Investment Appraisal

PAST EXAM QUESTIONS

Question 1

Please answer both parts.

Part I

You are the manager of a pharmaceutical company and are considering what
type of laptop computers to purchase for your field salespeople. You have two,
mutually exclusive, alternatives:

You can buy relatively inexpensive (and less powerful) older machines for
about 500 each. These machines will be obsolete in three years and are
expected to have an annual maintenance cost of 100.

Alternatively, you can buy newer and more powerful laptops for about
1,000 each. These are expected to last about five years and to have an
annual maintenance cost of 50.

If your cost of capital is 10%, which course of action would you choose and why?

(15 marks)

Part II

Eugene Fama and Robert Shiller were awarded the Nobel Economic Laureate
(together with Lars Peter Hansen) in 2013. In October that year, The Economist
magazine wrote of the two:

In the 1960s, Mr Fama, based at the University of Chicago, showed that

predicting how stock prices would change in the short run is extremely difficult.
Market prices react surprisingly fast to new pieces of information, he suggested,
and stock price movements are unpredictable, following a random walk
pattern. Mr Shiller, based at Yale University, showed that what is true at very
short horizons is not necessarily true over longer periods. Seminal work by Mr
Shiller found that while asset prices are meant to be an aggregate of expected
changes in pay-offs (like dividends in the case of stocks) dividends vary much
less than stock prices. Interestingly, this makes future stock price movements
easier to predict. When the price-dividend ratio is high prices tend to fall. Not
only does this relationship hold for stocks, but for other assets such as bonds
too.

Required

Do you believe that markets are efficient (as Fama argues) or that they can be
quite inefficient (as Shiller argues)? Why?

(10 marks)
Investment Appraisal

(Total 25 marks)
Investment Appraisal

Answer 1

Part A

The way to convert the up-front costs into annualized equivalents is to divide the
NPVs by:

{1 (1 / [1+kc] life)} / kc

Annualized cost of inexpensive machines

= - 500 (APV, 10%, 3) - 100

= - 500 / 2.4869 - 100

= - 301

Annualized cost of expensive machines

= - 1,000 (APV, 10%, 5) - 50

= -1,000 / 3.791 - 50

= - 314

I would pick the less expensive machine. They are cheaper on an annual basis.

Part B

Eugene Fama is an advocate of the Efficient Markets Hypothesis (EMH). This

argues that financial markets are "informationally efficient". In consequence of
this, one cannot consistently achieve returns in excess of average market returns
on a risk-adjusted basis, given the information available at the time the
investment is made. There are three major versions of the hypothesis: "weak",
"semi-strong", and "strong".

1. The weak-form EMH claims that prices on traded assets (e.g., stocks,
bonds, or property) already reflect all past publicly available information.

2. The semi-strong-form EMH claims both that prices reflect all publicly
available information and that prices instantly change to reflect new public
information.

3. The strong-form EMH additionally claims that prices instantly reflect even
hidden or "insider" information.

Belief in strong-form market efficiency is contradicted by legislation which

penalises trading while using insider information across the developed world. So I
dont believe in the strong-form EMH. And several trends appear to contradict
the semi-strong-form of the EMH. It has been found that there are several asset
trading strategies which appear to outperform just a risk-adjusted form of the
market return:
Investment Appraisal

Investments in stocks with low price to book value ratios appear to

outperform the market.

Investments in stocks with low price to sales ratios appear to outperform

the market.

Shiller has found that the market over-reacts to economic news and
factors and that the extent of share price volatility is not justified by the
variation in discounted cash flow estimates of the shares underlying
value. It was for this work that Shiller received his share of the Novel
economics laureate.

Even Fama, together with French, argues (with his three-factor model) that
expected asset returns are not simply a function of their non-diversifiable
risk (as measured by their beta). Fama believes that (i) small stocks and
(ii) stocks with a low price to book value do better than expected. His
three-factor model expressly incorporates (other with a revised beta)
these latter two factors.

But the simple reality is that if there is a generally known method to

outperform markets market prices will adapt to incorporate the price signals
sent by these methods. Another simple reality is that just because a particular
strategy may have outperformed the market in the past does not necessarily
mean that it must outperform again in the future. So while there may have been
clear price anomalies and resulting trading opportunities in the past that doesnt
mean that, today, there is a proven method to outperform market averages
other than by taking on additional risk. At this conceptual level at least, Fama
may be right.
Investment Appraisal

Question 2

Answer all three parts of this question.

Part A

Fresnillo plc explores and mines gold and silver in Mexico. The gold production
accounts for 55 per cent of the activities of the firm, with the rest of the effort
involved in silver mining. Other gold mining firms have an average beta of 0.8
and a debt to equity ratio of 1/3. Silver mining is less risky and the average beta
of silver mining firms is 0.6. However, these companies tend to have more debt,
with an average debt to equity ratio of . Fresnillo has a market capitalization of
equity of 11.93 billion and it has no debt.

Required
Determine the expected return on the Fresnillos shares if the expected return on
the FTSE 100 is 12 per cent and the risk free rate is 3 per cent.

(5 marks)

Part B

Fresnillo plc is considering a new three-year expansion project that requires an

initial non-current asset investment of 3.9 million. The non-current asset will be
depreciated using the 20 per cent reducing-balance method. At the end of three
years it will be worthless. The project is estimated to generate 2,650,000 in
annual sales, with costs of 840,000. The tax rate is 24% and is paid in the same
year in which the tax liability arises.

Required

If you apply the cost of capital estimated in Part A above, what is the Net Present
Value (NPV) of this project?

(15 marks)

Part C

Briefly explain four reasons why Net Present Value (NPV) may be superior to
Internal Rate of Return (IRR) as an investment appraisal technique.

(5 marks)

(Total 25 marks)
Investment Appraisal

Answer 2

Part A

Beta of Fresnillo plc: 0.55*0.8 + 0.45*0.6 = 0.71

Expected Return on Shares:
R = RF + * (R RF)
= 0.03 + 0.71*(0.12 0.03) = 0.0939
= 9.39%

Part B

Depreciation Schedule

Beginning Depreciatio Ending Book

Year Value n Value

3,900,000. 780,000.0
1 00 0 3,120,000.00

3,120,000. 624,000.0
2 00 0 2,496,000.00

2,496,000. 2,496,000
3 00 .00 0.00

Operating Cash Flows

Depreciati Profit Before

Sales Costs on Tax Tax OCF

2,650,0 840,00 288,40 1,521,6

1 00 0 780,000 1,030,000 0 00

2,650,0 840,00 332,08 1,477,9

2 00 0 624,000 1,186,000 0 20

-
2,650,0 840,00 192,08 2,002,0
3 00 0 2,496,000 -686,000 0 80

NPV

Year CF DF PV
0 -3,900,000 1.0000 -3,900,000
1 1,521,600 0.9142 1,390,986
2 1,477,920 0.8357 1,235,082
3 2,002,080 0.7640 1,529,497

NPV 255,565
Part C
Investment Appraisal

Reasons why NPV is superior to IRR include:

1. The reinvestment rate assumption implicit in the NPV method (surplus

funds generated at intermediate stages of the project are reinvested at a
rate of return equal to the cost of capital) is probably more realistic than
that implicit in the IRR method (surplus funds generated at intermediate
stages of the project are reinvested at a rate of return equal to the IRR).
2. In the case of mutually exclusive projects where the signals generated by
the NPV and IRR methods conflict, the NPV methods offers a true signal
while IRR can mislead.
3. The NPV method is fully aligned with measurements of shareholder value
in a way that IRR measure are not i.e. the NPV of a project is the precise
amount by which it is expected to boost shareholder value.
4. Unlike IRR, NPV never generates multiple answers for a given set of
project cash flows.
Investment Appraisal

Question 3

Answer both parts.

Part I
You are the new financial manager of the bed mattress firm, Fairy Tale Lullaby
Ltd. The firm has always used payback period and accounting rate of return to
appraise new investments. With your trusty copy of Corporate Finance to hand,
you believe that other methods may be more appropriate for the firm. Write a
report to the owners of Fairy Tale Lullaby Ltd that reviews the different methods
that can be used in investment appraisal together with their strengths and
weaknesses. Comment on any practical issues that Fairy Tale Lullaby may face
in implementing these methods.

(15 marks)

Part II
A Solar panel production firm Soleil SA, is considering an investment in new solar
production technology. The new investment would require initial funding of 4
million today and further expenditure on manufacture of 1m in each of the
years 6 and 7. The net cash inflow for the years 1 to 4 is 2.34 million per year.
Some equipment could be sold in the end of year 5 when the production ends
and together with the cash flows from operation would produce a net cash flow
of 4.85 million.

Evaluate the investment using two investment appraisal criteria. The required
rate of return of Soleil SA is 12% and Soleil has been known to use a payback
period of 2 years in the past. However, the firms managers believe that this
payback period may be too short.

(15 marks)

(Total 30 marks)
Answer 3
Part II
Investment Appraisal

Question 4

Part I
Weir Group plc is considering the development of a new slurry pump in its
existing products. The pump is expected to improve market share for the
company if it is fully integrated into its existing product line-up. With the pace of
new technological developments, you expect the slurry pump to be obsolete by
the end of five years. The equipment required for the project has no salvage
value. The required return for projects of this type is 15 per cent, and the
company has a 24 per cent tax rate. Assume that any tax due is paid one year in
arrears. Assume 20 per cent reducing balance depreciation with any remaining
balance fully written off in the assets final year.

Using the Net Present Value method to evaluate it, would you recommend this
project?

