MN22154

Practice 1 Solutions

Exercise 1: Cash Payments

You are saving for retirement. To live comfortably, you decide you will need to save $2 million
by the time you are 65. Today is your 30th birthday, and you decide, starting today and
continuing on every birthday up to and including your 65th birthday, that you will put an amount
into a savings account. Because your income will increase over your lifetime, it would be more
realistic to save less now and more later. You decide to let the amount that you set aside grow
by 3% per year.
If the interest rate is 5%, how much must you set aside each year to make sure that you will
have $2 million in the account on your 65th birthday?

Timeline:
30 31 32 33 65
0 1 2 3 35

C C(1.03) C(1.03)2 C(1.03)3 C(1.03)35

FV = 2 million
The PV of the cash flows must equal the PV of $2 million in 35 years.
The cash flow consists of a 35-year growing annuity, plus the
contribution today. So the PV is:
# ($%C! ) " " $%C! #!" #
'( = $$ ! $ % % + #%
C%C" ! C%C! & & $%C" ' '

(Caution! Saving starts today so you cannot use C directly as the

first payment, because this will give you PV of age 29, one year
earlier (Recall the discussion in the lecture). To find the correct PV
of today, you need to use C(1.03) as the first payment)

The PV of $2 million in 35 years is:

#$ %%%$ %%%
= &!'#$ "(%)"*)
(+)%")!"
Setting these equal gives:
# ($%C! ) " " $%C! #!" #
$$ ! $ % % + # = !'() "*C%"+%
C%C" , C%C! & & $%C" ' '
 Solving for C,
!#$% "C'(")
*= = +,!% C$!(-,(
,('! " " ,('! #!" #
$, ! $ % % +,
'('" ! '('! & & ,('" ' '

Exercise 2 Determining Free Cash Flow

Elmdale Enterprises is deciding whether to expand its production facilities. Although long-term
cash flows are difficult to estimate, management has projected the following cash flows for the
first two years (in millions of dollars):

1. 2. Year 1 3. Year 2
Revenues 4. 108.2 5. 156.1
Costs of goods sold and operating expenses6. 36.6 7. 36.6
other than depreciation
Depreciation 8. 24.2 9. 38.6
Increase in net working capital 10. 5.1 11. 8.9
Capital expenditures 12. 32.1 13. 42.5
Marginal corporate tax rate 14. 43% 15. 43%

a. What are the incremental earnings for this project for years 1 and 2?
b. What are the free cash flows for this project for the first two years?

a. The incremental earnings is calculated by

𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 (𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒)
= (𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠 − 𝐶𝑜𝑠𝑡𝑠 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛) × (1 − 𝜏! )
Therefore,
For year 1
𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 = (108.2 − 36.6 − 24.2) × (1 − 43%) = 27.0
For year 2
𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 = (156.1 − 36.6 − 38.6) × (1 − 43%) = 46.1

The table below shows the calculation of each step:

 Year 1 2
Unlevered Net Income Forecast ($000s)
1 Sales 108 156
COGS & Operating Expenses (other than
2 depreciation) -36.6 -36.6
3 Depreciation -24.2 -38.6
4 EBIT 47.4 80.9
5 Income tax at 43% -20 -35

6 Unlevered Net Income 27.0 46.1

b. The free cash flow is calculated by

𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑠
= 𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 (𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
− 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 − ∆𝑁𝑒𝑡 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

Therefore,
For year 1
𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 = 27.0 + 24.2 − 32.1 − 5.1 = 14.0
For year 2
𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 = 46.1 + 38.6 − 42.5 − 8.9 = 33.3

Year 1 2
Free Cash Flow ($000s)
6 Unlevered Net Income 27.0 46.1
7 Add: Depreciation 24.2 38.6
8 Less: Capital Expenditures 32.1 42.5
9 Less: Increase in net working capital 5.1 8.9

