Analyzing Project Cash Flows: T 0 T 1 Through T 10 Assumptions

Chapter 12
Analyzing Project Cash Flows
12-1. Morten’s new product line is expected to generate $60 million in sales next year but only 40% of
that amount should be considered incremental revenue to Morten:
a. $60,000,000 × 0.4 = $24,000,000.
Since some of Morten’s existing customers would have selected a non-Morten product if the
company did not introduce the healthier baked chips, the incremental revenue to Morten from
introducing the new product is actually greater than the $24,000,000 calculated in part a. In that
case, the amount of additional revenue from the introduction of the new product would also
include the value of the sales that would be lost from the defection of existing customers.
12-2. a. Part 1:
t=0 t=1 through t=10 assumptions:
revenue $1,300,000 (price)*(# of units sold)
less: cost of goods sold ($1,000,000) (VC/unit)*(# of units sold)
gross profit $300,000
less: cash operating expenses ($32,000) fixed costs (which we assume exclude depreciation)
less: depreciation ($70,000) depreciation = ($700,000 - $0)/(10)
net operating income $198,000
less: taxes ($59,400)
net operating profit after taxes (NOPAT) $138,600
plus: depreciation $70,000
operating cash flow $208,600
less: capital expenditures (capex) ($700,000)

less: additional net operating working capital $0
free cash flow ($700,000) $208,600
The cash operating expenses of $32,000 were inferred given the level of net operating income
stated in the problem ($198,000).
Part 2: The cost of debt financing is not included in the analysis of project cash flow as the
required discount rate for the project takes into account how the project is financed.
Consequently, interest expense is omitted from the analysis above.
b. Assuming no salvage value and a book value of zero in year t=10, the NPV of the project is:
  1 
1 −  
NPV =
−$700,000 + $208,600 ×   (1.10)10  
=
−$700,000 + ($208,600 × 6.144567106 =
$581,757.
 0.10 
 
 
289
Copyright © 2018 Pearson Education Ltd.
290 Titman/Keown/Martin • Financial Management, Thirteenth Edition, Global Edition
12-3. Fastfoot shoes should pursue this deal as it would aim to generate an additional cash flow of
£31,200 as outlined below:
Fastfoot
Current New
Revenue 1,000,000 1,300,000
Profit 35% 350,000 30% 390,000
Tax 22% 77,000 22% 85,800
Net 273,000 304,200
Additional cashflow 31,200
The two main risks faced by Fastfoot shoes are: (1) The margin is lower than calculated, and (2)
additional sales are lower than calculated.
12-4. For Soko Industries, the following information appears most pertinent:
original price new price
sPad unit sales 400,000
sPad price $600 $450
sPad cost/unit $400 $400
applications price $100
application cost/unit $25
The incremental revenue attributable to the new pricing strategy is $________, the difference
between $180 million (the revenue generated with the new price) and $______ million (the
revenue generated with the original price).
The incremental impact on the firm’s operating profit is $________, the difference between $50
million (the firm’s operating profit with the new price on sPads including the sales of
applications), and $_________ (the firm’s operating profit with the original price on sPads).
12-5. The cash projection now delivers a reduction in cashflow of £24,150.
Fastfoot
Current New
Revenue 1,000,000 1,300,000
Profit 35% 350,000 30% 390,000 75,000 315,000
Tax 22% 77,000 22% 85,800 66,150 21%
Net 273,000 304,200 248,850
Additional cashflow 31,200 (24,150)
If the operating margin can be increased to 33%, then the project would return to a cash positive
result.

Solutions to End-of-Chapter Problems—Chapter 12 291
Fastfoot
Current New
Revenue 1,000,000 1,300,000
Profit 35% 350,000 33% 429,000 75,000 354,000
Tax 22% 77,000 22% 94,380 74,340 21%
Net 273,000 334,620 279,660
Additional cashflow 61,620 6,660
12-6. The business needs to achieve a 10% sales growth.
Current 5% 10% 15%

Sales 3,000,000 3,150,000 3,300,000 3,450,000
Op margin 10% 300,000 290,000 305,000 320,000
Tax 20% 60,000 58,000 61,000 64,000
NOPAT 240,000 232,000 244,000 256,000
Marketing cost
25,000
In terms of risks, the business should also consider issues such as market saturation, and, by
extension, a limitation on sales.
12-7. Here we have a new cereal launch for Stones n’ Stuff. Fruity Stones, the manufacturer, expects
that this new cereal will generate $100 million in sales, and that 40% of these sales come from
former buyers of the firm’s other cereal, Jolt n’ Stones. In Problem 12, we reduced the sales
attributable to a new cereal by the sales it cannibalized from an existing cereal. However, the Stones
n’ Stuff case is different. Jolt n’ Stones (the existing cereal) would have lost sales regardless of the
Stones n’ Stuff launch since a competitor is also launching a new cereal. Thus, even if the Fruity
Stones company did not launch Stones n’ Stuff (the new cereal), Jolt n’ Stones would have lost
sales. We cannot therefore attribute this loss in sales of the existing cereal to the new cereal. We
therefore consider the full $100 million in sales to be incremental to Stones n’ Stuff.
We can see this with equation 12-1:
incremental project cash flows = firm cash flows with project − firm cash flows without project.
incremental project cash flows = firm sales with both cereals − firm sales with Jolt n’ Stones only
= [new Stones n’ Stuff sales + new Jolt n’ Stones sales] − new Jolt n’ Stones sales
= [$100 mil. + (old Jolt n’Stones sales − $40 mil. lost to competitor’s cereal)]
− (old Jolt n’Stones sales − $40 mil. lost to competitor’s cereal)
= $100 million.

12-8. To find the free cash flow of Tetious Dimensions’ new product, we will first calculate its required
net investment in working capital (WC). We will do this using the “with versus without” method
we always use to identify incremental cash flows: determine the total WC investment the firm
requires with the project, and compare that to the required investment without the project.
We will look at three accounts: accounts receivable (A/R, a current asset), inventory (a current asset),
and accounts payable (A/P, a current liability). Increases in current assets are cash outflows (uses
of cash), since the firm must tie up cash in these other assets. (For example, if inventory increases,
the firm uses cash to buy extra inventory; if A/R rises, the firm has sold items but not received cash
for them yet.) On the other hand, increases in current liabilities are sources of cash (if Tetious’s A/P
rises, its suppliers have allowed it to take supplies without yet paying for them). We will net the
outflows and the inflows to determine the net increase in operating working capital, as follows:
A B C=B-A
without project with project change cash flow effect
accounts receivable $105,000 $130,000 $25,000 outflow
inventory $200,000 $280,000 $80,000 outflow
accounts payable $90,000 $130,000 $40,000 inflow
total working capital increment = ($65,000)
Thus this new project will require an initial (t = 0) investment of $65,000.

Given this WC increment, we can go on to find the free cash flows for the project as shown on the
next page. We have assumed the following:
initial cash flow (t = 0)
• There was no mention of the amount of money spent on the project (capex) at t = 0, so we
haven’t included any.
• The only t = 0 cash flow is the increment to working capital, an outflow of $65,000.
operating cash flows (t = 1 through t = n)
• We assume that the project’s useful and depreciable life are n years.
• Operating cash flows for years 1 through n are (NOPAT + depreciation), which for this project
are [NOI ∗ (1 − T) + depreciation] = [$475,000*(1 – 0.30) + $200,000 = $532,500.
terminal cash flow (t = n)
• At t = n, the firm recoups its investment in net WC, for an inflow of $65,000.
t=0 t=1 t=2 ...t=n assumptions:
revenues
less: cost of goods sold These numbers not given;
gross profit they are combined into the NOI value of $475,000.
less: cash operating expenses
less: depreciation ($200,000) ($200,000) ($200,000) We assume that the depreciable life of this project is n years.
net operating income $475,000 $475,000 $475,000 We assume that the project's life is n years.
less: taxes ($142,500) ($142,500) ($142,500)
net operating profit after taxes (NOPAT) $332,500 $332,500 $332,500
plus: depreciation $200,000 $200,000 $200,000
operating cash flow $532,500 $532,500 $532,500
less: capital expenditures (capex) We were not given an initial investment amount.
less: additional net operating working capital ($65,000) $65,000 The WC investment is recovered at t=n, when the project unwinds.
free cash flow ($65,000) $532,500 $532,500 $597,500
12-9. To find the free cash flow of Duncan Motors’ new product, we will first calculate its required net
investment in working capital (WC). We will do this using the “with versus without” method we
always use to identify incremental cash flows: Determine the total WC investment the firm
requires with the project and compare that to the required investment without the project.

the firm uses cash to buy extra inventory; if A/R rises, the firm has sold items but not received
cash for them yet.) On the other hand, increases in current liabilities are sources of cash (if Duncan’s
A/P rises, its suppliers have allowed it to take supplies without yet paying for them). We will net
the outflows and the inflows to determine the net increase in operating working capital as follows:
A B C=B-A
accounts receivable $33,000 $23,000 ($10,000) inflow
total working capital increment = $31,000
Thus this new project will release an extra $31,000 cash inflow at t = 0. This is not the usual case;
generally, we expect that a new project will require supporting WC outflows. But here, the new
project causes Duncan’s A/R to fall—meaning that its customers pay more in cash instead of on
credit than they did before, reducing the A/R balance by $10,000. The firm also is able to get
$36,000 extra financing from its suppliers (the increase in A/P). These two inflows outweigh the extra
$15,000 increase in inventory, resulting in an overall WC inflow at t = 0.
• There was no mention of the amount of money spent on the project (capex) at t = 0, so we
haven’t included any.
• The only t = 0 cash flow is the inflow from working capital, $31,000.
are [NOI ∗ (1 − T) + depreciation] = [$300,000 ∗ (1 − 0.34)] + $50,000 = $248,000.

