CHAPTER 10

Making Capital Investment Decisions

Learning Objectives

LO1 How to determine relevant cash flows for a proposed project.

LO2 How to project cash flows and determine if a project is acceptable.
LO3 How to calculate operating cash flow using alternative methods.
LO4 How to calculate the present value of a tax shield on CCA.
LO5 How to evaluate cost-cutting proposals.
LO6 How to analyze replacement decisions.
LO7 How to evaluate the equivalent annual cost of a project.
LO8 How to set a bid price for a project.

Answers to Concepts Review and Critical Thinking Questions

1. (LO1) An opportunity cost is the most valuable alternative that is foregone if a particular project is undertaken.
The relevant opportunity cost is what the asset or input is actually worth today, not, for example, what it cost
to acquire.

2. (LO1) It’s probably only a mild over-simplification. Current liabilities will all be paid presumably. The cash
portion of current assets will be retrieved. Some receivables won’t 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 project’s life) acts to increase working capital. These effects tend to offset.

3. (LO7) 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.

4. (LO1) 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 included to get the total incremental aftertax cash flows.

5. (LO1) 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 publisher’s
perspective) or new books (not good). The concern arises any time there is an active market for used product.

6. (LO1) This market was heating up rapidly, and a number of other competitors were planning on entering. Any
erosion of existing services would be offset by an overall increase in market demand.

7. (LO1) Pistachio should have realized that abnormally large profits would dwindle as more supply of services
came into the market and competition became more intense.

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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. (LO1) The $3.5 million acquisition cost of the land six years ago is a sunk cost. The $3.9 million current
aftertax value of the land is an opportunity cost if the land is used rather than sold off. The $16.7 million cash
outlay and $850,000 grading expenses are the initial fixed asset investments needed to get the project going.
Therefore, the proper Year 0 cash flow to use in evaluating this project is

$3,900,000 + 16,700,000 + 850,000 = $21,450,000

2. (LO1) Sales due solely to the new product line are:

25,000($19,000) = $475,000,000

Increased sales of the motor home line occur because of the new product line introduction; thus:

2,700($73,000) = $197,100,000

in new sales is relevant. Erosion of luxury motor coach sales is also due to the new portable campers; thus:

1,300($120,000) = $156,000,000 loss in sales

is relevant. The net sales figure to use in evaluating the new line is thus:

$475,000,000 + 197,100,000 – 156,000,000 = $516,100,000

3. (LO1) We need to construct a basic Statement of Comprehensive Income. The Statement of Comprehensive
Income is:

Sales $ 635,000
Variable costs 279,400
Fixed costs 193,000
Depreciation 54,000
EBT $ 108,600
Taxes@35% 38,010
Net income $ 70,590

Taxes $108,600 x (35%) = $38,010

4. (LO3) To find the OCF, we need to complete the Statement of Comprehensive Income as follows:

Sales $ 713,500
Costs 497,300
Depreciation 87,400
EBIT $ 128,800
Taxes@34% 43,792
Net income $ 85,008

10-2
 The OCF for the company is:

OCF = EBIT + Depreciation – Taxes

OCF = $128,800 + 87,400 – 43,792
OCF = $172,408

The depreciation tax shield, also called the CCA tax shield, is the depreciation times the tax rate, so:

Depreciation tax shield = tc(Depreciation)

Depreciation tax shield = 0.34($87,400)
Depreciation tax shield = $29,716

The depreciation tax shield shows us the increase in OCF by being able to expense depreciation.

5. (LO3) To calculate the OCF, we first need to calculate net income. The Statement of Comprehensive Income
is:

Sales $ 164,000
Variable costs 87,000
Depreciation 15,200
EBT $ 61,800
Taxes@35% 21,630
Net income $ 40,170

Using the most common financial calculation for OCF, we get:

OCF = EBIT + Depreciation – Taxes

OCF = $61,800 + 15,200 – 21,630
OCF = $55,370

The top-down approach to calculating OCF yields:

OCF = Sales – Costs – Taxes

OCF = $164,000 – 87,000 – 21,630
OCF = $55,370

The tax-shield approach is:

OCF = (Sales – Costs)(1 – tC) + tC(Depreciation)

OCF = ($164,000 – 87,000)(1 – 0.35) + 0.35(15,200)
OCF = $55,370

And the bottom-up approach is:

OCF = Net income + Depreciation

OCF = $40,170 + 15,200
OCF = $55,370

All four methods of calculating OCF should always give the same answer.

10-3
6. (LO1)
Sales $ 940,000
Variable costs 385,400
Fixed costs 147,000
CCA 104,000
EBIT $ 303,600
Taxes@35% 106,260
Net income $ 197,340

Taxes $303,600 x (35%) = $106,260

7. (LO1, 2)
Cash flow year 0 = -990,000
Cash flow years 1 through 5 = 460,000(1 – 0.40) = $276,000

PV of CCATS = 990,000(0.3)(0.4) x (1 + 0.5(0.15))

0.15 + 0.3 1 + 0.15
= $246,782.61

NPV = -990,000 + 276,000 x PVIFA (15%, 5) + 246,782.61

= -990,000 + 276,000 x {1 – [1/1+0.15]5/0.15} + 246,782.61
= $181,977.42

8. (LO2)
Cash flow year 0 = -990,000 – 47,200 = -$1,037,200
Cash flow years 1 through 5 = 460,000(1 – 0.4) = $276,000
Ending cash flow = 100,000 + 47,200 = $147,200