Pessimistic Expected Optimistic

25% likely 50% likely 25% likely

Market size 1,000 1,500 1,700

Market share 15% 20% 25%
Selling price 10,000 15,000 20,000
Variable costs per unit 72% 70% 68%
Fixed costs per year 400,000 450,00 550,000

0
Initial investment 2,500,000 2,500,00 2,500,000

(32 marks)
Part II

Briefly explain four reasons why Net Present Value (NPV) may be superior to
Internal Rate of Return (IRR) as an investment appraisal technique.
(8 marks)

(Total 40 marks)

Answer 4

Part I
With a positive expected Net Present Value, I would recommend that Weir Group
proceeds with this project.
Investment Appraisal
Investment Appraisal
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Part II

Reasons why NPV is superior to IRR include:

1. The reinvestment rate assumption implicit in the NPV method (surplus

funds generated at intermediate stages of the project are reinvested at a
rate of return equal to the cost of capital) is probably more realistic than
that implicit in the IRR method (surplus funds generated at intermediate
stages of the project are reinvested at a rate of return equal to the IRR).
2. In the case of mutually exclusive projects where the signals generated by
the NPV and IRR methods conflict, the NPV methods offers a true signal
while IRR can mislead.
3. The NPV method is fully aligned with measurements of shareholder value
in a way that IRR measure are not i.e. the NPV of a project is the precise
amount by which it is expected to boost shareholder value.
4. Unlike IRR, NPV never generates multiple answers for a given set of
project cash flows.
Investment Appraisal

BASIC
12. Relevant Cash Flows [LO1]Parker & Stone NV is looking
at setting up a new manufacturing plant in Rotterdam to produce
garden tools. The company bought some land six years ago for 6
million in anticipation of using it as a warehouse and distribution
site, but the company has since decided to rent these facilities from
a competitor instead. If the land were sold today, the company
would net 6.4 million. The company wants to build its new
manufacturing plant on this land; the plant will cost 14.2 million to
build, and the site requires 890,000 worth of grading before it is
suitable for construction. What is the proper cash flow amount to
use as the initial investment in non-current assets when evaluating
this project? Why?
Answer: 21,490,000

Explanation:
The 6 million acquisition cost of the land six years ago is a sunk cost. The
6.4 million current after-tax value of the land is an opportunity cost if the
land is used rather than sold off. The 14.2 million cash outlay and
890,000 grading expenses are the initial non-current asset investments
needed to get the project going. Therefore, the proper year zero cash flow
to use in evaluating this project is

6,400,000 + 14,200,000 + 890,000 = 21,490,000

13. Relevant Cash Flows [LO1]Winnebagel plc. currently sells

30,000 mobile caravans per year at 53,000 each, and 12,000
luxury stationary caravans per year at 91,000 each. The company
wants to introduce a new caravanette to fill out its product line; it
hopes to sell 19,000 of these caravanettes per year at 13,000
each. An independent consultant has determined that if Winnebagel
introduces the new caravanettes, it should boost the sales of its
existing luxury stationary caravans by 4,500 units per year, and
reduce the sales of its mobile caravans by 900 units per year. What
is the amount to use as the annual sales figure when evaluating this
project? Why?
Answer: Sales due solely to the new product line are:

19,000(13,000) = 247,000,000

Increased sales of the caravan line occur because of the new product line
introduction; thus:

4,500(91,000) = 409,500,000

in new sales is relevant. Erosion of luxury caravan sales is also due to the
new caravanettes; thus:
Investment Appraisal

900(53,000) = 47,700,000 loss in sales

is relevant. The net annual sales figure to use in evaluating the new line is
thus:

247,000,000 + 409,500,000 47,700,000 = 608,800,000

14. Calculating Projected Net Income [LO1]A proposed new

investment has projected sales of 830,000. Variable costs are 60
per cent of sales, and fixed costs are 181,000; depreciation is
77,000. Prepare a pro forma income statement assuming a tax rate
of 28 per cent. What is the projected net income?

Answer: We need to construct a basic income statement. The income

statement is:

Sales 830,000
Variable costs 498,000
Fixed costs 181,000
Depreciation 77,000
EBT 74,000
Taxes@28% 20,720
Net income 53,280
Investment Appraisal

15. Calculating OCF [LO1]Consider the following income

statement:

Sales () 1,824,500
Costs () 838,900
Depreciation () 226,500
Profit before taxes () ?
________
Taxes (28%) () ?
________
Net income () ?
________

Fill in the missing numbers and then calculate the OCF. What is the
depreciation tax shield?

Answer: To find the OCF, we need to complete the income statement as

follows:

Sales 1,824,500
Costs 838,900
Depreciation 226,500
Profit before Taxes 759,100
Taxes@28% 212,548
Net income 546,552

The OCF for the company is:

OCF = Profit Before Taxes + Depreciation Taxes

OCF = 759,100 + 226,500 212,548
OCF = 773,052

The depreciation tax shield is the depreciation times the tax rate, so:

Depreciation tax shield = tcDepreciation

Depreciation tax shield = .28(226,500)
Depreciation tax shield = 63,420

The depreciation tax shield shows us the increase in OCF by being able to
expense depreciation.
Investment Appraisal

16. OCF from Several Approaches [LO1]A proposed new

project has projected sales of NKr108,000, costs of NKr51,000, and
depreciation of NKr6,800. The tax rate is 35 per cent. Calculate
operating cash flow using the four different approaches described in
the chapter, and verify that the answer is the same in each case.

Answer: To calculate the OCF, we first need to calculate net income. The
income statement is:

Sales Nkr 108,000

Variable costs 51,000
Depreciation 6,800
EBT Nkr50,200
Taxes@35% 17,570
Net income Nkr32,630

Using the most common financial calculation for OCF, we get:

OCF = EBT + Depreciation Taxes

OCF = Nkr50,200 + Nkr 6,800 Nkr 17,570
OCF = Nkr39,430

The top-down approach to calculating OCF yields:

OCF = Sales Costs Taxes

OCF = Nkr108,000 Nkr 51,000 Nkr 17,570
OCF = Nkr39,430

The tax-shield approach is:

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

OCF = (Nkr108,000 Nkr 51,000)(1 .35) + .35(Nkr 6,800)
OCF = Nkr39,430

And the bottom-up approach is:

OCF = Net income + Depreciation

OCF = Nkr32,630 + Nkr 6,800
OCF = Nkr39,430

All four methods of calculating OCF should always give the same answer.
Investment Appraisal

17. alculating Depreciation [LO1]A piece of newly purchased

industrial equipment costs 1,080,000, and is depreciated using 20
per cent reducing-balance. Calculate the annual depreciation
allowances and end-of-the-year book values for this equipment.
Answer: The ending book value for any year is the beginning book value
minus the depreciation for the year. Remember, to find the amount of
depreciation for any year, you multiply the beginning book value times the
depreciation percentage for the year. The depreciation schedule for this
asset for the first ten years is given below. All further years after year 10
follow the same formula:

Beginning Depreciati Ending Book

Year Value on Value
1,080,000.0 216,000.
1 0 00 864,000.00
172,800.
2 864,000.00 00 691,200.00
138,240.
3 691,200.00 00 552,960.00
110,592.
4 552,960.00 00 442,368.00
88,473.6
5 442,368.00 0 353,894.40
70,778.8
6 353,894.40 8 283,115.52
56,623.1
7 283,115.52 0 226,492.42
45,298.4
8 226,492.42 8 181,193.93
36,238.7
9 181,193.93 9 144,955.15
28,991.0
10 144,955.15 3 115,964.12

18. Calculating Salvage Value [LO1]Consider an asset that

costs 548,000 and is depreciated using 20 per cent reducing-
balance. The asset is to be used in a five-year project; at the end of
the project, the asset can be sold for 105,000. If the relevant tax
rate is 35 per cent, what is the after-tax cash flow from the sale of
this asset?
Answer: We want to find the BV of the asset after 5 years. With 20 per
cent reducing balance depreciation, the depreciation schedule and ending
book values each year will be:

Beginning Depreciati Ending Book

Year Value on Value
109,600.
1 548,000.00 00 438,400.00
87,680.0
2 438,400.00 0 350,720.00
Investment Appraisal

70,144.0
3 350,720.00 0 280,576.00
56,115.2
4 280,576.00 0 224,460.80
44,892.1
5 224,460.80 6 179,568.64

The asset is sold at a loss to book value, so the depreciation tax shield of the
loss is recaptured.

After-tax salvage value = 105,000 + (179,568.64 105,000)(0.35)

After-tax salvage value = 131,099.02

To find the taxes on salvage value, remember to use the equation:

Taxes on salvage value = (BV MV)tc

This equation will always give the correct sign for a tax inflow (refund) or
outflow (payment).
Investment Appraisal

19. Calculating Salvage Value [LO4]An asset used in a four-

year project is to be depreciated using the 18 per cent reducing-
balance method. The asset has an acquisition cost of 7,900,000
and will be sold for 1,400,000 at the end of the project. If the tax
rate is 23 per cent, what is the after-tax salvage value of the asset?
Answer: To find the BV at the end of four years, we need to find the
accumulated depreciation for the first four years.

Ending Book
Year Beginning Value Depreciation
Value
1 7,900,000 1,422,000 6,478,000
2 6,478,000 1,166,040 5,311,960
3 5,311,960 956,153 4,355,807
4 4,355,807 784,045 3,571,762

The asset is sold at a loss to book value, so the depreciation tax shield of the
loss is recaptured.

After-tax salvage value = 1,400,000 + ((3,571,762 1,400,000) (0.23))

After-tax salvage value = 1,899,505

20. Calculating Project OCF [LO1]Summer Tyme plc. is

considering a new three-year expansion project that requires an
initial non-current asset investment of 3.9 million. The non-current
asset will be depreciated using the 20 per cent reducing-balance
method. At the end of three years it will be worthless. The project is
estimated to generate 2,650,000 in annual sales, with costs of
840,000. If the tax rate is 28 per cent, what is the OCF for each
year of this project?
Answer: First calculate the depreciation schedule.

