Chapter 10 Problems 10-7, 10-9, 10-11, 10-13, and 10-16 pages 414-417

(10-7) NPV
Your division is considering two investment projects, each oI which requires an upIront
expenditure oI $15 million. You estimate that the investments will produce the Iollowing net
cash Ilows:
Year Project A Project B
1 $5,000,000 $20,000,000
2 10,000,000 10,000,000
3 20,000,000 6,000,000
a. hat are the two projects` net present values, assuming the cost oI capital is 5?
Year Project A Project B Cost oI
Capital
NPV Proj A NPV Proj B
0 -15,000,000 -15,000,000 1 -15,000,000 -15,000,000
1 5,000,000 20,000,000 0.9524 4,762,000 19,048,000
2 10,000,000 10,000,000 0.907 9,070,000 9,070,000
3 20,000,000 6,000,000 0.8638 17,276,000 5,182,800
NPVs 16,108,000 18,300,800

b. hat are the two projects` IRRs at these same costs oI capital?
ear ro[ A ro[ 8 Ikk ro[ A Ikk ro[ 8
0 13000000 13000000 44 82
1 3000000 20000000

2 10000000 10000000

3 20000000 6000000

IRR(B2:B5)
(10-9) NPVs and IRRs Ior Mutually Exclusive Projects
Davis Industries must choose between a gas-powered and an electric-powered IorkliIt truck Ior
moving materials in its Iactory. Since both IorkliIts perIorm the same Iunction, the Iirm will
choose only one. (They are mutually exclusive investments.) The electric-powered truck will
cost more, but it will be less expensive to operate; it will cost $22,000, whereas the gas-powered
truck will cost $17,500. The cost oI capital that applies to both investments is 12. The liIe Ior
both types oI truck is estimated to be 6 years, during which time the net cash Ilows Ior the
electric-powered truck will be $6,290 per year and those Ior the gas-powered truck will be
$5,000 per year. Annual net cash Ilows include depreciation expenses. Calculate the NPV and
IRR Ior each type oI truck, and decide which to recommend.
For the electric powered
Npv -220006290 |(1/0.12)-(1/(0.12*(10.12)`6)|
-220006290(4.1114)2200025861$3,861 IRR 18
For the gas powered
NPv175005000 |(1/0.12)-(1/(0.12*(10.12)`6)|
175005000(4.1114)1750020557$3057 IRR18
The electric powered IorkliIt would be preIerred since it has the higher NPV and IRR.
(10-11) MRR and NPV
Your company is considering two mutually exclusive projects, X and Y, whose costs and cash
Ilows are shown below:
Year X Y
0 -$1,000 -$1,000
1 100 1,000
2 300 100
3 400 50
4 700 50
The projects are equally risky, and their cost oI capital is 12. You must make a
recommendation, and you must base it on the modiIied IRR (MIRR). hich project has the
higher MIRR?
Project x -10001664.81/(1MI?RR)`4 13.59
Project y -10001636.37/(1mirr)`4 13.10
Since project x is higher, it is the preIerred.
(10-13) NPV and IRR Analysis
Cummings Products is considering two mutually exclusive investments whose expected net cash
Ilows are as Iollows:
EXPECTED NET CASH FLOS
Year Project A Project B
0 -$300 -$405
1 -387 134
2 -193 134
3 -100 134
4 600 134
5 600 134
6 850 134
7 -180 0

a. Construct NPV proIiles Ior Projects A and B.

b. hat is each project`s IRR?

181 240
c. II you were told that each project`s cost oI capital was 10, which project, iI either,
should be selected? II the cost oI capital were 17, what would be the proper choice?
lor r 10
ro[ecL has Lhe hlgher nv $28334
ro[ecL nv $17860
ro[ecL would be Lhe preferred one
lor r 17
ro[ecL nv $7393
ro[ecL nv $3103
ro[ecL would be selecLed

d. hat is each project`s MIRR at the cost oI capital oI 10? At 17? (39 Consider
Period 7 as the end oI Project B`s liIe.)
, for ro[ecL when r 10

v cosLs $300 + $387/(110)
1
+ $193/(110)
2

+ $100/(110)
3
+ $180/(110)
7
$97882

$97882 $243960(1 + ,)
7

,

1407
,

1389

L r 17
,

1737
,

1991

e. hat is the crossover rate, and what is its signiIicance?

Year Project a
0 105
1 -521
2 -327
3 -234
4 466
5 466
6 716
7 -180

Cross over rate= 14.53%
Both projects are mutually exclusive but only the one with the cost of capital higher than
the crossover rate can be selected.
(10-16) Unequal Lives
Shao Airlines is considering two alternative planes. Plane A has an expected liIe oI 5 years, will
cost $100 million, and will produce net cash Ilows oI $30 million per year. Plane B has a liIe oI
10 years, will cost $132 million, and will produce net cash Ilows oI $25 million per year. Shao
plans to serve the route Ior only 10 years, InIlation in operating costs, airplane costs, and Iares is
expected to be zero, and the company`s cost oI capital is 12. By how much would the value oI
the company increase iI it accepted the better project (plane)? hat is the equivalent annual
annuity Ior each plane?
Plane a:
Expected liIe 5 years; cost100 mill; ncI 30 mill; coc12
Plane b:
Exp liIe 10ys; cost132 mill;ncI25 mill;cic12
Npv $9.26
Project a is better since it will increase the value oI the company by $12.764 mill
Chapter 11 Problems 11-2, 11-3, 11-4, 11-5, and 11-6, pages 459-460
(11-2) Operating Cash Flow
Cairn Communications is trying to estimate the Iirst-year operating cash Ilow (at t 1) Ior a
proposed project. The Iinancial staII has collected the Iollowing inIormation:
Projected sales $10 million
Operating costs (not including depreciation) $7 million
Depreciation $2 million
Interest expense $2 million
The company Iaces a 40 tax rate. hat is the project`s operating cash Ilow Ior the Iirst year (t
1)?
Operating Cash Flows: t 1
Sales revenues $10,000,000
Operating costs 7,000,000
Depreciation 2,000,000
Operating income beIore taxes $ 1,000,000
Taxes (40) 400,000
Operating income aIter taxes $ 600,000
Add back depreciation 2,000,000
Operating cash Ilow $ 2,600,000