• At t = n, the firm reverses its t = 0 inflow from net WC, for an outflow of $31,000.
revenues
gross profit they are rolled into the NOI value of $300,000.
less: taxes ($102,000) ($102,000) ($102,000)
less: additional net operating working capital $31,000 ($31,000) The WC increment is lost at t=n, when the project unwinds.
free cash flow $31,000 $248,000 $248,000 $217,000

12-10. a. Faraway Fabricators needs additional working capital if it expands its welding and stamping
division. The firm’s CFO has estimated the following levels of sales and COGS:
0 1 2 3 4 5
Sales $150,000 $162,000 $174,960 $188,957 $204,073 $220,399
COGS $90,000 $97,200 $104,976 $113,374 $122,444 $132,240
This expansion requires that the firm increase its accounts receivable by 12% of the added sales,
increase its inventory by 15% of the added cost of goods sold, and increase its accounts payable
by 10% of the added cost of goods sold. The additional working capital investment occurs in the
period prior to the increase in sales. That is, the expenditure for operating net working capital for
Year 1 is made in Year 0, and so forth.
The additional working capital requirements are given below. Recall that an increase in accounts
receivable or inventory requires cash (an increase in working capital needed), whereas an increase
in accounts payable provides cash (a decrease in working capital needed).
0 1 2 3 4 5
Sales $150,000 $162,000 $174,960 $188,957 $204,073 $220,399
COGS $90,000 $97,200 $104,976 $113,374 $122,444 $132,240
12% (change in A/R) $1,440.00 $1,555.20 $1,679.64 $1,813.92 $1,959.12 expenditure made in period t-1
15% (change in inventory) $1,080.00 $1,166.40 $1,259.70 $1,360.50 $1,469.40
10% (change in A/P) $720.00 $777.60 $839.80 $907.00 $979.60
operating working
capital requirements $1,800.00 $1,944.00 $2,099.54 $2,267.42 $2,448.92
b. The additional funds needed for working capital in years 0 through 4 are given the last line of
the table above.
12-11. To find the free cash flow of Visible Fence’s new product, we will first calculate its required net
investment in working capital (WC). We will do this using the “with versus without” method we
always use to identify incremental cash flows: Determine the total WC investment the firm requires
with the project, and compare that to the required investment without the project.
the firm uses cash to buy extra inventory; if A/R rises, the firm has sold items but not received cash
for them yet.) On the other hand, increases in current liabilities are sources of cash (if Duncan’s A/P
rises, its suppliers have allowed it to take supplies without yet paying for them). We will net the
outflows and the inflows to determine the net increase in operating working capital as follows:
A B C=B-A
accounts receivable $55,000 $63,000 $8,000 outflow
total working capital increment = ($7,000)

Thus this new project will require an initial investment of $7000. Visible Fences must invest an
extra $8000 in A/R and $15,000 in inventory; these two outflows are offset by the additional
supplier financing of $16,000 coming from the increase in A/P, but the net cash flow is still
negative. Visible Fences will recoup this initial investment when the project is unwound.
• There was no mention of the amount of money spent on the project (capex) at t = 0, so we haven’t
included any.
• The only t = 0 cash flow is the outflow from the incremental investment in working capital,
$7000.
are [NOI ∗ (1 − T) + depreciation] = [$900,000 ∗ (1 − 0.34)] + $300,000 = $894,000.
• At t = n, the firm recoups its t = 0 outflow from net WC, for an inflow of $7000.
revenues
gross profit they are rolled into the NOI value of $900,000.
less: taxes ($306,000) ($306,000) ($306,000)
less: additional net operating working capital ($7,000) $7,000 The WC increment is lost at t=n, when the project unwinds.
free cash flow ($7,000) $894,000 $894,000 $901,000
12-12. At 300,000 units, the cash flow is 11,700.

At 285,000 units, the cash flow is (12,000) NB no tax on an operating loss.
At 315,000 units, the cash flow is 32,760.
The spreadsheet below outlines these calculations.
Timeapp -30% 30%
300,000 10 210,000 10 390,000 10
Revenue 3,000,000 Revenue 2,100,000 Revenue 3,900,000
Op profit 3% 90,000 Op profit 63,000 Op profit 117,000

HO costs 75,000 HO costs 75,000 HO costs 75,000
PBT 15,000 PBT (12,000) PBT 42,000
Tax 22% 3,300 Tax 22% 0 Tax 22% 9,240
11,700 (12,000) 32,760

12-13. 300,000 units with the new parameters delivers a negative cashflow of 10,000.
If the operating margin is improved to 3.85%, then a net cashflow of £11,780 is restored.

Timeapp
300,000 10 300,000 10
Revenue 3,000,000 Revenue 3,000,000
Op profit 3% 90,000 Op profit 3.85% 115,500

HO costs 100,000 HO costs 100,000
PBT (10,000) PBT 15,500
Tax 24% Tax 24% 3,720
(10,000) 11,780
12-14. a. The initial cash flow (t = 0) for the gas-powered skateboard project will be the cost to purchase
the new production equipment, $450,000, plus the incremental investment in inventory of
$50,000 = $500,000.
b. The annual net cash flows for the project from t = 1 to t = 9 will be the revenue from the sales
of the new skateboards, less the variable and fixed cash costs of production, less taxes, plus the
benefits of the depreciation tax shield. That is, using equation 12-3:
operating cash flow = net operating income − taxes + depreciation,
NOPAT
where
net operating income = revenue − cost of goods sold − cash operating
expenses − depreciation.
For our project, revenue is (2,000 units) ∗ ($200/unit) = $400,000. The cost of goods sold is
the variable cost per unit, $40, times the number of units: (2,000 units) ∗ ($40/unit) = $80,000.
We will assume that the cash operating expenses are the fixed costs of $160,000 (which we
assume do not include depreciation). To find depreciation, we use the straight-line method:
$450,000 - $0
( depreciable =
basis-salvage value
# years of depreciable life
) (= 10
) $45,000. Thus we find:
net operating income 1 = $400,000− $80,000− $160,000 − $45,000

= $115,000.
Operating cash flow is therefore:
operating cash flow = [$115,000∗ (1 − 0.34)] + $45,000= $120,900.

t=0 t=1 through t=9 t=10 assumptions:

revenue $400,000 $400,000
less: cost of goods sold ($80,000) ($80,000) (VC/unit)*(# of units sold)
gross profit $320,000 $320,000
less: cash operating expenses ($160,000) ($160,000) fixed costs (which we assume exclude depreciation)
less: depreciation ($45,000) ($45,000) depreciation = ($450,000 - $0)/(10)
net operating income $115,000 $115,000
less: taxes ($39,100) ($39,100)
net operating profit after taxes (NOPAT) $75,900 $75,900
plus: depreciation $45,000 $45,000
operating cash flow $120,900 $120,900

less: additional net operating working capital ($50,000) $50,000 WC is recovered at end of project (t=10).
free cash flow ($500,000) $120,900 $170,900
This will be our project’s cash flow amount for years 1 through 9.
c. In year 10, we will add to this amount our recovery of the $50,000 working capital investment,
for a total t = 10 cash flow of $170,900. The spreadsheet below outlines all of these cash flow
calculations.
d. To find the project’s NPV, we use equation 11-1:
CF1 CF2 CFn
=
NPV CF0 + + ... + ,
(1 + k ) (1 + k )
1 2
(1 + k )n
where our required return, k, is 10%. Substituting for our project’s values, we have:
$120,900 $120,900 $120,900 $170,900
NPV =
−500,000 + 1
+ 2
+ ... + + =
$262,155.
(1.10) (1.10) (1.10)9 (1.10)10
Since the NPV is greater than zero, the project should be accepted.
We can easily calculate NPV in Excel. We show various ways below:
10%
t CFt PV(CFt)
0 ($500,000) ($500,000)
1 $120,900 $109,909
2 $120,900 $99,917
3 $120,900 $90,834
4 $120,900 $82,576
5 $120,900 $75,069
6 $120,900 $68,245
7 $120,900 $62,041
8 $120,900 $56,401
9 $120,900 $51,273
10 $170,900 $65,889
NPV = $262,155
where the PV column is simply the cash flow for the period divided by (1.10)t,
or with the PV function:
= −500000 − PV(0.10, 10 − 1, 120900) + 170900/(1.10)^10  NPV = $262,155,

or with the NPV function:

= NPV(0.10, 120900, 120900, 120900, 120900, 120900, 120900, 120900, 120900, 120900,
1709000) − 500000  NPV = $262,155.
(Recall that the PV function in Excel reports results as negative numbers. The sign is reversed
with a minus sign before the PV function.)
12-15. a. The initial cash flow (t = 0) for the elliptical trainer project will be the cost to purchase the new
production equipment, $5,000,000, plus the incremental investment in inventory of $1,000,000.
b. The annual net cash flows for the project from t = 1 to t = 4 will be the revenues from the sales
of the new trainers, less the variable and fixed cash costs of production, less taxes, plus the
benefits of the depreciation tax shield. That is, using equation 12-3:
operating cash flow = net operating income − taxes + depreciation,
NOPAT
where net operating income = revenue − cost of goods sold − cash operating
expenses − depreciation.
For our project, revenues are (5000 units) ∗ ($1000/unit) = $5 million. The cost of goods sold
is the variable cost per unit, $500, times the number of units: (5000 units) ∗ ($500/unit) = $2.5
million. We will assume that the cash operating expenses are the fixed costs of $1 million
(which we assume do not include depreciation). To find depreciation, we use the straight-line
method: ( depreciable basis-salvage value
#years of depreciable life
) = $1 million. Thus, we find:
net operating income = $5 mil. − $2.5 mil. − $1 mil. − $1 mil.

= $500,000.
Operating cash flow is therefore:
operating cash flow = [$500,000 ∗ (1 − 0.34)] + $1 mil. = $1.33 mil.
revenues $5,000,000 $5,000,000
less: cost of goods sold ($2,500,000) ($2,500,000) (VC/unit)*(# of units sold)
gross profit $2,500,000 $2,500,000
less: cash operating expenses ($1,000,000) ($1,000,000) fixed costs (which we assume exclude depreciation)
less: depreciation ($1,000,000) ($1,000,000) depreciation = ($5M - $0)/(5)
net operating income $500,000 $500,000
less: taxes ($170,000) ($170,000)
plus: depreciation $1,000,000 $1,000,000
operating cash flow $1,330,000 $1,330,000
less: capital expenditures (capex) ($5,000,000)

less: additional net operating working capital ($1,000,000) $1,000,000 WC is recovered at end of project (t=5).
free cash flow ($6,000,000) $1,330,000 $2,330,000
This will be our project’s cash flow amount for years 1 through 4.
c. In year 5, we will add to this amount our recovery of the $1 million working capital
investment, for a total t = 5 cash flow of $2.33 million. The spreadsheet below outlines all of
these cash flow calculations.
d. To find the project’s NPV, we use equation 11-1:
CF1 CF2 CFn
NPV= CF0 + + + ... + ,
(1 + k ) (1 + k )
1 2
(1 + k )n

where our required return, k, is 10%. Substituting for our project’s values, we have:
$1,330,000 $1,330,000 $2,330,000
NPV =
−$6,000,000 + 1
+ 2
+ ... + =
−$337,332.
(1.10) (1.10) (1.10)5
Since the NPV is less than zero, the project should be rejected.
We can easily calculate NPV in Excel. We show various ways below:
10%
t CFt PV(CFt)
0 ($6,000,000) ($6,000,000)
1 $1,330,000 $1,209,091
2 $1,330,000 $1,099,174
3 $1,330,000 $999,249
4 $1,330,000 $908,408
5 $2,330,000 $1,446,747
NPV = ($337,332)
= −6000000 − PV(0.10 5 − 1, 1330000) + 2330000/(1.10)^5  NPV = −$337,332,
= NPV(0.10, 1330000, 1330000, 1330000, 1330000, 2330000) – 6000000 
NPV = −$337,332.
12-16. The spreadsheet below outlines these calculations.
0 1 2 3 4
Units 2% 125,000 127,500 130,050 132,651
Price 3% £ 5.00 £ 5.15 £ 5.30 £ 5.46
Revenue £ 625,000 £ 656,625 £ 689,850 £ 724,757

Costs 3% (£475,000) (£489,250) (£503,928) (£519,045)
Alterations (£400,000)
Research (£60,000)
Maintenance (£15,000) (£15,000) (£15,000) (£15,000)
Inspection (£50,000)
CASHFLOWS (£460,000) £135,000 £152,375 £120,923 £190,711
Payback (£460,000) (£325,000) (£172,625) (£51,702) PAYBACK

3.27 years
NPV 6% (£460,000) £127,358 £135,613 £101,529 £151,061

NPV £55,562

12-17. Discount rate adjusted to 10%.

0 1 2 3 4
Units 2% 125,000 127,500 130,050 132,651
Price 3% £ 5.00 £ 5.15 £ 5.30 £ 5.46
Revenue £ 625,000 £ 656,625 £ 689,850 £ 724,757

Costs 3% (£475,000) (£489,250) (£503,928) (£519,045)
Research (£60,000)
Maintenance (£15,000) (£15,000) (£15,000) (£15,000)
CASHFLOWS (£460,000) £135,000 £152,375 £120,923 £190,711
Payback (£460,000) (£325,000) (£172,625) (£51,702) PAYBACK

3.27 years
NPV 10% (£460,000) £122,727 £125,930 £90,851 £130,258

NPV £9,766
Payback is slightly beyond the expected 3 years, but the project still delivers a
positive NPV and therefore adds value (even at a 10% cost of funds). An argument
against undertaking the project would be the potential straight-line uncertainty of
the various growth factors in the projections. Of course, this could work either
way—positive or negative.
a. A unit growth rate of 5% will deliver the required NPV in excess of £100,000.
0 1 2 3 4
Units 5% 125,000 131,250 137,813 144,703
Price 3% £ 5.00 £ 5.15 £ 5.30 £ 5.46
Revenue £ 625,000 £ 675,938 £ 731,026 £ 790,605

Costs 3% (£475,000) (£489,250) (£503,928) (£519,045)
Research (£60,000)
Maintenance (£15,000) (£15,000) (£15,000) (£15,000)
CASHFLOWS (£460,000) £135,000 £171,688 £162,099 £256,560
Payback (£460,000) (£325,000) (£153,313) £8,786 PAYBACK

2.97 years
NPV 10% (£460,000) £122,727 £141,890 £121,787 £175,234

NPV £101,639

b. If the £60,000 was treated as sunk funds and therefore removed from the calculation, the unit
growth would only need to be 3% to achieve the £100,000 target NPV.
Units 3% 125,000 128,750 132,613 136,591

Price 3% £ 5.00 £ 5.15 £ 5.30 £ 5.46
Revenue £ 625,000 £ 663,063 £ 703,443 £ 746,283

Costs 3% (£475,000) (£489,250) (£503,928) (£519,045)
Research
Maintenance (£15,000) (£15,000) (£15,000) (£15,000)
CASHFLOWS (£400,000) £135,000 £158,813 £134,516 £212,237
Payback (£400,000) (£265,000) (£106,188) £28,328 PAYBACK

2.87 years
NPV 10% (£400,000) £122,727 £131,250 £101,063 £144,961

NPV £100,002
12-18. a. To find the NPV of the production machine for Weir’s Trucking, we first must find the
project’s relevant cash flows. For t = 0, the initial cash flow is the cost of the machine,
$100,000, plus the cost of the installation, $5000, plus the cost of the required training session,
$5000, plus the cost of the required increment to working capital, $25,000 (the increase in
inventory). Thus the initial cash outflow is $135,000.
b. The annual cash flows for years 1 through 9 can be found as:
operating cash flow = net operating income (EBIT) − taxes + depreciation.
NOPAT
We were told that the increase in net operating income (or EBIT) is $25,000. Thus net
operating profit after taxes (NOPAT) is [EBIT ∗ (1 − T)] = [$25,000 ∗ (1 − 0.34)] = $16,500.
To find depreciation, we note that the depreciable basis for the new machine is the initial cost
of $100,000, plus the installation costs of $5000, plus the cost of the training session, $5000.
We therefore find the annual depreciation expense as ($100,000 + $5,000
10
+ $5,000 − $0)
= $11,000. Adding
this to our NOPAT value gives us an operating cash flow amount of $27,500.
What about the $80,000 loan? We ignore it. As shown in equation 12-3 and clarified in the
associated discussion, we do not account for interest expense when we determine the cash
flows from a project. It’s not that those interest payments don’t exist; it’s that we account for
them in our required rate of return term, which we use when we discount the cash flows back
to the present. If we accounted for the interest in both the numerator and the denominator of
the present value terms, we’d be counting it twice. Thus at this stage—finding the cash
flows—we assume that the project is all equity-financed. (Another point: The project’s
acceptance should not rise or fall based on its financing. We should be willing to accept the
project if it were all equity-financed. 1)
c. Finally, our terminal cash flow (t = 10) will be the NOPAT value of $27,500 plus the working
capital recovery of $25,000, for a total of $52,500.
1
There are exceptions to this rule. In higher-level courses, the concept of adjusted present value (APV) is introduced; this
approach does consider financing cash flows. It is used when the project’s financing is an integral part of the project—for
example, when government grants a business special incentives to undertake a project.

