Corporate Finance Canadian 7th

Edition Jaffe Solutions Manual

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 Chapter 8 : Net Present Value and Capital Budgeting

8.1 a. Yes, the reduction in the sales of the company’s other products, referred to as erosion, and should be
treated as an incremental cash flow. These lost sales are included because they are a cost
(a revenue reduction) that the firm must bear if it chooses to produce the new product.

b. Yes, expenditures on plant and equipment should be treated as incremental cash flows. These are costs of
the new product line. However, if these expenditures have already occurred, they are sunk costs and are not
included as incremental cash flows.

c. No, the research and development costs should not be treated as incremental cash flows. The costs of
research and development undertaken on the product during the past 3 years are sunk costs and should not
be included in the evaluation of the project. Decisions made and costs incurred in the past cannot be
changed. They should not affect the decision to accept or reject the project.

d. Yes, the annual CCA expense should be treated as an incremental cash flow. CCA expense must be taken
into account when calculating the cash flows related to a given project. While CCA is not a cash expense
that directly affects cash flow, it decreases a firm’s net income and hence, lowers its tax bill for the year.
Because of this CCA tax shield, the firm has more cash on hand at the end of the year than it would have
had without expensing depreciation.

e. No, dividend payments should not be treated as incremental cash flows. A firm’s decision to pay or not
pay dividends is independent of the decision to accept or reject any given investment project. For this
reason, it is not an incremental cash flow to a given project. Dividend policy is discussed in more detail in
later chapters.

f. Yes, the resale value of plant and equipment at the end of a project’s life should be treated as an
incremental cash flow. The price at which the firm sells the equipment is a cash inflow, and any difference
between the book value of the equipment and its sale price will create gains or losses that result in either a
tax credit or liability.

g. Yes, salary and medical costs for production employees on leave should be treated as incremental cash
flows. The salaries of all personnel connected to the project must be included as costs of that project. Thus,
the costs of employees who are on leave for a portion of the project life must be included as costs of that
project.

8.2 Since there is uncertainty surrounding the bonus payments, which Sundin might receive, you must use the
expected value of Sundin’s salary in the computation of the PV of his contract. The expected value of
Sundin’s salary is:

PV = $8,000,000+ $10,000,000 A122 .5% + [($3,000,000 A127 .5% )/ 1.1252] + $2,000,000 A122 .5%
= $8,000,000 + $16,790,123.46 + $10,648,416.98 + $3,358,024.69
= $38,796,565.12

Answers to End–of–Chapter Problems 8-1

8.3 Tax Shield Approach

Product A:

t=0 t = 1-14 t = 15
Revenues $180,000.00 $180,000.00
Foregone rent –61,000.00 –61,000.00
Expenditures –70,000.00 –70,000.00
Restoration costs –55,000.00
EBT 49,000.00 -6,000.00
Taxes at 34% 16,660.00 -2,040.00
Net operating cash flow 32,340.00 -3,960.00
Building Modifications tax shield 2,153.33 2,153.33
Capital investments -290,000.00
Tax shield on equipment 39,217.63
After tax cash flows -$250,782.37 $34,493.33 -$1,806.67

(1) Building Modifications: The tax shield on these is Straight–line and therefore can be included in the
annual cash flow calculations. The calculation of the annual tax shield is:
($95,000 / 15 ) x 0.34 = $2,153.33

(2) PV of CCA Tax Shield on the Equipment :

CDT c 1 + 0.5k
= x
k+d 1+ k
$195,000 x 0.20 x 0.34 1 + ( 0.5 x 0.12 )
= x = $39,217.63
0.12 + 0.20 1 + 0.12

NPV = – $250,782.37 + $34,493.33 A12

14
% – $1,806.67/(1.12)
15

= – $22,484.82

Product B:

t=0 t = 1-14 t = 15
Revenues $215,000.00 $215,000.00
Foregone rent –61,000.00 –61,000.00
Expenditures –90,000.00 –90,000.00
Restoration costs –80,000.00
EBT 64,000.00 16,000.00
Taxes at 34% 21760.00 -5,440.00
Net operating cash flow 42,240.00 –10,560.00
Building Modifications tax shield 2,833.33 2,833.33
Capital investments –355,000.00
Tax shield on equipment 46,256.70
After tax cash flows –$308,743.30 $45,073.33 –$7,726.67