Beginning Depreciati Ending Book

Year Value on Value
3,900,000. 780,000. 3,120,000.0
1 00 00 0
3,120,000. 624,000. 2,496,000.0
2 00 00 0
2,496,000. 2,496,00
3 00 0.00 0.00

The operating cash flow for each year is calculated as follows:

Depreciati Profit Before

Sales Costs on Tax Tax OCF
2,650,0 840,00 288,40 1,521,6
1 00 0 780,000 1,030,000 0 00
2 2,650,0 840,00 624,000 1,186,000 332,08 1,477,9
Investment Appraisal

00 0 0 20
-
2,650,0 840,00 192 2,002,0
3 00 0 2,496,000 -686,000 ,080 80
Investment Appraisal

21. Calculating Project NPV [LO1]In the previous problem,

suppose the required return on the project is 12 per cent. What is
the projects NPV?
Answer: Since we have the OCF for each year, it is easy to calculate the
NPV

Year CF PV(CF)
-
3,90
0 -3,900,000 0,000
1,358,57
1 1,521,600 1
1,178,18
2 1,477,920 9
1,425,04
3 2,002,080 1

NPV = 61,801

22. Calculating Project Cash Flow from Assets [LO1]In the

previous problem, suppose the project requires an initial investment
in net working capital of 300,000, and the non-current asset will
have a market value of 210,000 at the end of the project. What is
the projects year 0 net cash flow? Year 1? Year 2? Year 3? What is
the new NPV?
Answer: 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. So, the cash flows for each year of the project will
be:

Year Cash Flow

0 = 3,900,000 300,000
4,200,000
1 1,521,60
0
2 1,477,92
0
3 2,453,28 = 2,002,080 + 300,000 + 210,000 + (0
0 210,000)(.28)

And the NPV of the project is:

NPV = 82,956
Investment Appraisal

23. NPV and Straight-Line Depreciation [LO1]In the

previous problem, suppose the non-current asset actually is
depreciated straight-line to zero over the three years of the project.
All the other facts are the same. What is the projects year 1 net
cash flow now? Year 2? Year 3? What is the new NPV?
Answer: First we will calculate the annual depreciation and book value for
the equipment necessary for the project. The depreciation amount each year
will be the cost of the non-current asset divided by the life of the project (3
years). Note that in the final year we adjust the depreciation amount to
reflect the sale of the non-current asset:

Beginning Depreciati Ending Book

Year Value on Value
1,300,00
1 3,900,000 0 2,600,000
1,300,00
2 2,600,000 0 1,300,000
1,300,00
3 1,300,000 0 0

We now calculate the operating cash flow (OCF).

Depreciati Profit Before

Sales Costs on Tax Tax OCF
2,650,0 840,00 1,300,00 142,80 1,667,2
1 00 0 0 510,000 0 00
2,650,0 840,00 1,300,00 142,80 1,667,2
2 00 0 0 510,000 0 00
2,650,0 840,00 1,300,00 142,80 1,667,2
3 00 0 0 510,000 0 00

Finally, the net cash flows must be calculated.

Investmen
OCF t NWC NCF PV(NCF)
- - - -
3,90 300 4,20 4,20
0 0,000 ,000 0,000 0,000
1,667,2 1,667,20 1,488,57
1 00 0 1
1,667,2 1,667,20 1,329,08
2 00 0 2
1,667,2 300,00 2,118,40 1,507,83
3 00 0 0 5

NCF3=1,667,200+300,000+210,000+(0-210,000)*0.28= 2,118,400

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:
Investment Appraisal

NPV = 125,488
Investment Appraisal

24. Project Evaluation [LO1]Dog Up! Franks is looking at a

new sausage system with an installed cost of 390,000. This cost
will be depreciated straight-line to zero over the projects five-year
life, at the end of which the sausage system can be scrapped for
60,000. The sausage system will save the firm 120,000 per year
in pre-tax operating costs, and the system requires an initial
investment in net working capital of 28,000. If the tax rate is 30
per cent and the discount rate is 10 per cent, what is the NPV of this
project?
Answer: First, we will calculate the annual depreciation of the new
equipment. It will be:

Annual depreciation = 390,000/5

Annual depreciation = 78,000

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

After-tax salvage value = MV + (BV MV)tc

Very often, the book value of the equipment is zero as it is in this case. If the
book value is zero, the equation for the after-tax salvage value becomes:

After-tax salvage value = MV + (0 MV)tc

After-tax salvage value = MV(1 tc)

We will use this equation to find the after-tax salvage value since we know
the book value is zero. So, the salvage value is:

After-tax salvage value = 60,000(1 0.34)

After-tax salvage value = 39,600

Using the tax shield approach, we find the OCF for the project is:

OCF = 120,000(1 0.34) + 0.34(78,000)

OCF = 105,720

Now we can find the project NPV. Notice that we include the NWC in the
initial cash outlay. The recovery of the NWC occurs in Year 5, along with the
salvage value.

NPV = 390,000 28,000 + 105,720(PVIFA10%,5) + [(39,600 +

28,000) / 1.15]
NPV = 24,736.26
 Investment Appraisal

25. Bid Price [LO3] Blue Operations plc. needs someone to

supply it with 150,000 cartons of machine screws per year to
support its manufacturing needs over the next five years, and
youve decided to bid on the contract. It will cost you 780,000 to
install the equipment necessary to start production; youll
depreciate this cost using 18 percent reducing balances over the
projects life. You estimate that in five years this equipment can be
salvaged for 50,000. Your fixed production costs will be 240,000
per year, and your variable production costs should be 8.50 per
carton. You also need an initial investment in net working capital of
75,000. If your tax rate is 23 percent and you require a 16 percent
return on your investment, what bid price should you submit?
Answer: For this project, you will need to use a spreadsheet and trial and
error or solver. Solver is an exceptionally useful add-on in Excel that
allows you to quickly solve these types of problems. The approach in this
question is similar to all capital budgeting decisions. First, determine the
depreciation schedule, then estimate the operating cash flows, and finally
undertake the cash flow analysis.

Determine the depreciation schedule of the investment asset.

Year 1 2 3 4 5
(a Starting Value 780, 639, 524, 430, 352,
) 000 600 472 067 655
(b Depreciation 140, 115, 94,4 77,4 302,
) 18% 400 128 05 12 655
(c Accumulated 140, 255, 349, 427, 730,
) Depreciation 400 528 933 345 000
(d Residual Value 639, 524, 430, 352, 50,0
) 600 472 067 655 00

Estimate the operating cash flows and carry out the cash flow analysis. Using
Solver, the minimum bid price that is found to make the project feasible is
11.93. The spreadsheet with cash flows pertaining to this amount is
presented below. Notice that the IRR is 16.00%, which would be expected
given that the discount rate is 16%.

0 () 1 () 2 () 3 () 4 () 5 ()
Sales 150,000 150,000 150,000 150,000 150,000

Revenues 1,789,1 1,789,1 1,789,1 1,789,1 1,789,1

08 08 08 08 08
Variable Costs 1,275,0 1,275,0 1,275,0 1,275,0 1,275,0
00 00 00 00 00
Fixed Costs 240,000 240,000 240,000 240,000 240,000
Depreciation
18% 140,400 115,128 94,405 77,412 302,655
 Investment Appraisal

EBT 133,708 158,980 179,703 196,696 -28,547

Tax 30,753 36,565 41,332 45,240 -6,566
Net Income 102,955 122,415 138,371 151,456 -21,981
Operating Cash
Flow 243,355 237,543 232,776 228,868 280,674
- 1 2 3 4 5
Operating Cash
Flow 243,355 237,543 232,776 228,868 280,674
Net Working -
Capital 75,000 75,000
Investment -
780,00
0 50,000
Net Cash Flow -
855,00
0 243,355 237,543 232,776 228,868 405,674
PV Cash Flows -
@ 16% 855,00
0 209,789 176,533 149,130 126,402 193,147
NPV -0
IRR 16.00
%
Investment Appraisal

26. Project Evaluation [LO1]Your firm is contemplating the

purchase of a new 925,000 computer-based order entry system.
The system will be depreciated using the 20 per cent reducing-
balance method over its five-year life. It will be worth 90,000 at the
end of that time. You will save 360,000 before taxes per year in
order-processing costs, and you will be able to reduce working
capital by 125,000 (this is a onetime reduction). If the tax rate is
28 per cent, what is the IRR?
Answer: First, we will calculate the annual depreciation of the new
equipment. It will be:

Year 1 2 3 4 5
( Starting 925,000 740,000 592,000 473,600 378,880
a Value
)
( Depreciation 20%*(a 185,000 148,000 118,400 94,720 288,880
b 20% )
)
( Accumulated 185,000 333,000 451,400 546,120 835,000
c Depreciation
)
( Residual (a)-(c) 740,000 592,000 473,600 378,880 90,000
d Value
)

Notice that in the last year of the project, we calculated the annual depreciation
figure as 288,880. This comprises two components. The first component is the
20% depreciation charge on the year 5 starting value of 378,880, which is equal
to 75,776. This leaves a residual value of 303,104. The second component is
the tax loss that the company experiences from selling the system for 90,000.
This is equal to 303,104 - 90,000 = 213,104. Combined, they equal
288,880. Next we calculate the operating cash flows from the project:

1 2 3 4 5
Cash 360,0 360,00 360,00 360,00 360,00
Savings 00 0 0 0 0
Depreciati 185, 148,0 118,4 94,72 288,8
on 000 00 00 0 80
Pre-Tax 175, 212,0 241,6 265,2 71,12
Savings 000 00 00 80 0
Tax @ 28% 49,0 59,36 67,64 74,27 19,91
00 0 8 8 4
After Tax 126, 152,6 173,9 191,0 51,20
Savings 000 40 52 02 6
OCF 311, 300,6 292,3 285,7 340,0
000 40 52 22 86

Now we can find the project IRR. There is an unusual feature that is a part of this
project. Accepting this project means that we will reduce NWC. This reduction in
Investment Appraisal

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 salvage value at the end of the project (the tax effects have
already been incorporated into the analysis). The cash flows arising from the
project are:

0 1 2 3 4 5
Investment - 90,000
925,00
0
NWC 125,00 -
0 125,00
0
OCF 311,0 300,6 292,3 285,7 340,08
00 40 52 22 6
Net Cash - 311,0 300,6 292,3 285,7 305,08
Flow 800,00 00 40 52 22 6
0

311, 000 300, 640 292,352 285, 722 305,086

NPV 0 800, 000
(1 IRR) (1 IRR) 2 (1 IRR)3 (1 IRR) 4 (1 IRR) 5
IRR = 25.49%
27. Calculating EAC [LO4]A five-year project has an initial
fixed non-current asset investment of 270,000, an initial NWC
investment of 25,000, and an annual OCF of 42,000. The non-
current asset is depreciated 20 per cent reducing-balance over the
life of the project, and has no salvage value. If the required return is
11 per cent, what is this projects equivalent annual cost, or EAC?
Answer: To calculate the EAC of the project, we first need the NPV of the
project.

