Chapter 8: Net Present Value and Capital Budgeting

Questions and Problems:

8.1 8.1 Which of the following should be treated as incremental cash flows when computing the
NPV of an investment?
A. The reduction in the sales of the company’s other products.
B. The expenditure on plant and equipment.
C. The cost of research and development undertaken in connection with the product during the past
three years.
D. The annual CCA expense.
E. Dividend payments.
F. The resale value of plant and equipment at the end of the project’s life.
G. Salary and medical costs for production employees on leave.

a. Yes, the reduction in the sales of the company’s other products, referred to as erosion, 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. The costs cannot be recovered if we reject the
project.

d. No, the annual CCA expense per se should not be treated as an incremental cash flow.
However, 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 taxable 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 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.

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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.

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8.2 Suppose Frederik Andersen is negotiating a new contract with the Toronto Maple Leafs in
2021. The Leafs offer him a two-year contract in January 2021 with the following provisions:
A. $8 million signing bonus.
B. $10 million per year for two years.
C. Seven years of deferred payments of $3 million per year, with the first payment starting at the end
of year 3.
D. A games-played bonus provision that totals $2 million per year for the two years of the contract.

Assume that Frederik achieved his bonus requirements both years and he signed the contract right
away on January 1, 2021. Assume that cash flows are discounted at 12.5 percent. Ignore any taxes.
Frederik’s signing bonus was paid on the day the contract was signed. His salary and bonuses, other
than the signing bonus, are paid at the end of the year. What was the PV of this contract in January
when Frederik signed it?

The PV of Sundin’s salary is:

PV = $8,000,000 + $10,000,000 × A20.125 + [($3,000,000 × A20.125 )/1.1252]

+ $2,000,000 × A20.125 = $38,796,565.12

8.3 Victoria Enterprises Inc. is evaluating alternative uses for a three-storey manufacturing and
warehousing building that it has purchased for $1,450,000. The company could continue to rent the
building to the present occupants for $61,000 per year. These tenants have indicated an interest in
staying in the building for at least another 15 years. Alternatively, the company could make
improvements to modify the existing structure to use for its own manufacturing and warehousing needs.
Victoria’s production engineer feels the building could be adapted to handle one of two new product
lines. The cost and revenue data for the two product alternatives follow:

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The building will be used for only 15 years for either product A or product B. After 15 years, the
building will be too small for efficient production of either product line. At that time, Victoria plans to
rent the building to firms similar to the current occupants. To rent the building again, Victoria will need
to restore the building to its present layout. The estimated cash cost of restoring the building if product A
has been undertaken is $55,000; if product B has been produced, the cash cost will be $80,000. These
cash costs can be deducted for tax purposes in the year the expenditures occur. Victoria will depreciate
the original building shell (purchased for $1,450,000) at a CCA rate of 5 percent, regardless of which
alternative it chooses. The building modifications are depreciated using the straight-line method over a
15-year life. Equipment purchases for either product are in class 8 and have a CCA rate of 20 percent.
The firm’s tax rate is 34 percent, and its required rate of return on such investments is 12 percent. For
simplicity, assume all cash flows for a given year occur at the end of the year. The initial outflows for
modifications and equipment will occur at t = 0, and the restoration outflows will occur at the end of year
15. Also, Victoria has other profitable ongoing operations that are sufficient to cover any losses. Which
use of the building would you recommend to management?

Tax Shield Approach

Product A:

t=0 t = 1– t = 15
14

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 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 2,153.33 2,153.33
tax shield
Capital investments –290,000.00
Tax shield on equipment 43,657.37
After tax cash flows –$246,342.63 $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) × 0.34 = $2,153.33

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

Cd T
= k +d c × 1+1.5
1+k
k

$ 195,000 × 0.20 ×0.34 1+1.5 ×0.12

= × =$ 43,657.37
0.12+0.20 1+0.12

NPV = –$246,342.63 + $34,493.33 × A14

0.12 – $1,806.67/(1.12)
15

= –$18,045.11

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 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 51,493.30
After tax cash flows –$303,506.70 $45,073.33 –$7,726.67

