MANAGEMENT ADVISORY SERVICES Capital Budgeting

1 3
. Net Investment, Incremental Cash Flow & Income Tax L&H . Net Present Value L & H 10e
Rusk Company is considering replacing a machine that has the following characteristics. Warrenton Golf currently produces 200,000 cases of golf balls per year at a variable cost of
Book value $200,000 $9.75. Equipment is available for $500,000 that will reduce variable costs by $2.25 per unit,
Remaining useful life 4 years while increasing cash fixed costs by $200,000. The equipment will have no salvage value at
Annual straight-line depreciation $ ??? the end of its four-year life. Warrenton faces a 40% income tax rate and a 12% cutoff rate.
Current market value $160,000 Required:
The replacement machine would cost $300,000, have a four-year life, and save $37,500 per 1. Determine the NPV of the investment.
year in cash operating costs. It would be depreciated using the straight-line method. The tax 2. Determine the change in NPV if the equipment has a $25,000 residual value.
rate is 40%.
4
. Net Present Value G&N
Required: Vernon Company has been offered a 7-year contract to supply a part for the military. After
a. Find the net investment required to replace the existing machine. careful study, the company has developed the following estimated data relating to the contract:
b. Compute the increase in annual income taxes if the company replaces the machine. Cost of equipment needed ............................. $300,000
c. Compute the increase in annual net cash flows if the company replaces the machine. Working capital needed ............................... $ 50,000
Annual cash receipts from the delivery of parts, less cash operating costs $ 70,000
2
. Payback Period Horngren Salvage value of equipment at termination of the contract $ 5,000
Terrain Vehicle has received three proposals for its new vehicle-painting machine. Information It is not expected that the contract would be extended beyond the initial contract period. The
on each proposal is as follows: company's discount rate is 10%.
Proposal X Proposal Y Proposal Z
Initial investment in equipment $180,000 $120,000 $190,000 Required:
Working capital needed 0 0 10,000 Use the net present value method to determine if the contract should be accepted. Round all
Annual cash saved by operations: computations to the nearest dollar.
Year 1 75,000 50,000 80,000
5
Year 2 75,000 48,000 80,000 . Net Present Value L & H 10e
Year 3 75,000 44,000 80,000 Fidsound has developed a new high-performance videotape. The managers’ expectations
Year 4 75,000 8,000 80,000 appear below.
Salvage value end of year: Annual volume 60,000 units for four years
Year 1 100,000 80,000 60,000 Selling price $9
Year 2 80,000 60,000 50,000 Unit variable cost $4
Year 3 40,000 40,000 30,000 Cost of required machinery $300,000
Year 4 10,000 20,000 15,000 Annual cash fixed costs $140,000
Working capital returned 0 0 10,000 Increase in receivables $80,000
Increase in inventory $20,000
Required:
1. Determine each proposal's payback.
2. Determine each proposal’s bailout payback.

