Answers to Concepts Review and Critical Thinking Questions

1.

In this context, an opportunity cost refers to the value of an asset or other input that will be
used in a project. The relevant cost is what the asset or input is actually worth today, not, for
example, what it cost to acquire.

2.

For tax purposes, a firm would choose MACRS because it provides for larger depreciation
deductions earlier. These larger deductions reduce taxes, but have no other cash
consequences. Notice that the choice between MACRS and straight-line is purely a time
value issue; the total depreciation is the same, only the timing differs.

3.

Its probably only a mild over-simplification. Current liabilities will all be paid, presumably.
The cash portion of current assets will be retrieved. Some receivables wont be collected,
and some inventory will not be sold, of course. Counterbalancing these losses is the fact that
inventory sold above cost (and not replaced at the end of the projects life) acts to increase
working capital. These effects tend to offset.

4.

Managements discretion to set the firms capital structure is applicable at the firm level. Since any
one particular project could be financed entirely with equity, another project could be financed with
debt, and the firms overall capital structure remains unchanged, financing costs are not relevant in the
analysis of a projects incremental cash flows according to the stand-alone principle.

5.

The EAC approach is appropriate when comparing mutually exclusive projects with different lives
that will be replaced when they wear out. This type of analysis is necessary so that the projects have a
common life span over which they can be compared; in effect, each project is assumed to exist over
an infinite horizon of N-year repeating projects. Assuming that this type of analysis is valid implies
that the project cash flows remain the same forever, thus ignoring the possible effects of, among other
things: (1) inflation, (2) changing economic conditions, (3) the increasing unreliability of cash flow
estimates that occur far into the future, and (4) the possible effects of future technology improvement
that could alter the project cash flows.

6.

Depreciation is a non-cash expense, but it is tax-deductible on the income statement. Thus depreciation causes taxes paid, an actual cash outflow, to be reduced by an amount equal to the depreciation
tax shield tcD. A reduction in taxes that would otherwise be paid is the same thing as a cash inflow, so
the effects of the depreciation tax shield must be added in to get the total incremental aftertax cash
flows.

7.

There are two particularly important considerations. The first is erosion. Will the
essentialized book simply displace copies of the existing book that would have otherwise
been sold? This is of special concern given the lower price. The second consideration is
competition. Will other publishers step in and produce such a product? If so, then any
erosion is much less relevant. A particular concern to book publishers (and producers of a
variety of other product types) is that the publisher only makes money from the sale of new
books. Thus, it is important to examine whether the new book would displace sales of used
books (good from the publishers perspective) or new books (not good). The concern arises
any time there is an active market for used product.

8.

This market was heating up rapidly, and a number of other manufacturers were planning
competing products.

9.

One company may be able to produce at lower incremental cost or market better. For
example, GM may have been able to retool existing production more cheaply, and GM also
has a larger dealer network. Also, of course, one of the two may have made a mistake!

10. GM would recognize that the outsized profits would dwindle as more product comes to
market and competition becomes more intense.
Solutions to Questions and Problems
Basic
1.

The $5 million acquisition cost of the land six years ago is a sunk cost. The $4.2 million current
appraisal of the land is an opportunity cost if the land is used rather than sold off. The $7.3 million
cash outlay and $325,000 grading expenses are the initial fixed asset investments needed to get the
project going. Therefore, the proper year zero cash flow to use in evaluating this project is $4,200,000
+ 7,300,000 + 325,000 = $11,825,000.

2.

Sales due solely to the new product line are 16,000($12,000) = $192 million. Increased sales of the
motor home line occur because of the new product line introduction; thus 5,000($45,000) = $225
million in new sales is relevant. Erosion of luxury motor coach sales is also due to the new mid-size
campers; thus 1,000($78,000) = $78 million loss in sales is relevant. The net sales figure to use in
evaluating the new line is thus $192 million + 225 million 78 million = $339 million.

3.

Sales
Variable costs
Fixed costs
Depreciation
EBT
Taxes@35%
Net income

$ 700,000
420,000
175,000
75,000
$ 30,000
10,500
$ 19,500

4.