PV of CCATS = 990,000(0.3)(0.4) x (1 + 0.5(0.15)) – 100,000(0.3)(0.4) x 1

0.15 + 0.3 1 + 0.15 0.15 + 0.3 (1.15)5

= $233,524.56

NPV = -1,037,200+ 276,000 x PVIFA(15%, 5) + (147,200)/(1.15)5 + 233,524.56 = $194,703.78

9. (LO2)
a. Cash flow year 0 = -990,000 – 47,200 = -$1,037,200
Cash flow years 1 through 5 = 460,000(1 – 0.4) = $276,000
Ending cash flow = 100,000 + 47,200 = $147,200

PV of CCATS = 990,000(0.3)(0.4) x (1 + 0.5(0.15)) – 100,000(0.3)(0.4) x 1

0.15 + 0.3 1 + 0.15 0.15 + 0.3 (1.15)5

= $233,524.56

NPV = -1,037,200+ 276,000 x PVIFA(15%, 5) + (147,200)/(1.15)5 + 233,524.56 = $194,703.78

b. PV of CCATS = 990,000(0.25)(0.4) x (1 + 0.5(0.15)) – 100,000(0.25)(0.4) x 1

0.15 + 0.25 1 + 0.15 0 .15 + 0.25 (1.15)5

= $218,929.28

Therefore with a 25% CCA rate, the

NPV = 194,703.79 + (218,929.28– 233,524.57) = $181,108.50

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 c. The NPV will be smaller because the Capital Cost Allowances are smaller early on.

10. (LO1) Neither one is correct. What should be considered is the opportunity cost of using the land, at the very
least what the land could be sold for today.

11. (LO4) Generally, as long as there are other assets in the class, the pool remains open and there are no tax
effects from the sale. This fact does not hold here since we are told that there will be no assets left in the
class in 6 years.

Beyond the first year, the UCC at the beginning of the Nth year is given by the formula:
 d
UCCN =C 1 −  (1 − d )
N −2

 2 
Where C = installed capital cost; d = CCA rate. Note that the half-year rule has been incorporated. In this
case:

UCC6 = $730,000 (1 – (0.2/2)) (1-0.2)6-2 = $269,107.20

This is the book value of the asset at the end of the 5th year (beginning of the sixth).

The asset is sold at a (terminal) loss to book value = $269,107.20– $192,000 = $77,107.20. The terminal loss
acts as a tax shield which the company can use to reduce its taxes. The reduction in taxes is a cash inflow.

The tax shield = 0.40 × $77,107.20= $30,842.88

The after tax salvage value = $192,000 + $30,842.88= $222,842.88 .

12. (LO2) A/R fell by $6,140, and inventory increased by $5,640, so net current assets fell by $500. A/P rose by
$6,930.

∆NWC = ∆(CA – CL) = –500 – 6,930 = – 7,430

Net cash flow = S – C – ∆NWC = 102,000 – 43,500 – (– 7,430) = $65,930

13. (LO3)
CCA1 = 0.3($3.9M/2) = $585,000; CCA2 = 0.3(3.9M – $585,000) = $994,500;
CCA3 = 0.3($3.9M – 585,000 – 994,500) = $696,150.
OCF1 = (S – C)(1 – tc) + tcD = ($2.65M – $840K)(1 – 0.35) + 0.35($585,000) = $1,381,250
OCF2 = (S – C)(1 – tc) + tcD = ($2.65M – $840K)(1 – 0.35) + 0.35($994,500) = $1,524,575
OCF3 = (S – C)(1 – tc) + tcD = ($2.65M – $840K)(1 – 0.35) + 0.35($696,150) = $1,420,152.50

10-5
14. (LO2)
Initial Cash Flow year 0 = -$2,650,000

After-tax net revenue years 1-3 = (S – C)(1 – tC) = ($2,650,000 – 840,000)(1 – 0.35) = $1,176,500
Ending cash flows (year 3) = salvage value = $1,624,350

PV of CCATS = 3,900,000(0.3)(0.35) x (1 + 0.5(0.12)) – 1,624,350 (0.3)(0.35) x 1

0.12 + 0.3 1 + 0.12 0.12 + 0.3 (1.12)3

= $633,722.80

Since we have the OCF, we can find the NPV as the initial cash outlay plus the PV of the OCFs, which are an
annuity, so the NPV is:

NPV = – $3.9M + $1,176,500(PVIFA12%, 3) + $633,722.80 + $1,624,350/1.123

= $715,657.53

15. (LO1, 2)
Cash Flow year 0 = -$3,900,000 – 300,000 = -$4,200,000
After-tax net revenue years 1-3 = (S – C)(1 – Tc) = ($2,650,000 – 840,000)(1 – 0.35) = $1,176,500
Ending cash flows (year 3) = recovery of NWC + salvage value = $300,000 + 210,000 = $510,000

PV of CCATS = 3,900,000(.3)(.35) x (1 + .5(.12)) –

.12 + .3 1 + .12

210,000(.3)(.35) x 1
.12 + .3 (1.12)3

= $885,399.39

NPV = –$4.2M + $1,176,500(PVIFA12%,3) + $885,399.39 + $510,000/1.123 = -$125,838.20

16. (LO1, 2)
Initial Cash Flow year 0 = -785,000 – 140,000 = -$925,000
After-tax net revenue years 1 through 5 = (13,500,000 – 11,700,000 – 215,000)(1 – 0.35) = $1,030,250
Ending cash flows (year 5) = $140,000

PV of CCATS = 785,000(0.25)(0.35) x (1 + 0.5(0.19))

0.19 + 0.25 (1 + 0.19)

= $143,645.55

NPV = -925,000 + 143,645.55 + 1,030,250 x PVIFA(19%,5) + 140,000/(1.19)5

= $2,427,440.81

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

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17. (LO2) Assuming that all outstanding accounts receivable from the previous quarter are collected in the current
quarter, the amount of cash collections in the current quarter is:

$15,200 – 9,500 = $5,700

This can be seen by making collections from current quarter sales a plug number Y in the current quarter’s
cash flow summary for accounts receivable:

Opening balance of A/R X

Current quarter sales $15,200
Collections of outstanding A/R from previous quarter –X
Collections from current quarter sales –Y
Closing balance of A/R $15,200 - Y

This gives the equation: 15,200 – Y = X + 9,500

So the total cash collections in the current are:

X + Y = $5,700

18. (LO1) Management’s discretion to set the firm’s 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
firm’s overall capital structure remains unchanged, financing costs are not relevant in the analysis of a
project’s incremental cash flows according to the stand-alone principle.