(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) × 0.34 = $2,833.33

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

Cd T
= k +d c × 1+1.5
1+k
k

$ 230,000 × 0.20 ×0.34 1+1.5 ×0.12

= 0.12+0.20
×
1+0.12
=$ 51,493.30

NPV = –$303,506.70 + $45,073.33 × A14

0.12 – $7,726.67/(1.12)
15

= – $6,164.72

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

8.4 The Regina Wheat Company (RWC) has wheat fields that currently produce annual profits of
$750,000. These fields are expected to produce average annual profits of $750,000 in real terms,
forever. RWC has no depreciable assets, so the annual cash flow is also $750,000. RWC is an all-
equity firm with 320,000 shares outstanding. The appropriate discount rate for its stock is 15
percent. RWC has an investment opportunity with a gross PV of $2.5 million. The investment
requires a $1.8 million outflow now. RWC has no other investment opportunities. Assume all
cash flows are received at the end of each year. What is the price per share of RWC?

The price will rise by the NPVGO per share

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

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

Price = (EPS/r) + NPVGO

= ($2.34/0.15) + $2.19
= $17.79

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8.5 Consider the following cash flows on two mutually exclusive projects:

Cash flows of project A are expressed in real terms, while those of project B are expressed in nominal
terms. The appropriate nominal discount rate is 13 percent, and inflation is 5 percent. Which project
should you choose?

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

= $2,858.92

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

= –$3,849.76

Choose project A as it has the higher positive NPV.

8.6 Phillips Industries runs a small manufacturing operation. For this year, it expects to have real net
cash flows of $275,000. Phillips is an ongoing operation, but it expects competitive pressures to
erode its (inflation-adjusted) net cash flows at 8.5 percent per year. The appropriate real discount
rate for Phillips is 13 percent. All net cash flows are received at year-end. What is the PV of the
net cash flows from Phillips’ operations?

PV = $275,000/[0.13 – (–0.085)]
= $1,279,069.77

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8.7 The Montreal IT Corporation is considering an investment in a cloud platform. The initial
investment is $5 million. There will be nominal cash flows of $2 million each year over the next
four years. The nominal discount rate is 10 percent. Using nominal cash flows, what is the NPV
of the project? If the inflation rate is 2 percent, what is the NPV of the project using cash flows in
real terms?

Using cash flows in nominal terms, we have:

4
NPV = –$5,000,000 + $2,000,000 × A0.10 = $1,339,730.89

Alternatively, we can compute NPV using the cash flows and discount rate in real terms.

Note that: (1+discount rate in real terms) = (1+discount rate in nominal terms)/(1+inflation rate)

NPV = –$5,000,000 + ($2,000,000/1.02)/(1.1/1.02) + ($2,000,000/(1.02)2)/(1.1/1.02)2

+ ($2,000,000/(1.02)3)/(1.1/1.02)3 + ($2,000,000/(1.02)4)/(1.1/1.02)4

NPV = –$5,000,000 + $2,000,000/1.1 + $2,000,000/(1.1)2 + $2,000,000/(1.1)3

+ $2,000,000/(1.1)4
NPV = $1,339,730.89

Thus, it does not matter whether we conduct the analysis in real or nominal terms. We always
find the same NPV as long as we maintain consistency between cash flows and discount rates.

8.8 The Biological Insect Control Corporation (BICC) has hired you as a consultant to evaluate the
NPV of its proposed toad ranch. BICC plans to breed toads and sell them as ecologically desirable
insect-control mechanisms. It anticipates that the business will continue in perpetuity. Following
the negligible start-up costs, BICC expects the following nominal cash flows at the end of the
year:

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The company will rent machinery for $90,000 per year. The rental payments start at the end of year 1
and are expressed in nominal terms. Revenues will increase by 4 percent per year in real terms.
Labour costs will increase by 3 percent per year in real terms. Other costs will increase by 1 percent
per year in real terms. The rate of inflation is expected to be 6 percent per year. BICC’s required rate
of return is 10 percent in real terms. There are no taxes. All cash flows occur at year-end. What is the
NPV of BICC’s proposed toad ranch today?

