Contemporary Engineering Economics (4th Edition) (Solution Manual)
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Contemporary
Engineering
Economics
Fourth Edition
Chan S. Park
Depar tment of Industr ial
and Systems Engineer ing
Aubur n Univer sity
Solution Manual
Upper Saddle River, NJ 07458
2-1
Chapter 2 Understanding Financial Statements
Financial Statement
2.1
(a)
Current assets = $150,000 + $200,000 + $150,000 + $50,000 + $30,000 =
$580,000
Current liabilities = $50,000 + $100,000 + $80,000 = $230,000
Working capital = $580,000 – $230,000 = $350,000
Shareholders’ equity = $100,000 + $150,000 + $150,000 + $70,000 =
$470,000
(b) EPS = $500,000/10,000 = $50 per share
(c) Par value = $15; capital surplus = $150,000/10,000 = $15;
Market price = $15 + $15 = $30 per share
2.2
(a) Working capital = Current assets – Current liabilities;
Working capital requirements = Changes in current assets – Changes in
current liabilities
WC req. = (+$100,000 – $20,000) – (+$30,000 - $40,000) = $90,000
(b) Taxable income = $1,500,000 – $650,000 – $150,000 – $20,000 = $680,000
(c) Net income = $680,000 – $272,000 = $408,000
(d) Net cash flow:
A. Operating activities = net income + depreciation – WC = $408,000 +
$200,000 – $90,000 = $518,000
B. Investing activities = equipment purchase = ($400,000)
C. Financing activities = borrowed fund = $200,000
D. Net cash flow = $518,000 – $400,000 + $200,000 = $318,000
2.3 *
(a) Debt ratio = $55,663/$513,378 = 10.84%
(b) Time-interest-earned ratio: not defined
(c) Current ratio = $377,833/$55,663 = 6.79
(d) Quick ratio = ($377,833 – 0)/$55,633 = 6.79
*
An asterisk next to a problem number indicates that the solution is available to students
on the Companion Website.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
2-1
(e) Inventory turn over ratio: not defined
(f) DSO = ($24,582 – $632)/($102,606/365) = 85.20 days
(g) Total assets turnover ratio = $102,606/$513,378 = 0.20 times
(h) Profit margin on sales = -$9,034/$102,606 = -8.8%
(i) Return on total assets = (-$9,034 + 0)/(($513,378 + $36,671)/2) = -3.28%
(j) Return on common equity = -$9,034/(($457,713 + $17,064)/2) = -3.81%
(k) Price-earning ratio = $56.67/(–0.10) = -566.70
(l) Book value per share = $457,713,000/90,340,000 = $5.07 (Note: The total
number of outstanding shares in year 2009 was 90,340,000.)
2.4 *
(a) Debt ratio = ($922,653 + $113,186)/$4,834,696 = 42.11%
(b) Time-interest-earned ratio = ($432,342 + $36,479)/$36,479 = 12.85 times
(c) Current ratio = $3,994,084/$1,113,186 = 3.59 times
(d) Quick ratio = ($3,994,084 – $1,080,083)/$1,113,186 = 2.62 times
(e) Inventory turn over ratio = $8,391,409/(($1,080,083 + $788,519)/2) = 8.98
times
(f) DSO = ($1,123,901 – $5,580)/($8,391,409/365) = 48.64 days
(g) Total assets turnover ratio = $8,391,409/$4,834,696 = 1.74 times
(h) Profit margin on sales = $293,935/$8,391,409 = 3.5%
(i) Return on total assets = ($293,935 + $36,479(1 – 0.3201))/(($4,834,696 +
$2,410,568)/2) = 8.80%
(j) Return on common equity = $293,935/(($2,793,091 + $1,181,326)/2) =
14.79%
(k) Price-Earning ratio = $65/$1.19 = $54.62
(l) Book value per share = $2,793,091,000/247,004,200 = $11.30
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2-1
2.5
Given Olson’s EPS = $8 per share; Cash dividend = $4 per share; Book
value per share = $80; Changes in the retained earnings = $24 million;
Total debt = $240 million; Find debt ratio = total debt/total assets
Net Income
EPS $8
X
where X = the number of outstanding shares
Total shareholders' equity
Book value $80
X
Retained earnings = Net income – Cash dividend; Net income = 8X from
EPS relationship and the total cash dividend = 4X, so we rewrite 8X – 4X
= $24 million, or X = 6 million shares
From book value per share, we know that total shareholders’ equity =
80X, or $480 million; Total assets = Total liabilities + Total shareholders’
equity = $240 million + $480 million = $720 million
Debt ratio = $240 million/$720 million = 0.33
2.6 (b)
2.7 (b)
2.8 (d)
2.9 (b)
Short Case Studies
ST2.1 & ST2.2 Not given
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3-1
Chapter 3 Time Value of Money and Economic
Equivalence
Types of Interest
3.1
$10,000 $5,000(1 0.08 N )
Simple interest: (1 0.08 N ) 2
1
N 12.5 years
0.08
$10,000 $5,000(1 0.07) N
Compound interest: (1 0.07) N 2
N 10.2 years
3.2
Simple interest:
I iPN (0.08)($1,000)(5) $400
Compound interest:
I P[(1 i ) N 1] $1,000(1.4693 1) $469
3.3
Option 1: Compound interest with 8%:
F $3,000(1 0.08) 5 $3,000(1.4693) $4,408
Option 2: Simple interest with 9%:
$3,000(1 0.09 5) $3,000(1.45) $4,350
Option 1 is better.
3.4
End of Year Principal Interest Remaining
Repayment Payment Balance
0 $10,000
1 $1,671 $900 $8,329
2 $1,821 $750 $6,508
3 $1,985 $586 $4,523
4 $2,164 $407 $2,359
5 $2,359 $212 $0
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3-2
Equivalence Concept
*
3.5
P $12,000( P / F , 5%, 5) $12,000(0.7835) $9,402
*
3.6
F $20,000( F / P, 8%, 2) $20,000(1.1664) $23,328
Single Payments (Use of F/P or P/F Factors)
3.7
(a) F $5,000( F / P, 5%, 8) $7,388
(b) F $2,250( F / P, 3%,12) $3,208
(c) F $8,000( F / P, 7%, 31) $65,161
(d) F $25,000( F / P, 9%, 7) $45,700
3.8
(a) P $5,500( P / F ,10%, 6) $3,105
(b) P $8,000( P / F , 6%,15) $3,338
(c) P $30,000( P / F , 8%, 5) $20,418
(d) P $15,000(P /F,12%,8) $6,058
3.9
(a) P $10,000( P / F ,13%, 5) $5,428
(b) F $25,000( F / P,13%, 4) $40,763
*
3.10
F 3P P (1 0.12) N
log 3 N log(1.12)
N 9.69 years
*
An asterisk next to a problem number indicates that the solution is available to students
on the Companion Website.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
3-3
3.11
F 2 P P(1 0.15) N
log 2 N log(1.15)
N 4.96 years
Rule of 72: 72 /15 4.80 years
3.12
(a) Single-payment compound amount ( F / P, i, N ) factors for
n 9% 10%
35 20.4140 28.1024
40 31.4094 45.2593
To find ( F / P, 9.5%, 38) , first interpolate for n 38
n 9% 10%
38 27.0112 38.3965
Then interpolate for i 9.5%
( F / P, 9.5%, 38) 32.7039
As compared to formula determination
( F / P, 9.5%, 38) 31.4584
(b) Single-payment compound amount ( P / F ,8%, N ) factors for
n 45 50
0.0313 0.0213
Then interpolate for n 47
( P / F , 8%, 47) 0.0273
As compared with the result from formula
( P / F , 8%, 47) 0.0269
Uneven Payment Series
*
3.13
$32,000 $43,000 $46,000 $28,000
P $114,437
1.08 2 1.08 3 1.08 4 1.08 5
3.14
F $1,500( F / P, 6%,15) $1,800( F / P, 6%,13) $2,000( F / P,6%,11) $11,231
3.15
P $3, 000, 000 $2, 400, 000( P / F ,8%,1)
$3, 000, 000( P / F ,8%,10)
$20, 734, 618
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3-4
Or
P $3, 000, 000 $2, 400, 000( P / A,8%,5)
$3, 000, 000( P / A,8%,5)( P / F ,8%,5)
$20, 734, 618
3.16
P $7,500( P / F , 6%, 2) $6,000( P / F , 6%, 5) $5,000( P / F ,6%,7) $14,484
Equal Payment Series
3.17 *
(a) With deposits made at the end of each year
F $1,000( F / A, 7%,10) $13,816
(b) With deposits made at the beginning of each year
F $1,000( F / A, 7%,10)(1.07) $14,783
3.18
(a) F $3,000( F / A, 7%, 5) $16,713
(b) F $4,000( F / A, 8.25%,12) $77,043
(c) F $5,000( F / A, 9.4%, 20) $267,575
(d) F $6,000( F / A,10.75%,12) $134,236
3.19 *
(a) A $22,000( A / F , 6%,13) $1,166
(b) A $45,000( A / F , 7%, 8) $4,388
(c) A $35,000( A / F , 8%, 25) $479.5
(d) A $18,000( A / F ,14%, 8) $1,361
3.20
$30, 000 $1,500( F / A, 7%, N )
( F / A, 7%, N ) 20
N 12.94 13 years
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3-5
3.21
$15, 000 A( F / A, 11%, 5)
A $2, 408.56
3.22 *
(a) A $10,000( A / P, 5%, 5) $2,310
(b) A $5,500( A / P, 9.7%, 4) $1,723.70
(c) A $8,500( A / P, 2.5%, 3) $2,975.85
(d) A $30,000( A / P, 8.5%, 20) $3,171
3.23
Equal annual payment:
A $25,000( A / P,16%, 3) $11,132.5 0
Interest payment for the second year:
End of Year Principal Interest Remaining
Repayment Payment Balance
0 $25,000.00
1 $7,132.50 $4,000.00 $17,867.50
2 $8,273.70 $2,858.80 $9,593.80
3 $9,593.80 $1,535.00 -
3.24 *
(a) P $800( P / A, 5.8%,12) $6,781.20
(b) P $2,500( P / A, 8.5%,10) $16,403.25
(c) P $900( P / A, 7.25%, 5) $3,665.61
(d) P $5,500( P / A, 8.75%, 8) $30,726.3
3.25
(a) The capital recovery factor ( A / P, i, N ) for
n 6% 7%
35 0.0690 0.0772
40 0.0665 0.0750
To find ( A / P, 6.25%, 38) , first interpolate for n 38
n 6% 7%
38 0.0675 0.0759
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3-6
Then, interpolate for i 6.25% ; ( F / P, 6.25%, 38) 0.0696
As compared with the result from formula
( F / P, 6.25%, 38) 0.0694
(b) The equal payment series present-worth factor ( P / A, i, 85) for
i 9% 10%
11.1038 9.9970
Then interpolate for i 9.25%
( P / A, 9.25%, 85) 10.8271
As compared with the result from formula
( P / A, 9.25%, 85) 10.8049
Linear Gradient Series
*
3.26
F F1 F2
$5,000( F / A, 8%, 5) $2,000( F / G, 8%,5)
$5,000( F / A,8%,5) $2,000( A / G, 8%, 5)( F / A,8%,5)
$50,988.35
3.27
F $3,000( F / A, 7%, 5) $500( F / G, 7%,5)
$3,000( F / A,7%,5) $500( P / G, 7%, 5)( F / P,7%,5)
$11,889.47
3.28
P $100 [$100( F / A, 9%,7) $50( F / A, 9%, 6) $50( F / A, 9%,4)
$50( F / A, 9%, 2)]( P / F ,9%, 7)
$991.26
3.29
A $15,000 $1,000( A / G,8%,12)
$10,404.30
3.30
(a) P $6,000,000( P / A1 ,10%,12%,7) $21,372,076
(b) Note that the oil price increases at the annual rate of 5% while the oil
production decreases at the annual rate of 10%. Therefore, the annual revenue
can be expressed as follows:
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3-7
An $60(1 0.05) n 11000,000(1 0.1) n 1
$6,000,000(0.945) n 1
$6,000,000(1 0.055) n 1
This revenue series is equivalent to a decreasing geometric gradient series
with g = –5.5%.
