Chapter 11

Capital Budgeting Cash Flows

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.

 Suggested Answers to Opener-in-Review

The chapter opener talked about the $12 billion acquisition by Molson Coors of the MillerCoors joint
venture. According to Molson, the acquisition provided 15 years’ worth of tax savings in the amount of $250
million per year. These tax benefits had a present value at the time of the acquisition of $2.4 billion. Assume
that the tax benefit stream is an annuity due,; meaning that the first year of benefits comes immediately. What
is the discount rate that Molson Coors is applying to this deal.
The discount rate is the “r” that makes the following equation hold:
CF 1 CF 2 CF 3 CF 15
Present value = 1 + 2 + 3 +…+
(1+r ) (1+r ) (1+r ) (1+r )15
$ 250 million $ 250 million $ 250 million $ 250 million
$2.4 billion = 1 + 2 + 3 +…+ 15
(1+r ) (1+r ) (1+r ) (1+ r )

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2 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

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.

 Answers to Review Questions

11-1 The decision to invest (or to refrain from investing) should be based on whether the added benefits
justify the added costs. Thus, capital budgeting projects should be evaluated using incremental after-
tax cash flows. Evaluating projects in this way answers the question, how is the firm different if it
invests in this project relative to if it did not invest in the project? Only when the incremental cash
inflows exceed incremental cash outflows (all on a present value basis) does undertaking the
investment increasing shareholder wealth.

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)

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 Chapter 11 Capital Budgeting Cash Flows 3

11-6 The book value of an asset is its strict accounting value.

Book value  installed cost of asset – accumulated depreciation
Gains and losses in the sale of an asset may have tax consequences, and hence, these are key forms of
taxable income. More specifically, taxable income may arise from (1) capital gain: portion of sale
price above initial purchase price, taxed at the ordinary rate; (2) recaptured depreciation: portion of
sale price in excess of book value that represents a recovery of previously taken depreciation, taxed at
the ordinary rate; and (3) loss on the sale of an asset: amount by which sale price is less than book
value, taxed at the ordinary rate and deducted from ordinary income if the asset is depreciable and
used in business. If the asset is not depreciable or is not used in business, it is also taxed at the
ordinary rate but is deductible only against capital gains.

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

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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.

 Suggested Answer to Focus on Ethics Box: “Fumbling Sunk Costs”

Recommitting to a losing project for emotional or reputational reasons can destroy shareholder wealth. What
safeguards could a firm use to remove such bias from recommitment decisions?

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.

 Suggested Answer to Global Focus Box:

“Changes May Influence Future Investments in China”
Although China has been actively campaigning for foreign investment, how do you think having
a communist government affects its foreign investment?

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 Chapter 11 Capital Budgeting Cash Flows 5

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.

 Answers to Warm-Up Exercises

E11-1 Categorizing a firm’s expenditures
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.

E11-2 Classification of project costs and cash flows

Answer: $3.5 billion already spent—sunk cost (irrelevant)
$350 million incremental cash outflow—relevant cash flow
$15 million per year cash inflow—relevant cash flow
$450 million for satellites—opportunity cost and relevant cash flow

E11-3 Initial investment

Answer: Initial investment
= Price of new asset + Installation cost – After-tax proceeds of sale of old asset
± ∆ Net working capital
= $35,000 + $6,500 – $8,250 + $0 = $33,250.

E11-4 Book value and recaptured depreciation

Answer: Book value  $325,000 − $215,250 = $109,750
Recaptured depreciation  $236,000 − $109,750 = $126,250

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E11-5 Initial investment

Answer: Initial investment
= Price of new asset + Installation cost – After-tax proceeds of sale of old asset
± ∆ Net working capital
= €5,500,000 + €130,000 – €230,000 + €100,000 = €5,500,000

 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.

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 Chapter 11 Capital Budgeting Cash Flows 7

P11-1 Classification of expenditures (LG 2; Basic)

a. Capital expenditure—the lease will expire after a year.

b. Capital expenditure—the trademark will be utilized for many years.

c. Operating expenditure—repair and maintenance expenses will expire within one year.

d. Operating expenditure—petrol or diesel consumption is an expenditure involving day-to-day

operations.

e. Capital expenditure—the building will last for more than one year.

f. Capital expenditure—research and development benefits last many years.

g. Operating expenditure—bad debt is an expenditure involving day-to-day operations.

h. Capital expenditure—a major structural improvement to an existing office building will last for
more than one year.

P11-2 Relevant cash flow and timeline depiction (LG 1, 2; Intermediate)

a.
Year Cash Flow

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.

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This is a nonconventional cash flow pattern, which has several cash flow series of equal size, which is
referred to as an embedded annuity.

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 Chapter 11 Capital Budgeting Cash Flows 9

P11-3 Expansion versus replacement cash flows (LG 3; Intermediate)

a.
Year Relevant Cash Flows
Initial investment ($22,000)
1 6,000
2 6,000
3 3,000
4 4,000
5 4,000

b. An expansion project is simply a replacement decision in which all cash flows from the old asset
are zero.

