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Chapter 6
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CHAPTER 6
HOW TO ANALYZE INVESTMENT PROJECTS
Objectives
To show how to use discounted cash flow analysis to make investment decisions such as:
Summary
The unit of analysis in capital budgeting is the investment project. From a finance perspective,
investment projects are best thought of as consisting of a series of contingent cash flows over time,
whose amount and timing are partially under the control of management.
The objective of capital budgeting procedures is to assure that only projects which increase
shareholder value (or at least do not reduce it) are undertaken.
Most investment projects requiring capital expenditures fall into three categories: new products, cost
reduction, and replacement. Ideas for investment projects can come from customers and competitors,
or from within the firms own R&D or production departments.
Projects are often evaluated using a discounted cash flow procedure wherein the incremental cash
flows associated with the project are estimated and their NPV is calculated using a risk-adjusted
discount rate which should reflect the risk of the project.
If the project happens to be a mini-replica of the assets currently held by the firm, then management
should use the firms cost of capital in computing the projects net present value. However, sometimes
it may be necessary to use a discount rate which is totally unrelated to the cost of capital of the firms
current operations. The correct cost of capital is the one applicable to firms in the same industry as the
new project.
It is always important to check whether cash flow forecasts have been properly adjusted to take
account of inflation over a projects life. There are two correct ways to make the adjustment:
1. Use the nominal cost of capital to discount nominal cash flows.
2. Use the real cost of capital to discount real cash flows.
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Project A
Present Values of
Project B
Present Values of B
A @ 10%
@ 10%
1
$1 million
909,091
$5 million
4,545,454
2
2 million
1,652,893
4 million
3,305,785
3
3 million
2,253,944
3 million
2,253,944
4
4 million
2,732,054
2 million
1,366,027
5
5 million
3,104,607
1 million
620,921
Total PV
10,652,589
12,092,132
NPV
652,589
2,092,132
Project B is better than A because it has a higher NPV, a result of paying cash earlier.
Investing in Cost-Reducing Equipment
2. A firm is considering investing $10 million in equipment which is expected to have a useful life
of four years and is expected to reduce the firms labor costs by $4 million per year. Assume the
firm pays a 40% tax rate on accounting profits and uses the straight line depreciation method.
What is the after-tax cash flow from the investment in years 1 through 4? If the firms hurdle rate
for this investment is 15% per year, is it worthwhile? What are the investments IRR and NPV?
SOLUTION:
We have to find the incremental cash flows resulting from this investment. There are two methods that we
can use to find the after tax cash flow.
1. Find the (incremental) net income, then add (incremental) depreciation. Hence:
Annual depreciation (using straight-line method) = $10MM/4 = $2.5MM
Pretax income increases by: $4MM - $2.5MM = $1.5MM
Net income increase by : 1.5x(1-0.4) = $0.9MM
Adding back depreciation (non cash expense): OCF = 0.9 + 2.5 = $3.4MM
2. Add the depreciation tax shield to the after-tax incremental cost saving. Hence, the yearly OCF from
year 1 to 4 is: 4x(1-0.4) + 2.5x0.4 = $3.4MM
Year
0
1
2
3
4
CFI
-$10MM
+$3.4MM
+$3.4MM
+$3.4MM
+$3.4MM
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Result
PV = $648,937
IRR = 29.09%
n = 2.87 years
d. In order for the NPV to be 0, what must the cash flow from operations be?
n
i
PV
FV
PMT
Result
4
15
500,000
0
?
