CHAPTER 11

CASH FLOW ESTIMATION

OBJECTIVE
Subjective
FOCUS
Cash flow estimation focuses on the numerical methodology used in putting together an estimate
of a capital project. We keep the question of accuracy and risk in mind throughout, and continue in
the next chapter with a discussion of the methods available to incorporate risk into the process.

PEDAGOGY
This chapter contains an important pedagogical point with respect to practicality. Most texts
present capital budgeting as more accurate and reliable than it is, and students can get the incorrect
impression finance has the precision of engineering.
In real companies, the cash flow estimates associated with capital projects are generally very
fluid. If an analysis results in an unfavorable IRR, the people behind the project often change the
input numbers until they get the result they want. This reality creates a problem and a challenge at
the same time. The problem is bias and inaccuracy. The challenge lies in the role created for
finance in ensuring that estimated cash flows are reasonable and likely to come true.
This chapter provides a thorough discussion of the sources of error and vagueness in estimated
figures.

TEACHING OBJECTIVES
At the end of this chapter students should be fully aware of the difficulties and uncertainties
associated with making cash flow estimates in a capital budgeting context. They should also be able
to make estimates in fairly complex situations.

OUTLINE

I. CASH FLOW ESTIMATION

A. Capital Budgeting Processes
Conceptually divides capital budgeting into the calculation process and the more arbitrary
and difficult estimation process.

II. PROJECT CASH FLOWS - AN OVERVIEW AND SOME SPECIFICS

A. The General Approach to Cash Flow Estimation
A general outline. Consider the initial investment first, then periodic revenues, costs and
expenses, or savings. Include tax effects and plan to acquire the required assets.
B. A Few Specific Issues
The typical cash flow pattern, the incremental concept, sunk costs, opportunity costs,
impacts on the rest of the company, overheads, taxes, working capital, financing costs, and
old equipment.
C. Estimating New Venture Cash Flows
A comprehensive example in a manufacturing context.
D. Terminal Values
Treating cash flows that can be expected to continue indefinitely.
E. Accuracy and Estimates

3
4 Chapter 11

NPV and IRR give answers to several decimal places, but the accuracy isn't real, because
the results are no better than input estimates of the future. This section contains an
important discussion of the practical sources of error in capital budgeting including well-
meaning biases.
F. Estimating Cash Flow for Replacement Projects
Replacements are usually simpler projects, but the cash flows can be trickier to properly
identify and quantify. A comprehensive example.

QUESTION

1. The typical cash flow pattern for business projects involves cash outflows first, then
inflows. However, it's possible to imagine a project in which the pattern is reversed. For example,
we might receive inflows now in return for guarantying to make payments later. Would the
Payback, NPV, and IRR methods work for such a project? What would the NPV profile look like?
Would the NPV and IRR methods give conflicting results?

ANSWER: Payback wouldn't make sense for such a product, because there would be no initial
outlay to recover. The NPV and IRR methods would work because they're based on the present
value of future cash flows regardless of their pattern. The NPV profile would slope upward, because
higher rates would reduce the present values of the negative flows in the distant future more than
those of the positive short-term flows. This would result in a more positive NPV as the interest rate
rose. NPV and IRR could give conflicting results if the up-sloping profiles crossed in the first
quadrant just as in the case of the traditional patterns.

BUSINESS ANALYSIS

1. You are a new financial analyst at Belvedere Corp, a large manufacturing firm that is
currently looking into diversification opportunities. The vice president of marketing is particularly
interested in a venture that is only marginally connected with what the firm does now. Other
managers have suggested enterprises in more closely related fields. The proponents of the various
ideas have all provided you with business forecasts from which you have developed financial
projections including project cash flows. You have also calculated each project's IRR with the
following results:

Project IRR Comments

A 19.67% Marketing's project, an almost totally new field

B 19.25% Proposed by manufacturing, also a very different field.

C 18.05% Proposed by engineering, a familiar field.

You are now in a meeting with senior managers that was called to discuss the options. You have
just presented your analysis ending your talk with the preceding information.
After your presentation, the vice president of marketing stands, congratulates you on a fine job,
and states that the figures clearly show that Project A is the best option. He also says that your
financial analysis shows that project A has the full backing of the finance department. All eyes,
including the CFO's, turn to you. How do you respond?

ANSWER: Although A's IRR is highest it isn't likely to be the best project because of its risk.
Projects of significantly different risk aren't directly comparable without risk adjustments. In this
 Cash Flow Estimation 5

case Projects A and B are likely to be much riskier than C, because they're in unfamiliar fields.
They should therefore be measured against a substantially higher hurdle rate than Project C.
Further, the difference shown between A and B is finer than makes sense for capital budgeting
techniques. Remember that a calculated IRR can be no more accurate than the estimated cash flows
input to the model. Those are certainly not good to four significant figures as shown. This analysis
essentially says that the three projects are about equal in terms of IRR without adjusting for risk.
Part of the problem is in the presentation. The analyst should not have displayed results to a
hundredth of a percent. Doing so gives the wrong impression to people unfamiliar with financial
analysis techniques.

2. Most top executives are graded primarily on their results in terms of net income rather than
net cash flow. Why then, is capital budgeting done with incremental cash flows rather than with
incremental net income?

ANSWER: Net income is an accounting construction designed to indicate the long-term health of a
business rather than its immediate cash performance. Presumably, executives are graded on long
term results of the business as a going concern that will last over a long period, so net income is an
appropriate measure. Capital budgeting is aimed at allocating resources among competing uses as
objectively as possible. It is not concerned with painting a picture of the business the way
accounting results do.
The best basis for resource allocation among uses is the contribution those uses make to wealth.
That contribution is best measured by the present value of expected cash flows which is therefore
the basis for capital budgeting.

3. Creighton Inc. is preparing a bid to sell a large telephone communications system to a major
business customer. It is characteristic of the telephone business that the vendor selling a system gets
substantial follow-on business in later years by making changes and alterations to that system. The
marketing department wants to take an incremental approach to the bid, basically treating it as a
capital budgeting project. They propose selling the system at or below its direct cost in labor and
materials (the incremental cost) to ensure getting the follow-on business. They've projected the
value of that business by treating future sales less direct costs as cash inflows.
They maintain that the initial outlay is the direct cost to install the system, which is almost
immediately paid back by the price. Future cash flows are then the net inflows from the follow-on
sales. These calculations have led to an enormous NPV and IRR for the sale viewed as a project.
Both support and criticize this approach. (Hint: what would happen if Creighton did most of its
business this way?)

