Part 3

Long-Term Investment Decisions

Chapters in this Part

Chapter 8 Capital Budgeting Cash Flows
Chapter 9 Capital Budgeting Techniques
Chapter 10 Risk and Refinements in Capital Budgeting

Integrative Case 3: Lasting Impressions Company

Chapter 8
Capital Budgeting Cash Flows

T Instructors Resources
Overview
This chapter prepares the student for the techniques of capital budgeting presented in the next chapter
(Chapter 9). The steps in the capital budgeting process are described, beginning with proposal generation
and ending with follow-up, and the associated terminology is defined. The special concerns involved in
international capital budgeting projects are discussed next. The chapter concludes with the basics of
determining relevant after-tax cash flows of a project, from the initial cash outlay to annual cash stream of
costs and benefits and terminal cash flow. It also describes the special concerns facing capital budgeting
for the multinational company.

Study Guide
The following Study Guide example is suggested for classroom presentation:

Example Topic
2 Expansion-type cash flows

T Suggested Answer to Chapter Opening Critical

Thinking Question
Where might financial managers find the type of information they need to evaluate the cost-
effectiveness of a new project?

Depending upon the scope of a project, financial managers may need to draw information from many areas
of a corporation including research and development, marketing, operations, human resources and within
the various departments dealing with corporate finance. It may be possible to get some of the information
directly from the project managers if they have done some of the legwork already.
194 Part 3 Long-Term Investment Decisions

T Answers to Review Questions

1. Capital budgeting is the process used to evaluate and select long-term investments consistent with the
goal of owner wealth maximization. Capital expenditures are outlays made by the firm that are
expected to produce benefits over the long term (a period greater than one year). Not all capital
expenditures are made for fixed assets. An expenditure made for an advertising campaign may have
long-term benefits.

2. The primary motives for making capital expenditures include:

Expansionincreasing the productive capacity of the firm, usually through the acquisition of fixed
assets.
Replacementreplacing existing assets with new or more advanced assets which provide the same
function.
Renewalrebuilding or overhauling existing assets to improve efficiency.
Other motives include expenditures for non-tangible projects that improve a firms profitability, such
as advertising, research and development, and product development. A firm may also be required by
law to undertake pollution control and similar projects.
Expansion and replacement involve the purchase of new assets as compared with renewal, where old
assets are upgraded.

3. (1) Proposal generation is the origination of proposed capital projects for the firm by individuals at
various levels of the organization.
(2) Review and analysis is the formal process of assessing the appropriateness and economic
viability of the project in light of the firms overall objectives. This is done by developing cash
flows relevant to the project and evaluating them through capital budgeting techniques. Risk
factors are also incorporated into the analysis phase.
(3) Decision making is the step where the proposal is compared against predetermined criteria and
either accepted or rejected.
(4) Implementation of the project begins after the project has been accepted and funding is made
available.
(5) Follow-up is the post-implementation audit of expected and actual costs and revenues generated
from the project to determine if the return on the proposal meets preimplementation projections.

4. (a) Independent projects have cash flows unrelated to or independent of each other. Mutually
exclusive projects have the same function as the other projects being considered. Therefore, they
compete with one another; accepting one eliminates the others from further consideration.
(b) Firms under capital rationing have only a fixed amount of dollars available for the capital budget,
whereas a firm with unlimited funds may accept all projects with a specified rate of return.
(c) The accept-reject approach evaluates capital expenditures using a predetermined minimum
acceptance criterion. If the project meets the criterion, its accepted and vice versa. With ranking,
projects are ranked from best to worst based on some predetermined measure, such as rate of
return.
(d) A conventional cash flow pattern consists of an initial outflow followed by a series of inflows. A
nonconventional cash flow pattern is any pattern in which an initial outlay is not followed by a
series of inflows.
 Chapter 8 Capital Budgeting Cash Flows 195

5. Capital budgeting projects should be evaluated using incremental after-tax cash flows, since after-tax
cash flows are what is available to the firm. When evaluating a project, concern is placed only on
added cash flows expected to result from its implementation. Expansion decisions can be treated as
replacement decisions in which all cash flows from the old assets are zero. Both expansion and
replacement decisions involve purchasing new assets. Replacement decisions are more complex
because incremental cash flows deriving from the replacement must be determined.

6. The three components of cash flow for any project are (1) initial investment, (2) operating cash flows,
and (3) terminal cash flows.

7. Sunk costs are costs that have already been incurred and thus the money has already been spent.
Opportunity costs are cash flows that could be realized from the next best alternative use of an owned
asset. Sunk costs are not relevant to the investment decision because they are not incremental. These
costs will not change no matter what the final accept/reject decision. Opportunity costs are a relevant
cost. These cash flows could be realized if the decision is made not to change the current asset
structure but to utilize the owned asset for its alternative purpose.

8. To minimize long-term currency risk, companies can finance a foreign investment in local capital
markets so that the projects revenues and costs are in the local currency rather than dollars.
Techniques such as currency futures, forwards, and options market instruments protect against short-
term currency risk. Financial and operating strategies that reduce political risk include structuring the
investment as a joint venture with a competent and well-connected local partner; and using debt
rather than equity financing, since debt service payments are legally enforceable claims while equity
returns such as dividends are not.