19. (LO1) The $7.2 million acquisition cost of the land seven years ago is a sunk cost, and so it is not relevant.
The $586,000 grading cost to make the land usable is relevant. The $962,000 current appraisal of the land is an
opportunity cost if the land is used rather than sold off. If the land is sold at $962,000 there will be a capital
loss of (7,200,000 – 962,000) $6,238,000 of which the company can write off 50% of it against any taxable
Capital Gains. This means that at a tax rate of 30% they would be able to write off 30% x $3,119,000 and thus
save $935,700 in taxes.

The $25 million cash outlay is the initial fixed asset investment needed to get the project going. Therefore, the
proper year zero cash flow to use in evaluating this project is = $0.962M + $25M + 0.586M - $0.9357M=
$25,612,300.

20. (LO1) Currently the firm has sales of 23,000($14,690) + (38,600) ($43,700) = $2,024,690,000. With the
introduction of a new mid-sized car its sales will change by (28,500) ($33,600) + (12,500) ($14,690) – (8,200)
($43,700) = $782,885,000. This amount is the incremental sales and is the amount that should be considered
when evaluating the project.

21. (LO1, 2)
Initial Cash Flow 0 = -540,000 – 29,000 = -$569,000
After-tax savings in Operating Costs years 1 through 5 = (170,000) (1 – 0.34) = $112,200
Ending cash flows (year 5) = $80,000 + 29,000 = $109,000

PV of CCATS = 540,000(0.2)(0.34) x (1 + 0.5(0.10)) – 80,000(0.2)(0.34) x 1

(0.10 + 0.20) (1 + 0.10) (0.10 + 0.20) (1.10)5

= $105,576.99

NPV = -569,000 + 105,576.99 + 112,200 x PVIFA(10%, 5) + 109,000/(1.10)5

= $29,583.69

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22. (LO1, 2)
Initial cash flow net revenue year 0 = -425,000 + 60,000 = -$365,000
After-tax savings in order processing costs years 1 through 5 = (130,000)(1 – 0.35) = $84,500
Ending cash flows (year 5) = $30,000 – 60,000 = -$30,000

PV of CCATS = $91,209

NPV = 0 = -365,000 + 91,209 + 84,500 x PVIFA(IRR%,5) - 30,000/(1+IRR)5

NPV = 0 = -365,000 + 91,209 + 84,500 x ({1-[1/(1+IRR)]5}/IRR) - 30,000/(1+IRR)5

IRR = 14.12%

23. (LO1, 2)
$150,000 cost saving case
Initial cash flow net revenue year 0 = -425,000 + 60,000 = -$365,000
After-tax savings in processing costs years 1 through 5 = (150,000)(1 – 0.35) = $97,500
Ending cash flows (year 5) = $30,000 – 60,000 = -$30,000

PV of CCATS = $98,888.97

NPV = -365,000+ 98,888.97 + 97,500x PVIFA(11%,5) - 30,000/(1+0.11)5 = $76,435.39

Accept the project.

$100,000 cost saving case

Initial cash flow net revenue year 0 = -425,000 + 60,000 = -$365,000
After-tax savings in processing costs years 1 through 5 = (100,000)(1 – 0.35) = $65,000
Ending cash flows (year 5) = $30,000 – 60,000 = -$30,000

PV of CCATS = $98,888.97

NPV = -365,000+ 98,888.97 + 65,000 x PVIFA(11%,5) - 30,000/(1+0.11)5 = -$43,681.26

Reject the project.

Required pretax cost saving case (RCS)

Initial cash flow net revenue year 0 = -425,000 + 60,000 = -$365,000
Ending cash flows (year 5) = $30,000 – 60,000 = -$30,000

PV of CCATS = $98,888.97

NPV = 0 = -365,000+ 98,888.97 + RCS(1 – 0.35) x PVIFA(11%,5) - 30,000/(1+0.11)5

Solve for RCS

RCS = Required pretax cost saving = $118,182.85

24. (LO8)
Cash flow Year PV @ 20%
Capital Spending -1,300,000 0 -$1,300,000
Salvage 650,000 3 376,157.41
Additions to NWC -340,000 0 -340,000
340,000 3 196,759.26
Aftertax operating income 1 to 3 ?
Tax shield on CCA* 146,791.67
NPV 0

10-8
 Solving for PV of after-tax operating income we obtain: $ 920,291.67
Dividing by PVIFA(20%,3) we find that annual after-tax operating income must be $436,885.71

Consequently, sales must be $436,885.71/ (1 – 0.36) + 89($96,000) = $9,226,633.93 in order to break even.
Therefore the selling price should be no less than $9,226,633.92 / 89 or $103,670.04 per system.

