CASH FLOW ESTIMATION

CHAPTERAND
11 RISK ANALYSIS

(Difficulty: E = Easy, M = Medium, and T = Tough)

Multiple Choice: Conceptual

Easy:
Relevant cash flows Answer: d Diff: E
1
. Which of the following statements is most correct?

a. The rate of depreciation will often affect operating cash flows, even
though depreciation is not a cash expense.
b. Corporations should fully account for sunk costs when making
investment decisions.
c. Corporations should fully account for opportunity costs when making
investment decisions.
d. Statements a and c are correct.
e. All of the statements above are correct.

Relevant cash flows Answer: c Diff: E

2
. A company is considering a new project. The companys CFO plans to
calculate the projects NPV by discounting the relevant cash flows
(which include the initial up-front costs, the operating cash flows, and
the terminal cash flows) at the companys cost of capital (WACC). Which
of the following factors should the CFO include when estimating the
relevant cash flows?

a. Any sunk costs associated with the project.

b. Any interest expenses associated with the project.
c. Any opportunity costs associated with the project.
d. Statements b and c are correct.
e. All of the statements above are correct.

Relevant cash flows Answer: d Diff: E

3
. When evaluating potential projects, which of the following factors
should be incorporated as part of a projects estimated cash flows?

a. Any sunk costs that were incurred in the past prior to considering
the proposed project.
b. Any opportunity costs that are incurred if the project is undertaken.
c. Any externalities (both positive and negative) that are incurred if
the project is undertaken.
d. Statements b and c are correct.
e. All of the statements above are correct.

Chapter 11 - Page 1
Relevant cash flows Answer: b Diff: E
4
. Which of the following statements is most correct?

a. When evaluating corporate projects it is important to include all

sunk costs in the estimated cash flows.
b. When evaluating corporate projects it is important to include all
relevant externalities in the estimated cash flows.
c. Interest expenses should be included in project cash flows.
d. Statements a and b are correct.
e. All of the statements above are correct.

Relevant cash flows Answer: c Diff: E

5
. Which of the following is not a cash flow that results from the decision
to accept a project?

a. Changes in net operating working capital.

b. Shipping and installation costs.
c. Sunk costs.
d. Opportunity costs.
e. Externalities.

Relevant cash flows Answer: b Diff: E N

6
. When evaluating a new project, the firm should consider all of the
following factors except:

a. Changes in net operating working capital attributable to the project.

b. Previous expenditures associated with a market test to determine the
feasibility of the project, if the expenditures have been expensed
for tax purposes.
c. Current rental income of a building owned by the firm if it is not
used for this project.
d. The decline in sales of an existing product directly attributable to
this project.
e. All of the statements above should be considered.

Relevant cash flows Answer: d Diff: E N

7
. Which of the following items should Bevs Beverage Inc. take into account
when evaluating a proposed prune juice project?

a. The company spent $300,000 two years ago to renovate its Cincinnati
plant. These renovations were made in anticipation of another project
that the company ultimately did not undertake.
b. If the company did not proceed with the prune juice project, the
Cincinnati plant could generate leasing income of $75,000 a year.
c. If the company proceeds with the prune juice project, it is estimated
that sales of the companys apple juice will fall by 3 percent a year.
d. Statements b and c are correct.
e. All of the statements above are correct.

Chapter 11 - Page 2
Relevant cash flows Answer: d Diff: E N
8
. Which of the following should a company consider in an analysis when
evaluating a proposed project?

a. The new project is expected to reduce sales of the companys existing

products by 5 percent a year.
b. Vacant facilities not currently leased out could instead be leased
out for $10 million a year.
c. The company spent $30 million last year to improve the vacant
facilities in which the new project will be housed.
d. Statements a and b are correct.
e. All of the statements above are correct.

Relevant cash flows Answer: d Diff: E N

9
. Hancock Furniture Inc. is considering new expansion plans for building a
new store. In reviewing the proposed new store, several members of the
firms financial staff have made a number of points regarding the
proposed project. Which of the following items should the CFO include
in the analysis when estimating the projects net present value (NPV)?

a. The new store is expected to take away sales from two of the firms
existing stores located in the same town.
b. The company owns the land that is being considered for use in the
proposed project. This land could instead be leased to a local
developer.
c. The company spent $2 million two years ago to put together a national
advertising campaign. This campaign helped generate the demand for
some of its past products, which have helped make it possible for the
firm to consider opening a new store.
d. Statements a and b are correct.
e. All of the statements above are correct.

Relevant and incremental cash flows Answer: a Diff: E N

10
. Twin Hills Inc. is considering a proposed project. Given available
information, it is currently estimated that the proposed project is
risky but has a positive net present value. Which of the following
factors would make the company less likely to adopt the current project?

a. It is revealed that if the company proceeds with the proposed

project, the company will lose two other accounts, both of which have
positive NPVs.
b. It is revealed that the company has an option to back out of the
project 2 years from now, if it is discovered to be unprofitable.
c. It is revealed that if the company proceeds with the project, it will
have an option to repeat the project 4 years from now.
d. Statements a and b are correct.
e. Statements b and c are correct.

Chapter 11 - Page 3
New project cash flows Answer: a Diff: E N
11
. A company is considering a proposed expansion to its facilities. Which
of the following statements is most correct?

a. In calculating the project's operating cash flows, the firm should

not subtract out financing costs such as interest expense, since
these costs are already included in the WACC, which is used to
discount the projects net cash flows.
b. Since depreciation is a non-cash expense, the firm does not need to
know the depreciation rate when calculating the operating cash flows.
c. When estimating the projects operating cash flows, it is important
to include any opportunity costs and sunk costs, but the firm should
ignore cash flows from externalities since they are accounted for
elsewhere.
d. Statements a and c are correct.
e. None of the statements above is correct.

Corporate risk Answer: b Diff: E

12
. Which of the following statements is correct?

a. Well-diversified stockholders do not consider corporate risk when

determining required rates of return.
b. Undiversified stockholders, including the owners of small businesses,
are more concerned about corporate risk than market risk.
c. Empirical studies of the determinants of required rates of return (k)
have found that only market risk affects stock prices.
d. Market risk is important but does not have a direct effect on stock
price because it only affects beta.
e. All of the statements above are correct.

Risk analysis Answer: e Diff: E

13
. Which of the following is not discussed in the text as a method for
analyzing risk in capital budgeting?

a. Sensitivity analysis.
b. Beta, or CAPM, analysis.
c. Monte Carlo simulation.
d. Scenario analysis.
e. All of the statements above are discussed in the text as methods for
analyzing risk in capital budgeting.

Chapter 11 - Page 4
Risk analysis Answer: c Diff: E
14
. Lieber Technologies is considering two potential projects, X and Y. In
assessing the projects risk, the company has estimated the beta of each
project and has also conducted a simulation analysis. Their efforts
have produced the following numbers:

Project X Project Y
Expected NPV $350,000 $350,000
Standard deviation (NPV) $100,000 $150,000
Estimated project beta 1.4 0.8
Estimated correlation of Cash flows are not Cash flows are highly
projects cash flows with highly correlated with correlated with the
the cash flows of the the cash flows of the cash flows of the
companys existing projects. existing projects. existing projects.

Which of the following statements is most correct?

a. Project X has a higher level of stand-alone risk relative to Project Y.

b. Project X has a higher level of corporate risk relative to Project Y.
c. Project X has a higher level of market risk relative to Project Y.
d. Statements b and c are correct.
e. All of the statements above are correct.

Risk analysis Answer: a Diff: E N

15
. Currently, Purcell Products Inc. has a beta of 1.0, and the sales of all
of its products tend to be positively correlated with the overall economy
and the overall market. The company estimates that a proposed new project
has a higher standard deviation than the typical project undertaken by the
firm. The company also estimates that the new projects sales will do
better when the overall economy is down and do poorly when the overall
economy is strong. On the basis of this information, which of the
following statements is most correct?

a. The proposed new project has more stand-alone risk than the firms
typical project.
b. If undertaken, the proposed new project will increase the firms
corporate risk.
c. If undertaken, the proposed new project will increase the firms
market risk.
d. Statements a and b are correct.
e. All of the statements above are correct.

Chapter 11 - Page 5
Risk analysis Answer: e Diff: E N
16
. In conducting its risk analysis, Hanratty Inc. estimates that on a
stand-alone basis, a proposed projects estimated returns has more risk
than its existing projects. The project is also expected to be more
sensitive to movements in the overall economy and market than are its
existing projects. However, Hanratty estimates that the overall
standard deviation of the companys total returns would fall if the
company were to go ahead with this project. On the basis of this
information, which of the following statements is most correct?

a. The proposed projects estimated returns have a higher standard

deviation compared to the average existing project.
b. The proposed project will reduce the companys corporate risk.
c. The proposed project will increase the companys market risk.
d. The proposed projects returns are not perfectly correlated with the
returns of its existing projects.
e. All of the statements above are correct.

Accepting risky projects Answer: e Diff: E

17
. A firm is considering the purchase of an asset whose risk is greater
than the current risk of the firm, based on any method for assessing
risk. In evaluating this asset, the decision maker should

a. Increase the IRR of the asset to reflect the greater risk.

b. Increase the NPV of the asset to reflect the greater risk.
c. Reject the asset, since its acceptance would increase the firms risk.
d. Ignore the risk differential, if the asset to be accepted would
comprise only a small fraction of the firms total assets.
e. Increase the cost of capital used to evaluate the project to reflect
the projects higher risk.

Risk adjustment Answer: b Diff: E

18
. Risk in a revenue-producing project can best be adjusted for by

a. Ignoring it.
b. Adjusting the discount rate upward for increasing risk.
c. Adjusting the discount rate downward for increasing risk.
d. Picking a risk factor equal to the average discount rate.
e. Reducing the NPV by 10 percent for risky projects.

Risk and project selection Answer: b Diff: E

19
. A company estimates that an average-risk project has a WACC of 10
percent, a below-average risk project has a WACC of 8 percent, and an
above-average risk project has a WACC of 12 percent. Which of the
following independent projects should the company accept?

a. Project A has average risk and an IRR = 9 percent.

b. Project B has below-average risk and an IRR = 8.5 percent.
c. Project C has above-average risk and an IRR = 11 percent.
d. All of the projects above should be accepted.

Chapter 11 - Page 6
 e. None of the projects above should be accepted.
Risk and project selection Answer: c Diff: E
20
. Downingtown Industries has an overall (composite) WACC of 10 percent. This
cost of capital reflects the cost of capital for a Downingtown project
with average risk; however, there are large risk differences among its
projects. The company estimates that low-risk projects have a cost of
capital of 8 percent and high-risk projects have a cost of capital of 12
percent. The company is considering the following projects:

Project Expected Return Risk

A 15% High
B 12 Average
C 11 High
D 9 Low
E 6 Low

Which of the projects should the company select to maximize shareholder

wealth?

a. A and B.
b. A, B, and C.
c. A, B, and D.
d. A, B, C, and D.
e. A, B, C, D, and E.

Sensitivity, scenario, and simulation analyses Answer: c Diff: E

21
. Which of the following statements is most correct?

a. Sensitivity analysis is a good way to measure market risk because it

explicitly takes into account diversification effects.
b. One advantage of sensitivity analysis relative to scenario analysis
is that it explicitly takes into account the probability of certain
effects occurring, whereas scenario analysis does not consider
probabilities.
c. Simulation analysis is a computerized version of scenario analysis that
uses continuous probability distributions of the input variables.
d. Statements a and b are correct.
e. All of the statements above are correct.

Chapter 11 - Page 7
Medium:
Cash flows and accounting measures Answer: d Diff: M
22
. Which of the following statements is correct?

a. An asset that is sold for less than book value at the end of a
projects life will generate a loss for the firm and will cause an
actual cash outflow attributable to the project.
b. Only incremental cash flows are relevant in project analysis and the
proper incremental cash flows are the reported accounting profits
because they form the true basis for investor and managerial
decisions.
c. It is unrealistic to expect that increases in net operating working
capital required at the start of an expansion project are simply
recovered at the projects completion. Thus, these cash flows are
included only at the start of a project.
d. Equipment sold for more than its book value at the end of a projects
life will increase income and, despite increasing taxes, will
generate a greater cash flow than if the same asset is sold at book
value.
e. None of the statements above is correct.

Relevant cash flows Answer: d Diff: M

23
. Adams Audio is considering whether to make an investment in a new type
of technology. Which of the following factors should the company
consider when it decides whether to undertake the investment?

a. The company has already spent $3 million researching the technology.

b. The new technology will affect the cash flows produced by its other
operations.
c. If the investment is not made, then the company will be able to sell
one of its laboratories for $2 million.
d. Statements b and c should be considered.
e. All of the statements above should be considered.

Relevant cash flows Answer: d Diff: M

24
. Laurier Inc. is a household products firm that is considering developing a
new detergent. In evaluating whether to go ahead with the new detergent
project, which of the following items should Laurier explicitly include in
its cash flow analysis?

a. The company will produce the detergent in a vacant facility that they
renovated five years ago at a cost of $700,000.
b. The company will need to use some equipment that it could have leased
to another company. This equipment lease could have generated
$200,000 per year in after-tax income.
c. The new detergent is likely to significantly reduce the sales of the
other detergent products the company currently sells.
d. Statements b and c are correct.
e. All of the statements above are correct.

Chapter 11 - Page 8
Relevant cash flows Answer: d Diff: M
25
. Sanford & Son Inc. is thinking about expanding their business by opening
another shop on property they purchased 10 years ago. Which of the
following items should be included in the analysis of this endeavor?

a. The property was cleared of trees and brush five years ago at a cost
of $5,000.
b. The new shop is expected to affect the profitability of the existing
shop since some current customers will transfer their business to the
new shop. The firm estimates that profits at the existing shop will
decrease by 10 percent.
c. Sanford & Son can lease the entire property to another company (that
wants to grow flowers on the lot) for $5,000 per year.
d. Both statements b and c should be included in the analysis.
e. All of the statements above should be included in the analysis.

Relevant cash flows Answer: d Diff: M

26
. Pickles Corp. is a company that sells bottled iced tea. The company is
thinking about expanding its operations into the bottled lemonade
business. Which of the following factors should the company incorporate
into its capital budgeting decision as it decides whether or not to
enter the lemonade business?

a. If the company enters the lemonade business, its iced tea sales are
expected to fall 5 percent as some consumers switch from iced tea to
lemonade.
b. Two years ago the company spent $3 million to renovate a building for
a proposed project that was never undertaken. If the project is
adopted, the plan is to have the lemonade produced in this building.
c. If the company doesnt produce lemonade, it can lease the building to
another company and receive after-tax cash flows of $500,000 a year.
d. Statements a and c are correct.
e. All of the statements above are correct.

Incremental cash flows Answer: d Diff: M

27
. Which of the following constitutes an example of a cost that is not
incremental, and therefore, not relevant in a capital budgeting decision?

a. A firm has a parcel of land that can be used for a new plant site, or
alternatively, can be used to grow watermelons.
b. A firm can produce a new cleaning product that will generate new
sales, but some of the new sales will be from customers who switch
from another product the company currently produces.
c. A firm orders and receives a piece of new equipment that is shipped
across the country and requires $25,000 in installation and set-up
costs.
d. Statements a, b, and c are examples of incremental cash flows, and
therefore, relevant cash flows.
e. None of the statements above is an example of an incremental cash flow.

Chapter 11 - Page 9
Incremental cash flows Answer: d Diff: M
28
. Which of the following is not considered a relevant concern in deter-
mining incremental cash flows for a new product?

a. The use of factory floor space that is currently unused but available
for production of any product.
b. Revenues from the existing product that would be lost as a result of
some customers switching to the new product.
c. Shipping and installation costs associated with preparing the machine
to be used to produce the new product.
d. The cost of a product analysis completed in the previous tax year and
specific to the new product.
e. None of the statements above. (All of the statements above are
relevant concerns in estimating relevant cash flows attributable to a
new product.)

Cash flow estimation Answer: b Diff: M

29
. Which of the following rules are essential to successful cash flow
estimates, and ultimately, to successful capital budgeting analysis?

a. The return on invested capital is the only relevant cash flow.

b. Only incremental cash flows are relevant to the accept/reject
decision.
c. Total cash flows are relevant to capital budgeting analysis and the
accept/reject decision.
d. Statements a and b are correct.
e. All of the statements above are correct.