Exercises & Problems Page 1 of 16

MANAGEMENT ADVISORY SERVICES Capital Budgeting

The increase in working capital will be returned in full at the end of the four years. The tax rate Required: (Moderate)
is 40% and cost of capital is 12%. a. Machine A will cost $25,00 and have a life of 15 years. Its salvage value will be $1,000,
and cost savings are projected at $3,500 per year. Compute the machine’s net present
Required: value.
Determine the NPV of the investment. b. How much will Prince Company be willing to pay for Machine B if the machine promises
annual cash inflows of $5,000 per year for 8 years?
6
. Relationships L & H 10e c. Machine C has a projected life of 10 years. What is the machine's internal rate of return if it
Fill in the blanks for each of the following independent cases. There are no salvage values for costs $30,000 and will save $6,000 annually in cash operating costs? Interpolate to the
the investments. nearest tenth of a percent. Would you recommend purchase? Explain.
A. B. C. D. E. F. G.
9
Annual . Investment, Profitability Index & IRR Barfield
After-tax Cutoff Internal Net (Present value tables needed to answer this question.) Jane has an opportunity to invest in a
Useful Cash Rate of Rate of Present Profitability project that will yield four annual payments of $12,000 with no salvage. The first payment will
Case life Flows Investment Return Return Value Index be received in exactly one year. On low-risk projects of this type, Jane requires a return of 6
1 15 $40,000 _______ ___% 14% ____ 1.109 percent. Based on this requirement, the project generates a profitability index of 1.03953.
2 8 ______ $448,470 16% 18% ____ ____
3 __ $80,000 $361,600 12% ___% ____ 1.25 REQUIRED:
a. How much is Jane required to invest in this project?
7
. Relationships L & H 10e b. What is the internal rate of return on Jane's project?
Required: 10
Fill in the blanks for each of the following independent cases. Each investment has a useful life . After-tax Cash Flow, ARR, NPV, PI & IRR Barfield
of ten years and no salvage value. The Sun Corp. is contemplating the acquisition of an automatic car wash. The following
A. B. C. D. E. information is relevant:
 The cost of the car wash is $160,000
Annual Net Investment Cost of Internal Rate Net Present
 The anticipated revenue from the car wash is $100,000 per annum.
Cash Inflow Capital of Return Value
 The useful life of the car wash is 10 years.
1. $ 45,000 $ 188,640 14% ____ $_______
 Annual operating costs are expected to be:
2. $ 75,000 $_______ 12% 18% $_______
3. $______ $ 300,000 ____ 16% $ 81,440 Salaries $30,000
4. $______ $ 450,000 12% ____ $115,000 Utilities 9,600
Water usage 4,400
8 Supplies 6,000
. Investment, NPV & IRR G&N
Repairs/maintenance 10,000
Prince Company’s required rate of return is 10%. The company is considering the purchase of
three machines, as indicated below. Consider each machine independently.  The firm uses straight-line depreciation.
 The salvage value for the car wash is zero.

Exercises & Problems Page 2 of 16

MANAGEMENT ADVISORY SERVICES Capital Budgeting
12
 The company's cutoff points are as follows: . Accounting Rate of Return, Payback & NPV L&H
Payback 3 years Scottso has an investment opportunity costing $180,000 that is expected to yield the following
Accounting rate of return 18% cash flows over the next five years:
Internal rate of return 18% Year One $ 30,000
Ignore income taxes. Year Two $ 60,000
Year Three $ 90,000
REQUIRED: Year Four $ 60,000
a. Compute the annual cash inflow. Year Five $ 30,000
b. Compute the net present value.
c. Compute internal rate of return. Required:
d. Compute the payback period. a. Find the payback period of the investment.
e. Compute the profitability index. b. Find the book rate of return of the investment.
f. Should the car wash be purchased? c. Find the NPV of the investment at a cutoff rate of 12%.
13
11
. After-tax Cash Flow, NPV & Sensitivity Analysis L&H . Accounting Rate of Return, Payback, NPV & IRR L & H 10e
Frank Co. has the opportunity to introduce a new product. Frank expects the product to sell for Janet Prawl is the owner-manager of a small maker of custom windows. She has the
$60 and to have per-unit variable costs of $35 and annual cash fixed costs of $4,000,000. opportunity to buy new, automated equipment that will speed up the production process. She
Expected annual sales volume is 275,000 units. The equipment needed to bring out the new is unsure whether it is good idea. She asks for your advice and gives you the following
product costs $6,000,000, has a four-year life and no salvage value, and would be depreciated information.
on a straight-line basis. Frank's cost of capital is 14% and its income tax rate is 40%. Cost of equipment $150,000
Annual cash savings $50,000
Required: The equipment should last five years and have no salvage value. Ms. Pawl tells you she wants
a. Compute the annual net cash flows for the investment. a 10% return on investments.
b. Compute the NPV of the project.
c. Suppose that some of the 275,000 units expected to be sold would be to customers who Required:
currently buy another of Frank's products, the X-10, which has a $12 per-unit contribution 1. Ignoring income tax,
margin. Find the sales of X-10 that can Frank lose per year and still have the investment A. Calculate the NPV of the investment.
in the new product return at least the 14% cost of capital. B. Calculate the approximate IRR on the investment.
d. Suppose that selling the new product has no complementary effects but that Frank's C. Determine the payback period for the investment.
production engineers anticipate some production problems in making the new product and D. Determine the book rate of return on the average investment.
are not confident of the $35 estimate of per-unit variable costs for the new product. Find 2. Assuming the company is subject to a 30% income tax rate,
the amount by which Frank's estimate of per-unit variable cost could be in error and the A. Calculate the NPV of the investment.
investment still have a return at least equal to the 14% cost of capital. B. Calculate the approximate IRR on the investment.
C. Determine the payback period for the investment.
D. Determine the book rate of return on the average investment.