*PV of CCATS = 1,300,000(0.2)(0.36) x (1 + 0.5(0.2)) – 650,000(0.2)(0.36) x 1

3
(0.2 + 0.2) (1 + 0.2) (0.2 + 0.2) (1.2)

= $146,791.67

25. (LO3)
a. EBIT = Sales – cost – depreciation = $425,000 – $96,000 – $375,000 × 0.2 = $254,000

b. According to the bottom-up approach:

OCF = (S – C – D)(1 – T) + D = $254,000 × (1 – 0.35) + $75,000 = $ 240,100

c. According to the tax shield approach:

OCF = (S – C)(1 – T) + TD = ($425,000 – $96,000) × (1 – 0.35) + 0.35 × $75,000 = $240,100

26. (LO3)
Depreciation = $280,000/2 ×0.25 = $35,000
According to the top down approach:
OCF = (S – C) – (S – C – D) × T = ($650,000 – $490,000) – (650,000 – $490,000 – $35,000) × 0.38
= $112,500

According to the tax shield approach:

OCF = (S – C)(1 – T) + TD = ($650,000 – $490,000) × (1 – 0.38) + 0.38 × $35,000 = $112,500

27. (LO7)
Method 1: PV @ 13%(Costs) = -$6,700 – 400 × PVIFA (13%, 3) = -$7,644.46
Method 2: PV @ 13%(Costs) = -$9,900 – 620 × PVIFA (13%, 4) = -$11,744.17
Difference = $4,099.71 in favour of Method 1

Without replacement: On this basis we would need to know whether the benefit of 1 more year’s use is
sufficient to offset the additional cost of $4,099.71.

With replacement: Method 1: EAC = -7,644.46/PVIFA(13%,3) = -$3,237.60

Method 2: EAC = -11,744.17/PVIFA(13%,4) = -$3,948.32

On this basis, Method 2 is again more expensive.

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28. (LO7)
Method 1: CF0 = -$6,700
PVCCATS = (6,700)(0.39)(0.25)(1.065)/[(0.13 + 0.25)(1.13)] = $1,620.19
PV(Costs) = -400(1 – 0.39)PVIFA (13%, 3) – 6,700 + 1,620.19 = -$5,655.93
EAC = -$5,655.93/PVIFA(13%, 3) = -$2,395.41

Method 2: CF0 = -$9,900

PVCCATS = (9,900)(0.39)(0.25)(1.065)/[(0.13 + 0.25)(1.13)] = $2,394.02
PV(Costs) = -620(1 – 0.39)PVIFA (13%, 4) – 9,900 + 2,394.02 = -$8,630.93
EAC = -$8,630.93/PVIFA(13%, 4) = -$2,901.67

Method 2 is more expensive.

29. (LO7) To calculate the EAC of the project, we first need the NPV of the project. Notice that we include the
NWC expenditure at the beginning of the project, and recover the NWC at the end of the project. The NPV of
the project is:

NPV = –$270,000 – 25,000 – $42,000(PVIFA11%,5) + $25,000/1.115 = –$435,391.39

Now we can find the EAC of the project. The EAC is:

EAC = –$435,391.39 / (PVIFA11%,5) = –$117,803.98

30. (LO7)
Assuming a carry-forward on taxes:
Both cases: salvage value = $40,000

Techron I: After-tax operating costs = $69,000(1 – 0.35) = $44,850

PVCCATS = (270,000)(0.35)(0.20)(1.05)/[(0.10 + 0.20)(1.10)] – {[(45,000)(0.20)(0.35)/[0.10 + 0.20]]
(1/1.10)3}= $52,247.56
PV(Costs) = -$290,000 – 44,850(PVIFA10%,3) + (45,000/1.103) + 52,247.56 = -$315,478.58
EAC = -$315,478.58/ (PVIFA10%,3) = -$126,858.61

Techron II: After-tax operating costs = $36,000(1 – 0.35) = $23,400

PVCCATS = (475,000)(0.35)(0.20)(1.05)/[(0.10 + 0.20)(1.10)] – {[(45,000)(0.20)(0.35)/[0.10 + 0.20]]
(1/1.10)5}= $99,275.78
PV(Costs) = -$475,000 – 23,400(PVIFA10%,5) + (45,000/1.105) 99,275.78 = -$436,487.17
EAC = -$436,487.17 / (PVIFA10%,5) = -$115,144.22

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 annual cost.

31. (LO7)
Pre-fab segments
Given: Initial cost = $6.5M; d = 4%; k = 11%; T = 35%; S = 0.25 x $6.5M = $1,625,000;
n = 25
PVCCATS = $565,442.71
Assuming end of year costs:
PV(Costs) = -$150,000x(1-0.35) x PVIFA(11%, 25) = -$821,120.10
Total PV(Costs) = -$6,500,000 – $821,120.10 + $565,442.71 + $1,625,000PVIF(11%, 25)
= -$6,636,064.25
EAC = -$6,636,064.25/PVIFA(11%, 25) = -$787,967.88

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 Carbon-fibre technology
Given: Initial cost = $8.2M; d = 4%; k = 11%; T = 35%; S = 0.25 x $8.2M = $2,050,000;
n = 40
PVCCATS = $724,467.86
Assuming end of year costs:
PV(Costs) = -$650,000x(1-0.35)x[PVIF(11%, 10) + PVIF(11%, 20) + PVIF(11%, 30) + PVIF(11%,
40)] = -$226,158.17
Total PV(Costs) = -$8,200,000 – $226,158.17 + $724,467.86 + $2,050,000PVIF(11%, 40)
= -$7,670,152.27
EAC = -$7,670,152.27/PVIFA(11%, 40) = -$856,899.65

The pre-fab segments represent a lower cost choice.

32. (LO7) The present value of the operating costs can be evaluated as a growing annuity. The first annual after-
tax operating cost = C =$32,000(1 – 0.35) = $20,800. We know that:

PV(Growing annuity) = C x (1 – (1+g/1+R)n) = $20,800 x (1 - {(1+0.02)/(1+0.11)}7)

(R – g) (0.11-0.02)

= $103,243,32

PVCCATS = $96,023.55
PV(Costs) = -$550,000 + $96,023.55 – $103,243.32 + $98,000/(1.11)7 = -$510,017.24
EAC = -$510,017.24/PVIFA(11%,7) = -$108,233.45

33. (LO8)
Given: Initial cost = $940,000; d = 30%; r = 12%; T = 35%; S = $85,000; n = 5; NWC=$90,000
PVCCATS = $
NPV = $0 = – $940,000 – 90,000 + + (After-tax net revenue)(PVIFA12%,5) +
[(85,000 + 90,000) / 1.125]
After-tax net revenue = $930,700.30/ PVIFA12%,5 = $258,185.34
$258,185.34 = [ (P–v)Q – FC ](1 – tc) = [(P – 15.10)140,000 – 435,000](0.65)
Solve for P to find:
P = $21.04
You should bid at least $21.04 per cartoon of screws.