So P $6,000,000( P / A1 ,5.5%,12%,7) $23,847,896
(c) Computing the present worth of the remaining series ( A4 , A5 , A6 , A7 ) at the end
of period 3 gives
P $5,063,460( P / A1 , 5.5%,12%,4) $14, 269,652
3.31
20
P An (1 i ) n
n 1
20
(2, 000, 000)n(1.06) n 1 (1.06) n
n 1
20
1.06 n
(2, 000, 000 /1.06) n( )
n 1 1.06
$396, 226, 415
Note: if i g ,
N
x[1 ( N 1) x N Nx N 1
nx n
n 1 (1 x) 2
When g 6% and i 8%,
1 g
x 0.9815
1 i
$2, 000, 000 0.9815[1 (21)(0.6881) 20(0.6756)]
P
1.06 0.0003
$334,935,843
3.32
(a) The withdrawal series would be
Period Withdrawal
11 $5,000
12 $5,000(1.08)
13 $5,000(1.08)(1.08)
14 $5,000(1.08)(1.08)(1.08)
15 $5,000(1.08)(1.08)(1.08)(1.08)
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3-8
P10 $5,000( P / A1 ,8%,9%,5) $22,518.78
Assuming that each deposit is made at the end of each year, then
$22,518.78 A( F / A, 9%, 10) 15.1929 A
A $1482.19
(b) P10 $5,000( P / A1 ,8%,6%,5) $24,491.85
$24, 491.85 A( F / A, 6%, 10) 13.1808 A
A $1858.15
Various Interest Factor Relationships
3.33
(a) ( P / F , 8%, 67) ( P / F , 8%,50)( P / F ,8%,17) (0.0213)(0.2703) 0.0058
( P / F , 8%, 67) (1 0.08) 67 0.0058
i
(b) ( A / P, i, N )
1 ( P / F , i, N )
( P / F , 8%, 42) ( P / F , 8%,40)( P / F ,8%,2) 0.0394
0.08
( A / P, 8%, 42) 0.0833
1 0.0394
0.08(1.08) 42
( A / P, 8%, 42) 0.0833
(1.08) 42 1
1 ( P / F , i, N ) 1 ( P / F ,8%,100)( P / F ,8%,35)
(c) ( P / A, i, N ) 12.4996
i 0.08
(1.08)135 1
( A / P, 8%,135) 12.4996
0.08(1.08)135
3.34
(a)
( F / P, i, N ) i ( F / A, i, N ) 1
(1 i ) N 1
(1 i ) i
N
1
i
(1 i ) N 1 1
(1 i ) N
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3-9
(b)
( P / F , i, N ) 1 ( P / A, i, N )i
(1 i ) N 1
(1 i ) N 1 i
i (1 i ) N
(1 i ) N (1 i ) N 1
(1 i ) N (1 i ) N
(1 i ) N
(c)
( A / F , i, N ) ( A / P, i, N ) i
i i (1 i ) N i (1 i ) N i[(1 i ) N 1]
i
(1 i ) N 1 (1 i ) N 1 (1 i ) N 1 (1 i ) N 1
i
(1 i ) N 1
(d)
i
( A / P, i, N )
[1 ( P / F , i, N )]
i (1 i ) N i
(1 i ) 1 (1 i )
N N
1
(1 i ) N
(1 i ) N
i (1 i ) N
(1 i ) N 1
(e) , (f), and (g) Divide the numerator and denominator by (1 i) N and take the
limit N .
Equivalence Calculations
3.35
P [$100( F / A,12%,9) $50( F / A,12%, 7) $50( F / A,12%,5)]( P / F ,12%,10)
$740.49
3.36
P(1.08) $200 $200( P / F , 8%,1) $120( P / F , 8%, 2) $120( P / F , 8%,3)
$300( P / F ,8%,4)
P $373.92
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3-10
3.37 Selecting the base period at n = 0, we find
$100( P / A,13%,5) $20( P / A,13%,3)( P / F ,13%, 2) A( P / A,13%,5)
$351.72 $36.98 (3.5172) A
A $110.51
3.38 Selecting the base period at n =0, we find
P1 $200 $100( P / A,6%,5) $50( P / F ,6%,1) $50( P / F ,6%,4) $100( P / F ,6%,5)
$782.75
P2 X ( P / A,6%,5) 4.2124 X
X $185.82
3.39
P $20( P / G,10%,5) $20( P / A,10%,12)
$0.96
$80
$60
$40
$20
0 1 2 3 4 5 6 7 8 9 10 11 12
$20
3.40 Establish economic equivalent at n 8 :
C ( F / A,8%,8) C ( F / A,8%,2)( F / P,8%,3) $6,000( P / A,8%,2)
10.6366C (2.08)(1.2597)C $6,000(1.7833)
8.0164C $10,699.80
C $1,334.73
3.41 The original cash flow series is
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3-11
n An n An
0 0 6 $900
1 $800 7 $920
2 $820 8 $300
3 $840 9 $300
4 $860 10 $300 $500
5 $880
3.42 Establishing equivalence at n = 8, we find
$300( F / A,10%,8) $200( F / A,10%,3) 2C ( F / P,10%,8) C ( F / A,10%,7)
$4,092.77 2C (2.1436) C (9.4872)
C $297.13
3.43
Establishing equivalence at n 5
$200( F / A,8%,5) $50( F / P,8%,1)
X ( F / A,8%,5) ($200 X )[( F / P,8%, 2) ( F / P,8%,1)]
$1,119.32 X (5.8666) ($200 X )(2.2464)
X $185.09
3.44 Computing equivalence at n 5
X $3,000( F / A,9%,5) $3,000( P / A,9%,5) $29,623.2
3.45 (2), (4), and (6)
3.46 (2), (4), and (5)
3.47
A1 ($50 $50( A / G,10%,5) [$50 $50( P / F ,10%,1)]( A / P,10%,5) $115.32
A2 A A( A / P,10%,5) 1.2638 A
A $91.25
3.48 (a)
3.49 (b)
3.50 (b)
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3-12
$25,000 $30,000( P / F ,10%,6)
C ( P / A,10%,12) $1,000( P / A,10%,6)( P / F ,10%,6)]
$41,935 6.8137C $2,458.60
C $5,793
Solving for an Unknown Interest Rate of Unknown Interest Periods
3.51
2 P P(1 i )5
log 2 5 log (1 i )
i 14.87%
3.52 Establishing equivalence at n 0
$2,000( P / A, i,6) $2,500( P / A1 ,25%, i,6)
Solving for i with Excel, we obtain i 92.35%
*
3.53
$35, 000 $10, 000( F / P, i,5) $10, 000(1 i )5
i 28.47%
3.54
$1, 000, 000 $2, 000( F / A, 6%, N )
(1 0.06) N 1
500
0.06
31 (1 0.06) N
log 30 N log1.06
N 58.37 years
Short Case Studies
ST 3.1 Assuming that they are paid at the beginning of each year
(a)
$17.95 $17.95( P / A,6%,3) $65.93
It is better to take the offer because of the lower cost to renew.
(b)
$57.44 $17.95 $17.95( P / A, i,3)
i 17.27%
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3-13
ST 3.2 The equivalent future worth of the prize payment series at the end of
Year 24 (or beginning of Year 25) is
F1 $1,000,000( F / A,6%,25)
$54,864,512
The equivalent future worth of the lottery receipts is
F2 $17, 000, 000( F / P, 6%, 24)
$68,831,888
The resulting surplus at the end of Year 20 is
F2 F1 $68,831,888 $54,864,512
$13,967,377
ST 3.3
(a) Compute the equivalent present worth (in 2006) for each option at i 6% .
PDeferred $2, 000, 000 $566, 000( P / F , 6%,1) $920, 000( P / F , 6%, 2)
$1, 260, 000( P / F , 6%,11)
$8,574, 490
PNon-Deferred $2, 000, 000 $900, 000( P / F , 6%,1) $1, 000, 000( P / F , 6%, 2)
$1,950, 000( P / F , 6%,5)
$7, 431,560
∴ At i 6% , the deferred plan is a better choice.
(b) Using either Excel or Cash Flow Analyzer, both plans would be
economically equivalent at i 15.72%
ST 3.4 The maximum amount to invest in the prevention program is
P $14,000( P / A,12%,5) $50,467
ST 3.5 Using the geometric gradient series present worth factor, we can establish
the equivalence between the loan amount $120,000 and the balloon payment
series as
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3-14
$120, 000 A1 ( P / A1 ,10%,9%,5) 4.6721A1
1)
A1 $25, 684.38
2) Payment series
n Payment
1 $25,684.38
2 $28,252.82
3 $31,078.10
4 $34,185.91
5 $37,604.50
ST 3.6
1) Compute the required annual net cash profit to pay off the investment and
interest.
$70, 000, 000 A( P / A,10%,5) 3.7908 A
A $18, 465, 759
2) Decide the number of shoes, X
$18, 465, 759 X ($100)
X 184, 657
ST 3.7
(a)
PContract $3,875, 000 $3,125, 000( P / F , 6%,1)
$5,525, 000( P / F , 6%, 2)
$8,875, 000( P / F , 6%, 7)
$39,547, 242
(b)
PBonus $1,375, 000 $1,375, 000( P / A, 6%, 7)
$9, 050, 775 $8, 000, 000
Stay with the original deferred plan.