9. (a) The cost of the new asset is the purchase price. (Outflow)
(b) Installation costs are any added costs necessary to get an asset into operation. (Outflow)
(c) Proceeds from sale of old asset are cash inflows resulting from the sale of an existing asset,
reduced by any removal costs. (Inflow)
(d) Tax on sale of old asset is incurred when the replaced asset is sold due to recaptured depreciation,
capital gain, or capital loss. (May be an inflow or an outflow.)
(e) The change in net working capital is the difference between the change in current assets and the
change in current liabilities. (May be an inflow or an outflow)
196 Part 3 Long-Term Investment Decisions

10. The book value of an asset is its strict accounting value.

Book value = Installed cost of asset Accumulated depreciation
The three key forms of taxable income are (1) capital gain: portion of sale price above initial
purchase price, taxed at the ordinary rate; (2) recaptured depreciation: portion of sale price in excess
of book value that represents a recovery of previously taken depreciation, taxed at the ordinary rate;
and (3) loss on the sale of an asset: amount by which sale price is less than book value, taxed at the
ordinary rate and deducted from ordinary income if the asset is depreciable and used in business. If
the asset is not depreciable or is not used in business, it is also taxed at the ordinary rate but is
deductible only against capital gains.

11. The asset may be sold (1) for more than its book value, (2) for the amount of its book value, (3) at a
price below book value. In the first case taxes arising from the amount by which the sale price
exceeded the book value. In the second case no taxes would be required. In the fourth case, a tax
credit would occur.

12. The depreciable value of an asset is the installed cost of a new asset and is based on the depreciable
cost of the new project, including installation cost.

13. Depreciation is used to decrease the firms total tax liability and then is added back to net profits after
taxes to determine cash flow. Table 8.7 and equation 3.4 are equivalent ways of expressing operating
cash flows. The earnings before interest and taxes in table 8.7 is the same as the EBIT terminology in
equation 3.4. Both models then take out taxes and add back in depreciation.

14. To calculate incremental operating cash inflow for both the existing situation and the proposed
project, the depreciation on assets is added back to the after-tax profits to get the cash flows
associated with each alternative. The difference between the cash flows of the proposed and present
situation, the incremental after-tax cash flows, are the relevant operating cash flows used in
evaluating the proposed project.

15. The terminal cash flow is the cash flow resulting from termination and liquidation of a project at the
end of its economic life. The form of calculating terminal cash flows is shown below:

Terminal Cash Flow Calculation:

After-tax proceeds from sale of new asset =
Proceeds from sale of new asset
Tax on sale of new asset
After-tax proceeds from sale of old asset =
Proceeds from sale of old asset
Tax on sale of old asset
Change in net working capital
= Terminal cash flow
 Chapter 8 Capital Budgeting Cash Flows 197

16. The relevant cash flows necessary for a conventional capital budgeting project are the incremental
after-tax cash flows attributable to the proposed project: the initial investment, the operating cash
inflows, and the terminal cash flow. The initial investment is the initial outlay required, taking into
account the installed cost of the new asset, proceeds from the sale of the old asset, tax on the sale of
the old asset, and any change in net working capital. The operating cash inflows are the additional
cash flows received as a result of implementing a proposal. Terminal cash flow represents the after-
tax cash flows expected to result from the liquidation of the project at the end of its life. These three
components represent the positive or negative cash flow impact if the firm implements the project
and are depicted in the following diagram.
Year 5
Operating Cash Inflow
Cash Flows ($) Operating Cash Flows + Terminal Cash Inflow

60,000

40,000

20,000

0
0 Year

1 2 3 4 5
20,000

40,000
Initial Investment
60,000

T Suggested Answer to Critical Thinking Question

for in Practice and Global Focus Box
The need to improve corporate and public sector integrity is not a problem confined to Russia. Can
you think of examples of corporate impropriety here in the United States?

With the Enron, World-Com, Arthur Anderson and Martha Stewart Co. scandals in the news over the past
several years, U.S. corporations are not entirely bastions of corporate integrity. While the number of large
well-publicized corporate scandals does not involve a significant percentage of the total population of U.S.
companies, the size and scope of each scandal made them news-worthy and had a negative impact upon
U.S stock markets and the public image of corporations in general. Trust once broken is often difficult to
regain.
198 Part 3 Long-Term Investment Decisions

T Suggested Answer to Critical Thinking Question

for Focus on Ethics Box
As a company manager, should you take into account net income rather than cash flows? If so, why?

For upper-level management the impact of the project on earnings often seems more relevant than
discounted cash flow. The reason is that as long as there is fear that the price of the stock may drop
drastically when the company misses analysts estimates even slightly, the management is likely to pursue
an inferior project based on the cash flow projections as long as its sensitivity to net earnings is smaller.

T Answers to Warm-Up Exercises

E8-1. Categorizing a Firms Expenditures
Answer: In this case, the tuition reimbursement should be categorized as a capital expenditure since the
outlay of funds is expected to produce benefits over a period of time greater than 1 year.

E8-2. Find the Rate of Return of a Project

Answer: You may use a financial calculator or a spreadsheet to calculate the internal rate of return for
each project. The solution below will use a financial calculator.
Project A: Set the calculator on 1 period/year.
PMT = 5,000
N=5
PV = 20,000
Solve for I. I = 7.93%
Project B: Set the calculator on 1 period/year.
PMT = 6,500
N=5
PV = 25,000
Solve for I. I = 9.43%%
Choose project B since it generates a higher rate of return than project A.

E8-3. Classification of Project Costs and Cash Flows

Answer: $3.5 billion already spent Sunk cost (irrelevant)
$350 million incremental cash outflow Relevant cash flow
$15 million per year cash inflow Relevant cash flow
$450 million for satellites Opportunity cost and relevant cash flow
 Chapter 8 Capital Budgeting Cash Flows 199

E8-4. Book Value and Recaptured Depreciation

Answer: Book Value = $175,000 $124, 250 = $50,750
Recaptured Depreciation = $110,000 $50, 750 = $59,250

E8-5. Initial Investment

Answer: Initial investment = purchase price + installation costs after tax proceeds from sale of old
asset + change in net working capital
= $55,000 + $7,500 $23,750 + $2,000 = $40,750

T Solutions to Problems
Note: The MACRS depreciation percentages used in the following problems appear in Chapter 3,
Table 3.2. The percentages are rounded to the nearest integer for ease in calculation.