(11-3) Net Salvage Value
Allen Air Lines is now in the terminal year oI a project. The equipment originally cost $20
million, oI which 80 has been depreciated. Caster can sell the used equipment today to another
airline Ior $5 million, and its tax rate is 40. hat is the equipment`s aIter-tax net salvage
value?
Cost 20,000,000
Depreciation 80 16,000,000
Book value 4,000,000
Gain on sale 5,000,000 400,000,000 $1,000,000
Tax on Gain 1,000,000(0.4) $400,000
Net salvage value 5,000,000 -400,000 $4,600,000
(11-4) Replacement Analysis
The Chen Company is considering the purchase oI a new machine to replace an obsolete one.
The machine being used Ior the operation has both a book value and a market value oI zero; it is
in good working order, however, and will last physically Ior at least another 10 years. The
proposed replacement machine will perIorm the operation so much more eIIiciently that Chen`s
engineers estimate it will produce aIter-tax cash Ilows (labor savings and depreciation) oI $9,000
per year. The new machine will cost $40,000 delivered and installed, and its economic liIe is
estimated to be 10 years. It has zero salvage value. The Iirm`s ACC is 10, and its marginal
tax rate is 35. Should Chen buy the new machine?
ash ouLflow $40000
ncrease ln annual afLerLax cash flows l $9000
lace Lhe cash flows on a Llme llne
nv $1330110 hen should buy Lhe new machlne
(11-5) Depreciation Methods
endy is evaluating a capital budgeting project that should last Ior 4 years. The project requires
$800,000 oI equipment. She is unsure what depreciation method to use in her analysis, straight-
line or the 3-year MACRS accelerated method. Under straight-line depreciation, the cost oI the
equipment would be depreciated evenly over its 4-year liIe (ignore the halI-year conversion Ior
the straight-line method). The applicable MACRS depreciation rates are 33, 45, 15, and
7, as discussed in Appendix 11A. The company`s ACC is 10, and its tax rate is 40.
a. hat would the depreciation expense be each year under each method?
Cost 80,000
Disc rate 10
Depreciation Method
Year MACRS Strt Ln
1 264000 200000
2 360000 200000
3 120000 200000
4 56000 200000
Total 800000 800000

b. hich depreciation method would produce the higher NPV, and how much higher would
it be?
Tax rate .4
MACRS Strt Ln
105600 80000
144000 80000
48000 80000
22400 80000

NPV T0 Yr 1 Yr 2 Yr 3 Yr 4 Total
MACRS -800000 96000 119008.3 36063.11 15299.5 -533629
Srtln -800000 72727.27 66115.7 60105.18 54641.08 -546411
MACRS seems the highest npv
(11-6) New-Project Analysis
The Campbell Company is evaluating the proposed acquisition oI a new milling machine. The
machine`s base price is $108,000, and it would cost another $12, 500 to modiIy it Ior special use.
The machine Ialls into the MACRS 3-year class, and it would be sold aIter 3 years Ior $65,000.
The machine would require an increase in net working capital (inventory) oI $5,500. The milling
machine would have no eIIect on revenues, but it is expected to save the Iirm $44,000 per year in
beIore-tax operating costs, mainly labor. Campbell`s marginal tax rate is 35.
a. hat is the net cost oI the machine Ior capital budgeting purposes? (That is, what is the
Year-0 net cash Ilow?)
The net cost is $126,000:

Price ($108,000)
ModiIication (12,500)
Increase in NC (5,500)
Cash outlay Ior new machine ($126,000)

b. hat is the additional Year 3 cash Ilow (i.e., the aIter-tax salvage and the return oI
working capital)?

Year 1 Year 2 Year 3
1. AIter-tax savings $28,600 $28,600 $28,600
2. Depreciation tax savings 13,918 18,979 6,326
Net cash Ilow $42,518 $47,579 $34,926

Notes:

1. The aIter-tax cost savings is $44,000(1 - T) $44,000(0.65)
$28,600.

2. The depreciation expense in each year is the depreciable basis, $120,500, times the MACRS
allowance percentages oI 0.33, 0.45, and 0.15 Ior Years 1, 2, and 3, respectively. Depreciation
expense in Years 1, 2, and 3 is $39,765, $54,225, and $18,075. The depreciation tax savings is
calculated as the tax rate (35) times the depreciation expense in each year.

c. II the project`s cost oI capital is 12, should the machine be purchase?
The terminal year cash Ilow is $50,702:

Salvage value $65,000
Tax on SV* (19,798)
Return oI NC 5,500
$50,702

BV in Year 4 $120,500(0.07) $8,435.
*Tax on SV ($65,000 - $8,435)(0.35) $19,798.

















d. The project has an NPV oI $10,841; thus, it should be accepted.
Year Net Cash Flow PV 12
0 ($126,000) ($126,000)
1 42,518 37,963
2 47,579 37,930
3 85,628 60,948
NPV $ 10,841
Alternatively, place the cash Ilows on a time line:

0 1 2 3
| | | |
-126,000 42,518 47,579 34,926
50,702
85,628

ith a Iinancial calculator, input the appropriate cash Ilows into the cash Ilow register, input I/YR 12,
and then solve Ior NPV $10,841.
12