ST 3.8
Suppose the interest rate is 6% per year. Then the present equivalent of the
annuity is
1
P1 $52, 000 P / A, 6%, $52, 000 $866, 667
6%
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3-15
If the remaining life expectancy of a winner is 30 years, then the present
equivalent of the annuity is
P2 $52,000 P / A,6%,30 $715,771
If a winner is expected to survive 20 more years instead, then
P3 $52,000 P / A,6%, 20 $596, 436
If i 4%, then Pl, P2, and P3 will be $1,300,000, $899,186, and $706,697
respectively.
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4-1
Chapter 4 Understanding Money and Its Management
Nominal and Effective Interest Rates
4.1 r 12.5%, M 365
365
12.5% 12
(a) Monthly interest rate: i 1 1 1.0469%
365
Annual effective rate: ia (1 0.010469)12 1 13.31%
(b) $2,000(1 0.010469) 2 $2,042.10
4.2
Nominal interest rate:
r 1.05% 12 12.6%
Effective annual interest rate:
ia (1 0.0105)12 1 13.35%
*
4.3
Assuming a weekly compounding
r 6.89%
0.0689 52
ia (1 ) 1 0.07128
52
4.4
Interest rate per week
Given : P $500, A 40, N 16 weeks
$500 $40( P / A, i,16)
i 3.06% per week
Nominal annual interest rate:
r 3.06% 52 159.12%
*
An asterisk next to a problem number indicates that the solution is available to students
on the Companion Website.
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4-2
Effective annual interest rate:
ia (1 3.06%)52 1 379.39%
4.5 Interest rate per week:
$450 $400(1 i )
i 12.5% per week
(a) Nominal interest rate:
r 12.5% 52 650%
• Effective annual interest rate
ia (1 0.125)52 1 45, 601%
4.6 r 6%, M 12, imonth 0.5%
24-month lease plan:
P ($2,500 $520 $500) $520( P / A,0.5%,23) $500( P / F ,0.5%,24)
$14,347
Up-front lease plan:
P $12,780 $500 $500( P / F ,0.5%, 24)
$12,782
∴ Select up-front lease plan
4.7 No. Since the debt interest rates are higher than the return on the investment
funds, it is better to pay off the debt.
Compounding More Frequent Than Annually
4.8
(a) Nominal interest rate:
r 1.8% 12 21.6%
(b) Effective annual interest rate:
ie (1 0.018)12 1 23.87%
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4-3
(c)
3P P (1 0.018) N
log 3 N log1.018
N 61.58 months
∴ 61.58 / 12 = 5.13 years
(d)
3 e0.018 N
ln(3) 0.018 N
N 61.03 months
∴ 61.03 / 12 = 5.08 years
4.9
0.09 4
F $10,000(1 ) $10,930.83
4
4.10
0.05 20
(a) F $5,635(1 ) $9,233.60
2
0.06 60
(b) F $7,500(1 ) $18,324.15
4
0.09 84
(c) F $38,300(1 ) $71,743.64
12
4.11
(a) Quarterly interest rate = 2.25%
3P P (1 0.0225) N
log 3 N log1.0225
N 49.37 quarters
∴ 49.37 / 4 = 12.34 years
(b) Monthly interest rate = 0.75%
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4-4
3P P(1 0.0075) N
log 3 N log1.0075
N 147.03 months
∴ 147.03 / 12 = 12.25 years
(c)
3 e0.09 N
ln(3) 0.09 N
N 12.21 years
4.12 r 9%,
(a) Quarterly interest rate = 2.25%
P $5,000( P / A,0.0225%,48) $145,848
(b) Quarterly effective interest rate = 2.2669%
P $5,000( P / A,0.022669%,48) $145,360
(c) Quarterly effective interest rate = 2.2755%
P $5,000( P / A,0.022755%,48) $145,112
*
4.13
r 8%, continuous compounding,
F A( F / A, i,20) $3,000( F / A,2.02%,20) $73,037
4.14 r 6%
(a) Quarterly interest rate = 1.5%
F $2,000( F / A,0.015%,60) $192,429
(b) Quarterly effective interest rate = 1.5075%
F $2,000( F / A,0.015075%,60) $192,912
(c) Quarterly effective interest rate = 1.5113%
F $2,000( F / A,0.015113%,60) $193,157
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4-5
4.15 (d)
Effective interest rate per
payment period
i = (1 + 0.01)3 – 1
= 3.03%
0 1 2 3 4 5 6 7 8 9 10 11 12
$1,000
4.16
i e 0.085 / 4 1 2.1477%
A $12,000( A / P,2.1477%,20) $744
*
4.17
(a) Monthly effective rate = 0.9902%
F $2,500( F / A,0.9902%,96) $397,670.75
(b) Monthly effective rate = 1.00%
F $2,500( F / A,1%,96) $399.818.25
(c) Monthly effective interest rate = 1.005%
F $2,500( F / A,1.005%,96) $400,909.25
4.18 (b)
4.19 Equivalent present worth of the series of equal quarterly payments of $2,000
over 15 years at 8% compounded continuously:
i e 0.02 1 2.02013%
P $2,000( P / A,2.02013%,60) $69,184
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4-6
Equivalent future worth of $69,184 at the end of 10 years:
F $69,184( F / P,2.02013%,40) $153,972
4.20 Nominal interest rate per quarter = 1.95%
Effective interest rate per quarter = e 0.0195 1 1.9691%
A $32,000( A / P,1.9691%,20) $1,952
*
4.21
Nominal interest rate per quarter = 2.1875%
Effective interest rate per quarter = e 0.021875 1 2.2116%
P $4,000(P / A,2.2116%,12) $41,756.8
4.22
(a) F $6,000( F / A,3%,12) $85,152
(b) F $42,000( F / A,2%,48) $3,332,847
(c) F $75,000( F / A,0.75%,96) $10,489,215
4.23
(a) A $21,000( A / F ,3.225%,20) $764.40
(b) A $9,000( A / F ,2.3375%,60) $70.20
(c) A $24,000( A / F ,0.5458%,60) $338.40
4.24
0.05
ie 365
1 0.0136996%
F $2.5( F / A, 0.0136996%,10950) $63,536.61
*
4.25
$24,000 $543.35( P / A, i,48)
i 0.3446%
ia (1 0.003446)12 1 4.21%
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4-7
*
4.26
$12,000 $445( P / A, i,30)
i 0.7021%
r 0.7021% 12 8.43%
4.27
A $22,000( A / F ,0.5%,24)
$865.05
4.28
(a) P $1,500( P / A,4%,24) $22,870.50
(b) P $2,500( P / A,2%,32) $58,670.75
(c) P $3,800( P / A,0.75%,60) $183,058.92
4.29
Equivalent future worth of the receipts:
F1 $1,500( F / P,2%,4) $2,500
$4,123.60
Equivalent future worth of deposits:
F2 A( F / A, 2%,8) A( F / P, 2%,8)
9.7546 A
∴ Letting F1 F2 and solving for A yields A $422.73
4.30
The balance just before the transfer:
F9 $15, 000( F / P, 0.5%,108) $14, 000( F / P, 0.5%, 72)
$12,500( F / P, 0.5%, 48)
$61, 635.22
Therefore, the remaining balance after the transfer will be $30,817.61. This
remaining balance will continue to grow at 6% interest compounded monthly.
Then the balance six years after the transfer will be:
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4-8
F15 $30,817.61( F / P,0.5%,72) $44,132.18
The funds transferred to another account will earn 8% interest compounded
quarterly. The resulting balance six years after the transfer will be:
F15 $30,817.61( F / P,2%,24) $49,568.19
*
4.31
Establish the cash flow equivalence at the end of 25 years. Let’s define A as the
required quarterly deposit amount. Then we obtain the following:
A( F / A,1.5%,100) $60,000( P / A,6.136%,10)
228.8038 A $438,774
A $1,917.69
4.32 *
Monthly installment amount:
A $15,000( A / P,1%,48) $394.5
The lump-sum amount for the remaining:
P20 $394.5( P / A,1%,28) $9,592.82
1
9% 6
4.33 r 9%, M 2, imonth 1 1 0.7363%
2
$100,000 $1,000( P / A,0.7363%, N )
( P / A,0.7363%, N ) 100
N 181.70 months or 15.14 years
*
4.34
$20,000 $922.90( P / A, i,24)
( P / A, i,24) 21.6708
i 0.8333%
APR 0.8333% 12 10%
4.35 Given r 6% per year compounded monthly, the effective annual rate is
6.186%.
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4-9
Now consider the four options:
1. Buy three single-year subscriptions at $66 each.
2. Buy a single-year ($66) subscription now, and buy a two-year ($120)
subscription next year
3. Buy a two-year ($120) subscription now, and buy a single-year ($66)
subscription at its completion
4. Buy a three-year subscription ($160) now.
To find the best option, compute the equivalent PW for each option.
o Poption 1 $66 $66( P / A, 6.186%, 2) $186.69
o Poption 2 $66 $120( P / F , 6.186%,1) $179.01
o Poption 3 $120 $66( P / F , 6.186%, 2) $178.53
o Poption 4 $160
∴ Option 4 is the best option.
4.36 Given r 6% per year compounded quarterly, the quarterly interest rate is
1.5% and the effective annual rate is 6.186%. To find the amount of quarterly
deposit (A), we establish the following equivalence relationship:
A( F / A,1.5%,60) $50,000 $50,000( P / A,6.136%,3)
A $183,314 / 96.2147
A $1,905.26
*
4.37
Setting the equivalence relationship at the end of 15 years gives
A( F / A,2%,60) $25,000( P / A,4.04%,10)
114.0515 A $202,369
A $1,774.37
6%
4.38 Given i 0.5% per month
12
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4-10
A $250,000( A / P,0.5%,120)
$2,775
4.39 First, compute the equivalent present worth of the energy cost savings during
the first operating cycle:
$25 $25 $25 $40 $40 $40
0 1 2 3 4 5 6 7 8 9 10 11 12
May June July Aug. Sept. Oct. Nov. Dec Jan. Feb. Mar. Apr.
P $25( P / A, 0.75%,3)( P / F , 0.75%,1) $40( P / A, 0.75%,3)( P / F , 0.75%, 7)
$185
Then compute the total present worth of the energy cost savings over five
years.