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

(1.06  1.10) – 1= 0.166

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 You are asked to evaluate the following project for a corporation with profitable ongoing operations.
The required investment on January 1 of this year is $56,000. The firm will depreciate the investment
at a CCA rate of 20 percent. The firm is in the 40 percent tax bracket. The price of the product on
January 1 will be $320 per unit. That price will stay constant in real terms. Labour costs will be $14
per hour on January 1. They will increase at 1 percent per year in real terms. Energy costs will be
$7.35 per physical unit on January 1; they will increase at 2.5 percent per year in real terms. The

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 inflation rate is 6 percent. Revenue is received and costs are paid at year-end:

The risk-free nominal discount rate is 7 percent. The real discount rate for costs and revenues is 4
percent. Calculate the NPV of this project.

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.

$ 56,000 × 0.20 ×0.4 1+1.5 ×0.07

PV CCATS = × =$ 17,135.34
0.07+0.20 1+0.07
NPV = –$56,000 + $17,135.34 – $73.80/1.04 + $18,921.56/1.042 + $28,314.57/1.043
– $694.80/1.044

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 = $3,136.06

8.10 Sparkling Water Inc. sells 4.6 million bottles of drinking water each year. Each bottle sells for
$2, and costs per bottle are $0.45. Sales income and costs occur at year-end. Sales income is
expected to rise at 6 percent annually in perpetuity, while costs are expected to rise at 4 percent
annually in perpetuity. The relevant discount rate is 12 percent. The corporate tax rate is 34
percent. What is Sparkling worth today?

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

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

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 PV after tax = $9,200,000 × (1 – 0.34)/(0.12 – 0.06) – $2,070,000 × (1 – 0.34)/(0.12 0.04)
= $84,122,500

8.11 International Buckeyes is building a factory that can make 1 million buckeyes a year for
five years. The factory costs $9 million. In year 1, each buckeye will sell for $4.50. The price
will rise 5 percent each year. During the first year, variable costs will be $0.375 per buckeye
and will rise by 2 percent each year. International Buckeyes will depreciate the factory at a
CCA rate of 25 percent.
International Buckeyes expects to be able to sell the factory for $750,000 at the end of year
5. Assume the company has other assets and UCC is always positive in the asset class. The
discount rate for risky cash flows is 25 percent. The discount rate for risk-free cash flows is
24 percent. Cash flows, except the initial investment, occur at the end of the year. The
corporate tax rate is 38 percent. What is the NPV of this project?

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 4,125,000.00 4,342,500.00 4,571,100.00 4,811,359.50 5,063,866.07
earnings
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 24% $2,062,500.00 $1,751,008.07 $1,486,439.91 $1,261,748.38 $1,326,771.63

The PV of the annual net operating cash flows using the nominal discount rate of 24% is
$7,888,467.99

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

PV of CCA TS = Cd Tc/(k+d) [(1+1.5k)/(1+k)] – SdTc/(k+d) [1/(1+k)T]

= ($9,000,000 × 0.25 × 0.38)/(0.24 + 0.25) × [(1.36/1.24)]
– ($750,000 × 0.25 × .0.38)/(0.24 + 0.25) × [(1/1.245)]

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 = $1,913,759.05 – $49,599.85
= $1,864,159.20

The asset disposal has no tax implications given the company has other assets and UCC is
always positive in the asset class.