ANSWER: The approach makes sense if the follow-on business is in total large relative to the
initial sale. If not, the idea creates several problems.
The fact that the installation is paid for immediately makes it seem as if the initial outlay for the
project is zero, and the subsequent inflows are free. This results in an NPV that is just the present
value of expected profits with no initial cost offset and an IRR that's virtually infinite.
However, it masks the fact that the project's risk is related to the level of resource committed to
the initial installation. Hence the risk may be out of proportion to the expected dollar return. For
example, if the job is underbid by 10%, the loss on the installation could be impossible to make up
through follow-on business.
It's also important to compare the project with alternate uses of the labor and material to be spent
on the installation. If they could be used on traditional sales with normal profit margins, the project
isn't likely to look good regardless of its IRR.
If the project takes up a large portion of the company's resources, incremental thinking may not
be appropriate. This is because a firm made up of too much incrementally acceptable business may
find itself without the income to support necessary overhead.
6 Chapter 11

4. Webley Motors, a manufacturer of small gas engines, has been working on a new design for
several years. It's now considering going into the market with the new product, and has projected
future sales and cash flows. The marketing and finance departments are putting together a joint
presentation for the board of directors that they hope will gain approval for the new venture. Part of
the presentation is a capital budgeting analysis of the project that includes only estimated future
costs and revenues. Dan Eyeshade, the head of investor relations, insists that calculations shown to
the board include the money spent on research in the past several years. He says that to ignore or
omit those costs would be deceiving the board about the true cost of the project, which would be
both unethical and legally dangerous. Comment on Dan's position. If you disagree, prepare an
argument that will convince him to change his mind, and suggest an alternative presentation that
will satisfy you both.

ANSWER: Dan is confusing decision making with honest and open reporting. Only future
revenues and costs matter to the decision, because only the future can be changed by it. Past costs
are "sunk", and cannot be changed by anything. In theory that means only future costs have to be
shown to the decision makers.
On the other hand, Dan is right that it would be less than honest and ethical to lead the board to
believe that the future costs were the only ones that went into the project.
The solution is fairly obvious. Present the decision in terms of the future cash flows but make a
side point about the effort that's gone on to date, being sure to point out that those costs are gone
regardless of the outcome of the project.

5. The Capricorn Company is launching a new venture in a field related to, but separate from,
its present business. Management is proposing that financing for the new enterprise be supplied by
a local bank that it has approached for a loan. Capricorn's finance department has done a capital
budgeting analysis of the venture projecting reasonable cash flows and calculating an NPV and an
IRR that both look very favorable .
The bank's loan officer, however, isn't satisfied with the analysis. She insists on seeing a
financial projection that made which calculates interest on cumulative cash flows, incorporates that
interest as a cost of the project, and shows the buildup and decline of the debt necessary to
accomplish the proposal. She essentially wants a business plan complete with projected financial
statements.
Reconcile the bank officer's position with capital budgeting theory.

ANSWER: Capital budgeting considers financing costs through the time value calculations
inherent in the techniques. Conceptually, capital budgeting draws money out of and pays it into a
general pool of funds maintained by the company, but isn't explicit about the size of the pool at any
point in time. It also charges interest at a conceptual weighted average rate, the cost of capital,
rather than a particular rate tied to a specific source of funds. This is the correct approach when
evaluating projects as part of the ongoing operation of a company.
The bank on the other hand is concerned about getting its money back on a specific loan at a
specific rate of interest. In this case, the loan is tied to a particular project, so the bank wants to
make sure the project will generate the cash flows required to pay the loan off. It also needs to
know when the money will be drawn and repaid so it can calculate the outstanding balance at any
time. This helps the bank forecast its own funding requirements.
Both approaches are correct from the perspectives of the respective decision making parties.

6. Wilson Petroleum is a local distributor of home heating oil. The firm also installs and
services furnaces and heating systems in homes and small commercial buildings. The customer
service department maintains sales and service records on current customers who number about 400.
Detailed customer records are kept manually in file cabinets, and a small computer system holds all
 Cash Flow Estimation 7

customer names and addresses for mailing and billing purposes. One full-time clerk maintains all
the records and handles all billing and customer inquiries. Customers occasionally complain if
delivery or service is late, but only one or two mild complaints are received each month. Delays are
primarily a result of problems in the field rather than problems in assigning calls in the service
department.
A consultant has proposed a new computer system that will completely automate the customer
service function. It will provide on-line billing and immediate access to all customer records. The
cost of the proposed system is $50,000 initially plus about $7,000 a year for maintenance and
support. It will still take a person to run it. The consultant says the new system will provide faster
service and superior insight into the needs of the customer base, which will result in better customer
relations and more sales in the long run.
Discuss the pros and cons of the consultant's proposal. What further justification should
management demand before buying? Could the consultant have made the proposal for reasons that
aren't in Wilson's best interest? Could the consultant be well meaning yet biased? Explain.

ANSWER: The new system can be viewed as a capital budgeting project in which the costs are
well known, but the benefits are hard to predict or measure. Estimating the actual increased cash
flows that will come from an improved administrative system is a difficult and very subjective
matter. In this case it seems that the system is unlikely to be a worthwhile project, because it doesn't
save any labor and the administrative problems it would fix are minor. Such situations are very
subject to overestimation of benefits. Before accepting the consultant's idea, management should
demand a detailed, well-supported estimate of the expected benefits. He or she will probably be
unable to provide this.
If the consultant also sells the proposed system, it's likely that a conflict of interest exists. He or
she could be motivated by the money to be made on the sale rather than by improving Wilson's
business. It's not at all unusual for technical salespeople to propose systems that do more than their
customers need in order to generate big commissions.
It's also possible that the consultant honestly believes that computers are the answer to virtually
all problems. People in high technology businesses are often biased toward computer solutions even
when doing things by hand is cheaper.

PROBLEMS

New Venture Cash Flows Depreciation: Example 11-1 (page 502)

1. A project that is expected to last six years will generate a profit and cash flow contribution
before taxes and depreciation of $23,000 per year. It requires the initial purchase of equipment
costing $60,000, which will be depreciated straight line over four years. The relevant tax rate is
25%. Calculate the projects cash flows. Round all figures within your computations to the nearest
thousand dollars.

SOLUTION:
The initial outlay is just the cost of the equipment. So C0 = ($60,000). The remaining cash
flows are calculated as follows ($000).

Year 1 2 3 4 5 6
Cash flow before interest
And depreciation $23 $23 $23 $23 $23 $23
Depreciation 15 15 15 15
EBT 8 8 8 8 23 23
Tax (@ 25%) 2 2 2 2 6 6
EAT 6 6 6 6 17 17
Add back Depreciation 15 15 15 15
8 Chapter 11

Cash Flow 21 21 21 21 17 17
2. Auburn Concrete Inc. is considering the purchase of a new concrete mixer to replace an
inefficient older model that is completely worn out. If purchased, the new machine will cost
$90,000 and is expected to generate savings of $40,000 per year for five years at the end of
which it will be sold for $20,000. The mixer will be depreciated to a zero salvage value over
three years using the straight line method. Develop a five year cash flow estimate for the
proposal. Auburns marginal tax rate is 30%. Work to the nearest thousand dollars.

SOLUTION:
Years 0 1 2 3 4 5
Cost 90
Savings 40 40 40 40 40
Depreciation 30 30 30
EBT impact 10 10 10 40 40
Tax 3 3 3 12 12
EAT impact 7 7 7 28 28
Add back deprec. 30 30 30
Sale in year 5 20
Tax on sale ( 6)
Cash Flow (90) 37 37 37 28 42

Replacement Projects Sale of an Old Asset: Example 11-3 (page 509)

3. Flextech Inc. is considering a project that will require new equipment costing $150,000. It
will replace old equipment with a book value of $35,000 that can be sold on the second hand market
for $75,000. The companys marginal tax rate is 35%. Calculate the projects initial outlay.