PMT = $175,133
Now we must find the number of units per year (Q), that corresponds to an operating cash flow of this
amount. A little algebra reveals that the breakeven level of Q is units per year:
CASH FLOW = NET PROFIT + DEPRECIATION
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Replacement Decision
5. Pepes Ski Shop is contemplating replacing its ski boot foam injection equipment with a new
machine. The old machine has been completely depreciated but has a current market value of
$2000. The new machine will cost $25,000 and have a life of ten years and have no value after this
time. The new machine will be depreciated on a straight-line basis assuming no salvage value. The
new machine will increase annual revenues by $10,000 and increase annual nondepreciation
expenses by $3000.
a. What is the additional after-tax net cash flow realized by replacing the old machine with the
new machine? (Assume a 50% tax rate for all income, i.e. the capital gains tax rate on the sale
of the old machine is also 50%. Draw a time line.)
b. What is the IRR of this project?
c. At a cost of capital of 12%, what is the net present value of this cash flow stream?
d. At a cost of capital of 12%, is this project worthwhile?
SOLUTION:
a.
t
ATNCF
0
-24,000 = -25,000 + 2000 x (1-0.5)
1,2,...,10
4,750 = (10,000 3,000 2,500)(1 0.5) + 2,500
b.
IRR =14.82%
c.
NPV = $2,838.56
d. This project is worthwhile because its NPV is positive. Also, its IRR is higher than its cost of capital.
6. PCs Forever is a company that produces personal computers. It has been in operation for two
years and is at capacity. It is considering an investment project to expand its production capacity.
The project requires an initial outlay of $1,000,000: $800,000 for new equipment with an expected
life of four years and $200,000 for additional working capital. The selling price of its PCs is $1,800
per unit, and annual sales are expected to increase by 1,000 units as a result of the proposed
expansion. Annual fixed costs (excluding depreciation of the new equipment) will increase by
$100,000, and variable costs are $1,400 per unit. The new equipment will be depreciated over four
years using the straight line method with a zero salvage value. The hurdle rate for the project is
12% per year, and the company pays income tax at the rate of 40%.
a. What is the accounting break-even point for this project?
b. What is the projects NPV?
c. At what volume of sales would the NPV be zero?
SOLUTION:
a. To find the accounting break-even quantity, apply the break-even formula:
Break-even quantity = total fixed costs/contribution margin
Total fixed costs = fixed costs (cash) + depreciation
The additional fixed costs due to the expansion project are $300,000 (fixed costs + depreciation) per
year and the contribution margin is $400 per unit. So the accounting breakeven quantity is 750
additional units per year.
b.
Increase in Sales Revenue
(1,000 units at a price of $1,800)
$1,800,000 per year
Increase in Total Variable Costs
(1,000 units at $1,400) per unit)
$1,400,000 per year
Increase in fixed costs excluding depreciation $100,000 per year
Increase in depreciation
$200,000 per year
Increase in Total Fixed Costs
$300,000 per year
Increase in Annual Operating Profit
$100,000 per year
Taxes @ 40%
$40,000 per year
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The initial investment $1,000,000: $800,000 for the equipment and $200,000 for working capital.
Using a financial calculator to find the NPV we find:
n
i
PV
FV
PMT
4
12
?
200,000
260,000
PV=916,814
NPV = PV $1,000,000
= $916,814 $1,000,000
= $83,186
The NPV is negative, hence the project is not worth taking.
c. To find the NPV breakeven value for the incremental cash flow from operations we do the following
calculation:
n
i
PV
FV
PMT
4
12
1,000,000
200,000
?
PMT = $287,387.55
(Note that the $200,000 terminal value in year 4 is the investment in working capital.)
Now we must find the incremental number of units per year ( Q), that corresponds to an incremental
operating cash flow of this amount.
Incremental Cash Flow = Increase in net profit + increase in depreciation
= (1-0.4)x(400 Q 300,000) + 200,000 = $287,387.55
Q = $445,646 = 1,114.1, the smallest rounded number is 1,115 units per year
400
So the expansion must result in at least 1,115 additional units per year in order to justify the capital
outlay.
Inflation and Capital Budgeting
7. Patriots Foundry (PF) is considering getting into a new line of business: producing souvenir
statues of Paul Revere. This will require purchasing a machine for $40,000. The new machine will
have a life of two years (both actual and for tax purposes) and will have no value after two years.
