CHAPTER 8/CAPITAL BUDGETING AND CASH FLOW ANALYSIS 1
CHAPTER 8
CAPITAL BUDGETING ANDCASH FLOW ANALYSIS
ANSWERS TO QUESTIONS:
1.a .Personnel managers -- the value of insurance programs and pension plans can be evaluated using discounted cash flow techniques.
b.Research and development staffs -- investments in new product research and product improvement research, having benefits that accrue over several years, can be evaluated using the methodology of capital budgeting.
c.Advertising executives -- advertising campaigns normally generate benefits (increased sales) that extend over several years. Hence investments in these campaigns can be evaluated using capital budgeting methodology.
2.Mutually exclusive projects -- the acceptance of one precludes the acceptance of another, e.g., the decision to buy one model of drillpress over a competing model.
Independent projects -- the acceptance of one project neither precludes the acceptance of another nor requires the acceptance of another, e.g., the decision to buy a replacement truck for deliveries is independent of the decision to buy a new data processing system.
Contingent projects -- the acceptance of one project requires ( is contingent upon) the acceptance of another project, e.g., the decision to build additional brewery capacity may be contingent on the decision to expand the company's marketing and distribution area.
3.Capital rationing is normally not consistent with shareholder wealth maximization, because some potentially profitable projects (projects offering an expected return greater than the required return) may not be undertaken.
4.The primary types of investment projects are projects generated by growth opportunities, projects generated by cost-reduction opportunities, and legally mandated projects. In all cases the appropriate framework for analysis is to compare the discounted benefits of the project with the project's cost. If benefits exceed costs, then the project should be undertaken. Normally growth opportunity projects will be riskier than cost-reduction projects, and hence a differential risk analysis approach should be used.
5.The objective of capital budgeting analysis is to estimate the total change in the firm's cash flows that result because a project is undertaken. Hence indirect effects on the costs and/or revenues associated with a firm's other projects that occur as a result of the acceptance of a new project should be considered when evaluating the cash flows from a new project.
6.The factors that should be considered when estimating a project's net investment include the new project cost plus shipping and installation charges, required increases in working capital at project inception, the net proceeds from the sale of old assets (in the case of replacement decisions) and the taxes associated with the sale of the old asset and/or the purchase of the new one.
7.Although depreciation itself is a noncash charge, it has the effect of reducing taxable net income and hence reducing income taxes, which are a cash outflow. The effect of depreciation on cash flows is equal to the amount of the depreciation times the firm's marginal tax rate.
8.If the old asset is sold for its book value there are no tax consequences. If the asset is sold for less than book value, the difference may be charged as a loss against ordinary income. If the asset is sold for more than book value but less than original cost, the difference is treated as ordinary income and taxed at the ordinary tax rate. If an asset is sold for more than original cost, the difference between book value and original cost is taxed as ordinary income and the difference between the sale price of the asset and its original cost is taxed as a capital gain. Under current tax laws the tax rate on capital gains is the same as the tax rate on ordinary income for most large U.S. corporations.
9.Interest charges are considered in the discounting process of capital budgeting analysis. Hence to consider their cash flow impact on a project would lead to double counting. Also, it is generally incorrect to associate a particular method of financing with the investment decision for a project.
10.An asset expansion project requires a firm to invest funds in additional assets in order to increase sales or reduce costs. Asset expansion projects frequently require a significant, incremental investment in net working capital by the firm. Expansion projects are often more risky than replacement investments because the revenues the project may generate are more uncertain.
Asset replacement investments involve the retiring of one asset and the replacement of that asset with a more efficient one. Replacement investments usually do not require significant, incremental net working capital investments.
11.The opportunity cost concept is considered in the capital budgeting process primarily through the use of the appropriate required return used to evaluate a project. This required return (the risk-adjusted discount rate) considers the returns (opportunities) that are available on other projects of equivalent risk.