SOLUTION:
Sale of old equip $75,000 $75,000
Book value 35,000
Accounting profit $40,000
Tax on profit 14,000 14,000
Cash flow from sale $61,000

Cost of new equipment $150,000

Less: cash from sale (61,000)
Initial outlay, C0 $ 89,000

Replacement Projects Initial Outlay: Example 11-3 (page 509)

4. Tomatoes Inc. is planning a project that involves machinery purchases of $100,000. The
new equipment will be depreciated over five years, straight line. It will replace old machinery that
will be sold for an estimated $36,000 and has a book value of $22,000. The project will also require
hiring and training ten new people at a cost of about $12,000 each. All of this must happen before
the project is actually started. The firms marginal tax rate is 40%. Calculate, C0, the projects
initial cash outlay.

SOLUTION:
First notice that the hiring and training costs are tax deductible:
Hiring and training cost $120,000
Tax saving at 40% $ 48,000
Net cash flow after tax $ 72,000
 Cash Flow Estimation 9

Next calculate the proceeds of the sale of the old equipment:

Sale of old equip $36,000 $36,000
Book value 22,000
Accounting profit $14,000
Tax on profit 5,600 5,600
Cash flow from sale $30,400

Then calculate the Initial Outlay:

Cost of new equipment $100,000
After tax cost of hiring and training 72,000
Less: cash from sale ( 30,400)
Initial outlay, C0 $141,600

5. The Olson Company plans to replace an old machine with a new one costing $85,000. The
old machine originally cost $55,000, and has six years of its expected 11-year life
remaining. It has been depreciated straight line assuming zero salvage value, and has a
current market value of $24,000. Olsons effective tax rate is 36%. Calculate the initial
outlay associated with selling the old machine and acquiring the new one.

SOLUTION:
Purchase price old machine $55,000
Accumulated depreciation 25,000
Book value 30,000

Salvage value old machine $24,000

Book value 30,000
Loss on sale (6,000)
Tax rate .36
Tax savings $ 2,160

Purchase new machine ($85,000)

Sell old machine 24,000
Tax savings on sale of old machine 2,160
Net after-tax outlay $ 58,840

6. A four-year project has cash flows before taxes and depreciation of $12,000 per year. The
project requires the purchase of a $50,000 asset that will be depreciated over five years, straight line.
At the end of the fourth year the asset will be sold for $18,000. The firm's marginal tax rate is 35%.
Calculate the cash flows associated with the project. (For convenience assume the gain on the sale
of the asset is taxed at 35%.)

SOLUTION:
Disposal: Sale Price $18,000 $18,000
NBV of asset $10,000
Gain $ 8,000
Tax (2,800) (2,800)
Net from sale $15,200
10 Chapter 11

CASH FLOWS
0 1 2 3 4
Asset ($50,000)
Income $12,000 $12,000 $12,000 $12,000
Depreciation $10,000 $10,000 $10,000 $10,000
EBT Contribution $ 2,000 $ 2,000 $ 2,000 $ 2,000
Tax (700) (700) (700) (700)
EAT Contribution $ 1,300 $ 1,300 $ 1,300 $ 1,300
Add Back Depreciation $10,000 $10,000 $10,000 $10,000
Annual CF $11,300 $11,300 $11,300 $11,300
Sale of Asset $15,200
Net Cash Flow:
NCF ($50,000) $11,300 $11,300 $11,300 $26,500

7. Voxland Industries purchased a computer for $10,000, which it will depreciate straight line
over five years to a $1,000 salvage value. The computer will then be sold at that price. The
companys marginal tax rate is 40%. Calculate the cash flows associated with the computer
from its purchase to its eventual sale including the years in between. (Hint: Depreciate the
difference between the cost of the computer and the salvage value. At the end of the
depreciation life theres a net book value remaining equal to the salvage value.)

SOLUTION:

CF0 (10,000)
CF1 720 (1800 depreciation x 40%)
CF2 720
CF3 720
CF4 720
CF5 1,720 (Depreciation tax savings + $1,000 sale price)

8. Resolve the previous problem assuming Voxland uses the 5-year Modified Accelerated Cost
Recovery System (MACRS) with no salvage value to depreciate the computer. Continue to assume
the machine is sold after five years for $1,000. (Hint: Apply the MACRS rules for computers in the
chapter to the entire cost of the computer. Notice, however, that there will be a positive net book
value after five years because MACRS takes five years of depreciation over six years due to the
half-year convention.)

SOLUTION:
Cash flow in years 1-4 is just the tax saved by depreciation.
Cash flow in year 5 is the tax saved by depreciation plus the proceeds from selling the machine less
taxes on that sale. The taxable profit on the sale is $1,000 less the book value at that time.
CF0 (10,000)
CF1 800 (10,000 x 20% x 40%)
CF2 1,280 (10,000 x 32% x 40%)
CF3 768 (10,000 x 19.2% x 40%)
CF4 460 (10,000 x 11.5% x 40%)
CF5 1,292 (10,000 x 11.5% x 40%) + ($1,000 - [1,000 580] x .4)
 Cash Flow Estimation 11

9. Shelton Pharmaceuticals Inc. is introducing a new drug for pain relief. Management expects
to sell 3 million units in the first year at $8.50 each, and anticipates 10% growth in sales per
year thereafter. Operating costs are estimated at 70% of revenues. Shelton invested $20
million in depreciable equipment to develop and produce this product. The equipment will
be depreciated straight line over 15 years to a salvage value of $2.0 million. Sheltons
marginal tax rate is 40%. Calculate the projects operating cash flows in its third year.

SOLUTION: ($000)
Revenues $30,855.0 3,000 x (1.1)2 x $8.50
Expenses 21,598.5 Revenues x 70%
Depreciation 1,200.0 ($20,000 $2,000)/15
EBT $ 8,056.5
Tax 3,222.6
EAT $ 4,833.9
Add Depreciation 1,200.0
Cash Flow $ 6,033.9

New Venture Cash Flows: Example 11-1 (page 498)

10. Harry and Flo Simone are planning to start a restaurant. Stoves, refrigerators, other kitchen
equipment, and furniture are expected to cost $50,000 all of which will be depreciated straight line
over five years. Construction and other costs of getting started will be $30,000. The Simones expect
the following revenue stream. ($000)

Year 1 2 3 4 5 6 7
Sales $60 $90 $140 $160 $180 $200 $200

Food costs are expected to be 35% of revenues while other variable expenses are forecast at
25% of revenues. Fixed overhead will be $40,000 per year. All operating expenses will be paid in
cash, revenues will be collected immediately and inventory is negligible, so working capital need
not be considered. Assume the combined state and federal tax rate is 25%. Do not assume a tax
credit in loss years and ignore tax loss carry forwards. (Taxes are simply zero when EBT is a loss.)
Develop a cash flow forecast for the Simones restaurant.

SOLUTION:
The initial outlay, C0, is simply the cost of the equipment, construction, and other getting
started expenses.
C0 = $50,000 + $30,000 = $80,000
The remaining cash flows are calculated as follows ($000).