P11-4 Sunk costs and opportunity costs (LG 2; Basic)

a. The €1,000,000 in development costs should not be considered part of the decision to go ahead with
the new production. This money has already been spent and cannot be retrieved, so it is a sunk cost.
b. The €300,000 sale price of the existing line is an opportunity cost. If Luxottica does not proceed with
the new line of eyewear, they will not receive the €300,000.
c.

P11-5 Sunk costs and opportunity costs (LG 2; Intermediate)

a. Sunk cost—The funds for the tooling had already been expended and would not change, no
matter whether the new technology would be acquired or not.
b. Opportunity cost—The development of the computer programs can be done without additional
expenditures on the computers; however, the loss of the cash inflow from the leasing
arrangement would be a lost opportunity to the firm.
c. Opportunity cost—Gen-X will not have to spend any funds for floor space, but the lost cash
inflow from the rent would be a cost to the firm.
d. Sunk cost—The money for the storage facility has already been spent, and no matter what
decision the company makes, there is no incremental cash flow generated or lost from the
storage building.

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10 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

e. Opportunity cost—Forgoing the sale of the crane costs the firm $180,000 of potential cash
inflows.

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 Chapter 11 Capital Budgeting Cash Flows 11

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

P11-7 Book value (LG 3; Basic)

Installed Accumulated Book

Asset Cost Depreciation Value
A $ 890,000 $ 462,800 $427,200
B 67,000 46,230 20,770

C 34,000 11,220 22,780

D 4,280,000 2,696,400 1,583,600

E 753,000 534,630 218,370

P11-8 Book value and taxes on sale of assets (LG 3, 4; Intermediate)

a. Book value  Installed cost of asset $80,000) – Accumulated depreciation
Book value = $96,000 − (0.69 × $96,000) = $29,760.
b.

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

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P11-9 Tax calculations (LG 3, 4; Intermediate)

Current book value = Installed cost of asset – Accumulated depreciation
Book value = $460,200 – [(0.78× $460,200)] = $101,244.
(a) (b) (c) (d)
apital gain $264,800 $189,800 $0. $ 0
ecaptured depreciation 358,956 358,956 0 –9,000
ax on capital gain 52,960 37,960 0 0
ax on depreciation
ecovery 71,791 71,791 0 –1,800
al tax $124,751 $109,751 $0 –$1,800

P11-10 Change in net working capital calculation (LG 3; Basic)

a.
Current Assets Current Liabilities
Cash $43,500 Accounts payable $230,000
Accounts receivable 378,000 Accruals 38,000
Inventory 69,000
Net change $352,500 $268,000
Net working capital  current assets  current liabilities  $352,500  $268,000  $84,500
b. An analysis of the purchase of the new machine reveals an increase in net working capital. This
increase should be treated as an initial outlay and is the cost of acquiring the new machine.
c. Yes, in computing the terminal cash flow, the net working capital increase should be reversed.

P11-11 Calculating initial investment (LG 3, 4; Intermediate)

a. Book value  $568,000 × (1 – 0.20 – 0.32 – 0.19) = $568,000 × 0.29 = $164,720
b. Sales price of old equipment $253,000
Book value of old equipment 164,720
Recapture of depreciation $ 88,280
Taxes on recapture of depreciation (20% tax rate) $88,280  0.20  $17,656
After-tax proceeds  $253,000  $17,656  $235,344
c. Cost of new machine $ 870,000
Less sales price of old machine $(253,000)
Plus tax on recapture of depreciation $ 17,656
Initial investment $ 634,656

P11-12 Initial investment: Basic calculation (LG 3, 4; Intermediate)

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 Chapter 11 Capital Budgeting Cash Flows 13

Installed cost of new asset 

Cost of new asset $38,800
 Installation costs 5,400
Total installed cost (depreciable value) $44,200
After-tax proceeds from sale of old asset 
Proceeds from sale of old asset ($27,300)
 Tax on sale of old asset 4,097
Total after-tax proceeds—old asset ($23,203)
Initial investment $20,997
Book value of existing machine  $23,500  (1  (0.20  0.32  0.19))  $ 6,815
Recaptured depreciation  $23,500  $6,815  $16,685
Capital gain  $27,300  $23,500  $ 3,800
Tax on recaptured depreciation  $16,685  (0.20) $ 3,337
Tax on capital gain  $3,800  (0.20)  $ 760
Total tax  $ 4,097

P11-13 Initial investment at various sale prices (LG 3, 4; Intermediate)

(a) (b) (c) (d)

Installed cost of new asset:
Cost of new asset CHf 700,000 CHf 700,000 CHf 700,000 CHf 700,000

