FIN60204 – CORPORATE FINANCE

TUTORIAL QUESTIONS

TOPIC 4 – CHAPTER 6 (MAKING CAPITAL INVESTMENT DECISIONS)

PART A – CONCEPT QUESTIONS (MCQ)

1. The changes in a firm's future cash flows that are a direct consequence of
accepting a project are called _____ cash flows.

A. incremental

B. stand-alone

C. after-tax

D. net present value

E. erosion

2. The annual annuity stream of payments with the same present value as a
project's costs is called the project's _____ cost.

A. incremental

B. sunk

C. opportunity

D. erosion

E. equivalent annual

3. A cost that has already been paid, or the liability to pay has already been
incurred, is a(n):

A. salvage value expense.

B. net working capital expense.

C. sunk cost.

D. opportunity cost.

E. erosion cost.

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4. The most valuable investment given up if an alternative investment is chosen is

a(n):

A. salvage value expense.

B. net working capital expense.

C. sunk cost.

D. opportunity cost.

E. erosion cost.

10. Interest rates or rates of return on investments that have been adjusted for the
effects of inflation are called _____ rates.

A. real

B. nominal

C. effective

D. stripped

E. coupon

11. The increase you realize in buying power as a result of owning a bond is
referred to as the _____ rate of return.

A. inflated

B. realized

C. nominal

D. real

E. risk-free

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9. Which of the following should be included in the analysis of a project?

I. sunk costs
II. opportunity costs
III. erosion costs
IV. incremental costs

A. I and II only

B. III and IV only

C. II and IV only

D. II, III, and IV only

E. I, II, and IV only

20. All of the following are anticipated effects of a proposed project. Which of
these should be included in the initial project cash flow related to net working
capital?

I. An inventory decrease of $5,000

II. An increase in accounts receivable of $1,500
III. An increase in fixed assets of $7,600
IV. A decrease in accounts payable of $2,100

A. I and II only

B. I and III only

C. II and IV only

D. I, II, and IV only

E. I, II, III, and IV

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21. Changes in the net working capital:

A. can affect the cash flows of a project every year of the project's life.

B. only affect the initial cash flows of a project.

C. are included in project analysis only if they represent cash outflows.

D. are generally excluded from project analysis due to their irrelevance to the
total project.

E. affect the initial and the final cash flows of a project but not the cash flows
of the middle years.

28. The salvage value of an asset creates an after-tax cash inflow to the firm in an
amount equal to the:
A. sales price of the asset.

B. sales price minus the book value.

C. sales price minus the tax due based on the sales price minus the book
value.

D. sales price plus the tax due based on the sales price minus the book value.

E. sales price plus the tax due based on the book value minus the sales price.

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PART B – PROBLEMS QUESTIONS

You are required to attempt Question 1 – 10.

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Additional question from textbook (Question 15)

1. Consider the following cash flows on 2 mutually exclusive projects. The cash
flows of project A are expressed in real terms, whereas those of project B are
expressed in nominal terms. The appropriate nominal discount rate is 13% and
the inflation rate is 4%. Which project should you choose?

Year Project A ($) Project B ($)

0 -50,000 -65,000

1 30,000 29,000

2 25,000 38,000

3 20,000 41,000

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Solutions to Questions and Problems

NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this
solutions manual, rounding may appear to have occurred. However, the final answer for each problem
is found without rounding during any step in the problem.

1. Straight Line Method (SLM) Depreciation

Depreciation = $9,000 / 5 = $1,800 per year

Operating Cash Flow Tax Shield Approach

OCF = (Sales – Costs)(1 – tC) + tCDepreciation

OCF = [($4.75 × 1,500) – ($2.30 × 1,500)](1 – 0.34) + 0.34($1,800)
OCF = $3,037.50 (cash flows from Y1 – Y5)

So, the NPV of the project is:

Financial Calculator Method

CF0 C01 F01 I CPT NPV

-$9,000 $3,037.50 5 14 $1,427.98

Decision: Raphael should purchase the soufflé maker because it gives positive NPV.