NPV = –$9,000,000 + $7,888,467.99 + $1,864,159.20 = $752,627.19

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8.12 Marvellous Mining Company (MMC) is negotiating for the purchase of a new piece of
equipment for its current operations. MMC wants to know the maximum price that it should be
willing to pay for the equipment. That is, how high must the price be for the equipment to have
an NPV of zero? You are given the following facts:
A. The new equipment would replace existing equipment that has a current market value of $35,000.
B. The new equipment would not affect revenues, but before-tax operating costs would be
reduced by $12,500 per year for five years. These savings in cost would occur at year-end. C
The old equipment is now five years old. It is expected to last for another five years and to have no
resale value at the end of those five years. It was purchased for $40,000 and is being depreciated
at a CCA rate of 30 percent.
4. The new equipment will also be depreciated at a CCA rate of 30 percent. MMC expects to be able
to sell the equipment for $6,000 at the end of five years. At that time, the firm plans to reinvest
in new equipment in the same CCA pool. 5. MMC has profitable ongoing operations. 6. The
appropriate discount rate is 14 percent. 7. The tax rate is 40 percent. 8. Assume the net
acquisitions cost is positive.

Let I be the maximum price the Majestic Mining Company should be willing to pay for the
equipment. We are told that the net acquisitions cost ( I−35 , 000) is positive, so we need to
apply the 50% rule to this amount in the first year. Examine the incremental cash flows from
purchasing the new equipment.

[ ][ ][ ] [ ]
−5
1−( 1+0.14 ) ( I −35,000 )( 0.40 ) ( 0.30 ) 1.21 ( 6,000−0 )( 0.40 )( 0.30 )
NPV =0=12,500 (1−0.40 ) + − ( 1+
0.14 0.14 +0.30 1.14 0.14+0.30

I = $74,427.73

The maximum price Majestic should be willing to pay for the equipment is $74,427.73

8.12 After extensive medical and marketing research, Pill Ltd. believes it can penetrate the
pain reliever market. It can follow one of two strategies. The first strategy is to manufacture
a medication aimed at relieving headache pain. The second strategy is to make a pill
designed to relieve headache and arthritis pain. Both products would be introduced at a
price of $8.35 per package in real terms. The headache and arthritis remedy would
probably sell 4.5 million packages per year, while the headache-only medication is projected
to sell 3 million packages per year. Cash costs of production in the first year are expected to
be $4.10 per package in real terms for the headache-only brand. Production costs are
expected to be $4.65 in real terms for the headache and arthritis pill. All prices and costs are
expected to rise at the general inflation rate of 3 percent. Either strategy would require
further investment in plant. The headache-only pill could be produced using equipment that
would cost $23 million, last three years, and have no resale value. The machinery required
to produce the headache and arthritis remedy would cost $32 million and last three years.
The firm would be able to sell it for $1 million (in real terms). Suppose that for both projects
the firm will use a CCA rate of 25 percent. Assume the company has other assets and UCC
is always positive in the asset class. The firm faces a corporate tax rate of 34 percent.

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 Management believes the appropriate real discount rate is 7 percent. Which pain reliever
should Pill Ltd. produce?

Analyze the cash flows in real terms.

Headache Only:

After–tax operating income = [(3,000,000 × $8.35) – (3,000,000 × $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 × 1.03) – 1 = 0.1021 or 10.21%

PV of CCATS = ($23,000,000 × 0.25 × 0.34)/(0.1021 + 0.25)] × (1+1.5 × 0.1021)/1.1021)

= $5,809,590.72

The asset disposal has no tax implications given the company has other assets and UCC is always
positive in the asset class.

The headache pill equipment has no resale value.

NPV = –$23,000,000 + $8,415,000 × A30.07 + $5,809,590.72

= $4,893,210.23

Headache and Arthritis:

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

= $10,989,000

Sale proceeds in nominal terms = $1,000,000 × 1.033 = $1,092,727

PV of CCA TS= [($32,000,000 × 0.25 × 0.34)/(0.1021 + 0.25)] × [(1+ (1.5 × 0.1021))/1.1021]

– [($1,092,727 × 0.25 × 0.34)/(0.1021 + 0.25) ] × (1/1.10213 )
= $7,885,847.42

The asset disposal has no tax implications given the company has other assets and UCC is always
positive in the asset class.

NPV = –$32,000,000 + $10,989,000 × A30.07 + $1,000,000/1.073 + $7,885,847.42

= $5,540,754.31

The firm should choose to manufacture Headache and Arthritis.