Answers to End–of–Chapter Problems 8-2

 (3) Building Modifications: The tax shield on these is Straight–line and therefore can be included in the annual
cash flow calculations. The calculation of the annual tax shield is:

($125,000 / 15 ) x 0.34 = $2,833.33

(4) PV of CCA Tax Shield on the Equipment:

CDTc 1 + 0.5k
x
k+d 1+ k

$230,000 x 0.20 x 0.34 1 + (0.5 x 0.12)

= x = $46,256.70
0.12 + 0.20 1 + 0.12

NPV = – $308,743.30 + $45,073.33 A12

14
% – $7,726.67/(1.12)
15

= – $11,401.30

Since both projects have negative NPVs, Victoria should continue to rent the building.

8.4 The price will rise by the NPVGO per share

EPS = $750,000 / 320,000 = $2.34

NPVGO = (–$1,800,000 + $2,500,000) / 320,000 = $2.19

Price = [EPS / r ] + NPVGO

= [$2.34 / 0.15] + $2.19
= $17.81

8.5 Real interest rate = (1.13 / 1.05) – 1 = 0.07619 or 7.619%

NPVA = –$55,000+ $30,000 / 1.07619 + $18,000 / 1.076192 + $18,000 / 1.076193

= –$55,000 + $27,876.10 +$15,541.54 +$14,441.25 = $2,858.91

NPVB = –$60,000+ $10,000 / 1.13 + $25,000/ 1.132 + $40,000/ 1.133

= –$60,000 + $8,849.55 + $19,578.66 + $27,722 = – $3,849.77

Choose project A as it has the higher positive NPV.

8.6 PV = $275,000 / { 0.13 – ( – 0.085 )}

= $226,337.45

8.7 a. The only mistake that Larry made was to discount at the risk–free rate of interest. The bankruptcy risk
adjustment to the cash flows was correct, but these should have been discounted by a risk–adjusted rate.
Given that Larry’s portfolio is un–diversified (all of his money would be in the restaurant), he should have
used a higher discount rate. The deduction of the managerial wage was appropriate since the opportunity to
earn that amount elsewhere is Larry’s opportunity cost of working in the restaurant.

Answers to End–of–Chapter Problems 8-3

 ADD: Larry's calculation is : ( $35,715.93 / ( 0.02 – ( – 0.065 ) ) / ( 1/1.02 4) = $388,188.24.

b. You should have chosen a higher discount rate and recomputed the value of the restaurant. For example,
with a discount rate of 10%, the value is ( $35,715.93 / ( 0.10 – ( – 0.065)) /(1/1.10 4) = $286,993.67.
Notice that the restaurant’s cash flows form a declining perpetuity.

8.8 The simplest approach to this problem is to discount the real cash flows. Since the revenues and costs are
growing perpetuities, the formula for computing the PV of such a stream can be used. The first year amounts
of the revenues and costs are stated in nominal terms. Since the growth rate and discount rate are real rates,
adjust the initial amounts. For revenues, labour costs and the other costs, those amounts are
$265,000 / 1.06, $185,000 / 1.06 and $55,000 / 1.06, respectively.

PV ( revenue ) = ( $265,000 / 1.06 ) / ( 0.10 – 0.04 ) = $4,166,666.67

PV ( labour costs ) = ( $185,000 / 1.06 ) / ( 0.10 – 0.03 ) = $2,493,261.46
PV (other costs) = ( $55,000 / 1.06) / { 0.10 – 0.01 } = $576,519.92

The lease payment is given in nominal terms and it should be discounted by the nominal rate which is
0.166 = (1.06  1.10) – 1.

Thus, the present value of the lease payments is $90,000 / 0.166 = $542,168.67.

To find the NPV of BICC’s toad ranch, deduct the present values of the costs from the present value of
revenues. Recall, the start–up costs are negligible.