Exercises & Problems Page 3 of 16

MANAGEMENT ADVISORY SERVICES Capital Budgeting
14
. Accounting Rate of Return & NPV L & H 10e this project?
Graham Auto Products is bringing out a new heavy-duty battery and has two choices with 7. Assume that the asset in this project is actually a replacement for one now in use that has
respect to the manufacturing process. No matter which choice it makes, it expects to sell a remaining life of four years, a book value (and tax basis) of $25,000, and a current
100,000 units per year for four years at $50 per unit. Data on the two processes are as market value of $40,000. What is the NPV of the project?
follows:
16
Labor-Intensive Capital-Intensive . NPV; PI; IRR; Fisher rate Barfield 4e
Process Process Scrooge Investments, which has a cost of capital of 12 percent, is evaluating two mutually
Per-unit variable cost $20 $10 exclusive projects (A and B), which have the following projections:
Annual fixed cash operating costs $400,000 $600,000 Project A Project B
Investment in equipment $4,000,000 $6,000,000 Investment $96,000 $160,000
After-tax cash flows $25,600 $30,400
Neither set of equipment is expected to have salvage value at the end of four years. The Asset life 6 years 10 years
company uses straight-line depreciation. The cutoff rate is 16% and the tax rate is 40%. A. Determine the net present value, profitability index, and internal rate of return for Projects A
and B.
Required: B. Using the answers to part (a), which is the more acceptable project? Why?
1. Which process will give the higher annual profit? C. What is the Fisher rate for the two projects?
2. Which process will give the higher book rate of return on average investment?
17
3. Which process will give the higher NVP? . Project Ranking Using Different Methods L & H 10e
4. Using the guidelines in Appendix A, write a memorandum to Morton Brown, Graham’s Baltusrol Inc. has the following three investment opportunities.
factory manager, giving and supporting your recommendation regarding which process A B C
should be selected. Cost $70,000 $ 70,000 $ 70,000
Cash inflows by year:
15
. Sensitivity Analysis L & H 10e Year 1 $35,000 $ 35,000 $ 4,000
Marshall Gear Works is considering machinery that costs $282,000 and has a useful life of four Year 2 35,000 10,000 8,000
years. The production manager believes that the machinery could reduce annual material and Year 3 0 45.000 10,000
labor costs by $100,000. Marshall pays a 30% income tax rate and requires a 12% return. Year 4 5,000 20,000 98,000
Marshall uses straight-line depreciation. Total $75,000 $110,000 $120,000
Average annual income $1,250 $10,000 $12,500
Required:
1. What is the IRR of this project? Required:
2. What is the NPV of this project? 1. Rank the investment opportunities in order of desirability using.
3. What is the PI on this project? A. Payback period.
4. What must annual savings be for the project to have a 12% IRR? B. Average book rate of return (use average net book value of the investment as the
5. For this question only, assume that Marshall could depreciate the asset evenly over three denominator), and
years for tax purposes, though the life of the project and the asset are still four years. C. NPV using a 16% discount rate.
What would the NVP of this project be? 2. Comment on the results.
6. For this question only, assume that undertaking this project means Marshall must increase 3. Determine the profitability index for each opportunity and rank the investments based on
its working capital by $12,000. What effect would this new information have on the NPV of
Exercises & Problems Page 4 of 16
MANAGEMENT ADVISORY SERVICES Capital Budgeting

these values.
18
. Project ranking & Fisher Rate Barfield 4e
Two independent potential capital projects are under evaluation by Bird & Company. Project 1
costs $400,000, will last 10 years, and will provide an annual annuity of after-tax cash flows of
$85,000. Project 2 will cost $600,000, last 10 years, and provide an annual annuity of $110,000
in annual after-tax cash flows.
A. At what discount rate would management be indifferent between these two projects?
B. What is this indifference rate called?
C. If the firm's cost of capital is 10 percent, which project would be ranked higher?