 Installation cost 5,000 5,000 5,000 5,000

Total installed cost 750,000 750,000 750,000 750,000

After-tax proceeds from sale

of old asset

Proceeds from sale

of old asset (400,000) (300,000) (200,000) (100,000)

 Tax on sale of old asset* 24,000 0 (24,000) (48,000)

Total after-tax proceeds (376,000) (300,000) (224,000) (148,000)

Initial investment CHf 374,000 CHf 450,000 CHf 526,000 CHf 526,000

Book value of existing machine  CHf500,000  [1  (0.20 0.20)]  CHf300,000

*
Tax Calculations:
a. Gain on sale of existing asset = CHf 400,000 − CHf 300,000 = CHf 100,000

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14 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

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

P11-14 Calculating initial investment (LG 3, 4; Challenge)

a. Book value  ($60,000  0.31)  $18,600
b. Sales price of old equipment $35,000
Book value of old equipment 18,600
Recapture of depreciation $16,400
Taxes on recapture of depreciation  $16,400  0.40  $6,560
Sale price of old roaster $35,000
Tax on recapture of depreciation (6,560)
After-tax proceeds from sale of old roaster $28,440
Under a 21% tax rate, taxes on depreciation recovery = $16,400  0.21  $3,444
After-tax proceeds from sale of old roaster $31,556
c. Changes in current asset accounts
Inventory $ 50,000
Accounts receivable 70,000
Net change $ 120,000
Changes in current liability accounts
Accruals $ (20,000)
Accounts payable 40,000
Notes payable 15,000
Net change $ 35,000
Change in net working capital $ 85,000

d. Cost of new roaster $130,000

Less after-tax proceeds from sale of old roaster 28,440
Plus change in net working capital 85,000
Initial investment $186,560
Under a 21% tax rate, initial investment would $183,444

P11-15 Depreciation (LG 5; Basic)

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 Chapter 11 Capital Budgeting Cash Flows 15

Depreciation Schedule
Year Depreciation Expense
1 $75,000  0.20 $15,000
2 75,000  0.32 24,000
3 75,000  0.19 14,250
4 75,000  0.12 ,000
5 75,000  0.12 ,000
6 75,000  0.05 3,750

P11-16 Incremental operating cash inflows (LG 5; Intermediate)

a. Incremental profits before depreciation and tax $1,200,000  $480,000 $720,000
each year.
b. PBDT = Profits before depreciation and taxes NPAT Net profits after taxes
NPBT Net profits before taxes
Year (1) (2) (3) (4) (5) (6)
PBDT $720,000 $720,000 $720,000 $720,000 $720,000 $720,000
Depr. 400,000 640,000 380,000 240,000 240,000 100,000

NPBT 320,000 80,000 340,000 480,000 480,000 620,000

Tax 128,000 32,000 136,000 192,000 192,000 248,000

NPAT 192,000 48,000 204,000 288,000 288,000 372,000

b. Cash Flow = NPAT  depreciation

Cash (1) (2) (3) (4) (5) (6)

flow $592,000 $688,000 $584,000 $528,000 $528,000 $472,000

P11-17 Personal finance: Incremental operating cash inflows (LG 5; Challenge)

Incremental Operating Cash Flows – Replacement of Olivetti’s PC
Year 1 Year 2 Year 3 Year 4 Year 5
Savings from new and improved mower €500 €500 €500 €500 €500
Annual maintenance cost 20 20 20 20 20
Depreciation* 300 300 300 300 300
Savings (loss) before taxes 180 (180) 180 180 180
Taxes (24%) 43 (43) 43 43 43
Savings (loss) after taxes 137 (137) 137 137 137
Depreciation 300 300 300 300 300
Incremental operating cash flow €437 €437 €437 €437 €437

P11-18 Incremental operating cash flows: Expense reduction (LG 5; Intermediate)

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16 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

Year (1) (2) (3) (4) (5)

Incremental

expense savings ₹2,000,000 ₹2,000,00 ₹2,000,00 ₹2,000,000 ₹2,000,00

0 0 0

Incremental profits

before dep. and taxes* 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000

Depreciation*** 1,600,000 960,000 576,000 346,000 207,000

Net profits

before taxes 400,000 1,040,000 1,424,000 1,654,000 1,793,000

Taxes 120,000 312,000 427,200 496200 537,900

Net profits

after taxes 280,000 728,000 996,800 1,157,800 1,255,100

Operating cash

inflows** 1880,000 1,688,000 1,572,800 1,503,800 1,462,100

*Incremental profits before depreciation and taxes will increase the same amount as the decrease in expenses.
**Net profits after taxes plus depreciation expense.
*** Reducing balance depreciation for each year is calculated according to the following table:

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

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P11-19 Incremental operating cash flows (LG 5; Intermediate)

a.
Expenses Net
(excluding Profits before Profits Net Operating
depreciation Depreciation Depre- before Profits Cash
Year Revenue and interest) and Taxes ciation Taxes Taxes after Tax Inflows
New
Equipment
1 400,000 300,000 100,000 20,000 80,000 19,200 60,800 80,800