PF will depreciate the machine on a straight-line basis. The firm thinks it will sell 3,000 statues per
year at a price of $10 each, variable costs will be $1 per statue and fixed expenses (not including
depreciation) will be $2,000 per year. PFs cost of capital is 10%. All of the foregoing figures assume
that there will be no inflation. The tax rate is 40%.
a. What is the series of expected future cash flows?
b. What is the expected net present value of this project? Is the project worth undertaking?
c. What is the NPV breakeven quantity?
Now assume instead that there will be inflation of 6% per year during each of the next two years
and that both revenues and nondepreciation expenses increase at that rate. Assume that the real
cost of capital remains at 10%.
d. What is the series of expected nominal cash flows?
e. What is the net present value of this project, and is this project worth undertaking now?
f. Why does the NPV of the investment project go down when the inflation rate goes up?
SOLUTION:
a. The expected future net cash flows are:
CF = (1 - tax rate) (revenue - cash expenses) + tax rate x depreciation
CF = .6 x ($30,000 - $3,000 -$2,000) + .4 x $20,000
CF = .6 x $25,000 + .4 x $20,000 = $23,000 in each of the next two years
b.
N
i
PV
FV
PMT
2
10
?
0
23,000
Result
39,917.36
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d.
e.
CFi
5000
55,000
61,500
61,500
61,500
61,500
72,750
0.65x10,000
0.75x15,000
Year 1
10,000
3,000
Year 2
10,000
3,000
Year 3
10,000
3,000
Year 4
10,000
3,000
Year 5
10,000
3,000
3,500
350
3,500
400
3,500
300
3,500
200
3,500
0
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Year 2
Year 3
Year 4
Year 5
+ 5,810
-50
+ 5,810
+100
+ 5,810
+100
+ 5,810
+200
5,760
5,910
5,910
6,010
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11. Leather Goods Inc. wants to expand its product line into wallets. It is considering producing
50,000 units per year. The price will be $15 per wallet the first year and the price will increase 3%
per year. The variable cost is expected to be $10 per wallet and will increase by 5% per year. The
machine will cost $400,000 and will have an economic life of 5 years. It will be fully depreciated
using the straight line method. The discount rate is 15% and the corporate tax is 34%. What is the
NPV of the investment?
SOLUTION:
Depreciation expense = 400,000/5 = 80,000
Year1 CF = Net income + depreciation
= (1-0.34) x (50,000x15 50,000x10 80,000) + 80,000
= 192,200
Year 2 CF = (1-0.34) x (50,000x15x1.03 50,000x10x1.05 80,000) + 80,000
= 190,550
Year 3 CF = (1-0.34) x (750,000x1.032 500,000x1.052 80,000) + 80,000
= 188,520.5
Year 4 CF = (1-0.34) x (750,000x1.033 500,000x1.053 80,000) +80,000
= 186,083.62
Year 5 CF = (1-0.34) x (750,000x1.034 500,000x1.054 80,000) +80,000
= 183,210.80
At 15% discount rate : NPV = $ 228,705.86
12. Steiness Danish Ham, Inc. is contemplating buying a new machine that has an economic life of 5
years. The cost of the machine is 1,242,000 krone and will be fully depreciated using the straight
line depreciation method over the 5 years. At the end of 5 years, it will have a market value of
138,000 krone. It is estimated that the new machine will save the company 345, 000 krone per year
due to reduced labor costs. Moreover, it will lead to a reduction in net working capital of 172,500
krone because of the higher yield from raw materials inventory. The net working capital will be
recovered by the end of the 5 years. If the corporate tax rate is 34% and the discount rate is 12%
what is the NPV of the project.