Sales
Variable costs
Depreciation
EBT
Taxes@34%
Net income

$ 864,350
501,500
112,000
$ 250,850
85,289
$ 165,561

5.

Sales
Variable costs
Depreciation
EBT
Taxes@35%
Net income

$ 85,000
43,000
3,000
$ 39,000
13,650
$ 25,350

OCF = EBIT + D T
= $250,850 + 112,000 85,289 = $277,561
Depreciation tax shield = tcD
= .34($112,000) = $38,080

OCF = EBIT + D T = $39,000 + 3,000 13,650

= $28,350
OCF = S C T = $85,000 43,000 13,650
= $28,350
OCF = (S C)(1 tc) + tcD = ($85,000 43,000)(1 .35) + .35(3,000) = $28,350
OCF = NI + D = $25,350 + 3,000
= $28,350

6.

Beginning
Year Book Value
1
$847,000.00
2
725,963.70
3
518,533.40
4
370,393.10

MACRS
%
14.29
24.49
17.49
12.49

Depreciation
Allowance
$121,036.30
207,430.30
148,140.30
105,790.30

Ending
Book Value
$725,963.70
518,533.40
370,393.10
264,602.80

5
6
7
8

264,602.80
188,965.70
113,328.60
37,691.50

8.93
8.93
8.93
4.45

75,637.10
75,637.10
75,637.10
37,691.50

188,965.70
113,328.60
37,691.50
0

7.

BV5 = $320,000 320,000(5/8) = $120,000

The asset is sold at a loss to book value, so the depreciation tax shield of the loss is recaptured.
Aftertax salvage value = $70,000 + ($120,000 70,000)(0.35) = $87,500

8.

BV4 = $8.4M 8.4M(0.2000 + 0.3200 + 0.1920 + 0.1152) = $1,451,520

The asset is sold at a gain to book value, so this gain is taxable.
Aftertax salvage value = $1,600,000 + ($1,451,520 1,600,000)(.35) = $1,548,032

9.

A/R fell by $3,380, and inventory increased by $2,580, so net current assets fell by $800
NWC = (CA CL) = $800 2,300 = $3,100
Net cash flow = S C NWC = $61,800 26,300 (3,100) = $38,600

10. OCF = (S C)(1 tc) + tcD = ($1.9M 850K)(1 0.35) + 0.35($2.1/3) = $927,500
11.
12.

NPV = $2.1M + $927,500(PVIFA15%,3) = $17,691.30

Year
0
1
2
3

Cash Flow
$2,375,000
927,500
927,500
1,413,750

= $2.1M 275K
= $927,500 + 275,000 + 325,000(1 - .35)

NPV = $2,375,000 + 927,500(PVIFA15%,2) + (1,413,750 / 1.153) = $62,408.56

13. D1 = $2.1M(0.3333) = $699,930; D2 = $2.1M(0.4444) = $933,240
D3 = $2.1M(0.1482) = $311,220; thus, BV3 = $2.1M (699,930 + 933,240 + 311,220) = $155,610
The asset is sold at a gain to book value, so this gain is taxable.

Aftertax salvage value = $325,000 + (155,610 325,000)(0.35) = $265,713.50

OCFt = (S C)(1 tc) + tcDt , so:

Year
0
1
2
3

Cash Flow
$2,375,000
927,475.50
1,009,134
1,332,140.50

= $2.1M 275K
= ($1,050,000)(.65) + 0.35($699,930)
= ($1,050,000)(.65) + 0.35($933,240)
= ($1,050,000)(.65) + 0.35($311,220) + 265,713.50 + 275,000

