29.

The project has a sales price that increases at five percent per year, and a variable cost per unit that
increases at 10 percent per year. First, we need to find the sales price and variable cost for each year.
The table below shows the price per unit and the variable cost per unit each year.

Sales price
Cost per unit

Year 1
$40.00
$20.00

Year 2
$42.00
$22.00

Year 3
$44.10
$24.20

Year 4
$46.31
$26.62

Year 5
$48.62
$29.28

Using the sales price and variable cost, we can now construct the pro forma income statement for
each year. We can use this income statement to calculate the cash flow each year. We must also
make sure to include the net working capital outlay at the beginning of the project, and the recovery
of the net working capital at the end of the project. The pro forma income statement and cash flows
for each year will be:
Year 0
Revenues
Fixed costs
Variable costs
Depreciation
EBT
Taxes
Net income
OCF

Year 1
Year 2
Year 3
Year 4
Year 5
$400,000.00 $420,000.00 $441,000.00 $463,050.00 $486,202.50
50,000.00
50,000.00
50,000.00
50,000.00
50,000.00
200,000.00 220,000.00 242,000.00 266,200.00 292,820.00
80,000.00
80,000.00
80,000.00
80,000.00
80,000.00
$70,000.00 $70,000.00 $69,000.00 $66,850.00 $63,382.50
23,800.00
23,800.00
23,460.00
22,729.00
21,550.05
$46,200.00 $46,200.00 $45,540.00 $44,121.00 $41,832.45
$126,200.00 $126,200.00 $125,540.00 $124,121.00 $121,832.45

Capital spending
NWC

$400,000
25,000

Total cash flow

$425,000 $126,200.00 $126,200.00 $125,540.00 $124,121.00 $146,832.45

25,000

With these cash flows, the NPV of the project is:

NPV = $425,000 + $126,200 / 1.15 + $126,200 / 1.152 + $125,540 / 1.153 + $124,121 / 1.154
+$146,832.45 / 1.155
NPV = $6,677.31
We could also answer this problem using the depreciation tax shield approach. The revenues and
variable costs are growing annuities, growing at different rates. The fixed costs and depreciation are
ordinary annuities. Using the growing annuity equation, the present value of the revenues is:
PV of revenues = C {[1/(r g)] [1/(r g)] [(1 + g)/(1 + r)]t}(1 tC)
PV of revenues = $400,000{[1/(.15 .05)] [1/(.15 .05)] [(1 + .05)/(1 + .15)]5} PV
of revenues = $1,461,850.00
And the present value of the variable costs will be:
PV of variable costs = C {[1/(r g)] [1/(r g)] [(1 + g)/(1 + r)]t}(1 tC)

PV of variable costs = $200,000{[1/(.15 .10)] [1/(.15 .10)] [(1 + .10)/(1 + .15)]5} PV

of variable costs = $797,167.58
The fixed costs and depreciation are both ordinary annuities. The present value of each is: PV
of fixed costs = C({1 [1/(1 + r)]t } / r )
PV of fixed costs = $50,000({1 [1/(1 + .15)]5 } / .15)
PV of fixed costs = $167,607.75
PV of depreciation = C({1 [1/(1 + r)]t } / r )
PV of depreciation = $80,000({1 [1/(1 + .15)]5 } / .15) PV
of depreciation = $268,172.41
Now, we can use the depreciation tax shield approach to find the NPV of the project, which is: NPV
= $425,000 + ($1,461,850.00 797,167.58 167,607.75)(1 .34) + ($268,172.41)(.34)
+ $25,000 / 1.155
NPV = $6,677.31
30. This is an in-depth capital budgeting problem. Probably the easiest OCF calculation for this problem
is the bottom up approach, so we will construct an income statement for each year. Beginning with
the initial cash flow at time zero, the project will require an investment in equipment. The project
will also require an investment in NWC. The NWC investment will be 15 percent of the next years
sales. In this case, it will be Year 1 sales. Realizing we need Year 1 sales to calculate the required
NWC capital at time 0, we find that Year 1 sales will be $27,625,000. So, the cash flow required for
the project today will be:
Capital spending
Change in NWC
Total cash flow