We can illustrate these calculations using the spreadsheet below:

EBIT $25,000 $25,000
less: taxes ($8,500) ($8,500)
plus: depreciation $11,000 $11,000 Depreciation equals the depreciable basis (cost + installation + training) less salvage, all divided by 10.

free cash flow ($135,000) $27,500 $52,500
d. Now that we have the relevant cash flows, we can determine the NPV for the production
machine as:
12%
t CFt PV(CFt)
0 ($135,000) ($135,000)
1 $27,500 $24,554
2 $27,500 $21,923
3 $27,500 $19,574
4 $27,500 $17,477
5 $27,500 $15,604
6 $27,500 $13,932
7 $27,500 $12,440
8 $27,500 $11,107
9 $27,500 $9,917
10 $52,500 $16,904
NPV = $28,430
= −135000 − PV(0.12, 10 − 1, 27500) + 52500/(1.12)10  NPV = $28,430,
= NPV(0.12, 27500, 27500, 27500, 27500, 27500, 27500, 27500, 27500, 27500, 52500)
−135000  NPV = $28,430.
Since the NPV of this project is positive, Weir Trucking should buy the production machine.
12-19. a. To find the NPV of the chemical analysis machine for Chung Chemical Corporation, we first
must find the project’s relevant cash flows. For t = 0, the initial cash flow is the cost of the
machine, $100,000, plus the cost of the installation, $5000, plus the cost of the required
increment to working capital, $5000 (the increase in inventory). Thus the initial cash outflow
is $110,000.
NOPAT

of $100,000 plus the installation costs of $5000. We therefore find the annual depreciation
expense as ($100,000 +10$5,000 −$0) = $10,500. Adding this to our NOPAT value gives us an operating
cash flow amount of $33,600.
c. Finally, our terminal cash flow (t = 10) will be the NOPAT value of $33,600 plus the
working capital recovery of $5000, for a total of $38,600.
EBIT $35,000 $35,000
less: taxes ($11,900) ($11,900)
plus: depreciation $10,500 $10,500 Depreciation equals the depreciable basis (cost + installation) less salvage, all divided by 10.

free cash flow ($110,000) $33,600 $38,600
d. Now that we have the relevant cash flows, we can determine the NPV for the chemical
analysis machine as:
15%
t CFt PV(CFt)
0 ($110,000) ($110,000)
1 $33,600 $29,217
2 $33,600 $25,406
3 $33,600 $22,093
4 $33,600 $19,211
5 $33,600 $16,705
6 $33,600 $14,526
7 $33,600 $12,631
8 $33,600 $10,984
9 $33,600 $9,551
10 $38,600 $9,541
NPV = $59,867
= −110000 − PV(0.15, 10 − 1, 33600) + 38600/(1.15)^10  NPV = $59,867,
= NPV(0.15, 33600, 33600, 33600, 33600, 33600, 33600, 33600, 33600, 33600, 38600)
−110000  NPV = $59,867.
Since the NPV of this project is positive, Chung Chemical Corporation should purchase the
chemical analysis machine.
12-20. a. To find the NPV of the production machine for Raymobile Motors, we first must find the
project’s relevant cash flows. For t = 0, the initial cash flow is the cost of the machine,
$500,000, plus the cost of the installation, $5000, plus the cost of the required training session,
$25,000, plus the required increment to working capital, $30,000 (the increase in inventory).
Thus the initial cash outflow is $560,000.

NOPAT
of $500,000, plus the installation cost of $5000 plus the training costs of $25,000. We
therefore find the annual depreciation expense as ($500,000 + $5,000
10
+ $25,000 − $0)
= $53,000. Adding this
to our NOPAT value gives us an operating cash flow amount of $152,000.
c. Finally, our terminal cash flow (t = 10) will be the NOPAT value of $152,000 plus the
working capital recovery of $30,000, for a total of $182,000.
EBIT $150,000 $150,000
less: taxes ($51,000) ($51,000)
plus: depreciation $53,000 $53,000 Depreciation equals the depreciable basis (cost + installation) less salvage, all divided by 10.

free cash flow ($560,000) $152,000 $182,000
d. Now that we have the relevant cash flows, we can determine the NPV for the production machine as:
15%
t CFt PV(CFt)
0 ($560,000) ($560,000)
1 $152,000 $132,174
2 $152,000 $114,934
3 $152,000 $99,942
4 $152,000 $86,906
5 $152,000 $75,571
6 $152,000 $65,714
7 $152,000 $57,142
8 $152,000 $49,689
9 $152,000 $43,208
10 $182,000 $44,988
NPV = $210,268
= −560000 − PV(0.15, 10 − 1, 152000) + 182000/(1.15)^10  NPV = $210,268,
= NPV(0.15, 152000, 152000, 152000, 152000, 152000, 152000, 152000,
152000, 152000, 182000) − 560000  NPV = $210,268.
Since the NPV of this project is positive, Raymobile Motors should purchase the production
machine.

12-21. a. To find the NPV of the production machine for Garcia’s Truckin’, Inc., we first must find the
project’s relevant cash flows. For t = 0, the initial cash flow is the cost of the machine, $200,000,
plus the cost of the installation, $5000, plus the cost of the required training session, $5000, plus
the required increment to working capital, $20,000 (the increase in inventory). Thus the initial
cash outflow is $230,000.
What about the $100,000 loan? We ignore it. As shown in equation 12-3 and clarified in the
associated discussion, we do not account for interest expenses when we determine the cash
flows from a project. It’s not that those interest payments don’t exist; it’s that we account for
them in our required rate of return term, which we use when we discount the cash flows back
to the present.
If we accounted for the interest in both the numerator and the denominator of the present value
terms, we’d be counting it twice. Thus, at this stage—finding the cash flows—we assume that
the project is all equity-financed. (Another point: The project’s acceptance should not rise or
fall based on its financing. We should be willing to accept the project if it were all equity-
financed. 2)
NOPAT
of $200,000, plus the installation costs of $5000, plus the training costs of $5000. We
therefore find the annual depreciation expense as ($200,000 + $5,000
10
+ $5,000 − $0)
= $21,000. Adding this
to our NOPAT value gives us an operating cash flow amount of $54,000.
c. Finally, our terminal cash flow (t = 10) will be the NOPAT value of $54,000 plus the working
capital recovery of $20,000, for a total of $74,000.
EBIT $50,000 $50,000
less: taxes ($17,000) ($17,000)
plus: depreciation $21,000 $21,000 Depreciation equals the depreciable basis (cost + installation + training) less salvage, all divided by 10.

free cash flow ($230,000) $54,000 $74,000
d. Now that we have the relevant cash flows, we can determine the NPV for the production
machine as:
2
There are exceptions to this rule. In higher-level courses, the concept of adjusted present value (APV) is introduced; this
approach does consider financing cash flows. It is used when the project’s financing is an integral part of the project—for
example, when government grants a business special incentives to undertake a project.