PVA = C({1 – [1/(1 + r)]t } / r )

= 3037.5({1 – [1/(1 + 0.14)]5 } / 0.14 )
= 3037.5({1 – 0.52 } / 0.14 )
= 3037.5({0.48 } / 0.14 )
= 3037.5 x 3.43
= 10427.98

NPV = -9000 + 10427.98

NPV = 1427.98

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2. We will use the bottom-up approach to calculate the operating cash flow for each
year. We also must be sure to include the net working capital cash flows each
year. So, the net income and total cash flow each year will be:

Year 0 Year 1 Year 2 Year 3 Year 4

Sales $12,500 $13,000 $13,500 $10,500
-Costs (2,700) (2,800) (2,900) (2,100)
-Depreciation1 (6,000) (6,000) (6,000) (6,000)
EBT $3,800 $4,200 $4,600 $2,400
Tax (34%) 1,292 1,428 1,564 816
Net income $2,508 $2,772 $3,036 $1,584
+ Depreciation 6,000 6,000 6,000 6,000
OCF 0 $8,508 $8,772 $9,036 $7,584
Capital spending
(investment) –$24,000
NWC Spending –300 –350 –400 –300 1,3502
Incremental cash flow –$24,300 $8,158 $8,372 $8,736 $8,934

Notes:

1. Depreciation (SLM) = Investment / project life span = $24,000/4 = $6,000

2. Fully recovered at the end of project (total of all NWC) = $300 + $350 + $400 +
$300 = $1,350

The NPV of the project is:

Financial Calculator Method

CF0 C01 F01 C02 F02 C03 F03 C04 F04 I CPT NPV

-$24,300 $8,158 1 $8,372 1 $8,736 1 $8,934 1 12 $1,553.87

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3. Using the tax shield approach to calculating OCF, we get:

Straight Line Method (SLM) Depreciation

Depreciation = $1,400,000 / 3 = $466,666.67 per year

Operating Cash Flow Tax Shield Approach

OCF = (Sales – Costs)(1 – tC) + tCDepreciation

OCF = ($1,120,000 – $480,000)(1 – 0.35) + 0.35 x $466,666.67
OCF = $579,333.33

Financial Calculator Method

CF0 C01 F01 I CPT NPV

-$1,400,000 $579,333.33 3 12 –$8,539.09

Decision: To reject the expansion project because NPV is negative.

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4. The cash outflow at the beginning of the project will increase because of the
spending on NWC. At the end of the project, the company will recover the
NWC, so it will be a cash inflow. The sale of the equipment will result in a cash
inflow, but we also must account for the taxes which will be paid on this sale.

Now, we calculate the aftertax salvage value. The aftertax salvage value is the
market price minus (or plus) the taxes on the sale of the equipment, so:

Aftertax salvage value (ATSV) = MV + (BV – MV)tc

*using both SLM & MACRS depreciations

Very often, the book value of the equipment is zero as it is in this case (using
straight-line method, SLM depreciation).

If the book value is zero, the equation for the aftertax salvage value becomes:

Aftertax salvage value = MV + (0 – MV)tc

Aftertax salvage value = MV(1 – tc) >>> (using SLM, book value 0)

ATSV = $225,000 (1 – 35%) = $146,250

BV = 0
MV = 225000
Capital Gain = 225000 -0 = 225000
Tax 35% x 225000 = 78750
Gain -tax = 146250

So, the cash flows for each year of the project will be:

Year 0 ($) Year 1 - 2 ($) Year 3 ($)

Operating Cash Flow (OCF) 579,333.33 579,333.33
Net Working Capital Spending (285,000.00) 285,000.00
Fixed Asset Investment (1,400,000.00)
After Tax Salvage Value (ATSV) 146,250.00
Incremental Cash Flow (1,685,000.00) 579,333.33 1,010,583.33

The NPV of the project is:

Financial Calculator Method

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TUTORIAL QUESTIONS

CF0 C01 F01 C02 F02 I CPT NPV

-$1,685,000 $579,333.33 2 $1,010,583.33 1 12 $13,416.14

5. First we will calculate the annual depreciation (using MACRS 3-years table: refer
to the attached table in last page of the question) for the equipment necessary
for the project. The depreciation amount each year will be:

Year 1 depreciation = $1,400,000(33.33%) = $466,620

Year 2 depreciation = $1,400,000(44.45%) = $622,300
Year 3 depreciation = $1,400,000(14.81%) = $207,340
Total depreciation until Year 3 = $1,296,260

So, the book value of the equipment at the end of three years, which will be the
initial investment minus the accumulated depreciation, is:

Book value in 3 years = $1,400,000 – $1,296,260

Book value in 3 years = $103,740

The asset is sold at a gain to book value, so this gain is taxable.

