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CHAPTER 9: MAKING CAPITAL INVESTMENT DECISIONS

Answers to Concepts Review and Critical Thinking Questions


1. An opportunity cost refers to the value of an asset that will be used in a project. The relevant cost is
what the asset is actually worth today, not, for example, what it cost to acquire.
2. For tax purposes, a firm would choose MACRS because it provides for larger depreciation
deductions earlier. The choice between MACRS and straight-line is purely a time value issue; the
total depreciation is the same, only the timing differs.
3. Its probably only a mild over-simplification. Current liabilities will all be paid presumably. The
cash portion of current assets will be retrieved. Some receivables wont be collected, and some
inventory will not be sold, of course. Counterbalancing these losses is the fact that inventory sold
above cost (and not replaced at the end of the projects life) acts to increase working capital. These
effects tend to offset.
4. Managements discretion to set the firms capital structure is applicable at the firm level. Since any
one particular project could be financed entirely with equity, another project could be financed with
debt, and the firms overall capital structure remain unchanged, financing costs are not relevant in
the analysis of a projects incremental cash flows according to the stand-alone principle.
5. Depreciation is a non-cash expense, but it is tax-deductible on the income statement. Thus
depreciation causes taxes paid, an actual cash outflow, to be reduced by an amount equal to the
depreciation tax shield TCD. A reduction in taxes that would otherwise be paid is the same thing as a
cash inflow, so the effects of the depreciation tax shield must be added in to get the total incremental
aftertax cash flows.
8. One company may be able to produce at lower incremental cost or market better. Also, of course,
one of the two may have made a mistake!
Solutions to Questions and Problems
1.

The $7 million acquisition cost of the land six years ago is a sunk cost.
The $9.8 million current aftertax value of the land is an opportunity cost.
The $21 million cash outlay and $850,000 grading expenses are the initial fixed asset investments
needed to get the project going.
Cash flow = $9,800,000 + 21,000,000 + 850,000 = $31,650,000

2.

Sales due solely to the new product line are:


23,000($19,000) = $437,000,000
Increased sales of the motor home line occur because of the new product line introduction; thus:
2,600($73,000) = $189,800,000
in new sales is relevant.
Erosion of luxury motor coach sales: 850($115,000) = $97,750,000 loss in sales
Net sales = $437,000,000 + 189,800,000 97,750,000 = $529,050,000

3.

Sales
$ 825,000
Variable costs
453,750
Fixed costs
187,150
Depreciation
91,000
EBIT
$ 93,100
Taxes@35%
32,585
Net income
$ 60,515

4.

Sales
$ 643,800
Variable costs
345,300
Depreciation
96,000
EBIT
$ 202,500
Taxes@35%
70,875
Net income
$ 131,625
OCF = EBIT + Depreciation Taxes = $202,500 + 96,000 70,875 = $227,625
Depreciation tax shield = Depreciation(T) = .35($96,000) = $33,600
5.
Beginning Beginning
Depreciation
Ending
Year
Book Value Depreciation Allowance Book Value
1
$960,000.00
14.29% $137,184.00 $822,816.00
2
822,816.00
24.49% 235,104.00
587,712.00
3
587,712.00
17.49% 167,904.00
419,808.00
4
419,808.00
12.49% 119,904.00
299,904.00
5
299,904.00
8.93%
85,728.00
214,176.00
6
214,176.00
8.92%
85,632.00
128,544.00
7
128,544.00
8.93%
85,728.00
42,816.00
8
42,816.00
4.46%
42,816.00
0

6.

Annual depreciation = $780,000 / 8 = $97,500


After five years, Accumulated depreciation = 5($97,500) = $487,500
BV5 = $780,000 487,500 = $292,500
Aftertax salvage value = $135,000 + ($292,500 135,000)(0.35) = $190,125
Taxes on salvage value = (BV MV)*T
This equation will always give the correct sign for a tax inflow (refund) or outflow (payment).

7.

BV4 = $7,100,000 7,100,000(0.2000 + 0.3200 + 0.1920 + 0.1152) = $1,226,880


Aftertax salvage value = $1,750,000 + ($1,226,880 1,750,000)(.34) = $1,572,139.20

8.

Sales of new
Lost sales of old
Variable costs
Fixed costs
Depreciation
EBT
Tax
Net income

$35,700,000
3,852,000
17,516,400
1,250,000
1,350,000
$11,731,600
4,458,008
$ 7,273,592

OCF = EBIT + Depreciation Taxes = $11,731,600 + 1,350,000 4,458,008 = $8,623,592


9.