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8.14 A machine that lasts four years has the following net cash outflows: $12,500 to purchase the
machine and $7,500 for the annual year-end operating cost. At the end of four years, the machine is
sold for $3,200; thus, the cash flow at year 4, C4, is only $4,300:

The cost of capital is 8 percent. What is the PV of the costs of operating a series of such machines in
perpetuity? Assume the tax rate is zero.

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 × A30.08 + $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 = $34,988.86/ A30.08

= $10,563.86

The present value of such a stream in perpetuity is

$10,563.86/0.08 = $132,048.25

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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

$1,206.10 = EAC × Α30.0857
EAC = $472.83

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

+ $95/1.08575 = $1,773.68
$1,773.68 = EAC × A50.0857
EAC = $450.92

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Choose RH45.

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8.16 Mixer X Cost Savings

NPV = –$500,000 + $120,000 × A50.13

= –$77,932.25
EAC= –$77,932.25/ A50.13 = –$22,157.27

Mixer Y Cost Savings

NPV = –$650,000 + $140,000 × A80.13
= $21,827.84
EAC = $21,827.84/ A80.13 = $4,548.63

Choose Mixer Y.

8.17 Which is better: (1) investing $10,000 in a guaranteed investment certificate (GIC) for one
year at 8 percent when expected inflation is 4 percent, or (2) investing $10,000 in a GIC
at 6 percent when expected inflation is 2 percent? In assessing these alternatives,
assume that interest received is taxed at a rate of 32 percent.

1) In nominal terms you could receive, one year from now, after–tax $10,544.00 ($10,000 +
10,000 × 0.08 ×0.68) which is $10,138.46 (=$10,544/1.04) in real terms.

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

2) In nominal terms you would receive $10,408.00 after–tax (=$10,000 + 10,000 × 0.06 × 0.68)
but only $10,203.92 (=$10,408.00/1.02) 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 A new electronic process monitor will cost Clarke Designs $145,000. This cost will be
depreciated at a 25 percent CCA rate. The monitor will actually be worthless in six years.
Assume the company has no other assets in the asset class. The new monitor would save Clarke
$62,000 per year before taxes in operating costs. If Clarke requires a 13.5 percent return, what
is the NPV of the purchase? Assume a tax rate of 38 percent.

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

PV of CCA TS = [ ($145,000 × 0.25 × 0.38)/(0.135+0.25)] × [(1+(1.5 × 0.135))/1.135]

= $37,907.06

Since the asset class is terminated, there is a terminal loss equal to:

UCC6 – min(C,S) = $145,000 × (1 – 1.5 × 0.25) × (1 – 0.25)5 – $0 = $21,505.74

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So, the tax saving on the terminal loss is equal to: $21,505.74 × 0.38 = $8,172.18

NPV = –$145,000 + $38,440 × A60.135 + $37,907.06 + $8,172.18/1.1356

= $48,279.56

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8.19 Be Safe Security believes it can sell 15,000 home security devices per year at $28 apiece. They
cost $19 each to manufacture (variable cost). Fixed production costs will run $30,000 per year. The
necessary equipment costs $180,000 to buy and will be depreciated at a 25 percent CCA rate. The
equipment will have zero salvage value after the five-year life of the project. When this project is
over, there will still be other assets in the CCA class. Be Safe will need to invest $42,500 in net
working capital up front, but no additional net working capital investment will be necessary. The
discount rate is 18 percent, and the tax rate is 40 percent. What do you think of the proposal?