Cash flow estimation Answer: d Diff: M

30
. Which of the following statements is correct?

a. In a capital budgeting analysis where part of the funds used to

finance the project are raised as debt, failure to include interest
expense as a cost in the cash flow statement when determining the
projects cash flows will lead to an upward bias in the NPV.
b. The preceding statement would be true if upward were replaced with
downward.
c. The existence of externalities reduces the NPV to a level below the
value that would exist in the absence of externalities.
d. If one of the assets to be used by a potential project is already
owned by the firm, and if that asset could be leased to another firm
if the new project were not undertaken, then the net rent that could
be obtained should be charged as a cost to the project under
consideration.
e. The rent referred to in statement d is a sunk cost, and as such it
should be ignored.

Chapter 11 - Page 10
Corporate risk Answer: e Diff: M
31
. In theory, the decision maker should view market risk as being of primary
importance. However, within-firm, or corporate, risk is relevant to a
firms

a. Well-diversified stockholders, because it may affect debt capacity

and operating income.
b. Management, because it affects job stability.
c. Creditors, because it affects the firms credit worthiness.
d. Statements a and c are correct.
e. All of the statements above are correct.

Sensitivity, scenario, and simulation analyses Answer: a Diff: M

32
. Which of the following statements is correct?

a. Sensitivity analysis is incomplete because it fails to consider the

range of likely values of key variables as reflected in their
probability distributions.
b. In comparing two projects using sensitivity analysis, the one with
the steeper lines would be considered less risky, because a small
error in estimating a variable, such as unit sales, would produce
only a small error in the projects NPV.
c. The primary advantage of simulation analysis over scenario analysis
is that scenario analysis requires a relatively powerful computer,
coupled with an efficient financial planning software package,
whereas simulation analysis can be done using a PC with a spreadsheet
program or even a calculator.
d. Sensitivity analysis is a risk analysis technique that considers both
the sensitivity of NPV to changes in key variables and the likely
range of variable values.
e. Statements c and d are correct.

Monte Carlo simulation Answer: e Diff: M

33
. Monte Carlo simulation

a. Can be useful for estimating a projects stand-alone risk.

b. Is capable of using probability distributions for variables as input
data instead of a single numerical estimate for each variable.
c. Produces both an expected NPV (or IRR) and a measure of the riskiness
of the NPV or IRR.
d. Statements a and b are correct.
e. All of the statements above are correct.

Chapter 11 - Page 11
Risk adjustment Answer: a Diff: M
34
. The Oneonta Chemical Company is evaluating two mutually exclusive
pollution control systems. Since the companys revenue stream will not
be affected by the choice of control systems, the projects are being
evaluated by finding the PV of each set of costs. The firms required
rate of return is 13 percent, and it adds or subtracts 3 percentage
points to adjust for project risk differences. System A is judged to be
a high-risk project because it might cost much more to operate than is
expected. System As risk-adjusted cost of capital is

a. 10 percent; this might seem illogical at first but it correctly adjusts

for risk, when outflows rather than inflows are being discounted.
b. 13 percent; the firms cost of capital should not be adjusted when
evaluating outflow-only projects.
c. 16 percent; since A is more risky, its cash flows should be
discounted at a higher rate because this correctly penalizes the
project for its high risk.
d. Somewhere between 10 percent and 16 percent, with the answer
depending on the riskiness of the relevant inflows.
e. Indeterminate, or, more accurately, irrelevant, because for such
projects we would simply select the process that meets the
requirements with the lowest required investment.

Multiple Choice: Problems

Easy:
Taxes on gain on sale Answer: b Diff: E
35
. St. Johns Paper is considering purchasing equipment today that has a
depreciable cost of $1 million. The equipment will be depreciated on a
MACRS 5-year basis, which implies the following depreciation schedule:
MACRS
Depreciation
Year Rates
1 0.20
2 0.32
3 0.19
4 0.12
5 0.11
6 0.06

Assume that the company sells the equipment after three years for $400,000
and the companys tax rate is 40 percent. What would be the tax
consequences resulting from the sale of the equipment?

a. There are no tax consequences.

b. The company would have to pay $44,000 in taxes.
c. The company would have to pay $160,000 in taxes.
d. The company would receive a tax credit of $124,000.
e. The company would receive a tax credit of $48,000.

Chapter 11 - Page 12
Inventory and NPV Answer: d Diff: E N
36
. Rojas Computing is developing a new software system for one of its
clients. The system has an up-front cost of $75 million (at t = 0). The
client has forecasted its inventory levels for the next five years as
shown below:

Year Inventory
1 $1.0 billion
2 1.2 billion
3 1.6 billion
4 2.0 billion
5 2.2 billion

Rojas forecasts that its new software will enable its client to reduce
inventory to the following levels:

Year Inventory
1 $0.8 billion
2 1.0 billion
3 1.4 billion
4 1.7 billion
5 1.9 billion

After Year 5, the software will become obsolete, so it will have no

further impact on the clients inventory levels. Rojas client is
evaluating this software project as it would any other capital budgeting
project. The client estimates that the weighted average cost of capital
for the software system is 10 percent. What is the estimated NPV (in
millions of dollars) of the new software system?

a. $233.56
b. $489.98
c. $625.12
d. $813.55
e. $956.43

NPV with externalities Answer: c Diff: E

37
. Ellison Products is considering a new project that develops a new laundry
detergent, WOW. The company has estimated that the projects NPV is $3
million, but this does not consider that the new laundry detergent will
reduce the revenues received on its existing laundry detergent products.
Specifically, the company estimates that if it develops WOW the company
will lose $500,000 in after-tax cash flows during each of the next 10
years because of the cannibalization of its existing products. Ellisons
WACC is 10 percent. What is the net present value (NPV) of undertaking
WOW after considering externalities?

a. $2,927,716.00
b. $3,000,000.00
c. -$ 72,283.55
d. $2,807,228.00

Chapter 11 - Page 13
 e. -$3,072,283.55
Medium:
After-tax salvage value Answer: c Diff: M N
38
. For a new project, Armstead Inc. had planned on depreciating new
machinery that costs $300 million on a 4-year, straight-line basis.
Suppose now, that Armstead decides to depreciate the new machinery on an
accelerated basis according to the following depreciation schedule:

MACRS
Depreciation
Year Rates
1 20%
2 32
3 19
4 12
5 11
6 6

The project for which the machinery has been purchased ends in four
years, and as a result the machinery is going to be sold at its salvage
value of $50,000,000. Under this accelerated depreciation method, what
is the after-tax cash flow expected to be generated by the sale of the
equipment in Year 4? Assume the firms tax rate is 40 percent.

a. $31,800,000
b. $41,600,000
c. $50,400,000
d. $51,600,000
e. $72,200,000

New project NPV Answer: e Diff: M

39
. Given the following information, calculate the NPV of a proposed
project: Cost = $4,000; estimated life = 3 years; initial decrease in
accounts receivable = $1,000, which must be restored at the end of the
projects life; estimated salvage value = $1,000; earnings before taxes
and depreciation = $2,000 per year; tax rate = 40 percent; and cost of
capital = 18 percent. The applicable depreciation rates are 33 percent,
45 percent, 15 percent, and 7 percent.

a. $1,137
b. -$ 151
c. $ 137
d. $ 804
e. $ 544

Chapter 11 - Page 14
New project NPV Answer: d Diff: M
40
. Mars Inc. is considering the purchase of a new machine that will reduce
manufacturing costs by $5,000 annually. Mars will use the MACRS
accelerated method to depreciate the machine, and it expects to sell the
machine at the end of its 5-year operating life for $10,000. The firm
expects to be able to reduce net operating working capital by $15,000
when the machine is installed, but required net operating working
capital will return to its original level when the machine is sold after
5 years. Mars marginal tax rate is 40 percent, and it uses a 12
percent cost of capital to evaluate projects of this nature. The
applicable depreciation rates are 20 percent, 32 percent, 19 percent, 12
percent, 11 percent, and 6 percent. If the machine costs $60,000, what
is the projects NPV?

a. -$15,394
b. -$14,093
c. -$58,512
d. -$21,493
e. -$46,901

New project NPV Answer: b Diff: M

41
. Stanton Inc. is considering the purchase of a new machine that will
reduce manufacturing costs by $5,000 annually and increase earnings
before depreciation and taxes by $6,000 annually. Stanton will use the
MACRS method to depreciate the machine, and it expects to sell the
machine at the end of its 5-year operating life for $10,000 before
taxes. Stantons marginal tax rate is 40 percent, and it uses a 9
percent cost of capital to evaluate projects of this type. The
applicable depreciation rates are 20 percent, 32 percent, 19 percent, 12
percent, 11 percent, and 6 percent. If the machines cost is $40,000,
what is the projects NPV?

a. $1,014
b. $2,292
c. $7,550
d. $ 817
e. $5,040

Chapter 11 - Page 15
New project NPV Answer: a Diff: M
42
. Maple Media is considering a proposal to enter a new line of business.
In reviewing the proposal, the companys CFO is considering the
following facts:

The new business will require the company to purchase additional

fixed assets that will cost $600,000 at t = 0. For tax and accounting
purposes, these costs will be depreciated on a straight-line basis
over three years. (Annual depreciation will be $200,000 per year at
t = 1, 2, and 3.)
At the end of three years, the company will get out of the
business and will sell the fixed assets at a salvage value of
$100,000.
The project will require a $50,000 increase in net operating
working capital at t = 0, which will be recovered at t = 3.
The companys marginal tax rate is 35 percent.
The new business is expected to generate $2 million in sales each
year (at t = 1, 2, and 3). The operating costs excluding deprecia-
tion are expected to be $1.4 million per year.
The projects cost of capital is 12 percent.

What is the projects net present value (NPV)?

a. $536,697
b. $ 86,885
c. $ 81,243
d. $ 56,331
e. $561,609

Chapter 11 - Page 16
New project NPV Answer: b Diff: M
43
. MacDonald Publishing is considering entering a new line of business. In
analyzing the potential business, their financial staff has accumulated
the following information:

The new business will require a capital expenditure of $5 million

at t = 0. This expenditure will be used to purchase new equipment.
This equipment will be depreciated according to the following
depreciation schedule:

MACRS
Depreciation
Year Rates
1 0.33
2 0.45
3 0.15
4 0.07

The equipment will have no salvage value after four years.

If MacDonald goes ahead with the new business, inventories will
rise by $500,000 at t = 0, and its accounts payable will rise by
$200,000 at t = 0. This increase in net operating working capital
will be recovered at t = 4.
The new business is expected to have an economic life of four
years. The business is expected to generate sales of $3 million at t
= 1,
$4 million at t = 2, $5 million at t = 3, and $2 million at t = 4.
Each year, operating costs excluding depreciation are expected to be
75 percent of sales.
The companys tax rate is 40 percent.
The companys weighted average cost of capital is 10 percent.
The company is very profitable, so any accounting losses on this
project can be used to reduce the companys overall tax burden.

What is the expected net present value (NPV) of the new business?

a. $ 740,298
b. -$1,756,929
c. -$1,833,724
d. -$1,961,833
e. $5,919,974

Chapter 11 - Page 17
New project NPV Answer: a Diff: M
44
. Rio Grande Bookstores is considering a major expansion of its business.
The details of the proposed expansion project are summarized below:

The company will have to purchase $500,000 in equipment at t = 0.

This is the depreciable cost.
The project has an economic life of four years.
The cost can be depreciated on a MACRS 3-year basis, which implies
the following depreciation schedule:

MACRS
Depreciation
Year Rates
1 0.33
2 0.45
3 0.15
4 0.07

At t = 0, the project requires that inventories increase by

$50,000 and accounts payable increase by $10,000. The change in net
operating working capital is expected to be fully recovered at t = 4.
The projects salvage value at the end of four years is expected
to be $0.
The company forecasts that the project will generate $800,000 in
sales the first two years (t = 1 and 2) and $500,000 in sales during
the last two years (t = 3 and 4).
Each year the projects operating costs excluding depreciation are
expected to be 60 percent of sales revenue.
The companys tax rate is 40 percent.
The projects cost of capital is 10 percent.

What is the net present value (NPV) of the proposed project?

a. $159,145
b. $134,288
c. $162,817
d. $150,776
e. -$257,060

Chapter 11 - Page 18
New project NPV Answer: b Diff: M
45
. Your company is considering a machine that will cost $1,000 at Time 0 and
can be sold after 3 years for $100. To operate the machine, $200 must be
invested at Time 0 in inventories; these funds will be recovered when the
machine is retired at the end of Year 3. The machine will produce sales
revenues of $900 per year for 3 years and variable operating costs
(excluding depreciation) will be 50 percent of sales. Operating cash
inflows will begin 1 year from today (at Time 1). The machine will have
depreciation expenses of $500, $300, and $200 in Years 1, 2, and 3,
respectively. The company has a 40 percent tax rate, enough taxable
income from other assets to enable it to get a tax refund from this
project if the projects income is negative, and a 10 percent cost of
capital. Inflation is zero. What is the projects NPV?

a. $ 6.24
b. $ 7.89
c. $ 8.87
d. $ 9.15
e. $10.41

New project NPV Answer: a Diff: M

46
. Your company is considering a machine that will cost $50,000 at Time 0
and that can be sold after 3 years for $10,000. $12,000 must be invested
at Time 0 in inventories and receivables; these funds will be recovered
when the operation is closed at the end of Year 3. The facility will
produce sales revenues of $50,000 per year for 3 years and variable
operating costs (excluding depreciation) will be 40 percent of sales. No
fixed costs will be incurred. Operating cash inflows will begin 1 year
from today (at t = 1). By an act of Congress, the machine will have
depreciation expenses of $40,000, $5,000, and $5,000 in Years 1, 2, and
3, respectively. The company has a 40 percent tax rate, enough taxable
income from other assets to enable it to get a tax refund on this project
if the projects income is negative, and a 15 percent cost of capital.
Inflation is zero. What is the projects NPV?

a. $ 7,673.71
b. $12,851.75
c. $17,436.84
d. $24,989.67
e. $32,784.25

Chapter 11 - Page 19
New project NPV Answer: d Diff: M
.
47
Buckeye Books is considering opening a new production facility in Toledo,
Ohio. In deciding whether to proceed with the project, the company has
accumulated the following information:

The estimated up-front cost of constructing the facility at t = 0 is

$10 million. For tax purposes the facility will be depreciated on a
straight-line basis over 5 years.
The company plans to operate the facility for 4 years. It estimates
today that the facilitys salvage value at t = 4 will be $3 million.
If the facility is opened, Buckeye will have to increase its
inventory by $2 million at t = 0. In addition, its accounts payable
will increase by $1 million at t = 0. The companys net operating
working capital will be recovered at t = 4.
If the facility is opened, it will increase the companys sales by $7
million each year for the 4 years that it will be operated (t = 1, 2,
3, and 4).
The operating costs (excluding depreciation) are expected to equal $3
million a year.
The companys tax rate is 40 percent.
The projects cost of capital is 12 percent.

What is the projects net present value (NPV)?

a. $0.28 million
b. $0.50 million
c. $0.63 million
d. $1.01 million
e. $1.26 million

Chapter 11 - Page 20
New project NPV Answer: e Diff: M N
48
. Burress Beverages is considering a project where they would open a new
facility in Seattle, Washington. The companys CFO has assembled the
following information regarding the proposed project:

It would cost $500,000 today (at t = 0) to construct the new

facility. The cost of the facility will be depreciated on a straight-
line basis over five years.
If the company opens the facility, it will need to increase its
inventory by $100,000 at t = 0. $70,000 of this inventory will be
financed with accounts payable.
The CFO has estimated that the project will generate the following
amount of revenue over the next three years:

Year 1 Revenue = $1.0 million

Year 2 Revenue = $1.2 million
Year 3 Revenue = $1.5 million

Operating costs excluding depreciation equal 70 percent of revenue.

The company plans to abandon the facility after three years. At t =
3, the projects estimated salvage value will be $200,000. At t = 3,
the company will also recover the net operating working capital
investment that it made at t = 0.
The projects cost of capital is 14 percent.
The companys tax rate is 40 percent.

What is the projects net present value (NPV)?

a. $ 69,207
b. $178,946
c. $286,361
d. $170,453
e. $224,451

Chapter 11 - Page 21
New project NPV Answer: c Diff: M R
49
. Mills Mining is considering an expansion project. The proposed project
has the following features:

The project has an initial cost of $500,000. This is also the

amount that can be depreciated using the following depreciation
schedule:

MACRS
Depreciation
Year Rates
1 0.33
2 0.45
3 0.15
4 0.07

If the project is undertaken, at t = 0 the company will need to

increase its inventories by $50,000, and its accounts payable will rise
by $10,000. This net operating working capital will be recovered at
the end of the projects life (t = 4).
If the project is undertaken, the company will realize an additional
$600,000 in sales over each of the next four years (t = 1, 2, 3, and 4).
The companys operating costs (not including depreciation) will equal
$400,000 a year.
The companys tax rate is 40 percent.
At t = 4, the projects economic life is complete, but it will have
a salvage value (before-tax) of $50,000.
The projects WACC is 10 percent.
The company is very profitable, so any accounting losses on this
project can be used to reduce the companys overall tax burden.

