Chapter 8: Planning investments – discounted cash flows

End of Chapter Questions

8.3 Identify two broad ways a business can grow. Is growth for its own sake a desirable objective? Why?

Growth can be achieved by expanding current operations or making investments in new activities. From the shareholder’s perspective,
growth for its own sake is not desirable. Shareholders only want growth that maintains or increases their returns.

8.8 Explain the concept of opportunity cost. What are the opportunity costs associated with your decision to study this
course?

Opportunity costs are the cash flows forgone when one path of action is chosen. They are what the firm will have to give up if it decides
to invest in a new project. This makes opportunity costs relevant cash flows because they are the cash flows forgone as a result of
accepting a project. Some opportunity costs associated with your study of this course could include the wages you would have earned
had you not chosen to study. This applies to students who were working then decided to study (clearly, the pay you would have received
had you continued in your employment) and to students who are working and studying (the overtime you turn down because you need
to complete your assignment) and to ‘full-time’ students working to support themselves while studying (you can do less hours if you go
to lecture or are preparing your assignment). You will all be fully aware of the non-financial opportunity costs associated with studying
(less time at the pub, with family, or just doing something you would rather be doing) but these are hard to put a dollar value on, so
don’t form part of your relevant cash flows.

8.9 What are sunk costs? When are they relevant to investment decisions?

Sunk costs are cash outflows that occur prior to the evaluation of a project. They have occurred in the past and cannot be changed by an
action (i.e. accepting a project) today. They are never relevant to investment decisions because they are not incremental. Sunk costs may
have been necessary to get to the stage of making an investment decision but they do not come about because a project is accepted.
8.13 What is the appropriate discount rate for evaluating a project with the same risk as the firm’s existing projects? Why?

The cost of capital is the appropriate discount rate for a project with the same level of risk as other projects in the firm. The firm’s cost
of capital reflects the required returns of the providers of capital given the current level of risk in the firm. Therefore, the cost of capital
represents the required return for new projects with the same level of risk.

8.15 What is the appropriate hurdle rate for evaluating a project with the same risk as the firm’s existing projects? Why?

The cost of capital is the appropriate hurdle rate for a project with the same level of risk as the other projects in the firm. The firm’s cost
of capital reflects the required returns of the providers of capital given the current level of risk in the firm. Therefore, the cost of capital
represents the required return for new projects with the same level of risk.

8.20 Do financial managers use IRR or NPV more? Why might managers use both techniques?

Research shows that Australian companies use both IRR and NPV with about the same frequency. The research also shows that managers
use more than one technique when evaluating the same project. Managers understand that the NPV is the more reliable evaluation tool
– they also understand that it is often easier for non-finance people to interpret a rate of return than it is for them to understand the
expected dollar increase in the value of the firm.

Financial Problems

8.1 Cupsley Ltd is a manufacturer of cutlery. The firm’s managers have asked you to evaluate a project proposal to diversify
into manufacturing nailfiles. A new machine to mould the plastic on to the end of the nailfiles would need to be purchased
at a cost of $150 000. Freight and insurance for the new machine will cost $3500 and installation will cost a further $1200.
The files would be pressed on existing equipment. The files would be produced by introducing a night shift, so will not
displace any current production capacity. The existing machine would be modified at a cost of $20 000.
 If the new project goes ahead, Cupsley will need to increase the raw materials inventory by $2500. The finished goods
inventory would need to be $4500 higher than its current level. Cupsley will supply 30-day terms to the distributors of
the nailfiles and this is expected to result in an increase of $60 000 in accounts receivable. The increase in accounts
receivable will occur during the first week of production for the project. Cupsley has arranged credit with suppliers of
the plastic that will be used in the production process. This is expected to result in an increase of $15 000 to accounts
payable.
(a) What is the installed cost of the project?
(b) What is the change in net working capital?
(c) What is the initial outlay for the nailfile project?

