A B C D E F G H I

1
2
3 Chapter 11. Tool Kit for Cash Flow Estimation and Risk Analysis
4
5 ESTIMATING CASH FLOWS (Section 11.1)
6
7 For a new project, the incremental cash flows usually can be divided into the following categories: initial investment outlay,
8 operating cash flows over the project's life, NOWC cash flows, and salvage cash flows occuring at the project's termination.
9
10 PROJECT ANALYSIS: AN EXAMPLE (Section 11.2)
11
12 In Part 1, we first list the key inputs used in the calculations. Part 2 goes on to calculate depreciation schedules for the building
13 and for the equipment. Part 3 then determines the after-tax salvage values (i.e., net cash flows) that will come from disposing of
14 the building and the equipment at the end of the project's life. Part 4 calculates the estimated cash flows over each year of the
15 project's life. Part 5 then uses the estimated cash flows to estimate the key outputs, including the project's NPV, IRR, MIRR, and
16 payback.
17
18 Note that all dollars are shown in thousands; this is done for convenience.
19
20
21 Figure 11-1. Analysis of a New (Expansion) Project (Dollars in thousands)
22
23
24 Part 1. Input Data
25 Key Output: NPV = $5,809
26 Building cost (= Depreciable basis) $12,000
27 Equipment cost (= Depreciable basis) $8,000 Market value of building at salvage $7,500
28 Net Operating WC / Sales 10% Market value of equip. at salvage $2,000
29 First year sales (in units) 20,000 Tax rate 40%
30 Growth rate in units sold 0.0% WACC 12.0%
31 Sales price per unit $3.00 Inflation: growth in sales price 2.0%
32 Variable cost per unit $2.10 Inflation: growth in VC per unit 2.0%
33 Nonvariable costs $8,000 Inflation: growth in nonvariable costs 1.0%
34
35 Part 2. Depreciation Schedulea Years
36 Cumulative
37 1 2 3 4 Depr'n.
38 Building depreciation rate 1.3% 2.6% 2.6% 2.6%
39 Building depreciation $156 $312 $312 $312 $1,092
40 Ending book val: Cost - cum. depr'n. 11,844 11,532 11,220 $10,908
41
42 Equipment depreciation rate 20.0% 32.0% 19.0% 12.0%
43 Equipment depreciation $1,600 $2,560 $1,520 $960 $6,640
44 Ending book val: Cost - cum. depr'n. 6,400 3,840 2,320 $1,360
45
46
a
The depreciation rates are multiplied by the depreciable basis ($12,000 for the building and $8,000 for the equipment) to determine the yearly
47 depreciation expense. The correct depreciation percentages for the building depend upon the month that the building is put in service. Because
48 this analysis assumes that all cash flows occur at the end of the year, and to prevent unnecessary complexity, we have rounded the depreciation
percentages. See the Worksheet named DeprTables for more details.
49
50
51 Part 3. Net Salvage Values at End of Project
52 Building Equipment Total
53 Market value when salvaged $7,500 $2,000
54 Book value when salvaged b 10,908 1,360
55 Expected gain or lossc -3,408 640
56 Taxes paid or tax credit -1,363 256
57 Net cash flow from salvaged $8,863 $1,744 $10,607
58
59 b
Book value equals depreciable basis (initial cost in this case) minus accumulated MACRS depreciation. For the building, accumulated
60 depreciation equals $1,092, so book value equals $12,000 - $1,092 = $10,908. For the equipment, accumulated depreciation equals $6,640, so book
61 value equals $8,000 - $6,640 = $1,360.
62 c
Building: $7,500 market value - $10,908 book value = -$3,408, a loss. This represents a shortfall in depreciation taken versus "true" depreciation,
63 and it is treated as an operating expense for Year 4. Equipment: $2,000 market value - $1,360 book value = $640, a profit. Here the depreciation
64 charge exceeds the "true" depreciation, and the difference is called "depreciation recapture." It is taxed as ordinary income in Year 4. The actual
65 book value at the time of disposition depends on the month of disposition. We have simplified the analysis and assumed that there will be a full
year of depreciation in Year 4.
66
67 d Net cash flow from salvage equals salvage (market) value minus taxes. For the building, the loss results in a tax credit, so net salvage value =

68 $7,500 - (-$1,363) = $8,863.