2 410,000 300,000 110,000 32,000 78,000 18,720 59,280 91,280

3 420,000 300,000 120,000 19,000 101,000 24,240 76,760 95,760

4 430,000 300,000 130,000 12,000 118,000 28,320 89,680 101,680

5 440,000 300,000 140,000 12,000 128,000 30,720 97,280 109,280

Old
Equipment

1– $350,000 $250,000 $100,000 0 $100,000 $24,000 $76,000 $76,000

5

b. Calculation of incremental cash flows

Year New Equipment Old Equipment Incremental Cash Flows
1 CHf 80,800 CHf 76,000 CHf 4,800

2 91,280 76,000 15,280

3 95,760 76,000 19,760

4 101,680 76,000 25,680

5 109,280 76,000 33,280

c.

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18 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

P11-20 Determining incremental operating cash flows (LG 5; Intermediate)

New Cruise 1 2 3 4 5 6 7 8 9 10

35,50
Revenues: (000)
35500 35,500 35,500 35,500 35,500 35,500 0 35,500 35,500 35,500

Expenses: (000) 1,200 1,200 1,200 1,200 1,200 1,200 1,200 1,200 1,200 1,200

Profit before
depreciation and taxes: 34,30
(000) 34,300 34,300 34,300 34,300 34,300 34,300 0 34,300 34,300 34,300

30,00
Depreciation (000)
30,000 30,000 30,000 30,000 30,000 30,000 0 30,000 30,000 30,000

Net profits before taxes

(000) 4,300 4,300 4,300 4,300 4,300 4,300 4,300 4,300 4,300 4,300

Taxes (000) 1,032 1,032 1,032 1,032 1,032 1,032 1,032 1,032 1,032 1,032

Net profits after taxes

(000) 3,268 3,268 3,268 3,268 3,268 3,268 3,268 3,268 3,268 3,268

Net operating cash 33,26

flows (000) 33,268 33,268 33,268 33,268 33,268 33,268 8 33,268 33,268 33,268

Old cruise

32,00
Revenues: (000)
32,000 32,000 32,000 32,000 32,000 32,000 0 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: 29,40
(000) 29,400 29,400 29,400 29,400 29,400 29,400 0 29,400 29,400 29,400

Depreciation: (000) 25,000 25,000 25,000 25,000 25,000

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 Chapter 11 Capital Budgeting Cash Flows 19

Net profits before taxes 29,40

(000) 4,400 4,400 4,400 4,400 4,400 29,400 0 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 22,34

(000) 3,344 3,344 3,344 3,344 3,344 22,344 4 22,344 22,344 22,344

Net operating cash 22,34

flows (000) 28,344 28,344 28,344 28,344 28,344 22,344 4 22,344 22,344 22,344

Net incremental cash 10,92

flows 4,924 4,924 4,924 4,924 4,924 10,924 4 10,924 10,924 10,924

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
2. Tax  ($170,000  $9,000)  0.4  $64,400.

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20 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

d. The higher the sale price, the higher the terminal cash flow.

P11-22 Terminal cash flow: Replacement decision (LG 6; Challenge)

After-tax proceeds from sale of new asset 
Proceeds from sale of new machine $75,000
Tax on sale of new machine l
(14,360)
Total after-tax proceeds—new asset $60,640
After-tax proceeds from sale of old asset
Proceeds from sale of old machine (15,000)
 Tax on sale of old machine 2
6,000
Total after-tax proceeds—old asset (9,000)
 Change in net working capital 25,000
Terminal cash flow $76,640

1
Book value of new machine at end of year 4: 2
Book value of old machine at end of year 4:$0
[1  (0.20  0.32 0.19  0.12)  ($230,000)]  $39,100 $15,000  $0 $15,000 recaptured depreciation
$75,000  $39,100 $35,900 recaptured depreciation $15,000  (0.40) $6,000 tax benefit
$35,900  (0.40) $14,360 tax liability

P11-23 Relevant cash flows for a marketing campaign (LG 3, 4, 5, 6; Challenge)

Barilla – Calculation of Relevant Cash Flow (€000)

Without Marketing With Marketing

Campaign Campaign

1 2 3 1 2 3

15,50 18,50
Sales
15,500 0 15,500 18,000 0 20,500

11,62 13,87
COGS (@ 75%)
11,625 5 11,625 13,500 5 15,375

Gross profit 3,875 3,875 3,875 4,500 4,625 5,125

Less: Operating expenses

General and administrative

(10% of sales) 1,550 1,550 1,550 1,800 1,850 2,050

Marketing campaign 500 500 500

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 Chapter 11 Capital Budgeting Cash Flows 21

