Solutions to Questions and Problems

NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this
solutions manual, rounding may appear to have occurred. However, the final answer for each problem is
found without rounding during any step in the problem.

Basic

1. Using the tax shield approach to calculating OCF, we get:

OCF = (Sales – Costs)(1 – TC) + TCDepreciation

OCF = [($4.95 × 1,400) – ($1.97 × 1,400)](1 – .21) + .21($9,300/5)
OCF = $3,686.48

So, the NPV of the project is:

NPV = –$9,300 + $3,686.48(PVIFA14%,5)

NPV = $3,355.98

2. We will use the bottom-up approach to calculate the operating cash flow for each year. We also must
be sure to include the net working capital cash flows each year. So, the net income and total cash
flow each year will be:

Year 1 Year 2 Year 3 Year 4

Sales $13,400 $15,000 $16,400 $12,900
  Costs 2,900 3,100 4,200 2,800
  Depreciation 6,575 6,575 6,575 6,575
  EBT $3,925 $5,325 $5,625 $3,525
  Tax 864 1,172 1,238 776
  Net income $3,062 $4,154 $4,388 $2,750
   
  OCF $9,637 $10,729 $10,963 $9,325
  Capital spending –$26,300
  NWC –300 –200 –225 –150 875
  Incremental cash flow –$26,600 $9,437 $10,504 $10,813 $10,200
 The NPV for the project is:

NPV = –$26,600 + $9,437/1.12 + $10,504/1.122 + $10,813/1.123 + $10,200/1.124

NPV = $4,376.86

3. Using the tax shield approach to calculating OCF, we get:

OCF = (Sales – Costs)(1 – TC) + TCDepreciation

OCF = ($1,090,000 – 475,000)(1 – .25) + .25($1,420,000/3)
OCF = $579,583.33

So, the NPV of the project is:

NPV = –$1,420,000 + $579,583.33(PVIFA12%,3)

NPV = –$27,938.63

4. The cash outflow at the beginning of the project will increase because of the spending on NWC. At
the end of the project, the company will recover the NWC, so it will be a cash inflow. The sale of the
equipment will result in a cash inflow, but we also must account for the taxes which will be paid on
this sale. So, the cash flows for each year of the project will be:

Year Cash Flow

0 – $1,670,000 = –$1,420,000 – 250,000
1 579,583.33
2 579,583.33
3 1,002,083.33 = $579,583.33 + 250,000 + 230,000 + (0 – 230,000)(.25)

And the NPV of the project is:

NPV = –$1,670,000 + $579,583.33(PVIFA12%,2) + ($1,002,083.33/1.123)

NPV = $22,788.53

5. First, we will calculate the annual depreciation for the equipment necessary for the project. The
depreciation amount each year will be:

Year 1 depreciation = $1,420,000(.3333) = $473,286

Year 2 depreciation = $1,420,000(.4445) = $631,190
Year 3 depreciation = $1,420,000(.1481) = $210,302

So, the book value of the equipment at the end of three years, which will be the initial investment
minus the accumulated depreciation, is:

Book value in 3 years = $1,420,000 – ($473,286 + 631,190 + 210,302)

Book value in 3 years = $105,222

The asset is sold at a gain to book value, so this gain is taxable.

Aftertax salvage value = $230,000 + ($105,222 – 230,000)(.25)

Aftertax salvage value = $198,805.50
 To calculate the OCF, we will use the tax shield approach, so the cash flow each year is:

OCF = (Sales – Costs)(1 – TC) + TCDepreciation

Year Cash Flow

0 – $1,670,000 = –$1,420,000 – 250,000
1 579,571.50 = ($615,000)(.75) + .25($473,286)
2 619,047.50 = ($615,000)(.75) + .25($631,190)
3 962,631.00 = ($615,000)(.75) + .25($210,302) + $198,805.50 + 250,000

Remember to include the NWC cost in Year 0, and the recovery of the NWC at the end of the
project. The NPV of the project with these assumptions is:

NPV = –$1,670,000 + $579,571.50/1.12 + $619,047.50/1.122 + $962,631.00/1.123

NPV = $26,157.16

6. The book value of the asset is zero, so the gain on the sale is taxable.

Aftertax salvage value = $230,000 + ($0 – 230,000)(.25)

Aftertax salvage value = $172,500

To calculate the OCF, we will use the tax shield approach, so the cash flow each year is:

OCF = (Sales – Costs)(1 – TC) + TCDepreciation

Year Cash Flow

0 – $1,670,000 = –$1,420,000 – 250,000
1 816,250 = ($615,000)(.75) + .25($1,420,000)
2 461,250 = ($615,000)(.75)
3 883,750 = ($615,000)(.75) + $172,500 + 250,000

Remember to include the NWC cost in Year 0, and the recovery of the NWC at the end of the
project. The NPV of the project with these assumptions is:

NPV = –$1,670,000 + $816,250/1.12 + $461,250/1.122 + $883,750/1.123

NPV = $55,536.11

7. First, we will calculate the annual depreciation of the new equipment. It will be:

Annual depreciation charge = $575,000/5

Annual depreciation charge = $115,000

The aftertax salvage value of the equipment is:

Aftertax salvage value = $60,000(1 – .23)

Aftertax salvage value = $46,200

Using the tax shield approach, the OCF is:

OCF = $176,000(1 – .23) + .23($115,000)

OCF = $161,970
 Now we can find the project IRR. There is an unusual feature that is a part of this project. Accepting
this project means that we will reduce NWC. This reduction in NWC is a cash inflow at Year 0. This
reduction in NWC implies that when the project ends, we will have to increase NWC. So, at the end
of the project, we will have a cash outflow to restore the NWC to its level before the project. We
also must include the aftertax salvage value at the end of the project. The IRR of the project is:

NPV = 0 = –$575,000 + 80,000 + $161,970(PVIFAIRR%,4)

+ [($161,970 + 46,200 – 80,000)/(1+ IRR)5]

IRR = 17.70%

8. First, we will calculate the annual depreciation of the new equipment. It will be:

Annual depreciation = $375,000/5

Annual depreciation = $75,000

Now, we calculate the aftertax salvage value. The aftertax salvage value is the market price minus
(or plus) the taxes on the sale of the equipment, so:

Aftertax salvage value = MV + (BV – MV)TC

Very often, the book value of the equipment is zero as it is in this case. If the book value is zero, the
equation for the aftertax salvage value becomes:

Aftertax salvage value = MV + (0 – MV)TC

Aftertax salvage value = MV(1 – TC)

We will use this equation to find the aftertax salvage value since we know the book value is zero. So,
the aftertax salvage value is:

Aftertax salvage value = $25,000(1 – .24)

Aftertax salvage value = $19,000

Using the tax shield approach, we find the OCF for the project is:

OCF = $95,000(1 – .24) + .24($75.000)

OCF = $90,200

Now we can find the project NPV. Notice that we include the NWC in the initial cash outlay. The
recovery of the NWC occurs in Year 5, along with the aftertax salvage value.

NPV = –$375,000 – 15,000 + $90,200(PVIFA10%,5) + ($19,000 + 15,000)/1.105

NPV = –$26,959.71

9. The book value of the asset will be zero at the end of the project, so the aftertax salvage value is:

Aftertax salvage value = $25,000(1 – .24)

Aftertax salvage value = $19,000
 Using the tax shield approach, we find the OCF for the first year of the project is:

OCF = $95,000(1 – .24) + .24($375,000)

OCF = $162,200

And the OCF for Years 2 to 5 is:

OCF = $95,000(1 – .24)

OCF = $72,200

Now we can find the project NPV. Notice that we include the NWC in the initial cash outlay. The
recovery of the NWC occurs in Year 5, along with the aftertax salvage value.

NPV = –$375,000 – 15,000 + $162,200/1.10 + $72,200/1.102 + $72,200/1.103 + $72,200/1.104

+ ($72,200 + 19,000 + 15,000)/1.105
NPV = –$13,375.69

10. To find the book value at the end of four years, we need to find the accumulated depreciation for the
first four years. We could calculate a table with the depreciation each year, but an easier way is to
add the MACRS depreciation amounts for each of the first four years and multiply this percentage
times the cost of the asset. We can then subtract this from the asset cost. Doing so, we get:

BV4 = $7,600,000 – 7,600,000(.2000 + .3200 + .1920 + .1152)

BV4 = $1,313,280

The asset is sold at a gain to book value, so this gain is taxable.

Aftertax salvage value = $1,400,000 + ($1,313,280 – 1,400,000)(.21)

Aftertax salvage value = $1,381,789

11. We will begin by calculating the initial cash outlay, that is, the cash flow at Time 0. To undertake the
project, we will have to purchase the equipment and increase net working capital. So, the cash outlay
today for the project will be:

  Equipment –$4,100,000
  NWC –150,000
  Total –$4,250,000

Using the bottom-up approach to calculating the operating cash flow, we find the operating cash
flow each year will be:

  Sales $2,350,000
  Costs 587,500
  Depreciation 1,025,000
  EBT $737,500
  Tax 184,375
  Net income $553,125
 The operating cash flow is:

OCF = Net income + Depreciation

OCF = $553,125 + 1,025,000
OCF = $1,578,125

To find the NPV of the project, we add the present value of the project cash flows. We must be sure
to add back the net working capital at the end of the project life, since we are assuming the net
working capital will be recovered. So, the project NPV is:

NPV = –$4,250,000 + $1,578,125(PVIFA13%,4) + $150,000/1.134

NPV = $536,085.37

12. We will need the aftertax salvage value of the equipment to compute the EAC. Even though the
equipment for each product has a different initial cost, both have the same salvage value. The
aftertax salvage value for both is:

Aftertax salvage value = $25,000(1 – .21)

Aftertax salvage value = $19,750

To calculate the EAC, we first need the OCF and PV of costs of each option. The OCF and PV of
costs for Techron I is:

OCF = –$41,000(1 – .21) + .21($265,000/3)

OCF = –$13,840

PV of costs = –$265,000 + –$13,840(PVIFA9%,3) + ($19,750/1.093)

PV of costs = –$284,782.49

EAC = –$284,782.49/(PVIFA9%,3)
EAC = –$112,504.68

And the OCF and PV of costs for Techron II is:

OCF = – $52,000(1 – .21) + .21($330,000/5)

OCF = –$27,220

PV of costs = –$330,000 – $27,220(PVIFA9%,5) + ($19,750/1.095)

PV of costs = –$423,040.16

EAC = –$423,040.16/(PVIFA9%,5)
EAC = –$108,760.43

The two milling machines have unequal lives, so they can only be compared by expressing both on
an equivalent annual basis, which is what the EAC method does. Thus, you prefer the Techron II
because it has the lower (less negative) annual cost.
 Intermediate

13. First, we will calculate the depreciation each year, which will be:

D1 = $670,000(.2000) = $134,000
D2 = $670,000(.3200) = $214,400
D3 = $670,000(.1920) = $128,640
D4 = $670,000(.1152) = $77,184

The book value of the equipment at the end of the project is:

BV4 = $670,000 – ($134,000 + 214,400 + 128,640 + 77,184)

BV4 = $115,776

The asset is sold at a loss to book value, so this creates a tax refund. The aftertax salvage value will
be:

Aftertax salvage value = $55,000 + ($115,776 – 55,000)(.23)

Aftertax salvage value = $68,978.48

So, the OCF for each year will be:

OCF1 = $245,000(1 – .23) + .23($134,000) = $219,470.00

OCF2 = $245,000(1 – .23) + .23($214,400) = $237,962.00
OCF3 = $245,000(1 – .23) + .23($128,640) = $218,237.20
OCF4 = $245,000(1 – .23) + .23($77,184) = $206,402.32

Now we have all the necessary information to calculate the project NPV. We need to be careful with
the NWC in this project. Notice the project requires $20,000 of NWC at the beginning, and $2,500
more in NWC each successive year. We will subtract the $20,000 from the initial cash flow and
subtract $2,500 each year from the OCF to account for this spending. In Year 4, we will add back the
total spent on NWC, which is $27,500. The $2,500 spent on NWC capital during Year 4 is
irrelevant. Why? Well, during this year the project required an additional $2,500, but we would get
the money back immediately. So, the net cash flow for additional NWC would be zero. With all this,
the equation for the NPV of the project is:

NPV = –$670,000 – 20,000 + ($219,470 – 2,500)/1.08 + ($237,962 – 2,500)/1.082

+ ($218,237.20 – 2,500)/1.083 + ($206,402.32 + 27,500 + 68,978.48)/1.084
NPV = $106,654.44

14. The book value of the asset is zero, so the aftertax salvage value will be:

Aftertax salvage value = $55,000 + ($0 – 55,000)(.23)

Aftertax salvage value = $42,350

So, the OCF for each year will be:

OCF1 = $245,000(1 – .23) + .23($670,000) = $342,750

OCF2 = $245,000(1 – .23) = $188,650
OCF3 = $245,000(1 – .23) = $188,650
OCF4 = $245,000(1 – .23) = $188,650
 Now we have all the necessary information to calculate the project NPV. We need to be careful with
the NWC in this project. Notice the project requires $20,000 of NWC at the beginning, and $2,500
more in NWC each successive year. We will subtract the $20,000 from the initial cash flow and
subtract $2,500 each year from the OCF to account for this spending. In Year 4, we will add back the
total spent on NWC, which is $27,500. The $2,500 spent on NWC capital during Year 4 is
irrelevant. Why? Well, during this year the project required an additional $2,500, but we would get
the money back immediately. So, the net cash flow for additional NWC would be zero. With all this,
the equation for the NPV of the project is:

NPV = –$675,000 – 20,000 + ($342,750 – 2,500)/1.08 + ($188,650 – 2,500)/1.082

+ ($188,650 – 2,500)/1.083 + ($188,650 + 27,500 + 42,350)/1.084
NPV = $122,417.01

15. If we are trying to decide between two projects that will not be replaced when they wear out, the
proper capital budgeting method to use is NPV. Both projects only have costs associated with them,
not sales, so we will use these to calculate the NPV of each project. Using the tax shield approach to
calculate the OCF, the NPV of System A is:

OCFA = –$73,000(1 – .23) + .23($265,000/4)

OCFA = –$40,973

NPVA = –$265,000 – $40,973(PVIFA7.5%,4)

NPVA = –$402,230.27

And the NPV of System B is:

OCFB = –$64,000(1 – .23) + .23($380,000/6)

OCFB = –$34,713

NPVB = –$380,000 – $34,713(PVIFA7.5%,6)

NPVB = –$542,939.06

If the system will not be replaced when it wears out, then System A should be chosen, because it
has the less negative NPV