$21,000,000
1,500,000
$22,500,000

Now we can begin the remaining calculations. Sales figures are given for each year, along with the
price per unit. The variable costs per unit are used to calculate total variable costs, and fixed costs
are given at $900,000 per year. To calculate depreciation each year, we use the initial equipment cost
of $21 million, times the appropriate MACRS depreciation each year. The remainder of each income
statement is calculated below. Notice at the bottom of the income statement we added back
depreciation to get the OCF for each year. The section labeled Net cash flows will be discussed
below:
Year
Ending book value

1
$17,997,000

2
$12,852,000

3
$9,177,000

4
$6,552,000

5
$4,683,000

Sales
Variable costs
Fixed costs
Depreciation
EBIT

$27,625,000
20,400,000
900,000
3,003,000
3,322,000

$31,850,000
23,520,000
900,000
5,145,000
2,285,000

$34,450,000
25,440,000
900,000
3,675,000
4,435,000

$37,050,000
27,360,000
900,000
2,625,000
6,165,000

$30,225,000
22,320,000
900,000
1,869,000
5,136,000

Taxes

1,162,700

799,750

1,552,250

2,157,750

1,797,600

Net income
Depreciation
Operating cash flow

2,159,300
3,003,000
$5,162,300

1,485,250
5,145,000
$6,630,250

2,882,750
3,675,000
$6,557,750

4,007,250
2,625,000
$6,632,250

3,338,400
1,869,000
$5,207,400

Net cash flows

Operating cash flow

$5,162,300

$6,630,250

$6,557,750

$6,632,250

$5,207,400

Change in NWC
Capital spending
Total cash flow

(633,750)
$4,528,550

(390,000)
$6,240,250

(390,000)
$6,167,750

1,023,750
$7,656,000

1,890,000
4,369,050
$11,466,450

After we calculate the OCF for each year, we need to account for any other cash flows. The other
cash flows in this case are NWC cash flows and capital spending, which is the aftertax salvage of the
equipment. The required NWC capital is 15 percent of the sales in the next year. We will work
through the NWC cash flow for Year 1. The total NWC in Year 1 will be 15 percent of sales increase
from Year 1 to Year 2, or:
Increase in NWC for Year 1 = .15($31,850,000 27,625,000)
Increase in NWC for Year 1 = $633,750
Notice that the NWC cash flow is negative. Since the sales are increasing, we will have to spend
more money to increase NWC. In Year 4, the NWC cash flow is positive since sales are declining.
And, in Year 5, the NWC cash flow is the recovery of all NWC the company still has in the project.
To calculate the aftertax salvage value, we first need the book value of the equipment. The book
value at the end of the five years will be the purchase price, minus the total depreciation. So, the
ending book value is:
Ending book value = $21,000,000 ($3,003,000 + 5,145,000 + 3,675,000 + 2,625,000 + 1,869,000)
Ending book value = $4,683,000
The market value of the used equipment is 20 percent of the purchase price, or $4.2 million, so the
aftertax salvage value will be:
Aftertax salvage value = $4,200,000 + ($4,683,000 4,200,000)(.35)
Aftertax salvage value = $4,369,050
The aftertax salvage value is included in the total cash flows are capital spending. Now we have all of
the cash flows for the project. The NPV of the project is:
NPV = $22,500,000 + $4,528,550/1.18 + $6,240,250/1.182 + $6,167,750/1.183 + $7,655,000/1.184
+ $11,466,450/1.185
NPV = $1,465,741.71
And the IRR is:

NPV = 0 = $22,500,000 + $4,528,550/(1 + IRR) + $6,240,250/(1 + IRR)2 + $6,167,750/(1 + IRR)3

+ $7,655,000/(1 + IRR)4 + $11,466,450/(1 + IRR)5
IRR = 15.47%
We should reject the project.