NPV = $4,166,666.67 – $2,493,261.46 – $576,519.92 – $542,168.67

= $554,716.62

8.9 The analysis of the NPV of this project is most easily accomplished by separating the CCA costs from the
project's other cash flows. The CCA costs are in nominal terms. Those costs should be discounted at a riskless
rate. The riskless nominal rate is given. The revenues, labour costs and energy costs are given in real terms, so
they are most easily discounted using the real rate for risky cash flows. Remember, you can use different types
of discount rates (real vs. nominal) in a problem as long as you are careful to discount real cash flows with the
real rate and nominal cash flows with the nominal rate.
First, determine the net income from the revenues and expenses not including depreciation.

t=1 t=2 t=3 t=4

Revenues $32,000.00 $64,000.00 $80,000.00 $32,000.00
Labor costs –30,800.00 –31,108.00 –31,419.08 –31,733.27
Energy costs –1,323.00 –1,356.08 –1,389.98 –1,424.73
EBT –123.00 31,535.93 47,190.94 –1,158.00
Taxes 40% –49.20 12,614.37 18,876.38 –463.20
Net Income –$73.80 $18,921.56 $28,314.57 –$694.80

The NPV of the project is the present value of the net income in each year plus the present value of the CCA tax
shield.

PV CCATS = [( $56,000 x 0.20 x 0.4 )/ ( 0.07+0.20 )] (1.035/1.07) = $16,049.84

Answers to End–of–Chapter Problems 8-4

 NPV = –$56,000 +$16,049.84 – $73.80/1.04 + $18,921.56/1.042 + $28,314.57/1.043 – $694.80/1.044
= –$56,000 +$16,049.84 – $70.96 + $17,494.04 + $25,171.55 – $593.92
= $2050.55

8.10 Initial revenues = $2.00  4,600,000 = $9,200,000

Initial expenses = $0.45  4,600,000 = $2,070,000

PV after tax = $9,200,000 (1 – 0.34) / (0.12 – 0.06) – $$2,070,000 (1 – 0.34) / (0.12 – 0.04)
= $101,200,000 – $17,077,500
= $84,122,500
8.11 The analysis of the NPV of this project is most easily accomplished by separating the CCA costs from the
project's other cash flows. The CCA costs are in nominal terms. Those costs should be discounted at a
riskless rate. The riskless nominal rate is given. The revenues and variable costs are given in nominal terms.
The revenues grow at the rate of 5% and the costs grow at the rate of 2%. Hence, they are discounted using
the nominal rate for risky cash flows.

First, determine the net income from the revenues and expenses not including CCA.

t=1 t=2 t=3 t=4 t=5

Revenue $4,500,000.00 $4,725,000.00 $4,961,250.00 $5,209,312.50 $5,469,778.13
Variable costs –375,000.00 –382,500.00 –390,150.00 –397,953.00 –405,912.06
Pre–tax earnings 4,125,000.00 4,342,500.00 4,571,100.00 4,811,359.50 5,063,866.07
Taxes at 38% 1,567,500.00 1,650,150.00 1,737,018.00 1,828,316.61 1,924,269.10
Net earnings 2,557,500.00 2,692,350.00 2,834,082.00 2,983,042.89 3,139,596.96
Sales proceeds 750,000.00
Net cash flows $2,557,500.00 $2,692,350.00 $2,834,082.00 $2,983,042.89 $3,889,596.96
PV at 25%* $2,046,000.00 $1,723,104.00 $1,451,049.98 $1,221,854.37 $1,274,543.13

The PV of the annual net operating cash flows using the nominal discount rate of 25% is $7,716,551.48
.
The NPV of the project is the present value of the net income in each year plus, the present value of the CCA tax
shield.
PV of CCA TS = Cd Tc / (k+d) [(1+.5k)/(1+k)] – SdTc/(k+d) [1/(1+k)T ]
= ( $9,000,000 x 0.25 x 0.38 ) / ( 0.24 + 0.25 ) [ ( 1.12/1.24 )]
– ( $750,000 x 0.25 x .0.38 ) / ( 0.24 + 0.25 ) [( 1/1.245 )]
= $1,576,036.87 – $49,599.85
= $1,526,437.02
Again, the CCA tax Shield is in nominal terms, so discount it using the nominal riskless rate.

NPV = –$9,000,000 + $7,716,551.48 + $1,526,437.02 = $242,988.50

.

Note that International Buckeyes will continue the CCA pool by replacing the plant so there are no further tax
implications for the sale of the factory.