10 Free Cash Flow 14.0 33.3

Exercise 3: Analysing the Project
Billingham Packaging is considering expanding its production capacity by purchasing a new
machine, the XC-750. The cost of the XC-750 is $2.68 million. Unfortunately, installing this
machine will take several months and will partially disrupt production. The firm has just
completed a $45,000 feasibility study to analyse the decision to buy the XC-750, resulting in
the following estimates:
■ Marketing: Once the XC-750 is operating next year, the extra capacity is expected to
generate $10.15 million per year in additional sales, which will continue for the 10-year life of
the machine.
■ Operations: The disruption caused by the installation will decrease sales by $5.01 million
this year. Once the machine is operating next year, the cost of goods for the products produced
by the XC-750 is expected to be 71% of their sale price. The increased production will require
additional inventory on hand of $1.12 million to be added in year 0 and depleted in year 10.
■ Human Resources: The expansion will require additional sales and administrative personnel
at a cost of $1.97 million per year.
■ Accounting: The XC-750 will be depreciated via the straight-line method over the 10-year
life of the machine. The firm expects receivables from the new sales to be 15% of revenues
and payables to be 10% of the cost of goods sold. Billingham’s marginal corporate tax rate is
35%.

a. Determine the incremental earnings from the purchase of the XC-750.

b. Determine the free cash flow from the purchase of the XC-750.
c. If the appropriate cost of capital for the expansion is 9.9%, compute the NPV of the purchase.

To solve this question, we need to first identify each element in deciding the incremental
earnings and free cash flows.
Feasibility study is a sunk cost so it will not be included in the analysis.
The cost of the machine $2.68 is considered as a capital expenditure for analysing the free
cash flows.
The additional sales of $10.15 is considered as revenue from year 1 to year 10
The cost of good sold is 71% of all sales,
For year 1 to year 10, 𝐶𝑜𝐺𝑆 = $10.15 × 71% = 7.207
Sales and Admin Expenses are 1.97 per year from year 1 to year 10
The depreciation is a straight-line depreciation over 10 years with no residual value, so the
depreciation each year would be
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = $2.68 ÷ 10 = 0.268
With all the information above we are able to calculate the incremental earnings for the project:
In year 0
𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 = [−5.01] × (1 − 35%) = −3.256
From year 1 to year 10
𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 = [10.150 − 7.207 − 1.97 − 0.268] × (1 − 35%) = 0.459

Then we need to calculate the free cash flows considering the changes in net working capital
and capital expenditure.
The increased production will require additional inventory on hand of $1.12 million to be
added in year 0 and depleted in year 10
Net working Capital = Cash + Inventory + Receivables – Payables

In year 0
𝑁𝑒𝑡 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 0 + 1.12 + 15% × (−5.010) − 10% × 0 = 0.369
From year 1 to year 9
𝑁𝑒𝑡 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 0 + 1.12 + 15% × (10.150) − 10% × 7.207 = 1.922
In year 10 as the inventory has been depleted
𝑁𝑒𝑡 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 0 + 0 + 15% × (10.150) − 10% × 7.207 = 0.802
In year 11 as the project ends
𝑁𝑒𝑡 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 0
REMEMBER to put changes in NWC in the calculation of free cash flows:
Year 0 ∆𝑁𝑊𝐶 = 0.369
Year 1 ∆𝑁𝑊𝐶 = 1.922 − 0.369 = 1.553
Year 2 to year 9 ∆𝑁𝑊𝐶 = 1.922 − 1.922 = 0
Year 10 ∆𝑁𝑊𝐶 = 0.802 − 1.922 = −1.120
Year 11 ∆𝑁𝑊𝐶 = 0 − 0.802 = −0.802

Then we could calculate the free cashflows for each year:

FCF = Incremental Earnings + Depreciation - ∆𝑁𝑊𝐶-Capital Expenditure

Year 0 𝐹𝐶𝐹 = −3.256 + 0 − 0.369 − 2.68 = −6.305

Year 1 𝐹𝐶𝐹 = 0.459 + 0.268 − 1.553 − 0 = −0.826
Year 2 to year 9 𝐹𝐶𝐹 = 0.459 + 0.268 − 0 − 0 = 0.727
Year 10 𝐹𝐶𝐹 = 0.459 + 0.268 − (−1.120) − 0 = 1.847
 Year 11 𝐹𝐶𝐹 = 0 + 0 − (−0.802) − 0 = 0.802

Using a 9.9% discount rate we could calculate the NPV of the project:
#
−0.826 0.727 1.847 0.802
𝑁𝑃𝑉 = −6.305 + +[ + + = −2.516
(1 + 9.9%) (1 + 9.9%)" (1 + 9.9%)&' (1 + 9.9%)&&
"$%

Therefore, the project is not worth investing.