Solutions

Exercises & Problems Page 5 of 16

1
.Net Investment, Incremental Cash Flow & Income Tax
a. Net investment: $124,000 [$300,000 - $160,000 - 40% x ($200,000 - 160,000)]
b. Increase in income taxes: $5,000 [40% x ($37,500 pretax flow - $75,000 depreciation + $50,000 lost depreciation)]
c. Increase in cash flows: $32,500 ($37,500 - $5,000 increase in income taxes)

2
.Payback Period
1. Proposal X payback = $180,000/75,000 = 2.4 years
Proposal Y Cash Savings Savings Accumulated To Be Recovered
Year 0 $120,000
Year 1 $50,000 $ 50,000 70,000
Year 2 48,000 98,000 22,000
Year 3 44,000 142,000 0

Proposal Y payback = 2 years plus $22,000/$44,000 or 2.5 years.

Proposal Z payback = ($190,000 + $10,000)/80,000 = 2.5 years

2. Proposal X bailout payback = 1.33

Proposal Y bailout payback = 0.8
Proposal z bailout payback = 1.75

3
.Basic Cost Savings (10-15 minutes)
1. $107,400
Tax Cash Flow
Cash savings (200,000 x $2.25) $450,000 $450,000
Cash fixed costs 200,000 200,000
Pretax cash flow 250,000 250,000
Depreciation ($500,000/4) 125,000
Increase in pretax income 125,000
Income tax at 40% $ 50,000 50,000
Net cash flow $200,000
Present value factor, 12%, 4 years 3.037
Present value of future flows $607,400
Investment 500,000
Net present value $107,400

2. NPV increases $9,540, the present value of the after-tax cash from the $25,000 residual value to be received 4
years hence ($25,000 x 60% x .636), since the company can ignore salvage value for depreciation.

Note to the Instructor: This is a good time to remind the class that the sooner flows come in, the better. The total tax
savings from the asset are the same whether or not salvage value is included in the depreciation calculations. But
leaving salvage value out accelerates the savings, which are partly repaid when the gain is realized and taxed.

4
.Net Present Value
 Description Years Amount 10% Factor Present Value
Equipment 0 ($300,000) 1.000 ($300,000)
Working capital 0 ($ 50,000) 1.000 ($ 50,000)
Net annual cash inflow 1-7 $ 70,000 4.868 $340,760
Salvage value, equipment 7 $ 5,000 0.513 $ 2,565
Release of working capital 7 $ 50,000 0.513 $ 25,650
Net present value $ 18,975

5
.Net Present Value
$46,262
Tax Cash Flow
Contribution margin [60,000 x ($9 - $4)] $300,000 $300,000
Cash fixed costs 140,000 140,000
Pretax cash flow 160,000 160,000
Depreciation ($300,000/4) 75,000
Increase in taxable income $ 85,000
Increased income taxes at 40% 34,000 34,000
Net cash flow 126,000
Present value factor, 4 years, 12% 3.037
Present value of operating flows $382,662
Present value of return on working capital* 63,600
Total present value 446,262
Investment ($300,000 + $80,000 + $20,000) 400,000
Net present value $ 46,262

* ($80,000 + $20,000) x .636

6
.Relationships (25 minutes)
1. (c) $245,680

Annual cash flows $ 40,000

Present value factor, 14%, 15 years 6.142
Equals cost $245,680

(f) $26,779
Cost $245,680
Times profitability index 1.109
Equals total present value of future flows $272,459
Less cost 245,680
Net present value $ 26,779

