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PFM15e IM CH11
PFM15e IM CH11
NOTE TO INSTRUCTORS: Shortly after the first press run for the 15th edition, Congress passed the Tax Cuts
and Jobs Act of 2017, which included changes in the corporate tax rate relevant to this chapter. In subsequent
printing runs, the text was updated to reflect the new tax law, but these updates may not appear in every student’s
copy of the text.
◼ Instructor Resources
Chapter Overview
This chapter expands upon capital-budgeting techniques presented in the previous chapter. Shareholder
wealth maximization relies upon selection of projects with positive net present values. The most important
and difficult aspect of the capital-budgeting process is developing good estimates of the relevant cash flows.
Chapter 11 focuses on the basics of determining relevant after-tax cash flows of a project, from the initial cash
outlay to annual cash stream of costs and benefits and terminal cash flow. It also describes the special
concerns facing capital budgeting for multinational companies. The text highlights the importance of capital
budgeting to the post-graduate professional and personal lives students.
In Excel, the RATE command will generate the answer with the following syntax:
=rate(number of periods,-payments, present value,0,1), where the “0” indicates there is no future value in the
problem (i.e., no payment at end of the annuity due), and the 1” indicates the payment is made at the
beginning rather than the end of the period.
=rate(15,-0.25,2.4,0,1) = 7.28%. Note: the annual tax savings is expressed as the fraction of $2.4.
11-2 The three components of cash flow for any project are (1) initial investment, (2) operating cash flows,
and (3) terminal cash flows. Expansion decisions are merely replacement decisions in which all cash
flows from the old asset are zero.
11-3 Sunk costs are costs that have already been incurred and cannot be recovered. They should be ignored
in project analysis because whether the firm invests or not, the sunk costs will not be recovered.
Opportunity costs are cash flows that could be realized from the next best alternative use of an asset.
Opportunity costs are a relevant cost. These cash flows could be realized if the decision is made not to
change the current asset structure but to utilize the owned asset for this alternative purpose.
11-4 To minimize long-term currency risk, companies can finance a foreign investment in local capital
markets so that the project’s revenues and costs are in the local currency rather than dollars.
Techniques such as currency futures, forwards, and options market instruments protect against short-
term currency risk. Financial and operating strategies that reduce political risk include structuring the
investment as a joint venture with a competent and well-connected local partner and using debt rather
than equity financing because debt service payments are legally enforceable claims while equity
returns such as dividends are not.
11-5 a. The cost of the new asset is the purchase price. (Outflow)
b. Installation costs are any added costs necessary to get an asset into operation. (Outflow)
c. Proceeds from sale of old asset are cash inflows resulting from the sale of an existing asset,
reduced by any removal costs. (Inflow)
d. Tax on sale of old asset is incurred when the replaced asset is sold due to recaptured
depreciation, capital gain, or capital loss. (May be an inflow or an outflow)
e. The change in net working capital is the difference between the change in current assets and the
change in current liabilities. (May be an inflow or an outflow)
11-7 The asset may be sold at a price (1) above book value, (2) equal to book value, or (3) below book
value. In the first case, taxes arise from the amount by which the sale price exceeded the book value.
In the second case, no taxes would be required. In the third case, a tax credit would occur.
11-8 The depreciable value of an asset is the cost of the asset plus any installation costs.
11-9 Depreciation is relevant because it reduces the firm’s tax liability even though it is not really a cash
outlay. In project cash flow calculations, subtract depreciation like any other expense, then calculate
after-tax income, then add depreciation back to obtain cash flow. Table 11.6 and Equation 4.3 (refer
to the text) are equivalent ways of expressing operating cash flows. The earnings before interest and
taxes in Table 11.6 is the same as the EBIT terminology in Equation 4.3. Both models then take out
taxes and add back in depreciation.
11-10 To calculate incremental operating cash inflow for both the existing situation and proposed project,
depreciation on assets is added back to after-tax profits to get cash flows associated with each
alternative. The difference between the cash flows of the proposed and present situation (incremental
after-tax cash flows), is the relevant measure for evaluating the proposed project.