What is the projects net present value (NPV)?

a. $11,122.87
b. $50,330.14
c. $54,676.59
d. $68,336.86
e. $80,035.52

Chapter 11 - Page 22
New project IRR Answer: b Diff: M
.
50
As one of its major projects for the year, Steinbeck Depot is considering
opening up a new store. The companys CFO has collected the following
information, and is proceeding to evaluate the project.

The building would have an up-front cost (at t = 0) of $14 million.

For tax purposes, this cost will be depreciated over seven years using
straight-line depreciation.
The store is expected to remain open for five years. At t = 5, the
company plans to sell the store for an estimated pre-tax salvage value
of $8 million.
The project also requires the company to spend $5 million in cash at t
= 0 to purchase additional inventory for the store. After purchasing
the inventory, the companys net operating working capital will remain
unchanged until t = 5. At t = 5, the company will be able to fully
recover this $5 million.
The store is expected to generate sales revenues of $15 million per
year at the end of each of the next five years. Operating costs
(excluding depreciation) are expected to be $10 million per year.
The companys tax rate is 40 percent.

What is the projects internal rate of return (IRR)?

a. 15.35%
b. 13.94%
c. 10.64%
d. 12.45%
e. 3.60%

Chapter 11 - Page 23
Risk-adjusted NPV Answer: c Diff: M N
51
. Parker Products manufactures a variety of household products. The company
is considering introducing a new detergent. The companys CFO has
collected the following information about the proposed product. (Note:
You may or may not need to use all of this information, use only relevant
information.)

The project has an anticipated economic life of 4 years.

The company will have to purchase a new machine to produce the
detergent. The machine has an up-front cost (t = 0) of $2 million.
The machine will be depreciated on a straight-line basis over 4 years
(that is, the companys depreciation expense will be $500,000 in each
of the first four years (t = 1, 2, 3, and 4). The company
anticipates that the machine will last for four years, and that after
four years, its salvage value will equal zero.
If the company goes ahead with the proposed product, it will have an
effect on the companys net operating working capital. At the
outset, t = 0, inventory will increase by $140,000 and accounts
payable will increase by $40,000. At t = 4, the net operating
working capital will be recovered after the project is completed.
The detergent is expected to generate sales revenue of $1 million the
first year (t = 1), $2 million the second year (t = 2), $2 million
the third year (t = 3), and $1 million the final year (t = 4). Each
year the operating costs (not including depreciation) are expected to
equal 50 percent of sales revenue.
The companys interest expense each year will be $100,000.
The new detergent is expected to reduce the after-tax cash flows of the
companys existing products by $250,000 a year (t = 1, 2, 3, and 4).
The companys overall WACC is 10 percent. However, the proposed
project is riskier than the average project for Parker; the projects
WACC is estimated to be 12 percent.
The companys tax rate is 40 percent.

What is the net present value of the proposed project?

a. -$ 765,903.97
b. -$1,006,659.58
c. -$ 824,418.62
d. -$ 838,997.89
e. -$ 778,583.43

Chapter 11 - Page 24
Risk-adjusted NPV Answer: a Diff: M
52
. Virus Stopper Inc., a supplier of computer safeguard systems, uses a cost
of capital of 12 percent to evaluate average-risk projects, and it adds or
subtracts 2 percentage points to evaluate projects of more or less risk.
Currently, two mutually exclusive projects are under consideration. Both
have a cost of $200,000 and will last 4 years. Project A, a riskier-than-
average project, will produce annual end-of-year cash flows of $71,104.
Project B, a less-than-average-risk project, will produce cash flows of
$146,411 at the end of Years 3 and 4 only. Virus Stopper should accept

a. B with a NPV of $10,001.

b. Both A and B because both have NPVs greater than zero.
c. B with a NPV of $8,042.
d. A with a NPV of $7,177.
e. A with a NPV of $15,968.

Risk-adjusted NPV Answer: e Diff: M

53
. An all-equity firm is analyzing a potential project that will require an
initial, after-tax cash outlay of $50,000 and after-tax cash inflows of
$6,000 per year for 10 years. In addition, this project will have an
after-tax salvage value of $10,000 at the end of Year 10. If the risk-
free rate is 6 percent, the return on an average stock is 10 percent,
and the beta of this project is 1.50, what is the projects NPV?

a. $13,210
b. $ 4,905
c. $ 7,121
d. -$ 6,158
e. -$12,879

Risk-adjusted NPV Answer: c Diff: M

54
. Real Time Systems Inc. is considering the development of one of two
mutually exclusive new computer models. Each will require a net
investment of $5,000. The cash flows for each project are shown below:

Year Project A Project B

1 $2,000 $3,000
2 2,500 2,600
3 2,250 2,900

Model B, which will use a new type of laser disk drive, is considered a
high-risk project, while Model A is an average-risk project. Real Time
adds 2 percentage points to arrive at a risk-adjusted cost of capital
when evaluating high-risk projects. The cost of capital used for
average-risk projects is 12 percent. Which of the following statements
regarding the NPVs for Models A and B is most correct?

a. NPVA = $ 380; NPVB = $1,815

b. NPVA = $ 197; NPVB = $1,590
c. NPVA = $ 380; NPVB = $1,590
d. NPVA = $5,380; NPVB = $6,590
e. NPVA = $ 197; NPVB = $1,815

Chapter 11 - Page 25
Risk-adjusted discount rate Answer: b Diff: M
55
. The Unlimited, a national retailing chain, is considering an investment in
one of two mutually exclusive projects. The discount rate used for
Project A is 12 percent. Further, Project A costs $15,000, and it would
be depreciated using MACRS. It is expected to have an after-tax salvage
value of $5,000 at the end of 6 years and to produce after-tax cash flows
(including depreciation) of $4,000 for each of the 6 years. Project B
costs $14,815 and would also be depreciated using MACRS. B is expected to
have a zero salvage value at the end of its 6-year life and to produce
after-tax cash flows (including depreciation) of $5,100 each year for 6
years. The Unlimiteds marginal tax rate is 40 percent. What risk-
adjusted discount rate will equate the NPV of Project B to that of Project
A?

a. 15%
b. 16%
c. 18%
d. 20%
e. 12%

Risk-adjusted discount rate Answer: e Diff: M

56
. California Mining is evaluating the introduction of a new ore production
process. Two alternatives are available. Production Process A has an
initial cost of $25,000, a 4-year life, and a $5,000 net salvage value,
and the use of Process A will increase net cash flow by $13,000 per year
for each of the 4 years that the equipment is in use. Production Process
B also requires an initial investment of $25,000, will also last 4 years,
and its expected net salvage value is zero, but Process B will increase
net cash flow by $15,247 per year. Management believes that a risk-
adjusted discount rate of 12 percent should be used for Process A. If
California Mining is to be indifferent between the two processes, what
risk-adjusted discount rate must be used to evaluate B?

a. 8%
b. 10%
c. 12%
d. 14%
e. 16%

Chapter 11 - Page 26
Discounting risky outflows Answer: e Diff: M
57
. Alabama Pulp Company (APC) can control its environmental pollution using
either Project Old Tech or Project New Tech. Both will do the job,
but the actual costs involved with Project New Tech, which uses unproved,
new state-of-the-art technology, could be much higher than the expected
cost levels. The cash outflows associated with Project Old Tech, which
uses standard proven technology, are less risky. (They are about as
uncertain as the cash flows associated with an average project.) APCs
cost of capital for average-risk projects is normally set at 12 percent,
and the company adds 3 percent for high-risk projects but subtracts 3
percent for low-risk projects. The two projects in question meet the
criteria for high and average risk, but the financial manager is concerned
about applying the normal rule to such cost-only projects. You must
decide which project to recommend, and you should recommend the one with
the lower PV of costs. What is the PV of costs of the better project?

Cash Outflows
Years: 0 1 2 3 4
Project New Tech 1,500 315 315 315 315
Project Old Tech 600 600 600 600 600

a. -$2,521
b. -$2,399
c. -$2,457
d. -$2,543
e. -$2,422

Discounting risky outflows Answer: c Diff: M

58
. Mid-State Electric Company must clean up the water released from its
generating plant. The companys cost of capital is 10 percent for
average-risk projects, and that rate is normally adjusted up or down by
2 percentage points for high- and low-risk projects. Clean-up Plan A,
which is of average risk, has an initial cost of -$1,000 at Time 0, and
its operating cost will be -$100 per year for its 10-year life. Plan B,
which is a high-risk project, has an initial cost of -$300, and its annual
operating cost over Years 1 to 10 will be -$200. What is the proper PV of
costs for the better project?

a. -$1,430.04
b. -$1,525.88
c. -$1,614.46
d. -$1,642.02
e. -$1,728.19

Chapter 11 - Page 27
Discounting risky outflows Answer: c Diff: M
59
. Your company must ensure the safety of its work force. Two plans are
being considered for the next 10 years: (1) Install a high electrified
fence around the property at a cost of $100,000. Maintenance and
electricity would then cost $5,000 per year over the 10-year life of the
fence.
(2) Hire security guards at a cost of $25,000 paid at the end of each
year. Because the company plans to build new headquarters with a state of
the art security system in 10 years, the plan will be in effect only
until that time. Your companys cost of capital is 15 percent for
average-risk projects, and that rate is normally adjusted up or down by 2
percentage points for high- and low-risk projects. Plan 1 is considered
to be of low risk because its costs can be predicted quite accurately.
Plan B, on the other hand, is a high-risk project because of the
difficulty of predicting wage rates. What is the proper PV of costs for
the better project?

a. -$104,266.20
b. -$116,465.09
c. -$123,293.02
d. -$127,131.22
e. -$135,656.09

Risky projects Answer: d Diff: M

60
. Cochran Corporation has a weighted average cost of capital of 11 percent
for projects of average risk. Projects of below-average risk have a cost
of capital of 9 percent, while projects of above-average risk have a cost
of capital equal to 13 percent. Projects A and B are mutually exclusive,
whereas all other projects are independent. None of the projects will be
repeated. The following table summarizes the cash flows, internal rate of
return (IRR), and risk of each of the projects.

Year Project A Project B Project C Project D Project E

0 -$200,000 -$100,000 -$100,000 -$100,000 -$100,000
1 66,000 30,000 30,000 30,000 40,000
2 66,000 30,000 30,000 30,000 25,000
3 66,000 40,000 30,000 40,000 30,000
4 66,000 40,000 40,000 50,000 35,000

IRR 12.110% 14.038% 10.848% 16.636% 11.630%

Project Below Below Average Above Above
Risk Average Average Average Average

Which projects will the firm select for investment?

a. Projects: A, B, C, D, E
b. Projects: B, C, D, E
c. Projects: B, D
d. Projects: A, D
e. Projects: B, C, D

Chapter 11 - Page 28
Scenario analysis Answer: c Diff: M
61
. Klott Company encounters significant uncertainty with its sales volume and
price in its primary product. The firm uses scenario analysis in order to
determine an expected NPV, which it then uses in its budget. The base-
case, best-case, and worst-case scenarios and probabilities are provided
in the table below. What is Klotts expected NPV (in thousands of
dollars), standard deviation of NPV (in thousands of dollars), and
coefficient of variation of NPV?

Probability Unit Sales Sales NPV

of Outcome Volume Price (In Thousands)
Worst case 0.30 6,000 $3,600 -$6,000
Base case 0.50 10,000 4,200 +13,000
Best case 0.20 13,000 4,400 +28,000

a. Expected NPV = $35,000; NPV = 17,500; CVNPV = 2.00

b. Expected NPV = $35,000; NPV = 11,667; CVNPV = 0.33
c. Expected NPV = $10,300; NPV = 12,083; CVNPV = 1.17
d. Expected NPV = $13,900; NPV = 8,476; CVNPV = 0.61
e. Expected NPV = $10,300; NPV = 13,900; CVNPV = 1.35

Optimal project selection Answer: a Diff: M N

62
. Jackson Corporation is evaluating the following four independent,
investment opportunities:

Project Cost Rate of Return

A $300,000 14%
B 150,000 10
C 200,000 13
D 400,000 11

Jacksons target capital structure is 60 percent debt and 40 percent

equity. The yield to maturity on the companys debt is 10 percent. Jackson
will incur flotation costs for a new equity issuance of 12 percent. The
growth rate is a constant 6 percent. The stock price is currently $35 per
share for each of the 10,000 shares outstanding. Jackson expects to earn
net income of $100,000 this coming year and the dividend payout ratio will
be 50 percent. If the companys tax rate is 30 percent, which of the
projects will be accepted?

a. Project A
b. Projects A and C
c. Projects A, C, and D
d. All of the investment projects will be taken.
e. None of the investment projects will be taken.

Chapter 11 - Page 29
Tough:
New project NPV Answer: b Diff: T N
63
. Blair Bookstores is thinking about expanding its facilities. In
considering the expansion, Blairs finance staff has obtained the following
information:

The expansion will require the company to purchase today (t = 0)

$5 million of equipment. The equipment will be depreciated over the
following four years at the following rate:

Year 1: 33%
Year 2: 45
Year 3: 15
Year 4: 7

The expansion will require the company to increase its net operating
working capital by $500,000 today (t = 0). This net operating working
capital will be recovered at the end of four years (t = 4).
The equipment is not expected to have any salvage value at the end of
four years.
The companys operating costs, excluding depreciation, are expected to
be 60 percent of the companys annual sales.
The expansion will increase the companys dollar sales. The projected
increases, all relative to current sales are:

Year 1: $3.0 million

Year 2: 3.5 million
Year 3: 4.5 million
Year 4: 4.0 million

(For example, in Year 4 sales will be $4 million more than they would
have been had the project not been undertaken.) After the fourth year,
the equipment will be obsolete, and will no longer provide any
additional incremental sales.
The companys tax rate is 40 percent and the companys other divisions
are expected to have positive tax liabilities throughout the projects
life.
If the company proceeds with the expansion, it will need to use a
building that the company already owns. The building is fully
depreciated; however, the building is currently leased out. The company
receives $300,000 before-tax rental income each year (payable at year
end). If the company proceeds with the expansion, the company will no
longer receive this rental income.
The projects WACC is 10 percent.

What is the proposed project's NPV?

a. -$1,034,876
b. -$1,248,378
c. -$1,589,885

Chapter 11 - Page 30
 d. -$5,410,523
e. -$ 748,378
New project NPV Answer: d Diff: T
64
. Foxglove Corp. is faced with an investment project. The following
information is associated with this project:

MACRS
Depreciation
Year Net Income* Rates
1 $50,000 0.33
2 60,000 0.45
3 70,000 0.15
4 60,000 0.07
*Assume no interest expenses and a zero tax rate.

The project involves an initial investment of $100,000 in equipment that

falls in the 3-year MACRS class and has an estimated salvage value of
$15,000. In addition, the company expects an initial increase in net
operating working capital of $5,000 that will be recovered in Year 4. The
cost of capital for the project is 12 percent. What is the projects net
present value? (Round your final answer to the nearest whole dollar.)

a. $153,840
b. $159,071
c. $162,409
d. $168,604
e. $182,344
New project NPV Answer: d Diff: T
65
. Pierce Products is deciding whether it makes sense to purchase a new piece
of equipment. The equipment costs $100,000 (payable at t = 0). The
equipment will provide cash inflows before taxes and depreciation of
$45,000 at the end of each of the next four years (t = 1, 2, 3, and 4).
The equipment can be depreciated according to the following schedule:

MACRS
Depreciation
Year Rates
1 0.33
2 0.45
3 0.15
4 0.07

At the end of four years the company expects to be able to sell the
equipment for an after-tax salvage value of $10,000. The company is in
the 40 percent tax bracket. The company has a weighted average cost of
capital of 11 percent. Because there is more uncertainty about the
salvage value, the company has chosen to discount the salvage value at 12
percent. What is the net present value (NPV) of purchasing the equipment?

a. $ 9,140.78
b. $16,498.72

Chapter 11 - Page 31
 c. $20,564.23
d. $22,853.90
e. $28.982.64

Chapter 11 - Page 32
New project NPV Answer: d Diff: T
66
. Lugar Industries is considering an investment in a proposed project that
requires an initial expenditure of $100,000 at t = 0. This expenditure
can be depreciated at the following annual rates:

MACRS
Depreciation
Year Rates
1 0.20
2 0.32
3 0.19
4 0.12
5 0.11
6 0.06

The project has an economic life of six years. The projects revenues are
forecasted to be $90,000 a year. The projects operating costs (not
including depreciation) are forecasted to be $50,000 a year. After six
years, the projects estimated salvage value is $10,000. The companys
WACC is 10 percent, and its corporate tax rate is 40 percent. What is the
projects net present value (NPV)?

a. $31,684
b. $33,843
c. $34,667
d. $38,840
e. $45,453

New project IRR Answer: b Diff: T

67
. After a long drought, the manager of Long Branch Farms is considering
the installation of an irrigation system that will cost $100,000. It is
estimated that the irrigation system will increase revenues by $20,500
annually, although operating expenses other than depreciation will also
increase by $5,000. The system will be depreciated using MACRS over its
depreciable life (5 years) to a zero salvage value. The applicable
depreciation rates are 20 percent, 32 percent, 19 percent, 12 percent,
11 percent, and 6 percent. If the tax rate is 40 percent, what is the
projects IRR?

a. 12.6%
b. -1.3%
c. 13.0%
d. 10.2%
e. -4.8%

Chapter 11 - Page 33
NPV and risk-adjusted discount rate Answer: e Diff: T
68
. Garcia Paper is deciding whether to build a new plant. The proposed
project would have an up-front cost (at t = 0) of $30 million. The
projects cost can be depreciated on a straight-line basis over three
years. Consequently, the depreciation expense will be $10 million in each
of the first three years, t = 1, 2, and 3. Even though the project is
depreciated over three years, the project has an economic life of five
years.