Investme
Sales nt NWC NCF PV(NCF)
-
- 25 - -
270, ,00 295 295
0 000 0 ,000 ,000
-
42
,00
1 0 -42,000 -37,838
-
42
,00
2 0 -42,000 -34,088
-
42
,00
3 0 -42,000 -30,710
Investment Appraisal

-
42
,00
4 0 -42,000 -27,667
-
42
,00 25,00
5 0 0 -17,000 -10,089

NPV = 435,391.39

Now we can find the EAC of the project. The EAC is:

EAC = 435,391.39 / (PVIFA11%,5) = 117,803.98

Investment Appraisal

28. Calculating EAC [LO4]You are evaluating two different

silicon wafer milling machines. The Techron I costs 210,000, has a
three-year life, and has pre-tax operating costs of 34,000 per year.
The Techron II costs 320,000, has a five-year life, and has pre-tax
operating costs of 23,000 per year. For both milling machines, use
20 per cent reducing-balance depreciation over the projects life and
assume a salvage value of 20,000. If your tax rate is 35 per cent
and your discount rate is 14 per cent, compute the EAC for both
machines. Which do you prefer? Why?
Answer: We need to first calculate the NPV of each machine. Focusing on the
Techron I first, the depreciation schedule of the machine is given below:

Year 1 2 3
(a) Starting Value 210,000 168,000 134,400
(b) Depreciation 20% 20%*(a 42,000 33,600 114,400
)
(c) Accumulated 42,000 75,600 190,000
Depreciation
(d) Residual Value (a)-(b) 168,000 134,400 20,000

We now calculate the income statement for the Techron I

1 2 3
Pre-Tax Operating Costs - 34,000 - 34,000 - 34,000
Depreciation -42,000 -33,600 -114,400
EBT -76,000 -67,600 -148,400
Tax -26,600 -23,660 -51,940
Net Income -49,400 -43,940 -96,460

This allows us to calculate the Operating Cash Flow of the Techron I.

1 2 3
Net Income -49,400 -43,940 -96,460
Depreciation 42,000 33,600 114,400
Operating Cash Flow -7,400 -10,340 17,940

Now we can estimate the NPV of the Techron I.

0 1 2 3
Investment - 20,000
210,000
Operating Cash Flow -7,400 -10,340 17,940
Cash Flows - -7,400 -10,340 37,940
210,000
PV Cash Flows - -6,491 -7,956 25,608
210,000

The NPV of Techron I is thus -198,839.

The equivalent annual cost of the Techron I is

-198,839 = EAC(PVIFA14%,3)
EAC = 85,646
Investment Appraisal

We now do the same with the Techron II. First the depreciation schedule:

Year 1 2 3 4 5
( Starting Value 320,0 256,0 204,8 163,8 131,0
a 00 00 00 40 72
)
( Depreciation 20%*( 64,00 51,20 40,96 32,76 111,0
b 20% a) 0 0 0 8 72
)
(c Accumulated 64,00 115,2 156,1 188,9 300,0
) Depreciation 0 00 60 28 00
( Residual Value (a)-(b) 256,0 204,8 163,8 131,0 20,00
d 00 00 40 72 0
)

Then the income statement:

1 2 3 4 5
Pre-Tax Operating - 23,000 - 23,000 - 23,000 - 23,000 - 23,000
Costs
Depreciation -64,000 -51,200 -40,960 -32,768 -
111,072
EBT -87,000 -74,200 -63,960 -55,768 -
134,072
Tax -30,450 -25,970 -22,386 -19,519 -46,925
Net Income -56,550 -48,230 -41,574 -36,249 -87,147

This allows us to calculate operating cash flow:

1 2 3 4 5
Net Income -56,550 -48,230 -41,574 -36,249 -87,147
Depreciation 64,000 51,200 40,960 32,768 111,072
Operating Cash Flow 7,450 2,970 -614 -3,481 23,925

Now we can estimate the Net Present Value of the Techron II:

0 1 2 3 4 5
Investment - 20,000
320,000
Operating Cash Flow 7,450 2,970 -614 -3,481 23,925
Cash Flows - 7,450 2,970 -614 -3,481 43,925
320,000
PV Cash Flows - 6,535 2,285 -414 -2,061 22,813
320,000

The Net Present Value of the Techron II is -290,842 and the equivalent annual
cost is:

-290,842 = EAC(PVIFA14%,5)
EAC = 84,717
Comparing the EAC of the Techron I (85,646) with the EAC of the Techron II
(84,717) leads us to go with the Techron II.
Investment Appraisal

29. Calculating a Bid Price [LO3]Alson Enterprises needs

someone to supply it with 185,000 cartons of machine screws per
year to support its manufacturing needs over the next five years,
and youve decided to bid for the contract. It will cost you 940,000
to install the equipment necessary to start production; youll
depreciate this cost straight-line to zero over the projects life. You
estimate that, in five years, this equipment can be salvaged for
70,000. Your fixed production costs will be 305,000 per year, and
your variable production costs should be 9.25 per carton. You also
need an initial investment in net working capital of 75,000. If your
tax rate is 23 per cent and you require a 12 per cent return on your
investment, what bid price should you submit?
Answer:

To find the bid price, we need to calculate all other cash flows for the project,
and then solve for the bid price. The after-tax salvage value of the
equipment is:

After-tax salvage value = 70,000 (1 0.23) = 53,900

Now we can solve for the necessary OCF that will give the project a zero
NPV. The equation for the NPV of the project is:

NPV = 0 = 940,000 75,000 + OCF(PVIFA12%,5) + [(75,000 +

53,900 ) / 1.125]

Solving for the OCF, we find the OCF that makes the project NPV equal to
zero is:

OCF = 941,858.68 / PVIFA12%,5 = 261,280.76

The easiest way to calculate the bid price is the tax shield approach, so:

OCF = 261,280.76 = [(P v)Q FC ](1 tc) + tcD

261,280.76 = [(P 9.25)(185,000) 305,000 ](1 0.23) +
0.23(940,000/5)
P = 9.13
Investment Appraisal

INTERMEDIATE
30. Cost-Cutting Proposals [LO2]Geary Machine Shop is
considering a four-year project to improve its production efficiency.
Buying a new machine press for 560,000 is estimated to result in
210,000 in annual pretax cost savings. The press is depreciated
using the 20 per cent reducing-balance method, and it will have a
salvage value at the end of the project of 80,000. The press also
requires an initial investment in spare parts inventory of 20,000,
along with an additional 3,000 in inventory for each succeeding
year of the project. If the shops tax rate is 28 per cent and its
discount rate is 9 per cent, should the company buy and install the
machine press?
Answer: First, we will calculate the depreciation each year, which will be:

Beginning Depreciati Ending Book

Year Value on Value
112,000.
1 560,000.00 00 448,000.00
89,600.0
2 448,000.00 0 358,400.00
71,680.0
3 358,400.00 0 286,720.00
206,720.
4 286,720.00 00 80,000.00

So, the OCF for each year will be:

Depreciat Profit before

Year Savings ion Tax Tax OCF
112,000. 27,440. 182,560
1 210,000 00 98,000.00 00 .00
89,600.0 33,712. 176,288
2 210,000 0 120,400.00 00 .00
71,680.0 38,729. 171,270
3 210,000 0 138,320.00 60 .40
206,720. 209,081
4 210,000 00 3,280.00 918.40 .60

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 3,000 more in NWC each successive
year. We will subtract the 20,000 from the initial cash flow, and subtract
3,000 each year from the OCF to account for this spending. In Year 4, we
will add back the total spent on NWC, which is 29,000. The 3,000 spent on
NWC capital during Year 4 is irrelevant. Why? Well, during this year the
project required an additional 3,000, 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:
Investment Appraisal

Investme
Year OCF nt NWC NCF PV(NCF)
-
- 20 - -
560, ,00 580 580,0
0 000 0 ,000 00.00
182,560. 179,56 164,733.9
1 00 -3,000 0 4
176,288. 173,28 145,853.0
2 00 -3,000 8 4
171,270. 168,27 129,935.6
3 40 -3,000 0 2
209,081. 29,00 318,08 225,337.0
4 60 80,000 0 2 2

NPV = 85,859.64

Yes, the company should buy and install the machine press.

31. Comparing Mutually Exclusive Projects [LO1]Hagar

Industrial Systems Company (HISC) is trying to decide between two
different conveyor belt systems. System A costs 430,000 Norwegian
kroner (NKr), has a four-year life, and requires NKr120,000 in pre-tax
annual operating costs. System B costs NKr540,000, has a six-year
life, and requires NKr80,000 in pre-tax annual operating costs. Both
systems are to be depreciated using the reducing-balance method
of 50 per cent per annum, and will have zero salvage value at the
end of their life. Whichever system is chosen, it will not be replaced
when it wears out. If the tax rate is 28 per cent and the discount
rate is 20 per cent, which system should the firm choose?
Answer: In this question, the two machines cannot be compared using
the equivalent annual cost method because once one machine runs out, it
will not be replaced. In addition, with this type of question, it is important
to know the relative income streams arising from each conveyor belt. This
is because the longer lasting conveyer belt will provide income beyond the
lifetime of the conveyor belt that breaks down first. This information isnt
provided by the question and so, it is impossible to compare each
machine.
 Investment Appraisal

32. Comparing Mutually Exclusive Projects [LO4]Suppose

in the previous problem that HISC always needs a conveyor belt
system; when one wears out, it must be replaced. Which project
should the firm choose now?
Answer: If the conveyor belt can be replaced, we can use the EAC method. We
calculate the EAC of System A by first determining its depreciation schedule.

Year 1 2 3 4
(a) Starting Value NKr430,0 NKr215,0 NKr107,5 NKr53,75
00 00 00 0
(b) Depreciation 50% 50% NKr215,0 NKr107,5 NKr53,75 NKr53,75
00 00 0 0
(c) Accumulated NKr215,0 NKr322,5 NKr376,2 NKr430,0
Depreciation 00 00 50 00
(d) Residual Value (a)- NKr215,0 NKr107,5 NKr53,75 NKr0
( 00 00 0
b
)

We now calculate net income from System A.