11-11 The terminal cash flow is the cash flow resulting from termination and liquidation of a project at the
end of its economic life. The form of calculating terminal cash flows is shown below:
Terminal Cash Flow Calculation:
After-tax After-tax Change in Terminal
proceeds from – proceeds from net working = cash
sale of new asset sale of old asset capital flow
Extended Presentation:
Proceeds from Proceeds from Change in Terminal
sale of new asset sale of old asset net working cash
– =
Tax on sale of Tax on sale of capital flow
new asset old asset
11-12 The relevant cash flows necessary for a conventional capital-budgeting project are the incremental
after-tax cash flows attributable to the proposed project: the initial investment, net operating cash
inflows, and terminal cash flow. The initial investment is the initial outlay required, taking into
account cost of installing the new asset, proceeds from selling the old asset, taxes on sale of the old
asset, and any change in net working capital. Operating cash inflows are the additional cash flows
received as a result of implementing a proposal. Terminal cash flow represents the after-tax cash
flows expected from the liquidation of the project at the end of its life. These three components
represent the positive or negative cash flow impact if the firm implements the project, and are
depicted in the following diagram for a project lasting five years.
The most important safeguard is to recognize the problem. If, for example, the project under consideration for
renewal is the “CEO’s Baby,” she is not likely to approach the decision objectively. In such cases, it makes
sense whenever possible for the firm to rely on external analysis of project NPV. Moreover, this analysis
should be available to the board as well as the CEO. The larger point here is to look for ways to insure the
analysis supporting a renewal decision is made by parties outside the reporting chain of the executive
responsible for the initial commitment.
Having a communist government has a negative effect on foreign direct investment (FDI). As in all
investments abroad, FDI in China entails high travel and communications expenses. The differences of
political system and culture that exist between the country of the investor and the host country will also cause
problems with FDI in China. Due to its control of the economy, the communist party has more control over
employment, raw materials, and repatriation of revenues to a parent firm than found in non-communist
countries. There is also the chance that a company may lose ownership of its overseas operations to a Chinese
company. Hence, foreign firms often partner with Chinese firms in their development efforts, but this requires
coordination and raises the costs of FDI in China.
Answer: In this case, the tuition reimbursement should be categorized as a capital expenditure because the
outlay of funds is expected to produce benefits over a period of time greater than 1 year.
◼ Solutions to Problems
Note: The MACRS depreciation percentages used in the following problems appear in Chapter 4, Table 4.2.
Percentages are rounded to the nearest integer for ease in calculation. For simplification, five-year-lived
projects with five years of cash inflows are typically used throughout this chapter. Projects with usable lives
equal to the number of years of cash inflows are also included in the end-of-chapter problems. It is important
to recall from Chapter 4 that under the Tax Reform Act of 1986, MACRS depreciation results in n + 1 years
of depreciation for an n-year class asset. This means in actual practice projects will typically have at least one
year of cash flow beyond their recovery period.
This is a conventional cash flow pattern, where the cash inflows are of equal size, which is referred to as an
annuity.
b.
This is a conventional cash flow pattern, where the subsequent cash inflows vary, which is referred to as a
mixed stream.
c.
This is a nonconventional cash flow pattern, which has several cash flow series of equal size, which is
referred to as an embedded annuity.
b. An expansion project is simply a replacement decision in which all cash flows from the old asset
are zero.
P11-6 Personal finance: Sunk and opportunity cash flows (LG 2; Intermediate)
a. Sunk costs or cash outlays are expenditures made in the past that have no effect on the cash
flows relevant to a current situation. The cash outlays made before Hans decided to rent out his
apartment would be classified as sunk costs. An opportunity cost or cash flow is one that can be
realized from an alternative use of an existing asset. Here, Hans has decided to rent out his
apartment, and all the costs associated with getting the apartment in “rentable” condition would
be relevant.
b.