P $185 $185( P / F , 0.75%,12) $185( P / F , 0.75%, 24)
$185( P / F , 0.75%,36) $185( P / F , 0.75%, 48)
$779.37
Continuous Payments With Continuous Compounding
4.40 Given i 12% , N 12 years, and A $63,000 365 $22,995,000
Daily payment with daily compounding:
P $63,000( P / A,12% / 365,4380) $146,212,973
Continuous payment and continuous compounding:
12
P A e rt dt
0
e ( 0.12 )(12 ) 1
$22,995,000 ( 0.12 )(12 )
0.12e
$146,223,718
∴ The difference between the two compounding schemes is only $10,745.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
4-11
4.41 Given i 11% , N 3, F0 $500,000, FN $40,000, and 0 t 3,
f (t )
$500,000
$40,000
0 1 2 3 t
460,000
f (t ) 500,000 t
3
3 460,000 rt
P (500,000 t )e dt
0 3
1 e rN F0 FN
500,000 2
[ rNe rN e rN 1]
r Nr
$1,277,619.39 $555,439.67
$722,179.72
4.42 Given r 9% , A $80,000, N s 2, N e 7,
7
P 80,000e rt dt
2
e 0.09 ( 2 ) e 0.09 ( 7 )
$80,000
0.09
$269,047.48
4.43
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4-12
yt 5e 0.25t , ut $55(1 0.09t )
0.25t
yt ut 275e 24.75te 0.25t
20 20
P 275e 0.25t e 0.12t dt 24.75te 0.25t e 0.12t dt
0 0
e 1 24.75
0.37(20)
24.75
275 0.37(20)
2
(1 e 0.37(20) ) (20e 0.37(20) )
0.37e 0.37 0.37
$742.79 $179.86 $922.65
Changing Interest Rates
4.44 Given r1 6% compounded quarterly, r2 10% compounded quarterly, and
r3 8% compounded quarterly, indicating that i1 1.5% per quarter,
i2 2.5% per quarter, and i3 2% per quarter.
(a) Find P:
P $2,000( P / F ,1.5%,4) $2,000( P / F ,1.5%,8)
$3,000( P / F ,2.5%,4)( P / F ,1.5%,8) $2,000( P / F ,2.5%,8)( P / F ,1.5%,8)
$2,000( P / F ,2%,4)( P / F ,2.5%,8)( P / F ,1.5%,8)
$8,875.42
(b) Find F:
F P( F / P,1.5%,8)( F / P,2.5%,8)( F / P,2%,4)
$13,186
(c) Find A, starting at 1 and ending at 5:
F A A( F / P,2%,4) A( F / P,2.5%,4)( F / P,2%,4)
A( F / P,2.5%,8)( F / P,2%,4) A( F / P,1.5%,4)( F / P,2.5%,8)( F / P,2%,4)
5.9958 A
$13,186
A $2,194.22
5.9958
4.45
(a)
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4-13
P $300( P / F ,0.5%,12) $300( P / F ,0.75%,12)( P / F ,0.5%,12)
$500( P / F ,0.75%,24)( P / F ,0.5%,12)
$500( P / F ,0.5%,12)( P / F ,0.75%,24)( P / F ,0.5%,12)
$1,305.26
(b)
$1,305.26 $300( P / A, i, 2) $500( P / A, i, 2)( P / F , i, 2)
i 7.818% per year
4.46 Since payments occur annually, you may compute the effective annual interest
rate for each year.
0.09 365
i1 (1 ) 1 9.416% , i2 e 0.09 1 9.417%
365
F $400( F / P,9.416%, 2)( F / P,9.417%, 2) $250( F / P,9.416%,1)( F / P,9.417%, 2)
$100( F / P,9.417%, 2) $100( F / P,9.417%,1) $250
$1,379.93
Amortized Loans
*
4.47
Loan repayment schedule for the first six months:
End of month Interest Repayment of Remaining
(n) Payment Principal Balance
1 $150.00 $347.7 $19,652.30
2 $147.39 $350.31 $19,301.99
3 $144.76 $352.94 $18,949.05
4 $142.12 $355.58 $18,593.47
5 $139.45 $358.25 $18,235.22
6 $136.76 $360.94 $17,874.28
4.48
(a)
(i) $10,000( A / P,0.75%,24)
(b)
(iii) B12 A( P / A,0.75%,12)
4.49 Given information:
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4-14
i 8.48% / 365 0.02323% per day , N = 36 months.
Effective monthly interest rate, i = (1 0.0002323)30 1 0.6993% per month
Monthly payment, A = $10, 000( A / P, 0.6993%,36) $315 per month
Total interest payment, I = $315 36 $10,000 $1,340
4.50 Given data: Purchase price = $18,000, Down payment = $1,800, Monthly
payment = $421.85, N = 48 end-of-month payments.
(a) Using the bank loan at 11.75% compound monthly
A $16,200( A / P, (11.75 / 12)%,48) $424.62
(b) Using the dealer’s financing, find the effective interest rate:
$421.85 $16, 200( A / P, i, 48)
i 0.95% per month
r 0.95% 12 11.40%
4.51 Given data: P = $25,000, r = 10% compounded monthly, N = 36 month i =
0.8333% per month.
Required monthly payment:
A $25,000( A / P,0.8333%,36) $807.5
The remaining balance immediately after the 20th payment:
B20 $807.5( P / A,0.8333%,16) $12,048.87
4.52 Given data: P = $200,000 - $20,000 = $180,000.
Option 1:
N = 20 years × 12 = 240 months
APR = 9%, M = 2, imonth 0.7363%
∴ A $180,000( A / P,0.7363%, 240) $1,600.52
Option 2:
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4-15
N = 30 years × 12 = 360 months
APR = 10%, M = 2, imonth 0.8165%
∴ A $180,000( A / P,0.8165%,360) $1,552.83
∴ Difference = $1,600.52 – $1,552.83 = $47.69
4.53
The monthly payment to the bank: Deferring the loan payment for six months
is equivalent to borrowing
$4,800( F / P,1%,6) $5,095.30
To payoff the bank loan over 36 months, the required monthly payment is
A $5, 095.30( A / P,1%,36) $169.24 per month
The remaining balance after making the 16th payment:
$169.24( P / A,1%,20) $3,054.03
The loan company will pay off this remaining balance and will charge $104
per month for 36 months. The effective interest rate for this new arrangement
is:
$3, 054.03 $104( P / A, i,36)
( P / A, i,36) 29.3657
i 1.1453% per month
∴ r 1.1453% 12 13.74% per year
4.54
(a) r 8.5%, M 2, imonth 0.6961%
A $200,000( A / P,0.6961%,180) $1,952.32
(b) Remaining balance at the end of sixth payment:
B6 $1,952.32( P / A,0.6961%,174) $196,580.35
Interest for the seventh payment = (0.6961%) B6 $1,368.41
Principal payment for the seventh payment = $1,952.32 $1,368.41 $583.91
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4-16
4.55 *
r 9%, M 2, imonth 0.7363%
A $350,000( A / P,0.7363%, 240) $3,112.16
Total payments over the first five years (60 months)
= $3,112.16 60 $186,729.60
Remaining balance at the end of five years:
B60 $3,112.16( P / A,0.7363%,180) $309,816.31
Reduction in principal = $350,000 - $309,816.31 = $40,183.69
Total interest payments = $186,729.60 - $40,183.69 = $146,545.91
4.56 The amount to finance = $400,000 - $60,000 = $340,000
A $340,000( A / P,0.7363%,360) $2,695.63
Then the minimum acceptable monthly salary (S) should be,
A $2,695.63
S $10,782.52
0.25 0.25
4.57 Given data: purchase price = $150,000, down payment (sunk equity) =
$30,000, interest rate = 0.7363% per month, N = 360 months,
Monthly payment:
A $120,000( A / P,0.7363%,360) $951.40
Balance at the end of five years (60 months):
B60 $951.40( P / A, 0.7363%,300) $114,906.41
Realized equity = sales price – balance remaining – sunk equity:
$185,000 - $114,906.41 - $30,000 = $40,093.59
4.58 Given data: interest rate = 0.7363% per month, each family has the identical
remaining balance prior to their 15th payment, that is, $80,000:
∴ With equal remaining balances, all will pay the same interest.
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4-17
$80,000(0.7363%) = $589.04
4.59 Given data: loan amount = $130,000, point charged = 3%, N = 360 months,
interest rate = 0.75% per month, actual amount loaned = $126,100:
Monthly repayment:
A $130,000( A / P,0.75%,360) $1,046
Effective interest rate on this loan
$126,100 $1, 046( P / A, i,360)
i 0.7787% per month
∴ ia (1 0.007787)12 1 9.755% per year
4.60
(a)
$35,000 $5,250( P / A, i,5) $1,750( P / G, i,5)
i 6.913745%
(b)
P = $35,000
Total payments = $5,250 + $7,000 + $8,750 + $10,500 + $12,250 = $43,750
Interest payments = $43,750 - $35,000 = $8,750
Period Beginning Interest Repayment of Remaining
(n) Balance Payment Principal Balance
1 $35,000.00 $2,149.81 $5,250 $32,169.81
2 $32,169.81 $2,224.14 $7,000 $27,393.95
3 $27,393.95 $1,893.95 $8,750 $20,537.90
4 $20,537.90 $1,419.94 $10,500 $11,457.85
5 $11,457.85 $792.17 $12,250 0
4.61 Given data: r = 7% compounded daily, N = 360 years
Since deposits are made at year end, the effective annual interest rate is
ia (1 0.07 / 365) 365 1 7.25%
Total amount accumulated at the end of 25 years
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4-18
F $3,000( F / A,7.25%,25) $150( F / G,7.25%,25)
$3,000( F / A,7.25%,25) $150( P / G,7.25%,25)( F / P,7.25%,25)
$280,626
4.62
(a) The dealer’s interest rate to calculate the loan repayment schedule.
(b)
Required monthly payment under Option A:
1.9%
A $26, 200( A / P, ,36) $749.29
12
Break-even savings rate
$24, 048 $749.29( P / A, i,36)
i 0.6344% per month
r 0.6344% 12 7.6129% per year
As long as the decision maker’s APR is greater than 7.6129%, the dealer’s
financing is a least cost alternative.
(c) The dealer’s interest rate is only good to determine the required monthly
payments. The interest rate to be used in comparing different options should
be based on the earning opportunity foregone by purchasing the vehicle. In
other words, what would the decision maker do with the amount of $24,048 if
he or she decides not to purchase the vehicle? If he or she deposits the money
in a saving account, then the savings rate is the interest rate to be used in the
analysis.