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 × 0.25 × 0.40)/(0.18 + 0.25)] × (1.27/1.18 )

= $45,053.21
4
NPV = –$222,500 + $63,000 × A0.18 + $105,500/1.185 + $45,053.21
= –$222,500 + $169,473.89 + $46,115.02 + $45,053.21
= $38,142.12

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

8.20
This problem is much easier if you are working with a spreadsheet. Sparky Fireworks Inc. is contemplating the purchase
of a $1.2 million computer-based customer order management system. CCA on the system will be calculated at a rate of
25 percent. In five years it will be worth $575,000. When this project is over, there will still be other assets and UCC is
always positive in the CCA class. Sparky would save $440,000 before taxes per year in order processing costs and would
reduce working capital by $225,000 (a one-time reduction). What is the DCF return on this investment? The relevant tax
rate is 34 percent.
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

$440,000.0
Cost savings $440,000.00 $440,000.00 0 $440,000.00 $440,000.00
CCA at 25% –450,000.00 –187,500.00 – –105,468.75 –79,101.56

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 140,625.00
EBIT –10,000.00 252,500.00 299,375.00 334,531.25 360,898.44
Taxes at 34% –3,400.00 85,850.00 101,787.50 113,740.63 122,705.47
NI –6,600.00 166,650.00 197,587.50 220,790.63 238,192.97
Add back CCA 450,000.00 187,500.00 140,625.00 105,468.75 79,101.56
Cash flow from
operations 443,400.00 354,150.00 338,212.50 326,259.38 317,294.53
$338,212.5
Total cash flows –975,000.00 $443,400.00 $354,150.00 0 $326,259.38 $667,294.53

Set NPV = – $975,000 + $443,400/(1+IRR) + $354,150/(1+IRR)2 + $338,212.50/(1+IRR)3

+ $326,259.38/(1+IRR)4 + $667,294.53/(1+IRR)5 = 0
IRR = 31.21%

8.21 a. PV of CCATS = [($60,500 × 0.25 × 0.41)/(0.13 + 0.25)] × (1.195/1.13) = $17,257.79

NPV=0
$60,500 – $17,257.79 = PMT × Α60.13
PMT = $10,817.18

Cost savings must exceed $18,334.20 (=$10,817.18/0.59)

b. PV of CCATS = [($60,500 × 0.25 × 0.41)/( 0.13 + 0.25)] × (1.195/1.13)

– [($21,000 × 0.25 × 0.41)/(0.13 + 0.25)] × (1/1.136)
= $14,537.04

$60,500 – $14,537.04 = PMT × Α60.13 + 21,000/(1.13) 6

PMT = $8,974.56

Cost savings must exceed $15,211.13 (=$8,974.56/0.59)

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

NPV = –$2,500,000 – $30,000,000 –$9,000,000 – $10,000,000 – $1,400,000 × (1– 0.4)

+ $6,696,000 × A80.13 + ($9,000,000 × 0.04 × 0.4)/(0.18 + 0.04) × [(1.27/1.18)]
– ($4,000,000 × 0.04 × 0.4)/(0.18 + 0.04) × [(1/1.188 )]
+ ($30,000,000 × 0.2 × 0.4)/(0.18 + 0.2) × [(1.27/1.18 )]
– ($6,300,000 × 0.2 × 0.4 )/(0.18 + 0.2) × [(1/1.188 )] + $4,000,000/1.188
+ $6,300,000/1.188 + $2,500,000/1.188 + $10,000,000/1.188
= –$11,899,222.46

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

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8.23 NPV (A) = –$2,900,000 – $80,000 × (1 – 0.35) × A80.13 + $340,000/1.138
+ ($2,900,000 × 0.3 × 0.35)/(0.13 + 0.3) × [ (1.195/1.13)]
– ($340,000 × 0.3 × 0.35)/(0.13 + 0.3) × [(1/1.138)]
= –$2,303,998.50

EACA = –$2,303,998.50/ A80.13 = –$480,122.69

NPV (B) = –$5,700,000 – $69,000 × (1 – 0.35) × A120.13 + $420,000/1.13

12

+ ($5,700,000 × 0.3 × 0.35)/(0.13 + 0.3) × [(1.195/1.13)]

– ($420,000 × 0.3 × 0.35)/(0.13 + 0.3) × [(1/1.1312)]
= –$4,420,247.53
EAC B = –$4,420,247.53/ A12
0.13 = –$746,960.32

Choose equipment A as its EAC is lower.

