Chapter 10

6. The MACRS depreciation schedule is shown in Table 10.7. The ending book value for any year is the
beginning book value minus the depreciation for the year. Remember, to find the amount of
depreciation for any year, you multiply the purchase price of the asset times the MACRS
percentage for the year. The depreciation schedule for this asset is:

Beginning Ending

Year Book Value MACRS   Depreciation Book Value

1 $1,375,000.00 0.1429 $196,487.50 $1,178,512.50

2 1,178,512.50 0.2449 336,737.50 841,775.00
3 841,775.00 0.1749 240,487.50 601,287.50
4 601,287.50 0.1249 171,737.50 429,550.00
5 429,550.00 0.0893 122,787.50 306,762.50
6 306,762.50 0.0892 122,650.00 184,112.50
7 184,112.50 0.0893 122,787.50 61,325.00
8 61,325.00 0.0446 61,325.00 0

7. The asset has an eight-year useful life and we want to find the BV of the asset after five years. With
straight-line depreciation, the depreciation each year will be:
Annual depreciation = $680,000/8
Annual depreciation = $85,000
So, after five years, the accumulated depreciation will be:
Accumulated depreciation = 5($85,000) = $425,000

The book value at the end of Year 5 is thus:

BV5 = $680,000 – 425,000 = $255,000
The asset is sold at 143000, which is lower than BV at the end of the fifth year – i.e. at a loss to book
value, so the taxes are negative.
Aftertax salvage value = $143,000 - ($143,000 –255,000)(.21)
Aftertax salvage value = $166,520 – Yes, after tax salvage value > salvage value.
8. To find the BV at the end of four years, we need to find the accumulated depreciation for the first
four years. We could calculate a table as in Problem 6, 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:

Year Depreciable basis MACRS   Depreciation

0.2*5,100,000 =
1 5,100,000 0.20 1,020,000
0.32*5,100,000 =
0.32
2 1,632,000
0.192*5,100,000
0.192
3 = 979,200
0.1152*5,100,00
0.1152
4 0 = 587,520

Accumulated depreciation = 4,218,720

BV4 = 5,100,000 - 4,218,720 = $881,280

The asset is sold at $1.6million i.e. a gain to book value, so this gain is taxable.
Aftertax salvage value = $1,600,000 - ($1,600,000 - 881,280)(.21)
Aftertax salvage value = $1,449,069

9) Depreciation/year = 2,320,000/3 = 773,333

EBT or EBIT= sales – cost – depreciation = $1,735,000 – 650,000 – 773,333.33 = 311,666.7

NI = EBT(1-tax rate) = 311.667*.79 = 246,217

OCF = NI +Dep = 246,217+773,333= 1,019,550

The OCF is same for each year.

10) No working capital or salvage value. we can find the NPV as the initial cash outlay plus the PV of the
OCFs, which are an annuity, so the NPV is:
Initial investment = 2320000
OCF each year = 1,019,550 (PMT)
PV of annuity of OCF = 2,448,787.1 (PMT = 1019550, N = 3, R= 12%, FV = 0, CPT PV)
 NPV = –$2,320,000 + 2,448,787.1 = $128,787.07

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

Annual depreciation = $460,000/5 = $92,000 (straight line over 5 years)

Now, we calculate the after-tax salvage value. The after-tax salvage value is the market price minus
the taxes on the profit on sale of the equipment, so:
After-tax salvage value = MV - (MV – BV)TC
After-tax salvage value = $55,000 – (55000 – 0)(0 .21)
After-tax salvage value = $43,450

In this case the project just reduces operating costs – incremental or relevant cash flow is the
reduction in costs due to this project. OCF therefore will be calculated as cash savings in operating
costs – taxes.
NI = (155000-92000)(1-.21) = 49770
OCF = 92,000+49,770
OCF = $141,770

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

  0 1 2 3 4 5
OCF   141,770 141,770 141,770 141,770 141,770
CF due to
ΔNWC -29,000 0 0 0 0 29,000
Initial investment -460,000 0 0 0 0 0
Salvage value           43,450
             