10%
t CFt PV(CFt)
0 ($230,000) ($230,000)
1 $54,000 $49,091
2 $54,000 $44,628
3 $54,000 $40,571
4 $54,000 $36,883
5 $54,000 $33,530
6 $54,000 $30,482
7 $54,000 $27,711
8 $54,000 $25,191
9 $54,000 $22,901
10 $74,000 $28,530
NPV = $109,517
= −230000 − PV(0.10, 10 − 1, 54000) + 74000/(1.10)^10  NPV = $109,517,
= NPV(0.10, 54000, 54000, 54000, 54000, 54000, 54000, 54000, 54000, 54000, 74000)
– 230000  NPV = $109,517.
Since the NPV of this project is positive, Garcia’s Truckin’ should purchase the production
machine.
12-22. Traid Winds Corporation is considering a project. Some of the details of this project are as follows:
depreciable & useful life of project (years) 5

cost of new plant and equipment $26,800,000
shipping and installation costs $200,000
variable cost/unit $200
annual fixed costs $950,000
depreciation method straight-line
salvage value $0
initial increment to net working capital $200,000
marginal tax rate 34%
required rate of return 15%
We are also told that the unit sales will vary over time, as will the sales price. The working capital
investment will initially be $200,000, but then will equal 10% of sales for years 1 through 4. We are
to find the project’s NPV, IRR, and profitability index (PI).
The calculations are shown on the next page. Note the following:

• Total working capital investment is shown at the top of each year’s column. However, only
the change in WC is included as a cash flow in any year. So, for example, in year 3 the WC
total is $3.6 million, but in year 4 it is $2.4 million. Thus we have reduced the investment in
WC by ($3.6 million − $2.4 million) = $1.2 million in year 4. This reduction is included as a
cash inflow for year 4.
• We have assumed that the annual fixed costs that were given ($950,000) do not include
depreciation (which makes sense, since depreciation is $5,400,000/year!).
• We find the depreciation deduction for each year as the depreciable basis, less the salvage
value, all divided by the number of years of depreciable life. Thus for this project, we
have ($26,800,000 +5$200,000 −$0) = $5, 400,000/year. (Note that the shipping and installation costs are
part of the depreciable basis.)

total working capital

investment at time t $200,000 $1,950,000 $3,750,000 $3,600,000 $2,400,000
notes/assum
t=0 t=1 t=2 t=3 t=4 t=5 ptions
unit sales 65,000 125,000 120,000 80,000 70,000 A
price/unit $300 $300 $300 $300 $250 B
revenues $19,500,000 $37,500,000 $36,000,000 $24,000,000 $17,500,000 C = A*B
less: variable costs ($13,000,000) ($25,000,000) ($24,000,000) ($16,000,000) ($14,000,000) D = B*($140)
We assume these costs
do not include
less: fixed cash costs ($950,000) ($950,000) ($950,000) ($950,000) ($950,000) depreciation.
less: depreciation ($5,400,000) ($5,400,000) ($5,400,000) ($5,400,000) ($5,400,000)
net operating
income (NOI) $150,000 $6,150,000 $5,650,000 $1,650,000 ($2,850,000)
less: taxes ($51,000) ($2,091,000) ($1,921,000) ($561,000) $969,000
net operating profit
after taxes (NOPAT) $99,000 $4,059,000 $3,729,000 $1,089,000 ($1,881,000)
Depreciation equals the
depreciable basis (cost +
installation + shipping) less
plus: depreciation $5,400,000 $5,400,000 $5,400,000 $5,400,000 $5,400,000 salvage, all divided by 5.
operating cash flow $5,499,000 $9,459,000 $9,129,000 $6,489,000 $3,519,000
less: capital
expenditures (capex) ($27,000,000)
WC equals 10% of sales. Incremental
less: additional net operating investments in WC included in CF.
working capital ($200,000) ($1,750,000) ($1,800,000) $150,000 $1,200,000 $2,400,000 All recoved at t=5.
free cash flow ($27,200,000) $3,749,000 $7,659,000 $9,279,000 $7,689,000 $5,919,000
required return = 15%
309
To find this project’s NPV, we will discount the cash flows given above by the required rate of
return for the project, 15%:
15%
t CFt PV(CFt)
0 ($27,200,000) ($27,200,000)
1 $3,749,000 $3,260,000
2 $7,659,000 $5,791,304
3 $9,279,000 $6,101,093
4 $7,689,000 $4,396,211
5 $5,919,000 $2,942,789
NPV = ($4,708,603)
or:
= NPV(0.15, 3749000, 7659000, 9279000, 7689000, 5919000) − 27200000 
NPV = −$4,708,603.
Given the negative NPV, we would reject this project.
If we wanted to find the project’s IRR, we would search for the discount rate that would equate the
PV of the cash flows we found above to $0, as shown in equation 11-4:
$3,749,000 $7,659,000 $9, 279,000
$0 =
−$27, 200,000 + + + +
(1 + IRR)1 (1 + IRR)2 (1 + IRR)3
$7,689,000 $5,919,000
+ .
(1 + IRR)4 (1 + IRR)5
We know that this IRR must be less than 15%, since the project has a negative NPV at 15%.
To find the actual value, we can use Excel’s IRR function:
= IRR(−27200000, 3749000, 7659000, 9279000, 7689000, 5919000)  IRR = 7.846%.
Thus, as long as the firm’s required rate of return is greater than 7.846% (as it is), it would reject
this project.
We can verify the IRR by seeing what happens when we discount the cash flows at 7.846%:
15% 7.85%
t CFt PV(CFt) PV(CFt)
0 ($27,200,000) ($27,200,000) ($27,200,000)
1 $3,749,000 $3,260,000 $3,476,246
2 $7,659,000 $5,791,304 $6,585,099
3 $9,279,000 $6,101,093 $7,397,527
4 $7,689,000 $4,396,211 $5,683,951
5 $5,919,000 $2,942,789 $4,057,177
NPV = ($4,708,603) $0

The last column shows this discounting, and verifies that the sum of the discounted cash flows is
$0 in this case.
Finally, if we wanted to find the profitability index (PI), we use equation 11-3:
PV(future cash flows) $22, 491,397
=PI = = 0.827.
initial cash outlay $27, 200,000
Since this is less than 1, the project is not acceptable.
Note that all three of these measures told us to reject the project. That’s not surprising: All three
measures are based on exactly the same idea—taking (the same) relevant cash flows and discounting
them. The capital budgeting measures that get us into trouble are those that ignore cash flows,
calculate them incorrectly, and/or don’t discount them.
12-23. The Carson Dsitribution Corporation is considering a project. Some of the details of this project
are as follows:

salvage value $0
investment will initially be $100,000, but then will equal 10% of sales for years 1 through 4. We
are to find the project’s NPV, IRR, and profitability index (PI).
• Total working capital investment is shown at the top of each year’s column. However, only the
change in WC is included as a cash flow in any year. So, for example, in year 3 the WC total is
$3,920,000, but in year 4 it is $1,960,000. Thus we have reduced the investment in WC by
($3,920,000 − $1,960,000) = $1,960,000 in year 4. This reduction is included as a cash inflow
for year 4.
depreciation (which makes sense, since depreciation is $2 million/year!).
have ($9,900,000 + $100,000
5
− $0))
= $2 million/year. (Note that the shipping and installation costs are


15%
t CFt PV(CFt)
0 ($10,100,000) ($10,100,000)
1 $5,090,000 $4,426,087
2 $8,882,000 $6,716,068
3 $12,298,000 $8,086,135
4 $8,910,000 $5,094,321
5 $4,026,000 $2,001,634
NPV = $16,224,245
or:
= NPV(0.15, 5090000, 8882000, 12298000, 8910000, 4026000) − 10100000
 NPV = $16,224,245.
Given the positive NPV, we would accept this project.
$5,090,000 $8,882,000 $12,298,000
$0 =
−$10,100,000 + + + +
(1 + IRR ) (1 + IRR ) (1 + IRR )
1 2 3
$8,910,000 $4,026,000
+ .
(1 + IRR ) (1 + IRR )
4 5
We know that this IRR must be greater than 15%, since the project has a positive NPV at 15%. To
find the actual value, we can use Excel’s IRR function:
= IRR( − 10100000, 5090000, 8882000, 12298000, 8910000, 4026000)  IRR = 68.66%.
Thus as long as the firm’s required rate of return is less than 68.66% (as it is), it would accept this
project.
15% 68.66%
0 ($10,100,000) ($10,100,000) ($10,100,000)
1 $5,090,000 $4,426,087 $3,017,947
2 $8,882,000 $6,716,068 $3,122,472
3 $12,298,000 $8,086,135 $2,563,399
4 $8,910,000 $5,094,321 $1,101,167
5 $4,026,000 $2,001,634 $295,014
NPV = $16,224,245 ($0)

The last column shows this discounting and verifies that the sum of the discounted cash flows is
$0 in this case.
PV(future cash flows) $26,324,245
=PI = = 2.61.
initial cash outlay $10,100,000
Since this is greater than 1, the project is acceptable.
Note that all three of these measures told us to accept the project. That’s not surprising: All three
12-24. The Shome Corporation is considering a project. Some of the details of this project are as follows:

salvage value $0
investment will initially be $100,000, but then will equal 10% of sales for years 1 through 4. We
change in WC is included as a cash flow in any year. So, for example, in year 3 the WC total is
$3,000,000, but in year 4 it is $1,750,000. Thus we have reduced the investment in WC by
($3,000,000 − $1,750,000) = $1,250,000 in year 4. This reduction is included as a cash inflow
for year 4.
depreciation (which makes sense, since depreciation is $1.4 million/year!).
have ($6,900,000 +5$100,000 −$0) = $1, 400,000 million/year. (Note that the shipping and installation
costs are part of the depreciable basis.)