(a) Installed cost of new asset

Purchase price 150 000

Installation 3 500
Transport cost 1 200
Modification 20 000
174 700

(b) Change in net working capital

Add increase in raw materials 2 500

Add increase in finished goods 4 500
Add increase in accounts receivable 60 000
Subtract increase in accounts payable (15 000)
52 000

(c) Initial outlay

Installed cost of new asset 174 700

Add increase in net working capital 52 000
226 700
8.7 Using 12% as the discount and hurdle rates, calculate the NPV and IRR for each of the following three projects:

Which projects should be accepted and which should be rejected? Why?

n
CFt
Using equation 8.1 NPV    IO
t 1 (1  k a )
t

NPVA = –50 000 + 15 000 PVIFA0.12,10

= –50 000 + 15 000 (5.6502)
= $34 753

NPVB = –75 000 + 10 000 (1.12)–1 + 10 000 (1.12)–2 + 15 000 (1.12)–3 + 15 000 (1.12)–4 + 18 000 (1.12)–5 + 18 000 (1.12)–6 + 17 000
(1.12)–7 + 15 000 (1.12)–8
= –75 000 + 8928.57 + 7971.94 + 10 676.70 + 9532.77 + 10 213.68 + 9119.36 + 7689.94 + 6058.25
= $–4808.80

NPVC = –100 000 + 25 000 (1.12)–1 + 25 000 (1.12)–2 + 35 000 (1.12)–3 – 10 000 (1.12)–4 + 40 000 (1.12)–5 + 45 000 (1.12)–6
 = –100 000 + 22 321.43 + 19 929.85 + 24 912.31 – 6355.18 + 22 697.07
+ 22 798.40
= $6303.88

Using the NPV as our acceptance criterion, Projects A and C would be accepted. The positive NPVs of these projects indicate that
acceptance will increase shareholder wealth. Project B should be rejected as its negative NPV tells us that adoption will decrease
shareholder wealth.

IRRA = 27.32% IRRB = 10.31% IRRC = 14.05%

Using the IRR as our acceptance criterion, Projects A and C would be accepted. The IRRs of these projects exceed the hurdle rate of
12% so indicate that acceptance will increase shareholder wealth. Project B should be rejected as its IRR is lower than the required
return of 12%. If there had been conflict with the accept–reject decision under NPV and IRR for Project C, the NPV result should be
the deciding factor. Project C has a net cash outflow in year 4, making the results of the IRR method unreliable.

8.9 Given your interest in sports and computers, you are considering establishing a computer games development business.
You would like to run the business for the next 5 years and your required return is 18%. You would need hardware
worth around $200 000 to start development and production of your first game ‘Super Hoop Croquet’. The equipment
would be scrapped at the end of the project.
You have decided to locate your business in a regional centre rather than the city in order to lower rental costs. Your
annual rent will be $30 000. The going rate for programmers in the area is $70 000 p.a. and you would employ 4 of these.
Sales for the first year are expected to be 3 700 units. Sales are expected to grow at 7% p.a. for the following 4 years of
the project. The selling price will be around $130 per unit and the production costs will be $16 per unit. Marketing costs
are expected to be 20% of annual sales and are paid at the start of each year based on the sales estimate for the year. An
inventory worth $52 000 will also be needed at the commencement of operations. The inventory cost will be recovered at
the end of the project.
Showing all relevant cash flows, calculate the project’s NPV and IRR. No incomplete units can be sold, so round the unit
sales to the nearest whole number. Should you start this business?
 Installed cost –200 000
Increase in inventory –52 000
Initial outlay –252 000

Year 1 sales = 3 700 × 130 = 481 000

Year 2 sales = 3 700(1.07) × 130 = 514 670
Year 3 sales = 3 959 (1.07) × 130 = 550 680
Year 4 sales = 4 236 (1.07) × 130 = 589 290
Year 5 sales = 4 533 (1.07) × 130 = 630 500

initial outlay = 200 000 + 52 000 = 252 000

terminal value = return of working capital = 52 000
Salaries = 70 000 * 4 = 280 000

t=0 Year 1 Year 2 Year 3 Year 4 Year 5

Initial outlay –252 000
Sales 481 000 514 670 550 680 589 290 630 500
COGS –59 200 –63 344 –67 776 –72 528 –77 600
Rent –30 000 –30 000 –30 000 –30 000 –30 000
Salaries –280 000 –280 000 –280 000 –280 000 –280 000
Marketing –96 200 –102 934 –110 136 –117 858 –126 100
Operating CF –96 200 8 866 31 190 55 046 80 662 242 900
Terminal value** 52 000
Cash flows –348 200 8 866 31 190 55 046 80 662 294 900
PVF (18%) 1 0.8475 0.7182 0.6086 0.5158 0.4371
PV of CF –348 200 7 514 22 401 33 501 41 605 128 901

NPV = -$114 278 - reject

IRR = 7.29%
000 and inventory would increase by $10 000. What is the initial outlay for the new welding system?