Total cash flow -489,000 141,770 141,770 141,770 141,770 214,220
PV -489,000 128,882 117,165 106,514 96,831 133,014
NPV 93,405.6          

22. The aftertax salvage value is: The asset is fully depreciated in year 1 – so the BV becomes zero at
the end of year 1.
Aftertax salvage value = $25,000(1 – .22)
Aftertax salvage value = $19,500
 And the OCF each year will be:

  Year 1   Years 2-5

  Sales $275,000 $275,000
  Variable costs 96,250 96,250
  Fixed costs 47,000 47,000
  Depreciation 425,000 0
  EBIT –$293,250 $131,750
  Tax –64,515 28,985
  Net income –$228,735 $102,765
  + Depreciation 425,000 0
  OCF $196,265 $102,765

Now we have all the necessary information to calculate the project NPV. The project NPV is:

  0 1 2 3 4 5
OCF   196,265 102,765 102,765 102,765 102,765
CF due to
ΔNWC -25,000 0 0 0 0 25,000
Initial
investment -425,000 0 0 0 0 0
Salvage value           19,500
         
   
Total cash flow -450,000 196,265 102,765 102,765 102,765 147,265
PV -450,000 180,060 86,495 79,353 72,801 95,712
NPV 64,421          

25.
Sunk cost – 750000, Opportunity cost – 1125000
Initial investment = 5.1 million
Depreciation/yr = 1.02million
SV = 450000
Tax rate = 23%, R = 10%
Q = 100mn/year, Variable cost = 0.38/unit, Fixed cost = 1.1mn/year
All figures in million hereafter:
NI = (Q*P – Q*v – FC – Dep)*(1-T) = (100P - .38 - 1.1 – 1.02)*0.77 = 77P – 1.925
OCF each year = NI+Dep = 77P-1.925+1.02 = 77P-0.903
After tax salvage value = (BV will be 0 as fully depreciated) = SV(1-T) = 0.45*.77 = 0.3465
CF due to change in working capital
  NWC CF
0 0.425 -0.425
1 0.475 -0.05
2 0.525 -0.05
3 0.575 -0.05
4 0.625 -0.05
5 0 0.625

  CF0 CF1 CF2 CF3 CF4 CF5

77P - 77P - 77P - 77P - 77P -
OCF   0.903 0.903 0.903 0.903 0.903
             
CF due to working capital -0.425 -0.050 -0.050 -0.050 -0.050 0.625
Opportunity cost -1.125          
             
Net capital spending            
Initial Investment -5.1          
SV           0.3465
Land sale           1.295
FCF -6.650 77P-0.953 77P-0.953 77P-0.953 77P-0.953 77P+1.364

NPV = 291.89P-8.824
So minimum bid price should be the price at which NPV = 0 i.e. 291.89P – 8.824 = 0
P = 3.02cents/unit so bid price should be greater than the minimum price.
36. This is an in-depth capital budgeting problem. Probably the easiest OCF calculation for this problem
is the bottom-up approach, so we will construct an income statement for each year. Beginning with
the initial cash flow at Time 0, the project will require an investment in equipment.
To calculate depreciation each year, we use the initial equipment cost of $16.5 million, times the
appropriate MACRS depreciation each year. The remainder of each income statement is calculated
below. Notice at the bottom of the income statement we added back depreciation to get the OCF for
each year. The section labeled “Net cash flows” will be discussed below:
Calculating depreciation

Year Initial MACRS Depreciation

 Investment
1 16,500,000 0.1429 2,357,850
2 0.2449 4,040,850
3 0.1749 2,885,850
4 0.1249 2,060,850
5 0.0893 1,473,450
To calculate the aftertax salvage value, we first need the book value of the equipment. The book value at
the end of the five years will be the purchase price, minus the total depreciation.
Accumulated depreciation = 12,818,850, So, the ending book value is: BV 5 = 3,681,150
The market value of the used equipment is 20 percent of the purchase price, or $3.3 million, so the
aftertax salvage value will be $3,300,000 - ($ 3,300,000 - 3,681,150)(.21) = $3,380,042
Now we can begin the remaining calculations. Sales figures are given for each year, along with the price
per unit. The variable costs per unit are used to calculate total variable costs, and fixed costs are
given at $3.2 million per year.