32. To find the bid price, we need to calculate all other cash flows for the project, and then solve for the
bid price. The aftertax salvage value of the equipment is:
Aftertax salvage value = $50,000(1 0.35) = $32,500
Now we can solve for the necessary OCF that will give the project a zero NPV. The equation for the
NPV of the project is:
NPV = 0 = $780,000 75,000 + OCF(PVIFA16%,5) + [($75,000 + 32,500) / 1.165]
Solving for the OCF, we find the OCF that makes the project NPV equal to zero is:
OCF = $803,817.85 / PVIFA16%,5 = $245,493.51
The easiest way to calculate the bid price is the tax shield approach, so:
OCF = $245,493.51 = [(P v)Q FC ](1 tc) + tcD
$245,493.51 = [(P $8.50)(150,000) $240,000 ](1 0.35) + 0.35($780,000/5) P
= $12.06
38. We are given the real revenue and costs, and the real growth rates, so the simplest way to solve this
problem is to calculate the NPV with real values. While we could calculate the NPV using nominal
values, we would need to find the nominal growth rates, and convert all values to nominal terms. The
real labor costs will increase at a real rate of two percent per year, and the real energy costs will
increase at a real rate of three percent per year, so the real costs each year will be:

Real labor cost each year

Real energy cost each year

Year 1
$15.30
$5.15

Year 2
$15.61
$5.30

Year 3
$15.92
$5.46

Year 4
$16.24
$5.63

Remember that the depreciation tax shield also affects a firms aftertax cash flows. The present value
of the depreciation tax shield must be added to the present value of a firms revenues and expenses
to find the present value of the cash flows related to the project. The depreciation the firm will
recognize each year is:
Annual depreciation = Investment / Economic Life
Annual depreciation = $32,000,000 / 4
Annual depreciation = $8,000,000

Depreciation is a nominal cash flow, so to find the real value of depreciation each year, we discount
the real depreciation amount by the inflation rate. Doing so, we find the real depreciation each year
is:
Year 1 real depreciation = $8,000,000 / 1.05 = $7,619,047.62
Year 2 real depreciation = $8,000,000 / 1.052 = $7,256,235.83
Year 3 real depreciation = $8,000,000 / 1.053 = $6,910,700.79
Year 4 real depreciation = $8,000,000 / 1.054 = $6,581,619.80
Now we can calculate the pro forma income statement each year in real terms. We can then add back
depreciation to net income to find the operating cash flow each year. Doing so, we find the cash flow
of the project each year is:
Year 0
Revenues
Labor cost
Energy cost
Depreciation
EBT
Taxes
Net income
OCF
Capital spending

$32,000,000

Total cash flow

$32,000,000

Year 1
$40,000,000.00
30,600,000.00
1,030,000.00
7,619,047.62
$750,952.38
255,323.81
$495,628.57
$8,114,676.19

Year 2
$80,000,000.00
31,212,000.00
1,060,900.00
7,256,235.83
$40,470,864.17
13,760,093.82
$26,710,770.35
$33,967,006.18

Year 3
$80,000,000.00
31,836,240.00
1,092,727.00
6,910,700.79
$40,160,332.21
13,654,512.95
$26,505,819.26
$33,416,520.05

Year 4
$60,000,000.00
32,472,964.80
1,125,508.81
6,581,619.80
$19,819,906.59
6,738,768.24
$13,081,138.35
$19,662,758.15

$8,114,676.19 $33,967,006.18 $33,416,520.05 $19,662,758.15

We can use the total cash flows each year to calculate the NPV, which is:
NPV = $32,000,000 + $8,114,676.19 / 1.08 + $33,967,006.18 / 1.082 + $33,416,520.05 / 1.083
+ $19,662,758.15 / 1.084
NPV = $45,614,647.30