The project is expected to increase the companys sales by $20 million.

Sales will remain at this higher level for each year of the project (t =
1, 2, 3, 4, and 5). The operating costs, not including depreciation,
equal 60 percent of the increase in annual sales. The projects interest
expense is $5 million per year and the companys tax rate is 40 percent.
The company is very profitable, so any accounting losses on this project
can be used to reduce the companys overall tax burden. The project does
not require any additions to net operating working capital. The company
estimates that the projects after-tax salvage value at t = 5 will be $1.2
million. The project is of average risk, and, therefore, the CFO has
decided to discount the operating cash flows at the companys overall WACC
of 10 percent. However, the salvage value is more uncertain, so the CFO
has decided to discount it at 12 percent. What is the net present value
(NPV) of the proposed project?

a. $11.86 million
b. $14.39 million
c. -$26.04 million
d. -$12.55 million
e. -$ 1.18 million

Multiple Part:

(The following information applies to the next four problems.)

The president of Real Time Inc. has asked you to evaluate the proposed
acquisition of a new computer. The computers price is $40,000, and it falls in
the MACRS 3-year class. The applicable depreciation rates are 33 percent, 45
percent, 15 percent, and 7 percent. Purchase of the computer would require an
increase in net operating working capital of $2,000. The computer would
increase the firms before-tax revenues by $20,000 per year but would also
increase operating costs by $5,000 per year. The computer is expected to be
used for three years and then sold for $25,000. The firms marginal tax rate is
40 percent, and the projects cost of capital is 14 percent.

New project investment Answer: a Diff: E

69
. What is the net investment required at t = 0?

a. -$42,000
b. -$40,000
c. -$38,600
d. -$37,600

Chapter 11 - Page 34
 e. -$36,600
Operating cash flow Answer: e Diff: M
70
. What is the operating cash flow in Year 2?

a. $ 9,000
b. $10,240
c. $11,687
d. $13,453
e. $16,200

Non-operating cash flows Answer: a Diff: M

71
. What is the total value of the terminal year non-operating cash flows at
the end of Year 3?

a. $18,120
b. $19,000
c. $21,000
d. $25,000
e. $27,000

New project NPV Answer: c Diff: M

72
. What is the projects NPV?

a. $2,622
b. $2,803
c. $2,917
d. $5,712
e. $6,438

(The following information applies to the next four problems.)

You have been asked by the president of your company to evaluate the proposed
acquisition of a new special-purpose truck. The trucks basic price is $50,000,
and it will cost another $10,000 to modify it for special use by your firm. The
truck falls in the MACRS 3-year class, and it will be sold after three years for
$20,000. The applicable depreciation rates are 33 percent, 45 percent, 15
percent, and 7 percent. Use of the truck will require an increase in net
operating working capital (spare parts inventory) of $2,000. The truck will
have no effect on revenues, but it is expected to save the firm $20,000 per year
in before-tax operating costs, mainly labor. The firms marginal tax rate is 40
percent.

New project investment Answer: d Diff: E

73
. What is the net investment in the truck? (That is, what is the Year 0
net cash flow?)

a. -$50,000
b. -$52,600
c. -$55,800
d. -$62,000

Chapter 11 - Page 35
 e. -$65,000
Operating cash flow Answer: c Diff: M
74
. What is the operating cash flow in Year 1?

a. $17,820
b. $18,254
c. $19,920
d. $20,121
e. $21,737

Non-operating cash flows Answer: c Diff: M

75
. What is the total value of the terminal year non-operating cash flows at
the end of Year 3?

a. $10,000
b. $12,000
c. $15,680
d. $16,000
e. $18,000

New project NPV Answer: a Diff: M

76
. The trucks cost of capital is 10 percent. What is its NPV?

a. -$1,547
b. -$ 562
c. $ 0
d. $ 562
e. $1,034
(The following information applies to the next four problems.)

Bruener Retail is considering opening a new store. In evaluating the proposed

project the companys CFO has collected the following information:
It will cost $10 million to construct the new store. These costs will be
incurred at t = 0. These costs will be depreciated on a straight-line basis
over the next 10 years.
The company will need an additional $5 million of inventory to stock the new
store. $2 million of this inventory will be financed with accounts payable,
the other $3 million will be paid for in cash. The cost of this net increase
in operating working capital will be incurred at t = 0. Assume that this net
operating working capital is fully recovered at t = 4.
The new store will be open for four years. During each of the four years (t
= 1, 2, 3, and 4) the store will produce the following financial projections
(in millions of dollars):
t = 1 t = 2 t = 3 t = 4
EBITDA $8.0 $8.0 $8.0 $8.0
Depreciation 1.0 1.0 1.0 1.0
EBIT 7.0 7.0 7.0 7.0
Taxes 2.8 2.8 2.8 2.8
Net income 4.2 4.2 4.2 4.2

Chapter 11 - Page 36
Bruener finances its projects with 100 percent equity; thus, there is no
interest expense. The company has a 10 percent weighted average cost of
capital. The company assigns a 7 percent cost of capital for its low-risk
projects, a 10 percent cost of capital for its average-risk projects, and a 13
percent cost for its above-average risk projects. Bruener estimates that this
new store has average risk, so therefore the proposed projects cost of capital
is 10 percent.

Operating cash flows Answer: e Diff: E N

77
. What are the projects after-tax operating cash flows for each of the
four years?

a. $2.8 million
b. $3.6 million
c. $4.2 million
d. $4.8 million
e. $5.2 million

After-tax salvage value Answer: d Diff: M N

78
. The CFO estimates that the store can be sold after four years for $7.5
million. Brueners tax rate is 40 percent. What is the stores after-
tax salvage value at t = 4?

a. $4.5 million
b. $6.0 million
c. $6.6 million
d. $6.9 million
e. $7.5 million

New project NPV Answer: d Diff: M N

79
. Assuming the store is sold after four years for $7.5 million, what is
the projects net present value (NPV)?

a. $ 6.87 million
b. $ 7.49 million
c. $ 7.99 million
d. $10.25 million
e. $10.65 million

Chapter 11 - Page 37
Scenario analysis Answer: e Diff: M N
80
. After taking into account all of the relevant cash flows from the
previous question, the companys CFO has estimated the projects NPV and
has also put together the following scenario analysis:

Scenario Prob. of Scenario Occurring Expected NPV

County taxes increased 25% $ 5 million
County taxes unchanged 50 8 million
County taxes decreased 25 10 million

On the basis of the numbers calculated above, the CFO estimates that the
standard deviation of the projects NPV is 2.06. The company typically
calculates a projects coefficient of variation (CV) and uses this
information to assess the projects risk. Here is the scale that
Bruener uses to evaluate project risk:

Range for Coefficient Risk Projects

of Variation (CV) Assessment WACC
CV > 0.3 High risk 12%
0.2 < CV < 0.3 Average risk 10
CV < 0.2 Low risk 8

On the basis of this scenario analysis, which of the following

statements is most correct?

a. The projects expected NPV is $7.75 million.

b. The project would be classified as an average-risk project.
c. If the project were classified as a high-risk project, the company
should go back and recalculate the projects NPV using the higher
cost of capital estimate.
d. Statements a and b are correct.
e. All of the statements above are correct.

Chapter 11 - Page 38
 (The following information applies to the next two problems.)

Mitts Beverage Inc. manufactures and distributes fruit juice products. Mitts
is considering the development of a new prune juice product. Mitts CFO has
collected the following information regarding the proposed project:

The project can be operated at the companys Dayton plant, which is

currently vacant.
The project will require that the company spend $1 million today (t = 0) to
purchase a new machine. For tax purposes, the equipment will be depreciated
on a straight-line basis. The company plans to use the machine for all
3 years of the project. At t = 3, the equipment is expected to have no
salvage value.
The project will require a $200,000 increase in net operating working
capital at t = 0. The cost of the net operating working capital will be
fully recovered at t = 3.
The project is expected to increase the companys sales $1 million a year
for three years (t = 1, 2, and 3).
The projects annual operating costs (excluding depreciation) are expected
to be 60 percent of sales.
The companys tax rate is 40 percent.
The company is extremely profitable, so any losses incurred from the prune
juice project can be used to partially offset taxes paid on the companys
other projects.
The project has a WACC equal to 10 percent.

New project NPV Answer: e Diff: M N

81
. What is the projects net present value?

a. -$162,621
b. -$159,464
c. -$142,035
d. -$135,201
e. -$121,313

After-tax salvage value Answer: c Diff: E N

82
. There is a possibility that the company may be forced to end the project
after only the second year. If forced to end the project, the company will
have to sell its equipment. If it sells its equipment after the second
year, Mitts expects to sell it for $400,000. What is the after-tax salvage
value that would be incorporated into the projects cash flow analysis?

a. $383,333.33
b. $362,444.50
c. $373,333.33
d. $383,333.33
e. $400,000.00

Chapter 11 - Page 39
 (The following information applies to the next two problems.)

Bucholz Brands is considering the development of a new ketchup product. The

ketchup will be sold in a variety of different colors and will be marketed to
young children. In evaluating the proposed project, the company has collected
the following information:

The company estimates that the project will last for four years.
The company will need to purchase new machinery that has an up-front cost
of $300 million (incurred at t = 0). At t = 4, the machinery has an
estimated salvage value of $50 million.
The machinery will be depreciated on a 4-year straight-line basis.
Production on the new ketchup product will take place in a recently vacated
facility that the company owns. The facility is empty and Bucholz does not
intend to lease the facility.
The project will require a $60 million increase in inventory at t = 0. The
company expects that its accounts payable will rise by $10 million at t =
0. After t = 0, there will be no changes in net operating working capital,
until t = 4 when the project is completed, and the net operating working
capital is completely recovered.
The company estimates that sales of the new ketchup will be $200 million
each of the next four years.
The operating costs, excluding depreciation, are expected to be $100
million each year.
The companys tax rate is 40 percent.
The projects WACC is 10 percent.

Operating cash flows Answer: e Diff: M N

83
. What is the projects after-tax operating cash flow the first year (t =
1)?

a. $22.5 million
b. $45.0 million
c. $60.0 million
d. $72.5 million
e. $90.0 million

New project NPV Answer: a Diff: M N

84
. What is the projects estimated net present value (NPV)?

a. -$10.07 million
b. -$25.92 million
c. -$46.41 million
d. -$60.07 million
e. +$ 5.78 million

Chapter 11 - Page 40
 Web Appendix 11A
Multiple Choice: Conceptual

Easy:
NPV and depreciation Answer: c Diff: E
85
11A- . Other things held constant, which of the following would increase the
NPV of a project being considered?

a. A shift from MACRS to straight-line depreciation.

b. Making the initial investment in the first year rather than
spreading it over the first three years.
c. A decrease in the discount rate associated with the project.
d. An increase in required net operating working capital.
e. All of the statements above will increase the projects NPV.

Medium:
Depreciation cash flows Answer: c Diff: M
11A-86. Which of the following statement completions is incorrect? For a
profitable firm, when MACRS accelerated depreciation is compared to
straight-line depreciation, MACRS accelerated allowances produce

a. Higher depreciation charges in the early years of an assets life.

b. Larger cash flows in the earlier years of an assets life.
c. Larger total undiscounted profits from the project over the
projects life.
d. Smaller accounting profits in the early years, assuming the company
uses the same depreciation method for tax and book purposes.
e. None of the statements above. (All of the statements above are
correct.)

Chapter 11 - Page 41
 Web Appendix 11B
Multiple Choice: Conceptual

Medium:
Replacement cash outflows Answer: d Diff: M
11B-87. Given the following information, what is the required cash outflow
associated with the acquisition of a new machine; that is, in a
project analysis, what is the cash outflow at t = 0?

Purchase price of new machine $8,000

Installation charge 2,000
Market value of old machine 2,000
Book value of old machine 1,000
Inventory decrease if new machine
is installed 1,000
Accounts payable increase if new
machine is installed 500
Tax rate 35%
Cost of capital 15%

a. -$ 8,980
b. -$ 6,460
c. -$ 5,200
d. -$ 6,850
e. -$12,020

Tough:
Replacement decision Answer: b Diff: T
88
11B- . Topsider Inc. is considering the purchase of a new leather-cutting
machine to replace an existing machine that has a book value of $3,000
and can be sold for $1,500. The old machine is being depreciated on a
straight-line basis, and its estimated salvage value 3 years from now
is zero. The new machine will reduce costs (before taxes) by $7,000
per year. The new machine has a 3-year life, it costs $14,000, and it
can be sold for an expected $2,000 at the end of the third year. The
new machine would be depreciated over its 3-year life using the MACRS
method. The applicable depreciation rates are 0.33, 0.45, 0.15, and
0.07. Assuming a 40 percent tax rate and a cost of capital of 16
percent, find the new machine's NPV.

a. -$ 2,822
b. $ 1,658
c. $ 4,560
d. $15,374
e. $ 9,821

Chapter 11 - Page 42
Replacement decision Answer: a Diff: T
89
11B- . Meals on Wings Inc. supplies prepared meals for corporate aircraft (as
opposed to public commercial airlines), and it needs to purchase new
broilers. If the broilers are purchased, they will replace old
broilers purchased 10 years ago for $105,000 and which are being
depreciated on a straight-line basis to a zero salvage value (15-year
depreciable life). The old broilers can be sold for $60,000. The new
broilers will cost $200,000 installed and will be depreciated using
MACRS over their 5-year class life; they will be sold at their book
value at the end of the fifth year. The applicable depreciation rates
are 0.20, 0.32, 0.19, 0.12, 0.11, and 0.06. The firm expects to
increase its revenues by $18,000 per year if the new broilers are
purchased, but cash expenses will also increase by $2,500 per year.
If the firm's cost of capital is 10 percent and its tax rate is 35
percent, what is the NPV of the broilers?

a. -$60,644
b. $17,972
c. $28,451
d. -$44,553
e. $ 5,021

Replacement decision Answer: c Diff: T

11B-90. Mom's Cookies Inc. is considering the purchase of a new cookie oven.
The original cost of the old oven was $30,000; it is now 5 years old,
and it has a current market value of $13,333.33. The old oven is
being depreciated over a 10-year life toward a zero estimated salvage
value on a straight-line basis, resulting in a current book value of
$15,000 and an annual depreciation expense of $3,000. The old oven
can be used for 6 more years but has no market value after its
depreciable life is over. Management is contemplating the purchase of
a new oven whose cost is $25,000 and whose estimated salvage value is
zero. Expected before-tax cash savings from the new oven are $4,000 a
year over its full MACRS depreciable life. Depreciation is computed
using MACRS over a 5-year life, and the cost of capital is 10 percent.
The applicable depreciation rates are 0.20, 0.32, 0.19, 0.12, 0.11,
and 0.06. Assume a 40 percent tax rate. What is the net present
value of the new oven?

a. -$2,418
b. -$1,731
c. $2,635
d. $ 163
e. $1,731

Chapter 11 - Page 43
Replacement project IRR Answer: c Diff: T
91
11B- . Tech Engineering Company is considering the purchase of a new machine
to replace an existing one. The old machine was purchased 5 years ago
at a cost of $20,000, and it is being depreciated on a straight-line
basis to a zero salvage value over a 10-year life. The current market
value of the old machine is $14,000. The new machine, which falls
into the MACRS 5-year class, has an estimated life of 5 years, it
costs $30,000, and Tech plans to sell the machine at the end of the
fifth year for $1,000. The applicable depreciation rates are 0.20,
0.32, 0.19, 0.12, 0.11, and 0.06. The new machine is expected to
generate before-tax cash savings of $3,000 per year. The company's
tax rate is 40 percent. What is the IRR of the proposed project?

a. 4.1%
b. 2.2%
c. 0.0%
d. -1.5%
e. -3.3%

Replacement project Answer: d Diff: T

11B-92. XYZ Manufacturing Corporation currently has production equipment that
has 4 years of remaining life. The equipment was purchased a year ago
at a cost of $10,000. The annual depreciation for this machine is
$1,800 and its expected salvage value is $1,000. The equipment can be
sold today for $8,000. The company has been considering the purchase
of a new machine that will replace the existing one. The new
equipment costs $15,000 and would increase sales (through increased
production) by $2,000 per year and decrease operating costs by $1,000
per year. The equipment falls into the 3-year MACRS class and will be
worthless after 4 years. The applicable depreciation rates are 0.33,
0.45, 0.15, and 0.07. The company's tax rate is 40 percent and its
cost of capital is 12 percent. By how much would the value of the
company change if it accepts the replacement project?

a. $2,112.05
b. $ 318.27
c. -$5,887.95
d. $ 552.62
e. $1,497.91

Chapter 11 - Page 44
New project NPV Answer: d Diff: T
93
11B- . Foxglove Corp. is faced with an investment project. The following
information is associated with this project:
MACRS
Depreciation
Year Net Income* Rates
1 $50,000 0.33
2 60,000 0.45
3 70,000 0.15
4 60,000 0.07
*Assume no interest expenses and a zero tax rate.