1 2 3 4
Pre-Tax Operating -Kr - -Kr -Kr
Costs 120,0 Kr12 120,0 120,0
00 0,000 00 00
Depreciation - - -Kr53,750 -Kr53,750
Kr21 Kr10
5,000 7,500
EBT - - - -
Kr33 Kr22 Kr17 Kr17
5,000 7,500 3,750 3,750
Tax 28% -Kr93,800 -Kr63,700 -Kr48,650 -Kr48,650
Net Income - - - -
Kr24 Kr16 Kr12 Kr12
1,200 3,800 5,100 5,100

Operating Cash Flow is:

1 2 3 4
Net Income - - - -
NKr2 Kr16 Kr12 Kr12
41,20 3,800 5,100 5,100
0
Depreciation Kr215,00 Kr107,50 Kr53,750 Kr53,750
0 0
Operating Cash -Kr26,200 -Kr56,300 -Kr71,350 -Kr71,350
Flow

PV of cash flows:

0 1 2 3 4
Investment -
Kr43
0,000
Operating Cash - - - -
Investment Appraisal

Flow Kr26 Kr56 Kr71 Kr71

,200 ,300 ,350 ,350
Cash Flows - - - - -
Kr43 Kr26 Kr56 Kr71 Kr71
0,000 ,200 ,300 ,350 ,350
PV Cash Flows - - - - -
Kr43 Kr21 Kr39 Kr41 Kr34
0,000 ,833 ,097 ,291 ,409

The NPV of System A is -NKr566,630 and the EAC is:

-NKr566,630= EAC(PVIFA20%,4)
EAC = Kr218,883

Now for System B. The same series of tables will be presented.

Depreciation Schedule:

Year 1 2 3 4 5 6
Starting Value Kr540,0 Kr270,0 Kr135,0 Kr67,50 Kr33,750 Kr16,875
00 00 00 0
Depreciation 50% Kr270,0 Kr135,0 Kr67,50 Kr33,75 Kr16,875 Kr16,875
00 00 0 0
Accumulated Kr270,0 Kr405,0 Kr472,5 Kr506,2 Kr523,12 Kr540,00
Depreciation 00 00 00 50 5 0
Residual Value Kr270,0 Kr135,0 Kr67,50 Kr33,75 Kr16,875 Kr0
00 00 0 0

Income Statement:
1 2 3 4 5 6
Pre-Tax Operating -Kr -Kr -Kr -Kr -Kr -Kr
Costs 80,0 80,0 80,0 80,0 80,0 80,0
00 00 00 00 00 00
Depreciation - - - - - -
Kr27 Kr13 Kr67 Kr33 Kr1 Kr1
0,00 5,00 ,500 ,750 6,87 6,87
0 0 5 5
EBT - - - - - -
Kr35 Kr21 Kr14 Kr11 Kr9 Kr9
0,00 5,00 7,50 3,75 6,87 6,87
0 0 0 0 5 5
Tax - - - - - -
Kr98 Kr60 Kr41 Kr31 Kr2 Kr2
,000 ,200 ,300 ,850 7,12 7,12
5 5
Net Income - - - - - -
Kr25 Kr15 Kr10 Kr81 Kr6 Kr6
2,00 4,80 6,20 ,900 9,75 9,75
0 0 0 0 0

Operating Cash Flow:

1 2 3 4 5 6
Net Income - - - - - -
Kr25 Kr15 Kr10 Kr81 Kr69 Kr69
2,000 4,800 6,200 ,900 ,750 ,750
Depreciation Kr270,00 Kr135,00 Kr67,500 Kr33,750 Kr16,875 Kr16,875
0 0
Investment Appraisal

Operating Cash Kr18,000 -Kr19,800 -Kr38,700 - - -

Flow Kr48 Kr52 Kr52
,150 ,875 ,875

PV of cash flows:
0 1 2 3 4 5 6
Investm -
ent Kr54
0,000
Operatin Kr18,00 - - - - -
g 0 Kr19 Kr38 Kr48 Kr52 Kr52
Cash ,800 ,700 ,150 ,875 ,875
Flow
Cash - Kr18,00 - - - - -
Flow Kr54 0 Kr19 Kr38 Kr48 Kr52 Kr52
s 0,000 ,800 ,700 ,150 ,875 ,875
PV Cash - Kr15,00 - - - - -
Flow Kr54 0 Kr13 Kr22 Kr23 Kr21 Kr17
s 0,000 ,750 ,396 ,220 ,249 ,708

The Net Present Value of System B is -Kr623,323 and the equivalent annual cost
is:
-Kr623,323 = EAC(PVIFA20%,6)

EAC = Kr187,437

The equivalent annual cost of System B is significantly smaller than that of

System A and so System B should be chosen.
Investment Appraisal

33. Calculating a Bid Price [LO3]Consider a project to supply

100 million postage stamps per year to the Royal Mail for the next
five years. You have an idle parcel of land available that cost
2,400,000 five years ago; if the land were sold today, it would net
you 2,700,000 after tax. In five years the land can be sold for
3,200,000 after tax. You will need to install 4.1 million in new
manufacturing plant and equipment to actually produce the stamps:
this plant and equipment will be depreciated straight-line to zero
over the projects five-year life. The equipment can be sold for
540,000 at the end of the project. You will also need 600,000 in
initial net working capital for the project, and an additional
investment of 50,000 in every year thereafter. Your production
costs are 0.5 pence per stamp, and you have fixed costs of
950,000 per year. If your tax rate is 34 per cent and your required
return on this project is 12 per cent, what bid price should you
submit on the contract?
Answer: To find the bid price, we need to calculate all other cash flows
for the project, and then solve for the bid price. The after-tax salvage
value of the equipment is:

After-tax salvage value = 540,000(1 0.34)

After-tax salvage value = 356,400

Now we can solve for the necessary OCF that will give the project a zero NPV.
The current after-tax value of the land is an opportunity cost, but we also
need to include the after-tax value of the land in five years since we can sell
the land at that time. The equation for the NPV of the project is:

NPV = 0 = 4,100,000 2,700,000 600,000 + OCF(PVIFA 12%,5)

50,000(PVIFA12%,4)
+ {(356,400 + 600,000 + 4(50,000) + 3,200,000] / 1.12 5}

Solving for the OCF, we find the OCF that makes the project NPV equal to
zero is:

OCF = 5,079,929.11 / PVIFA12%,5

OCF = 1,409,221.77

The easiest way to calculate the bid price is the tax shield approach, so:

OCF = 1,409,221.77 = [(P v)Q FC ](1 tC) + tcD

1,409,221.77 = [(P 0.005)(100,000,000) 950,000](1 0.34) +
0.34(4,100,000/5)
P = 0.03163

34. Interpreting a Bid Price [LO3]In the previous problem,

suppose you could keep working capital investments down to only
25,000 per year. How would this new information affect your
calculated bid price?
Investment Appraisal

Answer: At a given price, taking accelerated depreciation compared to

straight-line depreciation causes the NPV to be higher; similarly, at a given
price, lower net working capital investment requirements will cause the
NPV to be higher. Thus, NPV would be zero at a lower price in this
situation. In the case of a bid price, you could submit a lower price and still
break-even, or submit the higher price and make a positive NPV.
Investment Appraisal

35. Comparing Mutually Exclusive Projects [LO4]Vandalay

Industries is considering the purchase of a new machine for the
production of latex. Machine A costs 2,900,000 and will last for six
years. Variable costs are 35 per cent of sales, and fixed costs are
170,000 per year. Machine B costs 5,100,000 and will last for nine
years. Variable costs for this machine are 30 per cent of sales, and
fixed costs are 130,000 per year. The sales for each machine will
be 10 million per year. The required return is 10 per cent, and the
tax rate is 35 per cent. Both machines will be depreciated on a
straight-line basis. If the company plans to replace the machine
when it wears out on a perpetual basis, which machine should you
choose?
Answer: Since we need to calculate the EAC for each machine, sales are
irrelevant. EAC only uses the costs of operating the equipment, not the sales.
Using the bottom up approach, or net income plus depreciation, method to
calculate OCF, we get:

Machine A Machine B
Variable costs 3,500,000 3,000,000
Fixed costs 170,000 130,000
Depreciation 483,333 566,667
EBT 4,153,333 3,696,667
Tax 1,453,667 1,293,833
Net income 2,699,667 2,402,833
+ Depreciation 483,333 566,667
OCF 2,216,333 1,836,167

The NPV and EAC for Machine A is:

NPVA = 2,900,000 2,216,333(PVIFA10%,6)

NPVA = 12,552,709.46

EACA = 12,552.709.46 / (PVIFA10%,6)

EACA = 2,882,194.74

And the NPV and EAC for Machine B is:

NPVB = 5,100,000 1,836,167(PVIFA10%,9)

NPVB = 15,674,527.56

EACB = 15,674,527.56 / (PVIFA10%,9)

EACB = 2,721,733.42

You should choose Machine B since it has smaller EAC (absolute value).
Investment Appraisal

36. Equivalent Annual Cost [LO4]Compact fluorescent lamps

(CFLs) have become more popular in recent years, but do they make
financial sense? Suppose a typical 60 watt incandescent light bulb
costs 0.50 and lasts 1,000 hours. A 15 watt CFL, which provides
the same light, costs 3.50 and lasts for 12,000 hours. A kilowatt-
hour of electricity costs 0.101, which is about the national average.
A kilowatt-hour is 1,000 watts for 1 hour. If you require a 10 per cent
return and use a light fixture for 500 hours per year, what is the
equivalent annual cost of each light bulb?
Answer: A kilowatt hour is 1,000 watts for 1 hour. A 60-watt bulb burning
for 500 hours per year uses

30,000 watt hours, or 30 kilowatt hours. Since the cost of a kilowatt hour is
0.101, the cost per year is:

Cost per year = 30(0.101)

Cost per year = 3.03

The 60-watt bulb will last for 1,000 hours, which is 2 years of use at 500
hours per year. So, the NPV of the 60-watt bulb is:

NPV = 0.50 3.03(PVIFA10%,2)

NPV = 5.76

And the EAC is:

EAC = 5.83 / (PVIFA10%,2)

EAC = 3.32

Now we can find the EAC for the 15-watt CFL. A 15-watt bulb burning for 500
hours per year uses 7,500 watts, or 7.5 kilowatts. And, since the cost of a
kilowatt hour is 0.101, the cost per year is:

Cost per year = 7.5(0.101)

Cost per year = 0.7575

The 15-watt CFL will last for 12,000 hours, which is 24 years of use at 500
hours per year. So, the NPV of the CFL is:

NPV = 3.50 0.7575(PVIFA10%,24)

NPV = 10.31

And the EAC is:

EAC = 10.85 / (PVIFA10%,24)

EAC = 1.15

Thus, the CFL is much cheaper. But see our next two questions.
Investment Appraisal

37. Break-Even Cost [LO2]The previous problem suggests

that using CFLs instead of incandescent bulbs is a no-brainer.
However, electricity costs actually vary quite a bit, depending on
location and user type (you can get information on your rates from
your local power company). An industrial user in the Scottish
Highlands might pay 0.04 per kilowatt-hour, whereas a residential
user in Essex might pay 0.25. Whats the break-even cost per
kilowatt-hour in Problem 36?
Answer: To solve the EAC algebraically for each bulb, we can set up the
variables as follows:

W = light bulb wattage

C = cost per kilowatt hour
H = hours burned per year
P = price the light bulb

The number of watts use by the bulb per hour is:

WPH = W / 1,000

And the kilowatt hours used per year is:

KPY = WPH H

The electricity cost per year is therefore:

ECY = KPY C

The NPV of the decision to but the light bulb is:

NPV = P ECY(PVIFAR%,t)

And the EAC is:

EAC = NPV / (PVIFAR%,t)

Substituting, we get:

EAC = [P (W / 1,000 H C)PVIFA R%,t] / PFIVAR%,t

We need to set the EAC of the two light bulbs equal to each other and solve
for C, the cost per kilowatt hour. Doing so, we find:

[0.50 (60 / 1,000 500 C)PVIFA10%,2] / PVIFA10%,2

= [3.50 (15 / 1,000 500 C)PVIFA 10%,24] / PVIFA10%,24

C = 0.004509

So, unless the cost per kilowatt hour is extremely low, it makes sense to use
the CFL. But when should you replace the incandescent bulb? See the next
question.
Investment Appraisal
Investment Appraisal

38. Break-Even Replacement [LO2]The previous two

problems suggest that using CFLs is a good idea from a purely
financial perspective unless you live in an area where power is
relatively inexpensive, but there is another wrinkle. Suppose you
have a residence with a lot of incandescent bulbs that are used on
average for 500 hours a year. The average bulb will be about
halfway through its life, so it will have 500 hours remaining (and you
cant tell which bulbs are older or newer). At what cost per kilowatt-
hour does it make sense to replace your incandescent bulbs today?
Answer: We are again solving for the break-even kilowatt hour cost, but
now the incandescent bulb has only 500 hours of useful life. In this case,
the incandescent bulb has only one year of life left. The break-even
electricity cost under these circumstances is:

[0.50 (60 / 1,000 500 C)PVIFA10%,1] / PVIFA10%,1

= [3.50 (15 / 1,000 500 C)PVIFA 10%,24] / PVIFA10%,24

C = 0.007131

Unless the electricity cost is negative (Not very likely!), it does not make
financial sense to replace the incandescent bulb until it burns out.
Investment Appraisal

39. Issues in Capital Budgeting [LO1]The debate regarding

CFLs versus incandescent bulbs (see Problems 3638) has even
more wrinkles. In no particular order:
Incandescent bulbs generate a lot more heat than CFLs.
CFL prices will probably decline relative to incandescent bulbs.
CFLs unavoidably contain small amounts of mercury, a significant
environmental hazard, and special precautions must be taken in
disposing of burned-out units (and also in cleaning up a broken
lamp). Currently, there is no agreed-upon way to recycle a CFL.
Incandescent bulbs pose no disposal/breakage hazards.
Depending on a lights location (or the number of lights), there can
be a non-trivial cost to change bulbs (i.e., labour cost in a
business).
Coal-fired power generation accounts for a substantial portion of
the mercury emissions in Europe, though the emissions will drop
sharply in the relatively near future.
Power generation accounts for a substantial portion of CO 2
emissions in Europe.
CFLs are more energy and material intensive to manufacture. On-
site mercury contamination and worker safety are issues.
If you install a CFL in a permanent lighting fixture in a building, you
will probably move long before the CFL burns out.
Another lighting technology based on light-emitting diodes (LEDs)
exists, and is improving. LEDs are currently much more expensive
than CFLs, but costs are coming down. LEDs last much longer than
CFLs, and use even less power. Also, LEDs dont contain mercury.
Qualitatively, how do these issues affect your position in the CFL
versus incandescent light bulb debate? Australia recently proposed
banning the sale of incandescent bulbs altogether, as have several
European countries. Does your analysis suggest such a move is wise?
Are there other regulations, short of an outright ban, that make sense
to you?
Answer: The debate between incandescent bulbs and CFLs is not just a
financial debate, but an environmental one as well. The numbers below
correspond to the numbered items in the question:

1. The extra heat generated by an incandescent bulb is waste, but not

necessarily in a heated structure, especially in northern climates.

2. Since CFLs last so long, from a financial viewpoint, it might make sense
to wait if prices are declining.

3. Because of the nontrivial health and disposal issues, CFLs are not as
attractive as our previous analysis suggests.

4. From a companys perspective, the cost of replacing working

incandescent bulbs may outweigh the financial benefit. However, since
CFLs last longer, the cost of replacing the bulbs will be lower in the long
run.
Investment Appraisal

5. Because incandescent bulbs use more power, more coal has to be

burned, which generates more mercury in the environment, potentially
offsetting the mercury concern with CFLs.

6. As in the previous question, if CO 2 production is an environmental

concern, the lower power consumption from CFLs is a benefit.

7. CFLs require more energy to make, potentially offsetting (at least

partially) the energy savings from their use. Worker safety and site
contamination are also negatives for CFLs.

8. This fact favors the incandescent bulb because the purchasers will only
receive part of the benefit from the CFL.

9. This fact favours waiting for new technology.

While there is always a best answer, this question shows that the analysis
of the best answer is not always easy and may not be possible because of
incomplete data. As for how to better legislate the use of CFLs, our analysis
suggests that requiring them in new construction might make sense. Rental
properties in general should probably be required to use CFLs (why rentals?).

Another piece of legislation that makes sense is requiring the producers of

CFLs to supply a disposal kit and proper disposal instructions with each one
sold. Finally, we need much better research on the hazards associated with
broken bulbs in the home and workplace and proper procedures for dealing
with broken bulbs.
Investment Appraisal

40. Replacement Decisions [LO2]Your small remodelling

business has two hydrogen-battery/petrol hybrid eco-vehicles. One
is a small passenger car used for jobsite visits and for other general
business purposes. The other is a heavy truck used to haul
equipment. The car gets 50 miles per litre. The truck gets 20 miles
per litre. You want to improve petrol mileage to save money, and
you have enough money to upgrade one vehicle. The upgrade cost
will be the same for both vehicles. An upgraded car will get 80 miles
per litre; an upgraded truck will get 25 miles per litre. The cost of
petrol is 1.09 per litre. Assuming an upgrade is a good idea in the
first place, which one should you upgrade? Both vehicles are driven
12,000 miles per year.
Answer: Surprise! You should definitely upgrade the truck. Heres why. At
20 mpl, the truck burns 12,000 / 20 = 600 litres of petrol per year. The new
truck will burn 12,000 / 25 = 480 litres of petrol per year, a savings of 120
litres per year. The car burns 12,000 / 50 = 240 litres of petrol per year, while
the new car will burn 12,000 / 80 = 150 litres of petrol per year, a savings of
90 litres per year, so its not even close.

This answer may strike you as counterintuitive, so lets consider an extreme

case. Suppose the car gets 6,000 mpl, and you could upgrade to 12,000 mpl.
Should you upgrade? Probably not since you would only save one litre of
petrol per year. So, the reason you should upgrade the truck is that it uses so
much more petrol in the first place.

Notice that the answer doesnt depend on the cost of petrol, meaning that if
you upgrade, you should always upgrade the truck. In fact, it doesnt depend
on the miles driven, as long as the miles driven are the same.
Investment Appraisal

41. Replacement Decisions [LO2]In the previous problem,

suppose you drive the truck x miles per year. How many miles would
you have to drive the car before upgrading the car would be the
better choice? (Hint: Look at the relative petrol savings.)
Answer: We can begin by calculating the litres saved by purchasing the
new truck. The current and new litre usage when driving x miles per year
are:

Current truck litres = x / 20

New truck litres = x / 25

So the litres saved by purchasing the new truck are:

Truck litres saved = x / 20 x / 25

If we let y equal the increased mileage for the car, the litres used by the
current car, the new car, and the savings by purchasing the new car are:

Current car litres = (x + y) / 50

New car litres = (x + y) / 80
Car litres saved = (x + y) / 50 (x + y) / 80

We need to set the litre savings from the new truck purchase equal to the
litre savings from the new car purchase equal to each other, so:

x / 20 x / 25 = (x + y) / 50 (x + y) / 80

From this equation you can see again that the cost per litre is irrelevant.
Each term would be multiplied by the cost per litre, which would cancel out
since each term is multiplied by the same amount. To add and subtract
fractions, we need to get the same denominator. In this case, we will choose
a denominator of 1,000 since all four of the current denominators are
multiples of 1,000. Doing so, we get:

50x / 1,000 40x / 1,000 = 20(x + y) / 1,000 12.5(x + y) / 1,000

10x / 1,000 = 7.5(x + y) / 1,000
10x = 7.5x + 7.5y
2.5x = 7.5y
y = x/3

The difference in the mileage should be 1/3 of the miles driven by the truck.
So, if the truck is driven 12,000 miles, the breakeven car mileage is 16,000
miles (12,000 + 12,000/3).
Investment Appraisal

CHALLENGE
42. Calculating Project NPV [LO1]You have been hired as a
consultant for Pristine Urban-Tech Zither plc. (PUTZ), manufacturers
of fine zithers. The market for zithers is growing quickly. The
company bought some land three years ago for 1.4 million in
anticipation of using it as a toxic waste dump site, but has recently
hired another company to handle all toxic materials. Based on a
recent appraisal, the company believes it could sell the land for 1.5
million on an after-tax basis. In four years the land could be sold for
1.6 million after taxes. The company also hired a marketing firm to
analyse the zither market, at a cost of 125,000. An excerpt of the
marketing report is as follows: The zither industry will have a rapid
expansion in the next four years. With the brand name recognition
that PUTZ brings to bear, we feel that the company will be able to
sell 3,200, 4,300, 3,900 and 2,800 units each year for the next four
years, respectively. Again, capitalizing on the name recognition of
PUTZ, we feel that a premium price of 780 can be charged for each
zither. Because zithers appear to be a fad, we feel that, at the end of
the four-year period, sales should be discontinued.