Depreciation 1,000 1,000 1,000 1,000 1,000 1,000

Total operating expenses 2,550 2,550 2,550 3,300 3,350 3,550

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

Incremental cash flows (95) (38) 190

P11-24 Relevant cash flows: No terminal value (LG 3, 4, 5; Challenge)

a.
40% Tax 21% Tax
Installed cost of new asset: Rate Rate
Cost of new asset $ 76,000 $ 76,000 Book value of old machine:
+Installation costs $ 4,000 $ 4,000 [1  (0.20  0.32  0.19)]  $50,000
1 =Total cost of new asset $ 80,000 $ 80,000 $14,500. So, taxable amount = $55,000 
After-tax proceeds of old asset: $14,500 $40,500, and taxes owed = tax rate
Proceeds from sale $ (55,000) $ (55,000) $40,500
+Tax on sale of old asset $ 16,200 $ 8,505
2 =Total proceeds sale of old asset $ (38,800) $ (46,495)
Initial investment [(1)+(2)] $ 41,200 $ 33,505

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22 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

b. and c. (40% tax rate)

Year = (1) (2) (3) (4) (5) (6)
Old Machine
Revenue - Operating Expenses $ 14,000 $ 16,000 $ 20,000 $ 18,000 $ 14,000 $ -
Less: Depreciation $ (6,000) $ (6,000) $ (2,500) $ - $ - $ -
Net Profit Before Taxes $ 8,000 $ 10,000 $ 17,500 $ 18,000 $ 14,000 $ -
Less: Taxes (40%) $ (3,200) $ (4,000) $ (7,000) $ (7,200) $ (5,600) $ -
Net Profit After Taxes $ 4,800 $ 6,000 $ 10,500 $ 10,800 $ 8,400 $ -
Add: Depreciation $ 6,000 $ 6,000 $ 2,500 $ - $ - $ -
Operating Cash Flow (Old) $ 10,800 $ 12,000 $ 13,000 $ 10,800 $ 8,400 $ -

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

Cash Flows (40% Tax Rate)

-$41,200 $13,600 $16,240 $11,080 $11,040 $13,440 $1,600

0 1 2 3 4 5 6

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 Chapter 11 Capital Budgeting Cash Flows 23

b. and c. (21% tax rate)

Year = (1) (2) (3) (4) (5) (6)
Old Machine
Revenue - Operating Expenses $ 14,000 $ 16,000 $ 20,000 $ 18,000 $ 14,000 $ -
Less: Depreciation $ (6,000) $ (6,000) $ (2,500) $ - $ - $ -
Net Profit Before Taxes $ 8,000 $ 10,000 $ 17,500 $ 18,000 $ 14,000 $ -
Less: Taxes (21%) $ (1,680) $ (2,100) $ (3,675) $ (3,780) $ (2,940) $ -
Net Profit After Taxes $ 6,320 $ 7,900 $ 13,825 $ 14,220 $ 11,060 $ -
Add: Depreciation $ 6,000 $ 6,000 $ 2,500 $ - $ - $ -
Operating Cash Flow (Old) $ 12,320 $ 13,900 $ 16,325 $ 14,220 $ 11,060 $ -

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

Cash Flows (21% Tax Rate)

-$33,505 $14,740 $15,176 $10,567 $11,496 $14,656

21% 0 1 2 3 4 5

P11-25 Integrative: Determining relevant cash flows (LG 3, 4, 5, 6; Challenge)

a. Initial investment:
Installed cost of new asset 
Cost of new asset €1,200,000
 Installation costs 150,000
Total cost of new asset €1,350,000
 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 from sale of old asset (150,000)
 Change in working capital 130,000
Initial investment €1,330,000
Book value of old asset: 400,000 ÷ 8 × 3 €150,000. So, €150,000 − €150,000  €0 gain on sale of asset.
*

Hence, the total tax of sale of asset is €0.

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24 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

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
€450 €270 €180, €43 €136, €406
, , 0 , 8 ,
0 0 0 2 0 8
0 0 0 0 0 0
0 0 0 0
450, 270, 180,0 43, 136,8 406,
0 0 0 2 0 8
0 0 0 0 0 0
0 0 0 0
450, 270, 180,0 43, 136,8 406,
0 0 0 2 0 8
0 0 0 0 0 0
0 0 0 0
450, 270, 180,0 43, 136,8 406,
0 0 0 2 0 8
0 0 0 0 0 0
0 0 0 0
450, 270, 180,0 43, 136,8 406,
0 0 0 2 0 8
0 0 0 0 0 0
0 0 0 0
Existing Line
€280 €50, €230, €55 €174, €224
, 0 0 , 8 ,
0 0 0 2 0 8
0 0 0 0 0 0
0 0 0
250, 50,0 200,0 48, 152,0 202,
0 0 0 0 0 0
0 0 0 0 0 0
0 0 0
200, 50,0 150,0 36, 114,0 164,
0 0 0 0 0 0
0 0 0 0 0 0
0 0 0
180, 0 180,0 43, 136,8 136,
0 0 2 0 8
0 0 0 0 0
0 0 0
150, 0 150,0 36, 114,0 114,
0 0 0 0 0
0 0 0 0 0
0 0 0