Sunk costs (cash flows): Opportunity costs (cash flows):
Replace coffee machine Rental income
Replace washing machine Real estate agency advertising
Miscellaneous repairs and maintenance Apartment painting cost
Sale Price Capital Gain Tax on Capital Depreciation Tax on Total Tax
Gain Recovery Recovery
$120,000 $ 24,000 $ 7,200 $ 66,240 $ 19,872 $ 27,072
$ 56,000 –$ 3,760 –$ 1,128 –$ 1,128
$231,200 $135,200 $ 40,560 $ 66,240 $ 19,872 $ 60,432
$ 21,000 –$ 8,760 –$ 2,628 –$ 2,628
*
Tax Calculations:
a. Gain on sale of existing asset = CHf 400,000 − CHf 300,000 = CHf 100,000
Tax on capital gain = CHf 100,000 × (0.24) = CHf 24,000
b. 0 tax liability
c. Loss on sale of existing asset = CHf 200,000 − CHf 300,000 = CHf 100,000
Tax benefit = (CHf 100,000) × (0.24) = CHf 24,000
d. Loss on sale of existing asset = CHf 100,000 − CHf 300,000 = CHf 200,000
Tax benefit = (CHf 200,000) × (0.24) = CHf 48,000
With a 21% tax rate, the lower half of the table would be:
Year Calculation of Yearly Depreciation Book Value
Year 1 (5,000,000 – 1,000,000) 0.4 = 1,600,000 3,400,000
Year 2 (3,400,000 – 1,000,000) 0.4 = 960,000 2,440,000
Year 3 (2,440,000 – 1,000,000) 0.4 = 576,000 1,864,000
Year 4 (1,864,000 – 1,000,000) 0.4 = 345,600 1,518,400
Year 5 (1,518,000 – 1,000,000) 0.4 = 207,360 1,311,040
Old
Equipment
1–5 $350,000 $250,000 $100,000 0 $100,000 $24,000 $76,000 $76,000
c.
Old cruise
Revenues: (000) 32,000 32,000 32,000 32,000 32,000 32,000 32,000 32,000 32,000 32,000
Expenses: (000) 2,600 2,600 2,600 2,600 2,600 2,600 2,600 2,600 2,600 2,600
Profit before
depreciation and taxes:
(000) 29,400 29,400 29,400 29,400 29,400 29,400 29,400 29,400 29,400 29,400
Depreciation: (000) 25,000 25,000 25,000 25,000 25,000
Net profits before taxes
(000) 4,400 4,400 4,400 4,400 4,400 29,400 29,400 29,400 29,400 29,400
Taxes (000) 1,056 1,056 1,056 1,056 1,056 7,056 7,056 7,056 7,056 7,056
Net profits after taxes
(000) 3,344 3,344 3,344 3,344 3,344 22,344 22,344 22,344 22,344 22,344
Net operating cash
flows (000) 28,344 28,344 28,344 28,344 28,344 22,344 22,344 22,344 22,344 22,344
P11-21 Terminal cash flows: Various lives and sale prices (LG 6; Challenge)
a.
After-tax proceeds from sale of new asset = 3-Year* 5-Year* 7-Year*
Proceeds from sale of proposed asset $10,000 $10,000 $10,000
Tax on sale of proposed asset* +16,880 −400 −4,000
Total after-tax proceeds—new $26,880 $9,600 $ 6,000
+ Change in net working capital +30,000 +30,000 +30,000
Terminal cash flow $56,880 $39,600 $36,000
*
1. Book value of asset = [1− (0.20 + 0.32 + 0.19)] $180,000 = $52,200
Proceeds from sale = $10,000. So, $10,000 − $52,200= ($42,200) loss
$42,200 (0.40) = $16,880 tax benefit
2. Book value of asset = [1 − (0.20 + 0.32 + 0.19 + 0.12 + 0.12)] $180,000 = $9,000
$10,000 − $9,000 = $1,000 recaptured depreciation. So $1,000 (0.40) = $400 tax liability
3. Book value of asset = $0
$10,000 − $0 = $10,000 recaptured depreciation. So $10,000 (0.40)= $4,000 tax liability
b. If the usable life is less than the normal recovery period, the asset has not been depreciated fully
and a tax benefit may be taken on the loss; therefore, the terminal cash flow is higher.
c.
(1) (2)
After-tax proceeds from sale of new asset =
Proceeds from sale of new asset $ 9,000 $170,000
+ Tax on sale of proposed asset* 0 (64,400)
+ Change in net working capital +30,000 +30,000
Terminal cash flow $39,000 $135,600
1. Book value of the asset = $180,000 0.05 = $9,000; no taxes are due
d. The higher the sale price, the higher the terminal cash flow.