The project involves an initial investment of $100,000 in equipment

that falls in the 3-year MACRS class and has an estimated salvage
value of $15,000. In addition, the company expects an initial
increase in net working capital of $5,000 which will be recovered in
year 4. The cost of capital for the project is 12 percent.

What is the projects net present value? (Round your final answer to
the nearest whole dollar.)

a. $153,840
b. $159,071
c. $162,409
d. $168,604
e. $182,344

Chapter 11 - Page 45
ANSWERS
CHAPTER
AND SOLUTIONS
11
1. Relevant cash flows Answer: d Diff: E

Statements a and c are true; therefore, statement d is the correct answer. Net
cash flow = Net income + depreciation; therefore, depreciation affects
operating cash flows. Sunk costs should be disregarded when making investment
decisions, while opportunity costs should be considered when making investment
decisions, as they represent the best alternative use of an asset.

2. Relevant cash flows Answer: c Diff: E

The correct answer is c. Sunk costs should be excluded from the analysis,
and interest expense is incorporated in the WACC so it should not be
incorporated in the projects cash flows.

3. Relevant cash flows Answer: d Diff: E

Sunk costs should be ignored, but externalities and opportunity costs should
be included in the project evaluation. Therefore, the correct choice is
statement d.

4. Relevant cash flows Answer: b Diff: E

Sunk costs are never included in project cash flows, so statement a is false.
Externalities are always included, so statement b is true.
Since the weighted average cost of capital includes the cost of debt, and
this is the discount rate used to evaluate project cash flows, interest
expense should not be included in project cash flows. Therefore, statement c
is false.
5
. Relevant cash flows Answer: c Diff: E

6. Relevant cash flows Answer: b Diff: E N

7. Relevant cash flows Answer: d Diff: E N

The correct answer is statement d. Statement a is a sunk cost and should not
be included. Statement b is an opportunity cost and should be included.
Statement c is an externality and should be included. Therefore, statement d
is the correct choice.

8 . Relevant cash flows

Answer: d Diff: E N

The correct answer is statement d. Statement c is incorrect because it is a

sunk cost. Both statements a and b are correct, since statement a impacts
expected cash flows and statement b is a relevant opportunity cost.
9. Relevant cash flows Answer: d Diff: E N

The correct answer is statement d. Statement a is correct. This represents

a future loss in revenue to the firm. Statement b is also correct because
the firm needs to consider the best alternative use of the land. Statement
c, on the other hand, is NOT correct since it represents a sunk cost. So,
Statement d is the correct choice.

10. Relevant and incremental cash flows Answer: a Diff: E N

 Statement a is true; the other statements are false. If the company lost two
other accounts with positive NPVs, this would obviously be a huge negative when
considering the proposed project. If the firm has an option to abandon a
project if it is unprofitable, this would make the company more likely to
accept the project. An option to repeat a project is a plus not a negative.

11. New project cash flows Answer: a Diff: E N

Statement a is true; the others are false. Depreciation cash flows must be
considered when calculating operating cash flows. In addition, externality
cash flows should be considered; however, sunk costs are not included in the
analysis.

12. Corporate risk Answer: b Diff: E

13. Risk analysis Answer: e Diff: E

14. Risk analysis Answer: c Diff: E

Statement a is false. Stand-alone risk is measured by standard deviation.

Therefore, since Ys standard deviation is higher than Xs, Y has higher stand-
alone risk than X. Statement b is false. Corporate risk is measured by the
correlation of project cash flows with other company cash flows. Therefore,
since Ys cash flows are highly correlated with the cash flows of existing
projects, while Xs are not, Y has higher corporate risk than X. Market risk
is measured by beta. Therefore, since Xs beta is greater than Ys, statement
c is true.

15. Risk analysis Answer: a Diff: E N

The correct answer is statement a. Since the proposed new project has a higher
standard deviation than the firms typical project, it has more stand-alone risk
than the firms typical project. Statement b is incorrect; it will actually
lower corporate risk. Statement c is incorrect; we do not know what effect the
project will have on the firms market risk.

16. Risk analysis Answer: e Diff: E N

The correct answer is statement e. Statement a comes directly from the first
sentence. Statement c comes from the second sentence. Statements b and d
follow directly from the third sentence.
17. Accepting risky projects Answer: e Diff: E

18. Risk adjustment Answer: b Diff: E

19. Risk and project selection Answer: b Diff: E

20. Risk and project selection Answer: c Diff: E

Determine the required rate of return on each project. High-risk projects must
have a higher required rate of return than low-risk projects. The following
table shows the required return for each project on the basis of its risk
level.

Required return for

Project Expected Return Risk the risk level
A 15% High 12%
 B 12 Average 10
C 11 High 12
D 9 Low 8
E 6 Low 8

The company will accept all projects whose expected return exceeds its
required return. Therefore, it will accept Projects A, B, and D.

21. Sensitivity, scenario, and simulation analyses Answer: c Diff: E

Statement a is false; sensitivity analysis measures a projects stand-alone

risk. Statement b is false; sensitivity analysis doesnt consider
probabilities, while scenario analysis does. Statement c is true.

22. Cash flows and accounting measures Answer: d Diff: M

23. Relevant cash flows Answer: d Diff: M

Statements b and c are true; therefore, statement d is the correct choice. The
$3 million spent on researching the technology is a sunk cost and should not be
considered in the investment decision.

24. Relevant cash flows Answer: d Diff: M

Statement a is a sunk cost and sunk costs are never included in the capital
budgeting analysis. Therefore, statement a is not included. Statement b is
an opportunity cost and should be included in the capital budgeting analysis.
Statement c is the cannibalization of existing products, which will cause the
company to forgo cash flows and profits in another division. Therefore, it
is included in the capital budgeting analysis. Therefore, the correct answer
is statement d.

25. Relevant cash flows Answer: d Diff: M

Statements b and c are true; therefore, statement d is the correct choice. The
cost of clearing the land is a sunk cost and should not be considered in the
analysis. The expected impact of the new store on the existing store should be
considered. In addition, the opportunity to lease the land represents an
opportunity cost of opening the new store on the land and should be considered.
26
. Relevant cash flows Answer: d Diff: M

Statements a and c are true; therefore, statement d is the correct choice.

Externalities and opportunity costs should be considered in the analysis,
while sunk costs should not be included.

27. Incremental cash flows Answer: d Diff: M

28. Incremental cash flows Answer: d Diff: M

29. Cash flow estimation Answer: b Diff: M

30. Cash flow estimation Answer: d Diff: M

 Statement d is true. The forgone rent is an opportunity cost that should
be charged to the project under consideration. Note that Statements a and b
are false. The cash flows should not consider interest because financial
costs are included in the analysis by discounting at the WACC. If interest
were deducted to find cash flows, then this cost would be double counted,
and the NPV would be downward biased. Ignoring interest when determining
cash flows produces no bias in the NPV whatsoever. Note also that
externalities can be either positive or negative--they tend to be negative if
the new project is a substitute for an existing product, but positive if the
new project is complementary to the firms other products.

31. Corporate risk Answer: e Diff: M

32. Sensitivity, scenario, and simulation analyses Answer: a Diff: M

33. Monte Carlo simulation Answer: e Diff: M

34. Risk adjustment Answer: a Diff: M

kA = 13% - 3% = 10%. If the cash flows are cost-only outflows, and the
analyst wants to correctly reflect their risk, the discount rate should be
adjusted downward (in this case by subtracting 3 percentage points) to make
the discounted flows comparatively larger.

35 . Taxes on gain on sale

Answer: b Diff: E

When the machine is sold the total accumulated depreciation on it is: (0.20 +
0.32 + 0.19) $1,000,000 = $710,000. The book value of the equipment is:
$1,000,000 - $710,000 = $290,000. The machine is sold for $400,000, so the
gain is $400,000 - $290,000 = $110,000. Taxes are calculated as $110,000
0.4 = $44,000.

36. Inventory and NPV Answer: d Diff: E N

We are given the up-front cost. The new software systems cash flows are the
annual cash amounts freed up by not having to invest in inventory.

0 10% 1 2 3 4 5 Years
| | | | | |
-75,000,000 +200,000,000 +200,000,000 +200,000,000 +300,000,000 +300,000,000

$200,000,000 $200,000,000 $200,000,000

NPV = -$75,000,000 + + 2
+
(1.1) (1.1) (1.1)3
$300,000,000 $300,000,000
+ 4
+
(1.1) (1.1)5
NPV = -$75,000,000 + $181,818,000 + $165,289,000 + $150,263,000 +
$204,904,000 + $186,276,000
NPV = $813,550,000.
37. NPV with externalities Answer: c Diff: E

Step 1: Calculate the NPV of the negative externalities due to the

cannibalization of existing projects:
Enter the following input data in the calculator:
CF0 = 0; CF1-10 = -500000; I = 10; and then solve for NPV =
$3,072,283.55.

Step 2: Recalculate the new projects NPV after considering externalities: +

$3,000,000 - $3,072,283.55 = -$72,283.55.

38 . After-tax salvage value

Answer: c Diff: M N

The book value of the machinery at the end of Year 4 is 0.17 $300,000,000 =
$51,000,000. The salvage value of the machinery is $50,000,000, so the
company has a loss of $50,000,000 - $51,000,000 = $1,000,000. However, the
firm will receive a tax credit on the sale of the machinery of 0.4
$1,000,000 = $400,000. So, the after-tax cash flow received from the sale of
the machinery is $50,000,000 + $400,000 = $50,400,000.

39. New project NPV Answer: e Diff: M

Time line:
0 k = 18% 1 2 3 Years
| | | |
-3,000 1,728 1,920 1,152
NPV = ?

Depreciation cash flows:

MACRS
Depreciation Depreciable Annual
Year Rates Basis Depreciation
1 0.33 $4,000 $1,320
2 0.45 4,000 1,800
3 0.15 4,000 600
4 0.07 4,000 280
$4,000

Project analysis worksheet:

0 1 2 3
I Initial outlay
1) Cost ($4,000)
2) Decrease in NOWC 1,000
3) Total net investment ($3,000)
II Operating flows:
4) EBT and depreciation $2,000 $2,000 $2,000
5) Oper. income after taxes
(line 4 0.6) 1,200 1,200 1,200
6) Depreciation (from table) 1,320 1,800 600
7) Tax savings from
 depreciation (line 6 0.4) 528 720 240
8) Net operating cash flows
(lines 5 + 7) $1,728 $1,920 $1,440
III Terminal year cash flows:
9) Estimated salvage value $1,000
10) Tax on salvage value
(($1,000 - $280) 0.4) (288)
11) Return of NOWC (1,000)
12) Total termination CFs ($ 288)
IV Net cash flows: ______ ______ ______ ______
13) Net CFs ($3,000) $1,728 $1,920 $1,152

Numerical solution:
$1,728 $1,920 $1,152
NPV = -$3,000 2
= $544.46 $544.
1.18 (1.18) (1.18)3

Financial calculator solution:

Inputs: CF0 = -3000; CF1 = 1728; CF2 = 1920; CF3 = 1,152; I = 18.
Output: NPV = $544.46 $544.

40. New project NPV Answer: d Diff: M

Time line:
0 1 2 3 4 5 Years
| k = 12% | | | | |
-45,000 7,800 10,680 7,560 5,880 -1,920
NPV = ?

Depreciation cash flows:

MACRS
Depreciation Depreciable Annual
Year Rates Basis Depreciation
1 0.20 $60,000 $12,000
2 0.32 60,000 19,200
3 0.19 60,000 11,400
4 0.12 60,000 7,200
5 0.11 60,000 6,600
6 0.06 60,000 3,600
$60,000

Project analysis worksheet:

0 1 2 3 4 5
I Initial outlay
1) Machine cost ($60,000)
2) Decrease in NOWC 15,000
3) Total net inv. ($45,000)
II Operating cash flows
4) BT Reduction in cost $ 5,000 $ 5,000 $ 5,000 $ 5,000 $ 5,000
5) After-tax dec. in cost 3,000 3,000 3,000 3,000 3,000
6) Deprec. (from table) 12,000 19,200 11,400 7,200 6,600
7) Tax savings deprec.
(line 6 0.4) 4,800 7,680 4,560 2,880 2,640
8) Net operating CFs
(lines 5 + 7) $ 7,800 $10,680 $ 7,560 $ 5,880 $ 5,640
III Terminal year CFs
9) Estimated salvage value $10,000
10) Tax on salvage value
[($10,000 - $3,600)(0.4)] (2,560)
 11) Return of NOWC (15,000)
12) Total termination CFs (7,560)
IV Net CFs _______ _______ _______ _______ _______ _______
13) Net CFs ($45,000) $ 7,800 $10,680 $ 7,560 $ 5,880($ 1,920)

Numerical solution:
$7,800 $10,680 $7,560 $5,880 $1,920
NPV = -$45,000 2
3
4

1.12 (1.12) (1.12) (1.12) (1.12)5
= -$21,493.24 -$21,493.

Financial calculator solution:

Inputs: CF0 = -45000; CF1 = 7800; CF2 = 10680; CF3 = 7560; CF4 = 5880;
CF5 = -1920; I = 12.
Output: NPV = -$21,493.24 -$21,493.

41. New project NPV Answer: b Diff: M

Time line:
0 k = 9% 1 2 3 4 5 Years
| | | | | |
-40,000 9,800 11,720 9,640 8,520 15,320
NPV = ?
Depreciation cash flows:
MACRS
Depreciation Depreciable Annual
Year Rates Basis Depreciation
1 0.20 $40,000 $ 8,000
2 0.32 40,000 12,800
3 0.19 40,000 7,600
4 0.12 40,000 4,800
5 0.11 40,000 4,400
6 0.06 40,000 2,400
$40,000
Project analysis worksheet:
0 1 2 3 4 5
I Initial outlay
1) Machine cost ($40,000)
2) NOWC --
3) Total net inv. ($40,000)
II Operating cash flows
4) Inc. in earnings
before deprec. & taxes $ 6,000 $ 6,000 $ 6,000 $ 6,000 $ 6,000
5) After-tax increase in
earnings (line 4 0.6) 3,600 3,600 3,600 3,600 3,600
6) Before tax reduction
in cost 5,000 5,000 5,000 5,000 5,000
7) After tax reduction
in cost (line 6 0.4) 3,000 3,000 3,000 3,000 3,000
8) Deprec. (from table) 8,000 12,800 7,600 4,800 4,400
9) Deprec. tax savings
(line 8 0.4) 3,200 5,120 3,040 1,920 1,760
10) Net operating CFs
(lines 5 + 7 + 9) $ 9,800 $11,720 $ 9,640 $ 8,520 $ 8,360
III Terminal year CFs
11) Estimated salvage value $10,000
12) Tax on salvage value
[($10,000 - $2,400)(0.4)] (3,040)
13) Return of NOWC --
14) Total termination CFs 6,960
 IV Net CFs _______ _______ _______ _______ _______ _______
15) Net CFs ($40,000) $ 9,800 $11,720 $ 9,640 $ 8,520 $15,320
Numerical solution:
$9,800 $11,720 $9,640 $8,520 $15,320
NPV = -$40,000 2
3
4

1.09 (1.09) (1.09) (1.09) (1.09)5
= $2,291.90 $2,292.