Year 0 1 2 3 4 5 6 7 8 9 10 11

Sales -5.010 10.150 10.150 10.150 10.150 10.150 10.150 10.150 10.150 10.150 10.150

Manufacturing Expenses (other than

deprecation) -7.207 -7.207 -7.207 -7.207 -7.207 -7.207 -7.207 -7.207 -7.207 -7.207

Sales & Administrative Expenses -1.970 -1.970 -1.970 -1.970 -1.970 7.2070 -1.970 -1.970 -1.970 -1.970

Depreciation -0.268 -0.268 -0.268 -0.268 -0.268 -0.268 -0.268 -0.268 -0.268 -0.268

EBIT -5.010 0.706 0.706 0.706 0.706 0.706 0.706 0.706 0.706 0.706 0.706

Taxes at 35% 1.754 -0.247 -0.247 -0.247 -0.247 -0.247 -0.247 -0.247 -0.247 -0.247 -0.247

a. Incremental Income -3.256 0.459 0.459 0.459 0.459 0.459 0.459 0.459 0.459 0.459 0.459

Depreciation 0.268 0.268 0.268 0.268 0.268 0.268 0.268 0.268 0.268 0.268

Additions to Net Working Capital -0.369 -1.553 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 1.120 0.802

Capital Expenditure -2.680

b. Free Cash Flow -6.305 -0.826 0.727 0.727 0.727 0.727 0.727 0.727 0.727 0.727 1.847 0.802

PV (9.9%) -6.305 -0.752 0.602 0.547 0.498 0.453 0.412 0.375 0.341 0.311 0.718 0.284

c. NPV (9.9%) -2.516

Exercise 4: Project Selection with Resource Constraints
Kaimalino Properties (KP) is evaluating six real estate investments. Management plans to buy
the properties today and sell them five years from today. The following table summarizes the
initial cost and the expected sale price for each property, as well as the appropriate discount
rate based on the risk of each venture.

KP has a total capital budget of $18,000,000 to invest in properties.

a. What is the NPV of each investment?
b. Given its budget of $18,000,000, which properties should KP choose?
c. Explain why the profitability index method could not be used if KP’s budget were
$12,000,000 instead. Which properties should KP choose in this case?

a. We can compute the NPV for each as NPV = Sale Price/(1 + r)5 – Cost. See
spreadsheet below.
4R S %C D% IGT - 8% G !"# >MD- ? M8 MD. G
! "#$ % CD E# ) DGH#I - . L M )C # NO DGP -D% ! "MC % GMO GV %- "GW ;P P Y != ;O I %R
@ #N O D-M O GPM I A% bG B Ca aa Ca aa c Wd b GGGGGc e Caa a Caa a fB gc d b GGGGW Ch fh Cc ec c ghe
iC % -O G! -"j G4 )D -D% ) G cW Ca aa Ca aa c Wd b GGGGGk W CWa a Caa a Be gl d G ll CW BP Ce ff c gWa
n -j % oM %p G GG h Ca aa Ca aa c Wd b GGGGGW a Caa a Caa a fa gh d G cW Ce We Ce Bk c gkP
T %- ? "%% T % GG P Ca aa Ca aa ed b GGGGGB W CWa a Caa a fl gk d G ce Cc Pa Ck aB B gaB
r"% % OGs M 88 ) GG B Ca aa Ca aa ed b GGGGGc a Caa a Caa a lk gl d GGG B Ce aW Ce Bl c glk
t %) DGP - OC u GG h Ca aa Ca aa ed b GGGGGf P CWa a Caa a Be gh d G ll CP fk Cc ch l gWl

b. We can rank projects according to their profitability index = NPV/Cost, as shown below.
Thus, KP should invest in Seabreeze, West Ranch, and Mountain Ridge. (Note that ranking
projects according to their IRR would not maximize KP’s total NPV, and so would not lead to
the correct selection.)
c. The profitability index fails because the top-ranked projects do not completely use up
the budget. In this case, you should take Mountain Ridge and West Ranch.