Year 0
Initial
investment -1,242,000
Change in
net working +172,500
capital
Terminal
value
OCF
Total
incremental -1,069,500
cash flows
a
Year 1
Year 2
Year 3
Year 4
Year 5
-172,500
+312,156b
+312,156
+312,156
+312,156
+91,080a
+312,156
+312,156
+312,156
+312,156
+312,156
+230,736
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13. Hus Software Design, Inc. is considering the purchase of computer that has an economic life of
4 years and it is expected to have no salvage value. It will cost $80,000 and it will be depreciated
using the straight line depreciation method. It will save the company $35,000 the first year and it is
assumed that the savings after that will have a growth rate of 5%. It will also reduce net working
capital requirements by $7,000. The corporate tax rate is 35% and the appropriate discount rate is
14%. What is the value that the purchase will add to the firm?
Year
0
1
2
3
4
CFI
-80,000 + 7,000 = -73,000
(1-0.35) x (35,000) + 20,000 x 0.35 = 29,750
0.65 x 35,000 x 0.95 + 20,000 x 0.35 = 28,612.5
0.65 x 35,000 x 0.952 + 20,000 x 0.35 =
27,531.88
0.65x35,000x0.953 + 20,000 x 0.35 7000 =
19,505.28
I
11%
PV
78,449
FV
0
PMT
?
Result
PMT = -25,286
PV
FV
PMT
Result
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11%
137,43
3
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PMT = -32,486
Since the first alternative has the lowest annual costs, choose the first computer system.
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15. Vogels Classic Autos is doing a booming business exporting re-built vintage American vehicles
to Japan. Fortunately, it is an almost perfect world and consequently the owner is certain of all
revenues and costs. The problem is the revenues are in Yen and the costs are in dollars. The current
rate of exchange is 100 Yen to $1. The risk free rate in Japan is 3% and the risk free rate in the U.S.
is 7%. Due to a loophole in the tax code, no taxes have to be paid on the companys profits. The
business has contracts for delivery outstanding for the next 4 years, at which time the owner will
retire and close the business. Using the certain cash flows below, determine the NPV of the business.
Revenues in Yen
Cost in dollars
Parts
Labor
Shipping
Other
Total costs
Year 1
Year 2
Year 3
Year 4
50,000,000 60,000,000 40,000,000 20,000,000
50,000
100,000
75,000
75,000
300,000
60,000
105,000
90,000
75,000
330,000
40,000
85,000
60,000
65,000
250,000
20,000
50,000
30,000
55,000
155,000
SOLUTION:
Present Value of revenues denominated in Yen: Since the cash flows are certain, we can use the riskfree
rate to discount them:
CF0
CF1
CF2
CF3
CF4
i
PV
0
50,000,000
60,000,000
40,000,000
20,000,000
3%
159,474,851
0
300,000
330,000
250,000
155,000
7%
$890,932
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The reason why you are troubled about the depreciation tax shield and cash flows in real terms is
because depreciation tax shields are always in nominal terms. Therefore, when using real cash flows
you run the risk of mixing nominal numbers into the total cash flow figures. This could lead to
discounting nominal cash flows with a real discount rate.
17. Your next assignment at Wigit, Inc. also entails determining the NPV of a project which is
expected to last four years. There is an initial investment of $400,000, which will be depreciated at
the straight line method over four years. At the end of four years, it is assumed that you will be able
to sell some of the equipment that is part of the initial investment for $35,000 (a nominal figure).
Revenues for the first year are expected to be $225,000 in real terms. The costs involved in the
project for the first year are as follows: (1) parts will be $25,000 in real terms the first year; (2)
labor will be $60,000 in real terms for the first year and (3) other costs will be $30,000 in real terms
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for the first year. The growth rates of revenues and costs are as follows: (1) revenue will have a real
growth rate of 5%; (2) the cost of parts will have a 0% real growth rate; (3) cost of labor will have a
2% real growth rate; and (4) other costs will have a 1% real growth rate from year 2 to year 3 and
a 1% growth rate the last two years. The real changes in net working capital for the year 0 to year
4 are as follows: (1) -$20,000; (2) -$30,000; (3) -$10,000; (4) $20,000; (5) $40,000. The real discount
rate is 9.5% and the inflation rate is 3%. The tax rate is 35%.