Aftertax salvage value = MV + (BV – MV)tc

Aftertax salvage value = $225,000 + ($103,740 – $225,000)(0.35)

Aftertax salvage value = $182,559

To calculate the OCF, we will use the tax shield approach, so the cash flow each
year is:

OCF = (Sales – Costs)(1 – tC) + tCDepreciation

OCF Year 1 = = ($1,120,000 – $480,000)(1 – 0.35) + 0.35 x $466,620 = 579,317

OCF Year 2 = = ($1,120,000 – $480,000)(1 – 0.35) + 0.35 x $622,300 = 633,805
OCF Year 3 = = ($1,120,000 – $480,000)(1 – 0.35) + 0.35 x $207,340 = 488,569

Year 0 ($) Year 1 ($) Year 2 ($) Year 3 ($)

Operating Cash Flow (OCF) 579,317 633,805 488,569
Net Working Capital
Spending (285,000.00) 285,000.00

Fixed Asset Investment (1,400,000.00)

After Tax Salvage Value
(ATSV) 182,559.00

Incremental Cash Flow (1,685,000.00) 579,317.00 633,805.00 956,128.00

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Remember to include the NWC cost in Year 0, and the recovery of the NWC at the
end of the project. The NPV of the project with these assumptions is:

The NPV of the project is:

Financial Calculator Method

CF0 C01 F01 C02 F02 C03 F03 I CPT NPV

-$1,685,000 $579,317 1 $633,805 1 956,128.00 1 12 $18,065.81

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TUTORIAL QUESTIONS

6. First, we will calculate the annual depreciation of the new equipment.

Straight Line Method (SLM) Depreciation

Depreciation = $670,000 / 5 = $134,000 per year

Now, we calculate the aftertax salvage value. The aftertax salvage value is the
market price minus (or plus) the taxes on the sale of the equipment, so:

Aftertax salvage value (ATSV) = MV + (BV – MV)tc

*using both SLM & MACRS depreciations

If the book value is zero, the equation for the aftertax salvage value becomes:

Aftertax salvage value = MV + (0 – MV)tc

Aftertax salvage value = MV(1 – tc) >>> (using SLM, book value 0)

ATSV = $50,000 (1 – 35%) = $32,500

Using the tax shield approach, the OCF is:

OCF = (Sales – Costs)(1 – tC) + tCDepreciation

OCF (Year 1 - 5) = ($240,000 – $0)(1 – 0.35) + 0.35 x $134,000 = $202,900

There is an unusual feature that is a part of this project. Accepting this project means
that we will reduce NWC. This reduction in NWC is a cash inflow at Year 0. This reduction
in NWC implies that when the project ends, we will have to increase NWC. So, at the
end of the project, we will have a cash outflow to restore the NWC to its level before
the project. We also must include the aftertax salvage value at the end of the project.

Year 0 ($) Year 1 - 4 ($) Year 5 ($)

Operating Cash Flow (OCF) 202,900 202,900
Net Working Capital Spending 85,000.00 (85,000.00)
Fixed Asset Investment (670,000.00)
After Tax Salvage Value (ATSV) 32,500.00
Incremental Cash Flow (585,000.00) 202,900.00 150,400.00

The IRR of the project is:

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Financial Calculator Method

CF0 C01 F01 C02 F02 CPT IRR

-$585,000 $202,900 4 150,400.00 1 20.06%

7. First, we will calculate the annual depreciation of the new equipment. It will be:

Straight Line Method (SLM) Depreciation

Depreciation = $375,000 / 5 = $75,000 per year

Now, we calculate the aftertax salvage value. The aftertax salvage value is the
market price minus (or plus) the taxes on the sale of the equipment, so:

Aftertax salvage value (ATSV) = MV + (BV – MV)tc

*using both SLM & MACRS depreciations

If the book value is zero, the equation for the aftertax salvage value becomes:

Aftertax salvage value = MV + (0 – MV)tc

Aftertax salvage value = MV(1 – tc) >>> (using SLM, book value 0)

ATSV = $40,000 (1 – 34%) = $26,400

Using the tax shield approach, the OCF is:

OCF = (Sales – Costs)(1 – tC) + tCDepreciation

OCF (Year 1 - 5) = ($105,000 – $0)(1 – 0.34) + 0.34 x $75,000 = $94,800

Notice that we include the NWC in the initial cash outlay. The recovery of the NWC
occurs in Year 5, along with the aftertax salvage value.