Answers to End–of–Chapter Problems 8-5

8.12 Let I be the maximum price the Majestic Mining Company should be willing to pay for the equipment.
Examine the incremental cash flows from purchasing the new equipment.

1 − (1 + 0.14) −5   ( I − 35,000)(0.40)(0.30)  1.07 

NPV = 0 = 12,500(1 − 0.40)  +  1.14 
 0.14   0.14 + 0.30
 (6,000 − 0)(0.40)(0.30) 
−  (1 + 0.14) − 5 + (6,000 − 0)(1 + .14) − 5 − ( I − 35,000)
 0.14 + 0.30 
I  $70,487,331.66

The maximum price Majestic should be willing to pay for the equipment is $70,487 ,331 .66 .

8.13 Analyze the cash flows in real terms.

Headache Only:

After–tax operating income = [ ( 3,000,000 x $8.35 ) – ( 3,000,000 x $4.1 ) ] (1 – 0.34)

= $8,415,000

The CCA tax shield is in nominal terms, so discount it using the nominal rate.

Nominal discount rate = ( 1.07 x 1.03 ) – 1 = 0.1021 or 10.21%

PV of CCATS = ( $23,000,000 x 0.25 x 0.34)/( 0.1021 + 0.25)]( 1+0.5(0.1021)) / 1.1021) = $5,295,209

The headache pill equipment has no resale value.

NPV = –$23,000,000 + $8,415,000 A7%

3
+ $5,295,209
= –$23,000,000 + $22,083,619.51 + $5,295,209
= $4,378,829

Headache and Arthritis:

After–tax operation income = [ (4,500,000 x $8.35) – ( 4,500,000 x $4.65)] ( 1– 0.34 )

= $10,989,000

Sale proceeds in nominal terms = $1,000,000 x (1.03)3 = $1,092,727

PV of CCA TS = [( $32,000,000 x 0.25 x 0.34) / ( 0.1021 + 0.25 ) ] ( 1+ 0.5(0.1021 ) / 1.1021)

– [($1,092,727 x 0.25 x 0.34 ) / ( 0.1021 + 0.25 ) ] ( 1/1.10213 )
= $7,367,247.38 – $197,061.40 = $7,170,185.98

NPV = –$32,000,000 + $10,989,000 A73% + $1,000,000/1.073 + $7,170,185.98

= –$32,000,000 + $28,838,609.01 + $816,297.88 + $7,170,185.98
= $4,825,092.87

The firm should choose to manufacture Headache and Arthritis.

Answers to End–of–Chapter Problems 8-6

8.14 Assume the tax rate is zero.

t=0 t=1 t=2 t=3 t=4

$12,500 $7,500 $7,500 $7,500 $4,300

The present value of one cycle is:

PV = $12,500 + $7,500 A83% + $4,300/ 1.084

= $12,500 + $19,328.23 + $3,160.63
= $34,988.86

The cycle is four years long, so use a four–year annuity factor to compute the equivalent annual cost (EAC).

EAC = $34,878.66/ A84%

= $10,563.86

The present value of such a stream in perpetuity is

$10,563.86/ 0.08 = $132,048.29

8.15 Real discount rate = ( 1.14 / 1.05) – 1 = 0.0857 or 8.57%

PV – XX40 = $900 + $120 / 1.0857 + $120 / 1.08572 + $120 / 1.08573

= $1,206.09

$1,206.09 = EAC 83.57% = EAC 2.5508

EAC = $472.84

PV – RH45 = $1,400 + $95 / 1.0857 + $95 / 1.08572 + $95 / 1.08573 + $95 / 1.08574 + $95/1.08575
= $1,773.67

$1,773.67 = EAC * 85.57% = EAC* 3.9333

EAC = $450.94

Choose RH45.

8.16 Mixer X Cost Savings

NPV = –$500,000 + $120,000 A135 %

= -$77,932.24
EAC = -$77,932.24 / A135 % = - $22,157.27

Mixer Y Cost Savings

NPV = –$650,000 + $140,000 A138 %

Answers to End–of–Chapter Problems 8-7

 = $21,827.84
EAC = $21,827.84 / A138 % = $4,548.63

Choose Mixer Y.

8.17 1) In nominal terms you could receive, one year from now, after–tax $10,544.00 ($10,000 + 10,000 x
0.08 x0.68) which is $10,138.46 in real terms ( $10,544/1.04 ).