For simplification, five-year-lived projects with 5 years of cash inflows are used throughout this chapter.
Projects with usable lives equal to the number of years of cash inflows are also included in the end-of-
chapter problems. It is important to recall from Chapter 3 that, under the Tax Reform Act of 1986,
MACRS depreciation results in n + 1 years of depreciation for an n-year class asset. This means that in
actual practice projects will typically have at least one year of cash flow beyond their recovery period.

P8-1. LG 1: Classification of Expenditures

Basic
(a) Operating expenditure
(b) Capital expenditure
(c) Capital expenditure
(d) Operating expenditure
(e) Capital expenditure
(f) Capital expenditure
(g) Capital expenditure
(h) Operating expenditure

P8-2. LG 2: Basic Terminology

Basic
Situation A Situation B Situation C
(a) mutually exclusive mutually exclusive independent
(b) unlimited unlimited capital rationing
(c) ranking accept-reject ranking
(d) conventional nonconventional conventional (2&4)
nonconventional (1&3)
200 Part 3 Long-Term Investment Decisions

P8-3. LG 3: Relevant Cash Flow Pattern Fundamentals

Intermediate
(a) Year Cash Flow
Initial investment ($120,000)
118 $25,000 $5,000 = $20,000

0 1 2 3 16 17 18

120,000 20,000 20,000 20,000 ------------------- 20,000 20,000 20,000

(b) Initial investment ($85,000 $30,000) = ($55,000)

15 = $20,000
6 $20,000 + $20,000 $10,000 = $30,000
0 1 2 3 4 5 6

55,000 20,000 20,000 20,000 20,000 20,000 30,000

(c) Initial investment ($2,000,000)

15 $300,000 $20,000 = $280,000
6 $300,000 $500,000 = ($200,000)
710 $300,000 $20,000 = 280,000
0 1 2 5 6 7 10

2,000,000 280,000 280,000 280,000 200,000 280,000 280,000

P8-4. LG 3: Expansion versus Replacement Cash Flows

Intermediate
(a)
Year Relevant Cash Flows
Initial investment ($28,000)
1 4,000
2 6,000
3 8,000
4 10,000
5 4,000

(b) An expansion project is simply a replacement decision in which all cash flows from the old
asset are zero.
 Chapter 8 Capital Budgeting Cash Flows 201

P8-5. LG 3: Sunk Costs and Opportunity Costs

Basic
(a) The $1,000,000 development costs should not be considered part of the decision to go ahead
with the new production. This money has already been spent and cannot be retrieved so it is a
sunk cost.
(b) The $250,000 sale price of the existing line is an opportunity cost. If Masters Golf Products
does not proceed with the new line of clubs they will not receive the $250,000.
(c)
Cash Flows

$1,800,000 $750,000 $750,000 $750,000 $750,000 $750,000

+ $250,000
||||||>
0 1 2 3 9 10

End of Year

P8-6. LG 3: Sunk Costs and Opportunity Costs

Intermediate
(a) Sunk costThe funds for the tooling had already been expended and would not change, no
matter whether the new technology would be acquired or not.
(b) Opportunity costThe development of the computer programs can be done without
additional expenditures on the computers; however, the loss of the cash inflow from the
leasing arrangement would be a lost opportunity to the firm.
(c) Opportunity costCovol will not have to spend any funds for floor space but the lost cash
inflow from the rent would be a cost to the firm.
(d) Sunk costThe money for the storage facility has already been spent, and no matter what
decision the company makes there is no incremental cash flow generated or lost from the
storage building.
(e) Opportunity costForegoing the sale of the crane costs the firm $180,000 of potential cash
inflows.

P8-7. LG 4: Book Value

Basic
Installed Accumulated Book
Asset Cost Depreciation Value
A $950,000 $674,500 $275,500
B 40,000 13,200 26,800
C 96,000 79,680 16,320
D 350,000 70,000 280,000
E 1,500,000 1,170,000 330,000
202 Part 3 Long-Term Investment Decisions

P8-8. LG 4: Book Value and Taxes on Sale of Assets

Intermediate
(a) Book value = $80,000 (0.71 $80,000)
= $23,200
(b)
Capital Tax on Depreciation Tax on Total
Sale Price Gain Capital Gain Recovery Recovery Tax
$100,000 $20,000 $8,000 $56,800 $22,720 $30,720
56,000 0 0 32,800 13,120 13,120
23,200 0 0 0 0 0
15,000 0 0 (8,200) (3,280) (3,280)

P8-9. LG 4: Tax Calculations

Intermediate
Current book value = $200,000 [(0.52 ($200,000)] = $96,000
(a) (b) (c) (d)
Capital gain $20,000 0 0 0
Recaptured depreciation 104,000 54,000 0 (16,000)
Tax on capital gain $8,000 0 0 0
Tax on depreciation
recovery 41,600 21,600 0 (6,400)
Total tax $49,600 $21,600 $0 ($6,400)

P8-10. LG 4: Change in Net Working Capital Calculation

Basic
(a)
Current Assets Current Liabilities
Cash +$15,000 Accounts payable +$90,000
Accounts receivable +150,000 Accruals +40,000
Inventory 10,000
Net change $155,000 $130,000

Net working capital = current assets current liabilities

NWC = $155,000 $130,000
NWC = $25,000
(b) Analysis of the purchase of a new machine reveals an increase in net working capital. This
increase should be treated as an initial outlay and is a cost of acquiring the new machine.
(c) Yes, in computing the terminal cash flow, the net working capital increase should be
reversed.
 Chapter 8 Capital Budgeting Cash Flows 203