69
70
71 Part 4. Projected Net Cash Flows Years
72
73 0 1 2 3 4
74 Investment Outlays: Long-Term Assets
75 Building ($12,000)
76 Equipment (8,000)
77
78 Operating Cash Flows over the Project's Life
79 Units sold 20,000 20,000 20,000 20,000
80 Sales price $3.00 $3.06 $3.12 $3.18
81 Sales revenue $60,000 $61,200 $62,424 $63,672
82 Variable costs 42,000 42,840 43,697 44,571
83 Nonvariable operating costs 8,000 8,080 8,161 8,242
84 Depreciation (building) 156 312 312 312
85 Depreciation (equipment) 1,600 2,560 1,520 960
86 Oper. income before taxes (EBIT) 8,244 7,408 8,734 9,587
87 Taxes on operating income (40%) 3,298 2,963 3,494 3,835
88 Net operating profit after taxes (NOPAT) 4,946 4,445 5,241 5,752
89 Add back depreciation 1,756 2,872 1,832 1,272
90 Operating cash flow $6,702 $7,317 $7,073 $7,024
91
92 Cash Flows Due to Net Operating Working Capital
93 Net operating working capital (based on sales) $6,000 $6,120 $6,242 $6,367 $0
94 Cash flow due to investment in NOWC ($6,000) ($120) ($122) ($125) $6,367
95
96 Salvage Cash Flows: Long-Term Assets
97 Net salvage cash flow: Building $8,863
98 Net salvage cash flow: Equipment 1,744
99 Total salvage cash flows $10,607
100
101 Net cash flow (Time line of cash flows) ($26,000) $6,582 $7,194 $6,948 $23,999
102
103
104 Part 5. Key Output and Appraisal of the Proposed Project (WACC = 12%)
105
106 Net Present Value $5,809
107 IRR 20.12%
108 MIRR 17.79%
109 PI 1.22
110
111 Years
112 0 1 2 3 4
113 Cumulative cash flow for payback (19,418) (12,223) (5,275) 18,723
114 Part of year required for payback: 1.00 1.00 1.00 0.22
115 Payback = 3.22
116
117 Years
118 0 1 2 3 4
119 Discounted cash flow for payback: 5,877 5,735 4,945 15,252
120 Cumulative cash flow for payback (20,123) (14,388) (9,442) 5,809
121 Part of year required for payback: 1.00 1.00 1.00 0.62
122 Payback = 3.62
123
124
125
126
127
128 Based on the firm's 12% weighted average cost of capital, this project has a NPV of $5,809. Since the NPV is positive,'we
tentatively conclude that the project should be accepted. The IRR and MIRR confirm this decision because both exceed the cost of
129
capital. Note, though, that no risk analysis has been conducted. It is possible that the firm's managers, after appraising the
130 project's risk, might conclude that its projected return is insufficient to compensate for its risk, and reject it.
131
132
133 PROJECT RISK ANALYSIS: TECHNIQUES FOR MEASURING STAND-ALONE RISK (Section 11.6)
134
135 Sensitivity Analysis
136
137
138 Risk in capital budgeting really means the probability that the actual outcome will be worse than the expected outcome. For
139 example, if there were a high probability that the $5,166 expected NPV as calculated above will actually turn out to be negative,
140 then the project would be classified as relatively risky. The reason for a worse-than-expected outcome is, typically, because sales
141 were lower than expected, costs were higher than expected, or the project turned out to have a higher than expected initial cost. In
142 other words, if the assumed inputs turn out to be worse than expected, then the output will likewise be worse than expected. We
143 use data tables below to examine the project's sensitivity to changes in the input variables.
144
145
146 Here we use an Excel "Data Table" to find NPV different unit sales, holding other thing constant.
147
148 % Deviation WACC % Deviation 1st YEAR UNIT SALES
149 from NPV from Units NPV
150 Base Case WACC 5,809 Base Case Sold $5,809
151 -30% 8.4% $9,030 -30% 14,000 -$3,628
152 -15% 10.2% $7,362 -15% 17,000 $1,091
153 0% 12.0% $5,809 Base Case 0% 20,000 $5,809
154 15% 13.8% $4,363 15% 23,000 $10,528
155 30% 15.6% $3,014 30% 26,000 $15,247
156
157
158 % Deviation VARIABLE COSTS % Deviation GROWTH RATE, UNITS
159 from Variable NPV from Growth NPV
160 Base Case Cost $5,809 Base Case Rate % $5,809
161 -30% $1.47 $29,404 -30% -30% -$4,923
162 -15% $1.79 $17,607 -15% -15% -$115
163 0% $2.10 $5,809 Base Case 0% 0% $5,809
164 15% $2.42 -$5,988 15% 15% $12,987
165 30% $2.73 -$17,785 30% 30% $21,556