NPV = $2.375M + ($927,475.50/1.15) + ($1,009,134/1.152) + ($1,332,140.50/1.153) = $70,454.72

14. Annual depreciation charge = $410,000/5 = $82,000
Aftertax salvage value = $70,000(1 0.34) = $46,200
OCF = $115,000(1 0.34) + 0.34($82,000) = $103,780
NPV = $410,000 15,000 + 103,780(PVIFA10%,5) + [($46,200 + 15,000) / 1.15] = $6,408.24
15. Annual depreciation charge = $750,000/5 = $150,000
Aftertax salvage value = $80,000(1 0.35) = $52,000
OCF = $310,000(1 0.35) + 0.35($150,000) = $254,000
NPV = 0 = $750,000 + 125,000 + 254,000(PVIFAIRR%,5) + [($52,000 125,000) / (1+IRR)5]
IRR = 27.74%
16. $300K cost savings case: OCF = $300,000(1 0.35) + 0.35($150,000) = $247,500
NPV = $750,000 + 125,000 + 247,500(PVIFA20%,5) + [($52,000 125,000) / (1.20)5]
= $85,839.44

$200K cost savings case: OCF = $200,000(1 0.35) + 0.35($150,000) = $182,500

NPV = $750,000 + 125,000 + 182,500(PVIFA20%,5) + [($52,000 125,000) / (1.20)5]
= $108,550.35
Required pretax cost-savings case:
NPV = 0 = $750,000 + $125,000 + OCF(PVIFA20%,5) + [($52,000 125,000) / (1.20)5] ,
so OCF = $218,797.03 = (S C)(1 0.35) + 0.35($150K); (S C) = $255,841.59
17. NPV = $225,000 20,000 25,000(PVIFA15%,5) + $20,000/1.155 = $318,860.34
EAC = $318,860.34 / (PVIFA15%,5) = $95,121
18. Both cases: aftertax salvage value = $20,000(1 0.35) = $13,000
Techron I: OCF = $32,000(1 0.35) + 0.35($195,000/3) = $1,950
NPV = $195,000 + 1,950(PVIFA14%,3) + ($13,000/1.143) = $181,698.19
EAC = $181,698.19 / (PVIFA14%,3) = $78,263.13
Techron II: OCF = $19,000(1 0.35) + 0.35($295,000/5) = $8,300
NPV = $295,000 + 8,300(PVIFA14%,5) + ($13,000/1.145) = $259,753.64
EAC = $259,753.64 / (PVIFA14%,5) = $75,661.96
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.
19. Aftertax salvage value = $40,000(1 0.35) = $26,000
NPV = 0 = $510,000 60,000 + OCF(PVIFA16%,5) + [($60,000 + 26,000) / 1.165]
OCF = $529,054.28 / PVIFA16%,5 = $161,578.14
OCF = $161,578 = [(Pv)Q FC ](1 tc) + tcD
$161,578 = [(P 8.00)(170,000) 160,000 ](1 0.35) + 0.35($510,000/5) ; P = $10.08
Intermediate
20. D1 = $450,000(0.20) = $90,000; D2 = $450,000(0.32) = $144,000
D3 = $450,000(0.192) = $86,400; D4 = $450,000(0.1152) = $51,840
BV4 = $450,000 ($90,000 + 144,000 + 86,400 + 51,840) = $77,760
The asset is sold at a gain to book value, so this gain is taxable.
After-tax salvage value = $90,000 + ($77,760 90,000)(0.35) = $85,716
OCF1 = $150,000(1 0.35) + 0.35($90,000) = $129,000
OCF2 = $150,000(1 0.35) + 0.35($144,000) = $147,900
OCF3 = $150,000(1 0.35) + 0.35($86,400) = $127,740
OCF4 = $150,000(1 0.35) + 0.35($51,840) = $115,644
NPV = $450,000 18,000 + ($129,000 3,000)/1.14 + ($147,900 3,000)/1.142
+ ($127,740 3,000)/1.143 + ($115,644 + 27,000 + 85,716)/1.144 = $26,574.44
21. OCFA = $105,000(1 0.34) + 0.34($405,000/3) = $23,400
NPVA = $405,000 23,400(PVIFA20%,3) = $454,291.67
OCFB = $60,000(1 0.34) + 0.34($450,000/5) = $9,000
NPVB = $450,000 9,000(PVIFA20%,5) = $476,915.51
If the system will not be replaced when it wears out, then system A should be chosen, because it has
the more positive NPV.
22. EACA = $454,291.67 / (PVIFA20%,3) = $215,663.74
EACB = $476,915.51 / (PVIFA20%,5) = $159,470.87
23. After-tax salvage value = $400,000(1 0.34) = $264,000
NPV = 0 = $2,400,000 900,000 600,000 + OCF (PVIFA15%,5) 50,000(PVIFA15%,4)
+ [($264,000 + 800,000) / 1.155]
OCF = $3,513,752.87 / PVIFA15%,5 = $1,048,207.13
OCF = $1,048,207.13 = [(Pv)Q FC ](1 tc) + tcD
$1,048,207.13 = [(P 0.006)(60,000,000) 600,000](1 0.34) + 0.34(2,400,000/5); P = $0.03835