34. (LO5)
PVCCATS = $85,474.83
Annual after-tax savings = $150,000(1 – 0.35) = $97,500
There is an initial increase in inventory of $20,000, and in each year there is any additional cash outflow of
$3,100 to finance inventory costs. At the end of the project, there is a recovery of the initial and annual
outflows = $20,000 + 4($3,100) = $32,400
NPV = -$410,000 – $20,000 + $85,474.83 + ($97,500 – $3,100)PVIFA(9%,4) + ($55,000 + $32,400)/1.094 =
$23,220.75

Accept the project.

10-11
Intermediate

35. (LO2) CF0 = -24,000,000 – 1,800,000 = -$25,800,000

ΔNWC= (15% × ΔSales) = – 15% (next period sales – current period sales)

1 2 3 4 5
Sales 35,340,000 39,900,000 48,640,000 50,920,000 33,060,000
Variable costs 24,645,000 27,825,000 33,920,000 35,510,000 23,055,000
Fixed costs 1,200,000 1,200,000 1,200,000 1,200,000 1,200,000
Net profit 9,495,000 10,875,000 13,520,000 14,210,000 8,805,000
Taxes(35%) 3,323,250 3,806,250 4,732,000 4,973,500 3,081,750
Net profit after-tax 6,171,750 7,068,750 8,788,000 9,236,500 5,723,250
ΔNWC= (15% × ΔSales) -684,000 -1,311,000 -342,000 2,679,000 1,458,000
NWC balance -2,484,000 -3,795,000 -4,137,000 -1,458,000 0
Cash flow = Net profit 5,487,750 5,757,750 8,446,000 11,915,500 7,181,250
after-tax + (ΔNWC) or
NWC recovered
Salvage value (20%) 4,800,000
Total cash flow 5,487,750 5,757,750 8,446,000 11,915,500 11,981,250
PV(t = 0) 4,650,635.59 4,135,126.40 5,140,496.35 6,145,882.34 5,237,114.80

PVCCATS = $3,697,357.13
NPV = -$25,800,000 + $3,697,357.13 + $4,650,635.59+ $4,135,126.40+ $5,140,496.35+ $6,145,882.34
+ $5,237,114.80
= $3,206,612.61
The project should be accepted because NPV is positive.

36. (LO6) New excavator costs = $950,000 but SV0=$50,000; Therefore, ∆CF0 = $900,000. ∆Operating revenues
=$90,000 and ∆SV10=175,000 – 3,000=$172,000.

PV of CCATS = 900,000(0.25)(0.35) x (1 + 0.5(0.14)) - 172,000(0.25)(0.35) x 1

10
(0.14 + 0.25) (1 + 0.14) (0.14 + 0.25) (1.14)

= $179,114.95

NPV = 90,000(1 – 0.35) x PVIFA (14%, 10) + 172,000 x PVIF (14%, 10) + 179,114.95 – 900,000
= -$369,346.35
Do not replace the existing excavator.

37. (LO6)
∆CF0 = 12,000 – 500 = $11,500, ∆SV4 = 1,600 – 250 = $1,350, and ∆Operating revenues = $8,000.

PV of CCATS = 11,500(0.25)(0.22) x (1 + 0.5(0.15)) – 1,350(0.25)(0.22) x 1

4
(0.15 + 0.25) (1 + 0.15) (0.15 + 0.25) (1.15)

= $1,372

NPV = 8,000(1 – 0.22) x PVIFA (15%, 4) +1,372 + 1,350 x PVIF (15%, 4) – 11,500
= $8,458.93

The student should buy the new equipment.

38. (LO7) Underground (U): CF0 = $9.2M, annual costs = $80,000, n=20

10-12
 PV(CostsU) = [-$80,000(1 – 0.39) + ($9.2M/20)(0.39)] x PVIFA (13%, 20) – $9.2M = -$8,282,567.44

EACU = -$8,282,567.44/PVIFA(13%, 20) = -$1,179,054.85

Above ground (A): CF0 = $6.8M, annual costs = $190,000, n = 9

PV(CostsA) = [-$190,000(1 – 0.39) + ($6.8M/9)(0.39)] x PVIFA (13%, 9) – $6.8M = -$5,882,631.12

EACA = -$5,882,631.12/PVIFA(13%, 9) = -$1,146,341.87

The above ground system is cheaper for the firm.

39. (LO1, 2)
Product A:

PV of CCATS = 382,000(0.2)(0.36) x (1 + 0.5(0.16)) + (102,000/15)(0.36) x PVIFA (16%, 15) = $84,779.75

(0.2 + 0.16) (1 + 0.16)

PV (Net cash flows) = (323,100 – 174,700) (1 – 0.36) x PVIFA (16%, 15) = $529,534.52

NPV = 84,779.75 + 529,534.52 – 19,200(1 – 0.36) x PVIF (16%, 15) – (102,000 + 382,000) = $128,988.07

Product B:

PV of CCATS = 456,000(0.2)(0.36) x (1 + 0.5(0.16)) + (192,250/15)(0.36) x PVIFA (16%, 15) = $110,635.50

(0.2 + 0.16) (1 + 0.16)

PV (Net cash flows) = (396,000 – 235,700)(1 – 0.36) x PVIFA (16%, 15) = $571,997.20

NPV = 110,635.50 + 571,997.20 – 129,250(1 – 0.36) x PVIF (16%, 15) – (192,250 + 456,000) = $25,454.98

Continue to rent:

NPV = 75,000(1 – 0.36) x PVIFA (16%, 15) = $267,621.90

Continue to rent the building (highest NPV).

