1. Your company is deciding whether to invest in a new machine.

The new machine will

increase cash flow by $475,000 per year. You believe the technology used in the
machine has a 10-year life; in other words, no matter when you purchase the machine, it
will be obsolete 10 years from today. The machine is currently priced at $2,900,000. The
cost of the machine will decline by $210,000 per year until it reaches $2,270,000, where
it will remain. If you’re required return is 9 percent, should you purchase the machine? If
so, when should you purchase it?

Solution:

If we buy the machine today, the NPV is the cost plus the present value of the increased
cash flows,so:
NPV 0=– $ 2,900,000+ $ 475,000( PVIFA 9 % ,10)
NPV 0=$ 148,387.41
We mustn't essentially purchase the machine today. we would need to buy the
machine once the NPV is the highest. So, we'd like to calculate the NPV every year. The
NPV every year are going to be the cost plus the present value of the increased cash
savings. we should be careful, however. In order to create the proper decision, the NPV
for every year should be taken to a common date. we'll discount all of the NPVs to today.
Doing so, we get:
Year 1 :
NPV 1 =[ – $ 2,690,000+ $ 475,000( PVIFA 9 %,9 )]/1.12
NPV 1 =$ 148,387.14
Year 2 :
2
NPV 2 =[ – $ 2,480,000+ $ 475,000(PVIFA 9 % , 8) ]/1.12
NPV 2 =$ 125,443.21
Year 3 :
3
NPV 3 =[ – $ 2,270,000+ $ 475,000( PVIFA 9 % ,7)]/1.12
NPV 3 =$ 93,165.94
Year 4 :
4
NPV 4=[– $ 2,270,000+ $ 475,000( PVIFA 9 % , 6)]/1.12
NPV 4=– $ 98,604.76
Year 5 :
NPV 5 =[ – $ 2,270,000+ $ 475,000( PVIFA 9 % ,5)]/1.125
NPV 5 =– $ 274,541.19
Year 6 :
NPV 6 =[ – $ 2,270,000+ $ 475,000 ( PVIFA 9 % , 4)]/1.126
NPV 6 =– $ 435,950.75

2. Consider a four-year project with the following information: Initial fixed asset investment
= $480,000; straight-line depreciation to zero over the four-year life; zero salvage value;
price = $37; variable costs = $23; fixed costs = $195,000; quantity sold = 90,000 units;
tax rate = 34 percent. How sensitive is Operating Cash Flow to changes in quantity sold?
 Solution:
Using the tax shield approach, the OCF at 90,000 units will be:
OCF=[ ( P – v ) Q−FC ](1 – t C )+ t C ( D)
OCF=[( $ 37 – 23)(90,000) – 195,000](0.66)+0.34 ( $ 480,000 / 4)
OCF=$ 743,700
We can calculate the OCF at 91,000 units. the choice of the second level of
quantity sold is arbitrary and irrelevant. regardless of what level of units sold we decide
we will still get constant sensitivity. So, the OCF at this level of sales is:
OCF=[( $ 37 – 23)(91,000) – 195,000](0.66)+0.34 ( $ 480,000 / 4)
OCF=$ 752,940

The sensitivity of the OCF to changes in the quantity sold is:

Sensitivity=OCF /Q=( $ 743,700 – 752,940)/(90,000 – 91,000)
OCF /Q=+ $ 9.24
OCF will increase by $9.24 for every additional unit sold.

3. A firm is considering an investment in a new machine with a price of $18 million to

replace its existing machine. The current machine has a book value of $6 million and a
market value of $4.5 million. The new machine is expected to have a four-year life, and
the old machine has four years left in which it can be used. If the firm replaces the old
machine with the new machine, it expects to save $6.7 million in operating costs each
year over the next four years. Both machines will have no salvage value in four years. If
the firm purchases the new machine, it will also need an investment of $250,000 in net
working capital. The required return on the investment is 10 percent, and the tax rate is
39 percent. What are the NPV and IRR of the decision to replace the old machine?

4. Allied Products, Inc., is considering a new product launch. The firm expects to have an
annual operating cash flow of $10.5 million for the next 10 years. Allied Products uses a
discount rate of 13 percent for new product launches. The initial investment is $51
million. Assume that the project has no salvage value at the end of its economic life.
a. What is the NPV of the new product?
b. After the first year, the project can be dismantled and sold for $31 million. If the
estimates of remaining cash flows are revised based on the first years’ experience,
at what level of expected cash flows does it make sense to abandon the project?
What is the NPV of the new product?