Net profit before taxes 1,325 1,325 1,325 1,200 1,275 1,575
Less: Taxes 24% 318 318 318 288 306 378
Net profit after taxes 1,007 1,007 1,007 912 969 1,197
+ Depreciation 1,000 1,000 1,000 1,000 1,000 1,000
Operating cash flows 2,007 2,007 2,007 1,912 1,969 2,197
New Machine
Revenue - Operating Expenses $ 30,000 $ 30,000 $ 30,000 $ 30,000 $ 30,000 $ -
Less: Depreciation $ (16,000) $ (25,600) $ (15,200) $ (9,600) $ (9,600) $ (4,000)
Net Profit Before Taxes $ 14,000 $ 4,400 $ 14,800 $ 20,400 $ 20,400 $ (4,000)
Less: Taxes (40%) $ (5,600) $ (1,760) $ (5,920) $ (8,160) $ (8,160) $ 1,600
Net Profit After Taxes $ 8,400 $ 2,640 $ 8,880 $ 12,240 $ 12,240 $ (2,400)
Add: Depreciation $ 16,000 $ 25,600 $ 15,200 $ 9,600 $ 9,600 $ 4,000
Operating Cash Flow (New) $ 24,400 $ 28,240 $ 24,080 $ 21,840 $ 21,840 $ 1,600
Incremental Cash Flow
(New - Old) = $ 13,600 $ 16,240 $ 11,080 $ 11,040 $ 13,440 $ 1,600
0 1 2 3 4 5 6
New Machine
Revenue - Operating Expenses $ 30,000 $ 30,000 $ 30,000 $ 30,000 $ 30,000 $ -
Less: Depreciation $ (16,000) $ (25,600) $ (15,200) $ (9,600) $ (9,600) $ (4,000)
Net Profit Before Taxes $ 14,000 $ 4,400 $ 14,800 $ 20,400 $ 20,400 $ (4,000)
Less: Taxes (21%) $ (2,940) $ (924) $ (3,108) $ (4,284) $ (4,284) $ 840
Net Profit After Taxes $ 11,060 $ 3,476 $ 11,692 $ 16,116 $ 16,116 $ (3,160)
Add: Depreciation $ 16,000 $ 25,600 $ 15,200 $ 9,600 $ 9,600 $ 4,000
Operating Cash Flow (New) $ 27,060 $ 29,076 $ 26,892 $ 25,716 $ 25,716 $ 840
Incremental Cash Flow
(New - Old) = $ 14,740 $ 15,176 $ 10,567 $ 11,496 $ 14,656 $ 840
0 1 2 3 4 5 6
b.
Calculation of Operating Cash Flows
Profits before Operating
Depreciation Net Profits Net Profits Cash
Year and Taxes Depreciation before Taxes Taxes after Taxes flows
New Line
1 €450,000 €270,000 €180,000 €43,200 €136,800 €406,800
2 450,000 270,000 180,000 43,200 136,800 406,800
3 450,000 270,000 180,000 43,200 136,800 406,800
4 450,000 270,000 180,000 43,200 136,800 406,800
5 450,000 270,000 180,000 43,200 136,800 406,800
Existing Line
1 €280,000 €50,000 €230,000 €55,200 €174,800 €224,800
2 250,000 50,000 200,000 48,000 152,000 202,000
3 200,000 50,000 150,000 36,000 114,000 164,000
4 180,000 0 180,000 43,200 136,800 136,800
5 150,000 0 150,000 36,000 114,000 114,000
Terminal cash flow 358,000 (1,330,000.00) 182,000.00 204,800.00 242,800.00 270,000.00 650,800.00
P11-26 Personal finance: Determining relevant cash flows for a new boat (LG 3, 4, 5, 6; Challenge)
[Note: The print book question will be corrected at reprints to read as follows. Answer has been solved
accordingly.