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MINI–CASE 1: Beaver Mining Company

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

I. Income
(1) Sales revenues 50,120,000.00 54,680,000.00 58,480,000.00 47,840,000.00
(2) Variable costs 19,220,000.00 21,080,000.00 22,630,000.00 18,290,000.00
(3) 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
(4) CCA 85,000,000.00 0.00 0.00 0.00
(5) EBIT –58,200,000.00 29,500,000.00 31,750,000.00 25,450,000.00 –2,700,000.00 –6,000,000.00
(6) Taxes –22,116,000.00 11,210,000.00 12,065,000.00 9,671,000.00 –1,026,000.00 –2,280,000.00
(7) Net income –36,084,000.00 18,290,000.00 19,685,000.00 15,779,000.00 –1,674,000.00 –3,720,000.00

II. Investments
(8) NWC 2,506,000.00 2,734,000.00 2,924,000.00 2,392,000.00 0.00
(9) Change in NWC –2,506,000.00 –228,000.00 –190,000.00 532,000.00 2,392,000.00
(10) Equipment costs –85,000,000.00
(11) land costs –5,500,000.00
(12) Recapture tax
liability (equipment) –19,380,000.00
(13) Equipment
salvage value 51,000,000.00

III. Incremental cash

flows
(14) Operating cash
flows [(1)–(2)–(3)
–(6)] 0.00 48,916,000.00 18,290,000.00 19,685,000.00 15,779,000.00 –1,674,000.00 –3,720,000.00
(15) Investment cash –93,006,000.00 –228,000.00 –190,000.00 532,000.00 34,012,000.00 0.00 0.00
flows
[(9)+(10)+(11)+(12)

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+(13)]
(16) Total project cash
flows [(14)+(15)] –93,006,000.00 48,688,000.00 18,100,000.00 20,217,000.00 49,791,000.00 –1,674,000.00 –3,720,000.00
(17) PV of total
project cash flow –93,006,000.00 43,471,428.57 14,429,209.18 14,390,061.27 31,643,080.64 –949,872.56 –1,884,667.77
(18) NPV 8,093,239.34

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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

(1) Contract sales revenues $41,000,000 $41,000,000 $41,000,000 $41,000,000
(2) Spot sales revenues $9,120,000 $13,680,000 $17,480,000 $6,840,000
(3) Sales revenues [(1)+(2)] $50,120,000 $54,680,000 $58,480,000 $47,840,000

The CCA calculation is as follows. The new accelerated capital cost allowance measures provide that
in the year of acquisition, the full cost of machinery and equipment used in the manufacturing and
processing of goods (Class 53) may be deducted as CCA. (The normal CCA rate is 50% for
Class 53). This immediate 100% write–off applies to property acquired after November 20, 2018 and
before 2024. So, we deduct the full cost of the equipment ($85,000,000) in year 1.

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 after–tax salvage value of the land is provided.
The implicit assumption in our calculation is that the after–tax salvage value of the land in Year 6 is
equal to the $6 million charitable expense.

The current after–tax 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

We need to account for the salvage value of the equipment and the tax consequences of the
termination of the asset class. Since the salvage value of the equipment is $51 million (60% of the
initial cost of $85 million) and the UCC at year 4 is $0, the company incurs a recapture tax liability
of:
Recapture tax liability on sale of equipment = ($51,000,000 – $0) × 0.38 = $19,380,000

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

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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 costs 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 above the
inflation rate, and the inflation rate is 3.25 percent, the nominal growth in both variables is:

(1 + R) = (1 + r)(1 + h)
R = [(1.01) × (1 + 0.0325)] – 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 nominal cash flows, although using real 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
6,200,00
Automobiles sold 0 6,355,000 6,513,875 6,676,722
24,800,00
Tires for automobiles sold 0 25,420,000 26,055,500 26,706,888
2,728,00
SuperTread tires sold 0 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
32,000,00
Total tires sold in market 0 32,640,000 33,292,800 33,958,656
2,560,00
SuperTread tires sold 0 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
$46.5
OEM $41.00 $42.76 $44.59 0
$70.3
Replacement $62.00 $64.66 $67.42 1