Add-on Loans
4.63
(a)
$3, 000 $156.04( P / A, i, 24)
i 1.85613% per month
r 1.85613% 12 22.2735%
(a)
P $156.04( P / A,1.85613%,12) $1,664.85
*
4.64
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
4-19
$5, 025 $146.35( P / A, i, 48)
i 1.46% per month
P $146.35( P / A,1.46%,33) 3,810.91
Loans With Variable Payments
4.65
(a) Amount of dealer financing = $15,458(0.90) = $13,912
A $13,912( A / P,0.9583%,60) $305.96
(b) Assuming that the remaining balance will be financed over 56 months,
B4 $305.96( P / A,0.9583%,56) $13,211.54
A $13,211.54( A / P,0.875%,56) $299.43
(c) Interest payments to the dealer:
I dealer $305.96 4 ($13,912 $13, 211.54) $523.38
Interest payments to the credit union:
I union $299.43 56 $13, 211.54 $3,556.54
∴ Total interest payments = $4,079.92
4.66 Given: purchase price = $155,000, down payment = $25,000
Option 1: i 0.6155% per month , N = 360 months
Option 2: For the assumed mortgage, P1 $97, 218 , i1 0.4532% per month ,
N1 300 months , A1 $593 per month ; For the 2nd mortgage P2 $32,782 ,
i2 0.7363% per month , N 2 120 months
(a) For the second mortgage, the monthly payment will be
A2 P2 ( A / P, i2 , N 2 ) $32,782( A / P,0.7363%,120) $412.36
$130,000 $593( P / A, i,300) $412.36( P / A, i,120)
i 0.4935% per month
ia 1 0.4935% 1 6.0854%
12
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
4-20
(b) Monthly payment
Option 1: A $130,000( A / P,0.6155%,360) $898.80
Option 2: $1,005.36 for 120 months, then $593 for remaining 180 months,
(c) Total interest payment
Option 1: I $898.80 360 $130,000 $193,568
Option 2: I $227,383.20 $130,000 $97,383.20
(d) Equivalent interest rate:
$898.80( P / A, i,360) $593( P / A, i,300) $412.36( P / A, i,120)
i 1.1700% per month
ia 1 1.17% 1 14.98%
12
Loans With Variable Payments
4.67
$10,000 A( P / A,0.6667%,12) A( P / A,0.75%,12)( P / F ,0.6667%,12)
22.05435 A
∴ A $453.43
4.68 Given: i 0.75% per month , deferred period = 6 months, N = 36 monthly
payments, first payment due at the end of seventh month, the amount of initial
loan = $15,000
(a) First, find the loan adjustment required for the six-month grace period
$15,000( F / P,0.75%,6) $15,687.78 .
Then the new monthly payments should be
A $15,687.78( A / P,0.75%,36) $498.87
(b) Since there are 10 payments outstanding, the loan balance after the 26th
payment is
B26 $498.87( P / A,0.75%,10) $4,788.95
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(c) The effective interest rate on this new financing is
$4,788.95 $186( P / A, i,30)
i 1.0161% per month
r 1.0161% 12 12.1932%
ia (1 0.010161)12 1 12.90%
4.69 Given: P $120,000 , N = 360 months, i 0.75% per month
(a)
A $120,000( A / P,0.75%,360) $965.55
(b) If r 9.75% APR after five years, then i 0.8125% per month
The remaining balance after the 60th payment:
B60 $965.55( P / A,0.75%,300) $115,056.50
Then we determine the new monthly payments as
A $115.056.50( A / P,0.8125%,300) $1,025.31
Investment in Bonds
4.70 Given: Par value = $1,000, coupon rate = 12%, paid as $60 semiannually, N =
60 semiannual periods
(a) Find YTM
$1, 000 $60( P / A, i, 60) $1, 000( P / F , i, 60)
i 6% semiannually
ia 12.36% per year
(b) Find the bond price after five years with r = 9%: i = 4.5% semiannually, N =
2(30 – 5) = 50 semiannual periods.
P $60( P / A,4.5%,50) $1,000( P / F ,4.5%,50)
$1,296.43
(c)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
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Sale price after 5½ years later = $922.38, the YTM for the new investors:
$922.38 $60( P / A, i, 49) $1, 000( P / F , i, 49)
i 6.5308% semiannually
ia 13.488%
Current yield at sale = $60/$922.38 = 6.505% semiannually
Nominal current yield = 6.505% × 2 = 13.01% per year
Effective current yield = 13.433% per year
*
4.71
Given: Purchase price = $1,010, par value = $1,000, coupon rate = 9.5%, bond
interest ($47.50) semiannually, required YTM = 10% per year compounded
semiannually, N = 6 semiannual periods
F $47.5( F / A,5%,6) $1,010( F / P,5%,6) 0
∴ F $1,030.41
4.72 Given: Par value = $1,000, coupon rate = 8%, $40 bond interest paid
semiannually, purchase price = $920, required YTM = 9% per year compounded
semiannually, N = 8 semiannual periods
$920 $40( P / A,4.5%,8) F ( P / F ,4.5%,8)
∴ F $933.13
4.73
Option 1: Given purchase price = $513.60, N = 10 semiannual periods, par
value at maturity = $1,000
$513.60 $1, 000( P / F , i,10)
i 6.89% semiannually
ia 14.255% per year
Option 2: Given purchase price = $1,000, N = 10 semiannual periods, $113
interest paid every six months
$1, 000 $113( P / A, i,10) $1, 000( P / F , i,10)
i 11.3% semiannually
ia 23.877% per year
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
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∴ Option 2 has a better yield.
*
4.74
Given: Par value = $1,000, coupon rate = 15%, or $75 interest paid
semiannually, purchase price = $1,298.68, N = 8 semiannual periods
$1, 298.68 $75( P / A, i, 24) $1, 000( P / F , i, 24)
i 5.277% semiannually
ia 10.84% per year
4.75 Given: Par value = $1,000, interest payment = $75 semiannually or i 4.5%
semiannually, N A 30, N B 2 semiannual periods
PA $100( P / A,4.5%,30) $1,000( P / F ,4.5%,30) $1,895.89
PB $100( P / A,4.5%,2) $1,000( P / F ,4.5%,2) $1,103
4.76 Given: Par value = $1,000, coupon rate = 8.75%, or $87.5 interest paid
annually, N = 4 years
(a) Find YTM if the market price is $1,108:
$1,108 $87.5( P / A, i,4) $1,000( P / F , i,4)
i 5.66%
(b) Find the present value of this bond if i = 9.5%:
P $87.5( P / A,9.5%,4) $1,000( P / F ,9.5%,4)
$975.97
∴ It is good to buy the bond at $930.
4.77 Given: Par value = $1,000, coupon rate = 12%, or $60 interest paid every six
months, N = 30 semiannual periods
(a)
P $60( P / A,4.5%,26) $1,000( P / F ,4.5%,26) $1,227.20
(b)
P $60( P / A,6.5%,26) $1,000( P / F ,6.5%,26) $934.04
(c) Current yield = $60 / $738.58 = 7.657% semiannually. The effective annual
current yield = 15.9%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
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4.78 Given: Par value = $1,000, coupon rate = 10%, paid as $50 every six months,
N = 20 semiannual periods,
P $50( P / A,3%,14) $1,000( P / F ,3%,14)
$1,225.91
Short Case Studies
ST 4.1
(a)
Bank A: ia (1 0.0155)12 1 20.27%
Bank B: ia (1 0.165 / 12)12 1 17.81%
(b) Given i 6% / 365 0.01644% per day, the effective interest rate per
payment period is i (1 0.0001644)30 1 0.494% per month.
We also assume that the $300 remaining balance will be paid off at the
end of 24 months. So the present worth of the annual cost for the credit
cards is
Bank A:
P $20 $4.65( P / A,0.494%,24) $20( P / F ,0.494%,12)
$143.85
Bank B:
P $30 $4.13( P / A,0.494%, 24) $30( P / F ,0.494%,12)
$151.55
∴ Select Bank A
(c) Assume that Jim makes either the minimum 5% payment or $20, whichever is
larger, every month. It will take 60 months to pay off the loan. The total
interest payments are $488.22.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
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Period Beg. Bal Interest Payment End. Bal.
0 $ 1,500.00
1 $ 1,500.00 $ 20.63 $ 75.00 $ 1,445.63
2 $ 1,445.63 $ 19.88 $ 72.28 $ 1,393.22
3 $ 1,393.22 $ 19.16 $ 69.66 $ 1,342.72
4 $ 1,342.72 $ 18.46 $ 67.14 $ 1,294.04
5 $ 1,294.04 $ 17.79 $ 64.70 $ 1,247.13
6 $ 1,247.13 $ 17.15 $ 62.36 $ 1,201.93
31 $ 495.48 $ 6.81 $ 24.77 $ 477.52
32 $ 477.52 $ 6.57 $ 23.88 $ 460.21
33 $ 460.21 $ 6.33 $ 23.01 $ 443.52
34 $ 443.52 $ 6.10 $ 22.18 $ 427.45
35 $ 427.45 $ 5.88 $ 21.37 $ 411.95
36 $ 411.95 $ 5.66 $ 20.60 $ 397.02
37 $ 397.02 $ 5.46 $ 20.00 $ 382.48
38 $ 382.48 $ 5.26 $ 20.00 $ 367.74
39 $ 367.74 $ 5.06 $ 20.00 $ 352.79
40 $ 352.79 $ 4.85 $ 20.00 $ 337.64
57 $ 64.88 $ 0.89 $ 20.00 $ 45.78
58 $ 45.78 $ 0.63 $ 20.00 $ 26.40
59 $ 26.40 $ 0.36 $ 20.00 $ 6.77
60 $ 6.77 $ 0.09 $ 6.86 $ 0.00
$488.22 $1,988.2
ST 4.2 To explain how Trust Company came up with the monthly payment scheme, let’s
assume that you borrow $10,000 and repay the loan over 24 months at 13.4%
interest compounded monthly. Note that the bank loans up to 80% of the sticker
price. If you are borrowing $10,000, the sticker price would be $12,500. The
assumed residual value will be 50% of the sticker price, which is $6,250.
(a) Monthly payment:
A $10,000( A / P,13.4% / 12,24) $6,250( A / F ,13.4% / 12,24)
$249
(b) Equivalent cost of owning or leasing the automobile:
Alternative Auto Loan:
P $211( P / A,8% / 12,36) $6,250( P / F ,8% / 12,36)
$11,653.73
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Conventional Loan:
P $339( P / A,8% / 12,36)
$10,818.10
∴ It appears that the conventional loan is a better choice.
ST 4.3
The cash flow diagram for this scenario is given below.
At i=4% per year, the future equivalent value at the end of year 18 of the cash
flows is:
F = $2400(F/A, 4%, 18)*1.04 + $500(F/P, 4%, 18)+ $100*(1.044+1.047 +1.0410)
= $65,420.46
ST 4.4
(a) Monthly payment for each option:
Option 1: Fixed rate mortgage, r = 5.85%, five-year term, M = 2, 25-year
amortization
imonth = (1+5.85%/2)^(1/6) – 1 = 0.4817%
A = $160,000(A/P, 0.4817%, 300) = $1,009.47 per month
Option 2: Variable rate mortgage, r = 3.25%, five-year term, M =2, 25-year
amortization
imonth = (1+3.25%/2)^(1/6) – 1 = 0.2690%
A = $160,000(A/P, 0.2690%, 300) = $777.87 per month
(a) Depending on my income, I can choose any one of the two. If I choose the
monthly payment of $1,009.47, I will be able to reduce my balance much faster.