Year 0 ($) Year 1 – 4 ($) Year 5 ($)

Operating Cash Flow (OCF) 94,800 94,800
Net Working Capital Spending (28,000.00) 28,000.00
Fixed Asset Investment (375,000.00)
After Tax Salvage Value (ATSV) 26,400.00
Incremental Cash Flow (403,000.00) 94,800.00 149,200.00

The NPV of the project is:

Financial Calculator Method

CF0 C01 F01 C02 F02 I CPT NPV

-$403,000 $94,800 4 $149,200 1 10 -$9,855.29

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8. First we need to find the book value at the end of year four. We will calculate
the annual depreciation (using MACRS 5-years table: refer to the attached
table in last page of the question) for the equipment necessary for the project.
The depreciation amount each year will be:

Year 1 depreciation = $7,100,000(20%) = $1,420,000

Year 2 depreciation = $7,100,000(32%) = $2,272,000
Year 3 depreciation = $7,100,000(19.20%) = $1,363,200
Year 4 depreciation = $7,100,000(11.52%) = $817,920
Total depreciation until Year 4 = $5,873,120

So, the book value of the equipment at the end of four years, which will be the
initial investment minus the accumulated depreciation, is:

Book value in 4 years = $7,100,000 – $5,873,120 = $1,226,880

The asset is sold at a gain to book value, so this gain is taxable.

Aftertax salvage value = MV + (BV – MV)tc

Aftertax salvage value = $1,400,000 + ($1,226,880 – $1,400,000)(0.35)

Aftertax salvage value = $1,339,408

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9. Straight Line Method (SLM) Depreciation

Depreciation = $3,800,000 / 4 = $950,000 per year

Using the bottom-up approach to calculating the operating cash flow, we find the
operating cash flow each year will be:

Sales $2,500,000
Costs (625,000)
Depreciation (950,000)
EBT $925,000
Tax (35%) (323,750)
Net income $601,250

The operating cash flow is:

OCF = Net income + Depreciation

OCF (Year 1 – 4) = $601,250 + 950,000 = $1,551,250

We must be sure to add back the net working capital at the end of the project life,
since we are assuming the net working capital will be recovered.

Year 0 ($) Year 1 - 3 ($) Year 4 ($)

Operating Cash Flow (OCF) 1,551,250 1,551,250
Net Working Capital Spending (150,000.00) 150,000.00
Fixed Asset Investment (3,800,000.00)
After Tax Salvage Value (ATSV)
Incremental Cash Flow (3,950,000.00) 1,551,250.00 1,701,250.00

The NPV of the project is:

Financial Calculator Method

CF0 C01 F01 C02 F02 I CPT NPV

-$3,950,000 $1,551,250 3 $1,701,250 1 16 $473,521.38

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10. Steps for EAC calculation:

a. Compute NPV
b. Use NPV as PV and compute PMT.

After tax salvage value for both machines:

Aftertax salvage value (ATSV) = MV + (BV – MV)tc
*using both SLM & MACRS depreciations

If the book value is zero, the equation for the aftertax salvage value becomes:

Aftertax salvage value = MV + (0 – MV)tc

Aftertax salvage value = MV(1 – tc) >>> (using SLM, book value 0)

ATSV = $20,000 (1 – 35%) = $13,000

Techron I

Straight Line Method (SLM) Depreciation

Depreciation = $215,000 / 3 = $71,667 per year

Using the tax shield approach, the OCF is:

OCF = (Sales – Costs)(1 – tC) + tCDepreciation

OCF (Year 1 - 3) = ($0 – $35,000)(1 – 0.35) + 0.35 x $71,667 = $2,333.45

Year 0 ($) Year 1-2 ($) Year 3 ($)

Operating Cash Flow (OCF) 2,333.45 2,333.45
Fixed Asset Investment (215,000.00)
After Tax Salvage Value (ATSV) 13,000.00
Incremental Cash Flow (215,000.00) 2,333.45 15,333.45

The NPV of the machine is:

Financial Calculator Method

CF0 C01 F01 C02 F02 I CPT NPV

-$215,000 $2,333.45 2 $15,333.45 1 12 -$200,142.30

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EAC of the machine:

Financial Calculator Method

PV N I/Y CPT PMT

$200,142.30 3 12 -$83,329

Techron II

Straight Line Method (SLM) Depreciation

Depreciation = $270,000 / 5 = $54,000 per year

Using the tax shield approach, the OCF is:

OCF = (Sales – Costs)(1 – tC) + tCDepreciation

OCF (Year 1 - 5) = ($0 – $44,000)(1 – 0.35) + 0.35 x $54,000 = -$9,700

Year 0 ($) Year 1-4 ($) Year 5 ($)

Operating Cash Flow (OCF) (9,700.00) (9,700.00)