SOLUTIONSTO PROBLEMS:
1.a. After tax operating cash flow (assuming straight-line depreciation):
Revenues$200.0 MM
Total operating expenses$130.0 MM
Depreciation$15.0 MM
Operating earnings before tax$55.0 MM
Tax @ 40%22.0 MM
Operating earnings after tax$33.0 MM
Depreciation$15.0 MM
After tax operating cash flow$48.0 MM
After tax operating cash flow (assuming accelerated depreciation):
Revenues$200.0 MMTotal operating expenses$130.0 MM
Depreciation$25.0 MMOperating earnings before tax$45.0 MM
Tax @ 40 %18.0 MM
Operating earnings after tax$27.0 MMDepreciation$25.0 MM
After tax operatingcash flow$52.0 MM
b.The income statement reported to the stockholders will be the same as the cash flow statement shown in part (a) above under the straight-line depreciation assumption, except that the income statement ends with the item "Operating earnings after tax" of $33 million. The after tax operating cash flow is affected by the tax depreciation charged by the firm, not the book depreciation. In this case tax depreciation is accelerated, hence the after tax operating cash flow is $52 million. The income statement of the firm would show $18 million of current income tax expense and $4 million of deferred income tax expense.
2.Annual depreciation amount = Installed cost / Number of years over which the asset is depreciated
= ($50,000 + $1,000) / 10
= $5,100
3.a. Projects A,B D,E, and G should be adopted because they offer returns which equal or exceed the acceptability criterion.
b.A capital budgeting funds constraint could eliminate some of the less promising projects, such as D and E, depending on the level of funds available. Projects would be eliminated in reverse order of profitability in order to meet the constraint.
c.If these projects differed with respect to risk, the expected project return would have to be compared to the risk-adjusted required rate of return - which could be above or below 10%.
4.a.NINV = $100,000 + $2,500 + $20,000
= $122,500
b.Annual depreciation = $102,500/8
= $12,812.50
5.Net investment = $100,000 (There are no tax consequences assumed to be associated with this purchase.)
Annual net cash flow:
Annual depreciation = $100,000/12 = $8,333NCF = (_R - _O - _Dep)(1 - T) + _Dep
NCF = [$0 - (-$15,000) - $8,333](1 - 0.4) + $8,333 = $12,333
6. a.
Year Cash OutlayPVIF0.12,t Present Value of Cash Outlays
0$4,000,0001.000$4,000,000
12,000,0000.8931,786,000
2500,0000.797398,500
$6,184,500
b.$6,500,000
7.Net investment: $1,200,000
Net cash flows: (in thousands of dollars)
Years R-_O-_Dep_OEBT-T_OEAT NCF
1-10$400$200$120$80$32$48$168
8.Net investment calculation:
Installed cost$600,000
Plus: Net working capital increase20,000
Less: Proceeds from sale of old assets-250,000
Plus: Tax on sale of machine 1
($100,000 - $95,000) x .402,000
Plus: Tax on sale of machine 2
($150,000 - $75,000) x .4030,000
Net Investment$402,000
9.a.Sale for $15,000:
Current book value of asset = $15,000 ($30,000 original cost less 5 years of depreciation at $3,000 per year). Hence the saleof the old machine for $15,000 (book value) has no tax consequences.
b.Sale for $5,000:
Tax loss on sale: $15,000 - $5,000 = $10,000
Tax saving on tax loss: .4($10,000) = $4,000
c.Sale for $26,000:
Recapture of depreciation: $26,000 - $15,000 = $11,000
Tax on depreciation recapture: .4($11,000) = $4,400
d.Sale for $32,000:
Recapture of depreciation: $30,000 - $15,000 = $15,000
Tax on depreciation recapture: .4($15,000) = $6,000
Capital gain on sale: $32,000 - $30,000 = $2,000
Capital gains tax: .40($2,000) = $800
10.Calculation of net investment:
Installed cost of new computer$160,000
Less: Proceeds from sale of old computer20,000
Plus: Tax on sale of old computer (.4)($20,000)8,000
Net investment$148,000
Net cash flows:
Depreciation computed on basis of installed cost ($160,000).