166
167
168 % Deviation SALES PRICE % Deviation NONVARIABLE COSTS
169 from Sales NPV from Nonvariable NPV
170 Base Case Price $5,809 Base Case Costs $5,809
171 -30% $2.10 -$27,223 -30% $5,600 $10,243
172 -15% $2.55 -$10,707 -15% $6,800 $8,026
173 0% $3.00 $5,809 Base Case 0% $8,000 $5,809
174 15% $3.45 $22,326 15% $9,200 $3,593
175 30% $3.90 $38,842 30% $10,400 $1,376
176
177 We summarize the data tables, arranged by sensitivity, and graphed the most sensitive items in the following chart:
178
179
180 Figure 11-2. Evaluating Risk: Sensitivity Analysis (Dollars in Thousands)
181
182
NPV ($)
183 $40,000
184 Sales price
185 $30,000 Variable cost
186 Growth rate
187 $20,000
188 Units sold
189 $10,000 Nonvariable cost
190 WACC
191 $0
192
193 ($10,000)
194
195 ($20,000)
196
197 ($30,000)
198 -30% -15% 0% 15% 30%
199
Deviation from Base-Case Valu e (%)
200
201
202
203 Deviation NPV at Different Deviations from Base
204 from Sales Variable Growth Year 1 Nonvariable
205 Base Case Price Cost/Unit Rate Units Sold Cost WACC
206 -30% ($27,223) $29,404 ($4,923) ($3,628) $10,243 $9,030
207 -15% ($10,707) $17,607 ($115) $1,091 $8,026 $7,362
208 0% $5,809 $5,809 $5,809 $5,809 $5,809 $5,809
209 15% $22,326 ($5,988) $12,987 $10,528 $3,593 $4,363
210 30% $38,842 ($17,785) $21,556 $15,247 $1,376 $3,014
211
212 Range $66,064 $47,189 $26,479 $18,875 $8,867 $6,016
213
214 We see from the tables and graph that NPV is most sensitive to changes in the sales price and variable costs,
215 somewhat sensitive to changes in first-year sales and the sales growth rate, and not very sensitive to changes in
216 WACC and nonvariable costs. Thus, the real issue is our confidence in the forecasts of the sales price and variable
217 costs, as well as the first-year sales and the growth rate in units sold.
218
219 NPV Breakeven Analysis
220
221 In breakeven analysis, we find the value of the input variable that produes a zero NPV. It is easiest to do this with
222 Goal Seek. For example, the screen shot below shows the Goal Seek inputs we used to set the cell for NPV to a
223 value of zero by changing the cell for the sales price. We repeated this for the other inputs.
224
225
226
227
228
229
230
231
232
233
234
235
236
237 Table 11-3. NPV Breakeven Analysis (Dollars in Thousands)
238
239 Input Input Value that Produces Zero NPV
240 Sales price
241 Variable cost/unit
242 Growth rate
243 Year 1 units sold
244 Nonvariable cost
245 WACC
246
247
248 Data Tables: Multiple Outputs for a Single Input
249
250 Data tables can easily be extended to show multiple outputs for a single input. Simply add an additional column
251 with a cell reference to the desired additional output. Highlight the specified values for the input and highlight all
252 the columns for the output (be sure to also highlight the cell references above the outputs). Then use the Data,
253 Tables, and set "Column input" to the cell refernce of the desired input.
254
255
256 Example: NPV and IRR for Changes in Sales Price
257
258 % Deviation SALES PRICE
259 from Sales NPV IRR
260 Base Case Price
261 -30% $2.10
262 -15% $2.55
263 0% $3.00
264 15% $3.45
265 30% $3.90
266
267
268 Two-Way Data Tables: Two Inputs and One Output
269
270
Data tables can also be extended to show the output given two inputs. Put one set of input variables in the left-most
271
column and the other set of inputs in the top row; put the cell reference to the output in the intersection of the row
272 and column for inputs. Highlight the range that includes the specified values for the inputs (this will also highlight
273 the cell reference for the output). Then use the Data, Tables, and set "Row input" to the cell reference for the
274 inputs shown in the table's row and set "Column input" to the cell refernce for the input shown in the tables
275 column.
276
277 Example: NPV for Changes in Sales Price and Units Sold
278 % Deviation from Base Case
279 -30% -15% 0% 15% 30%
%
280 Deviation NPV cell
from reference Units Sold
281 Base Case $14,000 $17,000 $20,000 $23,000 $26,000
282 -30% $2.10
Sales Price