(d) 12%
Present value of future flows $272,459
Divided by annual flows $ 40,000
Equals present value factor for 15 years, equals 12% factor 6.811

2. (b) $110,000
Investment $448,470
Divided by present value factor for 8 years, 18% 4.077
 Equals annual cash flow $110,000

(f) $29,370

Cash flow $110,000

Times the present value factor for 8 years at 16% 4.344
Equals total present value of future flows $477,840
Less cost 448,470
Net present value $ 29,370

(g) 1.065

Present value (from f) $477,840

Divided by investment $448,470
Profitability index 1.065

3. (a) 10 years
Present value of future flows (from part f) $452,000
Divided by annual flows $ 80,000
Equals present value factor for 12% cost of capital 5.65
That factor is appropriate for 12% and 10 years

(e) IRR = 17.84% Investment of $361,600 divided by annual flows of $80,000 produces a factor (4.52) for 10
years that falls between the factors for 16% and 18%.

(f) $90,400
Profitability index 1.25
Times investment $361,600
Equals total present value of future cash flows 452,000
Less investment 361,600
Net present value $ 90,400

7
.Relationships
1. (d) 20%, the factor for 20%, 10 years is 4.192
Cost $188,640
Divided by annual cash flow $ 45,000
Present value factor for 10 years 4.192

(e) $46,080
Annual cash flow $ 45,000
Times the present value factor for 14%, 10 years 5.216
Present value of future cash flows $234,720
Less cost 188,640
Net present value $ 46,080

2. (b) $337,050
Annual cash flow $ 75,000
Times present value factor for 18%, 10 years 4.494
Cost $337,050

(e) $86,700
 Annual cash flow $ 75,000
Times present value factor for 12%, 10 years 5.650
Present value of future cash flows $423,750
Less cost 337,050
Net present value $ 86,700

3. (a) $62,073
Cost $300,000
Divided by the present value factor, 16%, 10 years 4.833
Equals annual cash flow $ 62,073

(c) 10%, the factor for 10%, 10 years is 6.145.

Cost $300,000
Plus net present value 81,440
Total present value of future cash flows $381,440
Divided by annual cash flow $ 62,073
Equals present value factor for 10 years 6.145

4. (a) $100,000
Cost $450,000
Plus net present value 115,000
Total present value $565,000
Divided by present value factor for 12%, 10 years 5.650
Equals annual cash flow $100,000

(d) IRR = 17.96% the factor for 18%, 10 years is 4.494

Cost $450,000
Divided by annual cash flow $100,000
Equals present value factor for 10 years 4.500

8
.Investment, NPV & IRR
a. Year Amount 10% Factor Present Value
Investment required now ($25,000) 1.000 ($25,000)
Annual cost savings 1-15 3,500 7.606 26,621
Salvage value ..... 15 1,000 0.239 239
Net present value $ 1,860

b. Year Amount 10% Factor Present Value

Annual cash inflows 1-8 $ 5,000 5.335 $26,675
Since the present value of the cash inflows is $26,675, the company should be willing to pay up to this amount to
acquire the machine.

c. Investment required ÷ Net annual cash flow = Factor of the internal rate of return
$30,000 ÷ %6,000 = 5.000
14% factor ............ 5.216 5.216
True factor ........... 5.000
16% factor ............ 4.833
0.216 0.383

14% + 2%(0.216 ÷ 0.383) = 15.1%

The machine should be purchased, since the internal rate of return is greater than the required rate of return.
9
. Investment, Profitability Index & IRR
a. The present value of the $12,000 annuity is found by multiplying $12,000 by the annuity discount factor associated
with 6 percent interest for four years: $12,000 x 3.4651 = $41,581.20.
From the information on the profitability index, it is known that the present value of the cash inflows is 1.03953 times
the initial investment. Thus, the initial investment is $41,581.20/1.03953 = $40,000.
b. By dividing $40,000 by the annual cash inflow of $12,000, it is determined that the discount factor associated with
the IRR is 3.3333. This discount factor is associated with an interest rate that lies between 7 and 8 percent. Using
interpolation, the IRR is computed to be approximately 7.72 percent.