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 Chapter 11 Capital Budgeting Cash Flows 25

Calculation of Incremental Cash Flows

Year New Line Existing Line Incremental Operating Cash Flow
€406, €224,8 €182,000
80 00
0
406,8 202,00 204,800
00 0

406,8 164,00 242,800

00 0

406,8 136,80 270,000

00 0

406,8 114,00 292,800

00 0

c. Terminal cash flow:

After-tax proceeds from sale of new asset 
Proceeds from sale of new asset €300,000
Tax on sale of new asset *
(72,000)
Total proceeds from sale of new asset 228,000
After-tax proceeds from sale of old asset 
Proceeds from sale of old asset 0
 Tax on sale of old asset 0
Total proceeds from sale of old asset 0
 Change in net working capital 130,000
Terminal cash flow €358,000
*
Book value of asset at end of year 5 €0. Hence, taxes due are (€300,000 – 0)  0.24 €72,000.

d. Year 5 relevant cash flow:

Incremental Cash flows
Operating cash flow €292,800 (1,330,000.00) 182,000.00 204,800.00 242,800.00 270,000.00 650,800.00

Terminal cash flow 358,000 0 1 2 3 4 5

Total inflow €650,800

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.

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26 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

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

Using these cash flow estimates, calculate the following:

a. The initial investment and its payment over years

b. Operating cash flow
c. Terminal cash flow
d. Summary of annual cash flow
e. Based on their disposable annual income, what advice would you give Antonio and Alessia regarding
the proposed car purchase?]

------

Antonio and Alessia - Cash Flow Budget for Car Purchase

a. Initial investment
Total cost of new boat €(52,000)
Add: Taxes (20%) (10,400)
Initial investment €(62,400)
Investment cash flows Year 0 Year 1 Year 2 Year 3
€(17,100) €(17,100) €(17,100) €(17,100)
b. Operating cash flows Year 1 Year 2 Year 3 Year 4
Maint. & repair 12 months at €200 €(2,400) €(2,400) €(2,400) €(2,400)
Docking fees 12 months at €200 €(1,200) €(1,200) €(1,200) €(1,200)
Operating cash flows €(3,600) €(3,600) €(3,600) €(3,600)
c. Terminal cash flow—end of year 4
Proceeds from the sale of boat €12,000

d. Summary of cash flows.

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 Chapter 11 Capital Budgeting Cash Flows 27

Year Cash Flows

0 €(17,100)
1 (20,700)
2 (20,700)
3 (20,700)
4 8,400

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

P11-27 Integrative: Determining relevant cash flows (LG 3, 4, 5, 6; Challenge)

[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

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28 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

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

Calculation of Incremental Cash Flows

Year New line Existing line Incremental Operating
Cash flows
1 €228,400 €228,400 €3,600
2 228,400 202,000 26,400

3 228,400 164,000 64,400

4 228,400 136,800 91,600

5 228,400 114,000 114,400

c. Terminal cash flow:

After-tax proceeds from sale of new asset
Proceeds from sale of new asset €100,000
 Tax on sale of new assetl (24,000)
Total proceeds—new asset 76,000
 After-tax proceeds from sale of old asset
Proceeds from sale of old asset 0
 Tax on sale of old asset2 0

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 Chapter 11 Capital Budgeting Cash Flows 29

Total proceeds—old asset 0

 Change in net working capital 500,000
Terminal cash flow = €576,000
1
Book value of Hoist A at end of year 5  €0
Recapture depreciation = €100,000  0 0.24 €24,000.
Book value of Hoist B at end of year 5  $3,000. So recaptured depreciation = $20,000  $3,000
$17,000. Tax consequences are: $17,000  0.40 $6,800 tax
Year 5 relevant cash flow:
Operating cash flow €114,400
Terminal cash flow 576,000
Total inflow €690,400

Incremental Cash flows

(1,150,000.00) 3,600.00 26,400.00 64,400.00 91,600.00 690,400.00

d. 0 1 2 3 4 5

P11-28 Integrative: Complete investment decision (LG 1, 2, 3, 4, 5, 6; Challenge)

a.
Calculation of Operating Cash Flows (€000)

Profits before Net profits Net profits Operating

Year Depreciation Taxes
depreciation of taxes before taxes after taxes cash flows

Existing line

1 77,440 25,000 52,440 13,110 39,330 64,330

2 77,440 25,000 52,440 13,110 39,330 64,330

3 77,440 25,000 52,440 13,110 39,330 64,330

4 77,440 25,000 52,440 13,110 39,330 64,330

5 77,440 25,000 52,440 13,110 39,330 64,330

6 77,440 25,000 52,440 13,110 39,330 64,330

7 77,440 25,000 52,440 13,110 39,330 64,330

8 77,440 25,000 52,440 13,110 39,330 64,330

9 77,440 25,000 52,440 13,110 39,330 64,330

10 77,440 25,000 52,440 13,110 39,330 64,330

b. Cash Flows:

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30 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

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

c. PV = − MNT 250,000,000; N = 10; PMT = MNT 64,330,000

IRR = 22.29%

d. To solve for NPV

N = 10, I = 13.8%, PMT = MNT 64,330,000
Solve for PV = MNT 250,000,000
NPV = MNT 1,209,103.26 − MNT 250,000,000
NPV = MNT 88,188,337.56
e. The NPV is a positive MNT 88,188,338, and the IRR of 22% is well above the cost of capital of
14%. Based on both decision criteria, the project should be accepted.

P11-29 Integrative: Complete investment decision (LG 1, 2, 3, 4, 5, 6; Challenge)

a. Initial investment:
Installed cost of new press 
Cost of new press $2,200,000
 After-tax proceeds from sale of old asset
Proceeds from sale of existing press (1,200,000)
 Taxes on sale of existing press* 480,000
Total after-tax proceeds from sale (720,000)
Initial investment $1,480,000
*
Book value $0. So $1,200,000  $0  $1,200,000 income from sale of existing press. Taxes due are:
$1,200,000 income from sale  (0.40)  $480,000.

b.
Calculation of Operating Cash Flows
Net Profits Net Profits Cash
Year Revenues Expenses Depreciation before Taxes Taxes after Taxes Flow
1 $1,600 $800 $440, $360,0 $144 $216 $656,000
,0 , 0 00 , ,
00 0 0 0 0
0 0 0 0
0 0 0
2 1,600, 800, 704,0 96,000 38,4 57,6 761,600
00 0 0 0 0
0 0 0 0 0
0
3 1,600, 800, 418,0 382,00 152, 229, 647,200
00 0 0 0 8 2
0 0 0 0 0
0 0 0
4 1,600, 800, 264,0 536,00 214, 321, 585,600
00 0 0 0 4 6

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 Chapter 11 Capital Budgeting Cash Flows 31

0 0 0 0 0
0 0 0
5 1,600, 800, 264,0 536,00 214, 321, 585,600
00 0 0 0 4 6
0 0 0 0 0
0 0 0
6 0 0 110,0 110,0 44, 66, 44,000
0 00 0 0
0 0 0
0 0
c. Payback period  2 years  ($62,400 ¸ $647,200)  2.1 years
d. NPV may be found in Excel in two steps:
(i) Find the present value of cash inflows CF1 through CF6 using the NPV command, start by
arranging the inflows in adjacent cells in a row or column. If, for example, CF 1 through CF6
appear B1:G1, proper syntax is:
=NPV(discount rate,B1:G1) =NPV(0.11,B1:G1) = $2,439,151.85
(ii) Subtract the initial outlay from the present value of cash inflows:
Net present value = Present value of cash inflows – Initial outlay ($1,480,000)
= $2,439,151.85 – $1,480,000 = $959,152
IRR is the interest rate that makes the following equation hold:

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32 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

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.

P11-30 Integrative: Investment decision (LG 1, 2, 3, 4, 5, 6; Challenge)

a. Initial investment:
Installed cost of new asset 
Cost of the new machine $1,200,000
 Installation costs 150,000
Total cost of new machine $1,350,000
 After-tax proceeds from sale of old asset 
Proceeds from sale of existing machine (185,000)
 Tax on sale of existing machine* (79,600)
Total after-tax proceeds from sale (264,600)
 Increase in net working capital 25,000
Initial investment $1,110,400
*
Book value $384,000. So $185,000  $384,000  $199,000 loss from sale of existing press. Tax
consequences are $199,000 loss from sale(0.40) $79,600.

Calculation of Operating Cash Flows – New Machine

Reduction in Net Profits Net Profits Cash
Year Operating Costs Depreciation before Taxes Taxes after Taxes Flow
$350,000 $270,0 $80,00 $32, $48,0 $31
00 0 0 0 8
0 0 ,
0 0
0
0
350,000 432,00 82,00 32, 49,2 382
0 0 8 0 ,
0 0 8
0 0
0
350,000 256,50 93,500 37,4 56,10 312
0 0 0 ,
0 6
0
0
350,000 162,00 188,00 75,2 112,8 274
0 0 0 0 ,
0 0 8
0
0
350,000 162,00 188,00 75,2 112,8 274
0 0 0 0 ,

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 Chapter 11 Capital Budgeting Cash Flows 33