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Costs:
Parts
Labor
Other
Depreciation
$25,750
$61,800
$30,900
$100,000
$13,300
$4,655
$8,645
$100,000
$108,645
Initial investment
Salvage Value
Change in Net working
Total Cash flow from
investment
*Salvage Value:
Revenue growth rate
(real)
Cost growth rates (real):
Parts
Labor
Other Year 2
Year 3 and 4
$26,523
$64,927
$32,145
$100,00
0
$27,043
$9,465
$17,578
$100,00
0
$117,57
8
$27,318
$68,212
$32,779
$100,00
0
$42,756
$14,965
$27,791
$100,00
0
$127,79
1
$28,138
$71,664
$33,424
$100,00
0
$59,930
$20,976
$38,954
$100,00
0
$138,95
4
CF0
CF1
($420,000)
$77,745
CF2
$106,969
CF3
$149,646
CF4
$206,724
i
12.79%
NPV ($34,959.22
)
($400,000)
$22,750
*
($20,000) ($30,900 ($10,609 $21,855 $45,020
)
)
($420,000) $77,745 $106,96 $149,64 $206,72
9
6
4
$35,000 - .35($35,000 - $0 Book Value) = $22,750
5.00%
Inflation:
3.00%
0.00%
2.00%
1.00%
tax rate
35%
Real discount rate
Nominal discount
rate
9.50%
12.79%=(1.095)(1.03)
-1.00%
Note that all cash flows as well as the discount rate were converted into nominal figures. For example
revenues were calculated in the following manner:
Revenue (year 1) = $225,000 x (1 + inflation rate)
= $225,000 x (1.03) = $231,750
Revenue (year 2) = Year 1 x (1 + growth rate) x (1 + inflation)
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18. Finnertys Brew Pub is considering buying more machinery that will allow the pub to increase
its portfolio of beers on tap. The new machinery will cost $65,000 and will be depreciated on a 10
year basis. It is expected to have no value after 10 years. The improved selection is anticipated to
increase sales by $30,000 for the first year and increase at the rate of inflation of 3% for each year
after that. Production costs are expected to be $15,000 for the first year and are also expected to
increase at the rate of inflation. The real discount rate is 12% and the nominal riskfree interest rate
is 6%. The corporate tax rate is 34%. Should Mr. Finnerty buy the machinery?
SOLUTION:
Because depreciation is always nominal, the depreciation tax shield needs to be discounted at the nominal
rate of return. Since Cash Flow = NI (only cash expenses) + depreciation tax shield, unless we convert all
the figures into nominal, we need to find each term of the Cash Flow separately, and discount it at its
appropriate discount rate.
In year 1 : NI = (30,000-15,000) x 0.66 = 9900. This figure is in year 1 $ terms (nominal). To convert this
figure to real terms (Year 0 $), we divide by 1.03, we get $9612. Since both revenues and expenses
increase at the inflation rate each year, $9612 is also the annual real NI (incremental).
We then find the PV of those NI using the real discount rate 12%:
n
10
i
12
PV
?
PMT
9612
FV
0
Result
PV = $54,310
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20. Mr. Salles is considering a business venture that would offer guided tours of the romantic Greek
isles and the Italian county side. After four years, Mr. Salles intends to retire. The initial investment
would be $50,000 in a computer and phone system. This investment would be depreciated on the
straight line method, and is expected to have no salvage value. The corporate tax rate is 35%. The
price of each tour will be $5,000 per customer and the price will remain constant in real terms. Mr.
Salles will pay himself $50 per hour and anticipates an annual increase in salary of 5% in real
terms. The cost of each customer during the tours is $3,500, and this cost is expected to increase by
3% in real terms. Assume that all revenues and costs occur at year end. The inflation rate is 3.5%.