NPV =– $ 51,000,000+ $ 10,500,000(PVIFA(13 % ,10) )

NPV =$ 5,975,556.50

After the first year, the project can be dismantled and sold for $31 million. If the
estimates of remaining cash flows are revised based on the first years’ experience, at
what level of expected cash flows does it make sense to abandon the project?
 The company should abandon the project if the PV of the revised cash flows for
ensuing 9 years is a smaller amount than the project’s aftertax salvage value. Since the
choice to abandon the project happens in Year 1, discount the revised cash flows to
Year 1 as well. to see the level of expected cash flows below which the company ought
to abandon the project, calculate the equivalent annual cash flows the project should
earn to equal the aftertax salvage value. we are going to solve for C2, the revised cash
flow starting in Year 2. So, the revised annual cash flow below that it is sensible to
abandon the project is:

Aftertax salvage value=C2 ( PVIFA (13% ,9) )

$ 31,000,000=C 2 (PVIFA(13 % ,9 ))

C 2=$ 31,000,000/PVIFA (13 % ,9)

C 2=$ 6,040,935.96
5. We are evaluating a project that costs $644,000, has an eight-year life, and has no
salvage value. Assume that depreciation is straight-line to zero over the life of the
project. Sales are projected at 70,000 units per year. Price per unit is $37, variable cost
per unit is $21, and fixed costs are $725,000 per year. The tax rate is 35 percent, and
we require a 15 percent return on this project.
a. Calculate the accounting break-even point.
b. Calculate the base-case cash flow and NPV. What is the sensitivity of NPV to
changes in the sales figure? Explain what your answer tells you about a 500-unit
decrease in projected sales.
c. What is the sensitivity of OCF to changes in the variable cost figure? Explain what
your answer tells you about a $1 decrease in estimated variable costs.
d. Suppose the projections given for price, quantity, variable costs, and fixed costs are
all accurate to within ±10 percent. Calculate the best-case and worst-case NPV
figures.
Solution:
a. Calculate the accounting break-even point.

To calculate the accounting breakeven, we first need to find the depreciation for each
year. The depreciation is:
Depreciation=$ 644,000/8
Depreciation=$ 80,500 per year
And the accounting breakeven is:

QA=($ 725,000+80,500)/( $ 37 – 21)

QA=50,344 units
 b. Calculate the base-case cash flow and NPV. What is the sensitivity of NPV to
changes in the sales figure? Explain what your answer tells you about a 500-unit
decrease in projected sales.

Using the tax shield approach, we now calculate the OCF. The OCF is:

OCF base=[(P – v ) Q – FC ](1 – t c )+t c D

OCF base=[($ 37 – 21)(70,000) – $ 725,000]( 0.65)+0.35 ($ 80,500)

OCF base=$ 284,925

We can now solve for the NPV using our base-case projections. There is no salvage
value or NWC, so the NPV is:

NPV base=– $ 644,000+ $ 284,925(PVIFA 15 % ,8 )

NPV base=$ 634,550.08

To calculate the sensitivity of the NPV to changes in the quantity sold, we will calculate
the NPV at a different quantity. We will use sales of 71,000 units. The OCF at this sales level is:

OC Fnew =[($ 37 – 21)(71,000)– $ 725,000 ](0.65)+0.35($ 80,500)

OC Fnew =$ 295,325
And the NPV is

NPV new =– $ 644,000+ $ 295,325(PVIFA 15 %,8 )

NPV new =$ 681,218.22

So, the change in NPV for every unit change in sales is:

NPV /S=( $ 634,550.08 – 681,218.22)/(70,000 – 71,000)

NPV /S=+$ 46.668
If sales were to drop by 500 units, then NPV would drop by:

NPV drop=$ 46.668 (500 )=$ 23,334.07

You may wonder why we chose 71,000 units. Because it doesn’t matter! Whatever sales
number we use, when we calculate the change in NPV per unit sold, the ratio will be the same.

