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**ANSWERS TO END-OF-CHAPTER QUESTIONS
**

13-3 Since the cost of capital includes a premium for expected inflation, failure to adjust cash flows means that the denominator, but not the numerator, rises with inflation, and this lowers the calculated NPV. Capital budgeting analysis should only include those cash flows which will be affected by the decision. Sunk costs are unrecoverable and cannot be changed, so they have no bearing on the capital budgeting decision. Opportunity costs represent the cash flows the firm gives up by investing in this project rather than its next best alternative, and externalities are the cash flows (both positive and negative) to other projects that result from the firm taking on this project. These cash flows occur only because the firm took on the capital budgeting project; therefore, they must be included in the analysis. When a firm takes on a new capital budgeting project, it typically must increase its investment in receivables and inventories, over and above the increase in payables and accruals, thus increasing its net operating working capital. Since this increase must be financed, it is included as an outflow in Year 0 of the analysis. At the end of the project’s life, inventories are depleted and receivables are collected. Thus, there is a decrease in NOWC, which is treated as an inflow.

13-4

13-5

**SOLUTIONS TO END-OF-CHAPTER PROBLEMS
**

13-1 Equipment NWC Investment Initial investment outlay Operating Cash Flows: t = 1 Sales revenues Operating costs Depreciation Operating income before taxes Taxes (40%) Operating income after taxes Add back depreciation Operating cash flow $ 9,000,000 3,000,000 $12,000,000 $10,000,000 7,000,000 2,000,000 $ 1,000,000 400,000 $ 600,000 2,000,000 $ 2,600,000

13-2

T) = $44.500 $50.225. and $18.15 for Years 1.000.702: Salvage value Tax on SV* Return of NWC $65.926 Notes: 1.918 18.000 = $1. c. Depreciation expense in Years 1.000.000 . times the MACRS allowance percentages of 0. 0. 13-4 a. Tax on gain = $1.4) = $400.000 .$400.798.000 (19.000) b. 2.35) = $19.13-3 Equipment's original cost Depreciation (80%) Book value $20.326 Net cash flow $42.$4.979 6.500) Increase in NWC (5.518 $47.075.45.500) Cash outlay for new machine ($126. and 3 is $39.000.600 2. and 3. AT net salvage value = $5.000.500.765. The depreciation expense in each year is the depreciable basis.000(0. After-tax savings $28.579 $34.000.000) Modification (12. 2. The terminal year cash flow is $50.000.600.000 $ 4.000: Price ($108.435.000 16. Depreciation tax savings 13.435)(0. The after-tax cost savings is $44. 2.000.$8.000 .702 BV in Year 4 = $120.798) 5.000.000.000. The net cost is $126. . and 0.600 $28. The depreciation tax savings is calculated as the tax rate (35%) times the depreciation expense in each year.000(1 .600 $28.600.07) = $8. $54.000 Gain on sale = $5.65) = $28. respectively. *Tax on SV = ($65.000 = $4. $120.000(0.000.33. The operating cash flows follow: Year 1 Year 2 Year 3 1.500(0.

100 Notes: 1.000) (4.d. $85.000.45.518 37. .518 47.702 85. and then solve for NPV = $10. it should be accepted.000. 13-5 a.579 37.6) = $15.000: Price Modification Change in NWC ($70.000 42. 2 and 3.33. The depreciation shield is calculated as the tax rate (40%) times the depreciation expense in each year.841. Depreciation expense in Years 1.300 $20. The depreciation expense in each year is the depreciable basis.000) (15.948 NPV = $ 10. The operating cash flows follow: Year 1 Year 2 Year 3 After-tax savings $15.000(1 – T) = $25. The after-tax cost savings is $25.841 Alternatively. 2. $38.628 With a financial calculator.000 $15. Year Net Cash Flow PV @ 12% 0 ($126. respectively. and $12.000) b. thus.930 3 85. The project has an NPV of $10.926 50.579 34. The net cost is $89.300 Net cash flow $26.000) 1 42.628 60.750. input the appropriate cash flows into the cash flow register. times the MACRS allowance percentage of 0. input I/YR = 12.220 $30.000(0.000) ($89.250.000 5.100 Depreciation shield 11.000 $15.15 for Years 1.841. and 0.000) ($126.050.963 2 47. place the cash flows on a time line: 0 | 12% 1 | 2 | 3 | -126.220 15. 0. 2. and 3 is $28.

CF1 = 26220.780 = -$4.000 (9. input the following: CF0 = -89000. Year 0 1 2 3 Net Cash Flow ($89. The project has an NPV of -$6.703. .950.300 44.620) 4. Note that the remaining BV in Year 4 = $85.15 (1 + rr)(1.15 Considering inflation.780 Not considering inflation.0849.220 30.4) = $9. Thus.000 $ 33.000 . the real cost of capital is calculated as follows: (1 + rr)(1 + i) = 1.480 With a financial calculator.380: Salvage value Tax on SV* Return of NWC $30.000 + $21. d.800. 13-6 a.$5.83. assuming sales and costs remain constant over the life of the project.705. This value is calculated as -$150.15 rr = 0. it should not be accepted. and I/YR = 10 to solve for NPV = -$6.380 *Tax on SV = ($30.000 105.000($105) Net before tax Taxes (34%) Net after tax $138.000 $24.220 $ 21.950)(0.000 11.07) = $5. The additional end-of-project cash flow is $24. NPV is -$4. Sales = 1.800. CF2 = 30300.620.000($138) Cost = 1.000) 26.06) = 1. 0.000(0.c. that is. CF3 = 44480.

The first cash flow would be $21. Using the constant growth formula.20(-$25) + 0. the present value as of Year 0 of the growing cash flows from Year 1 out into the future is PVYear 1 = $21. and there are no fixed costs. σNPV= [0. and hence did not rise with inflation.$3)2 + 0.0 + $6.$3)2 + 0.537.000 + $256.0849 After adjusting for expected inflation. This demonstrates the bias that inflation can induce into the capital budgeting process: Inflation is already reflected in the denominator (the cost of capital).06) = $256. the NPV considering inflation is calculated as -$150.20($20 . except for rounding differences on the real cost of capital. 13-7 E(NPV) = 0.520.05(-$70) + 0.5 = $3. and since both costs and revenues grow at the same rate. However.20($20) + 0. which is the same as above. then is this present value less the initial investment: -$150.05($30) = -$3.$3)2 + 0. we see that the project has a positive NPV and should be accepted. then sales revenues would rise faster than total costs.0 + $1. CVNPV = $23.$3)2 + 0.520 The NPV of the project. If part of the costs were fixed.05($30 .0. b. necessitating a sharp output price increase to cover the now higher depreciation charges.622 = 7.50($12) + 0.874. Alternately.0 .5 + -$5. 0.$3)2]0.0 million.05(-$70 .780 = $106. so it must also be reflected in the numerator.000 + $21.520 = $106. this cash flow will grow at 6% per year indefinitely.780(1.20(-$25 .5 = $23. when the plant wears out and must be replaced.0 + $4.780.50($12 . $3.Thus. you could incorporate inflation explicitly into the cash flows and discount them at the nominal rate. inflation will cause the replacement cost to jump.15 .622 million.06)/(0.

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