15%
t CFt PV(CFt)
0 ($7,100,000) ($7,100,000)
1 $4,714,000 $4,099,130
2 $7,698,000 $5,820,794
3 $9,282,000 $6,103,066
4 $7,072,000 $4,043,439
5 $5,262,000 $2,616,144
NPV = $15,582,573
where the PV column is simply the cash flow for the period divided by (1.15)t, or:
= NPV(0.15, 4714000, 7698000, 9282000, 7072000, 5262000) − 7100000 
NPV = $15,582,573.
$4,714,000 $7,698,000 $9, 282,000
$0 =
−$7,100,000 + + +
(1 + IRR)1 (1 + IRR)2 (1 + IRR)3
$7,072,000 $5, 262,000
+ + .
(1 + IRR)4 (1 + IRR)5
We know that this IRR must be greater than 15%, since the project has a positive NPV at 15%. To
find the actual value, we can use Excel’s IRR function:
= IRR( − 7100000, 4714000, 7698000, 9282000, 7072000, 5262000)  IRR = 85.12%.
project.
15% 85.12%
0 ($7,100,000) ($7,100,000) ($7,100,000)
1 $4,714,000 $4,099,130 $2,546,436
2 $7,698,000 $5,820,794 $2,246,282
3 $9,282,000 $6,103,066 $1,463,090
4 $7,072,000 $4,043,439 $602,164
5 $5,262,000 $2,616,144 $242,029
NPV = $15,582,573 ($0)

PV(future cash flows) $22,682,573
PI = = = 3.2
12-25. McNabb Fabrications, Inc. is considering a project. Some of the details of this project are as
follows:

shipping and installation costs $2,000,000
annual fixed costs $10,000,000
salvage value $0
initial increment to net working capital $2,000,000
investment will initially be $2,000,000, but then will equal 10% of sales for years 1 through 4. We
change in WC is included as a cash flow in any year. So, for example, in year 3 the WC total
is $144 million, but in year 4 it is $96 million. Thus we have reduced the investment in WC by
($144 million − $96 million) = $48 million in year 4. This reduction is included as a cash
inflow for year 4.
• We have assumed that the annual fixed costs that were given ($10 million) do not include
depreciation (which makes sense, since depreciation is $40 million/year!).
have ($198,000,000 +5$2,000,000 −$0) = $40 million/year. (Note that the shipping and installation costs are


15%
t CFt PV(CFt)
0 ($202,000,000) ($202,000,000)
1 $193,000,000 $167,826,087
2 $418,200,000 $316,219,282
3 $482,200,000 $317,054,327
4 $371,800,000 $212,577,857
5 $195,400,000 $97,148,334
NPV = $908,825,887
or:
= NPV(0.15, 193000000, 418200000, 482200000, 371800000, 195400000) − 202000000
 NPV = $908,825,887.
$193,000,000 $418,200,000 $482,200,000
$0 = −$202,000,000 + + + +
(1 + IRR)1 (1 + IRR)2 (1 + IRR)3
$371,800,000 $195,400,000
+ .
(1 + IRR)4 (1 + IRR)5
We know that this IRR must be greater than 15%, since the project has a positive NPV at 15%.
To find the actual value, we can use Excel’s IRR function:
= IRR(-202000000, 193000000, 418200000, 482200000, 371800000, 195400000)
 IRR = 139.73%.
project.
15% 139.73%
0 ($202,000,000) ($202,000,000) ($202,000,000)
1 $193,000,000 $167,826,087 $80,507,416
2 $418,200,000 $316,219,282 $72,768,125
3 $482,200,000 $317,054,327 $34,999,589
4 $371,800,000 $212,577,857 $11,257,027
5 $195,400,000 $97,148,334 $2,467,843
NPV = $908,825,887 $0
The last column shows this discounting and verifies that the sum of the discounted cash flows is
$0 in this case.

PV(future cash flows) $1,110,825,887
=PI = = 5.50.
12-26.
Current price 1.12
Projected price in 5 years
Inflation 3% 1.30 1.12 x (1+0.03)5
5% 1.43 1.12 x (1+0.05)5
8% 1.65 1.12 x (1+0.08)5
12-27.
5 years ago 20,000
Today 25,000
Increase 5,000
Rate of inflation 4.5640% (((25,000/20,000)0.2)-1)
Today 25,000
2 years time 27,334 (25,000 x (1.0564)2)
The expected price in 2 years’ time would be £27,334.
12-28. Carlyle Chemicals is considering a new chemical compound. However, it expects that the price
per unit for the product it creates will not be able to rise quickly enough to compensate for the
inflation in the raw materials costs. Specifically, price rises by only 2%/year, while costs rise by
10%/year. Does this disparity threaten Carlyle’s profitability?
Given the unit sales of 5, 7, and 9 million units for the next three years, we have:
inflation rate t=0 t=1 t=2 t=3 notes
# of units sold 5,000,000 7,000,000 9,000,000 A
2% price/unit $1.00 $1.02 $1.04 $1.06 B (grows by factor of 1.02/year)
revenues $5,100,000 $7,282,800 $9,550,872 C = A*B
10% VC/unit $0.80 $0.88 $0.97 $1.06 D (grows by factor of 1.10/year)
total variable costs ($4,400,000) ($6,776,000) ($9,583,200) E = A*D
gross profit $700,000 $506,800 ($32,328) F=C-E

(Note that we have assumed that the “current” price of the product means the t = 0 price of
$1.00/unit, and that the “current” cost of $0.80/unit is also at t = 0.)
This project is a problem: The fast growth of costs overwhelms the slowly growing revenue,
turning gross profit negative in year 3. This will get progressively worse if allowed to continue, as
shown below (where we have assumed that unit sales continue to rise by 2,000,000 units/year):
$17,000,000
$15,000,000
$13,000,000
$11,000,000
$9,000,000
revenues
$7,000,000
variable costs
gross profit
$5,000,000
$3,000,000
$1,000,000
1 2 3 4 5
($1,000,000)
($3,000,000)
year
Carlyle needs to decrease the rate of growth in costs (probably outside its control), increase the
rate of growth in price (probably more under its control, but dependent on the price elasticity of
demand), or move on to another project.
12-29. If Carlyle were able to lock in the price of its raw material today at $0.90/unit, it would make their
project’s gross profit positive, as shown below:
inflation rate t=0 t=1 t=2 t=3 notes
# of units sold 5,000,000 7,000,000 9,000,000 A
2% price/unit $1.00 $1.02 $1.04 $1.06 B (grows by factor of 1.02/year)
revenues $5,100,000 $7,282,800 $9,550,872 C = A*B
0% VC/unit $0.90 $0.90 $0.90 $0.90 D (fixed at $0.90)
total variable costs ($4,500,000) ($6,300,000) ($8,100,000) E = A*D
gross profit $600,000 $982,800 $1,450,872 F=C-E
In this case, the 2% rate of growth in price, combined with the increases in the number of units,
translates into 64% growth in gross profit between t = 1 and t = 2, then a 48% growth between t = 2
and t = 3. However, the t = 1 gross profit is lower, since the firm pays $0.90 for its inventory that
year, instead of $0.88.
In addition, all of the raw material costs must be paid at t = 0. For 21,000,000 units, this means an
initial cash outflow of $18.9 million (an increase in inventory is an increase in working capital
investment). It is possible that this acceleration of costs could make the NPV of the prepaid plan
lower than that of the initial plan.