24. At a given price, taking accelerated depreciation compared to straight-line depreciation causes the
NPV to be higher; similarly, at a given price, lower net working capital investment requirements will
cause the NPV to be higher. Thus, NPV would be zero at a lower price in this situation. In the case of
a bid price, you could submit a lower price and still break-even, or submit the higher price and make a
positive NPV.
Challenge
25
.

Year

Ending book value

Units/year
Price/unit
Variable cost/unit

$11,999,400
95,000
$330
$210

$8,570,800
107,000
$330
$210

$6,122,200
110,000
$330
$210

$4,373,600
112,000
$330
$210

$3,123,400
85,000
$330
$210

Sales
Variable costs
Fixed costs
Depreciation
EBIT
Taxes (35%)
Net Income
Dep
Operating CF

$31,350,000
19,950,000
750,000
2,000,600
8,649,400
3,027,290
5,621,110
2,000,600
$7,622,710

$35,310,000
22,470,000
750,000
3,428,600
8,661,400
3,031,490
5,629,910
3,428,600
$9,058,510

$36,300,000
23,100,000
750,000
2,448,600
10,001,400
3,500,490
6,500,910
2,448,600
$8,949,510

$36,960,000
23,520,000
750,000
1,748,600
10,941,400
3,829,490
7,111,910
1,748,600
$ 8,860,510

$28,050,000
17,850,000
750,000
1,250,200
8,199,800
2,869,930
5,329,870
1,250,200
$6,580,070

Year
Operating CF
Change in NWC
Capital spending

Total CF

$0
(1,500,000)
(14,000,000)
($15,500,000
)

Net present value = $5,765,104.97;

1
$7,622,710
(792,000)
0

2
$9,058,510
(198,000)
0

3
$8,949,510
(132,000)
0

4
$8,860,510
1,782,000
0

5
$6,580,070
840,000
3,823,190

$6,830,710

$8,860,510

$8,817,510

$10,642,510

$11,243,260

IRR = 46.77%

26. D1 = $540,000(0.3333) = $179,982

D2 = $540,000(0.4444) = $239,976
D3 = $540,000(0.1482) = $80,028
D4 = $540,000(0.0741) = $40,014
After-tax salvage value = $60,000(1 0.35) = $39,000
OCF1 = (S C)(1 0.35) + 0.35($179,982)
OCF2 = (S C)(1 0.35) + 0.35($239,976)
OCF3 = (S C)(1 0.35) + 0.35($80,028)
OCF4 = (S C)(1 0.35) + 0.35($40,014)
OCF5 = (S C)(1 0.35)
NPV = 0 = $540,000 40,000 + (S C)(0.65)(PVIFA12%,5) + 0.35($179,982/1.12
+ $239,976/1.122 + $80,028/1.123 + $40,014/1.124) + ($39,000 + 40,000)/1.125
(S C)(0.65)(PVIFA12%,5) = $383,134.12; (S C) = $163,515.59
27.a. Assume price per unit = $11 and units/year = 170,000
Year
1
2
Sales
$1,870,000
$1,870,000
Variable costs
1,360,000
1,360,000
Fixed costs
160,000
160,000
Depreciation
102,000
102,000
EBIT
248,000
248,000
Taxes (35%)
86,800
86,800
Net Income
161,200
161,200
Dep
102,000
102,000
Operating CF
$263,200
$263,200