Year 1 2 3 4 5 6 7
Sales $60 $90 $140 $160 $180 $200 $200
Variable Costs @ 60% 36 54 84 96 108 120 120
Overhead 40 40 40 40 40 40 40
Depreciation 10 10 10 10 10 - -
EBT ( 26) ( 14) 6 14 22 40 40
Tax (@ 25%) - - 2 4 6 10 10
EAT ( 26) ( 14) 4 10 16 30 30
Add back Depreciation 10 10 10 10 10 _
Cash Flow ( 16) ( 4) 14 20 26 30 30
12 Chapter 11

Terminal Values: Example 11.2 (page 504)

11. Oxbow Inc. is contemplating a new venture project and has done a detailed five year cash flow
estimate with the following result ($000):

C0 C1 C2 C3 C4 C5
(257) (65) 50 90 130 170

The firms cost of capital is 12%.

a. Use a financial calculator to compute the projects NPV and IRR, and make the
appropriate recommendation to management. (If you dont have a financial calculator
just calculate NPV.)
b. Charles Dunn, Oxbows Marketing VP, has argued that its unreasonable to exclude
cash flows past year five from the analysis. Calculate the projects terminal value
assuming year fives cash flow goes on forever. Recalculate the projects NPV and IRR
under that Charles assumption.
c. Charles further argues that the most appropriate assumption is that cash flows beyond
the fifth year incorporate a three percent long run growth rate. Calculate the terminal
value, NPV, and IRR implied by this assumption.
d. Comment on the results implied by the use of aggressive terminal value assumptions.

Solution:
a. Using a financial calculator enter the following according to the instructions in the chapter:
CFo (257)
C01 (65)
F01 1.0
C02 50
F02 1.0
C03 90
F03 1.0
C04 165
F04 1.0
C05 170
F05 1.0
Press NPV, enter I = 12% for the cost of capital, press enter, down arrow, and compute.
The resulting NPV is ($32,036). Next punch IRR and then compute. The resulting IRR is 8.8%.
The project should clearly be rejected as the NPV<0 and IRR<k.

b. The terminal value at the end of period five is the present value of a perpetuity of $170,000 per
year at an interest rate of 12%.
TV = $170 / .12 = $1,417
Then F05 becomes
F05 = $1,417 + $170 = $1,587

Recalculate the projects NPV and IRR using $1,587 as C05.

The result is NPV = $772 and IRR = 48.0. The project is now clearly acceptable in terms of
both NPV and IRR

c. Follow the procedure in b. using

TV = $170 / (.12 - .03) = $1,889
and
F05 = $1,889 + $170 = $2,059
 Cash Flow Estimation 13

From which NPV = $1,040 and IRR = 54.8. The project now appears to be even better.

d. Aggressive terminal value assumptions just about always overwhelm short run detailed cash flow
estimates. Virtually any project can be made to look good if were willing to assume a long period
of very positive cash flows after a short period of realism. This kind of technique is often used to
support projects that dont make financial sense but people at the top simply want to do.

12. Sam Dozier, a very bright computer scientist, has come up with an idea for a new product.
He plans to form a corporation to develop the idea and market the resulting product. He has
estimated that it will take him and one employee about a year to develop a prototype and another
year to bring a working model to market. There will be no income during those years. After that he
expects sales to grow rapidly, estimating revenues of $700,000, $1,500,000, and $5,000,000 in the
third, fourth, and fifth years respectively.
Starting the project will require research equipment costing about $500,000 which will be
depreciated for federal tax purposes under the MACRS system (see page xxx). Beyond that it will
take another $400,000 in tax deducible expenses to get going.
Sam thinks he can fund the development work including supporting himself and paying an
employee with about $200,000 per year. Once sales begin in the third year, direct costs will be 40%
of revenues and indirect costs, including salaries for Sam and all employees, will be $300,000,
$500,000, and $1,800,000 in the third, fourth and fifth years respectively. The nature of the
business is such that working capital requirements are minimal. A net investment of $200,000 in the
third is expected to provide for working capital needs. Sam has $1,500,000 saved which he thinks is
enough to launch and operate the business until it begins to generate income.
Sam plans to sell the business at the end of the fifth year. He thinks it will be worth
$2,500,000 at that time.
The business will be a C-type corporation subject to federal corporate income taxes. Sam
will be the sole stockholder and will be subject to federal (personal) capital gains tax when he sells
the company (assume the top capital gains rate discussed in chapter 2). Ignore state taxes.
a. Develop a cash flow estimate for Sams business. Include the effect of tax loss carry
forwards as well as any capital gains taxes he will pay on its sale. Does Sam have enough cash to
fund this venture without contributions from outside investors?
b. Calculate the projects NPV and IRR (a financial calculator is recommended). Assume
the cost of capital is 12%. Is the venture a good investment of Sams time and money?

SOLUTION: ($000)
a. First develop the equipment depreciation schedule noticing that under MACRS, research
equipment is depreciated over 3 years.

Year MACRS % % x $500

1 33.3 $167 (rounded up)
2 44.4 222
3 14.8 74
4 7.5 37 (rounded down)
$500
14 Chapter 11

A Cash Flow estimate for the project is then ($000)

Year
0 1 2 3 4 5
Equipment 500

Revenue 700 1500 5000

Direct Cost 280 600 2000

Expense 400 200 200 300 500 1800
Depreciation 167 222 74 37
Total cost/exp 400 367 422 654 1137 3800

EBT (400) (367) (422) 46 363 1200

Loss Carry fwd (46) (363) (780)
Adjusted EBT 0 0 420
Tax @ 34% 0 0 0 0 0 (143)
EAT (400) (367) (422) 0 0 277

Add back depreciation 167 222 74 37 0

Preliminary C/F (900) (200) (200) 74 37 277

Working Capital (200)

Sale of business 2500
Capital gains tax on sale (180)

Total Cash Flow (900) (200) (200) (126) 37 2597

Cumulative C/F (900) (1100) (1300) (1426) (1389) 1208

Sam has $1,500,000 saved to start his business. Thats a little more than the maximum forecast cash
required requirement of $1,426,000. However, overruns are common in this kind of projection, and
it would be foolish to undertake the project without back up financing.

b. Enter the projects cash flows into a financial calculator following the instructions in the chapter
as follows:

CFo (900)
C01 (200)
F01 2.0
C02 (126)
F02 1.0
C03 37
F03 1.0
C04 2597
F04 1.0

Then press NPV, enter I = 12% for the cost of capital, press enter, down arrow, and
compute. The resulting NPV is $169,427. Next punch IRR and then compute. The resulting IRR is
15.1%
 Cash Flow Estimation 15

Analysis: The project is acceptable in accordance with capital budgeting rules in that the NPV is
positive and the IRR is greater than the cost of capital.
However, it plainly isnt a good idea for Sam. The reward in NPV terms is just a little more
than 10% of his current net worth, and undertaking the plan will tie him up for five years. This isnt
much of a payoff for risking everything he has as well as five years of his professional life. Theres
also a good chance that the whole idea wont work and that hell end up five years older and broke.
Hed be much better off to find a job with an established company or look for a more promising
entrepreneurial opportunity.

13. The Leventhal Baking Company is thinking of expanding its operations into a new line of
pastries. The firm expects to sell $350,000 of the new product in the first year and $500,000 each
year thereafter. Direct costs including labor and materials will be 60% of sales. Indirect
incremental costs are estimated at $40,000 a year. The project will require several new ovens that
will cost a total of $500,000 and be depreciated straight line over five years. The current plant is
underutilized, so space is available that cannot be otherwise sold or rented. The firm's marginal tax
rate is 35%, and its cost of capital is 12%. Assume revenue is collected immediately and inventory
is bought and paid for every day, so no additional working capital is required.
a. Prepare a statement showing the incremental cash flows for this project over an 8-year period.
(Structure as a new venture.)
b. Calculate the Payback Period, NPV, and PI.
c. Recommend either acceptance or rejection.
d. If the space to be used could otherwise be rented out for $30,000 a year, how would you put that
fact into the calculation. Would the project be acceptable in that case?