Year R-O-DepOEBT-T OEAT NCF
1-10$32,000-$2,000$16,000$18,000$7,200$10,800$26,800
11.Installed cost of ACE generator:
Cost$250,000Delivery and installation50,000Installed cost$300,000
Depreciation computed based on installed cost ($300,000).
Current book value of generator: $300,000 less first two years of depreciation = $300,000 - $60,000 - $60,000 = $180,000
Tax loss on sale of generator: $180,000 book value less actual salvage proceeds of $79,550 = $100,450
Tax saving on loss from sale of generator = .4($100,450) = $40,180
After-tax proceeds from sale:
Actual sales proceeds$79,550
Plus: Tax saving on loss from sale40,180
Plus: Recovery of working capital25,000
$144,730
12.a Net investment calculation:
Installed cost of equipment, etc$200,000
Plus: Net working capital200,000
Net investment$400,000
b.Net cash flows:
Depreciation is computed on the basis of installed cost = $200,000
YearR-O-DepOEBT-TaxOEAT NCF
1$1,000,000$700,000$40,000$260,000$104,000$156,000$196,000
21,080,000749,00040,000291,000116,400174,600214,600
31,166,400801,43040,000324,970129,988194,982234,982
41,259,712857,53040,000362,182144,873217,309257,309
51,360,489917,55740,000402,932161,173241,759281,759
61,469,328981,7860 487,542195,017292,525292,525
71,586,8741,050,5110536,363214,545321,818321,818
81,713,8241,124,0470589,777235,911353,866353,866
91,850,9301,202,7300648,200259,280388,920388,920
101,999,0051,286,9210712,084284,834427,250427,250*
* In addition to these operating cash flows, year 10 NCFs are increased by after-tax proceeds from the salvage of equipment and fixtures of $6,000 and the recovery of the $200,000 net working capital investment. This yields total NCF for year 10 of $633,250.
13.Net investment =$100,000
Net cash flows:
YearR-O-DOEBT-TOEATNCF
10-$15,000$14,290$710$284$426$14,716
20-15,00024,490-9,490-3,796-5,69418,796
30-15,00017,490-2,490-996-1,49415,996
40-15,00012,4902,5101,0041,50613,996
50-15,0008,9306,0702,4283,64212,572
60-15,0008,9206,0802,4323,64812,568
70-15,0008,9306,0702,4283,64212,572
80-15,0004,46010,5404,2166,32410,784
90-15,000015,0006,0009,0009,000
100-15,000015,0006,0009,0009,000
110-15,000015,0006,0009,0009,000
120-15,000015,0006,0009,0009,000
14.Calculation of net investment:
Installed cost of new computer$160,000
Less: Proceeds from sale of old computer20,000
Plus: Tax on sale of old computer (.4)($20,000)8,000
Net investment$148,000
Net cash flows:
Depreciation computed on basis of installed cost ($160,000).
YearR-O-DOEBT-TOEAT NCF
1$32,000-$2,000$22,864$11,136$4,454.4$6,681.6$29,545.6 2 32,000 -2,000 39,184 -5,184 -2,073.6 -3,110.4 36,073.6
332,000-2,00027,9846,0162,406.43,609.631,593.6 4 32,000 -2,000 19,984 14,016 5,606.4 8,409.6 28,393.6 5 32,000 -2,000 14,288 19,712 7,884.8 11,827.2 26,115.2 6 32,000 -2,000 14,272 19,728 7,891.2 11,836.8 26,108.8 7 32,000 -2,000 14,288 19,712 7,884.8 11,827.2 26,115.2 8 32,000 -2,000 7,136 26,864 10,745.6 16,118.4 23,254.4 9 32,000 -2,000 0 34,000 13,600 20,400 20,400
1032,000-2,000034,00013,60020,40020,400
15.Net investment:
Land$100,000
Building100,000
Equipment250,000
Installation40,000
Shipping10,000
Year 0 Net working capital70,000
Equals: NINV$570,000
Year 20 NCF:
EBIT*$210,700
Less: Tax84,280
OEAT126,420
Plus: Depreciation (building)5,000
Plus: Recovery of net working capital**150,000
Plus: After-tax land salvage ***160,000
Plus: After-tax building salvage **** 90,000
Equals: Net Cash Flow$531,420
* $100,000(FVIF.04,19)