283 -15% $2.55

284 0% $3.00
285 15% $3.45
286 30% $3.90
287
288
289 Scenario Analysis
290
291 Scenario analysis extends risk analysis in two ways: (1) It allows us to change more than one variable at a time,
292 hence to see the combined effects of changes in several variables on NPV, and (2) It allows us to bring in the
293 probabilities of changes in the key variables. Part 7 provides a scenario analysis of the computer project.
294
295 We saw from the sensitivity analysis that the key variables are sales price, variable costs, unit sales, and the unit
296 growth rate. Therefore, in our sensitivity analysis we hold the other variables at their base case levels and then
297 examine the situation when the key variables change. We assume that the company regards the worst case as one
298 where each of the three variables is 30% worse than the base level, and the best case has each variable 30% better
299 than base. We also assume that there is a 25% chance of the best and worst cases, and a 50% chance of base case
300 levels.
301
302 We used Tools-Scenarios to define the three different scenarios in the Scenario Manager dialog box. We then used
303 the Scenario Manager's Summary feature to creat a summary, shown in the worksheet "Scenario Summary." We
304 then copied the values from the Scenario Summary into the table below.
305
306 Table 11-4. Scenario Analysis (Dollars in Thousands) Squared
307 Deviation
308 Sales Unit Variable Growth Times
309 Scenario Probability Price Sales Costs Rate NPV Probability
310
311 Best Case 25% $3.90 26,000 $1.47 30% $146,180 3,366,596,001
312 Base Case 50% $3.00 20,000 $2.10 0% $5,809 295,883,220
313 Worst Case 25% $2.10 14,000 $2.73 -30% ($37,257) 1,135,428,840
314 4797908060
315 Expected NPV = sum, prob times NPV $30,135
316 Standard Deviation = Sq Root of column I sum $69,267
317 Coefficient of Variation = Std Dev / Expected NPV 2.30
318
319 An even easier way to do scenario analysis is with the Scenario Manager. To use this, click on Tools, then Scenarios. You will get
320 the dialog box shown below.
321
322 We have already defined the three
323 scenarios. See below for instructions on
324 how to create your own.
325
326
327
328
329
330
331
332
333
334
335
336
337
338
339
340
341
342 To show one of the existing scenarios, simply highlight that scenario, click Show, and Excel will replace all the variables in that
343 scenario with the desired numbers. To create a new scenario, select the Add button shown above and you will get the dialog box
344 that guides you through the steps (the same steps apply if you want to edit a scenario).
345
346 The Scenario Manager also has another powerful feature. Suppose you have already defined several scenarios, as we have, and
347 you would like to see the inputs and selected outputs for the various scenarios. To do this, click on Tool, Scenarios, and you will
348 get the box shown above.
349
350
351 If you click on Summary, you will get the dialog box shown below.
352
353 In our case, we would like to see the NPV for each scenario. To do this, enter the
354 appropriate references in the results cells (such as the cell for NPV), then click OK.
355 You will get a new worksheet, called Scenario Summary, with the results. To see our
356 result, click on the Tab Scenario Summary.
357
358
359
For those who want to use even more Excel features, you can give names to the input
360
and output cells before doing the Summary. To do this, select a particular cell, such as
361 the one with NPV, then put your cursor at the top left of the sheet on the Name box
362 which is to the left of the formula bar and type in a new name, such as NPV. Then
363 when you run the summary, the summary table will have the name for the variable,
364 and not its cell reference.
365
Base Case