(b) If the prime remains constant over the five-year term, the balances at the end of
five years are:
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
4-27
With monthly payment of $777.87, B60 = $777.87(P/A, 0.2690%, 240) =
$137,409.95
With monthly payment of $1,009.47, B60 = $160,000 (F/P, 0.2690%, 60) –
$1,009.47 (F/A, 0.2690%, 60) = $122,351.25
(c) For the conventional mortgage, the balance at the end of year 5 is
B60 = $1,009.47 (P/A, 0.4817%, 240) = $143,432.24
(d) With the variable rate mortgage, I can choose the monthly payment of $1,009.47,
given I have the payment ability. The monthly interest rate will be changing
following the pattern 0.2690% + x (n–1) for the nth six-month period, where x is
the regular increment jump amount. By letting the ending balance at the end of
year 6 for the two types of mortgages to equal to each other, we find
x = 0.05103% per month, or 0.6141% per year (effective).
That is, if the effective annual interest rate changes from the current 3.2762% by
+0.1717% every six months, the ending balances of the fixed rate mortgage and
the variable rate mortgage in five years will be identical. This means that the
variable rate mortgage will have an effective annual interest rate of 9.0983% by
the end of year 5. This 9.0983% is much higher than the fixed mortgage rate of
5.9360% (annual effective rate).
ST 4.5
Let Ai = the monthly payment for i th year and B j = the balance of the
loan at the end of j th month. Then
A1 $95,000( A / P,8.125% / 12,360) $705.37
B12 $705.37( P / A,8.125% / 12,348) $94,225.87
A2 $94,225.87( A / P,10.125% / 12,348) $840.17
B24 $840.17( P / A,10.125% / 12,336) $93,658.39
A3 $93,658.39( A / P,12.125% / 12,336) $979.77
B36 $979.77( P / A,12.125% / 12,324) $93,234.21
A430 $93,407.58( A / P,13.125% / 12,324) $1,050.71
(a) The monthly payments over the life of the loan are
A1 $95,000( A / P,8.125% / 12,360) $705.37
A2 $94,225.87( A / P,10.125% / 12,348) $840.17
A3 $93,658.39( A / P,12.125% / 12,336) $979.77
A430 $93,407.58( A / P,13.125% / 12,324) $1,050.71
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
4-28
(b)
($705.37 12) ($840.17 12) ($979.77 12) ($1,050.71 324) $95,000
$257,187.28
(c)
$95, 000 $705.37( P / A, i,12) $840.17( P / A, i,12)( P / F , i,12)
$979.77( P / A, i,12)( P / F , i, 24)
$1, 050.71( P / A, i,324)( P / F , i,36)
i 1.0058% per month
APR(r ) 1.0058% 12 12.0696%
ia (1 0.010058)12 1 12.77% per year
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
5-1
Part 2
Evaluation of Business and
Engineering Assets
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
5-2
Chapter 5 Analysis of Independent Projects
Identifying Cash Inflows and Outflows
5.1
(a) Cash inflows: (1) savings in labour, $45,000 per year, (2) salvage value,
$3,000 at year 5.
(b) Cash outflows: (1) capital expenditure = $30,000 at year 0, (2) operating
costs = $5,000 per year.
(c) Estimating project cash flows:
n Inflow Outflow Net flow
0 $30,000 -$30,000
1 $45,000 5,000 40,000
2 45,000 5,000 40,000
3 45,000 5,000 40,000
4 45,000 5,000 40,000
5 45,000+3,000 5,000 43,000
Payback Period
5.2
(a) Payback period: one year (discrete cash flows)
(b) Discounted payback period = 0.86 years, assuming continuous payments:
n Net Cash Flow Cost of Funds (15%) Cumulative Cash Flow
0 –$30,000 –$30,000
1 +$40,000 –$30,000(0.15) = –$4,500 +$5,500
5.3
(a) Payback period assuming end-of-year cash flows:
Project A B C D
Payback period No payback 2 years 3 years 1 years
(b) It may be viewed as a combination of two separate projects, where the first
investment is recovered at the end of year 1 and the investment that made
in year 2 and 3 will be recovered at the end of year 6.
(c) Discount payback period assuming end-of-year cash flows:
Project A B C D
Payback period No payback 2 years 4 years 1 years
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
5-3
NPW Criterion
5.4
(a)
PW (10%) A $1,500 $3, 000( P / F ,10%,3) $754
PW (10%) B $1,200 $600( P / F ,10%1) $800( P / F ,10%,2)
$1,500( P / F ,10%,3) $1,134
PW (10%) C $1,600 $1,800( P / F ,10%1) $800( P / F ,10%,2)
$2,500( P / F ,10%,3) $697
PW (10%) D $3,100 $800( P / F ,10%1) $1,900( P / F ,10%,2)
$2,300( P / F ,10%,3) $926
(b) Not provided. (Can easily obtain the graphs using Excel or other software)
*
5.5
(a)
PW (9%) $200,000 $24,000( P / A,9%,35) $35,000( P / F ,9%,35)
$55,317.71 0
(b)
PW (6%) $200,000 $24,000( P / A,6%,35) $35,000( P / F ,6%,35)
$152,511.60
(c)
PW (i) $200,000 $24,000( P / A, i,35) $35,000( P / F , i,35) 0
i 11.80%
∴ Therefore, the answer is (d).
5.6 *
Given: Estimated remaining service life = 25 years, current rental income =
$150,000 per year, O&M costs = $45,000 for the first year increasing by
$3,000 thereafter, salvage value $50, 000 , and MARR 12% .
Let A0 be the maximum investment required to break even.
* An asterisk next to a problem number indicates that the solution is available to
students on the Companion Website.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
5-4
PW (12%) A0 [$150, 000( F / A,12%, 25) $15, 000( F / A,12%, 20)
$16,500( F / A,12%,15) $18,150( F / A,12%,10)
$19,965( F / A,12%,5) $50, 000]( P / F ,12%, 25)
$45, 000( P / A,12%, 25) $3, 000( P / G,12%, 25)
0
∴ Solving for A0 yields
A0 $793,113
5.7
P $42, 000 [[$32, 400 [$33, 400 [$32,500 {$32,500
$33, 000( P / F ,12%,1)}( P / F ,15%,1)]( P / F ,13%,1)]
( P / F ,11%,1)]]( P / F ,10%,1)
$77, 417
5.8 Units are in thousand
PW (15%) $500 $3,200( P / F ,15%,1) $4,000( P / F ,15%,2)
($4,000 $2,000 $2,800)( P / A,15%,8)( P / F ,15%2)
$1,200( P / F ,15%,10)
$4,847.23
5.9 *
PW (18%) $3,000,000 [$1,550,000 $350,000 $150,000]( P / A,18%,10)
$200,000( P / F ,18%,10)
$1,757,018
Future Worth and Project Balance
5.10
(a)
PW (15%) A $12,500 $5,400( P / F ,15%,1) $14,400( P / F ,15%,2)
$7,200( P / F ,15%,3) $7,818
PW (15%) B $11,500 $3,000( P / F ,15%,1) $21,000( P / F ,15%,2)
$13,000( P / F ,15%,3) $10,318
PW (15%) C $12,500 $7,000( P / F ,15%,1) $2,000( P / F ,15%,2)
$4,000( P / F ,15%,3) $7,531
PW (15%) A $13, 000 $5,500( P / F ,15%,1) $5,500( P / F ,15%, 2)
$8,500( P / F ,15%,3) $1,530
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
5-5
(b)
FW (15%) A $7,818( F / P,15%,3) $11,890
FW (15%) B $10,318( F / P,15%,3) $15,694
FW (15%) C $7,531( F / P,15%,3) $11,454
FW (15%) D $1,530( F / P,15%,3) $2,327
All the projects are acceptable.
5.11
(a) The original cash flows of the project are as follows.
n An Project Balance
0 –$1,000 –$1,000
1 $100 –$1,100
2 $520 –$800
3 $460 –$500
4 $600 0
(b)
PB(i ) 3 $800(1 i) $460 $500
i 20%
(c) Yes, the project is acceptable.
5.12 *
PW (15%) $1, 000, 000( P / F ,15%,1) $750, 000( P / F ,15%, 2)
$562,500( P / F ,15%,3) $421,875( P / F ,15%, 4)
$2, 047, 734
5.13
(a) First find the interest rate that is used in calculating the project balances.
We can set up the following project balance equations:
PB (i )1 $10, 000(1 i ) A1 $11, 000
PB (i ) 2 $11, 000(1 i ) A2 $8, 200
PB (i )3 $8, 200(1 i ) $8, 000 $1,840
PB (i ) 4 $1,840(1 i ) A4 $3, 792
PB (i )5 $3, 792(1 i ) A5 $7,550
From PB(i )3 , we can solve for i : i 20% .
Substituting i into other PB(i )n yields
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
5-6
n An PB(i )n
0 –$10,000 –$10,000
1 1,000 –11,000
2 5,000 –8,200
3 8,000 –1,840
4 6,000 3,792
5 3,000 7,550
(b) Conventional payback period 3 years
5.14
(a) From the project balance diagram, note that PW ( 24%)1 0 for Project
1 and PW (23%) 2 0 for Project 2.
PW (24%)1 $1,000 $400( P / F ,15%,1) $800( P / F ,15%,2)
X ( P / F ,15%,3) 0
PW (23%) 2 $1,000 $300( P / F ,15%,1) Y ( P / F ,15%,2)
$800( P / F ,15%,3) 0
∴ X = $299.58, Y = $493.49
(b) Since PW ( 24%)1 0 , FW ( 24%)1 0 .
(c) ⓐ = $593.49, ⓑ = $499.56, ⓒ = 17.91%
5.15
(a) The original cash flows of the project are as follows:
n An Project Balance
0 –$3,000 –$3,000
1 $600 –$2,700
2 $1,470 –$1,500
3 $1,650 0
4 –$300 –$300
5 $600 $270
(b)
• PB(i) 2 $2,700(1 i) $1,470 $1,500
∴ i 10%
• PW (10%) $270( P / F ,10%,5) $167.65
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
5-7
5.16 i 10%
(a)
Project Balance as a Function of Time
Year A B C D
0 ($2,500) ($3,000) ($5,500) ($4,000)
1 ($2,450) ($1,300) ($4,050) $600
2 ($2,395) $70 ($2,455) ($2,340)
3 ($2,335) $1,577 ($701) ($5,074)
4 ($2,268) $2,235 $4,229 ($4,581)
5 ($2,195) $2,958 $9,652 ($4,040)
6 ($2,114) $4,754 ($2,443)
7 ($2,026) $312
8 ($1,928)
A
PB 12000
10000 B
8000 C
6000 D
4000
2000
0
-2000 1 2 3 4 5 6 7 8 9 n
-4000
-6000
-8000
(b)
Project A B C D
PB2 –$2,395 $70 –$2,455 –$2,340
∴ Project B because it is the only one with a positive balance at the end of
year 2.