10
.After-tax Cash Flow, ARR, NPV, PI & IRR
a. Revenue $100,000
- cash expenses (60,000)
Annual inflow $ 40,000

b. PV inflow $40,000 x 4.4941 = $179,764

PV outflow $160,000 x 1.0 = (160,000)
NPV = $ 19,764

c. IRR factor = $160,000/$40,000 = 4.0 which is 21.41%

d. Payback = $160,000/$40,000 = 4 yrs.

e. $179,764/$160,000 = 1.123525

f. Car wash exceeds minimum on ARR and IRR, but not payback.

11
.After-tax Cash Flow, NPV & Sensitivity Analysis
a. Annual net cash flows: $2,325,000
[$2,875,000 pretax - 40% x ($2,875,000 - $1,500,000 depreciation)]
pretax income = 275,000 x ($60 - $35) - $4,000,000 = $2,875,000

b. NPV: $775,050 [($2,325,000 x 2.914) - $6,000,000]

c. Allowable loss of X-10 sales, approximately 36,941 units [($775,050/2.914)/60%]/12

d. Allowable error in per-unit VC, $1.61

{[($775,050/2.914)/60%]/275,000 units}

12
.Accounting Rate of Return, Payback & NPV
a. Payback period: 3.0 years (30,000 + 60,000 + 90,000)

b. Book rate of return: 20%

Average return: $54,000 ($270,000 total / 5 years)
Depreciation: 36,000 ($180,000 / 5 years)
Average income $18,000
Average investment: $180,000 / 2 = $90,000
Book rate of return = $18,000 / $90,000 = 20%

c. NPV: $6,930
 Cash Factor PV
1 30,000 .893 26,790
2 60,000 .797 47,820
3 90,000 .712 64,080
4 60,000 .636 38,160
5 30,000 .567 17,010
193,860
Investment 180,000
NPV 13,860

13
.Accounting Rate of Return, Payback, NPV & IRR
1. Basic Capital Budgeting Without Taxes
A. $39,550
Cash Flow
Cash savings $ 50,000
Present value factor, 5 years, 10% 3.791
Present value of future flows $189,550
Investment 150,000
Net present value $ 39,550

B. 19.86% $150,000/$50,000 = 3.0 = factor for five years. The closest factor is 2.991, the factor for 20%.

C. 3.0 years, as calculated in requirement 2.

D. 27%, income of $20,000 ($50,000 - $30,000 depreciation) divided by $75,000 average investment

Note to the Instructor: We stated that Ms. Pawl wanted a 10% return from the business because an entrepreneur
such as she would probably not speak of cost of capital or cutoff rates. You might want to delve into how a small
business operator might make such judgments.

2. Basic Capital Budgeting With Taxes

14

1. $16,804

Tax Cash Flow

Pretax cash flow $50,000 $ 50,000
Depreciation ($150,000/5) 30,000
Increase in pretax income 20,000
Income tax at 30% $ 6,000 6,000
Net cash flow $ 44,000
Present value factor, 4 years, 10% 3.791
Present value of future flows 166,804
Investment 150,000
Net present value $ 16,804

2. 14.29%%. $150,000/$44,000 = 3.409 = the factor for five years. The closest factor is 3.433, for 14%. The IRR is
therefore a bit over 14%.

3. 3.41 years, as calculated in requirement 2.

4. 18.7%, income of $14,000 ($20,000 - $6,000) divided by the $75,000 average investment.
.Comparison of NPV and Profit
1. The capital-intensive process gives the higher income.
Labor Intensive Capital Intensive
Sales (100,000 x $50) $5,000,000 $5,000,000
Variable costs at $20, $10 2,000,000 1,000,000
Contribution margin 3,000,000 4,000,000
Fixed costs* 1,400,000 2,100,000
Taxable income 1,600,000 1,900,000
Income taxes (40%) 640,000 760,000
Net income $ 960,000 $1,140,000

* $400,000 + ($4,000,000/4); $600,000 + ($6,000,000/4)