20000
0
3
2.1

Page 2
Best case

26000
0.3
3.9
1.47

Page 3
Worst case

14000
-0.3
2.1
2.73

Page 4
DEPRECIATION TABLES

Recovery Allowance Percentage for Personal Property Note: we have rounded some numbers for clarity of presen

Class of Investment
Ownership
Year 3-Year 5-Year 7-Year 10-Year

1 33% 20% 14% 10%

2 45% 32% 25% 18%
3 15% 19% 17% 14%
4 7% 12% 13% 12%
5 11% 9% 9%
6 6% 9% 7%
7 9% 7%
8 4% 7%
9 7%
10 6%
11 3%
100% 100% 100% 100%

MACRS for Residential Real Property Note: we have rounded some numbers for clarity of presentation. The a
Month Property Placed in Service
Year 1 2 3 4 5 6 7 8
1 3.485% 3.182% 2.879% 2.576% 2.273% 1.970% 1.667% 1.364%
2-27 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636%
28 1.970% 2.273% 2.576% 2.879% 3.182% 3.458% 3.636% 3.636%
29 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.152% 0.455%
99.99% 99.99% 99.99% 99.99% 99.99% 99.96% 99.99% 99.99%

MACRS for Nonresidential Real Property

Month Property Placed in Service
Year 1 2 3 4 5 6 7 8
1 2.461% 2.247% 2.033% 1.819% 1.605% 1.391% 1.177% 0.963%
2-39 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564%
40 0.107% 0.321% 0.535% 0.749% 0.963% 1.177% 1.391% 1.605%
100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

Rounded Percentages Used in Analysis

Property Life (in years): 39
Depreciation in Year 1 (assuming half-year convention): 1.30%
Rounded Depreciation in Years 2-39: 2.60%
Depreciation in Year 40: 1.30%

Non-rounded IRS Tables

Recovery Allowance Percentage for Personal Property: Non-rounded

 Non-rounded IRS Tables
Class of Investment
Ownership
Year 3-Year 5-Year 7-Year 10-Year

1 33.33% 20.00% 14.29% 10.00%

2 44.45% 32.00% 24.49% 18.00%
3 14.81% 19.20% 17.49% 14.40%
4 7.41% 11.52% 12.49% 11.52%
5 11.52% 8.93% 9.22%
6 5.76% 8.92% 7.37%
7 8.93% 6.55%
8 4.46% 6.55%
9 6.56%
10 6.55%
11 3.28%
100.00% 100.00% 100.00% 100.00%