Financial calculator solution:

Inputs: CF0 = -40000; CF1 = 9800; CF2 = 11720; CF3 = 9640;
CF4 = 8520; CF5 = 15320; I = 9.
Output: NPV = $2,291.90 $2,292.
42. New project NPV Answer: a Diff: M

0 1 2 3
Equipment purchase -$ 600,000
NOWC -50,000
Sales increase $2,000,000 $2,000,000 $2,000,000
Operating costs 1,400,000 1,400,000 1,400,000
Depreciation 200,000 200,000 200,000
Oper. inc. before taxes $ 400,000 $ 400,000 $ 400,000
Taxes (35%) 140,000 140,000 140,000
Oper. inc. after taxes $ 260,000 $ 260,000 $ 260,000
+Depreciation 200,000 200,000 200,000
Operating cash flow $ 460,000 $ 460,000 $ 460,000
Recovery of NOWC 50,000
Equipment sale +100,000
Taxes on sale ___________ __________ __________ -35,000
Net CFs -$ 650,000 $ 460,000 $ 460,000 $ 575,000
NPV = -$650,000 + $460,000/1.12 + $460,000/(1.12)2 + $575,000/(1.12)3
= -$650,000 + $410,714.29 + $366,709.18 + $409,273.64
= $536,697.11 $536,697.
43
. New project NPV Answer: b Diff: M

Depreciation cash flows:

MACRS
Depreciation Depreciable Annual
Year Rates Basis Depreciation
1 0.33 $5,000,000 $1,650,000
2 0.45 $5,000,000 2,250,000
3 0.15 $5,000,000 750,000
4 0.07 $5,000,000 350,000
$5,000,000
Year 0 1 2 3 4
Project cost -$5,000,000
NOWC* -300,000
Sales $3,000,000 $4,000,000 $5,000,000 $2,000,000
Operating costs (75%) 2,250,000 3,000,000 3,750,000 1,500,000
Depreciation 1,650,000 2,250,000 750,000 350,000
Oper. inc. before taxes -$ 900,000 -$1,250,000 $ 500,000 $ 150,000
Taxes (40%) -360,000 -500,000 200,000 60,000
Oper. inc. after taxes -$ 540,000 -$ 750,000 $ 300,000 $ 90,000
Plus: Depreciation 1,650,000 2,250,000 750,000 350,000
Operating CF $1,110,000 $1,500,000 $1,050,000 $ 440,000
Recovery of NOWC 300,000
Net CFs -$5,300,000 $1,110,000 $1,500,000 $1,050,000 $ 740,000
 *An increase in inventories is a use of funds for the company, and an increase in
accounts payable is a source of funds for the company. Thus, the change in net
operating working capital will be $200,000 - $500,000 = -$300,000 at time 0.

NPV = -$5,300,000 + $1,110,000/1.10 + $1,500,000/(1.10)2 +

$1,050,000/(1.10)3 + $740,000/(1.10)4
NPV = -$5,300,000 + $1,009,091 + $1,239,669 + $788,881 + $505,430
NPV = -$1,756,929.
44 . New project NPV

Answer: a Diff: M

Depreciation cash flows:

MACRS
Depreciation Depreciable Annual
Year Rates Basis Depreciation
1 0.33 $500,000 $165,000
2 0.45 500,000 225,000
3 0.15 500,000 75,000
4 0.07 500,000 35,000
$500,000

0 1 2 3 4
Project cost ($500,000)
NOWC (40,000)
Sales $800,000 $800,000 $500,000 $500,000
Operating costs 480,000 480,000 300,000 300,000
Depreciation 165,000 225,000 75,000 35,000
Oper. costs bef. taxes $155,000 $ 95,000 $125,000 $165,000
Taxes (40%) 62,000 38,000 50,000 66,000
Oper. costs after taxes $ 93,000 $ 57,000 $ 75,000 $ 99,000
Plus: Depreciation 165,000 225,000 75,000 35,000
Recovery of NOWC ________ ________ ________ 40,000
Net CFs ($540,000) $258,000 $282,000 $150,000 $174,000

NPV = -$540,000 + $258,000/1.10 + $282,000/(1.10) 2 + $150,000/(1.10)3 +

$174,000/(1.10)4
= -$540,000 + $234,545.45 + $233,057.85 + $112,697.22 + $118,844.34
= $159,144.86 $159,145.

45. New project NPV Answer: b Diff: M

0 1 2 3
Cost ($1,000)
NOWC (200)

Sales $900 $900 $900

Costs 450 450 450
Depreciation 500 300 200
Oper. inc. before taxes ($ 50) $150 $250
Taxes (40%) (20) 60 100
Oper. inc. after taxes ($ 30) $ 90 $150
Add Depreciation 500 300 200
Operating CFs $470 $390 $350
Salvage value 100
Tax on SV (40)
Recovery of NOWC 200
Net CFs ($1,200) $470 $390 $610
 0 k = 10% 1 2 3 Years
| | | |
-1,200 470 390 610

$470 $390 $610

NPV = -$1,200 2

1.10 (1.10) (1.10)3
= $7.89.
46. New project NPV Answer: a Diff: M

0 k = 15% 1 2 3 Years
| | | |
Cost -50,000
Sales $50,000 $50,000 $50,000
VC 20,000 20,000 20,000
Depreciation 40,000 5,000 5,000
Oper. inc. before taxes ($10,000) $25,000 $25,000
Taxes (40%) (4,000) 10,000 10,000
Oper. inc. after taxes ($ 6,000) $15,000 $15,000
Depreciation 40,000 5,000 5,000
Operating CFs $34,000 $20,000 $20,000
NOWC (12,000) 12,000
AT Salvage _______ _______ _______ 6,000
NCFs ($62,000) $34,000 $20,000 $38,000

$34,000 $20,000 $38,000

NPV = -$62,000 2
= $7,673.71.
1.15 (1.15) (1.15)3
47
. New project NPV Answer: d Diff: M

The equipment is purchased for $10,000,000 and is depreciated over 5 years. The
depreciation table looks like this:
Straight-Line
Year Depreciation Rate Depreciation Book Value
1 1/5 $2,000,000 $8,000,000
2 1/5 2,000,000 6,000,000
3 1/5 2,000,000 4,000,000
4 1/5 2,000,000 2,000,000
5 1/5 2,000,000 0

Notice that the project has a life of only 4 years, while the equipment is
depreciated over 5 years. At the end of Year 4, the company sells the
equipment for $3 million, but its book value is only $2 million. The equipment
is sold for $1 million more than its book value; therefore, the firm will be
taxed on this $1 million. Consequently, at the end of the project, it receives
$3 million for the sale, but it has to pay $400,000 in taxes (40% of $1
million).
Net operating working capital required at t = 0 will be $1 million.
(Inventories are a use of working capital, so they increase operating working
capital by $2 million. Accounts payable are a source of operating working
capital, so they decrease operating working capital by $1 million. Net
operating working capital increases by $1 million). Remember that the firm gets
this back at t = 4.
Year 0 1 2 3 4
Sales $ 7,000,000 $ 7,000,000 $ 7,000,000 $ 7,000,000
Op. costs 3,000,000 3,000,000 3,000,000 3,000,000
Depn 2,000,000 2,000,000 2,000,000 2,000,000
Oper. inc. before taxes $ 2,000,000 $ 2,000,000 $ 2,000,000 $ 2,000,000
Taxes (40%) 800,000 800,000 800,000 800,000
Oper. inc. after taxes $ 1,200,000 $ 1,200,000 $ 1,200,000 $ 1,200,000
Depn 2,000,000 2,000,000 2,000,000 2,000,000
Oper. cash flow $ 3,200,000 $ 3,200,000 $ 3,200,000 $ 3,200,000
Equipment cost ($10,000,000) 3,000,000
Taxes on sale (400,000)
Change in NOWC (1,000,000) 1,000,000
Net cash flow ($11,000,000) $ 3,200,000 $ 3,200,000 $ 3,200,000 $ 6,800,000

Now, enter the net cash flows into the cash flow register and enter the
discount rate, I/YR = 12, and solve for the projects NPV = $1,007,383 $1.01
million.
48. New project NPV Answer: e Diff: M N

0 1 2 3
Equipment outlay -$500,000
Change in NOWC -30,000
Sales $1,000,000 $1,200,000 $1,500,000
Op. costs excl.deprec. (70%) 700,000 840,000 1,050,000
Depreciation 100,000 100,000 100,000
Oper. inc. before taxes $ 200,000 $ 260,000 $ 350,000
Taxes (40%) 80,000 104,000 140,000
Oper. inc. after taxes $ 120,000 $ 156,000 $ 210,000
Add back: Depreciation 100,000 100,000 100,000
Oper. cash flows $ 220,000 $ 256,000 $ 310,000
AT salvage value 200,000
Recovery of NOWC 30,000
Net cash flows -$530,000 $ 220,000 $ 256,000 $ 540,000
CF0 = -530000; CF1 = 220000; CF2 = 256000; CF3 = 540000; I/YR = 14; and then
solve for NPV = $224,450.76 $224,451.
49. New project NPV Answer: c Diff: M R

Get the depreciation using the MACRS table provided in the question.
0 1 2 3 4
Cost ($500,000)
NOWC (40,000)
Sales $600,000 $600,000 $600,000 $600,000
Operating Cost 400,000 400,000 400,000 400,000
Depreciation 165,000 225,000 75,000 35,000
Oper. inc. before taxes $ 35,000 ($ 25,000) $125,000 $165,000
Taxes (40%) 14,000 (10,000) 50,000 66,000
Oper. inc. after taxes $ 21,000 ($ 15,000) $ 75,000 $ 99,000
After-tax salvage value 30,000
Return of NOWC 40,000
+ Depreciation ________ 165,000 225,000 75,000 35,000
Net CFs ($540,000) $186,000 $210,000 $150,000 $204,000

Note in year 4 your $40,000 of net operating working capital is recovered

plus the after tax salvage value of $30,000.

Enter the cash flows into the cash flow register and solve for the NPV using
the WACC of 10%. NPV = $54,676.59.
50

. New project IRR Answer: b Diff: M

Step 1: Set up a time line in an income statement format to lay out the cash
flows:
0 1 2 3 4 5
 Building -$14.0
NOWC -5.0

Revenues $15.0 $15.0 $15.0 $15.0 $15.0

Oper. costs 10.0 10.0 10.0 10.0 10.0
Depreciation 2.0 2.0 2.0 2.0 2.0
Oper. inc. before taxes $ 3.0 $ 3.0 $ 3.0 $ 3.0 $ 3.0
Taxes (40%) 1.2 1.2 1.2 1.2 1.2
Oper. inc. after taxes $ 1.8 $ 1.8 $ 1.8 $ 1.8 $ 1.8
Plus Depreciation 2.0 2.0 2.0 2.0 2.0
Oper. CFs $ 3.8 $ 3.8 $ 3.8 $ 3.8 $ 3.8
Sale of building 8.0
Taxes on sale -1.6*
Recovery of NOWC 5.0
Net cash flows -$19.0 $ 3.8 $ 3.8 $ 3.8 $ 3.8 $15.2

*At the end of 5 years, the BV of the building will be $14,000,000 - (5

$2,000,000) = $4,000,000. The company sells it for $8 million; however,
the BV is only $4 million. So, the company will have a profit of $4
million, on which it will owe taxes. The taxes owed are calculated as:
Taxes = 0.4 $4 million = $1.6 million.

Step 2: Solve for the projects IRR:

Enter the following data in the calculator:
CF0 = -19; CF1-4 = 3.8; CF5 = 15.2; and then solve for IRR = 13.94%.

51. Risk-adjusted NPV Answer: c Diff: M N

(In thousands of dollars)

0 1 2 3
4 Initial cost-$2,000Change in NOWC -100Initial outlay
-2,100Sales$1,000$2,000$2,000$1,000Operating costs 500 1,000 1,000
500Depreciation 500 500 500 500Operating income$ 0 $ 500$ 500$
0Taxes (40%) 0 200 200 0Operating income$ 0$ 300$ 300$
0Depreciation 500 500 500 500Externalities -250 -250 -250 -250Return of
NOWC ________________________+ 100Net cash flow (NCF)-$2,100$ 250$ 550$ 550$
350
Entering the NCF amounts into the cash flow register (at 12%) gives you a NPV
of -$824,418.62.

52. Risk-adjusted NPV Answer: a Diff: M

Time lines:
Project A:
0 k = 14% 1 2 3 4 Years
| | | | |
CFsA -200,000 71,104 71,104 71,104 71,104
NPVA = ?

Project B:
0 k = 10% 1 2 3 4 Years
| | | | |
CFsB -200,000 0 0 146,411 146,411
NPVB = ?
Calculate required returns on A and B:
Project A High risk kRisk adjusted = 12% + 2% = 14%.
 Project B Low risk kRisk adjusted = 12% - 2% = 10%.
A Inputs: CF0 = -200000; CF1 = 71104; Nj = 4; I = 14.
Output: NPVA = $7,176.60 $7,177.
B Inputs: CF0 = -200000; CF1 = 0; Nj = 2; CF2 = 146411; Nj = 2; I = 10.
Output: NPVB = $10,001.43 $10,001.
53. Risk-adjusted NPV Answer: e Diff: M
Time line:
0 1 2 10 Years
k = 12%
| | | |
-50,000 6,000 6,000 6,000
NPV = ? Salvage value 10,000
16,000

kProject = 6% + 4%(1.5) = 12%.

Inputs: CF0 = -50000; CF1 = 6000; Nj = 9; CF10 = 16000; I = 12%.
Output: NPV = -$12,878.93 -$12,879.
54. Risk-adjusted NPV Answer: c Diff: M
Time lines:
0 k = 12% 1 2 3 Years
| | | |
CFsA -5,000 2,000 2,500 2,250
NPVA = ?
0 k = 14% 1 2 3 Years
| | | |
CFsB -5,000 3,000 2,600 2,900
NPVB = ?
Project A: kAverage risk = 12%.
Project B: kHigh risk = 12% + 2% = 14%.
A: Inputs: CF0 = -5000; CF1 = 2000; CF2 = 2500; CF3 = 2250; I = 12.
Output: NPV = $380.20 $380.
B: Inputs: CF0 = -5000; CF1 = 3000; CF2 = 2600; CF3 = 2900; I = 14.
Output: NPV = $1,589.61 $1,590.
55. Risk-adjusted discount rate Answer: b Diff: M

Time lines:
Project A
0 k = 12% 1 2 3 4 5 6 Years
| | | | | | |
CFsA -15,000 4,000 4,000 4,000 4,000 4,000 4,000
NPVA = ? = 3,978.78 5,000 Salvage value
Terminal CF = 9,000
Project B
0 k = ? 1 2 6 Years
| | | |
CFsB -14,815 5,100 5,100 5,100
NPVB = NPVA = 3,978.78 0 Salvage value
Terminal CF = 5,100
Calculate Project As NPV:
Inputs: CF0 = -15000; CF1 = 4000; Nj = 5; CF2 = 9000; I = 12.
Output: NPV = $3,978.78.

To calculate the discount rate at which Project Bs NPV is equal to Project

As, calculate Project Bs IRR with an initial cash flow (CF0) that is $3,978.78
greater than its current CF0. CF0 = -$14,815 +
(-$3,978.78) = -$18,793.78. Now calculate Project Bs IRR:
 Inputs: CF0 = -18793.78; CF1 = 5100; Nj = 6.
Output: IRR = 15.997% 16%.

Check: Calculate Project Bs NPV at k = 16%:

Inputs: CF0 = -14815; CF1 = 5100; Nj = 6.
Output: NPV = $3,977.15. (Difference is due to rounding k up to 16%.)

56. Risk-adjusted discount rate Answer: e Diff: M

Time lines:
Project A:
0 k = 12% 1 2 3 4 Years
| | | | |
CFsA -25,000 13,000 13,000 13,000 13,000
NPVA = ? = 17,663.13 5,000 Salvage Value
Terminal CF = 18,000

Project B:
0 k = ? 1 2 3 4 Years
| | | | |
CFsB -25,000 15,247 15,247 15,247 15,247
NPVB = NPVA = 17,663.13 0 Salvage Value
Terminal CF = = 15,247

A: Inputs: CF0 = -25000; CF1 = 13000; Nj = 3; CF2 = 18000; I = 12.

Output: NPVA = 17,663.13.

B: Inputs: CF0 = -42663.13 (-25000 + -17663.13); CF1 = 15247; Nj = 4.

Output: IRR = 16.0% = k.
57

. Discounting risky outflows Answer: e Diff: M

Time line:
0 1 2 3 4
| | | | |
CFsNew Tech -1,500 -315 -315 -315 -315
NPVNew Tech = ?
CFsOld Tech -600 -600 -600 -600 -600
NPVOld Tech = ?