P8-11. LG 4: Calculating Initial Investment

Intermediate
(a) Book value = ($325,000 0.48) = $156,000
(b) Sales price of old equipment $200,000
Book value of old equipment 156,000
Recapture of depreciation $44,000
Taxes on recapture of depreciation = $44,000 0.40 = $17,600
After-tax proceeds = $200,000 $17,600 = $182,400
(c) Cost of new machine $500,000
Less sales price of old machine (200,000)
Plus tax on recapture of depreciation 17,600
Initial investment $317,600

P8-12. LG 4: Initial InvestmentBasic Calculation

Intermediate
Installed cost of new asset =
Cost of new asset $35,000
+ Installation Costs 5,000
Total installed cost (depreciable value) $40,000
After-tax proceeds from sale of old asset =
Proceeds from sale of old asset ($25,000)
+ Tax on sale of old asset 7,680
Total after-tax proceeds-old asset ($17,320)
Initial investment $22,680
Book value of existing machine = $20,000 (1 (0.20 + 0.32 + 0.19)) = $5,800
Recaptured depreciation = $20,000 $5,800 = $14,200
Capital gain = $25,000 $20,000 = $5,000
Tax on recaptured depreciation = $14,200 (0.40) = $5,680
Tax on capital gain = $5,000 (0.40) = 2,000
Total tax = $7,680
204 Part 3 Long-Term Investment Decisions

P8-13. LG 4: Initial investment at Various Sale Prices

Intermediate
(a) (b) (c) (d)
Installed cost of new asset:
Cost of new asset $24,000 $24,000 $24,000 $24,000
+ Installation cost 2,000 2,000 2,000 2,000
Total installed-cost $26,000 $26,000 $26,000 $26,000
After-tax proceeds from sale
of old asset
Proceeds from sale
of old asset (11,000) (7,000) (2,900) (1,500)
+ Tax on sale of old asset
*
3,240 1,640 0 (560)
Total after-tax proceeds (7,760) (5,360) (2,900) (2,060)
Initial investment $18,240 $20,640 $23,100 $23,940

Book value of existing machine = $10,000 [1 (0.20 0.32 0.19)] = $2,900

*
Tax Calculations:
(a) Recaptured depreciation = $10,000 $2,900 = $7,100
Capital gain = $11,000 $10,000 = $1,000
Tax on ordinary gain = $7,100 (0.40) = $2,840
Tax on capital gain = $1,000 (0.40) = 400
Total tax = $3,240

(b) Recaptured depreciation = $7,000 $2,900 = $4,100

Tax on ordinary gain = $4,100 (0.40) = $1,640
(c) 0 tax liability

(d) Loss on sale of existing asset = $1,500 $2,900 = ($1,400)

Tax benefit = $1,400 (0.40) = $560

P8-14. LG 4: Calculating Initial Investment

Challenge
(a) Book value = ($60,000 0.31) = $18,600
(b) Sales price of old equipment $35,000
Book value of old equipment 18,600
Recapture of depreciation $16,400
Taxes on recapture of depreciation = $16,400 0.40 = $6,560
Sale price of old roaster $35,000
Tax on recapture of depreciation (6,560)
After-tax proceeds from sale of old roaster $28,440
 Chapter 8 Capital Budgeting Cash Flows 205

(c) Changes in current asset accounts

Inventory $50,000
Accounts receivable 70,000
Net change $120,000
Changes in current liability accounts
Accruals $(20,000)
Accounts payable 40,000
Notes payable 15,000
Net change $35,000
Change in net working capital $85,000
(d) Cost of new roaster $130,000
Less after-tax proceeds from sale of old roaster 28,440
Plus change in net working capital 85,000
Initial investment $186,560
P8-15. LG 4: Depreciation
Basic
Depreciation Schedule
Year Depreciation Expense
1 $68,000 0.20 = $13,600
2 68,000 0.32 = 21,760
3 68,000 0.19 = 12,920
4 68,000 0.12 = 8,160
5 68,000 0.12 = 8,160
6 68,000 0.05 = 3,400
P8-16. LG 5: Incremental Operating Cash Inflows
Intermediate
(a) Incremental profits before tax and depreciation = $1,200,000 $480,000
= $720,000 each year
(b)
Year (1) (2) (3) (4) (5) (6)
PBDT $720,000 $720,000 $720,000 $720,000 $720,000 $720,000
Depr. 400,000 640,000 380,000 240,000 240,000 100,000
NPBT 320,000 80,000 340,000 480,000 480,000 620,000
Tax 128,000 32,000 136,000 192,000 192,000 248,000
NPAT 192,000 48,000 204,000 288,000 288,000 372,000
(c) Cash (1) (2) (3) (4) (5) (6)
flow $592,000 $688,000 $584,000 $528,000 $528,000 $472,000
(NPAT + depreciation)
PBDT = Profits before depreciation and taxes
NPBT = Net profits before taxes
NPAT = Net profits after taxes
206 Part 3 Long-Term Investment Decisions

P8-17. LG 5: Incremental Operating Cash InflowsExpense Reduction

Intermediate
Year (1) (2) (3) (4) (5) (6)
Incremental
expense savings $16,000 $16,000 $16,000 $16,000 $16,000 $0
Incremental profits
*
before dep. and taxes $16,000 $16,000 $16,000 $16,000 $16,000 $0
Depreciation 9,600 15,360 9,120 5,760 5,760 2,400
Net profits
before taxes 6,400 640 6,880 10,240 10,240 2,400
Taxes 2,560 256 2,752 4,096 4,096 960
Net profits
after taxes 3,840 384 4,128 6,144 6,144 1,440
Operating cash
**
inflows 13,440 15,744 13,248 11,904 11,904 960

*
Incremental profits before depreciation and taxes will increase the same amount as the decrease in expenses.
**
Net profits after taxes plus depreciation expense.