PUTZ believes that fixed costs for the project will be 425,000 per
year, and variable costs are 15 per cent of sales. The equipment
necessary for production will cost 4.2 million, and will be depreciated
according to the 20 per cent reducing-balance method. At the end of
the project the equipment can be scrapped for 400,000. Net working
capital of 125,000 will be required immediately. PUTZ has a 28 per
cent tax rate, and the required return on the project is 13 per cent.
What is the NPV of the project? Assume the company has other
profitable projects.

Answer: We will begin by calculating the depreciation schedule of the

investment.

Beginning Depreciati Ending Book

Year Value on Value
4,200,000. 840,000.
1 00 00 3,360,000.00
3,360,000. 672,000.
2 00 00 2,688,000.00
2,688,000. 537,600.
3 00 00 2,150,400.00
2,150,400. 1,750,40
4 00 0.00 400,000.00

Now we need to calculate the operating cash flow each year. Revenues first:
Investment Appraisal

Year unit sales Unit Price Revenues

1 3,200 780 2,496,000
2 4,300 780 3,354,000
3 3,900 780 3,042,000
4 2,800 780 2,184,000

Now the operating cash flow:

Variable Profit
Revenue Fixed Cost Depreciati Before
Year s Costs s on Taxes Taxes OCF
2,496,0 374,40 239,8 1,456,7
1 00 425,000 0 840,000 856,600 48 52
3,354,0 503,10 1,753,90 491,0 1,934,8
2 00 425,000 0 672,000 0 92 08
3,042,0 456,30 1,623,10 454,4 1,706,2
3 00 425,000 0 537,600 0 68 32
-
8
2,184,0 327,60 1,750,40 9,3 1,520,7
4 00 425,000 0 0 -319,000 20 20

Now calculate the net cash flows:

Investmen
Year OCF Land t NWC NCF PV(NCF)
-
- - 12 - -
1,50 4,20 5,00 5,82 5,825,
0 0,000 0,000 0 5,000 000.00
1,456,7 1,456,75 1,289,161.
1 52 2 06
1,934,8 1,934,80 1,515,238.
2 08 8 47
1,706,2 1,706,23 1,182,504.
3 32 2 36
1,520,7 1,600,00 125,00 3,645,72 2,235,988.
4 20 0 400,000 0 0 35

Notice the calculation of the cash flow at time 0. The capital spending on
equipment and investment in net working capital are cash outflows are both
cash outflows. The after-tax selling price of the land is also a cash outflow.
Even though no cash is actually spent on the land because the company
already owns it, the after-tax cash flow from selling the land is an opportunity
cost, so we need to include it in the analysis. The company can sell the land
at the end of the project, so we need to include that value as well. With all
the project cash flows, we can calculate the NPV, which is:

NPV = 397,892.25

The company should accept the new product line.

 Investment Appraisal

43. Project Evaluation [LO1]Aguilera Acoustics (AA) projects

unit sales for a new seven-octave voice emulation implant as
follows:

Year Unit sales

1 85,000
2 98,000
3 106,000
4 114,000
5 93,000

Production of the implants will require 1,500,000 in net working

capital to start, and additional net working capital investments each
year equal to 15 per cent of the projected sales for the following year.
Total fixed costs are 900,000 per year, variable production costs are
240 per unit, and the units are priced at 325 each. The equipment
needed to begin production has an installed cost of 21,000,000.
Because the implants are intended for professional singers, this
equipment is considered industrial machinery, and is thus depreciated
by the reducing-balance method at 20 per cent per annum. In five
years this equipment can be sold for about 20 per cent of its
acquisition cost. AA is in the 35 per cent marginal tax bracket, and has
a required return on all its projects of 18 per cent. Based on these
preliminary project estimates, what is the NPV of the project? What is
the IRR?

Answer: This is an in-depth capital budgeting problem. Probably the easiest OCF
calculation for this problem is the bottom up approach, so we will construct
an income statement for each year. Beginning with the initial cash flow at
time zero, the project will require an investment in equipment.

To start off, we determine the depreciation schedule. The salvage value is 20%
of the installed cost, which is 20%*21,000,000 = 4,200,000.00

Year 1 2 3 4 5
(a) Starting Value 21,000,000 16,800,000 13,440,000 10,752,00
.00 .00 .00 0.00 8,601,6
00.00
(b) Depreciation
20% 4,200,00 3,360,00 2,688,00 2,150,4 4,401,6
0.00 0.00 0.00 00.00 00.00
(c) Accumulated 10,248,000 12,398,40 16,800,00
Depreciation 4,200,00 7,560,00 .00 0.00 0.00
0.00 0.00
(d) Residual Value 16,800,000 13,440,000 10,752,000
.00 .00 .00 8,601,6 4,200,0
00.00 00.00

The Income Statement is next in line.

 Investment Appraisal

1 2 3 4 5
Sales (in units) 85,000 98,000 106,000 114,000 93,000

Revenues 27,625,000.00 31,850,000 34,450,000 37,050,000 30,225,000

.00 .00 .00 .00
Variable Costs 20,400,000.00 23,520,000 25,440,000 27,360,000 22,320,000
.00 .00 .00 .00
Fixed Costs 900,000.00
900,000. 900,000. 900,000. 900,000.
00 00 00 00
Depreciation 20% 4,200,000.00
3,360,00 2,688,00 2,150,40 4,401,60
0.00 0.00 0.00 0.00
EBT 2,125,000.00
4,070,00 5,422,00 6,639,60 2,603,40
0.00 0.00 0.00 0.00
Tax 743,750.00
1,424,50 1,897,70 2,323,86 911,190.
0.00 0.00 0.00 00
Net Income 1,381,250.00
2,645,50 3,524,30 4,315,74 1,692,21
0.00 0.00 0.00 0.00
Operating Cash 5,581,250.00
Flow 6,005,50 6,212,30 6,466,14 6,093,81
0.00 0.00 0.00 0.00

Net Working Capital is a function of next years sales and so we can now calculate
how much net working capital is required each year.

0 1 2 3 4 5
Revenues 27,625,00 31,850,00 34,450,00 37,050,00 30,225,00
0.00 0.00 0.00 0.00 0.00
Net Working 1,500,000.
Capital 00* 4,777,5 5,167,5 5,557,5 4,533,7 0.00
00.00 00.00 00.00 50.00
*As per the question data 1,500,000 of NWC is required at the beginning
(year zero) of the project and additional net working capital investments each
year equal to 15 per cent of the projected sales for the following year. Here, we
should not be confused and consider an additional 15% NWC of sales in the
beginning (year zero), rather it is required starting from year 1.

The Cash Flow analysis can now be carried out.

0 1 2 3 4 5
Investment - 4,200,000.
21,000, 00
000.00
Operating Cash 5,581,250. 6,005,500 6,212,300 6,466,140 6,093,810.
Flows 00 .00 .00 .00 00
Change in NWC - - - - 1,023,750 4,533,750.
1,500,00 3,277, 390,0 390,0 .00 00
0.00 500.00 00.00 00.00
 Investment Appraisal

Net Cash Flow - 5,615,500 5,822,300 7,489,890 14,827,56

22,500, 2,303,7 .00 .00 .00 0.00
000.00 50.00
PV Cash Flows @ - 4,032,964 3,543,631 3,863,201 6,481,263.
18% 22,500, 1,952,3 .67 .53 .94 13
000.00 30.51

The NPV of the investment:

= -22,500,000.00 + 1,952,330.51 + 4,032,964.67 + 3,543,631.53 +
3,863,201.94 + 6,481,263.13
= -2,626,608.23

Using a spreadsheet, solver or trial and error, the IRR is 13.87%

Investment Appraisal

44. Calculating Required Savings [LO2]A proposed cost-

saving device has an installed cost of 480,000. The device will be
used in a five-year project, and will be depreciated using the
reducing-balance method at 20 per cent per annum. The required
initial net working capital investment is 40,000, the marginal tax
rate is 28 per cent, and the project discount rate is 12 per cent. The
device has an estimated year 5 salvage value of 45,000. What
level of pre-tax cost savings do we require for this project to be
profitable?

Answer: As with every capital budgeting decision that involves reducing

balance depreciation, the schedule must first be estimated.

Year 1 2 3 4 5
(a) Starting Value 480,00 384,00 307,20 245,76 196,60
0 0 0 0 8
(b) Depreciation 20% 96,000 76,800 61,440 49,152 151,60
8
(c) Accumulated 96,000 172,80 234,24 283,39 435,00
Depreciation 0 0 2 0
(d) Residual Value 384,00 307,20 245,76 196,60 45,000
0 0 0 8

Then the income statement is calculated. In this type of problem, you need to
calculate the break-even cost savings. For an analyst, the best approach is
to use a spreadsheet and then trial and error or Solver.

Using this technique, a cost savings of 148,548 leads to a net present value of
zero.