** Sum of year 0, 1, and 2 working capital requirements
*** $100,000 tax free plus $100,000 capital gain taxed at 40%
**** $100,000 recapture of depreciation plus $50,000 capital gain, both taxed at 40%.
16. Net investment:
Cost of store$7,000,000
Cost of fixtures700,000
Installation of fixtures50,000
Present land value500,000
Initial working capital600,000
Net investment$8,850,000
17.Net investment = Machine cost + Initial working capital
= $1,000,000 + $50,000 = $1,050,000
MACRS Depreciation:
Year 1$1,000,000 x 14.29% = $142,900
NCF1 = (R - O - Dep)(1 - T) + Dep - NWC
= [($300,000 - $25,000) - ($50,000 - $5,000)
- $142,900] (1 - 0.4) + $142,900 - $25,000
= $170,160
NCF10 = (R - O - Dep)(1 - T) + Dep - NWC
+ Salvage value (1 - T)
= [($300,000 - $25,000) - ($50,000 - $5,000) - $0](1 - 0.4)
+ $0 -(-$85,000) + $50,000 (1 - 0.4)
= $253,000
18. NCF10 = (R - O - Dep)(1 - T) + Dep - NWC
+ after-tax cash flow from sale of assets
= [$700,000 - $200,000 - $0] (1 - 0.4) + $0
- (-$400,000) + [$1,800,000
- ($1,800,000 - $1,000,000) (0.4)]
+ ($1,000,000) (1 - 0.4)
= $2,780,000
19. Net investment = $900,000 + $100,000 = $1,000,000
MACRS Depreciation:
Year 1$1,000,000 x 14.29% = $142,900
Year 2$1,000,000 x 24.49% = $244,900
NCF = (R - O - Dep) (1 - T) + Dep - NWC
NCF1 = ($0 - $300,000 - $142,900) (1 - 0.4) + $142,900 = -$122,840
NCF2 = ($800,000 - $300,000 - $244,900) (1 - 0.4) + $244,900 - $50,000
= $347,960
20.NCF10 = (R - O - Dep) (1 - T) + Dep - NWC + AT Salvage
= ($225,000 - $170,000 - 0)(1 - 0.4) + 0 - ($-85,000)
+ $50,000 (1 - 0.4)
= $148,000
21.After-tax operating cash flow
= (R - O - Dep) (1 - T) + Dep - NWC
= ($50 million - $25 million - $10 million)(1 - 0.34)
+ $10 million - ($5 million - $2 million)
= $16.9 million
22.Net working capital investments = $5,000 + $3,000 + $2,000 = $10,000
Book value at the beginning of year 8 = $100,000 (0.0446) = $4,460
Year 7 revenues = $25,000(FVIF.05,5)(0.9) = $25,000(1.276)(0.9) = $28,710
Year 7 cash costs = $10,000 (FVIF.10,6) = $10,000(1.772) = $17,720
Year 7 depreciation = $100,000(0.0893) = $8,930
NCF7 = ($28,710 - $17,720 - $8,930)(1 - 0.4) + $8,930 + $10,000 + [$4,460 + ($10,000 - $4,460)(1 - 0.4)] = $27,950
23.Year 3 NCF:
Revenues / $2,420,000Less: Operating expenses / 898,880
Less: Depreciation / 150,000
Equals: Operating income before tax / $1,371,120
Less: Tax @ 40 percent rate / 548,448
Equals: Operating income after tax / $ 822,672
Add back: Depreciation / 150,000
Less: Increase in net working capital / 85,000
Equals: Net cast flow in year 3 / $887,672