SOLUTION:
a.
CASH FLOWS ($000)

0 1 2-5 6-8 ___

Ovens ($500)
Revenue $350 $500 $500
Direct Cost ( 210) ( 300) ( 300)
Indirect Cost ( 40) ( 40) ( 40)
Depreciation ( 100) ( 100) -__
EBT Contribution $ 0 $ 60 $ 160
Tax ($ 21) ($ 56)
EAT Contribution $ 0 $ 39 $ 104
Add Back Depreciation $100 $100 -
NCF ($500) $100 $139 $104

b.
Year NCF Cum CF
0 ($500) ($500)
1 $100 ($400)
2 $139 ($261)
3 $139 ($122)
4 $139 $ 17
P/B Period = 3.9 yrs
16 Chapter 11

NPV = $500 + $100[PVF12,1] + [PVF12,1]{$139[PVFA12,4]} + [PVF12,5]{$104[PVFA12,3]}

= $500 + $100(.8929) + (.8929)($139)(3.0373) + (.5674)($104)(2.4018)
= $500 + $608
= $108

PI = $608 / $500 = 1.22

c. Accept, since NPV > 0 and PI > 1.0.

d. It would add a $30,000 per year pre-tax opportunity cost to the analysis. The after-tax effect
is
$30,000 .65 = $19,500

The impact on the analysis would be to reduce the NPV by the present value of an 8-year annuity of
this amount. Stated in thousands ($000):

PVA = $19.5 [PVFA12,8]

= $19.5 (4.9676)
= $97
Then,
Revised NPV = Old NPV $97
= $108 $97
= $11
Hence the project would be marginally acceptable under this added condition.

New Venture Cash Flows Working Capital: Example 11.1 (page 502)
14. Harrington Inc. is introducing a new product in its line of household appliances. Household
products generally have ten-year life cycles and are viewed as capital budgeting projects
over that period. Harringtons working capital forecast for the project is as follows:
- $1.0 million will be invested in inventory before the project begins.
- Inventory will increase by $100,000 in each of the first six years.
- Accounts receivable will increase by $150,000 in each of the first four
years, and by $100,000 in each of the next two years.
- Accounts payable will increase by $110,000 in each of the first six years.
- During the last four years, the balance in each of these accounts will
return to zero in four equal increments.
- Accruals are negligible.
Calculate the cash flows associated with working capital from the initial outlay to the end of
the projects life.

SOLUTION:
Year 0 1 2 3 4 5 6 7 8 9 10
Inv 1000 1100 1200 1300 1400 1500 1600 1200 800 400 0
A/R 150 300 450 600 700 800 600 400 200 0
A/P (110) (220) (330) (440) (550) (660) (495) (330) (165) 0
Total 1000 1140 1280 1420 1560 1650 1740 1305 870 435 0

Cash flow = Change In W/C

(1000) (140) (140) (140) (140) (90) (90) 435 435 435 435
 Cash Flow Estimation 17

Replacement Projects: Example 11.3 (page 508)

15. Meade Metals Inc plans to start doing its own deliveries instead of using an outside service
for which it has been paying $150,000 per year. To make the change Meade will purchase a
$200,000 truck that it will depreciate straight line over ten years to a $40,000 salvage value.
Annual operating expenses are estimated at $80,000 including insurance, fuel and
maintenance on the truck as well as the cost of a driver. Management plans to sell the truck
after five years for $100,000. Develop the projects five-year cash flows. Meads tax rate is
40%. (Hint: Treat as a replacement project. Savings are the difference in the contractors
cost and that of operating the truck with an old asset sale in the last year.)

SOLUTION: Initial outlay = $200,000

Operating cash flows years 1 through 5

$150,000 Savings related to contractor
(80,000) Annual truck expenses
(16,000) Depreciation (200,000 40,000)/10
$ 54,000 Operating income before tax
21,600 Tax
$ 32,400 Operating income after tax
16,000 Add back depreciation
$ 48,400 Operating cash flow

Additional Cash flow year 5

Tax on truck sale
Sale of truck $100,000 Sale value $100,000
Tax savings 8,000 Book value 120,000
cash flow $108,000 Loss on sale 20,000
Tax rate x .4
Tax savings $ 8,000
Total Year 5 Cash Flow = $48,400 + $108,000 = $156,400

16. Assume that Meade Metals Inc of the previous problem is replacing an old truck with a new
one instead of replacing an outside delivery service. The old truck was purchased 8 years
ago for $120,000. It has been depreciated straight line based on a ten-year life and a
$20,000 salvage value. The old trucks annual operating expenses are $110,000, and it has a
market value of $40,000. Develop a five-year cash flow projection for this replacement
project.

SOLUTION:
Initial Outlay
Purchase of new truck ($200,000)
Sale of old truck 40,000
No tax (old truck sold at book value) 0
Initial Cash Flow ($160,000)

Operating Cash Flows Years

1 and 2 3 through 5
Expenses of old truck saved 110,000 110,000
New truck expenses (80,000) (80,000)
Depreciation of old truck saved 10,000 0
New truck depreciation (16,000) (16,000)
EBT Impact 24,000 14,000
18 Chapter 11

Tax @ 40% 9,600 5,600

EAT Impact 14,400 8,400
Add back net depreciation 6,000 16,000
Cash Flow 20,400 24,400
Additional year 5 Cash Flow = $108,000 - See previous problem
Total Year 5 Cash Flow = $24,400 + $108,000 = $132,400

17. Olson-Jackson Corp. (OJC) is considering replacing a machine that was purchased only two
years ago because of dramatic improvements in new models. The old machine has been
depreciated straight line anticipating a ten years life based on a cost of $240,000 and an
expected salvage value of $20,000. It currently has a market value of $180,000. If the old
machine is kept five more years it would have a market value of $60,000 at the end of that
time. A new machine would cost $350,000 and would be depreciated straight line over five
years to a salvage value of $50,000, at which time it would be sold at that price. Develop a
cash flow projection showing the difference between keeping the old machine and acquiring
the new one. Assume OJCs tax rate is 40%. (Note: A complete cash flow projection for the
project would include the financial benefits of the better performance of the new machine as
well as a comparison of the operating costs of the two models. In this problem were just
focusing on the cost of the equipment.)