0 1 2 3 4 5
Pre-Tax Cost 148,54 148,54 148,54 148,54 148,54
Savings 8 8 8 8 8
Depreciation 20% 151,60
96,000 76,800 61,440 49,152 8
EBT 52,548 71,748 87,108 99,396 -3,060
Tax 14,713 20,089 24,390 27,831 -857
Net Income 37,835 51,659 62,718 71,565 -2,203
Operating Cash 133,83 128,45 124,15 120,71 149,40
Flow 5 9 8 7 5
0 1 2 3 4 5
Investment -
480,00
0 45,000
Operating Cash 133,83 128,45 124,15 120,71 149,40
Flows 5 9 8 7 5
Net Working
Capital -40,000 40,000
Net Cash Flow -
520,00 133,83 128,45 124,15 120,71 234,40
0 5 9 8 7 5
PV Cash Flows @ - 119,49 102,40 88,373 76,718 133,00
12% 520,00 5 6 8
Investment Appraisal

0
NPV 0
IRR 12.00%
Investment Appraisal

45. Calculating a Bid Price [LO3]Your company has been

approached to bid on a contract to sell 10,000 voice recognition
(VR) computer keyboards a year for four years. Because of
technological improvements, beyond that time they will be
outdated, and no sales will be possible. The equipment necessary
for the production will cost 2.4 million and will be depreciated on a
reducing-balance (20 per cent) method. Production will require an
investment in net working capital of 75,000 to be returned at the
end of the project, and the equipment can be sold for 200,000 at
the end of production. Fixed costs are 500,000 per year, and
variable costs are 165 per unit. In addition to the contract, you feel
your company can sell 3,000, 6,000, 8,000 and 5,000 additional
units to companies in other countries over the next four years,
respectively, at a price of 275. This price is fixed. The tax rate is 28
per cent, and the required return is 13 per cent. Additionally, the
managing director of the company will undertake the project only if
it has an NPV of 100,000. What bid price should you set for the
contract?
Answer: We start our analysis by first determining the depreciation schedule of
the investment.

Year 1 2 3 4
(a) Starting Value 2,400,00 1,920,00 1,536,0 1,228,80
0 0 00 0
(b) Depreciation 20% 480,000 384,000 307,200 1,028,80
0
(c) Accumulated 480,000 864,000 1,171,2 2,200,00
Depreciation 00 0
(d) Residual Value 1,920,00 1,536,00 1,228,8 200,000
0 0 00

There are two parts to this analysis. The first part is the original contract for
10,000 units. From the spreadsheet below, it can be seen that the investment on
its own would not be worthwhile if the bid price was set at 275.

0 1 2 3 4
Sales 10,000 10,000 10,000 10,000

Revenues 2,750,00 2,750,0 2,750,00 2,750,00

0 00 0 0
Variable Costs 1,650,00 1,650,0 1,650,00 1,650,00
0 00 0 0
Fixed Costs 500,000 500,000 500,000 500,000
Depreciation 20% 480,000 384,000 307,200 1,028,80
0
EBT 120,000 216,000 292,800 -428,800
Tax 33,600 60,480 81,984 -120,064
Net Income 86,400 155,520 210,816 -308,736
Operating Cash Flow 566,400 539,520 518,016 720,064
0 1 2 3 4
Investment Appraisal

Operating Cash Flow 566,400 539,520 518,016 720,064

Net Working Capital -75,000 75,000
Investment - 200,000
2,400,00
0
Net Cash Flow - 566,400 539,520 518,016 995,064
2,475,00
0
PV Cash Flows @ - 501,239 422,523 359,011 610,291
13% 2,475,00
0
NPV -581,935
IRR 2.10%

However, your company feels that it can also sell additional units to other
countries at 275 per unit. Since these cash flows are additional to the core cash
flows, fixed costs and depreciation become irrelevant cash flows.

The Cash Flow Analysis for this expansion is given below:

0 1 2 3 4
Sales 3,000 6,000 8,000 5,000

Revenues 825,000 1,650,0 2,200,00 1,375,00

00 0 0
Variable Costs 495,000 990,000 1,320,00 825,000
0
EBT 330,000 660,000 880,000 550,000
Tax 92,400 184,800 246,400 154,000
Net Income 237,600 475,200 633,600 396,000
Operating Cash Flow 237,600 475,200 633,600 396,000
0 1 2 3 4
Operating Cash Flow 237,600 475,200 633,600 396,000
Net Cash Flow 0 237,600 475,200 633,600 396,000
PV Cash Flows @ 0 210,265 372,151 439,117 242,874
13%
NPV 1,264,40
8

Since the NPV of this expansion is positive at 1,264,408, we can add this to the
original analysis and arrive at a bid price that gives the project an NPV of
100,000. This can be done easily in Solver and the spreadsheet is presented
below. The bid price that gives a 100,000 NPV is equal to 247.80.

0 1 2 3 4
Sales 10,000 10,000 10,000 10,000

Revenues 2,478,02 2,478,02 2,478,02 2,478,022.5

2.5 2.5 2.5
Variable Costs 1,650,000 1,650,000 1,650,000 1,650,000
Fixed Costs 500,000 500,000 500,000 500,000
Investment Appraisal

Depreciation 20% 480,000 384,000 307,200 1,028,800

EBT 151,977. 55,977.5 20,822.5 -700,777.5
5
Tax -42,553.7 - 5,830.3 -196,217.7
15,673.7
Net Income - - 14,992.2 -504,559.8
109,423. 40,303.8
8
Operating Cash Flow 370,576. 343,696. 322,192. 524,240.2
2 2 2
0 1 2 3 4
Operating Cash Flow 920,240.20
608,176.2 818,896.2 955,792.2
0 0 0
Net Working Capital -75,000 75,000
Investment - 200,000
2,400,00
0
Net Cash Flow - 1,195,240.20
2,475,00 608,176.2 818,896.2 955,792.2
0 0 0 0
PV Cash Flows @ - 733,063.20
13% 2,475,00 538,209.0 641,315.8 662,411.9
0 2 4 4
NPV 100,000
Investment Appraisal

46. Replacement Decisions [LO2]Suppose we are thinking

about replacing an old computer with a new one. The old one cost
us 650,000; the new one will cost 780,000. The new machine will
be depreciated straight-line to zero over its five-year life. It will
probably be worth about 150,000 after five years.
The old computer is being depreciated straight-line at a rate of
130,000 per year. It will be completely written off in three years. If
we dont replace it now, we shall have to replace it in two years. We
can sell it now for 210,000; in two years, it will probably be worth
60,000. The new machine will save us 145,000 per year in
operating costs. The tax rate is 38 per cent, and the discount rate is
12 per cent.
(a) Suppose we recognize that, if we dont replace the computer now,
we shall be replacing it in two years. Should we replace now or
should we wait? (Hint: What we effectively have here is a decision
either to invest in the old computer (by not selling it) or to invest
in the new one. Notice that the two investments have unequal
lives.)
(b) Suppose we consider only whether we should replace the old
computer now without worrying about whats going to happen in
two years. What are the relevant cash flows? Should we replace it
or not? (Hint: Consider the net change in the firms after-tax cash
flows if we do the replacement.)
Answer:
a. Since the two computers have unequal lives, the correct method to
analyze the decision is the EAC. We will begin with the EAC of the new
computer. Using the depreciation tax shield approach, the OCF for the new
computer system is:

OCF = (145,000)(1 .38) + (780,000 / 5)(.38) = 149,180

Notice that the costs are positive, which represents a cash inflow. The
costs are positive in this case since the new computer will generate a
cost savings. The only initial cash flow for the new computer is cost of
780,000. We next need to calculate the after-tax salvage value, which
is:

After-tax salvage value = 150,000(1 .38) = 93,000

Now we can calculate the NPV of the new computer as:

NPV = 780,000 + 149,180(PVIFA12%,5) + 93,000 / 1.125

NPV = 189,468.79

And the EAC of the new computer is:

EAC = 189,468.79 / (PVIFA12%,5) = 52,560.49

Analyzing the old computer, the only OCF is the depreciation tax shield,
so:

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Investment Appraisal

OCF = 130,000(.38) = 49,400

The initial cost of the old computer is a little trickier. You might assume
that since we already own the old computer there is no initial cost, but
we can sell the old computer, so there is an opportunity cost. We need to
account for this opportunity cost. To do so, we will calculate the after-tax
salvage value of the old computer today. We need the book value of the
old computer to do so. The book value is not given directly, but we are
told that the old computer has depreciation of 130,000 per year for the
next three years, so we can assume the book value is the total amount
of depreciation over the remaining life of the system, or 390,000. So,
the after-tax salvage value of the old computer is:

After-tax salvage value = 210,000 + (390,000 210,000)(.38) =

278,400

This is the initial cost of the old computer system today because we are
forgoing the opportunity to sell it today. We next need to calculate the
after-tax salvage value of the computer system in two years since we are
buying it today. The after-tax salvage value in two years is:

After-tax salvage value = 60,000 + (130,000 60,000)(.38) =

86,600

Now we can calculate the NPV of the old computer as:

NPV = 278,400 + 49,400 / 1.12 + (49,400 + 86,600) / 1.122

NPV = 125,874.49

And the EAC of the old computer is:

EAC = 125,874.49 / (PVIFA12%,2) = 74,479.70

Even if we are going to replace the system in two years no matter what
our decision today, we should replace it today since the EAC for a new
computer is less.

b. If we are only concerned with whether or not to replace the machine

now, and are not worrying about what will happen in two years, the
correct analysis is NPV. To calculate the NPV of the decision on the
computer system now, we need the difference in the total cash flows of
the old computer system and the new computer system. From our
previous calculations, we can say the cash flows for each computer
system are:

New Old
t computer computer Difference
0 780,000 278,400 501,600
1 149,180 49,400 99,780
2 149,180 136,000 13,180
3 149,180 0 149,180
4 149,180 0 149,180
5 242,180 0 242,180

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Investment Appraisal

Since we are only concerned with marginal cash flows, the cash flows of
the decision to replace the old computer system with the new computer
system are the differential cash flows. The NPV of the decision to
replace, ignoring what will happen in two years is:

NPV = 501,600 + 99,780/1.12 + 13,180/1.122 + 149,180/1.123 +

149,180/1.124
+ 242,180/1.125
NPV = -63,594.30

If we are not concerned with what will happen in two years, we should
not replace the old computer system as it gives us a negative NPV.

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