MACRS for Residential Real Property: Non-rounded

Month Property Placed in Service
Year 1 2 3 4 5 6 7 8
1 3.485% 3.182% 2.879% 2.576% 2.273% 1.970% 1.667% 1.364%
2–9 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636%
10 3.637% 3.637% 3.637% 3.637% 3.637% 3.637% 3.636% 3.636%
11 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.637% 3.637%
12 3.637% 3.637% 3.637% 3.637% 3.637% 3.637% 3.636% 3.636%
13 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.637% 3.637%
14 3.637% 3.637% 3.637% 3.637% 3.637% 3.637% 3.636% 3.636%
15 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.637% 3.637%
16 3.637% 3.637% 3.637% 3.637% 3.637% 3.637% 3.636% 3.636%
17 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.637% 3.637%
18 3.637% 3.637% 3.637% 3.637% 3.637% 3.637% 3.636% 3.636%
19 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.637% 3.637%
20 3.637% 3.637% 3.637% 3.637% 3.637% 3.637% 3.636% 3.636%
21 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.637% 3.637%
22 3.637% 3.637% 3.637% 3.637% 3.637% 3.637% 3.636% 3.636%
23 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.637% 3.637%
24 3.637% 3.637% 3.637% 3.637% 3.637% 3.637% 3.636% 3.636%
25 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.637% 3.637%
26 3.637% 3.637% 3.637% 3.637% 3.637% 3.637% 3.636% 3.636%
27 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.637% 3.637%
28 1.970% 2.273% 2.576% 2.879% 3.182% 3.485% 3.636% 3.636%
29 0.000% 0.000% 0.000% 0.000% 0.000% 0.000% 0.152% 0.455%
100.000% 100.000% 100.000% 100.000% 100.000% 100.000% 100.000% 100.000%
some numbers for clarity of presentation. The actual IRS table is shown at the end of this Worksheet.

ers for clarity of presentation. The actual IRS table is shown at the end of this Worksheet.

9 10 11 12
1.061% 0.758% 0.455% 0.152%
3.636% 3.636% 3.636% 3.636%
3.636% 3.636% 3.636% 3.636%
0.758% 1.061% 1.364% 1.667%
99.99% 99.99% 99.99% 99.99%