Real interest rate = ( 1.08 / 1.04 ) – 1 = 0.03846 or 3.85%

2) In nominal terms you would receive $10,408,000.00 after–tax ($10,000 + 10,000 x 0.06 x 0.68) but only
$10,203.92 in real terms.

Real interest rate = (1.06 / 1.02) –1 = 0.0392 or 3.92%

The second alternative is better since you would have more purchasing power at the end of the year.
This illustrates how inflation is a hidden tax.

8.18 After–tax savings = $62,000 x (1 – 0.38) = $38,440

PV of CCA TS = [ ( $145,000 x 0.25 x 0.38) / ( 0.135 +0.25 ) ] ( 1+0.5x0.135 / 1.135)
= $33,651.38
NPV = –$145,000 + $38,440 A136 .5% + $33,651.38
= –$145,000 + $151,549.87 + $33,651.38
= $40,201.25

8.19
t=0 t=1-4 t=5
Investment -$180,000.00
Net working capital –42,500.00 $42,500.00

Revenue $420,000.00 420,000.00

Variable costs –285,000.00 –285,000.00
Fixed costs –30,000.00 –30,000.00
EBIT 105,000.00 105,000.00
Taxes at 40% 42,000.00 42,000.00
Net income 63,000.00 63,000.00

After tax cash flows -$222,500.00 $63,000.00 $105,500.00

PV of CCA TS = [ ( $180,000 x 0.25 x 0.40) / ( 0.18 + 0.25 ) ] ( 1.09 / 1.185 )

= $19,944.38

NPV = –$222,500 + $63,000 A184 % + $105,500/1.185 + $19,944.38

= –$222,500 + $169,473.89 + $46,115.02 + $19,944.38
= $13,033.29

Since the NPV is positive, it is a good project.

Answers to End–of–Chapter Problems 8-8

8.20
t=0 t=1 t=2 t=3 t=4 t=5
Investment -$1,200,000.00
Sale of asset $575,000.00
Working capital $225,000.00 -$225,000.00

Cost savings $440,000.00 $440,000.00 $440,000.00 $440,000.00 $440,000.00

CCA at 25% -150,000.00 -262,500.00 -196,875.00 -147,656.25 -110,742.19
EBIT 290,000.00 177,500.00 243,125.00 292,343.75 329,257.81
Taxes at 34% 98,600.00 60,350.00 82,662.50 99,396.88 111,947.66
NI 191,400.00 117,150.00 160,462.50 192,946.88 217,310.16
Add back CCA 150,000.00 262,500.00 196,875.00 147,656.25 110,742.19
Cash flow from 341,400.00 379,650.00 357,337.50 340,603.13 328,052.34
operations
Total cash flows -975,000.00 $341,400.00 $379,650.00 $357,337.50 $340,603.13 $678,052.34

Set NPV = - $975,000 + $341,400/(1+IRR) + $379,650/(1+IRR)2 + $357,337.50/(1+IRR)3 + $340,603.13/(1+IRR)4

+ $678,052.34/(1+IRR)5 = 0
IRR = 0.2509 or 25.09%

8.21 a. PV of CCATS= [ ( $60,500 x 0.25 x 0.41 ) / ( 0.13 + 0.25 ) ] ( 1.065/1.13)

= $15,380.37
$60,500 – $15,380.37 = PMT 13
6
%

PMT = $11,286.82

Cost savings must exceed $19,130.21 (11,286.82/0.59)

b. PV of CCATS = [ ($60,500 x 0.25 x 0.41) / ( 0.13 + 0.25 ) ] ( 1.065/1.13 )

– [( $21,000 x 0.25 x 0.41) / ( 0.13 + 0.25 ) ] [ 1/1.136)
= $15,380.37 – $2,720.75 = $12,659.62

$60,500 – $12,659.62= PMT 13

6
% + 21,000/(1.13)
6

PMT = $9,444.21

Cost savings must exceed $16,007.13 (9,444.21/ 0.59)

8.22 We ignore the cost of the marketing study since it is not incremental.

Operating Cash flow (years 1 – 8 ):= [ 12,000 ($10,130 – $8,200) – $12,000,000 ] (1 – 0.40) = $6,696,000