Note: If the lost rent from renovations is included as an opportunity cost in the evaluation of Products A and
B, their NPVs would be negative, indicating that the firm should not produce either of those items and, instead,
continue to rent the facility.

40. (LO1, 2) The rule is to discount nominal cash flows using nominal rates and real cash flows using real rates.
Our choice is simple here. We should use nominal values for cash flows and rates since the rate of inflation is
not provided.

V = ($820K/0.16) + ($1,900,000 – $1,400,000) = $5,625,000.

Therefore, P0 = $5,625,000/385,000=$14.61/share.

41. (LO1, 2)

10-13
 Note the textbook incorrectly states the interest rate is 82%. It should be 8%.
Operating costsA = $80,000(1 – 0.34) = $52,800
PVCCATSA = $74,959.06
PV(CostsA) = -$290,000 – $52,800 x PVIFA(8%, 4) + $74,959.06 = -$389,921.24

Operating costsB = $74,000(1 – 0.34) = $48,840

PVCCATSB = $96,929.82
PV(CostsB) = -$375,000 – $48,840 x PVIFA(8%, 6) + $96,929.82 = -$503,851.62

If the system will not be replaced when it wears out, then system A should be chosen, because it has a lower
present value of costs.

42. (LO1, 2)

Operating costsA = $80,000(1 – 0.34) = $52,800

PVCCATSA = $74,959.06
PV(CostsA) = -$290,000 – $52,800 x PVIFA(8%, 4) + $74,959.06 = -$389,921.24

Operating costsB = $74,000(1 – 0.34) = $48,840

PVCCATSB = $96,929.82
PV(CostsB) = -$375,000 – $48,840 x PVIFA(8%, 6) + $96,929.82 = -$503,851.62

EACA = -$389,921.24 / PVIFA(8%, 4) = -$117,725.33

EACB = -$503,851.62 / PVIFA(8%, 6) = -$108,990.86

If the system is replaced, system B should be chosen because it has a smaller EAC.

43. (LO8)
NOTE PVIF = 1/(1+r)n
NOTE PVIFA = (1 – 1/(1+r)n)/r
where r = discount rate and n=number of periods

Let: After-tax net revenue = ATNR = [(P–v)Q – FC ](1 – tc)

v = $0.0045 per stamp
Q = 100 million
FC = $1,200,000
Tax rate = 34%
Required rate of return = 12%
After-tax opportunity cost of land today = $1,080,000
After-tax salvage value of land in 5 years = $1,150,000
Initial investment = $4,600,000
Salvage value = $400,000
NWC 0 = $600,000
NWC 1 – 5 = $50,000
All NWC recoverable in year 5
PVCCATS = $4,600,000(0.3)(0.34) x 1 + 0.5(0.12) - $400,000(0.3)(0.34) x 1
(0.3 + 0.12) 1.12 (0.3+0.12) 1.125
= $1,002,174.45

NPV = 0 = – $1,080,000 – $4,600,000 – $600,000 + $1,002,174.45 + ATNR*PVIFA(12%, 5) –

50,000*PVIFA(12%, 5) + (400,000 + (600,000 + 5*50,000) + 1,150,000)*PVIF(12%, 5)

NPV = 0 = -5,277,825.55 + ATNR*PVIFA(12%, 5) – 180,238.81 + 1,361,824.45

ATNR = $4,096,239.91 / PVIFA(12%, 5) = $1,136,336.82

ATNR = $1,136,336.82 = [(P–v)Q – FC ](1 – tc)

10-14
 $1,136,336.82 = [(P – 0.0045)(100,000,000) – 1,200,000](1 – 0.34)
$1,721,722.46 = [(P – 0.0045)(100,000,000) – 1,200,000]
P = $0.03372 per stamp (or higher)

44. (LO7) SAL5000 DET1000

12 machines needed 10 machines needed
cost/machine=$15,900 cost/machine=$19,000
Op. Costs=$1,850/yr Op. Costs=$1,700/yr
SV6 = $1,300 SV4 = 0

NPVSAL5000=[-1,850 x PVIFA (15%, 6) – 15,900 + 1,300 x PVIF (15%, 6)](12) = -$268,071.21

NPVDET1000=[-1,700 x PVIFA (15%, 4) – 19,000](10) = -$238,534.63

Using a replacement chain, we effectively assume that each alternative is duplicated over identical future
periods of time until they both meet at the same point in time. If the SAL5000 is repeated once it will extend
out to 12 years. If the DET1000 is repeated two more times (two subsequent four-year periods) it will also
extend out to the same point in time thus allowing for a more reasonable comparison between the two.

NPVSAL5000 = -268,071.21– 268,071.21 x PVIF (15%, 6) = -$383,965.79

NPVDET1000 = -238,534.63– 238,534.63 x PVIF (15%, 4) – 238,534.63 x PVIF (15%, 8) = -$452,894.98

Choose the SAL5000 model.

Note that we would have arrived at the same recommendation, namely choose the SAL model, if we had
calculated EAC values for the two alternatives. The EAC method implicitly assumes the replacement chain that
we have used here.