Recognize that (1) risky outflows must be discounted at lower rates, and (2)
since Project New Tech is risky, it must be discounted at a rate of 12% - 3% =
9%. Project Old Tech must be discounted at 12%.

Project New Tech: Inputs: CF0 = -1500; CF1 = -315; Nj = 4; I = 9.

Output: NPV = -$2,520.51.
Project Old Tech: Inputs: CF0 = -600; CF1 = -600; Nj = 4; I = 12.
Output: NPV = -$2,422.41.

58. Discounting risky outflows Answer: c Diff: M

The first thing to note is that risky cash outflows should be discounted at a
lower discount rate, so in this case we would discount the riskier Project
Bs cash flows at 10% - 2% = 8%. Project As cash flows would be discounted
at 10%.

Now we would find the PV of the costs as follows:

Project A: CF0 = -1000; CF1-10 = -100; I = 10.0; and then solve for NPV = -
 $1,614.46.
Project B: CF0 = -300; CF1-10 = -200; I = 8.0; and then solve for NPV =
-$1,642.02.

Project A has the lower PV of costs. If Project B had been evaluated with a
12% cost of capital, its PV of costs would have been -$1,430.04, but that
would have been wrong.
59

. Discounting risky outflows Answer: c Diff: M

Plan 1: (Low Risk)

0 i = 17% 1 10 Years
| | |
-100,000 -5,000 -5,000
With a financial calculator input the following:
CF0 = -100000; CF1-10 = -5000; I = 17; and then solve for
NPV1 = -$123,293.02.

Plan 2: (High Risk)

0 i = 13% 1 10 Years
| | |
0 -25,000 -25,000
With a financial calculator input the following:
CF0 = 0; CF1-10 = -25000; I = 13; and then solve for NPV2 =
-$135,656.09.

Note that because we are dealing with cash outflows, the higher-risk projects
discount rate must be lowered, while the lower-risk projects discount rate
must be increased. Thus, Plan 1 has the lower costs and should be accepted.

60. Risky projects Answer: d Diff: M

Look at the NPV, IRR, and hurdle rate for each project:
Project A B C D E
Hurdle rate 9.00% 9.00% 11.00% 13.00% 13.00%
NPV $13,822 $11,998
IRR 12.11% 14.04% 10.85% 16.64% 11.63%

$66,000 $66,000 $66,000 $66,000

NPVA = -$200,000 2
3
= $13,821.51 $13,822.
1.09 (1.09) (1.09) (1.09)4
 $30,000 $30,000 $40,000 $40,000
NPVB = -$100,000 2
3
= $11,997.68 $11,998.
1.09 (1.09) (1.09) (1.09)4

Projects A and B are mutually exclusive, so we cannot use the IRR method, so
their NPVs must be calculated. We pick project A because it has the largest
NPV. Projects C, D, and E are independent so we pick the ones whose IRR exceeds
the cost of capital, in this case, just D. Therefore, the projects undertaken
are A and D.
61

. Scenario analysis Answer: c Diff: M

Calculate expected value of NPV (in thousands):

Probability of Unit Sales Sales NPV
Outcome, Pi Volume Price (In 1000s) Pi(x)
Worst case 0.30 6,000 $3,600 -$6,000 0.3(-6,000) = -1,800
Base case 0.50 10,000 4,200 13,000 0.5(13,000) = 6,500
Best case 0.20 13,000 4,400 28,000 0.2(28,000) = 5,600
Expected NPV = $10,300

Calculate standard deviation of NPV (in thousands):

Pi(x - x )2 (x - x )2 Pi(x - x )2
____________________________________________________ ___________________________ ___________________________

Worst case 0.3(-6,000 10,300)2 265,690,000 79,707,000

Base case 0.5(13,000 10,300)2 7,290,000 3,645,000
Best case 0.2(28,000 10,300)2 313,290,000 62,658,000
2 = 146,010,000
NPV = (146,010,000) = 12,083.

Calculate coefficient of variation (CV) of NPV:

CVNPV = NPV/E(NPV) = $12,083/$10,300 = 1.17.
62. Optimal project selection Answer: a Diff: M N

Calculate the after-tax component cost of debt as 10%(1 - 0.3) = 7%. If the
company has earnings of $100,000 and pays out 50% or $50,000 in dividends, then
it will retain earnings of $50,000. The retained earnings breakpoint is
$50,000/0.4 = $125,000. Since it will require financing in excess of $125,000
to undertake any of the alternatives, we can conclude the firm must issue new
equity. Therefore, the pertinent component cost of equity is the cost of new
equity. Calculate the expected dividend per share (note this is D 1) as
$50,000/10,000 = $5. Thus, the cost of new equity is $5/[($35(1 - 0.12)] + 6% =
22.23%. Jacksons WACC is 7%(0.6) + 22.23%(0.4) = 13.09%. Only the return on
Project A exceeds the WACC, so only Project A will be undertaken.
63. New project NPV Answer: b Diff: T

Depreciation Schedule Depreciable Basis: $5,000,000

MACRS
Depreciation Annual
Year Rates Depreciation
1 0.33 $1,650,000
2 0.45 2,250,000
3 0.15 750,000
4 0.07 350,000

The following table shows how to compute the cash flows:

01234Cost($5,000,000)Net operating working capital(500,000)Sales$3,000,000$3,500,000$4,500,000$4,000,000Operating costs, excl.
depr. (60%) 1,800,000 2,100,000 2,700,000 2,400,000Depreciation 1,650,000 2,250,000__________ 750,000__________
350,000Operating income before taxes($ 450,000)($ 850,000)$1,050,000$1,250,000Taxes (40%) (180,000) (340,000) 420,000
500,000After-tax operating income($ 270,000)($ 510,000)$ 630,000$ 750,000Plus: Depreciation 1,650,000 2,250,000
750,000 350,000After-tax operating cash flows$1,380,000$1,740,000$1,380,000$1,100,000After-tax loss of rental
income(180,000)(180,000)(180,000)(180,000)Recovery of net operating working capital___________
____________________
___________________
___________________
_________$ 500,000
500,000Net cash flow($5,500,000)$1,200,000$1,560,000$1,200,000$1,420,000
Enter the NCF amounts into the cash flow register (at 10%) and obtain the NPV
of the cash flows is -$1,248,378.

64. New project NPV Answer: d Diff: T

Step 1: Calculate depreciation:

Dep1 = $100,000(0.33) = $33,000.
Dep2 = $100,000(0.45) = $45,000.
Dep3 = $100,000(0.15) = $15,000.
Dep4 = $100,000(0.07) = $ 7,000.
Step 2: Calculate cash flows:
CF0 = -$100,000 - $ 5,000 = -$105,000.
CF1 = $50,000 + $33,000 = $ 83,000.
CF2 = $60,000 + $45,000 = $105,000.
CF3 = $70,000 + $15,000 = $ 85,000.
CF4 = $60,000 + $ 7,000 + $5,000 + $15,000 = $87,000.
Step 3: Calculate NPV with your financial calculator:
CF0 = -105000; CF1 = 83000; CF2 = 105000; CF3 = 85000; CF4 = 87000; I =
12; and then solve for NPV. NPV = $168,603.89 $168,604.
65. New project NPV Answer: d Diff: T

First, find the after-tax CFs associated with the project. This is
accomplished by subtracting the depreciation expense from the raw CF, reducing
this net CF by taxes and then adding back the depreciation expense.

For t = 1: ($45,000 - $33,000)(1 - 0.4) + $33,000 = $40,200.

Similarly, the after-tax CFs for t = 2, t = 3, and t = 4 are $45,000, $33,000,
and $29,800, respectively.

Now, enter these CFs along with the cost of the equipment to find the pre-
salvage NPV (note that the after-tax salvage value is not yet accounted for in
these CFs). The appropriate discount rate for these CFs is 11 percent. This
yields a pre-salvage NPV of $16,498.72.

Finally, the after-tax salvage value must be discounted. The PV of the after-
tax salvage value is calculated as follows: N = 4; I = 12; PMT = 0; FV =
-10000; and PV = $6,355.18. Adding the PV of the after-tax salvage value to
the pre-salvage NPV yields the project NPV of $22,853.90.

66. New project NPV Answer: d Diff: T

The cash flows for each of the years are as follows:

0 -100,000
1 [90,000 - 50,000 - (100,000)(0.20)](1 - 0.4) + (100,000)(0.20) = 32,000
2 [90,000 - 50,000 - (100,000)(0.32)](1 - 0.4) + (100,000)(0.32) = 36,800
3 [90,000 - 50,000 - (100,000)(0.19)](1 - 0.4) + (100,000)(0.19) = 31,600
4 [90,000 - 50,000 - (100,000)(0.12)](1 - 0.4) + (100,000)(0.12) = 28,800
5 [90,000 - 50,000 - (100,000)(0.11)](1 - 0.4) + (100,000)(0.11) = 28,400
6 [90,000 - 50,000 - (100,000)(0.06)](1 - 0.4) + (100,000)(0.06) +
(10,000)(1 - 0.4) = 32,400
Enter the cash flows into the cash flow register (at 10%) and solve for the NPV
= $38,839.59 $38,840.

67. New project IRR Answer: b Diff: T

 Time line:
IRR = ?
0 1 2 3 4 5 6 Years
k = 12%
| | | | | | |
-100,000 17,300 22,100 16,900 14,100 13,700 11,700
NPV = ?
MACRS
Depreciation Depreciable Annual
Year Rates Basis Depreciation
1 0.20 $100,000 $20,000
2 0.32 100,000 32,000
3 0.19 100,000 19,000
4 0.12 100,000 12,000
5 0.11 100,000 11,000
6 0.06 100,000 6,000
$100,000

Project analysis worksheet:

0 1 2 3 4 5 6
I Initial outlay
1) Machine cost ($100,000)
2) NOWC --
3) Total net inv. ($100,000)
II Operating cash flows
4) Inc. in before taxes
& deprec. earnings $15,500 $15,500 $15,500 $15,500 $15,500 $15,500
5) After-tax inc. in
revenues (line 4 0.6) 9,300 9,300 9,300 9,300 9,300 9,300
6) Deprec. (from table) 20,000 32,000 19,000 12,000 11,000 6,000
7) Deprec. tax savings
(line 6 0.4) 8,000 12,800 7,600 4,800 4,400 2,400
8) Net operating CFs
(lines 5 + 7) $17,300 $22,100 $16,900 $14,100 $13,700 $11,700
III Terminal year CFs
9) Estimated salvage value 0
10) Tax on salvage value 0
11) Return of NOWC 0
12) Total termination CFs 0
IV Net CFs
13) Net CFs ($100,000)$17,300 $22,100 $16,900 $14,100 $13,700 $11,700

Financial calculator solution:

Inputs: CF0 = -100000; CF1 = 17300; CF2 = 22100; CF3 = 16900;
CF4 = 14100; CF5 = 13700; CF6 = 11700.
Output: IRR = -1.32%.

68. NPV and risk-adjusted discount rate Answer: e Diff: T

The following table shows the cash flows (in millions):

0 1 2 3 4 5
Initial invest. outlay -$30.0
Sales $20.0 $20.0 $20.0 $20.0 $20.0
Oper. cost 12.0 12.0 12.0 12.0 12.0
Depreciation 10.0 10.0 10.0 0.0 0.0
 Oper. inc. before taxes -$ 2.0 -$ 2.0 -$ 2.0 $ 8.0 $ 8.0
Taxes (40%) -0.8 -0.8 -0.8 3.2 3.2
Oper. inc. after taxes -$ 1.2 -$ 1.2 -$ 1.2 $ 4.8 $ 4.8
Add Depreciation 10.0 10.0 10.0 0.0 0.0
Net oper. cash flows -$30.0 $ 8.8 $ 8.8 $ 8.8 $ 4.8 $ 4.8
Numerical solution:
Step 1: Determine the NPV of net operating cash flows:
NPV = -$30 + $8.8/1.10 + $8.8(1.10)2 + $8.8/(1.10)3
+ $4.8/(1.10)4 + $4.8/(1.10)5
= -$30 + $8 + $7.2727 + $6.6116 + $3.2785 + $2.9804
= -$1.8568 million.
Step 2: Determine the NPV of the projects AT salvage value:
$1.2/(1.12)5 = $0.6809 million.
Step 3: Determine the projects NPV:
Add the PV of the salvage value to the NPV of the cash flows to get
the projects NPV.
NPV = -$1.8568 + $0.6809 = -$1.1759 million -$1.18 million.
Financial calculator solution:
Step 1: Determine the NPV of net operating cash flows:
Enter the following inputs in the calculator:
CF0 = -30, CF1-3 = 8.8, CF4-5 = 4.8, I = 10, and then solve for NPV = -
$1.8568 million.
Step 2: Determine the NPV of the projects AT salvage value:
Enter the following inputs in the calculator:
CF0 = 0, CF1-4 = 0, CF5 = 1.2, I = 12, and then solve for NPV =
$0.6809 million.
Step 3: Determine the projects NPV:
Add the PV of the salvage value to the NPV of the cash flows to get
the projects NPV.
-$1.8568 + $0.6809 = -$1.1759 million $-1.18 million.

69. New project investment Answer: a Diff: E

Initial investment:
Cost ($40,000)
Change in NOWC (2,000)
($42,000)
70
. Operating cash flow Answer: e Diff: M

Depreciation schedule:
MACRS
Depreciation Depreciable Annual
Year Rates Basis Depreciation
 1 0.33 $40,000 $13,200
2 0.45 40,000 18,000
3 0.15 40,000 6,000
4 0.07 40,000 2,800
$40,000

Operating cash flows:

1 2 3
1) Increase in revenues $20,000 $20,000 $20,000
2) Increase in costs (5,000) (5,000) (5,000)
3) Before-tax change in earnings $15,000 $15,000 $15,000
4) After-tax change in
earnings (line 3 0.60) $ 9,000 $ 9,000 $ 9,000
5) Depreciation 13,200 18,000 6,000
6) Deprec. tax savings
(line 5 0.40) 5,280 7,200 2,400
7) Net operating CFs
(lines 4 + 6) $14,280 $16,200 $11,400

71. Non-operating cash flows Answer: a Diff: M

Additional Year 3 cash flows:

3
Salvage value $25,000
Tax on Salvage value (8,880)*
Recovery of NOWC 2,000
Total terminal year CF $18,120

*(Market value - Book value)(Tax rate) ($25,000 - $2,800)(0.40) = $8,880.

72. New project NPV Answer: c Diff: M

Time line:
0 k = 14% 1 2 3 Years
| | | |
-42,000 14,280 16,200 11,400
TV = 18,120
29,520

Numerical solution:
$14,280 $16,200 $29,520
NPV = -$42,000 = $2,916.85 $2,917.
1.14 (1.14)2 (1.14)3

Financial calculator solution:

Inputs: CF0 = -42000; CF1 = 14280; CF2 = 16200; CF3 = 29520; I = 14.
Output: NPV = $2,916.85 $2,917.
73. New project investment Answer: d Diff: E

Initial investment:
Cost ($50,000)
Modification (10,000)
Change in NOWC (2,000)
Total net investment ($62,000)
74
. Operating cash flow Answer: c Diff: M

Depreciation schedule:
MACRS
Depreciation Depreciable Annual
Year Rates Basis Depreciation
1 0.33 $60,000 $19,800
2 0.45 60,000 27,000
3 0.15 60,000 9,000
4 0.07 60,000 4,200
$60,000

Operating cash flows:

Year 1 2 3
1) Before-tax cost reduction $20,000 $20,000 $20,000
2) After-tax cost reduction
(line 1 0.6) 12,000 12,000 12,000
3) Depreciation 19,800 27,000 9,000
4) Deprec. tax savings
(line 3 0.4) 7,920 10,800 3,600
5) Net operating CFs (lines 2 + 4) $19,920 $22,800 $15,600
75

. Non-operating cash flows Answer: c Diff: M

Additional Year 3 cash flows:

3
Salvage value $20,000
Tax on salvage value (6,320)*
Recovery of NOWC 2,000
Total terminal year CF $15,680

*(Market value - Book value)(Tax rate) = ($20,000 - $4,200)(0.40) = $6,320.

76
. New project NPV Answer: a Diff: M

Time line:
0 k = 10% 1 2 3 Years
| | | |
-62,000 19,920 22,800 15,600
TV = 15,680
31,280

Numerical solution:
 $19,920 $22,800 $31,280
NPV = -$62,000 = -$1,546.81 -$1,547.
1.10 (1.10)2 (1.10)3

Financial calculator solution:

Inputs: CF0 = -62000; CF1 = 19920; CF2 = 22800; CF3 = 31280; I = 10.
Output: NPV = -$1,546.81 -$1,547.