2. The labor-intensive process gives the higher book rate of return on average investment.
Labor Intensive Capital Intensive
Net income $ 960,000 $1,140,000
Divided by average investment $2,000,000 $3,000,000
Equals book rate of return 48% 38%

3. The labor intensive process has the higher NPV.

Labor Intensive Capital Intensive
Contribution margin from requirement 1 $3,000,000 $4,000,000
Fixed cash operating costs 400,000 600,000
Change in pretax cash flow 2,600,000 3,400,000
Depreciation ($4,000,000/4; $6,000,000/4) 1,000,000 1,500,000
Increase in taxable income 1,600,000 1,900,000
Increased taxes (40%) 640,000 760,000
Increase in net income 960,000 1,140,000
Add back depreciation (not a cash flow) 1,000,000 1,500,000
Net cash flow $1,960,000 $2,640,000
Present value factor, 4 years, 16% 2.798 2.798
Present value of future cash flows $5,484,080 $7,386,720
Investment required 4,000,000 6,000,000
Net present value $1,484,080 $1,386,720
Difference in NPVs = $97,360

4. The memo should report the NPVs of the two alternatives and express a preference for the labor-intensive process
because of its higher NPV. The memo should also note the relatively small difference between the NPVs and urge
further consideration of qualitative factors that might tip the decision one way or the other. The memo should
emphasize that the preference was based on NPV rather than book rate of return, and it could point out that book
rates of return overstate the differences between the two alternatives.

15
.Sensitivity Analysis
1. 11.13%
Tax Cash Flow
Annual cash flow:
Cost savings $100,000 $100,000
Depreciation ($282,000/4) 70,500
Increase in taxable income 29,500
Increase in income taxes, at 30% 8,850 8,850
 Increase in annual after-tax cash flows $ 91,150
Investment 282,000
Present value factor, $282,000/$91,150 3.094
Closest factors:
For 10% 3.170
For 12% 3.037

2. Negative $5,177.
Annual increase in after-tax cash flows (requirement 1) $ 91,150
Present value factor, 12%, 4 years 3.037
Total present value of increase in future cash flows $276,823
Less investment 282,000
Net present value ($ 5,177)

3. .982 $276,823 from requirement 2/$282,000

4. $102,436
Net present value, above ($ 5,177)
Divided by present-value factor for 12% for 4 years 3.037
Equals required annual after-tax cash flows $ 1,705
Divided by (1 - 30% tax rate) 70%
Equals required increase in pretax annual cash flow $ 2,436
Plus expected savings 100,000
Equals required savings to achieve 16% return $102,436

5. Negative $1,604
Years 1-3 Year 4
Tax Cash Flow Tax/Cash
Annual cash flows:
Savings $100,000 $100,000 $100,000
Depreciation ($282,000/3) 94,000
Taxable income $ 6,000 100,000
Taxes at 30% 1,800 1,800 30,000
Net cash flow $ 98,200 $ 70,000
Applicable present value factors:
Annuity factor for 12% and 3 years 2.402
Single-amount factor for 12%, 4 years . .636
Present value $235,876 $ 44,520

Total present value ($235,876 + $44,520) $280,396

Less investment 282,000
NPV ($ 1,604)

Note to the Instructor: This requirement is one of several opportunities to address the impact of using accelerated
depreciation for tax purposes without going into the specifics of MACRS.

6. NPV decreases $4,368

Decrease in NPV because of additional investment $12,000
Increase in NPV for present value of return of
working capital investment ($12,000 x .636) 7,632
Net decrease $ 4,368

7. $24,628
 Tax Cash Flow
Cost savings $100,000 $100,000
Additional depreciation:
Depreciation on new asset, as above $ 70,500
Depreciation on existing asset ($25,000/4) 6,250 64,250
Increase in taxable income $35,750
Increase in taxes at 30% 10,725 10,725
Increase in annual after-tax cash flow $ 89,275
Present value factor, 12%, 4 years 3.037
Present value of future flows $271,128
Less investment:
Purchase of new equipment $282,000
Sale of old asset:
Cash received $40,000 (40,000)
Less book value 25,000
Tax gain $15,000
Tax on gain at 30% 4,500
Net cost of investment 246,500
NPV $ 24,628