c. What is the sensitivity of OCF to changes in the variable cost figure? Explain what
your answer tells you about a $1 decrease in estimated variable costs.
 To find out how sensitive OCF is to a change in variable costs, we will compute the OCF
at a variable cost of $22. Again, the number we choose to use here is irrelevant: We will get the
same ratio of OCF to a one dollar change in variable cost no matter what variable cost we use.
So, using the tax shield approach, the OCF at a variable cost of $22 is:

OCF new=[($ 37 – 22)(70,000) – 725,000](0.65)+ 0.35( $ 80,500)

OCF new=$ 239,425

So, the change in OCF for a $1 change in variable costs is:

OCF /v =($ 284,925 – 239,425)/($ 21 – 22)

OCF /v =– $ 45,500
If variable costs decrease by $1 then, OCF would increase by $45,500

d. Suppose the projections given for price, quantity, variable costs, and fixed costs are
all accurate to within ±10 percent. Calculate the best-case and worst-case NPV
figures.

We will use the tax shield approach to calculate the OCF for the best- and worst-case
scenarios. For the best-case scenario, the price and quantity increase by 10 percent, so we will
multiply the base case numbers by 1.1, a 10 percent increase. The variable and fixed costs both
decrease by 10 percent, so we will multiply the base case numbers by .9, a 10 percent
decrease. Doing so, we get:

OCF best ={[( $ 37)(1.1)– ($ 21)(0.9)](70,000)(1.1) – $ 725,000(0.9)}( 0.65)+0.35 ($ 80,500)

OCF best =$ 695,140
The best-case NPV is:

NPV best =– $ 644,000+ $ 695,140(PVIFA 15 % , 8)

NPV best =$ 2,475,316.67
For the worst-case scenario, the price and quantity decrease by 10 percent, so we will
multiply the base case numbers by .9, a 10 percent decrease. The variable and fixed costs both
increase by 10 percent, so we will multiply the base case numbers by 1.1, a 10 percent
increase. Doing so, we get:

OCF worst ={[( $ 37)(0.9) – ($ 21)(1.1)](70,000)(0.9) – $ 725,000(1.1) }( 0.65)+0.35 ($ 80,500)

OCF worst =– $ 72,510

The worst-case NPV is:

 NPV worst =– $ 644,000 – $ 72,510(PVIFA 15 % , 8)
NPV worst =– $ 969,375.68

6. (30%) McGilla Golf has decided to sell a new line of golf clubs. The clubs will sell for
$875 per set and have a variable cost of $430 per set. The company has spent
$150,000 for a marketing study that determined the company will sell 60,000 sets per
year for seven years. The marketing study also determined that the company will lose
sales of 12,000 sets of its high-priced clubs. The high-priced clubs sell at $1,100 and
have variable costs of $620. The company will also increase sales of its cheap clubs by
15,000 sets. The cheap clubs sell for $400 and have variable costs of $210 per set. The
fixed costs each year will be $9,300,000. The company has also spent $1,000,000 on
research and development for the new clubs. The plant and equipment required will cost
$29,400,000 and will be depreciated on a straight-line basis. The new clubs will also
require an Department of Chemical Engineering College of Engineering Bicol University
Legazpi Cityincrease in net working capital of $1,400,000 that will be returned at the end
of the project. The tax rate is 40 percent, and the cost of capital is 14 percent.

a. Calculate the payback period, the NPV, and the IRR.

b. You feel that the values are accurate to within only ±10 percent. What are the best-
case and worstcase NPVs? ( Hint: The price and variable costs for the two existing
sets of clubs are known with certainty; only the sales gained or lost are uncertain.)
c. McGilla Golf would like to know the sensitivity of NPV to changes in the price of the
new clubs and the quantity of new clubs sold. What is the sensitivity of the NPV to
each of these variables?
Solution:
a. Calculate the payback period, the NPV, and the IRR.
Both the marketing report and the R&D project are sunk costs that can be ignored. First,
we'll figure out the revenue and variable costs. We must account for erosion because we will
lose sales of the expensive clubs while gaining sales of the cheap clubs. The current project's
net revenue will be:

Sales

New Clubs $875  60,000 = $52,500,000

Exp. Clubs $1,100  (–12,000) = –13,200,000

Cheap Clubs $400  15,000 = 6,000,000

$45,300,000

We must include the units earned or lost from existing clubs in the variable costs. It's
worth noting that the expensive clubs' variable costs are an inflow. We will save these variable
costs if we stop making the sets, which is an inflow. As a result:

Variable Cost
 New Clubs -$ 430×60,000 =$ 25,800,000

Exp. Clubs -$ 620×(12,000) = 7,440,000

Cheap Clubs -$ 210×15,000 = -3,150,000

-$ 21,150,000

Sales $ 45,600,000

Variable Costs 21,510,000

Fixed Costs 9,300,000

Depreciation 4,200,000

EBT $10,290,000

Taxes 4,116,000

Net income $6,174,000

Using the bottom up OCF calculation, we get:

Using the bottom up OCF calculation, we get:
OCF=¿+ Depreciation=¿ $ 6,174,000+ 4,200,000
OCF=$ 10,374,000
So, the payback period is:
Payback period=2+ $ 10,052,000/$ 10,374,000
Payback period=2.969 years
The NPV is:
1,400,000
NPV =−$ 29,400,000−1,400,000+ $ 10,374,000 ( PVIF A 14 % , 7 ) +
1.147
NPV =$ 14,246,366.65
And the IRR is:

IRR=– $ 29,400,000 – 1,400,000+ $ 10,374,000(PVIFA IRR % ,7 )+ $ 1,400,000 /(1+ IRR)7

IRR=27.89 %
 b. You feel that the values are accurate to within only ±10 percent. What are the best-
case and worstcase NPVs? ( Hint: The price and variable costs for the two existing
sets of clubs are known with certainty; only the sales gained or lost are uncertain.)

Base case Best Case Worst Case

Unit sales(new) 60,000 66,000 54,000

Price (new) $ 875 $ 963 $ 788

VC (new) $ 430 $ 387 $ 473

Fixed costs $ 9,300,000 $ 8,370,000 $ 10,230,000

Sales lost 12,000 10,800 13,200

(expensive)

Sales gained 15,000 16,500 13,500

(cheap)

Best-case
First, we'll figure out the revenue and variable costs. We must account for erosion
because we will lose sales of the expensive clubs while gaining sales of the cheap clubs. The
current project's net revenue will be:

Sales

New Clubs $ 963  66,000 = $63,525,000

Exp. Clubs $1,100  (–10,800) = – 11,880,000

Cheap Clubs $400  16,500 = 6,600,000

$58,245,000

We must include the units earned or lost from existing clubs in the variable costs. It's
worth noting that the expensive clubs' variable costs are an inflow. We will save these variable
costs if we stop making the sets, which is an inflow. As a result:

Variable Costs

New Clubs –$387  66,000 = –$25,542,000

Exp. Clubs –$620  (–10,800) = 6,696,000

 Cheap Clubs –$210  16,500 = –3,465,000

–$22,311,000

Sales $58,245,000

Variable Costs 22,311,000

Fixed Costs 8,370,000

Depreciation 4,200,000

EBT $23,364,000

Taxes 9,345,600

Net income $14,018,400

OCF=Net income+ Depreciation=$ 14,018,400+ 4,200,000

OCF=$ 18,218,400
And the best-case NPV is:

NPV =– $ 29,400,000 – 1,400,000+ $ 18,218,400( PVIFA 14 %,7 )+1,400,000/1.147

NPV =$ 47,885,545.13

Worst-case
We will calculate the sales and variable costs first. Since we will lose sales of the
expensive clubs and gain sales of the cheap clubs, these must be accounted for as erosion.
The total sales for the new project will be:

Sales

New Clubs $788  54,000 = $42,525,000

Exp. Clubs $1,100  (– 13,200) = – 14,520,000

Cheap Clubs $400  13,500 = 5,400,000

$33,405,000
 For the variable costs, we must include the units gained or lost from the existing clubs.
Note that the variable costs of the expensive clubs are an inflow. If we are not producing the
sets any more, we will save these variable costs, which is an inflow. So:

Variable Costs

New Clubs –$473  54,000 = –$25,542,000

Exp. Clubs –$620  (– 13,200) = 8,184,000

Cheap Clubs –$210  13,500 = –2,835,000

–$20,193,000

Sales $33,405,000

Variable Costs 20,193,000

Fixed Costs 10,230,000

Depreciation 4,200,000

EBT –$1,218,000

Taxes –487,200 *assumes a tax credit

Net income –$730,800

Using the bottom up OCF calculation, we get:

OCF=¿+ Depreciation=– $ 730,800+4,200,000

NPV =– $ 15,363,520.60

c. McGilla Golf would like to know the sensitivity of NPV to changes in the price of the
new clubs and the quantity of new clubs sold. What is the sensitivity of the NPV to
each of these variables?