SOLUTION:
Initial Outlay
Purchase of new machine ($350,000) *Sale of old machine $180,000
Sale of old machine 180,000 NBV of old machine 196,000
Tax savings* 6,400 Loss on sale $ 16,000
Initial cash flow ($163,600) Tax rate x .4
Tax savings $ 6,400

Operating Cash Flows Years 1-5

Old depreciation $ 22,000
New depreciation (60,000)
EBT Impact (38,000)
Tax Savings 15,200
EAT Impact (22,800)
Add depreciation 38,000
Operating CF $ 15,200

Total Cash Flow in Year 5

Sale of new machine $50,000
Tax on sale 0 *Salvage value $60,000
Opportunity cost of sale Book value 86,000
of old machine (60,000) Loss $26,000
Tax saving on opp. cost* 10,400 Tax rate x .4
Add: Operating Cash Flow 15,200 Tax saving
Total Cash Flow $15,600 on opp. cost $10,400

18. The Catseye Marble Co. is thinking of replacing a manual production process with a
machine. The manual process requires three relatively unskilled workers and a supervisor. Each
worker makes $17,500 per year while the supervisor earns $24,500. The new machine can be run
 Cash Flow Estimation 19

with only one skilled operator who will earn $41,000. Payroll taxes and fringe benefits are an
additional one third of all wages and salaries.
The machine costs $150,000 and has a tax depreciation life of five years. Catseye elects straight-
line depreciation for tax purposes. A service contract covers all maintenance for $5,000 a year. The
machine is expected to last six years, at which time it will have no salvage value. The machine's
output will be virtually indistinguishable from that of the manual process in both quality and
quantity. There are no other operating differences between the manual and the machine processes.
Catseye's marginal tax rate is 35%, and its cost of capital is 10%.
a. Calculate the incremental cash flows associated with the project to acquire the machine.
b. Calculate the project's payback and NPV. Would you accept or reject the project?
c. Suppose there is no alternative but to lay off the displaced employees, and the cost of severance
is about three months wages. How would you factor this information into the analysis? Does it
change the project's acceptability?
d. How would you characterize this project's risk?

SOLUTION:
a. Annual labor savings:
Old labor: $17,500 3 + $24,500 = $77,000
New labor: $41,000
Savings $36,000
Fringe Benefits @ 1/3 $12,000
Annual Labor Savings $48,000

CASH FLOWS ($000)

0 1-5 6_
Asset ($150,000)
Labor Savings $48,000 $48,000
Maintenance cost ($ 5,000) ($ 5,000)
Depreciation ($30,000) -___
EBT Contribution $13,000 $43,000
Tax ($ 4,550) ($15,050)
Add Back Depreciation $30,000 -___
Annual CF ($150,000) $38,450 $27,950

b. Payback Period = $150,000 / $38,450 = 3.9 years

NPV = $150,000 + $38,450 [PVFA10,5] + $27,950 [PVF10,6]
= $150,000 + $38,450 (3.7908)+ $27,950 (.5645)
= $11,534
A positive NPV indicates an acceptable project.

c. Three months severance, after tax, on old wages would increase initial cost by:
$77,000 (3/12) 1.333 .65 = $16,679
This would decrease the NPV to
NPV = $11,534 $16,679 = $5,145, and make the project unacceptable.

d. This project would probably be somewhat riskier than the usual replacement, because the
machine is a new and unfamiliar way of doing the job.
20 Chapter 11

Replacement Projects Subjective Issues: Example 11.3 (page 510)

19. Blackstone Inc manufactures western boots and saddles. The company is considering
replacing an outmoded leather-processing machine with a new, more efficient model. The old
machine was purchased for $48,000 six years ago and was expected to have an eight-year life. It has
been depreciated on a straight-line basis (ignore partial year conventions). The used machine has an
estimated market value of $15,323. The new machine will cost $60,000 and will be depreciated
straight line over five years. All depreciation assumes zero salvage.
The new machine is expected to actually last for eight years (its economic life) and then will have
to be replaced. Assume it has no actual salvage value at that time.
Assume Blackstone's marginal tax rate is 35%.
Operating cost savings are summarized as follows:

Old New
Annual $2,000 increasing by None for two years,
maintenance cost $200 in each future year $1,500 thereafter
Cost of fixing $3,000 $1,000
production defects
Operators 2 @ $20,000 1.5 @ 24,000

The shop foreman feels the new machine will produce a higher quality output and thus affect
customer satisfaction and repeat sales. He thinks that benefit should be worth at least $5,000 a year,
but he doesn't have a way to document the figure. Losses generate tax credits.
a. Calculate the relatively certain incremental cash flows associated with the new machine over
its projected economic life of eight years, and the NPV at a cost of capital of 12% based on
those cash flows. (Round to whole $.)
b. Suppose the foremans $5,000 quality improvement estimate were to be included. How big an
impact would it have in relation to the other numbers? Comment.

SOLUTION:
a. Initial outlay:
Sell old machine
Sales price $15,323 $15,323
NBV of asset $12,000
Taxable Gain $ 3,323
Tax @ 35% ($1,163) ($ 1,163)
Buy new machine ($60,000)
Net Initial Outlay ($45,840)

CASH FLOWS AFTER OUTLAY

($ and commas omitted)
YEARS

1 2 3 4 5 6 7 8

Maintenance:
Old 2000 2200 2400 2600 2800 3000 3200 3400
New - 1500 1500 1500 1500 1500 1500
Savings 2000 2200 900 1100 1300 1500 1700 1900
 Cash Flow Estimation 21

Depreciation:
Old 6000 6000
New 12000 12000 12000 12000 12000
Incr 6000 6000 12000 12000 12000

Savings on defects and labor:

Defects 2000 2000 2000 2000 2000 2000 2000 2000
Labor 4000 4000 4000 4000 4000 4000 4000 4000
Total 6000 6000 6000 6000 6000 6000 6000 6000

Impact on Earnings and taxes:

EBT 2000 2200 (5100) (4900) (4700) 7500 7700 7900
Tax ( 700) ( 770) 1785 1715 1645 (2625) (2695) (2765)
EAT 1300 1430 (3315) (3185) (3055) 4875 5005 5135
+ Depr 6000 6000 12000 12000 12000
NCF 7300 7430 8685 8815 8945 4875 5005 5135
PVF12,I .8929 .7972 .7118 .6355 .5674 .5066 .4523 .4039
NPVs 6518 5923 6182 5602 5075 2470 2264 2074

Project NPV = $45,840 + $36,108 = $9,732 unacceptable

Payback = approximately 6 years: Cum NCF = $45,840 + $46,050 = $210

b. Adding income of $5,000 per year has a significant effect. The after-tax addition to inflows
each year is $5,000 .65 = $3,250. The impact on NPV is the present value of an annuity of this
amount for eight years at 12%.
PV = $3,250 [PVFA12,8]
= $3,250 (4.9676)
= $16,145
This makes the NPV acceptable:
NPV = $9,732 + $16,145 = $6,413
This illustrates an important real world phenomenon. Subjective guesses added at the end of
capital budgeting analyses can completely override the computations based on more objectively
estimated cash flows.

New Venture/Expansion Terminal Values: Examples 11.1, 11.2 (pages 498 and 504)
20. The Ebitts Field Corp. manufactures baseball gloves. Charlie Botz, the company's top
salesman, has recommended expanding into the baseball bat business. He has put together a project
proposal including the following information in support of his idea.
New production equipment will cost $75,000, and will be depreciated straight line over five
years.
Overheads and expenses associated with the project are estimated at $20,000 per year during
the first two years and $40,000 per year thereafter.
There is enough unused space in the factory for the bat project. The space has no alternative
use or value.
Setting up production and establishing distribution channels before getting started will cost
$300,000 (tax deductible).
Aluminum and Wood bats will be produced and sold to sporting goods retailers. Wholesale
prices and incremental costs per unit (direct labor and materials) are as follows:
22 Chapter 11

Aluminum Wood
Price $18 $12
Cost 11 9
Gross Margin $ 7 $3

Charlie provides the following unit sales forecast is (000):

Year 1 2 3 4 5 6
Aluminum 6 9 15 18 20 22
Wood 8 12 14 20 22 24

The sixth year sales level is expected to hold indefinitely.