P8-18. LG 5: Incremental Operating Cash Inflows

Intermediate
(a)
Expenses Net
(excluding Profits Before Profits Net Net Operating
depreciation Depreciation Depre- Before Profits Profits Cash
Year Revenue and interest) and Taxes ciation Taxes Taxes After Tax Inflows
New Lathe
1 $40,000 $30,000 $10,000 $2,000 $8,000 $3,200 $4,800 $6,800
2 41,000 30,000 11,000 3,200 7,800 3,120 4,680 7,880
3 42,000 30,000 12,000 1,900 10,100 4,040 6,060 7,960
4 43,000 30,000 13,000 1,200 11,800 4,720 7,080 8,280
5 44,000 30,000 14,000 1,200 12,800 5,120 7,680 8,880
6 0 0 0 500 (500) (200) (300) 200
Old Lathe
15 $35,000 $25,000 $10,000 0 $10,000 $4,000 $6,000 $6,000
 Chapter 8 Capital Budgeting Cash Flows 207

(b) Calculation of Incremental Cash Inflows

Year New Lathe Old Lathe Incremental Cash Flows
1 $6,800 $6,000 $800
2 7,880 6,000 1,880
3 7,960 6,000 1,960
4 8,280 6,000 2,280
5 8,880 6,000 2,880
6 200 0 200
(c)
Cash Flows
$800 $1,880 $1,960 $2,280 $2,880 $200
| | | | | | |
0 1 2 3 4 5 6
End of Year
P8-19. LG 5: Determining Operating Cash Flows
Intermediate
(a)
Year
1 2 3 4 5 6
Revenues:(000)
New buses $1,850 $1,850 $1,830 $1,825 $1,815 $1,800
Old buses 1,800 1,800 1,790 1,785 1,775 1,750
Incremental revenue $50 $50 $40 $40 $40 $50
Expenses: (000)
New buses $460 $460 $468 $472 $485 $500
Old buses 500 510 520 520 530 535
Incremental expense $(40) $(50) $(52) $(48) $(45) $(35)
Depreciation: (000)
New buses $600 $960 $570 $360 $360 $150
Old buses 324 135 0 0 0 0
Incremental depr. $276 $825 $570 $360 $360 $150
Incremental depr. tax
savings @40% 110 330 228 144 144 60
Net Incremental Cash Flows
Cash Flows: (000)
Revenues $50 $50 $40 $40 $40 $50
Expenses 40 50 52 48 45 35
Less taxes @40% (36) (40) (37) (35) (34) (34)
Depr. tax savings 110 330 228 144 144 60
Net operating cash
inflows $164 $390 $283 $197 $195 $111
208 Part 3 Long-Term Investment Decisions

P8-20. LG 6: Terminal Cash FlowsVarious Lives and Sale Prices

Challenge
(a)
After-tax proceeds from sale of new asset = 3-year
* * *
5-year 7-year
Proceeds from sale of proposed asset $10,000 $10,000 $10,000
Tax on sale of proposed asset *
+16,880 400 4,000
Total after-tax proceeds-new $26,880 $9,600 $6,000
+ Change in net working capital +30,000 +30,000 +30,000
Terminal cash flow $56,800 $39,600 $36,000

= [1 (0.20 + 0.32 + 0.19) ($180,000)] = $52,200

*
(1) Book value of asset
Proceeds from sale = $10,000
$10,000 $52,200 = ($42,200) loss
$42,200 (0.40) = $16,880 tax benefit
(2) Book value of asset = [1 (0.20 + 0.32 + 0.19 + 0.12 + 0.12) ($180,000)] = $9,000
$10,000 $9,000 = $1,000 recaptured depreciation
$1,000 (0.40) = $400 tax liability
(3) Book value of asset = $0
$10,000 $0 = $10,000 recaptured depreciation
$10,000 (0.40) = $4,000 tax liability

(b) If the usable life is less than the normal recovery period, the asset has not been depreciated
fully and a tax benefit may be taken on the loss; therefore, the terminal cash flow is higher.
(c)
(1) (2)
After-tax proceeds from sale of new asset =
Proceeds from sale of new asset $9,000 $170,000
+ Tax on sale of proposed asset *
0 (64,400)
+ Change in net working capital +30,000 +30,000
Terminal cash flow $39,000 $135,600

(1) Book value of the asset = $180,000 0.05 = $9,000; no taxes are due
*

(2) Tax = ($170,000 $9,000) 0.4 = $64,400.

(d) The higher the sale price, the higher the terminal cash flow.
 Chapter 8 Capital Budgeting Cash Flows 209

P8-21. LG 6: Terminal Cash FlowReplacement Decision

Challenge
After-tax proceeds from sale of new asset =
Proceeds from sale of new machine $75,000
Tax on sale of new machine
l
(14,360)
Total after-tax proceeds-new asset $60,640
After-tax proceeds from sale of old asset
Proceeds from sale of old machine (15,000)
+ Tax on sale of old machine 2
6,000
Total after-tax proceeds-old asset (9,000)
+ Change in net working capital 25,000
Terminal cash flow $76,640
l
Book value of new machine at end of year.4:
[1 (0.20 + 0.32+ 0.19 + 0.12) ($230,000)] = $39,100
$75,000 $39,100 = $35,900 recaptured depreciation
$35,900 (0.40) = $14,360 tax liability
2
Book value of old machine at end of year 4:
$0
$15,000 $0 = $15,000 recaptured depreciation
$15,000 (0.40) = $6,000 tax benefit
210 Part 3 Long-Term Investment Decisions