Determining net cash flows for a new car Antonio and his wife Alessia are considering the purchase of a
new car, which they can pay over 3 years after an initial down payment of 25% of the price of the car, and
have decided that estimating its cash flows will help them in their decision process. They expect to have a
disposable annual income of €18,000. Their cash flows estimates for the car purchase are as follows:
Negotiated price of the new car €52,000
Sales tax rate (VAT rate applicable to purchase price) 20.0%
Car trade-in €0
Estimated value of new car in 4 years €12,000
Estimated monthly repair and maintenance €200
Estimated monthly parking fee €100
------
e. The ownership of a car is virtually just an annual outflow of money. Across the four years,
€68,400 will be spent in excess of the anticipated sales price in year 4. Over the same period,
Antonio and Alessia's disposable income is €72,000. Consequently, the annual cost exceeds the
expected annual disposable income for years 1 to 3. Noting that the proceeds from the sale of the
new car will come in first at the end of year 4, Antonio and Alessia will have to increase their
disposable income in order to accommodate car ownership. If a loan is needed, the monthly
interest payment would be another burden. However, there is no attempt here to measure
satisfaction of ownership
[Note: Correction to print question - Also, suppose that the alternative rubber extrusion line is amortized for
5years based on straight-line amortization, by 20% each year.]
a.
Initial Investment
Installed cost of new asset
Cost of new asset €800,000
+ Installation costs ……....0
Total proceeds, sale of new asset €800,000
− After-tax proceeds from sale of old asset
Proceeds from sale of old asset (150,000)
+ Tax on sale of old asset * ……....0
Total proceeds, sale of old asset (150,000)
+ Change in working capital 500,000
Initial investment €1,150,000
*
Book value of old asset: €400,000 ÷ 8 × 3 = €150,000. So, €150,000 − €150,000 = €0 gain on sale of asset.
Hence, total tax on sale of asset is €0.
b.
Calculation of Operating Cash Flows
Profits before Net Profits Net Profits Operating
Depreciation Depre- before after Cash
Year and Taxes ciation Taxes Taxes Taxes Inflows
Alternative line
1 €250,000 €160,000 €90,000 €21,600 €68,400 €228,400
2 250,000 160,000 90,000 21,600 68,400 228,400
3 250,000 160,000 90,000 21,600 68,400 228,400
4 250,000 160,000 90,000 21,600 68,400 228,400
5 250,000 160,000 90,000 21,600 68,400 228,400
Existing line
1 €280,000 €50,000 €230,000 €55,200 €174,800 224,800
2 250,000 50,000 200,000 48,000 152,000 202,000
3 200,000 50,000 150,000 36,000 114,000 164,000
4 180,000 180,000 43,200 136,800 136,800
5 150,000 150,000 36,000 114,000 114,000
d. 0 1 2 3 4 5
b. Cash Flows:
Cash flows
(250,000,000.00) 64,330,000.00 64,330,000.00 64,330,000.00 64,330,000.00 64,330,000.00 64,330,000.00 64,330,000.00 64,330,000.00 64,330,000.00 64,330,000.00
0 1 2 3 4 5 6 7 8 9 10
To find IRR in Excel with the IRR command, begin by arranging the cash outflow and inflows in
adjacent cells in a row or column. If, for example, the outflow appears in A1 and the inflows in
B1:G1, the proper syntax is: =IRR(A1:G1) = 35.04%.
e. The NPV is $959,289, and IRR of 35.04% is well above the cost of capital of 11%, so the project
should be accepted.
b. CF0 = −$1,110,400, CF1 = 257,200, CF2 = $344,400, CF3 = $274,200, CF4 = $258,800, and
CF5 = $274,800 + 172,000 = $446,800
In Excel, arrange CF1 through CF5 in adjacent cells in a row or column and use NPV command
to find present value of those cash flows. If, for example, the cash flows appear in cells A2:A6,
proper syntax is: =NPV(0.09:A2:A6) = $1,211,300.39. Now, subtract the upfront outflow to
obtain project NPV:
NPV = $1,211,300.39 – −$1,110,400 = $100,900.39.
$257,200 $344,400 $274,200 $258,800 $446,800
c. $0 = + + + + − $1,110,400
(1 + IRR)1 (1 + IRR)2 (1 + IRR)3 (1 + IRR)4 (1 + IRR)5
To use the IRR command in Excel, arrange all cash flows (including initial outlay) in adjacent
cells in a row or column beginning with the outflow. If, for example, the cash outflow is placed
in A1 and the other cash flows in A2:A6, proper syntax is: = IRR(A1:A6) = 12.24%.
d. Because the NPV 0 and the IRR cost of capital, the new machine should be purchased.
e. The criterion is the IRR must equal or exceed the cost of capital; therefore, 12.24% is the lowest
acceptable IRR.