Receivables will be collected in 30 days, inventories will be the cost of one month's
production, and payables are expected to be half of inventories. Assume no additional cash
or accruals are necessary. (Use 1/12 of the current year's revenue and cost for receivables
and inventory.)
Ebitts Field's marginal tax rate is 35% and its cost of capital is 12%.
a. Develop a six-year cash flow estimate for Charlie's proposal. Work to the nearest $1,000.
b. Calculate the payback period for the project.
c. Calculate the projects NPV, assuming a six-year life. Is the project acceptable?
d. Is the cost of capital an appropriate discount rate for the project considering its likely risk
relative to that of the rest of the business? Why?
e. What is the project's NPV if the planning horizon is extended to eight years? (Add the
incremental PV from two more years at year 6's cash flow.)
f. What is the NPV if management is willing to look at an indefinitely long time horizon? (Hint:
Think of the cash flows in years 6 and beyond as a perpetuity.)
g. Comment on the results of parts e. and f.

SOLUTION:
a. Gross Margin and W/C
0 1 2 3 4 5 6__
Aluminum
Units (000) 6 9 15 18 20 22
Rev @ $18 $108 $162 $270 $324 $360 $396
Cost @ $11 66 99 165 198 220 242

Wood
Units (000) 8 12 14 20 22 24
Rev @ $12 $ 96 $144 $168 $240 $264 $288
Cost @ $ 9 72 108 126 180 198 216

Total
Revenue $204 $306 $438 $564 $624 $684
Cost 138 207 291 378 418 458
Gross Margin $ 66 $ 99 $147 $186 $206 $226
Working Capital
Accounts Receivable $ 17 $ 26 $ 37 $ 47 $ 52 $ 57
Inventory $ 12 $ 17 $ 24 $ 32 $ 35 $ 38
Accounts Payable ($ 6) ($ 8) ($12) ($16) ($17) ($19)
Working Capital $ 23 $ 35 $ 49 $ 63 $ 70 $ 76
 Cash Flow Estimation 23

Increase in W/C $ 23 $ 12 $ 14 $ 14 $ 7 $ 6

Initial Outlay:
Expenses after tax ($300 .65) $195
Equipment $ 75
$270

CASH FLOWS
0 1 2 3 4 5 6__
Initial Outlay ($270)
Gross Margin $ 66 $ 99 $147 $186 $206 $226
Depreciation ($ 15) ($ 15) ($ 15) ($ 15) ($ 15) ($ 0)
Overhead & Expenses ($ 20) ($ 20) ($ 40) ($ 40) ($ 40) ($ 40)
EBT Impact $ 31 $ 64 $ 92 $131 $151 $171
Tax ($ 11) ($ 22) ($ 32) ($ 46) ($ 53) ($ 60)
EAT Impact $ 20 $ 42 $ 60 $ 85 $ 98 $111
Add back Depr $ 15 $ 15 $ 15 $ 15 $ 15 $ 0
Incr in W/C ($ 23) ($ 12) ($ 14) ($ 14) ($ 7) ($ 6)
NCF ($270) $ 12 $ 45 $ 61 $ 86 $106 $120

b. Payback Period:
NCF ($270) $ 12 $ 45 $ 61 $ 86 $106 $120
Cum CF ($270) ($258) ($213) ($152) ($ 66) $ 40 $155

Payback Period = 4.6 years

c. NPV:
NCF ($270) $ 12 $ 45 $ 61 $ 86 $106 $120
PVF12,i _____ .8929 .7972 .7118 .6355 .5674 .5066
PVs ($270) $ 11 $ 36 $ 43 $ 55 $ 60 $ 61

NPV = $270 + $266 = $4

Project is not acceptable since NPV < 0

d. Yes. The project is in the firm's traditional business and can be expected to use the same
distribution channels. Manufacturing may be a little risky, because making bats is unlike making
gloves, but that consideration seems minimal.

e. NCF for periods beyond six is the same as period six.

Hence:

3 4_
NCF $ 120 $ 120
PVF12,i .4523 .4039
PVs $ 54 $ 48

NPV8 = NPV6 + $54 + $48

= $4 + $102
= $98
24 Chapter 11

f. PVp = $120/.12 = $1000

Additional NPV = $1000 [PVF12,6]
= $1000 (.5066)
= $507

NPVinf = $4 + $507 = $503

g. Taking a longer view often makes projects look a lot better. However, the further into the
future cash flows are forecast, the less certain they are.

21. Segwick Corp manufactures men's shoes that it sells through its own chain of retail stores.
The firm is considering adding a line of women's shoes. Management considers the project a new
venture because there are substantial differences in marketing and manufacturing processes between
mens and womens footwear.
The project will involve setting up a manufacturing facility as well as expanding or modifying
the retail stores to carry two products. The stores are leased, so modification will involve leasing
larger spaces, installing new leasehold improvements, and writing off some old leasehold
improvements.*
The expected costs are summarized as follows:

Asset Items
New manufacturing equipment, straight line depreciation, five years .............. $750,000

Acquisition of a new facility for design and manufacturing

Land (no deprec.)....................$480,000
Building (311.5 yr. deprec.) ................ $630,000
$1,110,000
Leased retail space
Net new lease expense, per year ......$ 40,000
New leasehold improvements straight line depreciation, five years ....... $200,000
Write-off of old improvements ....... $ 90,000
Depreciation reduction due to written off improvements per year
for 3 more years ...... $ 30,000
Expense Items
Cost of hiring and training new people ... $150,000
Initial advertising and promotion ........ $200,000
Yearly advertising and promotion ........... $ 50,000
Yearly sales salaries .....................$900,000
Additional corporate overhead ($000/yr.) ........$20, $42, $60, $80, $80, $80

Revenue and Cost

The unit sales forecast is as follows in thousands
Year Units Average Price
1 30 $65
2 40 $68
3 50 $70
4 and on 60 $75

Direct cost excluding depreciation is 40% of sales

1*
Leasehold improvements are assets added to leased premises by the tenant. They are generally depreciated over the
remaining life of the lease.
 Cash Flow Estimation 25

Working Capital
Sales are to retail customers who pay with checks or credit cards. It takes about 10 days to clear
both of these and actually receive cash. Inventories are estimated to be approximately the cost of
two months sales.
Payables are estimated as one quarter of inventories.
Assume incremental cash is required equal to 2% of revenues.
Accruals are insignificant.
(Estimate the current accounts based on the current year's revenue and cost levels.)

Other Items
Management expects a few of the company's current male customers to be lost, because they
won't want to shop in a store that doesn't exclusively sell men's shoes. The gross margin impact of
these lost sales is estimated to be $60,000 per year.
The company has already purchased designs for certain styles of ladies' shoes for $60,000.
Segwick's cost of capital is 10%. Its marginal tax rate is 35%.

a. Develop a six-year forecast of after tax cash flows for Segwick.

b. Calculate the project's payback period, NPV, IRR, and PI, and make a recommendation about
acceptance.
c. Assume you are told that the men's shoe industry is very stable being served by the same
manufacturers year after year. However, firms enter and leave the ladies' shoe business regularly.
Would this knowledge make you more or less comfortable with the analysis you've done of this
project? Why?