77. Operating cash flows Answer: e Diff: E N

Operating cash flow is Net income + Depreciation, which is $5.2 million.

t = 1 t = 2 t = 3 t = 4
Depreciation $1.0 $1.0 $1.0 $1.0
Net income 4.2 4.2 4.2 4.2
Oper. CFs $5.2 $5.2 $5.2 $5.2

78. After-tax salvage value Answer: d Diff: M N

The original cost of the store is $10 million and the annual depreciation
expense is $1 million (since the store is being depreciated on a straight-
line basis over 10 years). So after 4 years the remaining BV = $10 - $4 = $6
million. If the store is sold for $7.5 million, the gain on the sale is $7.5
- $6.0 = $1.5 million. The tax on the gain is 0.4($1.5) = $0.6 million. The
after-tax salvage value is $7.5 - $0.6 = $6.9 million.

79. New project NPV Answer: d Diff: M N

The relevant cash flows are shown below:

t = 0 t = 1 t = 2 t = 3 t = 4
Construction cost -$10.0
NOWC -3.0 $3.0
Operating cash flow $5.2 $5.2 $5.2 5.2
AT Salvage value 6.9
Total cash flow -$13.0 $5.2 $5.2 $5.2 $15.1

Numerical solution:
$5.2 $5.2 $5.2 $15.1
NPV = -$13.0 + 2
3

1.10 (1.10) (1.10) (1.10)4
= -$13.0 + $4.7273 + $4.2975 + $3.9068 + $10.3135
= $10.245 $10.25 million.

Financial calculator solution:

CF0 = -13; CF1 = 5.2; CF2 = 5.2; CF3 = 5.2; CF4 = 15.1; I = 10; and then solve
for NPV = $10.245 $10.25 million.

80. Scenario analysis Answer: e Diff: M N

The correct answer is statement e. The expected NPV for the project = 0.25
$5 + 0.5 $8 + 0.25 $10 = $7.75 million. Therefore, statement a is correct.
The standard deviation of the project is given as 2.06. So, the coefficient of
 variation, or CV, is 7.75/2.06 = 0.2658. Thus, the project falls into the
Average-risk category, so statement b is correct. Recall that you discounted
cash flows using 10%, which is the weighted average cost of capital for an
Average-risk project. If the project were classified as a High-risk
project, the company should go back and recalculate the projects NPV using the
higher cost of capital estimate of 12%. So, statement c is also correct.
Therefore, statements a, b, and c are correct, and the correct choice is
statement e.

81. New project NPV Answer: e Diff: M N

t = 0 t = 1 t = 2 t = 3
Equipment -$1,000,000
Net oper. working capital -200,000
Sales $1,000,000 $1,000,000 $1,000,000
Oper. costs (60%) 600,000 600,000 600,000
Depreciation 333,333 333,333 333,333
EBIT $ 66,667 $ 66,667 $ 66,667
Taxes (40%) 26,667 26,667 26,667
EBIT(1 - T) $ 40,000 $ 40,000 $ 40,000
Depreciation 333,333 333,333 333,333
AT Oper. CF $ 373,333 $ 373,333 $ 373,333
Recovery of NOWC ___________ __________ __________ 200,000
Net cash flows -$1,200,000 $ 373,333 $ 373,333 $ 573,333

Enter the cash flows into the cash flow register (at 10%) and solve for the NPV
= -$121,313.
82. After-tax salvage value Answer: c Diff: E N

The tax due on the sale of equipment would be:

($400,000 - $333,333.33) 40% = $26,666.67.

Then, subtracting this tax from the sale price, ($400,000 - $26,666.67) you
get $373,333.33.

83. Operating cash flows Answer: e Diff: M N

After-tax operating CF = EBIT(1 - T) + Depreciation.

Depreciation expense = $300,000,000/4 = $75,000,000.

For each year, EBIT = Sales - Operating costs Depreciation

= $200,000,000 - $100,000,000 75,000,000
= $25,000,000.

After-tax operating CF = $25,000,000(1 0.4) + $75,000,000

= $15,000,000 + $75,000,000
= $90,000,000.

84. New project NPV Answer: a Diff: M N

The project cash flows are shown below (in millions of dollars):

0 1 2 3 4
Up-front costs -300
Increase in NOWC -50

Sales 200 200 200 200

 Operating costs -100 -100 -100 -100
Depreciation -75 -75 -75 -75
EBIT 25 25 25 25
Taxes (40%) -10 -10 -10 -10
EBIT(1 - T) 15 15 15 15
Depreciation 75 75 75 75
Operating CF 90 90 90 90
AT(SV) 30
NOWC recovery 50
Net CF -350 90 90 90 170

Using your financial calculator, enter the following data inputs:

CF0 = -350; CF1-3 = 90; CF4 = 170; I = 10; and then solve for NPV =
-$10.07 million.

WEB APPENDIX 11A SOLUTIONS

8511A-. NPV and depreciation Answer: c Diff: E

8611A-. Depreciation cash flows Answer: c Diff: M

87

WEB APPENDIX 11B SOLUTIONS

11B-. Replacement cash outflows Answer: d Diff: M

Cost plus installation ($10,000)

Sale of old machine 2,000
Tax effect of sale ($1,000 0.34) (350)
Decrease in working capital 1,500
Total investment at t = 0 ($ 6,850)
88
11B-. Replacement decision Answer: b Diff: T

Time line:
0 1 2 3 Years
k = 16%
| | | |
-11,900 5,648 6,320 6,232
NPV = ?
Depreciation cash flows:
MACRS
Depreciation New Asset Old Asset Change in
Year Rates Depreciation Depreciation Depreciation
1 0.33 $4,620 $1,000 $3,620
2 0.45 6,300 1,000 5,300
3 0.15 2,100 1,000 1,100
4 0.07 980 -- 980
Project analysis worksheet:
I Initial outlay
1) Machine cost ($14,000)
2) Sale of old machine 1,500*
3) Tax savings old machine 600
4) Total net inv. ($11,900)
*($3,000 - $1,500) = Loss; Loss Tax rate = Savings;
$1,500 0.40 = $600.
II Operating cash flows
Year: 0 1 2 3
5) Reduction in cost $7,000 $7,000 $7,000
6) After-tax decrease in
cost (line 5 0.60) 4,200 4,200 4,200
7) Deprec. new machine 4,620 6,300 2,100
8) Deprec. old machine 1,000 1,000 1,000
9) Change in depreciation
(line 7 - 8) 3,620 5,300 1,100
10) Tax savings from deprec.
(line 9 0.40) 1,448 2,120 440
11) Net operating cash flows
(line 6 + 10) $5,648 $6,320 $4,640
III Terminal year CFs
12) Estimated salvage value $2,000
13) Tax on salvage value
(2,000 - 980)(0.4) (408)
14) Return of NWC --
15) Total termination CFs 1,592
 IV Net CFs
16) Total Net Cfs ($11,900) $5,648 $6,320 $6,232

Financial calculator solution:

Inputs: CF0 = -11900; CF1 = 5648; CF2 = 6320; CF3 = 6232; I = 16.
Output: NPV = $1,658.33 $1,658.

8911B-. Replacement decision Answer: a Diff: T

Time line:
0 1 2 3 4 5 Years
k = 10%
| | | | | |
-148,750 21,625 30,025 20,925 16,025 27,325
NPV = ?
Depreciation cash flows*:
MACRS
Depreciation New Asset Old Asset Change in
Year Rates Depreciation Depreciation Depreciation
1 0.20 $40,000 $7,000 $33,000
2 0.32 64,000 7,000 57,000
3 0.19 38,000 7,000 31,000
4 0.12 24,000 7,000 17,000
5 0.11 22,000 7,000 15,000
6 0.06 12,000 -- 12,000
*Depreciation old equipment: 105,000/15 = 7,000 per year 10 years =
70,000 in accumulated depreciation.
Book value = $105,000
- 70,000
$ 35,000
Replacement analysis worksheet:
I Initial outlay
1) New equipment cost ($200,000)
2) Market value old equip. 60,000
3) Taxes on sale of old equip. (8,750)*
4) Increase in NWC --
5) Total net investment ($148,750)
*(Market value - Book value)(Tax rate)
(60,000 - 35,000)(0.35) = $8,750.
II Operating cash flows
Year: 0 1 2 3 4 5
6) Increase in revenues $18,000 $18,000 $18,000 $18,000 $18,000
7) Increase in expenses (2,500) (2,500) (2,500) (2,500) (2,500)
8) AT change in earnings
((line 6 + 7) 0.65) 10,075 10,075 10,075 10,075 10,075
9) Deprec. on new machine 40,000 64,000 38,000 24,000 22,000
10) Deprec. on old machine 7,000 7,000 7,000 7,000 7,000
11) Change in deprec.
(line 9 - 10) 33,000 57,000 31,000 17,000 15,000
12) Tax savings from deprec.
(line 11 0.35) 11,550 19,950 10,850 5,950 5,250
13) Net operating CFs
(line 8 + 12) $21,625 $30,025 $20,925 $16,025 $15,325
III Terminal year CFs
14) Estimated salvage value $12,000
15) Tax on salvage value --
16) Return of NWC --
17) Total termination CFs 12,000
IV Net CFs
18) Total Net CFs($148,750) $21,625 $30,025 $20,925 $16,025 $27,325

Financial calculator solution:

Inputs: CF0 = -148750; CF1 = 21625; CF2 = 30025; CF3 = 20925;
 CF4 = 16025; CF5 = 27325; I = 10.
Output: NPV = -$60,643.63 -$60,644.
9011B-. Replacement decision Answer: c Diff: T

Time line:
0 1 2 3 4 5 6 Years
k = 10%
| | | | | | |
-11,000 3,200 4,400 3,100 2,400 2,300 3,000
NPV = ?
Depreciation cash flows:
MACRS
Depreciation New Asset Old Asset Change in
Year Rates Depreciation Depreciation Depreciation
1 0.20 $ 5,000 $ 3,000 $ 2,000
2 0.32 8,000 3,000 5,000
3 0.19 4,750 3,000 1,750
4 0.12 3,000 3,000 0
5 0.11 2,750 3,000 (250)
6 0.06 1,500 1,500
$25,000 $15,000 $10,000
Project analysis worksheet:
I Initial outlay
1) New equipment cost ($25,000.00)
2) Market value old equip. 13,333.33
3) Tax savings sale of old equip. 666.67*
4) Increase in NWC --
5) Total net investment ($11,000.00)
*(Market value - Book value)(Tax rate)
($13,333.33 - $15,000)(0.4) = $666.67.
II Operating cash flows
Year: 0 1 2 3 4 5 6
6) Before-tax savings
new equip. $4,000 $4,000 $4,000 $4,000 $4,000 $4,000
7) After-tax savings new
equip.(line 6 0.6) 2,400 2,400 2,400 2,400 2,400 2,400
8) Deprec. new machine 5,000 8,000 4,750 3,000 2,750 1,500
9) Deprec. old machine 3,000 3,000 3,000 3,000 3,000 0
10) Change in deprec.
(line 8 - 9) 2,000 5,000 1,750 0 (250) 1,500
11) Tax savings from deprec.
(line 10 0.4) 800 2,000 700 0 (100) 600
12) Net operating CFs
(line 7 + 11) $3,200 $4,400 $3,100 $2,400 $2,300 $3,000
III Terminal year CFs
13) Estimated salvage value 0
14) Total terminal yr CF 0
IV Net CFs
15) Total Net
CFs ($11,000)$3,200 $4,400 $3,100 $2,400 $2,300 $3,000
Financial calculator solution:
Inputs: CF0 = -11000; CF1 = 3200; CF2 = 4400; CF3 = 3100;
CF4 = 2400; CF5 = 2300; CF6 = 3000; I = 10.
Output: NPV = $2,635.30 $2,635.
91
11B-. Replacement project IRR Answer: c Diff: T
 Time line:
0 1 2 3 4 5
IRR = ?
| | | | | |
-17,600 3,400 4,840 3,280 2,440 3,640
NPV = ?
Depreciation cash flows:
MACRS
Depreciation New Asset Old Asset Change in
Year Rates Depreciation Depreciation Depreciation
1 0.20 $ 6,000 $ 2,000 $ 4,000
2 0.32 9,600 2,000 7,600
3 0.19 5,700 2,000 3,700
4 0.12 3,600 2,000 1,600
5 0.11 3,300 2,000 1,300
6 0.06 1,800 1,800
$30,000 $10,000 $20,000

Project analysis worksheet:

I Initial outlay
1) New asset cost ($30,000)
2) Sale of old asset 14,000
3) Tax on sale of old asset (1,600)*
4) Increase in NWC --
5) Total net investment ($17,600)
*(Sale value - Book value)(Tax rate) = (14,000 - 10,000)(0.40) = $1,600.
II Operating cash flows
Year: 0 1 2 3 4 5
6) Before-tax savings
new asset $3,000 $3,000 $3,000 $3,000 $3,000
7) After-tax savings new
asset (line 6 0.6) 1,800 1,800 1,800 1,800 1,800
8) Deprec. new asset 6,000 9,600 5,700 3,600 3,300
9) Deprec. old asset 2,000 2,000 2,000 2,000 2,000
10) Change in deprec.
(line 8 - 9) 4,000 7,600 3,700 1,600 1,300
11) Tax savings from deprec.
(line 10 0.4) 1,600 3,040 1,480 640 520
12) Net operating CFs
(line 7 + 11) 3,400 4,840 3,280 2,440 2,320
III Terminal year CFs
13) Estimated salvage value $1,000
14) Tax on salvage value
(1,000 - 1,800)(0.4) 320
15) Return of NWC --
16) Total termination CFs $1,320
IV Net CFs
17) Total Net CFs ($17,600) $3,400 $4,840 $3,280 $2,440 $3,640

Financial calculator solution:

Inputs: CF0 = -17600; CF1 = 3400; CF2 = 4840; CF3 = 3280;
CF4 = 2440; CF5 = 3640.
Output: IRR = 0.0%.

9211B-. Replacement project Answer: d Diff: T

First calculate CF0: The old equipment can be sold for $8,000, but the book
value (BV) of the old equipment is $10,000 - $1,800 = $8,200. Thus, the
company will realize a loss on the sale of $200. The loss reduces taxes by
$200(0.40) = $80. CF0 includes the cost of the new equipment, net of the sale
proceeds and the tax effect of the sale equipment, or
 -$15,000 + $8,000 + $80 = -$6,920.

Second, we must calculate the operating CFs. The operating CFs are comprised
of the after-tax change in operating income and any tax effect of the change
in depreciation expense from the old machine to the new. The new equipment
will reduce costs by $1,000 per year and increase sales by $2,000 so before-
tax operating income will increase by $3,000 per year. The after-tax increase
in operating income for t = 1 - 4 is $3,000(1 - 0.4) = $1,800. The operating
CFs are calculated as follows:
Increased
Time Dep. New Dep. Old Diff. Tax Effect + Op Inc. = CF
1 $15,000(0.33) = $4,950 $1,800 $3,150 $3,150(0.4) = $1,260 $1,800 $3,060
2 $15,000(0.45) = 6,750 1,800 4,950 4,950(0.4) = 1,980 1,800 3,780
3 $15,000(0.15) = 2,250 1,800 450 450(0.4) = 180 1,800 1,980
4 $15,000(0.07) = 1,050 1,800 -750 -750(0.4) = -300 1,800 1,500

The old machine could have been sold for its BV or $1,000 at t = 4. This
represents an opportunity cost of replacement. Thus, CF4 = $1,500 - $1,000 =
$500. The relevant cash flows are then CF0 = -$6,920, CF1 = $3,060, CF2 =
$3,780, CF3 = $1,980, and CF4 = $1,500. Discounting at 12 percent yields an
NPV of $552.62.
93
11B-. New project NPV Answer: d Diff: T

Step 1: Calculate depreciation:

Dep 1 = 100,000(0.33) = 33,000.
Dep 2 = 100,000(0.45) = 45,000.
Dep 3 = 100,000(0.15) = 15,000.
Dep 4 = 100,000(0.07) = 7,000.

Step 2: Calculate cash flows:

CF 0 = -100,000 - 5,000 = -105,000.
CF 1 = 50,000 + 33,000 = 83,000.
CF 2 = 60,000 + 45,000 = 105,000.
CF 3 = 70,000 + 15,000 = 85,000.
CF 4 = 60,000 + 7,000 + 5,000 + 15,000 = 87,000.

Step 3: Calculate NPV:

Use CF key on calculator. Enter cash flows shown above. Enter
I/YR = 12%. Solve for NPV = $168,604.