5.17
(a)
FW (12%) A $1,800( F / P,12%,5) $500( F / P,12%,4)
$700
$700.18
FW (12%) B $5,200( F / P,12%,5) $2,500( F / P,12%,4)
$3,000
$5,141.91
FW (12%) C $3,800( F / P,12%,5) $4,000( F / P,12%,4)
$12,000
$18,160.7
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
5-8
FW (12%) D $4,000( F / P,12%,5) $500( F / P,12%,4)
$1,250
$6,040.45
FW (12%) E $6,500( F / P,12%,3) $1, 000( F / P,12%, 2)
$3, 600( P / F ,12%,1) $2, 400
$1, 445.63
(b) Accept all projects except E.
5.18
(a) You may plot the future worth for each project as a function of interest rate,
using Excel software.
(b)
n A B C D E
0 –$1,800.00 –$5,200.00 –$3,800.00 –$4,000.00 –$6,500.00
1 –$2,516.00 –$3,324.00 –$4,256.00 –$3,980.00 –$6,280.00
2 –$1,917.92 –$7,722.88 –$4,766.72 –$2,457.60 –$3,433.60
3 –$848.07 –$3,649.63 –$1,338.73 $247.49 –$1,445.63
4 $1,250.16 $1,912.42 $5,500.63 $4,277.19
5 $700.18 $5,141.91 $18,160.70 $6,040.45
(c) Note that PB (12%) N FW (12%)
5.19 *
From the project balance table shown below, it will take about eight years.
n Cash flow Balance
0 –$20,000.00 –$20,000.00
1 $5,000.00 –$18,000.00
2 $5,000.00 –$15,700.00
3 $5,000.00 –$13,055.00
4 $5,000.00 –$10,013.25
5 $5,000.00 –$6,515.24
6 $5,000.00 –$2,492.52
7 $5,000.00 $2,133.60
8 $5,000.00 $7,453.64
9 $5,000.00 $13,571.68
10 $5,000.00 $20,607.44
5.20
Equivalent investment made or required at n = 0:
PW (20%)investment $10M( F / A, 20%, 4) $30M $83.68M
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
5-9
Anticipated future benefits with $83.68M investment:
PW (20%)revenue $100M( P / A, 20%,10) $419.25M
∴ Potential asking price = $83.68M + $419.25M = $502.93M
Comments: The absolute minimum asking price is $83.68M because that is
how much you have invested in the project. However, if you go with this
absolute minimum, you are giving up the future benefits that the R&D project
would generate. Certainly, you have no way of knowing that Merck would
pay this price, but at least you know where you stand at the time of
negotiation.
5.21
(a)
PW (10%) A $404.40
PW (10%) B $191.59
PW (10%)C $0.53
(b)
FW (10%) A $404.40( F / P,10%,6) $716.42
FW (10%) B $191.59( F / P,10%,5) $308.56
FW (10%)C $0.53( F / P,10%,3) $0.7
(c)
PW (i) A $400 $150( P / A,10%, 2)
$350( P / F ,10%,3)
200 P / F ,15%,1 P / F ,10%,3
$368.07
PW i B $182.52
PW i C $0.53
5.22
(a) Since the project’s terminal project balance is equivalent to its future
worth, we can easily find the equivalent present worth for each project by
PW (10%) A $105( P / F ,10%,5)
$65.20
PW (10%)C $1, 000( P / F , 20%,5)
$401.80
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5-10
(b)
PB(10%)0 A0 $1, 000
PB (10%)1 PB (10%)0 (1 0.10) A1 $1, 000
PB (10%) 2 PB (10%)1 (1 0.10) A2 $900
PB(10%)3 PB (10%) 2 (1 0.10) A3 $690
PB (10%) 4 PB (10%)3 (1 0.10) A4 $359
PB (10%)5 PB (10%) 4 (1 0.10) A5 $105
From the project balance equations above, we derive
A0 $1, 000, A1 $100, A2 $200, A3 $300, A4 $400, and A5 $500 .
(c)
FW (20%) PB(20%)5 $1, 000
(d)
PW (i ) B FW (i ) B ( P / F , i, N )
$198 /(1 i )5
$79.57
∴Solving for i yields i 20%
5.23
(a)
PW (0%) A 0
PW (18%) B $575( P / F ,18%,5) $251.34
PW (12%)C 0
(b) Assume that A2 $500.
PW (12%)0 $1, 000
PW (12%)1 $1, 000(1.12) A1 $530
PW (12%) 2 $530(1.12) $500 X
Solving for X yields X = –$93.60.
(c) The net cash flows for each project are as follows:
Net Cash Flow
n A B C
0 –$1,000 –$1,000 –$1,000
1 $300 $500 $590
2 $280 $500 $500
3 $260 $300 -$106
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4 $240 $300 $147
5 $220 $300 $100
(d)
FW (0%) A 0
FW (18%) B $575
FW (12%)C 0
Capitalized Equivalent Worth
5.24 *
(a)
PW (13%) $50,000( P / A,13%,5) $70,000( P / A,13%,5)( P / F ,13%,5)
($90,000 / 0.13)( P / F ,13%,10) $513,435.45
(b)
A
PW (13%)
i
A $513, 435.45(0.13) $66, 746.61
5.25 *
Find the equivalent annual series for the first cycle:
A $100 [$60( F / A,14%,3) $20]( A / F ,14%,5)
$65.75
Capitalized equivalent amount:
$65.75
CE $469.64
0.14
5.26 Given: r = 6% compounded monthly, maintenance cost = $30,000 per year
0.06 12
ia (1 ) 1 6.17%
12
$30,000
∴ CE (6.17%) $486,223.66
0.0617
5.27 Given: Construction cost = $5,000,000, renovation cost = $1,000,000 every
15 years, annual O & M costs = $100,000 and i 5% per year
(a)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
5-12
P1 $5, 000, 000
$1, 000, 000( A / F ,5%,15)
P2
0.05
$926,846
P3 $100, 000 / 0.05
$2, 000, 000
CE (5%) P1 P2 P3
$7,926,846
(b)
P1 $5, 000, 000
$1, 000, 000( A / F ,5%, 20)
P2
0.05
$604,852
P3 $100, 000 / 0.05
$2, 000, 000
CE (5%) P1 P2 P3
$7, 604,852
(c)
A 10-year cycle with 10% of interest:
P1 $5, 000, 000
$1, 000, 000( A / F ,10%,15)
P2
0.10
$314, 738
P3 $100, 000 / 0.10
$1, 000, 000
CE (10%) $6,314, 738
A 20-year cycle with 10% of interest:
P1 $5, 000, 000
$1, 000, 000( A / F ,10%, 20)
P2
0.10
$174,596
P3 $100, 000 / 0.10
$1, 000, 000
CE (10%) $6,174,596
As interest rate increases, CE value decreases.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
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5.28 *
Given: Cost to design and build $650, 000 , rework cost $100, 000
every 10 years, a new type of gear $50, 000 at the end of fifth year,
annual operating costs $30, 000 for the first 15 years and $35, 000
thereafter
$100, 000( A / F ,8%,10)
CE (8%) $650, 000
0.08
$50, 000( P / F ,8%,5)
$30, 000( P / A,8%,15)
$35, 000
( P / F ,8%,15)
0.08
$1,165, 019
Annual Equivalent Worth Calculation
5.29
AE (10%) $5, 000( A / P,10%, 6)
[$2, 000( P / F ,10%,1)
$2,500( P / F ,10%, 6)]( A / P,10%, 6)
$1,103.50
5.30
AE (12%) $20,000( A / P,12%,6) $5,000
$3,000( P / G,12%,5)( P / F ,12%,1)( A / P,12%,6)
$4,303.13
5.31
AE (10%) [$3, 000 $3, 000( P / A,10%, 2)
$3, 000( P / A,10%, 4)( P / F ,10%, 2)
$1, 000( P / G,10%, 4)( P / F ,10%, 2)]( A / P,10%, 6)
$751.01
5.32 *
AE (13%) [$8, 000 $2, 000( P / A,13%, 6)
$1, 000( P / G,13%, 6) $4, 000( P / F ,13%, 2)
$2, 000( P / F ,13%, 4) $1, 000( P / F ,13%, 6)]( A / P,13%, 6)
$934.92
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5.33 *
AE (8%) $5, 000( A / P,8%, 6) $2, 000
[($500 $1, 000( P / A,8%, 2))( P / F ,8%, 2)
$500( P / F ,8%,5)]( A / P,8%, 6)
$421.37
5.34
AE (10%) A $2,500( A / P,10%,5) $400
$100( A / G,10%,5)
$78.47 (Reject)
AE (10%) B $4,500( A / P,10%,5) $500
[$2,500( P / F ,10%,1) $1,500( P / F ,10%, 2)
$500( P / F ,10%,3)]( A / P,10%,5)
$338.57 (Accept)
AE (10%)C [$8, 000 $2, 000( P / F ,10%,1)
$2, 000( P / F ,10%,5)]( A / P,10%,5)
$162.77 (Accept)
AE (10%) D [$12, 000 $2, 000( P / F ,10%,1)
$4, 000( P / F ,10%,5)]( A / P,10%,5)
$1,868.31 (Accept)
5.35 *
AE (12%) [$500, 000 $600, 000( P / F ,12%,1) $400, 000( P / F ,12%, 2)
$300, 000( P / F ,12%,3) $200, 000( P / F ,12%, 4)]( A / P,12%, 4)
$228,894
5.36
AE (13%) A $7,500( A / P,13%,3) $15,500( A / F ,13%,3)
$1,373.10 (Accept)
AE (13%) B $4, 000( A / P,13%,3) $1,500
$300( A / G,13%,3)
$81.53 (Accept)
AE (13%)C $5, 000( A / P,13%,3) $4, 000
$1, 000( A / G,13%,3)
$963.62 (Accept)
AE (13%) D $6, 600( A / P,13%,3) $3,800
$1, 004.70 (Accept)
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5.37 Since the project has the same cash flow cycle during the project life, you
just can consider the first cycle.
AE (10%) [$800 $900( P / F ,10%,1) $700( P / F ,10%, 2)
$500( P / F ,10%,3)]( A / P,10%,3)
$390.98
Accept the project.
5.38
$10, 000
CE (i ) $10, 000( P / A,8%,10) ( P / F ,8%,10)
0.06
$77,199 $67,101
$144,300
The amount of additional funds should be $44,300.
Capital (Recovery) Cost/Annual Equivalent Cost
5.39 *
Given: I $55, 000, S $6, 000, N 10 years, i 12%
(a)
CR(12%) ($55, 000 $6, 000)( A / P,12%,10)
$6, 000(0.12)
$9,392
(b)
AE (12%)Operating Revenue $5, 000 $2,500( A / G,12%,10)
$13,962
(c)
AE (12%) $13,962 $9,392
$4,570
This is a good investment.