The risk free nominal rate is 6% and the real discount rate for costs and revenues is 9%. Using the
additional following data, calculate the NPV of the project.
Year 1
100
2,080
Number of customers
Hours worked
Year 2
115
2,080
Year 3
130
2,080
Year 4
140
2,080
SOLUTION:
Revenues
Expenses
Labor
Variable cost of tours
Income before taxes
Taxes
Net Income
CF0
CF1
CF2
CF3
CF4
i
PV
($50,000)
$29,900
$33,296
$34,209
$28,711
9%
$52,211
Year 1
Year 2
Year 3
Year 4
$500,000
$575,000
$650,000
$700,000
$104,000
$350,000
$46,000
$16,100
$29,900
n
4
$109,200
$414,575
$51,225
$17,929
$33,296
i
6
$114,660
$482,710
$52,630
$18,421
$34,209
PV
?
$120,393
$535,436
$44,171
$15,460
$28,711
PMT
4,375
FV
0
Result
PV = $15,160
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21. Saunders Sportswear, Inc. is planning on expanding its line of sweatshirts. This will require an
initial investment of $8 million. This investment will be depreciated on a straight line method over 4
years and will have no salvage value. The firm is in the 35% tax bracket. The price of the
sweatshirts will be $30 the first year and will increase in price by 4% per year in nominal terms
thereafter. The unit cost of production will be $5 the first year and will increase by 3% per year in
nominal terms thereafter. Labor costs will be $10 per hour the first year and will increase by 3.5%
in nominal terms each subsequent year. Revenues and costs are paid at year-end. The nominal
discount rate is 12%. Calculate the NPV of the project using the following additional data.
Unit sales
Labor hours
Year 1
50,000
20,800
Year 2
100,000
20,800
Year 3
125,000
20,800
Year 4
100,000
20,800
SOLUTION:
Revenues
Expenses
Variable Costs
Labor Costs
Depreciation
Income before taxes
Taxes
Net Income
Depreciation add back
Operating Cash Flow
Year 1
$1,500,000
Year 2
Year 3
Year 4
$3,120,000 $4,056,000 $3,374,592
$250,000
$515,000
$663,063
$546,364
$208,000
$215,280
$222,815
$230,613
$2,000,000 $2,000,000 $2,000,000 $2,000,000
($958,000) $389,720 $1,170,122 $597,615
$0
$136,402
$409,543
$209,165
($958,000) $253,318
$760,579
$388,450
$2,000,000 $2,000,000 $2,000,000 $2,000,000
$1,042,000 $2,253,318 $2,760,579 $2,388,450
CF0
CF1
CF2
CF3
CF4
i
NPV
($8,000,000)
$1,042,000
$2,253,318
$2,760,579
$2,388,450
12%
($1,790,483)
Note that the depreciation is not discounted at the nominal risk free rate. In the first year of cash flows
there is no tax shield benefit since there was no profit in that year. By using the nominal discount rate, the
implicit assumption being made is that the cash flows are not necessarily risk free.
22. Camille, the owner of the Germanos Tree farm has contracted with the government of his
native land to provide Cedar tree saplings to aid in that governments efforts to reforest part of the
country and return the Cedar tree to its past glory. The project is expected to continue in
perpetuity. At the end of the first year, the following nominal and incremental cash flows are
expected:
Revenues
Labor Costs
Other Costs
$125,000
$65,000
$45,000
Camille has contracted with an air freight shipping company to transport the saplings. The contract
is for a fixed payment of $35,000 in nominal terms per year. The first payment is due at the end of
the first year. Revenues are expected to grow at 4% in real terms. Labor costs are expected to grow
at 3% per year. Other costs are expected to decrease at 0.5% per year. The real discount rate for
revenues and costs is 8% and inflation is expected to be 3.5%. There are no taxes and all cash flows
occur at year-end. What is the NPV of the contract?
SOLUTION:
Since the discount rate and growth rates are in real terms, it is easier to discount real cash flows.