45. (LO7) X: Y:
C0 = 743,000 C0 = 989,000
Savings/yr. = 296,000 Savings/yr. = 279,000
n=6 n=10

k = 12%

NPVX = $296,000 × PVIFA (12%,6) – $743,000 = $473,976.57

NPVY = $279,000 × PVIFA (12%, 10) – $989,000 = $587,412.22

Annuity Factor X [1-(1/(1.126)/0.12)] = 4.11141

Annuity Factor Y [1-(1/(1.1210)/0.12)] = 5.65022

EABX = $473,976.57/ 4.1141 = $115,283.22

EABY = $587,412.22/5.65022 = $103,962.68

Choose Mixer X, it has the higher Equivalent Annual Benefit.

Challenge

46. (LO1, 2)
a. Assuming the project lasts four years, the NPV is calculated as follows:

10-15
 Year 0 1 2 3 4
After-tax profit $1,525,000 $1,525,000 $1,525,000 $1,525,000

Change in NWC (2,000,000) 0 0 0 2,000,000

Capital spending (7,000,000) 0 0 0 0
Total cash flow ($9,000,000) $1,525,000 $1,525,000 $1,525,000 $3,525,000

PVCCATS = $1,941,860.08
Net present value = -$1,295,433.70

b. Abandoned after one year:

Year 0 1
After-tax profit $1,525,000

Change in NWC (2,000,000) 2,000,000

Capital spending (7,000,000) 5,000,000
Total cash flow ($9,000,000) $8,525,000

PVCCATS = $639,472.37
Net present value = -$816,279.85

Abandoned after two years:

Year 0 1 2
After-tax profit $1,525,000 $1,525,000

Change in NWC (2,000,000) 0 2,000,000

Capital spending (7,000,000) 0 4,740,000
Total cash flow ($9,000,000) $1,525,000 $8,265,000

PVCCATS = $849,237.47
Net present value = -$328,497.67

Abandoned after three years:

Year 0 1 2 3
After-tax profit $1,525,000 $1,525,000 $1,525,000

Change in NWC (2,000,000) 0 0 2,000,000

Capital spending (7,000,000) 0 0 2,600,000
Total cash flow ($9,000,000) $1,525,000 $1,525,000 $6,125,000

PVCCATS = $1,411,480.56
Net present value = -$799,730.99

The decision to abandon is an important variable when evaluating the NPV of a project. This particular project
should not proceed because all NPV values are negative, but it can be seen that the option to abandon results in
the maximum NPV occurring after two years.

47. (LO1, 2)
Cash flows for year 0 = -$364,000
Cash flows for years 1-5 = (36,000 + 43,000)(1 – 0.36) + (364,000/5)(0.36)
= $76,768

10-16
 PV of after-tax cash flows = $76,768*PVIFA(13%, 5) = $270,010.81
NPV = $270,010.81 – $364,000
= -$93,989.19

No, they should not renovate.

48. (LO5, 8)
PV of CCATS = 620,000(0.20)(0.35) x (1 + 0.5(0.11))
(0.11 + 0.20) (1 + 0.11)

= $133,063.06

a. 620,000 – 133,063.06 = PMT x PVIFA(11%, 5)

PMT = $131,750.68
Cost savings = 131,750.68 /(1 - 0.35) = $202,693.35

b. PV of CCATS = 620,000(0.20)(0.35) x (1 + 0.5(0.11) - 90,000(0.20)(0.35) x 1

5
(0.11 + 0.20) (1 + 0.11) (0.11 + 0.20) (1.11)

= $121,002.60
5
620,000 – 121,002.60= PMT x PVIFA (11%, 5) + 90,000/(1.11)
PMT = $120,562.55
Cost savings = 120,562.55/ (1 - 0.35) = $185,480.85

49. (LO1, 2)
Cash flow year 0 = -96,500,000 – 7,200,000 – 19,200,000 – 4,600,000(1 – 0.39) = -$125,706,000
Cash flow years 1-7 = [(19,600)(45,900 – 35,000) – 39,100,000](1 – 0.39) = $106,469,400
Cash flow year 8 = 106,469,400 + 27,900,000 + 19,200,000 = $153,569,400

PVCCATS (Class 3) = 16,000,000(0.05)(0.39) x (1 + 0.5(0.17)) - 8,700,000(0.05)(0.39) x 1

8
(0.17 + 0.05) (1 + 0.17) (0.17 + 0.05) (1 + 0.17)

= $1,095,545.47

PVCCATS (Class 8) = 80,500,000(0.20)(0.39) x (1 + 0.5(0.17)) - 12,000,000(0.20)(0.39) x 1

8
(0.17 + 0.20) (1 + 0.17) (0.17 + 0.20) (1 +0.17)

= $15,016,964.95

NPV = -125,706,000 + 106,469,400*PVIFA(17%, 7) + 153,569,400*PVIF(17%, 8) + 1,095,545.47+

15,016,964.95
= $351,753,827.90

The net present value is positive, so they should produce the robots.

10-17
50. (LO2)
Year 1 2 3 4 5
Units/yr 107,000 123,000 134,000 156,000 95,500
Price/unit 395 395 395 395 395
Vcost/unit 295 295 295 295 295

Sales 42,265,000 48,585,000 52,930,000 61,620,000 37,722,500

VC 31,565,000 36,285,000 39,530,000 46,020,000 28,172,500
FC 192,000 192,000 192,000 192,000 192,000
Net Rev 10,508,000 12,108,000 13,208,000 15,408,000 9,358,000
Taxes 4,203,200 4,843,200 5,283,200 6,163,200 3,743,200
(S-C)(1-T) 6,304,800 7,264,800 7,924,800 9,244,800 5,614,800

Year 0 1 2 3 4 5
A-T Rev 6,304,800 7,264,800 7,924,800 9,244,800 5,614,800
Ch in NWC -800,000 -2,528,000 -1,738,000 -3,476,000 0 8,542,000
Cap Spend -19,500,000 5,850,000
PVCCATS 2,902,121.33
Total CF -17,397,878.67 3,776,800 5,526,800 4,448,800 9,244,800 20,006,800

Net present value = $2,861,990.17

An approximate solution for the IRR can be found by assuming that the PVCCATS is discounted at the
23% cost of capital of the firm, so that the PVCCATS value in the table is held constant. In this case: IRR
= 28.691%.
The alternative is to enter the data into a spreadsheet and search for the rate that produces a NPV = 0,
where PVCCATS is discounted at the IRR.