12-30. When analyzing a replacement opportunity, we are concerned with two types of cash flows: those
from the new machine that we would gain by going ahead, and those from the old machine that we
would lose by going ahead. Thus the incremental cash flows for a replacement project are always
of the form (new − old):
incremental cash flow = new cash flow − old cash flow.
We have been using equation 12-3 to find operating cash flow as:
operating cash flow = net operating income − taxes + depreciation;
NOPAT
for a replacement project, we just clarify that we are considering changes (∆) in cash flow:
∆ operating cash flow = ∆ net operating income − ∆ taxes + ∆ depreciation,
∆NOPAT
where:
∆ net operating income = ∆ revenue − ∆ cash operating expenses − ∆ depreciation.
a. For Madrano Fruit Company’s tractor replacement project, we have:
∆ revenue = new revenue − old revenue = $0,
since this project has no direct impact on revenue. Instead, it has an effect on operating costs:
∆ cash operating expenses = new expenses − old expenses
= [new $150,000 fuel costs + new $12,000
maintenance costs] − [old $200,000 fuel costs +
old $35,000 maintenance costs]
= $162,000 − $235,000 = −$73,000/year.
Thus purchasing the new tractors lowers Madrano’s cash operating costs by $73,000/year,
which makes the firm more likely to go ahead.
To complete our consideration of the elements of net operating income, we turn to depreciation.
The old tractors are fully depreciated, so they will have no depreciation deductions (and the
resultant tax shields) to offer over the 5-year project life. However, the new tractors will:
They are being depreciated over a 5-year life, cost $400,000, and are being depreciated
toward a $40,000 salvage value. Their annual depreciation deduction is therefore
($400,000 − $40,000)
5
= $72,000. We will therefore have a ∆ depreciation value of:
∆ depreciation = new depreciation − old depreciation

= $72,000 − $0 = $72,000.
We can now find the change in net operating income as:
= $0 − (−$73,000) − $72,000 = $1000.

The decrease in operating costs causes NOI to rise, while the increase in depreciation causes it
to fall. The net effect is an increase in NOI of $1000/year.
Now we can find the change in operating cash flow from the replacement project:
∆NOPAT
= $1,000 − ∆ taxes + $72,000
= $1,000 ∗ (1 − T) + $72,000
= $1,000 ∗ (1 − 0.30) + $72,000 = $72,700.
Thus Madrano will realize an increase in after-tax cash flow of $72,700 from the purchase of
the new tractors.
b. There are two other cash flow types to consider: those that are specific to t = 0 (the initial cash
flows) and any special cash flows at the end of the project (the terminal cash flows, here at t = 5).
At t = 0, Madrano will need to pay $400,000 for the new tractors. It will also sell the old tractors
for $20,000; since these old rigs are fully depreciated, the full $20,000 sales price represents a
taxable gain, so Madrano will need to pay [($20,000) ∗ (30%)] = $6000 tax on the sale. The
net after-tax amount received for the old rigs is therefore ($20,000 - $6000) = $14,000. Since
there are no working capital effects from the new rigs, the total initial cash flow is therefore
(−$400,000 + $14,000) = −$386,000.
c. There will also be a special terminal cash flow at t = 5: when Madrano sells the “new” rigs for
$40,000. In this case, however, the sales price equals the book value, so there will be no tax
effect. We will therefore add the full $40,000 to the change in operating cash flow for year 5.
We can now visualize Madrano’s project opportunity like this:
−$386,000 $72,700 $72,700 $72,700 $72,700 $112,700
| | | | | |
0 1 2 3 4 5
∆ operating cash flow
− cost of new + sales price of “new”

+ sales price of old
− tax due on sale of old

d. The details for the cash flow calculations are shown in the spreadsheet on the next page. The
chart below outlines the NPV calculations, using Madrano’s cost of capital at 15%. It also
shows the IRR and PI calculations. Given the negative NPV, Madrano should reject this
replacement opportunity. It is better off keeping the old tractor rigs.
15% 1.40%
0 ($386,000) ($386,000) ($386,000)
1 $72,700 $63,217 $71,694
2 $72,700 $54,972 $70,703
3 $72,700 $47,801 $69,725
4 $72,700 $41,566 $68,760
5 $112,700 $56,032 $105,118
NPV = ($122,411) ($0)
at WACC at IRR
summary of capital budgeting measures:

NPV ($122,411) REJECT
IRR 1.40% REJECT
PI 0.68 REJECT


12-31. When analyzing a replacement opportunity, we are concerned with two types of cash flows: Those
from the new machine that we would gain by going ahead, and those from the old machine that we
would lose by going ahead. Thus the incremental cash flows for a replacement project are always
of the form (new − old):
operating cash flow = net operating income – taxes + depreciation;
NOPAT
∆ NOPAT
where:
a. For Minot Kit Aircraft Company’s tractor replacement project, we have:
∆ cash operating expenses = new expenses − old expenses
= new lower labor costs − old higher labor costs
= −$100,000.
We weren’t given the old and new details; we were just told that the increment was
$100,000 lower costs. Thus, purchasing the new cutter lowers Minot’s cash operating costs
by $100,000/year, which makes the firm more likely to go ahead.
The old cutter is not fully depreciated. It currently (at t = 0) has a book value of $80,000, and
is being depreciated at $20,000/year for the next 4 years (obviously down to a zero salvage
value). If the company goes ahead with the new cutter, it will lose these valuable depreciation
deductions (tax shields). However, they will get in return the deductions on the new cutter.
This is being depreciated over a 4-year life, cost $400,000, and are being depreciated toward a
$40,000 salvage value. Its annual depreciation deduction is therefore ($400,0004−$40,000) = $90,000.
We will therefore have a ∆ depreciation value of:
= $90,000 − $20,000 = $70,000.
= $0 − (−$100,000) − $70,000 = $30,000.

The decrease in operating costs causes NOI to rise, while the increase in depreciation causes it
to fall. The net effect is an increase in NOI of $30,000/year.
∆NOPAT
= $30,000 − ∆taxes + $70,000

= $30,000 ∗ (1 − T) + $70,000
= $30,000 ∗ (1 − 0.30) + $70,000 = $91,000.
Thus Minot will realize an increase in after-tax cash flow of $91,000 from the purchase of the
new cutter.
At t = 0, Minot will need to pay $400,000 for the new cutter. It will also sell the old cutter for
$80,000 (the current book value of the old cutter); since the salvage value and book values are
the same, there will be no tax consequence from this sale. The net after-tax amount received
for the old cutter is therefore $80,000 − $0 = $80,000. Since there are no working capital
effects from the new cutter, the total initial cash flow is therefore (−$400,000 + $80,000) =
−$320,000.
There will also be a special terminal cash flow at t = 4: when Minot sells the “new” cutter.
Although this sale is not specifically mentioned in the problem, we have assumed that the firm
sells the cutter for $40,000, its book value; there is therefore no tax effect from this sale. We
will therefore add the full $40,000 to the change in operating cash flow for year 4.
We can now visualize Minot’s project opportunity like this:
−$320,000 $91,000 $91,000 $91,000 $131,000
| | | | |
0 1 2 3 4
−cost of new + sales price of “new”

+ sales price of old

c. The details for the cash flow calculations are shown in the spreadsheet on the next page. The
chart below outlines the NPV calculations, using Minot’s required rate of return at 15%. It also
shows the IRR and PI calculations. Given the negative NPV, Minot should reject this
replacement opportunity. It is better off keeping the old cutter.
15% 9.42%
0 ($320,000) ($320,000) ($320,000)
1 $91,000 $79,130 $83,164
2 $91,000 $68,809 $76,002
3 $91,000 $59,834 $69,457
4 $131,000 $74,900 $91,377
NPV = ($37,327) $0
at WACC at IRR

NPV ($37,327) REJECT
IRR 9.42% REJECT
PI 0.88 REJECT


12-32. We have assumed the following when working this problem:

• The salvage value of the new rigs is $40,000 each at t = 5. For 10 rigs, the total salvage value
is ($40,000/rig)*(10 rigs) = $400,000.
• The “new” rigs could be sold at book value at t = 5.
• We are told that the old rigs will be “fully depreciated” in 1 year. We will assume that they are
being depreciated toward a $0 salvage value, so that there is ($25,000/rig) ∗ (10 rigs) = $250,000
of depreciation left at t = 0. This amount is the opportunity cost of lost old depreciation, which
will be accounted for at t = 1.
• We assume that the maintenance costs of $150,000 and $400,000 for the new and old rigs,
respectively, equals the total maintenance for the fleet of ten, per year.
• We assume that the firm’s marginal tax rate is 30%.
• We assume that the firm would have had to pay tax on the sale of the old rigs as scrap at t = 5
if it kept the old rigs. Thus, they would only have realized $5000 ∗ (1 − 0.30) = $3500. By
buying the new fleet at t = 0, this opportunity to sell the old rigs as scrap at t = 5 is lost. This
will therefore be counted as an opportunity cost of the new fleet, making LL&CC less likely to
go ahead with the purchase.
When analyzing a replacement opportunity, we are concerned with two types of cash flows:
those from the new machine that we would gain by going ahead, and those from the old
machine that we would lose by going ahead. Thus the incremental cash flows for a
replacement project are always of the form (new − old):
operating cash flow = net operating income − taxes + depreciation;
NOPAT
∆ NOPAT
where:
a. For Louisiana Land and Cattle Company’s (LL&CC) tractor replacement project, we have:
∆ cash operating expenses = new expenses – old expenses
= [new $200,000 fuel costs + new $150,000 maintenance costs]
− [old $300,000 fuel costs + old $400,000 maintenance costs]
= $350,000 − $700,000 = −$350,000/year.
Thus, purchasing the new rigs lowers LL&CC’s cash operating costs by $350,000/year, which
makes the firm more likely to go ahead.