SOLUTION: a. Forecast of cash flows:

Depreciation:
Equipment ($750,000 / 5) $150,000 5 years
Building ($630,000 /31.5) $ 20,000 6 years
New Leasehold Improvements $ 40,000 5 years
Old Leasehold Improvements ($ 30,000) 3 years

($000)
0 1 2 3 4 5 6__

Equipment $ 150 $ 150 $ 150 $ 150 $ 150

Building $ 20 $ 20 $ 20 $ 20 $ 20 $ 20
New L/H $ 40 $ 40 $ 40 $ 40 $ 40
Old L/H ($ 30) ($ 30) ($ 30) _____ _____ _____
Incr. Depreciation $ 180 $ 180 $ 180 $ 210 $ 210 $ 20

Initial Outlay:
Expenses
Hiring and Training $150,000
Advertising & Promotion $200,000
Write-off L/H Improve $ 90,000
EBT Impact $440,000
Tax Savings ($154,000)
Less Non-cash Write-off $ 90,000
Cash Outflow Expenses $196,000
26 Chapter 11

Capital
Equipment $750,000
Facility $1,110,000
New L/H Improve $200,000
Cash Outflow - Capital $2,060,000

Total Outlay $2,256,000

($000)
0 1 2 3 4 5 6_
Revenue and Cost
Units 30 40 50 60 60 60
Price _____ $65 $68 $70 $75 $75 $75
Revenue $1,950 $2,720 $3,500 $4,500 $4,500 $4,500

Cost @ 40% $ 780 $1,088 $1,400 $1,800 $1,800 $1,800

Lost GM _____ $ 60 $ 60 $ 60 $ 60 $ 60 $ 60
GM Contribution $1,110 $1,572 $2,040 $2,640 $2,640 $2,640

Expenses
New leases $ 40 $ 40 $ 40 $ 40 $ 40 $ 40
Advertising & Promotion 50 50 50 50 50 50
Salaries 900 900 900 900 900 900
Overhead 20 42 60 80 80 80
Incr. Depreciation _____ 180 180 180 210 210 20
Total Expenses $1,190 $1,212 $1,230 $1,280 $1,280 $1,090

Contribution to Earnings
EBT ($ 80) $ 360 $ 810 $1,360 $1,360 $1,550
Tax _____ 28 (126) (284) (476) (476) (543)
EAT ($ 52) $ 234 $ 526 $ 884 $ 884 $1,007
Add Incr. Deprec. _____ 180 180 180 210 210 20
Operating CF $ 128 $ 414 $ 706 $1,094 $1,094 $1,027

Working Capital
Cash (2% Rev) $ 39 $ 54 $ 70 $ 90 $ 90 $ 90
A/R (.33Rev/12) 54 76 97 125 125 125
Inv (Cost/6) 130 181 233 300 300 300
A/P (Inv/4) _____ ( 33) ( 45) ( 58) ( 75) ( 75) ( 75)
W/Cap $ 190 $ 266 $ 342 $ 440 $ 440 $ 440
Incr in W/C ($190) ($ 76) ($ 76) ($ 98) - -

Initial Outlay ($2,256) _____ _____ _____ ______ _____ _____

NCF ($2,256)($ 62) $ 338 $ 630 $ 996 $1,094 $1,027

b.
Payback Period
NCF ($2,256)($ 62) $ 338 $ 630 $ 996 $1,094 $1,027
Cum CF ($2,256)($2,318)($1,980)($1,350) ($ 354) $ 740 $1,767

Payback Period = 4.3 years

 Cash Flow Estimation 27

NPV and PI
NCF ($2,256) ($ 62) $338 $630 $996 $1,094 $1,027
PVF10,i .9091 .8264 .7513 .6830 .6209 .5645
PVs ($2,256) ($ 56) $ 279 $ 473 $ 680 $680 $580

NPV = $2,256 + $2,636 = $380

PI = $2,636 / $2,256 = 1.17
IRR
NCF ($2,256) ($ 62) $ 338 $ 630 $ 996 $1,094 $1,027
PVF14,i ______ .8772 .7695 .6750 .5921 .5194 .4556
PVs ($2,256) ($ 54) $ 260 $ 425 $ 590 $ 568 $ 468

NPV = $2,256 + $2,257 = $1

IRR = 14%

Accept since: NPV = $380,000 > 0

PI = 1.17 > 1.0
IRR = 14% > k = 10%

c. Worse. The venture is riskier than the existing business, which implies the analysis accepts it too
easily.

COMPUTER PROBLEMS
22. The Paxton Homes is a successful builder of moderate to high-priced houses. The firm is
currently considering an expansion into light commercial construction in which it would build
shopping centers and small office buildings. Management considers the idea a new venture because
of the major differences between commercial and residential construction.
Getting into the new line of business will require an investment of $12.5M in equipment and
$3M in expenses. The equipment will be depreciated over five years. Part of the start-up money
will come from the sale of some old trucks and cranes. These have a total market value of $1.8M
and an NBV of $600K. Selling the equipment will result in a depreciation reduction of $200K per
year for three years.
Revenue from the commercial line is expected to be $6M in the first year and to grow by $2M in
each succeeding year until it reaches $20M. After that growth is uncertain and may be anywhere
from 0 to 6% per year. Costs and expenses, including incremental overhead, will be 110% of
revenues in the first year, 85% in the next two years, and 70% thereafter. Economies of scale in
materials purchasing are expected to save the residential business about $250K per year but not until
the fourth year. Net working capital requirements are estimated at 10% of revenue. The combined
federal and state tax rate on the incremental business will be 40%. Losses can be offset against
other profits and can therefore be viewed as earning a tax credit at the same rate. Paxton's cost of
capital is 12%.
You are a financial analyst assigned to evaluate the commercial construction proposal. Use the
CAPBUD program to analyze the project and prepare a presentation in which you will make a
recommendation either favoring or opposing its undertaking. Here are some ideas for approaches to
your presentation:
a. Establish a base case using the information given.
Forecast into the future until the numbers stop changing (eight years). Assume a terminal value
based on a continuation of the eighth year's cash flows with no further growth. Is the project
acceptable based on NPV and IRR given these assumptions?
28 Chapter 11

b. Test the sensitivity of the base case analysis to the terminal value assumption by varying the
growth rate to 3% and 6%.
1) Comment on the difference the terminal growth rate assumption makes.
2) Construction is a cyclical industry in that it is very subject to the ups and downs of the
economy. In good times growth is enormous, but in bad times the industry and the firms in it shrink
rapidly. Given that fact, how do you feel about the terminal value assumption?
3) Evaluate the project's NPV and IRR assuming a ten-year planning horizon. That is, assuming
zero cash flows after the tenth year. Does this approach make more or less sense to you than the
terminal value assumptions used in part a.?
c. Test the sensitivity of the analysis to changes in revenue growth. For example, suppose revenue
grows by only $1M per year instead of two until the eighth year. Is the project a good idea then?
What if cost/expense is a higher percentage of revenue than anticipated?

SOLUTION: Solutions are outputs of the CAPBUD program given the inputs stated in the problem.