Moreover, since the contract is a perpetuity, the growing perpetuity formula can be used. The nominal
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revenue, labor costs and other costs must be discounted back at the inflation rate to get the real value of
Year 1 cash flows. These results must in turn be input into the growing perpetuity formula as follows:
PV (revenue) = ($125,000/1.035)/(.08 - .04) = $3,019,323.67
PV (labor costs) = ($65,000/1.035)/(.08 - .03) = $1,256,038.65
PV (other costs) = ($45,000/1.035)/(.08 - (-.005)) = $511,508.95
The shipping costs actually have a negative growth rate even though the nominal cash flows are constant.
This is due to inflation. The easiest way to see this is to find the real value of those cash flows. For
example,
PV (cash flow 1) = $35,000/1.035 = $33,816.43
PV (cash flow 2) = $35,000/1.0352 = $32,672.88
Hence the real negative growth rate g can be calculated as follows:
1/1.035 = 1+ g,
Hence (1/1.035) - 1 = -0.034 = 3.4% Use the growing perpetuity formula (remembering to use the
Present value of the first cash flow and not the nominal $35,000): $33,816.43/(.08 - (-.034))=
$296,635.35. Sum the revenues and costs to determine the NPV of the project.
NPV = $3,019,323.67 - $1,256,038.65 - $511,508.95 - $296,635.35 = $955,140.72
23. Kitchen Supplies, Inc. must replace a machine in its manufacturing plant that will have no
salvage value. It has a choice between two models. The first machine will last 5 years and will cost
$300,000. It will generate an annual cost savings of $50,000. Annual maintenance costs will be
$20,000. The machine will be fully depreciated using the straight line depreciation method and will
have no salvage value. The second machine will last 7 years and will cost $600,000. It will generate
an annual cost savings of $70,000. This machine will also be fully depreciated using the straight line
depreciation method, but is expected to have a salvage value of $60,000 at the end of the seventh
year. The annual maintenance cost is $15,000. Revenues in each case are expected to be the same.
The annual tax rate is 35% and the cost of capital is 10%. Which machine should the company
purchase?
SOLUTION:
Alternative 1: Yearly cash flow = NI (cash expenses only) + depreciation tax shield
= (50,000-20,000)x(1-0.35) + 60,000 x 0.35 = 40,500
Year CFI
0
-300,000
1
+40,500
2
+40,500
3
+40,500
4
+40,500
5
+40,500
At 10% discount rate : NPV = -$146,473
Annualized Capital Cost
n
i
PV
5
10%
146,473
PMT
?
FV
0
Result
PMT = $38,639.21
CFI
-600,000
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2
3
4
5
6
7
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+65,750
+65,750
+65,750
+65,750
+65,750
+65,750
+104,750*
PMT
?
Result
PMT = $53,382.42
Alternative 1 should be chosen; its annualized cost of capital is less.
24. Electricity, Inc. is choosing between two pieces of equipment. The first choice costs $500,000
and will last five years. It will be depreciated using the straight line depreciation method and will
have no salvage value. It will have an annual maintenance cost of $50,000. The second choice will
cost $600,000 and will last eight years. It will also be depreciated using the straight line depreciation
method and will have no salvage value. It will have an annual maintenance cost of $55,000. The
discount rate is 11% and the tax rate is 35%. Which machine should be chosen and what
assumptions underlie that choice?
SOLUTION:
Alternative 1: After tax maintenance cost
n
i
PV
PMT
5
11%
?
32,500
Annual maintenance
$50,000
DR
Tax rate
35%
FV
0
FV
Result
0
PV = $120,116.65
11%
PMT=(500,000/5)
(.35)
Result
PV = $129,356.40
n
5
i
PV
PMT
FV
11%
?
35,000.00
0
Cost
$500,000
NPV = -$500,000 -$120,116.65 + $129,356.40 = -$490,760.25
Annualized Capital Cost: Alternative 1
n
i
PV
PMT
5
11%
490,760.25
?