The old rigs are not fully depreciated. They currently (at t = 0) have a total book value of
($25,000/rig) ∗ (10 rigs) = $250,000, and they will be fully depreciated at the end of next year
(t = 1). Since we are assuming that they are being depreciated down to a zero salvage value
(see our assumptions above), their depreciation over the next year would have been $250,000.
If the company goes ahead with the new rigs, it will lose these valuable depreciation deductions
(tax shields). However, it will get in return the deductions on the new rigs. These are being
depreciated over a 5-year life, cost ($100,000/rig) ∗ (10 rigs) = $1 million, and are being
depreciated toward a $400,000 salvage value (aggregate). Their annual depreciation deduction
is therefore ($1,000,0005−$400,000) = $120,000. We will therefore have a ∆ depreciation value of:

= $120,000 − $250,000 = −$130,000
for year 1, and ($120,000− $0) = $120,000for years 2 through 5.
= $0 − (−$350,000) − (−$130,000) = $480,000
for year 1, and
= $0 − (−$350,000) − ($120,000) = $230,000
for years 2 through 5.
The decrease in operating costs causes NOI to rise, as does the initial decrease in depreciation,
while the increase in depreciation for the last 4 years causes it to fall. The net effect is an
increase in NOI of $480,000 for year 1, then $230,000/year for the remaining periods.
∆ operating cash flow 1 = ∆ net operating income − ∆ taxes + ∆ depreciation,
∆NOPAT
For year 1:
= $480,000− ∆ taxes + (−$130,000)
= [$480,000∗ (1 − T)] − $130,000
= [$480,000∗ (1 − 0.30)] − $130,000= $206,000.
For years 2-5:
∆ operating cash flow 2-5 = ∆ net operating income − ∆ taxes + ∆ depreciation,
∆NOPAT
= $230,000 − ∆ taxes + $120,000
= [$230,000∗ (1 − T)] + $120,000
= [$230,000∗ (1 − 0.30)] + $120,000= $281,000.
At t = 0, LL&CC will need to pay $1 million for the ten new rigs. It will also sell the old rigs
for $250,000 (which we assume equals the current book value of the old rigs); since the
salvage value and book values are the same, there will be no tax consequence from this sale.

The net after-tax amount received for the old rigs is therefore ($250,000 − $0) = $250,000.
Since there are no working capital effects from the new project, the total initial cash flow is
therefore (−$1 million + $250,000) = −$750,000.
There will also be several special terminal cash flows at t = 5. The first occurs when LL&CC
sells the “new” rigs. Although this sale is not specifically mentioned in the problem, we have
assumed that the firm sells the rigs for $40,000 each, their book value; there is therefore no tax
effect from this sale. We will therefore add the full $400,000 to the change in operating cash
flow for year 5.
As noted above, there will also be an opportunity cost at t = 5: LL&CC has lost the opportunity
to sell the original rigs for scrap at a pre-tax value of $5000. We therefore charge the new
project with an after-tax cost of $5000 ∗ (1 − 0.30) = $3500 at t = 5.
c. We can now visualize LL&CC’s project opportunity like this:
−$750,000 $206,000 $281,000 $281,000 $281,000 $677,500
| | | | | |
0 1 2 3 4 5
− cost of new + sales price of “new”

+ sales price of old − AT opportunity cost of scrap
d. The details for the cash flow calculations are shown in the spreadsheet on the next page. The
chart below outlines the NPV calculations, using LL&CC’s cost of capital at 15%. It also shows
the IRR and PI calculations. Given the positive NPV, LL&CC should accept this replacement
opportunity. It should update its fleet.
15% 29.03%
0 ($750,000) ($750,000) ($750,000)
1 $206,000 $179,130 $159,649
2 $281,000 $212,476 $168,774
3 $281,000 $184,762 $130,799
4 $281,000 $160,663 $101,368
5 $677,500 $336,837 $189,411
NPV = $323,869 $0
at WACC at IRR

NPV $323,869 ACCEPT
IRR 29.03% ACCEPT
PI 1.43 ACCEPT


SOLUTIONS TO APPENDIX 12A PROBLEMS

12A-1.
asset cost = $250,000
property class = 5 years
Depreciation Annual
Year Percentage Depreciation
1 20.0% $50,000
2 32.0% $80,000
3 19.2% $48,000
4 11.5% $28,750
5 11.5% $28,750
6 5.8% $14,500
100.0% $250,000
12A-2. a.
asset cost = $500,000
property class = 5 years
Depreciation Annual
Year Percentage Depreciation
1 14.3% $71,500
2 24.5% $122,500
3 17.5% $87,500
4 12.5% $62,500
5 8.9% $44,500
6 8.9% $44,500
7 8.9% $44,500
8 4.5% $22,500
100.0% $500,000
b. The modified accelerated cost recovery system (MACRS) assumes that personal
property such as machinery is placed in service (or disposed of) at the midpoint of the
taxable year. In effect, it assumes the asset is in service for 6 months during both the
first and last year. Real property, such as buildings, is treated as being placed in
service (or disposed of) in the middle of the month. Accordingly, a half-month of
depreciation is allowed for the month the property is placed in service and also for the
final month of service.

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Chapter 12

Analyzing Project Cash Flows

less: capital expenditures (capex) ($700,000)

free cash flow ($700,000) $208,600

Additional cashflow 31,200

12-5. The cash projection now delivers a reduction in cashflow of £24,150.

Additional cashflow 31,200 (24,150)

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Additional cashflow 61,620 6,660

12-6. The business needs to achieve a 10% sales growth.

Current 5% 10% 15%

Op margin 10% 300,000 290,000 305,000 320,000

Tax 20% 60,000 58,000 61,000 64,000

NOPAT 240,000 232,000 244,000 256,000

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Thus this new project will require an initial (t = 0) investment of $65,000.

free cash flow ($65,000) $532,500 $532,500 $597,500

Copyright © 2018 Pearson Education Ltd.

terminal cash flow (t = n)

free cash flow $31,000 $248,000 $248,000 $217,000

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Copyright © 2018 Pearson Education Ltd.

free cash flow ($7,000) $894,000 $894,000 $901,000

12-12. At 300,000 units, the cash flow is 11,700.

Revenue 3,000,000 Revenue 2,100,000 Revenue 3,900,000

Op profit 3% 90,000 Op profit 63,000 Op profit 117,000

Copyright © 2018 Pearson Education Ltd.

The spreadsheet below outlines these calculations.

Revenue 3,000,000 Revenue 3,000,000

Op profit 3% 90,000 Op profit 3.85% 115,500

net operating income 1 = $400,000− $80,000− $160,000 − $45,000

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t=0 t=1 through t=9 t=10 assumptions:

less: capital expenditures (capex) ($450,000)

free cash flow ($500,000) $120,900 $170,900

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or with the NPV function:

net operating income = $5 mil. − $2.5 mil. − $1 mil. − $1 mil.

less: capital expenditures (capex) ($5,000,000)

free cash flow ($6,000,000) $1,330,000 $2,330,000

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Revenue £ 625,000 £ 656,625 £ 689,850 £ 724,757

Payback (£460,000) (£325,000) (£172,625) (£51,702) PAYBACK

NPV 6% (£460,000) £127,358 £135,613 £101,529 £151,061

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12-17. Discount rate adjusted to 10%.

Revenue £ 625,000 £ 656,625 £ 689,850 £ 724,757

Payback (£460,000) (£325,000) (£172,625) (£51,702) PAYBACK

NPV 10% (£460,000) £122,727 £125,930 £90,851 £130,258

Revenue £ 625,000 £ 675,938 £ 731,026 £ 790,605

Payback (£460,000) (£325,000) (£153,313) £8,786 PAYBACK

NPV 10% (£460,000) £122,727 £141,890 £121,787 £175,234

Copyright © 2018 Pearson Education Ltd.

Units 3% 125,000 128,750 132,613 136,591

Revenue £ 625,000 £ 663,063 £ 703,443 £ 746,283

Payback (£400,000) (£265,000) (£106,188) £28,328 PAYBACK

NPV 10% (£400,000) £122,727 £131,250 £101,063 £144,961

Copyright © 2018 Pearson Education Ltd.