OCF = (Sales Costs)(1 T) + Depreciation(T)


OCF = ($2,150,000 1,140,000)(1 0.35) + 0.35($2,100,000/3) = $901,500

10. NPV = $2,100,000 + $901,500(PVIFA14%,3) = $7,048.73


11.

Year
0
1
2
3

Cash Flow
$2,250,000
901,500
901,500
1,165,250

= $2,100,000 150,000
= $901,500 + 150,000 + 175,000 + (0 175,000)(.35)

NPV = $2,250,000 + $901,500(PVIFA14%,2) + ($1,165,250 / 1.143) = $20,975.01


12. Year 1 depreciation = $2,100,000(0.3333) = $699,930
Year 2 depreciation = $2,100,000(0.4445) = $933,450
Year 3 depreciation = $2,100,000(0.1481) = $311,010
Book value in 3 years = $2,100,000 ($699,930 + 933,450 + 311,010) = $155,610
The asset is sold at a gain to book value, so this gain is taxable.
Aftertax salvage value = $175,000 + ($155,610 175,000)(0.35) = $168,214
OCF = (Sales Costs)(1 T) + Depreciation(T)
Year
0
1
2
3

Cash Flow
$2,250,000
901,475.50
983,207.50
1,083,567.00

= $2,100,000 150,000
= ($1,010,000)(.65) + 0.35($699,930)
= ($1,010,000)(.65) + 0.35($933,450)
= ($1,010,000)(.65) + 0.35($311,010) + $168,214 + 150,000

Note: NWC cost in Year 0, and the recovery of the NWC at the end of the project.
NPV = $2,250,000 + ($901,475.50/1.14) + ($983,207.50/1.142) + ($1,083,567 /1.143)
NPV = $28,691.09
13. Annual depreciation = $625,000/5 = $125,000
Aftertax salvage value = MV + (BV MV)T = MV + (0 MV)*T
Aftertax salvage value = MV*(1 T)
Aftertax salvage value = $95,000(1 0.34) = $62,700
OCF = $183,000(1 0.34) + 0.34($125,000) = $163,280
NPV = $625,000 41,000 + $163,280(PVIFA8%,5) + [($62,700 + 41,000) / 1.085]
NPV = $56,506.17
14. Annual depreciation charge = $520,000/5 = $104,000
Aftertax salvage value = $40,000(1 0.35) = $26,000
OCF = $160,000(1 0.35) + 0.35($104,000) = $140,400
NPV = 0 = $520,000 + 35,000 + $140,400(PVIFAIRR%,5) + [($26,000 35,000) / (1+IRR)5]
IRR = 13.33%

15. OCF = $190,000(1 0.35) + 0.35($104,000) = $159,900


NPV = $520,000 + 35,000 + $159,900(PVIFA10%,5) + [($26,000 35,000) / (1.10)5]
NPV = $115,558.51
OCF = $130,000(1 0.35) + 0.35($104,000) = $120,900
NPV = $520,000 + 35,000 + $120,900(PVIFA10%,5) + [($26,000 35,000) / (1.10)5]
NPV = $32,282.17
Accept the project if cost savings were $190,000; reject project if the cost savings were $130,000.
16.

20.

Scenario
Base case
Best case
Worst case

Unit Sales
70,000
80,500
59,500

Unit Price
$1,070
$1,231
$910

Sales of new product


Variable costs
Fixed costs
Depreciation
EBT
Tax
Net income

Unit Variable Cost


$290
$247
$334

Fixed Costs
$4,800,000
$4,080,000
$5,520,000

$575,000
115,000
179,000
155,000
$126,000
50,400
$ 75,600

OCF = $230,600
Payback period = $620,000 / $230,600 = 2.69 years
NPV = $620,000 + $230,600(PVIFA13%,4) = $65,913.09
0 = $620,000 + $230,600(PVIFAIRR%,4)

IRR = 18.03%

22. OCF at 90,000 units:


OCF = [(P v)Q FC](1 T) + Depreciation(T)
OCF = [($32.85 21.95)(90,000) 204,000](0.66) + 0.34($840,000/5) = $569,940
OCF at 91,000 units:
OCF = [($32.85 21.95)(91,000) 204,000](0.66) + 0.34($840,000/5) = $577,134
The sensitivity of the OCF to changes in the quantity sold is:
Sensitivity = OCF/Q = ($569,940 577,134)/(90,000 91,000)
OCF/Q = +$7.19
OCF will increase by $7.19 for every additional unit sold.