16
.NPV; PI; IRR; Fisher rate
a.
Year Cash Flow PV Factor Project A PV
0 $(96,000) 1.0000 $(96,000)
1-6 25,600 4.1114 105,252
NPV $ 9,252

PI = $105,252 ÷ $96,000 = 1.10

IRR: Discount factor for 6 periods is $96,000 ÷ $25,600 = 3.7500, which yields a rate of 15.34%.

Year Cash Flow PV Factor Project B PV

0 $(160,000) 1.0000 $(160,000)
1-10 30,400 5.6502 171,766
NPV $ 11,766

PI = $171,766 ÷ $160,000 = 1.07

IRR: Discount factor for 6 periods is $160,000 ÷ $30,400 = 5.2631, which yields a rate 13.77%.

b. Although the methods give conflicting results, the NPV of B is greater than that of A and this is probably the best
indication for choice. Although the IRR for Project A is higher, the reinvestment assumption of that method is less
attainable. Even though the PI of Project A is slightly higher, its NPV is less and usually dollars are the deciding
criterion when rates are close.

c. Project A's IRR is 15.5% and Project B's is 13.75%. Above 13.75%, Project B will have a negative NPV. At 12%,
Project A's NPV is $9,252 and Project B's is $11,766. By repeated trials, the Fisher rate (the rate at which the NPVs
are equal) is estimated to be between 12.50% and 13.0%. By programmable calculator, the rate is found to be
12.636676%. Net present value is $7,381
17
.Project Ranking Using Different Methods
1. (a) A 2.0 years
B 2.6 years
C 3.5 years

(b) C, B, A
A B C
Average income $ 1,250 $10,000 $12,500
Divided by average investment $70,000/2 $35,000 $35,000 $35,000
Equals book rate of return 3.6% 28.6% 35.7%

(c) B, C, A. Investment B is the only one with a positive NPV.

A B C
Cash Present Cash Present Cash Present
Year Flow Value Flow Value* Flow Value
1 $35,000 $30,170 $35,000 $30,170 $ 4,000 $ 3,448
2 35,000 26,005 10,000 7,430 8,000 5,944
3 0 0 45,000 28,845 10,000 6,410
4 5,000 2,760 20,000 11,040 98,000 54,096
Total $58,935 $77,485 $69,898
Investment 70,000 70,000 70,000
NPV ($11,065) $ 7,485 ($ 102)

* Present value factors are .862, .743, .641, and .552.

2. The results show that payback and book-rate-of-return rankings do not necessarily indicate relative profitability. B is
the only desirable investment, using discounted cash flow analysis.
Investment A illustrates that payback ignores profitability; the project has the quickest payback but little cash flow
after the payback period. Investment C has high income, but much of it comes in the last year, when the cash flow is
worth less than it would have been earlier. Investment C returns more in total than does A, but the wait is too long to
be worthwhile at 16%.

3. Comparison of Methods
Projec Total Present Value Investment Profitability Index Rank
t
A $58,935 $70,000 .842 3
B 77,485 70,000 1.107 1
C 69,898 70,000 .999 2
In this case, the rankings are the same as when the projects were analyzed using the net present value method.

18
.Project ranking & Fisher Rate
a. Find the rate that will cause the NPVs of the two projects to be equal. By trial and error, the indifference rate is just
above 4.277498%. At a 4.277498% rate the NPV of each project is computed as follows:
Project 1:
NPV = (8  $85,000) - $400,000
NPV = $280,000

Project 2:
NPV = (8  $110,000) - $600,000
 NPV = $280,000

b. This rate is known as the Fisher rate.

c. Project 1:
NPV = (6.1446  $85,000) - $400,000
NPV = $122,291

Project 2:
NPV = (6.1446  $110,000) - $600,000
NPV = $75,906

Project 1 would be preferred due to its higher NPV.