Answers to End–of–Chapter Problems 8-9

 NPV = −2,500,000 − 30,000,000 − 9,000,000 − 10,000,000 − 1,400,000 (1 − 0.4) + 6,696,000 A188 %
 9,000,000 x 0.05 x 0.40)  1.09   4,000,000 x 0.05 x 0.40) 
+    −  (1 + 0.18) −8
 0.18 + 0.05  1.18   0.18 + 0.05 
 30,000,000 x 0.20 x 0.40)  1.09   6,300,000 x 0.20 x 0.40) 
+    −  (1 + 0.18) −8
 0.18 + 0.20  1.18   0.18 + 0.20 
4,000,000 6,300,000 2,500,000 10,000,000
+ + + + = −$2,843,884.66
1.188 1.188 1.188 1.188

The net present value is negative, so they should not produce the robots.

8.23
340, 000
NPVA = −2,900, 000 − 80, 000 (1 − 0.35) A13%
8
+
(1 + 0.13)8
 2,900, 000 x 0.25 x 0.35)  1.065   340, 000 x 0.25 x 0.35) 
+    −  (1 + 0.13) −8
 0.13 + 0.25   1.13   0.13 + 0.25 
= - 2,434,782.06

EACA = – 2,434,782.06 / A138 % = – 507,376.25

420,000
NPVB = −5,700,000 − 69,000 (1 − 0.35) A13
12
% +
(1 + 0.13)12
 5,700,000 x 0.25 x 0.35)  1.065   420,000 x 0.25 x 0.35) 
+    −  (1 + 0.13) −12
 0.13 + 0.25   1.13   0.13 + 0.25 
= - 4,653,819.47
EAC B = – 4,653,819. 47 / A13 12
% = – 786,430.73

Choose equipment A as its EAC is lower.

Answers to End–of–Chapter Problems 8-10

 Mini Case # 1 Beaver Mining Company

To analyze this project, we must calculate the incremental cash flows generated by the project. Since net working
capital is built up ahead of sales, the initial cash flow depends in part on this cash
outflow. So, we will begin by calculating sales. Each year, the company will sell 500,000 tons under
contract, and the rest on the spot market. The total sales revenue is the price per ton under contract
times 500,000 tons, plus the spot market sales times the spot market price. The sales per year will be:

Year 1 Year 2 Year 3 Year 4

Contract $41,000,000 $41,000,000 $41,000,000 $41,000,000
Spot 9,120,000 13,680,000 17,480,000 6,840,000
Total $50,120,000 $54,680,000 $58,480,000 $47,840,000

The current aftertax value of the land is an opportunity cost. The initial outlay for net working
capital is the percentage required net working capital times Year 1 sales, or:

Initial net working capital = 0.05(50,120,000) = $2,506,000

So, the cash flow today is:

Equipment –$85,000,000
Land –5,500,000
NWC –2,506,000
Total –$93,006,000

Now we can calculate the OCF each year. The OCF is:

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Sales $50,120,000.00 $54,680,000.00 $58,480,000.00 $47,840,000.00
Var. costs –19,220,000.00 –21,080,000.00 –22,630,000.00 –18,290,000.00
Fixed costs –4,100,000.00 –4,100,000.00 –4,100,000.00 –4,100,000.00 –2,700,000.00 –6,000,000.00
CCA –10,625,000.00 –18,593,750.00 –13,945,312.50 –10,458,984.38
EBT 16,175,000.00 10,906,250.00 17,804,687.50 14,991,015.63 –2,700,000.00 –6,000,000.00
Tax - 38% 6,146,500.00 4,144,375.00 6,765,781.25 5,696,585.94 –1,026,000.00 –2,280,000.00
Net income 10,028,500.00 6,761,875.00 11,038,906.25 9,294,429.69 –1,674,000.00 –3,720,000.00
Add back
CCA. 10,625,000.00 18,593,750.00 13,945,312.50 10,458,984.38
OCF $20,653,500.00 $25,355,625.00 $24,984,218.75 $19,753,414.00 –$1,674,000.00 –$3,720,000.00

Years 5 and 6 are of particular interest. Year 5 has an expense of $2.7 million to reclaim the land, and it is the only
expense for the year. Taxes that year are a credit, an assumption given in the case. In Year 6, the charitable donation
of the land is an expense, again resulting in a tax credit. The land does have an opportunity cost, but no information
on the aftertax salvage value of the land is provided. The implicit assumption in this calculation is that the aftertax
salvage value of the land in
Year 6 is equal to the $6 million charitable expense.