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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

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

Revenues $270,568,000.00 $288,381,365.55 $307,369,292.13 327,609,345.73
Variable costs $153,352,000.00 $163,530,185.25 $174,384,952.03 –185,961,344.05
Marketing &
general costs $43,000,000.00 $44,397,500.00 $45,840,418.75 –47,330,232.36
CCA $48,000,000.00 $22,400,000.00 $17,920,000.00 –14,336,000.00
EBT $26,216,000.00 $58,053,680.30 $69,223,921.35 79,981,769.32
Taxes $10,486,400.00 $23,221,472.12 $27,689,568.54 31,992,707.73
Net income $15,729,600.00 $34,832,208.18 $41,534,352.81 47,989,061.59
Add CCA $48,000,000.00 $22,400,000.00 $17,920,000.00 14,336,000.00
OCF $63,729,600.00 $57,232,208.18 $59,454,352.81 62,325,061.59

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:

NWC Year 1 Year 2 Year 3 Year 4

$40,585,200. $43,257,204. $46,105,393.
Beginning $9,000,000.00 00 83 82
$40,585,200.0 $43,257,204. $46,105,393.
Ending 0 83 82 $0.00
– – –
NWC cash $31,585,200.0 $2,672,004.8 $2,848,188.9 $46,105,393.
flow 0 3 9 82

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

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 Yea UCC – UCC –
r Opening CCA Ending
$48,000,00
1 $240,000,000 0 $192,000,000
$22,400,00
2 $112,000,000 0 $89,600,000
$17,920,00
3 $89,600,000 0 $71,680,000
$14,336,00
4 $71,680,000 0 $57,344,000

Since the market value of the equipment is $65 million, the sale will incur a recapture tax liability:

Recapture tax on sale of equipment = ($65,000,000 – $57,344,000) × 0.40 = $3,062,400

And the after–tax salvage value of the equipment is:

After–tax salvage value = $65,000,000 – $3,062,400

After–tax salvage value = $61,937,600

So, the net cash flows each year, including the operating cash flow, net working capital, and after–tax
salvage value, are:
Time Cash flow
0 –160,000,000.00 – 9,000,000.00 = –$169,000,000.00
1 63,729,600.00 – 31,585,200.00 = $32,144,400.00
2 57,232,208.18 – 2,672,004.83 = $54,560,203.35
3 59,454,352.81 – 2,848,188.99 = $56,606,163.82
4 62,325,061.59 + 46,105,393.82 + 61,937,600 = $170,368,058.47

So, the capital budgeting analysis for the project is:

NPV = –169,000,000.00 + 32,144,400/1.134 + $54,560,203.35/1.1342 + $56,606,163.82/1.1343

+ 170,368,058.47/1.1344
NPV = $43,614,417.31

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

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Appendix 8A Questions and Problems:

8A.1. Under IFRS, the depreciation method should reflect the pattern in which the asset’s future
economic benefits are expected to be consumed by the entity and that appropriateness of
the method should be reviewed at least annually in case there has been a change in the
expected pattern. By contrast, CCA depreciation is calculated following the tax rules. To
compute cash flows, we should focus on the tax rules and use CCA depreciation.

8A.2.

Beginning Capital Ending

undepreciated cost undepreciated
Year capital cost allowance capital cost
1 $323,250 $64,650 $258,600
2 $150,850 $30,170 $120,680
3 $120,680 $24,136 $96,544
4 $96,544 $19,309 $77,235
5 $77,235 $15,447 $61,788
6 $61,788 $12,358 $49,431
7 $49,431 $9,886 $39,544
8 $39,544 $7,909 $31,636
9 $31,636 $6,327 $25,308
10 $25,308 $5,062 $20,247

8A.3 If the company sells the equipment after three years for $60,000 and terminates the asset
pool, there will be a CCA terminal loss equal to the remaining UCC:

Remaining UCC = $96,544 – $60,000 = $36,544

This loss is deductible from income and results in a tax saving of:

$36,544 × 40% = $14,617.60

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