Year 1 2 3 4 5
  Sales $27,375,000 $32,250,000 $39,375,000 $36,375,000 $25,125,000
  Variable costs 18,615,000 21,930,000 26,775,000 24,735,000 17,085,000
  Fixed costs 3,200,000 3,200,000 3,200,000 3,200,000 3,200,000
  Depreciation 2,357,850 4,040,850 2,885,850 2,060,850 1,473,450
  EBIT $3,202,150 $3,079,150 $6,514,150 $6,379,150 $3,366,550
  Taxes 672,452 646,622 1,367,972 1,339,622 706,976
  Net income $2,529,699 $2,432,529 $5,146,179 $5,039,529 $2,659,575
  Depreciation 2,357,850 4,040,850 2,885,850 2,060,850 1,473,450
  Operating CF $4,887,549 $6,473,379 $8,032,029 $7,100,379 $4,133,025

   
  Net cash flows
  Operating CF $4,887,549 $6,473,379 $8,032,029 $7,100,379 $4,133,025
  Change in NWC –731,250 –1,068,750 450,000 1,687,500 1,162,500
  Capital spending 3,380,042
  Total cash flow $4,156,299 $5,404,629 $8,482,029 $8,787,879 $8,675,566

After we calculate the OCF for each year, we need to account for any other cash flows.
The project will also require an investment in NWC. The initial NWC investment is given, and the
subsequent NWC investment will be 15 percent of the increase in the following year’s sales.
For the following table, we have year 0 (initial NWC as 1.5mn). For year 1 the change in NWC is
calculated as (year 2 sales- year 1 sales)*0.15, similarly we calculated change in net working capital
from year 1-4. By adding prior NWC and change in NWC we can calculate NWC at the end of each
year. At the end of year 5 all NWC investment is recovered.
Increase in NWC for Year 1 = .15($32,250,000 – 27,375,000) = $731,250: In this question we can
directly calculate change in working capital.

ΔNWC CF due to ΔNWC

0 1,500,000 -1,500,000
1 731,250 -731,250
2 1068750 -1,068,750
3 -450000 450,000
4 -1687500 1,687,500
5 -1,162,500 1,162,500

Now to final cash flows:

  CF0 CF1 CF2 CF3 CF4 CF5

OCF   4,887,549 6,473,379 8,032,029 7,100,379 4,133,025
             
CF due to working capital -1,500,000 -731,250 -1,068,750 450,000 1,687,500 1,162,500
Net capital spending            
Initial Investment -16,500,000          
SV           3,380,042
             
FCF -18,000,000 4,156,299 5,404,629 8,482,029 8,787,879 8,675,567
PV -18,000,000 3,522,287 3,881,520 5,162,425 4,532,690 3,792,170
NPV 2,891,093          
And the IRR is:
IRR = 23.98%

We should accept the project.

CHAPTER 11 solutions

7. The cash break-even equation is:

QC = FC/(P – v)

And the accounting break-even equation is:

QA = (FC + D)/(P – v)

Using these equations, we find the following cash and accounting break-even points:

a. QC = $8,100,000/($2,980 – 2,135) QA = ($8,100,000 + 3,100,000)/($2,980 – 2,135)

QC = 9,585.80 QA = 13,254.44

b. QC = $185,000/($46 – 41) QA = ($185,000 + 183,000)/($46 – 41)

QC = 37,000 QA = 73,600

c. QC = $2,770/($9 – 3) QA = ($2,770 + 1,050)/($9 – 3)

QC = 461.67 QA = 636.67

8. We can use the accounting break-even equation:

QA = (FC + D)/(P – v)

to solve for the unknown variable in each case. Doing so, we find:

(1): QA = 125,736 = ($820,000 + D)/($39 – 30)

D = $311,624

(2): QA = 165,000 = ($2,320,000 + 975,000)/(P – $27)

P = $46.97

(3): QA = 21,430 = ($237,000 + 128,700)/($92 – v)

v = $74.94