3
$1,870,000
1,360,000
160,000
102,000
248,000
86,800
161,200
102,000
$263,200

4
$1,870,000
1,360,000
160,000
102,000
248,000
86,800
161,200
102,000
$263,200

5
$1,870,000
1,360,000
160,000
102,000
248,000
86,800
161,200
102,000
$263,200

Year
Operating CF
Change in NWC
Capital spending
Total CF

0
$0
(60,000)
(510,000)
($570,000)

1
$263,200
0
0
$263,200

2
$263,200
0
0
$263,200

3
$263,200
0
0
$263,200

4
$263,200
0
0
$263,200

5
$263,200
60,000
26,000
$349,200

Net Present Value = $332,739.81

b. Aftertax salvage value = $40,000(1 0.35) = $26,000
NPV = 0 = $510,000 60,000 + OCF(PVIFA16%,5) + [($60,000 + 26,000) / 1.165]
OCF = $529,054.28 / PVIFA16%,5 = $161,578.14
OCF = $161,578 = [(Pv)Q FC ](1 tc) + tcD

$161,578 = [($11.00 8.00)Q 160,000 ](1 0.35) + 0.35($510,000/5) ; Q = 117,886

Year
Sales
Variable costs
Fixed costs
Depreciation
EBIT
Taxes (35%)
Net Income
Dep
Operating CF

1
$1,296,746
943,088
160,000
102,000
91,658
32,080
59,578
102,000
$161,578

Year
Operating CF
Change in NWC
Capital spending
Total CF

0
$0
(60,000)
(510,000)
($570,000)

2
$1,296,746
943,088
160,000
102,000
91,658
32,080
59,578
102,000
$161,578
1
$161,578
0
0
$161,578

3
$1,296,746
943,088
160,000
102,000
91,658
32,080
59,578
102,000
$161,578

2
$161,578
0
0
$161,578

4
$1,296,746
943,088
160,000
102,000
91,658
32,080
59,578
102,000
$161,578

3
$161,578
0
0
$161,578

5
$1,296,746
943,088
160,000
102,000
91,658
32,080
59,578
102,000
$161,578

4
$161,578
0
0
$161,578

5
$161,578
60,000
26,000
$247,578

Net Present Value $0

c. Aftertax salvage value = $40,000(1 0.35) = $26,000
NPV = 0 = $510,000 60,000 + OCF(PVIFA16%,5) + [($60,000 + 26,000) / 1.165]
OCF = $529,054.28 / PVIFA16%,5 = $161,578.14
OCF = $161,578 = [(Pv)Q FC ](1 tc) + tcD

$161,578 = [($11.00 8.00)(170,000) FC](1 0.35) + 0.35($510,000/5); FC = $316,342

Year
Sales
Variable costs
Fixed costs
Depreciation
EBIT
Taxes (35%)
Net Income
Dep
Operating CF

1
$1,870,000
1,360,000
316,342
102,000
91,658
32,080
59,578
102,000
$161,578

Year
Operating CF
Change in NWC
Capital spending
Total CF

Net Present Value $0

$0
(60,000)
(510,000)
($570,000)

2
$1,870,000
1,360,000
316,342
102,000
91,658
32,080
59,578
102,000
$161,578
1
$161,578
0
0
$161,578

3
$1,870,000
1,360,000
316,342
102,000
91,658
32,080
59,578
102,000
$161,578

2
$161,578
0
0
$161,578

3
$161,578
0
0
$161,578

4
$1,870,000
1,360,000
316,342
102,000
91,658
32,080
59,578
102,000
$161,578
4
$161,578
0
0
$161,578

5
$1,870,000
1,360,000
316,342
102,000
91,658
32,080
59,578
102,000
$161,578
5
$161,578
60,000
26,000
$247,578