Fixed Asset Investment (270,000.00)

After Tax Salvage Value (ATSV) 13,000.00

Incremental Cash Flow (270,000.00) (9,700.00) 3,300.00

The NPV of the machine is:

Financial Calculator Method

CF0 C01 F01 C02 F02 I CPT NPV

-$270,000 -$9,700 4 $3,300 1 12 -$297,589.78

EAC of the machine:

Financial Calculator Method

PV N I/Y CPT PMT

$297,589.78 5 12 -$82,554

Decision: The two milling machines have unequal lives, so they can only be compared
by expressing both on an equivalent annual basis, which is what the EAC method
does. Thus, you prefer the Techron II because it has the lower (less negative) annual
cost.

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Additional question from textbook (Question 15)

When we are dealing with nominal cash flows, we must be careful to discount cash
flows at the nominal interest rate, and we must discount real cash flows using the real
interest rate. Project A’s cash flows are in real terms, so we need to find the real interest
rate. Using the Fisher equation, the real interest rate is:

1 + R = (1 + r)(1 + h)
1.13 = (1 + r)(1 + .04)
r = .0865, or 8.65%

So, the NPV of Project A’s real cash flows, discounting at the real interest rate, is:

The NPV is:

Financial Calculator Method

CF0 C01 F01 C02 F02 CO3 FO3 I CPT NPV

-$50,000 $30,000 1 $25,000 1 20,000 1 8.65 $14,382.78

Project B’s cash flow are in nominal terms, so the NPV discounted at the nominal
interest rate is:

The NPV is:

Financial Calculator Method

CF0 C01 F01 C02 F02 CO3 FO3 I CPT NPV

-$65,000 $29,000 1 $38,000 1 41,000 1 13 $18,838.35

Decision: We should accept Project B if the projects are mutually exclusive since it has
the highest NPV.

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Q 11. First, we will calculate the depreciation each year, which will be:
D1 = $640,000(0.2000) = $128,000
D2 = $640,000(0.3200) = $204,800
D3 = $640,000(0.1920) = $122,880
D4 = $640,000(0.1150) = $73,728
The book value of the equipment at the end of the project is:
BV4 = $640,000 – ($128,000 + 204,800 + 122,880 + 73,728) = $110,592
The asset is sold at a loss to book value, so this creates a tax refund.
After-tax salvage value = $70,000 + ($110,592 – 70,000)(0.35) = $84,207.20
So, the OCF for each year will be:
OCF1 = $270,000(1 – 0.35) + 0.35($128,000) = $220,300.00
OCF2 = $270,000(1 – 0.35) + 0.35($204,800) = $247,180.00
OCF3 = $270,000(1 – 0.35) + 0.35($122,880) = $218,508.00
OCF4 = $270,000(1 – 0.35) + 0.35($73,728) = $201,304.80

Now we have all the necessary information to calculate the project NPV. We need to be
careful with the NWC in this project. Notice the project requires $20,000 of NWC at the
beginning, and $3,500 more in NWC each successive year. We will subtract the $20,000
from the initial cash flow and subtract $3,500 each year from the OCF to account for this
spending. In Year 4, we will add back the total spent on NWC, which is $30,500. The
$3,500 spent on NWC capital during Year 4 is irrelevant. Why? Well, during this year the
project required an additional $3,500, but we would get the money back immediately. So,
the net cash flow for additional NWC would be zero. With all this, the equation for the
NPV of the project is:
NPV = – $640,000 – 20,000 + ($220,300 – 3,500)/1.14 + ($247,180 – 3,500)/1.142
+ ($218,508 – 3,500)/1.143 + ($201,304.80 + 30,500 + 84,207.20)/1.144
NPV = $49,908.03

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12. If we are trying to decide between two projects that will not be replaced when they wear
out, the proper capital budgeting method to use is NPV. Both projects only have costs
associated with them, not sales, so we will use these to calculate the NPV of each project.
Using the tax shield approach to calculate the OCF, the NPV of System A is:

OCFA = –$85,000(1 – 0.34) + 0.34($290,000/4)

OCFA = –$31,450

NPVA = –$290,000 – $31,450(PVIFA11%,4)

NPVA = –$387,571.92
And the NPV of System B is:

OCFB = –$75,000(1 – 0.34) + 0.34($405,000/6)

OCFB = –$26,550

NPVB = –$405,000 – $26,550(PVIFA11%,6)

NPVB = –$517,320.78

If the system will not be replaced when it wears out, then System A should be chosen,
because it has the less negative NPV.

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