Clark Upholstery must decide whether to renew a major piece of machinery or replace the machine. The case
tests the students’ understanding of the concepts of initial investment and relevant cash flows.
a. Initial Investment:
Alternative 1 Alternative 2
Installed cost of new asset
Cost of asset $90,000 $100,000
+ Installation costs 0 10,000
Total proceeds, sale of new asset 90,000 110,000
− After-tax proceeds from sale of old asset
Proceeds from sale of old asset 0 (20,000)
+ Tax on sale of old asset* 0 8,000
Total proceeds, sale of old asset 0 (12,000)
+ Change in working capital 15,000 22,000
Initial investment $105,000 $120,000
*
Book value of old asset = 0, so recaptured depreciation = $20,000 − $0 = $20,000. The tax consequences are
$20,000 (0.40) = $8,000 tax
b.
Calculation of Operating Cash Inflows
Profits before Operating
Depreciation Net Profits Net Profits Cash
Year and Taxes Depreciation before Taxes Taxes after Taxes Inflows
Alternative 1
1 $198,500 $18,000 $180,500 $72,200 $108,300 $126,300
2 290,800 28,800 262,000 104,800 157,200 186,000
3 381,900 17,100 364,800 145,920 218,880 235,980
4 481,900 10,800 471,100 188,440 282,660 293,460
5 581,900 10,800 571,100 228,440 342,660 353,460
6 0 4,500 −4,500 −1,800 −2,700 1,800
Alternative 2
1 $235,500 $22,000 $213,500 $85,400 $128,100 $150,100
2 335,200 35,200 300,000 120,000 180,000 215,200
3 385,100 20,900 364,200 145,680 218,520 239,420
4 435,100 13,200 421,900 168,760 253,140 266,340
5 551,100 13,200 537,900 215,160 322,740 335,940
6 0 5,500 −5,500 −2,200 −3,300 2,200
Alternative 1 Alternative 2
Year 5 relevant cash flow: Year 5 relevant cash flow:
Operating cash flow: $33,460 Operating cash flow: $15,940
Terminal cash flow 20,400 Terminal cash flow 38,000
Total cash inflow $53,860 Total cash inflow $53,940
d. Alternative 1
Alternative 1
Cash Flows
-105,000 $26,300 36,000 35,980 43,460 53,860
0 1 2 3 4 5 6
END OF YEAR
Alternative 2
Cash Flows
-120,000 $50,100 65,200 39,420 16,340 53,940
0 1 2 3 4 5 6
END OF YEAR
e. Alternative 2 appears to be slightly better because it offers larger incremental cash flows in the early
years. Assuming a 9% discount rate, the NPV of Alternative 1 is $43,005.50, while the NPV of
Alternative 2 is $57,913.27. The IRR of Alternative 2 (27.77%) is also higher than the IRR of
Alternative 1 (22.04%).
◼ Spreadsheet Exercise
Answers to Chapter 11’s Damon Corporation exercise are available on www.pearson.com/mylab/finance.
◼ Group Exercise
Group exercises are available on www.pearson.com/mylab/finance.
Capital investment is revisited in this chapter’s group exercise. A long-term investment project will be
detailed across this and the following two chapters. Students are warned that while this chapter’s exercise is
apparently brief, the work is vital to the work in the following chapters.
The first task is to design two mutually exclusive investment projects. The design should focus on why these
investments should each be undertaken. After establishing the “why” for each project, the process
of rigorous numerical analysis is begun. Cash flows are to be estimated, and students should be encouraged to
use simple round numbers when estimating the initial investment and operating/terminal cash flows. All
numbers should be organized on an annual basis. Each group is asked to design a timeline with a minimum of
five years for each project’s numbers. The most feasible estimates will run from 5–10 years.
A payback period, net present value, and internal rate of return are estimated for both projects. If the projects
have different sizes, it may be possible for the smaller project to have a higher internal rate of return but a
lower net present value. Giving groups a variety of discount rates to use in the analysis also adds to the
richness of the project.