Installed cost
Purchase price –250 000
Insurance and transport –5 000
Installation –3 000
Sale of existing equipment 10 000
–248 000
Change in net working capital
Add increase in accounts receivable 30 000
Less increase in accounts payable –20 000
Add increase in inventory 10 000
20 000

Initial outlay –268 000

8.16 You have decided to cash in on the dancing craze in your town, so you are thinking about setting up a dance studio. You
can rent a warehouse close to the business district for $40 000 p.a. In order to attract the ‘right’ sort of clientele, you will
need to spend $120 000 on redecorating and installing mirrors on all surfaces. You will also purchase some equipment at
a cost of $70 000. You expect that the equipment can be sold at the end of four years for $7 000.
Your market research suggests you can attract and maintain 600 students. Each would pay an annual tuition fee of $900.
Instructors are usually paid a salary of $43 000 p.a. and you would employ 5 of these to keep the studio operating 7 days
a week. You will operate the business for 4 years before retiring. If your cost of capital is 14%, should you set up the
business? Calculate IRR and NPV to support your decision.
 Year 0 1 2 3 4
Redecorating –120 000
Equipment –70 000
Student fees 540 000 540 000 540 000 540 000
Rent –40 000 –40 000 –40 000 –40 000
Salaries –215 000 –215 000 –215 000 –215 000
Sale of equipment 7 000
Net cash flow –230 000 285 000 285 000 285 000 332 000
PVF 1 0.8772 0.7695 0.675 0.5921
–230 000 250 002 219 307.5 192 375 196 577.2
NPV 628 261.7
IRR 119.64%

Student fees are calculated as 600 × 900

Salaries are calculated as 43 000 × 5
IRR is calculated in Excel
The business should be established as the NPV is positive and the IRR is larger than the hurdle rate.

indicates that the project should be accepted to increase shareholder wealth.

8.18 Mick and Steve have a partnership that manufactures racing accessories that
can be fitted to street cars. They would like you to evaluate a project for them
and have provided the following details:

 The initial investment in the project is $300 000 for production equipment.
 The assets purchased at the commencement of the project will be sold at
the end of year 6 for $90 000.
 The assets require an overhaul that will cost $27 000 at the end of year 4.
 Working capital will be 5% of revenues for each year. The working capital
investment has to be made at the start of each period. All working capital
will be recovered.
 Cost of goods sold is 50% of sales.
 Wages are $250 000 per annum
 The required return of the partners is 17%.

(a) calculate the relevant cash flows for the project

 Year 0 1 2 3 4 5 6
Initial outlay –300 000
Sales 300 000 600 000 700 000 500 000 500 000 400 000
Cost of goods sold –150 000 –300 000 –350 000 –250 000 –250 000 –200 000
Wages –250 000 –250 000 –250 000 –250 000 –250 000 –250 000
Change in working capital* –15 000 –15 000 –5 000 10 000 0 5 000 20 000
Asset overhaul –27 000
Sale of assets 90 000
Net cash flows –315 000 –115 000 45 000 110 000 –27 000 5 000 60 000
PVF 1 0.8547 0.7305 0.6244 0.5337 0.4561 0.3898
PV –315 000 –98 290.5 32 872.5 68 684 –14 409.9 2 280.5 23 388
NPV –300 475.4
IRR –19.80%

* working capital equal to 5% of the next year’s revenues is required at the start of each year. The first working capital cash outflow
must be made at the start of the project.
Working capital is not ‘used up’ and is remains in the firm until the project is completed. We need to calculate the change in working
capital for each year to see how much more is required for the following year (years 0 – 2) or how much is freed up each year
(years 3 – 6). The year 6 cash flow is the return of the year 5 working capital amount when the project is completed. The following
table shows the annual amounts used for this calculation.

Working capital required –15 000 –30 000 –35 000 –25 000 –25 000 –20 000
Change in working capital –15 000 –15 000 –5 000 10 000 0 5 000 20 000
 (b) calculate the NPV for the project. Make a recommendation about the
acceptability of the project.

The NPV of the project is -$300 475.40 (see part a). As the NPV is negative, the project
should be rejected to avoid decreasing the owners’ wealth.

(c) calculate the IRR for the project. Make a recommendation about the
acceptability of the project

The IRR of the project is negative (calculated in Excel). As –19.08% is well below the
owners’ required return, the project should be rejected. If the IRR had been greater than
the required return, you would still reject this project. There is a negative net cash outflow
in year 4 making the IRR method unreliable, so given the negative NPV, you would reject
the project.

© John Wiley and Sons Australia, Ltd 2008 5.11