P8-22. LG 4, 5, 6: Relevant Cash Flows for a Marketing Campaign

Challenge
Marcus Tube
Calculation of Relevant Cash Flow
($000)
Calculation of Net Profits after Taxes and Operating Cash Flow:
with Marketing Campaign
2007 2008 2009 2010 2011
Sales $20,500 $21,000 $21,500 $22,500 $23,500
CGS (@ 80%) 16,400 16,800 17,200 18,000 18,800
Gross Profit $4,100 $4,200 $4,300 $4,500 $4,700
Less: Operating Expenses
General and
Administrative
(10% of sales) $2,050 $2,100 $2,150 $2,250 $2,350
Marketing Campaign 150 150 150 150 150
Depreciation 500 500 500 500 500
Total operating
expenses 2,700 2,750 2,800 2,900 3,000
Net profit
before taxes $1,400 $1,450 $1,500 $1,600 $1,700
Less: Taxes 40% 560 580 600 640 680
Net profit
after taxes $840 $870 $900 $960 $1,020
+Depreciation 500 500 500 500 500
Operating CF $1,340 $1,370 $1,400 $1,460 $1,520

Without Marketing Campaign

Years 20072011
Net profit after taxes $900
+ Depreciation 500
Operating cash flow $1,400

Relevant Cash Flow

($000)
With Marketing Without Marketing Incremental
Year Campaign Campaign Cash Flow
2007 $1,340 $1,400 $(60)
2008 1,370 1,400 (30)
2006 1,400 1,400 0
2010 1,460 1,400 60
2011 1,520 1,400 120
 Chapter 8 Capital Budgeting Cash Flows 211

P8-23. LG 4, 5: Relevant Cash FlowsNo Terminal Value

Challenge
(a) Installed cost of new asset
Cost of new asset $76,000
+ Installation costs 4,000
Total cost of new asset $80,000
After-tax proceeds from sale of old asset
Proceeds from sale of old asset (55,000)
+ Tax on sale of old asset *
16,200
Total proceeds, sale of old asset (38,800)
Initial investment $41,200
*
Book value of old machine:
[1 (0.20 + 0.32 + 0.19)] $50,000 = $14,500
$55,000 $14,500 = $40,500 gain on asset

$35,500 recaptured depreciation 0.40 = $14,200

$5,000 capital gain 0.40 = 2,000
Total tax on sale of asset = $16,200

(b) Calculation of Operating Cash Flow

Year (1) (2) (3) (4) (5) (6)
Old Machine
PBDT $14,000 $16,000 $20,000 $18,000 $14,000 $0
Depreciation 6,000 6,000 2,500 0 0 0
NPBT $8,000 $10,000 $17,500 $18,000 $14,000 0
Taxes 3,200 4,000 7,000 7,200 5,600 0
NPAT $4,800 $6,000 $10,500 $10,800 $8,400 $0
Depreciation 6,000 6,000 2,500 0 0 0
Cash flow $10,800 $12,000 $13,000 $10,800 $8,400 $0
New Machine
PBDT $30,000 $30,000 $30,000 $30,000 $30,000 $0
Depreciation 16,000 25,600 15,200 9,600 9,600 4,000
NPBT $14,000 $4,400 $14,800 $20,400 $20,400 $4,000
Taxes 5,600 1,760 5,920 8,160 8,160 1,600
NPAT $8,400 $2,640 $8,880 $12,240 $12,240 $2,400
Depreciation 16,000 25,600 15,200 9,600 9,600 4,000
Cash flow $24,400 $28,240 $24,080 $21,840 $21,840 $1,600
Incremental
After-tax
Cash flows $13,600 $16,240 $11,080 $11,040 $13,440 $1,600
212 Part 3 Long-Term Investment Decisions

(c)
Cash Flows
$41,200 $13,600 $16,240 $11,080 $11,040 $13,440 $1,600
| | | | | | |
0 1 2 3 4 5 6
End of Year

P8-24. LG 4, 5, 6: IntegrativeDetermining Relevant Cash Flows

Challenge
(a) Initial investment:
Installed cost of new asset =
Cost of new asset $105,000
+ Installation costs 5,000
Total cost of new asset $110,000
After-tax proceeds from sale of old asset =
Proceeds from sale of old asset (70,000)
+ Tax on sale of old asset
*
16,480
Total proceeds from sale of old asset (53,520)
+ Change in working capital 12,000
Initial investment $68,480
*
Book value of old asset:
[1 (0.20 + 0.32)] $60,000 = $28,800
$70,000 $28,800 = $41,200 gain on sale of asset
$31,200 recaptured depreciation 0.40 = $12,480
$10,000 capital gain 0.40 = 4,000
Total tax of sale of asset = $16,480
 Chapter 8 Capital Budgeting Cash Flows 213

(b)
Calculation of Operating Cash Inflows
Profits Before Operating
Depreciation Net Profits Net Profits Cash
Year and Taxes Depreciation Before Taxes Taxes After Taxes Inflows
New Grinder
1 $43,000 $22,000 $21,000 $8,400 $12,600 $34,600
2 43,000 35,200 7,800 3,120 4,680 39,880
3 43,000 20,900 22,100 8,840 13,260 34,160
4 43,000 13,200 29,800 11,920 17,880 31,080
5 43,000 13,200 29,800 11,920 17,880 31,080
6 0 5,500 5,500 2,200 3,300 2,200
Existing Grinder
1 $26,000 $11,400 $14,600 $5,840 $8,760 $20,160
2 24,000 7,200 16,800 6,720 10,080 17,280
3 22,000 7,200 14,800 5,920 8,880 16,080
4 20,000 3,000 17,000 6,800 10,200 13,200
5 18,000 0 18,000 7,200 10,800 10,800
6 0 0 0 0 0 0