25. To calculate the unit sales for each scenario, we multiply the market sales times the companys
market share. We can then use the quantity sold to find the revenue each year, and the variable costs
each year. After doing these calculations, we will construct the pro forma income statement for each
scenario. We can then find the operating cash flow using the bottom up approach, which is net
income plus depreciation. Doing so, we find:
Units per year

Pessimistic
24,200

Expected
30,000

Optimistic
35,100

Revenue
Variable costs
Fixed costs
Depreciation
EBT
Tax
Net income
OCF

$2,783,000
1,742,400
850,000
300,000
$109,400
43,760
$65,640
$234,360

$3,600,000
2,100,000
800,000
300,000
$400,000
160,000
$240,000
$540,000

$4,387,500
2,386,800
750,000
300,000
$950,700
380,280
$570,420
$870,420

Note that under the pessimistic scenario, the taxable income is negative. We assumed a tax credit in the
case. Now we can calculate the NPV under each scenario, which will be:
NPVPessimistic = $1,500,000 +$234,360(PVIFA13%,5)
NPV = $675,701.68
NPVExpected = $1,500,000 +$540,000(PVIFA13%,5)
NPV = $399,304.88
NPVOptimistic = $1,500,000 +$870,420(PVIFA13%,5)
NPV = $1,561,468.43
The NPV under the pessimistic scenario is negative, but the company should probably accept the
project.

26. a.

Using the tax shield approach, the OCF is:

OCF = [($230 210)(40,000) $450,000](0.62) + 0.38($1,700,000/5)
OCF = $346,200
And the NPV is:
NPV = $1.7M 450K + $346,200(PVIFA13%,5) + [$450K + $500K(1 .38)]/1.135
NPV = $519,836.99

b.

In the worst-case, the OCF is:

OCFworst = {[($230)(0.9) 210](40,000) $450,000}(0.62) + 0.38($1,955,000/5)

OCFworst = $204,820
And the worst-case NPV is:
NPVworst = $1,955,000 $450,000(1.05) + $204,820(PVIFA13%,5) +
[$450,000(1.05) + $500,000(0.85)(1 .38)]/1.135
NPVworst = $2,748,427.99
The best-case OCF is:
OCFbest = {[$230(1.1) 210](40,000) $450,000}(0.62) + 0.38($1,445,000/5)
OCFbest = $897,220
And the best-case NPV is:
NPVbest = $1,445,000 $450,000(0.95) +
$897,220(PVIFA13%,5) + [$450,000(0.95) +
$500,000(1.15)(1 .38)]/1.135
NPVbest = $1,708,754.02
27. To calculate the sensitivity to changes in quantity sold, we will choose a quantity of 41,000. The
OCF at this level of sale is:
OCF = [($230 210)(41,000) $450,000](0.62) + 0.38($1,700,000/5)
OCF = $358,600
The sensitivity of changes in the OCF to quantity sold is:
OCF/Q = ($358,600 346,200)/(41,000 40,000)
OCF/Q = +$12.40
The NPV at this level of sales is:
NPV = $1.7M $450,000 + $358,600(PVIFA13%,5) + [$450K + $500K(1 .38)]/1.135
NPV = $476,223.32

And the sensitivity of NPV to changes in the quantity sold is:

NPV/Q = ($476,223.32 (519,836.99))/(41,000 40,000)
NPV/Q = +$43.61
You wouldnt want the quantity to fall below the point where the NPV is zero. We know the NPV
changes $43.61 for every unit sale, so we can divide the NPV for 40,000 units by the sensitivity to
get a change in quantity. Doing so, we get:
$519,836.99 = $43.61(Q)
Q = 11,919
For a zero NPV, we need to increase sales by 11,919 units, so the minimum quantity is:
QMin = 40,000 + 11,919
QMin = 51,919