Alternative 2: After Tax maintenance cost
n
i
PV
PMT
8
11%
?
35,750
Annual maintenance
$55,000
DR
Tax rate
35%
FV
0
FV
Result
0
PV = $183,973.89
11%
PV
PMT
Result
PMT = -$132,785.15
FV
PMT=(600,000/8)
(.35)
Result
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8
11%
?
26,250.00
0
PV = $135,085.72
Cost
600,000
NPV = -$600,000 - 183,973.89 + $135,085.72 = -$648,888.17
Annualized Capital Cost: Alternative 2
n
i
PV
PMT
FV
Result
8
11%
648,888.17
?
0
PMT = -$126,092.63
Choose alternative 2; its annualized capital cost is less.
Note: The two assumptions being made are: 1) the time horizon is long (the same choice of machinery
will be used indefinitely) and there is no expected change in technology that would terminate the use of
the equipment prematurely for a significantly greater efficiency; 2) either machine will be replaceable
when its economic life ends.
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25. Refer to problem number 24. Now Electricity, Inc. is faced with the same choices, however now
it expects that a new technology will be introduced into the industry in year nine. This will force the
company to replace the choice made today at the end of year nine, because the new technology will
be so cost effective. All the other necessary information is the same as explained in problem 24.
Which choice should be made?
SOLUTION:
Choice 1 Capital
Dep. tax
Investment shield
Year 0
-500,000
Year 1
35,000
Year 2
35,000
Year 3
35,000
Year 4
35,000
Year 5
-500,000
35,000
Year 6
35,000
Year 7
35,000
Year 8
35,000
Year 9
35,000
Choice 2
After tax
Net Cash Flow
maintenance
-500,000 CF0
-500,000
-32,500
+2,500
CF1
2,500
-32,500
+2,500
CF2
2,500
-32,500
+2,500
CF3
2,500
-32,500
+2,500
CF4
2,500
-32,500
-497,500 CF5
-497,500
-32,500
2,500
CF6
2,500
-32,500
2,500
CF7
2,500
-32,500
2,500
CF8
2,500
-32,500
2,500
CF9
2,500
i
11%
NPV -$782,883.05
Capital
Dep. tax
Investment shield
-600,000
26,250
26,250
26,250
26,250
26,250
26,250
26,250
600,000
26,250
26,250
After tax
Net Cash Flow
maintenance
Year 0
-600,000 CF0
-600,000
Year 1
-35,750
-9,500
CF1
-9,500
Year 2
-35,750
-9,500
CF2
-9,500
Year 3
-35,750
-9,500
CF3
-9,500
Year 4
-35,750
-9,500
CF4
-9,500
Year 5
-35,750
-9,500
CF5
-9,500
Year 6
-35,750
-9,500
CF6
-9,500
Year 7
-35,750
-9,500
CF7
-9,500
Year 8
-35,750
-609,500 CF8
-609,500
Year 9
-35,750
-9,500
CF9
-9,500
i
11%
NPV -$912,957.85
Annualized Capital Cost: Alternative 1
n
i
PV
PMT
FV
Result
9
11%
782,883.05
?
0
PMT = -$141,389.98
Annualized Capital Cost: Alternative 2
n
i
PV
PMT
9
11%
912,957.85
?
FV
0
Result
PMT = -$164,881.71
Choose alternative 1; its annualized capital cost is less. This is the opposite choice as in question 17
because the second investment in alternative two (made in year eight) must be replaced at the end of year
nine.
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i
14%
PV
PMT
FV
Result
?
11,666.67
0
PV = $81,697.77
$1 million/30 =
$33,333.33
Depreciation
Lease Payment = 33.333.33 X .35 = 11,666.67
Step 3: Solve for the lease payment:
NPV = 0 = -$1,000,000 + Lease payment x 4.55176 + $81,697.77
Lease payment = $201,747