Calculation of Incremental Cash Inflows

Incremental Operating
Year New Grinder Existing Grinder Cash Flow
1 $34,600 $20,160 $14,440
2 39,880 17,280 22,600
3 34,160 16,080 18,080
4 31,080 13,200 17,880
5 31,080 10,800 20,280
6 2,200 0 2,200
214 Part 3 Long-Term Investment Decisions

(c) Terminal Cash Flow:

After-tax proceeds from sale of new asset =
Proceeds from sale of new asset $29,000
Tax on sale of new asset* (9,400)
Total proceeds from sale of new asset 19,600
After-tax proceeds from sale of old asset =
Proceeds from sale of old asset 0
+ Tax on sale of old asset 0
Total proceeds from sale of old asset 0
+ Change in net working capital 12,000
Terminal cash flow $31,600

Book value of asset at end of year 5 = $5,500

*

$29,000 $5,500 = $23,500 recaptured depreciation

$23,500 0.40 = $9,400

(d) Year 5 Relevant Cash Flow:

Operating cash flow $20,280
Terminal cash flow 31,600
Total inflow $51,880
0 1 2 3 4 5 6

68,480 14,400 22,600 18,080 17,880 51,880 2,200

P8-25. LG 4, 5, 6: IntegrativeDetermining Relevant Cash Flows

Challenge
(a)
Initial investment A B
Installed cost of new asset
Cost of new asset $40,000 $54,000
+ Installation costs 8,000 6,000
Total proceeds, sale of new asset 48,000 60,000
After-tax proceeds from sale of old asset
Proceeds from sale of old asset (18,000) (18,000)
+ Tax on sale of old asset
*
3,488 3,488
Total proceeds, sale of old asset (14,512) (14,512)
+ Change in working capital 4,000 6,000
Initial investment $37,488 $51,488

*
Book value of old asset:
[1 (0.20 + 0.32 + 0.19)] ($32,000) = $9,280
 Chapter 8 Capital Budgeting Cash Flows 215

(b) Calculation of Operating Cash Inflows

Profits
Before Net Profits Net Profits Operating
Depreciation Depre- Before After Cash
Year and Taxes ciation Taxes Taxes Taxes Inflows
Hoist A
1 $21,000 $9,600 $11,400 $4,560 $6,840 $16,440
2 21,000 15,360 5,640 2,256 3,384 18,744
3 21,000 9,120 11,880 4,752 7,128 16,248
4 21,000 5,760 15,240 6,096 9,144 14,904
5 21,000 5,760 15,240 6,096 9,144 14,904
6 0 2,400 2,400 960 1,440 960
Hoist B
1 $22,000 $12,000 $10,000 $4,000 $6,000 18,000
2 24,000 19,200 4,800 1,920 2,880 22,080
3 26,000 11,400 14,600 5,840 8,760 20,160
4 26,000 7,200 18,800 7,520 11,280 18,480
5 26,000 7,200 18,800 7,520 11,280 18,480
6 0 3,000 3,000 1,200 1,800 1,200
Existing Hoist
1 $14,000 $3,840 $10,160 $4,064 $6,096 $9,936
2 14,000 3,840 10,160 4,064 6,096 9,936
3 14,000 1,600 12,400 4,960 7,440 9,040
4 14,000 0 14,000 5,600 8,400 8,400
5 14,000 0 14,000 5,600 8,400 8,400
6 0 0 0 0 0 0

Calculation of Incremental Cash Inflows

Incremental Cash Flow
Year Hoist A Hoist B Existing Hoist Hoist A Hoist B
1 $16,440 $18,000 $9,936 $6,504 $8,064
2 18,744 22,080 9,936 8,808 12,144
3 16,248 20,160 9,040 7,208 11,120
4 14,904 18,480 8,400 6,504 10,080
5 14,904 18,480 8,400 6,504 10,080
6 960 1,200 0 960 1,200
216 Part 3 Long-Term Investment Decisions

(c) Terminal Cash Flow:

(A) (B)
After-tax proceeds form sale of new asset
Proceeds from sale of new asset $12,000 $20,000
Tax on sale of new asset
l
(3,840) (6,800)
Total proceeds-new asset 8,160 13,200
After-tax proceeds from sale of old asset
Proceeds from sale of old asset (1,000) (1,000)
+ Tax on sale of old asset 2 400 400
Total proceeds-old asset (600) (600)
+ Change in net working capital 4,000 6,000
Terminal cash flow $11,560 $18,600
Book value of Hoist A at end of year 5 = $2,400
1

$12,000 $2,400 = $9,600 recaptured depreciation

$9,600 0.40 = $3,840 tax
Book value of Hoist B at end of year 5 = $3,000
$20,000 $3,000 = $17,000 recaptured depreciation
$17,000 0.40 = $6,800 tax
Book value of Existing Hoist at end of year 5 = $0
2

$1,000 $0 = $1,000 recaptured depreciation

$1,000 0.40 = $400 tax
Year 5 Relevant Cash FlowHoist A:
Operating cash flow $6,504
Terminal cash flow 11,560
Total inflow $18,064
Year 5 Relevant Cash Flow - Hoist B:
Operating cash flow $10,080
Terminal cash flow 18,600
Total inflow $28,680
(d)
Hoist A
Cash Flows

$37,488 $6,504 $8,808 $7,208 $6,504 $18,064 $960

| | | | | | |
0 1 2 3 4 5 6
End of Year

Hoist B
Cash Flows

$51,488 $8,064 $12,144 $11,120 $10,080 $28,680 $1,200

| | | | | | |
0 1 2 3 4 5 6
End of Year
 Chapter 8 Capital Budgeting Cash Flows 217

P8-26. Ethics Problem

Intermediate
The likely explanation is that loan officers and bank credit analysts are often more preoccupied
with a firms ability to repay the loan and how soon rather then internal rate of return of the
project or its discounted cash flow. Another reason is maybe that owners or managers of small
businesses may not have sufficient skills to conduct the more tedious financial analysis.