9 10 11 12
0.749% 0.535% 0.321% 0.107%
2.564% 2.564% 2.564% 2.564%
1.819% 2.033% 2.247% 2.461%
100.00% 100.00% 100.00% 100.00%
 9 10 11 12
1.061% 0.758% 0.455% 0.152%
3.636% 3.636% 3.636% 3.636%
3.636% 3.636% 3.636% 3.636%
3.637% 3.637% 3.637% 3.637%
3.636% 3.636% 3.636% 3.636%
3.637% 3.637% 3.637% 3.637%
3.636% 3.636% 3.636% 3.636%
3.637% 3.637% 3.637% 3.637%
3.636% 3.636% 3.636% 3.636%
3.637% 3.637% 3.637% 3.637%
3.636% 3.636% 3.636% 3.636%
3.637% 3.637% 3.637% 3.637%
3.636% 3.636% 3.636% 3.636%
3.637% 3.637% 3.637% 3.637%
3.636% 3.636% 3.636% 3.636%
3.637% 3.637% 3.637% 3.637%
3.636% 3.636% 3.636% 3.636%
3.637% 3.637% 3.637% 3.637%
3.636% 3.636% 3.636% 3.636%
3.637% 3.637% 3.637% 3.637%
3.636% 3.636% 3.636% 3.636%
0.758% 1.061% 1.364% 1.667%
100.000% 100.000% 100.000% 100.000%
Scenario Summary
Current Values: Base Case Best case Worst case
Changing Cells:
$D$29 20,000 20,000 26,000 14,000
$D$30 0.0% 0.0% 30.0% -30.0%
$D$31 $3.00 $3.00 $3.90 $2.10
$D$32 $2.10 $2.10 $1.47 $2.73
Result Cells:
$I$25 $5,809 $5,809 $146,180 ($37,257)
Notes: Current Values column represents values of changing cells at
time Scenario Summary Report was created. Changing cells for each
scenario are highlighted in gray.
 A B C D E F G H I J
1 REPLACEMENT ANALYSIS
2
3
In this model, we analyze the issue of whether a piece of equipment should be replaced. While the mechanics
4 of the analysis are somewhat different from the analysis for a new project, the process is similar in that we
5 are concerned with incremental cash flows. In this instance, we will be looking at a case that consists of net
6 salvage value being an intial benefit of the project. This replacement project is deemed by the firm to be of
7 relatively low risk, and is evaluated with a cost of capital of 11.5%
8
9 Input Data
10
11 Cost of the new machine $12,000
12 Reduction in operating costs $5,000
13 New machine's salvage value at end of Year 5 $2,000
14 Old machine's current market value $1,000
15 Old machine's current book value $2,500
16 Increase in Net Operating WC $1,000
17 Tax rate 40%
18 WACC 11.5%
19
20 MACRS 3-year Depreciation Schedule
21
22 Year 1 2 3 4 5
23 Depr. Rate 33% 45% 15% 7%
24 Depr. Exp. $3,960 $5,400 $1,800 $840
25
26 New depr. $3,960 $5,400 $1,800 $840 0
27 Old depr. $500 $500 $500 $500 $500
28 Net depr. $3,460 $4,900 $1,300 $340 -$500
29
30 Replacement Project Net Cash Flow Schedule
31 Year: 0 1 2 3 4 5
32 Section I. Investment Outlay
33 Cost of new equipment ($12,000)
34 Market value of old equipment 1,000
35 Tax savings on old equipment sale 600
36 Increase in net operating WC (1,000)
37
38
39 Section II. Operating Inflows over the Project's Life
40 Decrease in operating costs $5,000 $5,000 $5,000 $5,000 $5,000
41 Net change in depreciation 3,460 4,900 1,300 340 (500)
42 Net earnings before taxes 1,540 100 3,700 4,660 5,500
43 Taxes 616 40 1,480 1,864 2,200
44 Net operating profit after taxes 924 60 2,220 2,796 3,300
45 Add back depreciation 3,460 4,900 1,300 340 (500)
46 Net operating cash flows $4,384 $4,960 $3,520 $3,136 $2,800
47
48 Section III. Terminal Year Cash Flows
49 Estimated salvage value of new machine $2,000
50 Tax on salvage value (40%) (800)
51 Return of net operating WC 1,000
52 Total termination cash flows $2,200
53
54 Section IV. Net Cash Flow ($11,400) $4,384 $4,960 $3,520 $3,136 $5,000
55 Cumulative cash flows (for payback) ($11,400) ($7,016) ($2,056) $1,464 $4,600 $9,600
56 Part of year required for payback: 1.00 1.00 0.58 - -
57
58 Section V. Capital Budgeting Analysis
59 Net Present Value (11.5%) $3,991.08
60 IRR 25.03%
61 MIRR 18.40%
62 Payback (in years) 2.58
63
64
This project carries much less risk than the firm's average project, hence it was only evaluated at 11.5%. The project's
NPV is positive; therefore, it should be accepted. A review of the IRR and MIRR also indicate that this project should be
accepted because their values are greater than the 11.5% cost of capital. In addition, the payback period for this project
is not very long, so if the required payback for this project were 3 years then according to the payback criterion this
project would also be accepted.
SECTION 11.2
SOLUTION TO SELF-TEST

1a a. If the WACC is 15%, what is the new NPV?

WACC 12.0%
Years
0 1 2 3 4
CFs -$27,800 $9,786 $10,462 $10,281 $29,347

NPV = $15,247