Answers to End–of–Chapter Problems 8-11

Next, we need to calculate the net working capital cash flow each year. NWC is 5 percent of next
year’s sales, so the NWC requirement each year is:

Year 1 Year 2 Year 3 Year 4

Beg. NWC $2,506,000 $2,734,000 $2,924,000 $2,392,000
End NWC 2,734,000 2,924,000 2,392,000 0
NWC CF –$228,000 –$190,000 $532,000 $2,392,000

The last cash flow we need to account for is the salvage value. The fact that the company is keeping the equipment
for another project is irrelevant. The aftertax salvage value of the equipment should be used as the cost of equipment
for the new project. In other words, the equipment could be sold after this project. Keeping the equipment is an
opportunity cost associated with that project. The undepreciated capital cost (UCC) of the equipment is the original
cost, minus the accumulated depreciation, or:

UCC - Opening CCA UCC- Closing

$85,000,000 $10,625,000 $74,375,000
74,375,000 18,593,750 55,781,250
55,781,250
13,945,312.50 41,835,937.50
41,835,937.50
10,458,984.38 31,376,953.13

Since the market value of the equipment is $51 million and the UCC at year 4 is $31,376,953.13,
it incurs a recapture tax liability of:
Recapture tax liability on sale of equipment = ($51,000,000 – $31,376,953.13)(0.38) = $7,456,757.81

And the aftertax salvage value of the equipment is:

Aftertax salvage value =$51,000,000 – $7,456,757.81

Aftertax salvage value = $43,543,242.19

So, the net cash flows each year, including the operating cash flow, net working capital, and aftertax
salvage value, are:
Time Cash flow
0 –$93,006,000.00
1 20,653,500.00 – 228,000.00 = 25,425,500.00
2 25,355,625.00 – 190,000.00= 25,165,625.00
3 24,984,218.00 + 532,000.00 = 25,516,218.75
4 19,753,414.00 + 2,392,000.00–2,506,000.00+43,543,242.19= 63,182,656.25
5 –1,674,000.00
6 –3,720,000.00

So, the net present value for the project is:

NPV = –93,006,000.00 + 25,425,500.00/1.12 + 25,165,625.00/1.122 + 25,516,218.75/1.123

+ 63,182,656.25/1.124 – 1,674,000.00/1.125 – 3,720,000.00/1.126
NPV = $774,056.21
In the final analysis, the company should accept the project since the NPV is positive.

Answers to End–of–Chapter Problems 8-12

Mini Case # 2 Goodweek Tires, Inc.

The cash flow to start the project is the $160 million equipment cost and the $9 million required for
net working capital, yielding a total cash outflow today of $169 million. The research and
development costs and the marketing test are sunk costs.

We can calculate the future cash flows on a nominal basis or a real basis. Since the depreciation is
given in nominal values, we will calculate the cash flows in nominal terms. The same solution can be
found using real cash flows. Since the price and variable costs increase by 1 percent, and the
inflation rate is 3.5 percent, the nominal growth in both variables is:

(1 + R) = (1 + r)(1 + h)
R = [(1.01)(1.0325)] – 1
R = 0.0428 or 4.28%

To analyze this project, we must calculate the incremental cash flows generated by the project. We
will calculate the real cash flows, although using nominal cash flows will result in the same NPV.
The sales of new automobiles will grow by 2.5 percent per year, and there are four tires per car.
Since the company expects to capture 11 percent of the market, the number of tires sold in the OEM
market will be:
Year 1 Year 2 Year 3 Year 4
Automobiles sold 6,200,000 6,355,000 6,513,875 6,676,722
Tires for automobiles sold 24,800,000 25,420,000 26,055,500 26,706,888
SuperTread tires sold 2,728,000 2,796,200 2,866,105 2,937,758

The number of tires sold in the replacement market will grow at 2 percent per year, and Goodweek
will capture 8 percent of the market. So, the number of tires sold in the replacement market will be:

Year 1 Year 2 Year 3 Year 4

Total tires sold in market 32,000,000 32,640,000 33,292,800 33,958,656
SuperTread tires sold 2,560,000 2,611,200 2,663,424 2,716,692

The tires will be sold in each market at a different price. The price will increase each year at 1% above the
inflation rate, so the price each year will be:
Year 1 Year 2 Year 3 Year 4
OEM $41.00 $42.76 $44.59 $46.50
Replacement $62.00 $64.66 $67.42 $70.31

Multiplying the number of tires sold in each market by the respective price in that market, the
revenue each year will be:
Year 1 Year 2 Year 3 Year 4
OEM market $111,848,000.00 $119,553,837.87 $127,790,574.25 $136,594,785.73
Replacement
market $158,720,000.00 $168,827,527.68 $179,578,717.88 $191,014,560.01
Total $270,568,000.00 $288,381,365.55 $307,369,292.13 $327,609,345.73

Answers to End–of–Chapter Problems 8-13

Now we can calculate the incremental cash flows each year. We will calculate the nominal cash
flows. Doing so, we find:

Year 1 Year 2 Year 3 Year 4

Revenue 270,568,000.00 288,381,365.55 307,369,292.13 327,609,345.73
Variable costs –153,352,000.00 –163,479,220.50 –174,276,273.63 –185,787,531.76
Mkt. and general costs –43,000,000.00 –44,397,500.00 -45,840,418.75 –47,330,232.36
CCA –20,000,000.00 –35,000,000.00 –26,250,000.00 –19,687,500.00
EBT 54,216,000.00 45,504,645.05 61,002,599.75 74,804,081.62
Tax at 40% 21,686,400.00 18,201,858.02 24,401,039.90 29,921,632.65
Net income 32,529,600.00 27,298,638.95 36,592,717.56 44,868,312.31
Add CCA 20,000,000.00 35,000,000.00 26,250,000.00 19,687,500.00
OCF 52,529,600.00 62,302,787.03 62,851,559.85 64,569,948.97

Net working capital is a percentage of sales, so the net working capital requirements will change
every year. The net working capital cash flows will be:
Beginning 9,000,000.00 40,585,200.00 43,257,204.83 46,105,393.82
Ending 40,585,200.00 43,257,204.83 46,105,393.82 …………….0
NWC cash flow –31,585,200.00 -2,672,004.83 -2,848,188.99 46,105,393.82

The undepreciated cost of capital of the equipment is the original cost minus the accumulated depreciation.
The undepreciated capital cost (UCC) of the equipment is the original cost, minus the accumulated depreciation, or:

UCC - Opening CCA UCC- Closing

$160,000,000. $20,000,000 $140,000,000
140,000,000 35,000,000 105,000,000
105,000,000 26,250,000 78,750,000
78,750,000 19,687,500 59,062,500
59,062,500 14,765,625 44,296,875

Since the market value of the equipment is $65 million, the equipment is sold at a gain to book
value, so the sale will incur the taxes of:

Recapture tax on sale of equipment = ($65,000,000 – $44,296,875.)(0.40) = $8,281,250.00

And the aftertax salvage value of the equipment is:

Aftertax salvage value = $65,000,000 – $8,281,250

Aftertax salvage value = $56,718,750

Answers to End–of–Chapter Problems 8-14

So, the net cash flows each year, including the operating cash flow, net working capital, and aftertax
salvage value, are:
Time Cash flow
0 –160,000,000.00 – 9,000,000.00= –$169,000,000.00
1 52,529,600.00 – 31,585,200.00= $20,944,400.00
2 62,302,787.03 – 2,672,004.83 = $59,627,671.14
3 62,851,559.85– 2,848,188.99= $54,995,702.12
4 64,569,948.97 + 46,105,393.82 –9,000,000.00+56,718,750.00 = $158,394,092.79

So, the capital budgeting analysis for the project is:

NPV = –169,000,000.00 + 20,944,400.00/1.134 + $59,630,782.20/1.1342 + $60,003,370.86/1.1343

+ 158,394,092.79/1.1344
NPV = $32,769,738.91

In the final analysis, the company should accept the project since the NPV is positive.

Answers to End–of–Chapter Problems 8-15