51. (LO5)
PVCCATS(class 8) = 645000 x 0.20 x 0.35 x (1+0.5(0.09)) –
0.20 + 0.09 1 + 0.09

75,000 x 0.20 x 0.35 x 1

0.20 + 0.09 (1.09)5
= $137,496.10

NPV = 0 = -$645,000 – $55,000+ (S-C)(1-0.35)*PVIFA(9%, 5) + $137,496.10 +

($75,000 + $55,000)/1.095
(S-C)(0.65)*PVIFA(9%, 5) = $478,012.82
(S-C)*PVIFA(9%, 5) = $735,404.34
(S-C) = $189,066.91

10-18
52. (LO6)
a. For the new computer: PVCCATS = 1,560,000 x 0.30 x 0.38 x (1+0.5(0.12)) –
0.30 + 0.12 1 + 0.12

300,000 x 0.30 x 0.38 x 1/(1.12)5 = $354,540.14

0.30 + 0.12

The old computer has already had depreciation for 1 year, so it’s initial UCC is
UCC (year 1) = 1,300,000 - 1,300,000 *.3 / 2 = 1,105,000
As the computer has already been owned for a year, we do not need to use the half-year rule for
the first year (it’s already been done). Therefore,
PVCCATS = IdTc / (r + d) - SndTc / (d+r) * 1/(1+r)n
= 1,105,000 *.3 *. 38 / (0.12 + 0.3) - 120,000 * 0.3 * 0.38 / (0.30 + 0.12) * 1/(1
+.12)5
= 281,446.67

Initial cash flow = -$1,560,000 + $354,540.14 – 281,446.67 + 420,000 = -$1,066,906.53

Annual cost savings for the new computer is

= 290,000 * (1 – 0.38) = 179,800

NPV New Computer

Year Cash Flow Discounted cash flow
0 -$1,066,906.53 -$1,066,906.53
1 $179,800.00 $160,535.71
2 $179,800.00 $143,335.46
3 $179,800.00 $127,978.09
4 $179,800.00 $114,266.15
5 $479,800.00 $272,251.41
Total NPV -$248,539.71

Initial cash flow = -$420,000 + 281,446.67

NPV Old Computer

Year Cash Flow Discounted cash flow
0 -$138,553.33 -$138,553.33
1 $0.00 $0.00
2 $120,000.00 $95,663.27
3
4
5
Total NPV -$42,980.06

The NPV of the old computer is much higher than the new computer. Therefore, you should choose to keep the old
computer.

b.

10-19
 New Computer:

Net present value = -$248,539.71

EAC = -$68,947.33

Old Computer:
Net present value = -$42,980.06
EAC = -$25,431.22

Once we consider that there is going to be a planned replacement of the old machine after the second year, we
must compare the EACs. The decision is to still keep the old computer.

53. (LO8)
a. Assume price per unit = $23 and units/year = 140,000

After-tax net revenue/yr. = [(P-V)Q − FC](1 − Tc) = [($23 – 15.10)(140,000) – 435,000](0.65) =

$436,150.00

PVCCATS = $210,352.89; Salvage value = $85,000; Initial working capital increase = $90,000

NPV = -$940,000 – 90,000 + 210,352.89 + 436,150.00*PVIFA(12%, 5) + (90,000 + 85,000)*PVIF(12%, 5)

= $$851,875.73

The positive NPV tells us that to break even the number of cartons sold must be less than 140,000, and that
our costs are lower than revenues.

b. NPV = $0 =-$940,000 – 90,000 + 210,352.89 + [($23– 15.10)(Q) – 435,000](0.65)*PVIFA(12%, 5) +

(90,000 + 85,000)*PVIF(12%, 5)

Solve for Q to find: Q ≈ 93,978.85 cartons. At Q = 93,978.85: NPV ≈ $0

c. NPV = $0 =-$940,000 – 90,000 + 210,352.89 + [($23 – 15.10)(140,000) – FC](0.65)*PVIFA(12%, 5) +

(90,000 + 85,000)*PVIF(12%, 5)

Solve for FC to find: FC ≈ $798,567.11 At FC = $798,567.11: NPV ≈ $0

Appendix 10A

A1. Nominal discount rate = 13%; Inflation rate = 3%

Real rate = (1.13/1.03) – 1 = 0.0970874 = 9.70874%

Real Cash Flows

Year Method 1 Method 2
0 $6,700.00 $9,900.00
1 388.35 601.94
2 377.04 584.41
3 366.06 567.39
4 550.86

Discounting the real cash flows at the real rate we get: Method 1: PV(Costs) = -$7,644.46

10-20
 Method 2: PV(Costs) = -$11,744.17

Note that these are the identical PV values as obtained in the earlier Problem 27. When nominal cash flows are
discounted by a nominal discount rate, the same PV is obtained as when real cash flows are discounted by a
real discount rate.

However, we do not get the same EAC values as before:

Method 1: EAC = -7,644.46 / PVIFA(9.71%,3) = -$3,058.20

Method 2: EAC = -11,744.17 / PVIFA(9.71%,4) = -$3,681.61

The EAC values from Problem 27 for Method 1 and 2 were -3,237.60 and -3,948.32, respectively. The
differences arise because, with inflation, the PVIFA values with the real rate are larger than with the nominal
rate since the real rate of 9.71% is lower than the nominal rate of 13%.

10-21