To calculate the sensitivity of the NPV to changes in the price of the new club, we simply
need to change the price of the new club. We will choose $880, but the choice is irrelevant as
the sensitivity will be the same no matter what price we choose.
 We will calculate the sales and variable costs first. Since we will lose sales of the
expensive clubs and gain sales of the cheap clubs, these must be accounted for as erosion.
The total sales for the new project will be:

Sales

New Clubs $880  60,000 = $52,800,000

Exp. Clubs $1,100  (– 12,000) = –13,200,000

Cheap Clubs $400  15,000 = 6,000,000

$45,600,000

For the variable costs, we must include the units gained or lost from the existing clubs.
Note that the variable costs of the expensive clubs are an inflow. If we are not producing the
sets any more, we will save these variable costs, which is an inflow. So:

Variable Costs

New Clubs –$430  60,000 = –$25,800,000

Exp. Clubs –$620  (–12,000) = 7,440,000

Cheap Clubs –$210  15,000 = –3,150,000

–$21,510,000

The pro forma income statement will be:

Sales $45,600,000

Variable Costs 21,510,000

Fixed Costs 9,300,000

Depreciation 4,200,000

EBT $10,590,000

Taxes 4,236,000

Net income $6,354,000

Using the bottom up OCF calculation, we get:

OCF=¿+ Depreciation=$ 6,354,000+ 4,200,000
 OCF=$ 10,554,000

And the NPV is:

1,400,000
NPV =−$ 29,400,000−1,400,000+ $ 10,554,000 ( PVIF A 14 % , 7 ) +
1.147
NPV =$ 15,018,261.52

So, the sensitivity of the NPV to changes in the price of the new club is:

∆ NPV /∆ P=($ 14,246,366.65−15,018,261.52)/($ 875−880)

∆ NPV /∆ P=$ 154,378.97

For every dollar increase (decrease) in the price of the clubs, the NPV increases
(decreases) by $154,378.97.

To calculate the sensitivity of the NPV to changes in the quantity sold of the new club,
we simply need to change the quantity sold. We will choose 65,000 units, but the choice is
irrelevant as the sensitivity will be the same no matter what quantity we choose.

We will calculate the sales and variable costs first. Since we will lose sales of the
expensive clubs and gain sales of the cheap clubs, these must be accounted for as erosion.
The total sales for the new project will be:

Sales

New Clubs $ 875  65,000 $ 56,875,000

Exp. Clubs $ 1,100  (– 12,000) –13,200,000

Cheap Clubs $ 400  15,000 6,000,000

$ 49,675,000

For the variable costs, we must include the units gained or lost from the existing clubs.
Note that the variable costs of the expensive clubs are an inflow. If we are not producing the
sets any more, we will save these variable costs, which is an inflow. So:

Variable Costs
 New Clubs –$390  65,000 = –$27,950,000

Exp. Clubs –$620  (–12,000) = 7,440,000

Cheap Clubs –$210  15,000 = –3,150,000

–$23,660,000

Sales $49,675,000

Variable Costs 23,660,000

Fixed Costs 9,300,000

Depreciation 4,200,000

EBT $12,515,000

Taxes 5,006,000

Net income $7,509,000

Using the bottom up OCF calculation, we get:

OCF=¿+ Depreciation=$ 7,509,000+ 4,200,000
OCF=$ 11,709,000
The NPV at this quantity is:

NPV =– $ 29,400,000 – $ 1,400,000+$ 11,709,000( PVIFA 14 % , 7)+ $ 1,400,000 /1.147

NPV =$ 19,971,253.61
So, the sensitivity of the NPV to changes in the quantity sold is:

NPV /Q=( $ 14,246,366.65 – 19,971,253.61)/(60,000 – 65,000)

NPV /Q=$ 1,144.98
For an increase (decrease) of one set of clubs sold per year, the NPV increases
(decreases) by $1,144.98.