0 0 8
0
0
0 67,500 67,50 27, 40,5 27,
0 0 0 0
0 0 0
0 0
Existing Machine
Net Profits Net Profits Cash
Year Depreciation before Taxes Taxes after Taxes Flow
1 $152,00 $152, $60, $91,20 $60,80
0 000 8 0 0
0
0
2 96,000 96,00 38,4 57,6 38,400
0 0 00
0
3 96,000 96,00 38,4 57,6 38,400
0 0 00
0
4 40,000 40,00 16,0 24,0 16,000
0 0 00
0
5 0 0 0 0 0
6 0 0 0 0 0

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34 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

Incremental Operating Cash Flows

Year New Machine Existing Machine Incremental Cash Flow
$318,00 $60,800 $257,200
0
382,800 38,400 344,400
312,600 38,400 274,200
274,800 16,000 258,800
274,800 0 274,800
27,000 0 27,000
Terminal cash flow:
After-tax proceeds from sale of new asset 
Proceeds from sale of new asset $200,000
 Tax on sale of new asset* (53,000)
Total proceeds—sale of new asset $147,000
 After-tax proceeds from sale of old asset 0
 Change in net working capital 25,000
Terminal cash flow $172,000
*
Book value of new machine at the end of year 5 is $67,500. So $200,000  $67,500 $132,500 income from
sale of old machine, and 132,500 ´ 0.40 $53,000 tax liability

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.

c.
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.

P11-31 Ethics problem (LG 2; Intermediate)

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 Chapter 11 Capital Budgeting Cash Flows 35

The person who came up with the idea for a new investment may have a selfish interest in seeing the
project approved or may simply be emotionally vested in the project. In either case, this individual may
have an incentive to make overly optimistic cash flow projections. It is best to have an objective third
party be responsible for cash flow projections.
 Case: “Developing Relevant Cash Flows for Clark Upholstery
Company’s Machine Renewal or Replacement Decision”
Case studies are available on www.pearson.com/mylab/finance.

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, $18,0 $180, $72 $108 $126
5 0 50 , ,
0 0 0 3 3
0 0 0
0 0

2 290,8 28,80 262,0 104 157, 186,

0 0 00 2 0
0 0 0

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36 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

0 0

3 381,9 17,10 364,8 145 218, 235,

0 0 00 8 9
0 8 8
0 0

4 481,9 10,80 471,1 188 282, 293,

0 0 00 6 4
0 6 6
0 0

5 581,9 10,80 571,1 228 342, 353,

0 0 00 6 4
0 6 6
0 0

6 0 4,500 4,50 1, 2,7 1,80

0 0 0
0

Alternative 2

1 $235, $22,0 $213, $85 $128 $150

5 0 50 , ,
0 0 0 1 1
0 0 0
0 0

2 335,2 35,20 300,0 120 180, 215,

0 0 00 0 2
0 0 0
0 0

3 385,1 20,90 364,2 145 218, 239,

0 0 00 5 4
0 2 2
0 0

4 435,1 13,20 421,9 168 253, 266,

0 0 00 1 3
0 4 4
0 0

5 551,1 13,20 537,9 215 322, 335,

0 7 9

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 Chapter 11 Capital Budgeting Cash Flows 37

0 0 00 4 4
0 0

6 0 5,500 5,50 2, 3,3 2,20

0 0 0
0

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38 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

Calculation of Incremental Cash Inflows

Incremental Cash Flow
Year Alternative 1 Alternative 2 Existing Alt. 1 Alt. 2
$126,30 $150,100 $100, $26,3 $50,
0 00 00 1
0 0
0
186,000 215,200 150,0 36,00 65,2
00 0 0
0

235,980 239,420 200,0 35,98 39,4

00 0 2
0

293,460 266,340 250,0 43,46 16,3

00 0 4
0

353,460 335,940 320,0 33,46 15,9

00 0 4
0

1,800 2,200 0 1,800 2,20

0

c. Terminal Cash Flow:

Alternative 1 Alternative 2
After-tax proceeds from
sale of new asset 
Proceeds from sale of new asset $8,000 $25,000
Tax on sale of new asset *
(1,400) (7,800)
Total proceeds, sale of new asset 6,600 17,200
 After-tax proceeds from sale of old asset
Proceeds from sale of old asset (2,000) (2,000)
 Tax on sale of old asset **
800 800
Total proceeds, sale of old asset (1,200) (1,200)
 Change in working capital 15,000 22,000
Terminal cash flow $20,400 $38,000
*
Book value of Alternative 1 at end of year 5 $4,500, so recaptured depreciation is $8,000  $4,500 $3,500, and
taxes due are: $3,500  (0.40) $1,400. Book value of Alternative 2 at end of year 5 $5,500. So recaptured
depreciation is: $25,000  $5,500 $19,500. Taxes due are: $19,500  (0.40) $7,800’

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 Chapter 11 Capital Budgeting Cash Flows 39

Book value of old asset at end of year 5  $0. So recaptured depreciation is $2,000  $0 $2,000. Taxes due are:
**

$2,000  (0.40) $800 tax

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

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40 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

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.

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