T Case
Developing Relevant Cash Flows for Clark Upholstery Companys Machine Renewal
or Replacement Decision
Clark Upholstery is faced with a decision to either renew its major piece of machinery or to replace the
machine. The case tests the students understanding of the concepts of initial investment and relevant cash
flows.
(a) Initial Investment
Alternative 1 Alternative 2
Installed cost of new asset
Cost of asset $90,000 $100,000
+ Installation costs 0 10,000
Total proceeds, sale of new asset 90,000 110,000
After-tax proceeds from sale of old asset
Proceeds from sale of old asset 0 (20,000)
+ Tax on sale of old asset *
0 8,000
Total proceeds, sale of old asset 0 (12,000)
+ Change in working capital 15,000 22,000
Initial investment $105,000 $120,000

Book value of old asset = 0

*

$20,000 $0 = $20,000 recaptured depreciation

$20,000 (0.40) = $8,000 tax
218 Part 3 Long-Term Investment Decisions

(b)
Calculation of Operating Cash Inflows
Profits Before Operating
Depreciation Depre- Net Profits Net Profits Cash
Year and Taxes ciation Before Taxes Taxes After Taxes Inflows
Alternative 1
1 $198,500 $18,000 $180,500 $72,200 $108,300 $126,300
2 290,800 28,800 262,000 104,800 157,200 186,000
3 381,900 17,100 364,800 145,920 218,880 235,980
4 481,900 10,800 471,100 188,440 282,660 293,460
5 581,900 10,800 571,100 228,440 342,660 353,460
6 0 4,500 4,500 1,800 2,700 1,800
Alternative 2
1 $235,500 $22,000 $213,500 $85,400 $128,100 $150,100
2 335,200 35,200 300,000 120,000 180,000 215,200
3 385,100 20,900 364,200 145,680 218,520 239,420
4 435,100 13,200 421,900 168,760 253,140 266,340
5 551,100 13,200 537,900 215,160 322,740 335,940
6 0 5,500 5,500 2,200 3,300 2,200

Calculation of Incremental Cash Inflows

Incremental Cash Flow
Year Alternative 1 Alternative 2 Existing Alt. 1 Alt. 2
1 $126,300 $150,100 $100,000 $26,300 $50,100
2 186,000 215,200 150,000 36,000 65,200
3 235,980 239,420 200,000 35,980 39,420
4 293,460 266,340 250,000 43,460 16,340
5 353,460 335,940 320,000 33,460 15,940
6 1,800 2,200 0 1,800 2,200
 Chapter 8 Capital Budgeting Cash Flows 219

(c) Terminal Cash Flow:

Alternative 1 Alternative 2
After-tax proceeds from
sale of new asset =
Proceeds from sale of new asset $8,000 $25,000
Tax on sale of new asset
l
(1,400) (7,800)
Total proceeds, sale of new asset 6,600 17,200
After-tax proceeds from sale of old asset =
Proceeds from sale of old asset (2,000) (2,000)
+ Tax on sale of old asset 2
800 800
Total proceeds, sale of old asset (1,200) (1,200)
+ Change in working capital 15,000 22,000
Terminal cash flow $20,400 $38,000

Book value of Alternative 1 at end of year 5: = $4,500

1

$8,000 $4,500 = $3,500 recaptured depreciation

$3,500 (0.40) = $1,400 tax

Book value of Alternative 2 at end of year 5: = $5,500

$25,000 $5,500 = $19,500 recaptured depreciation
$19,500 (0.40) = $7,800 tax

= $0
2
Book value of old asset at end of year 5:
$2,000 $0 = $2,000 recaptured depreciation
$2,000 (0.40) = $800 tax

Alternative 1
Year 5 Relevant Cash Flow: Operating Cash Flow: $33,460
Terminal Cash Flow 20,400
Total Cash Inflow $53,860
Alternative 2
Year 5 Relevant Cash Flow: Operating Cash Flow: $15,940
Terminal Cash Flow 38,000
Total Cash Inflow $53,940
220 Part 3 Long-Term Investment Decisions

(d) Alternative 1
Cash Flows

$105,000 $26,300 $35,980 $43,460 $33,460 $53,860 $1,800

| | | | | | |
0 1 2 3 4 5 6
End of Year

Alternative 2
Cash Flows

$120,000 $50,100 $65,200 $39,420 $16,340 $53,940 $2,200

| | | | | | |
0 1 2 3 4 5 6
End of Year

(e) Alternative 2 appears to be slightly better because it has the larger incremental cash flow
amounts in the early years.

T Group Exercises
Capital investment is revisited in this chapter. A long-term investment project will be detailed across this
and the following two chapters. Students are warned that while this chapters exercise is apparently brief,
the work is vital to the work in the following chapters.

The first task is to design two, mutually-exclusive investment projects. The design should focus on why
these investments should each be undertaken. After establishing the why for each project, the process of
rigorous numerical analysis is begun. Cash flows are to be estimated and students should be encouraged to
use simple round numbers when estimating the initial investment and operating/terminal cash flows. All
numbers should be organized on an annual basis. Each group is asked to design a timeline with a minimum
of 5 years for each projects numbers. The most feasible estimates will run from 510 years.

T Answers to Web Exercises

Annual reports for two corporations of the students choosing are the topic for this assignment.
Specifically, they are asked to look at the capital budgeting over the past 3 years for each firm.
Comparisons are asked between the levels of capital spending and any changes within either firm. A
description of the uses of this capital spending concludes the assignment. The link between the chapter and
this assignment is very strong and looking at actual, timely information should round out the
chapters work.