (d)


Installedcostofnewasset:

Costofnewasset $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

Aftertaxproceedsfromsale

ofoldasset

Proceedsfromsale

ofoldasset (11,000) (7,000) (2,900) (1,500)

Taxonsaleofoldasset* 3,240 1,640 0 (560)

Totalaftertaxproceeds (7,760) (5,360) (2,900) (2,060)

Initialinvestment $18,240 $20,640 $23,100 $23,940

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

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*
TaxCalculations:

a. 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) 400
Totaltax $3,240

b. Recaptureddepreciation $7,000$2,900 $4,100


Taxonordinarygain $4,100(0.40) $1,640

c. 0taxliability

d. Lossonsaleofexistingasset $1,500$2,900 ($1,400)


Taxbenefit $1,400(0.40) $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 $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

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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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 (1) (2) (3) (4) (5) (6)


flow $592,000 $688,000 $584,000 $528,000 $528,000 $472,000

(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
*

Year Base MACRS Depreciation

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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

Year (1) (2) (3) (4) (5) (6)


Incremental
expensesavings $16,000 $16,000 $16,000 $16,000 $16,000 $0
Incrementalprofits
beforedep.andtaxes* 16,000 16,000 16,000 16,000 16,000 0
Depreciation 9,600 15,360 9,120 5,760 5,760 2,400
Netprofits
beforetaxes 6,400 640 6,880 10,240 10,240 2,400
Taxes 2,560 256 2,752 4,096 4,096 960
Netprofits
aftertaxes 3,840 384 4,128 6,144 6,144 1,440
Operatingcash
inflows** 13,440 15,744 13,248 11,904 11,904 960
*
Incrementalprofitsbeforedepreciationandtaxeswillincreasethesameamountasthedecreaseinexpenses.
**
Netprofitsaftertaxesplusdepreciationexpense.

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

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

OldLathe

15 $35,000 $25,000 $10,000 0 $10,000 $4,000 $6,000 $6,000

b. Calculationofincrementalcashinflows

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Year NewLathe OldLathe IncrementalCashFlows


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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c.

P1120. Determiningincrementaloperatingcashflows
LG5;Intermediate

Year
1 2 3 4 5 6
Revenues:(000)

Newbuses $1,850 $1,850 $1,830 $1,825 $1,815 $1,800


Oldbuses 1,800 1,800 1,790 1,785 1,775 1,750
Incrementalrevenue $50 $50 $40 $40 $40 $50
Expenses:(000)
Newbuses $460 $460 $468 $472 $485 $500
Oldbuses 500 510 520 520 530 535
Incrementalexpense $(40) $(50) $(52) $(48) $(45) $(35)
Depreciation:(000)
Newbuses $600 $960 $570 $360 $360 $150
Oldbuses 324 135 0 0 0 0
Incrementaldepr. $276 $825 $570 $360 $360 $150
Incrementaldepr.tax
savings@40% 110 330 228 144 144 60
NetIncrementalCashFlows
Cashflows:(000)
Revenues $50 $50 $40 $40 $40 $50
Expenses 40 50 52 48 45 35
Lesstaxes@40% (36) (40) (37) (35) (34) (34)
Depr.taxsavings 110 330 228 144 144 60
Netoperatingcash
inflows $164 $390 $283 $197 $195 $111

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

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

Less:Less:Operatingexpenses
Generaland
administrative
(10%ofsales) $2,050 $2,100 $2,150 $2,250 $2,350

Marketingcampaign 150 150 150 150 150

Depreciation 500 500 500 500 500

Totaloperating

expenses 2,700 2,750 2,800 2,900 3,000

Netprofit

beforetaxes $1,400 $1,450 $1,500 $1,600 $1,700

Less:Taxes40% 560 580 600 640 680

Netprofit

aftertaxes $840 $870 $900 $960 $1,020

Depreciation 500 500 500 500 500

OperatingCF $1,340 $1,370 $1,400 $1,460 $1,520

WithoutMarketingCampaign
Years20132017
Netprofitaftertaxes $900

Depreciation 500

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Operatingcashflow $1,400

RelevantCashFlow
($000)
WithMarketing WithoutMarketing Incremental
Year Campaign Campaign CashFlow

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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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

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

Cashflow $10,800 $12,000 $13,000 $10,800 $8,400 $0

NewMachine

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

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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

Incremental

Aftertax

cashflows $13,600 $16,240 $11,080 $11,040 $13,440 $1,600

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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

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
ExistingGrinder
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

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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

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. 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

Installationcosts 8,000 6,000

Totalproceeds,saleofnewasset 48,000 60,000

Aftertaxproceedsfromsaleofoldasset

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Proceedsfromsaleofoldasset (18,000) (18,000)

Taxonsaleofoldasset* 3,488 3,488

Totalproceeds,saleofoldasset (14,512) (14,512)

Changeinworkingcapital 4,000 6,000

Initialinvestment $37,488 $51,48


8
*
Bookvalueofoldasset: [1(0.200.320.19)]($32,000)$9,280

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b.

CalculationofOperatingCashInflows
Profits
before NetProfits NetProfits Operating
Depreciation Depre before after Cash
Year andTaxes ciation Taxes Taxes Taxes Inflows
HoistA

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

HoistB
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

ExistingHoist
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

CalculationofIncrementalCashInflows
Incremental CashFlow

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Year HoistA HoistB ExistingHoist HoistA HoistB
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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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

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

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.

Developing Relevant Cash Flows for Clark Upholstery Companys Machine


Renewal or Replacement Decision
ClarkUpholsteryisfacedwithadecisiontoeitherrenewitsmajorpieceofmachineryortoreplacethe
machine.Thecaseteststhestudentsunderstandingoftheconceptsofinitialinvestmentandrelevantcash
flows.

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

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

Alternative2

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

CalculationofIncrementalCashInflows
IncrementalCashFlow
Year Alternative1 Alternative2 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

2012PearsonEducation,Inc.PublishingasPrenticeHall
305Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition
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

2012PearsonEducation,Inc.PublishingasPrenticeHall
307Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition
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.

2012PearsonEducation,Inc.PublishingasPrenticeHall