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5.40 *
CR(12%) ($45, 000 $9, 000)( A / P,12%, 4) (.12)($9, 000)
$11, 067
AE (12%)O&M $15, 000 $2, 000( A / G,12%,5)
$18,549
AEC (12%) $11, 067 $18,549
$29, 616
5.41 Given: P $250, 000, S $40, 000, N 5 years, i 18%
CR (18%) ($250, 000 $40, 000)( A / P,18%,5)
$40, 000(0.18)
$74,353
5.42
n Option 1 Option 2
0 –$600–$8,000
1 0 –$2,160
2 0 –$2,320
3 0 –$2,480
4 +$100 –$2,540
AEC (8%)Option 1 $8, 600( A / P,8%, 4) $100( A / F ,8%, 4)
$2,574.33
AEC (8%)Option 2 $2,160 $160( A / G,8%, 4)
$2,384.63
Select Option 2.
5.43 Given i 6% , N =12 years,
Conventional System:
AEC (6%)Conventional $471 $576 $1, 047
IONETIC System:
AEC (6%)IONETICS $185 $1, 200( A / P, 6%,12) $328.13
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5.44
(a)
AE (13%) $4,000( A / P,13%,4) $1,000
( X $1,000)( P / F ,13%, 2)( A / P,13%, 4)
0
AE (13%) $608.06 0.26328 X 0
X $2,309.55
(b)
AE (15%) $5,500( A / P,15%, 4) $1, 400
$526.46 0
Accept Project B.
5.45
Option 1: Purchase-annual installment option:
A $45, 000( A / P, 7%,5) $10,975
AEC (10%)1 $5, 000( A / P,10%,5) $10,975
$12, 294
Option 2: Cash payment option:
AEC (10%) 2 $46, 000( A / P,10%,5)
$12,135
Option 2 is a better choice.
5.46 The total investment consists of the sum of the initial equipment cost and the
installation cost, which is $135, 000 . Let R denote the break-even annual revenue.
AE (10%) $135, 000( A / P,10%,10) $30, 000
$5, 000 $10, 000 R
0
Solving for R yields
R $46,971
5.47
Capital cost:
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5-18
CR (15%) ($105, 000 $6, 000)( A / P,15%,5) $6, 000(0.15)
$30, 432
Annual operating costs: $45, 000
AEC (15%) $30, 432 $45, 000 $75, 432
Unit-Cost Profit Calculation
5.48 *
Capital recovery cost
CR(10%) ($20, 000 $10, 000)( A / P,10%, 2) $10, 000(0.10)
$6, 762
$30, 000 $40, 000
AE (10%) Revenue [ ]( A / P,10%, 2)
1.1 1.12
$34, 762
AE (10%) Net Savings =$34, 762 $6, 762
$28, 000
C (6, 000) C (8, 000)
AE (10%)Savings [ ]( A / P,10%, 2)
1.1 1.12
$6,952C
$28, 000 6,952C
C $4.02 per hour
5.49 Given data: Total cost of building: $1, 000 4 8 $32, 000, Salvage value =
$3,200, Annual taxes, insurance, maintenance = $1,920, Other operating cost =
$1,600, Number of engineers assigned = 3
Equivalent annual cost of operating the new building:
AEC (12%) ($32, 000 $3, 200)( A / P,12%, 25) (0.12)($3, 200)
$1,920 $1, 600
$7,576.00
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5-19
Required annual increase in productivity per engineer:
$7,576 / 3 $2,525.33 per engineer
5.50
Equivalent annual cost of owning and operating the vehicle:
AEC (6%) [$4, 680( P / F , 6%,1) $3, 624( P / F , 6%, 2)
$3, 421( P / F , 6%,3)]( A / P, 6%,3)
$3,933
Annualized cost of owning and operating the vehicle as a function of mileage.
C (14,500) C (13, 000) C (11,500)
AEC (6%) [ ]( A / P, 6%,3)
1.06 1.062 1.063
13, 058C
So
13,058C $3,933
C $0.3012 per kilometer
5.51
Option 1: Pay employee $0.38 per km (Annual cost: $8360)
Option 2: Provide a car to employee:
CR (10%) ($25, 000 $8, 000)( A / P,10%,3) (0.10)($8, 000)
$7, 636
AEC (10%)operating cost $900 ($0.22)(22, 000) $5, 740
AEC (10%) total cost $7, 636 $5, 740 $13,376
Operating cost per km $13,376 / 22, 000 $0.61
Option 1 is a better choice.
5.52
Capital costs:
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5-20
CR(7%) ($30, 000 $2, 000)( A / P, 7%,12) (0.07)($2, 000)
$3, 665.
Annual battery replacement cost:
AEC (7%) [$3, 000( P / F , 7%,3) ( P / F , 7%, 6)
( P / F , 7%,9)]( A / P, 7%,12)
$765.41
Annual recharging cost:
AEC (7%) ($0.015)(20, 000) $300
Total annual costs:
AEC (7%) $3, 665 $765.41 $300 $700
$5, 430.41
Costs per kilometre:
cost/km $5, 430.41 / 20,000 $0.2715
5.53 *
Minimum operating hours:
AEC (9%) ($30, 000 $2, 000)( A / P,9%,15)
(0.09)($2, 000) $500
$4,153.65
Let T denote the annual operating hours. Then the total kilowatt-hours generated
would be 40T . Since the value of the energy generated is considered to
be $0.08 per kilowatt-hour, the annual energy cost is
$0.08 40T $4,153.65
Solving for T yields
T 1, 298 hours
Annual worth of the generator at full load operation:
AE (9%) ($0.08)(100, 000) $4,153.65 $3,846.35
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Discounted payback period at full load of operation:
n Investment Revenue Maintenance Net
cost Cash flow
0 –$30,000 –$30,000
1 $8,000 –$500 7,500
15 +$2,000 8,000 –500 9,500
$30, 000 $7,500( P / A,9%, n)
Solving for n yields
n 5.185 years
5.54
Capital recovery cost:
CR (6%) ($150, 000 $3, 000)( A / P, 6%,12) (0.06)($3, 000)
$17, 714
Annual operating costs:
AEC (6%)O&M $50, 000 $10, 000 $3, 000
$63, 000
Total annual system costs:
AEC (6%) $17, 714 $63, 000 $80, 714
Number of rides required per year:
Number of rides $80, 714 /($0.10) 807,140 rides
5.55 Given: Investment cost $7 million, plant capacity 200, 000 kg/hour, plant
operating hours 3, 600 hours per year, O&M cost $4 million per year, useful
life 15 years, salvage value $900,000, and MARR = 15%.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
5-22
(a)
PW (15%) $7, 000, 000 ( R $4, 000, 000)( P / A,15%, 6)
3.7844 R $22,137,900
0
Solving for R yields
R $5,849, 700 per year
(b) Minimum processing fee per kg (after-tax):
$5,849, 700
$0.0081 per kg
(200, 000)(3, 600)
Comments: The minimum processing fee per kg should be higher before-tax basis.
5.56 Given: Investment $3 million, plant capacity 160 m3/day, useful plant
life 20 years, salvage value negligible, O&M cost $250, 000 per year,
MARR 10% compounded annually (or effective monthly rate of 0.7974%)
AEC (10%) $3, 000, 000( A / P,10%, 20) $250, 000
$602,379
Monthly water bill for each household:
$602,379( A / F , 0.7974%,12)
$162.83
295
5.57
Annual total operating hours:
(0.70)(8, 760) 6,132 hours per year
The amount of electricity generated annually:
50, 000 6,132 306, 600, 000 kilowatt-hours
Equivalent annual cost:
AEC (14%) $85, 000, 000( A / P,14%, 25) $6, 000, 000
$18,367,364
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5-23
Cost per kilowatt-hour:
$18,367,364 / 306, 600, 000 $0.06 per kilowatt-hour
5.58 Let X denote the average number of round-trip passengers per year.
Capital costs:
CR (15%) ($12, 000, 000 $2, 000, 000)( A / P,15%,15)
(0.15)($2, 000, 000)
$2, 010,171
Annual crew costs: $225,000
Annual fuel costs for round trips:
($1.80)(4,500)(2)(3)(52) $2,527, 200
Annual landing fees:
($250)(3)(52)(2) $78, 000
Annual maintenance, insurance, and catering costs:
$237,500 $166, 000 $75 X $403,500 $75 X
Total equivalent annual costs:
AEC (15%) $2, 010,171 $225, 000 $2,527, 200
$78, 000 $403,500 $75 X
$3, 400 X
Solving for X yields
X 1,577 Passengers per year
Or
1,577 /(52)(3) 10.11 11 passengers per round trip
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
5-24
Concept of Rate of Return
Note: Symbol convention—The symbol i* represents the break-even interest rate that
makes the NPW of the project equal to zero. The symbol IRR represents the internal rate of
return of the investment. For a simple (or pure) investment, IRR = i*. For a nonsimple
investment, generally i* is not equal to IRR.
5.59
$14,500 $267( P / A, i, 72)
i 0.8148% per month
r 0.8148% 12 9.7776%
ia (1 0.008148)12 1 10.23%
5.60
$2.5 $1.2( P / A, i,10)
i 46.98%
5.61 *
$104, 200, 000 $30, 000( F / P, i,54)
3, 473.33 (1 i )54
i 16.30%
Investment Classification and Calculation of i*
5.62
(a) Simple investment: Project A (Note: Project C is a simple borrowing.)
(b) Nonsimple investment: Project B and Project D
(c)
Project A:
PW (i ) $18, 000 $30, 000( P / A, i,3) $10, 000( P / G, i,3)
0
i* 126.54%
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5-25
Project B:
PW (i ) $30, 000 $32, 000( P / A, i, 2) $22, 000( P / F , i,3)
0
i* 45.34%
Project C:
PW (i ) $34,578 $18, 000( P / A, i,3)
0
i 26.08% Borrowing rate of return
*
(d) Project D has no rate of return.
5.63 The equivalent annual cash flow for the first cash flow cycle ($400, $800, $500,
$500) will be
AE (i ) $500 [$100( P / F , i,1) $300( P, F , i, 2)]( A / P, i, 4)
Then, the present worth of the infinite cash flow series is expressed as
AE (i )
PW (i ) $1, 000
i
[$100( P / F , i,1) $300( P, F , i, 2)]( A / P, i, 4)
$1, 000
i
0
i* 54.05%
5.64
(a) Classification of investment projects:
Simple projects: A, B, and E
Nonsimple projects: C and D
However, if you use the cumulative cash flow sign test, all are simple projects.
(b)
$60 $150
$100 0
1 i (1 i) 2
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
5-26
1
Let X , then,
(1 i )
$100 $60 X $150 X 2 0
X 1 0.6406, X 2 1.0406
i* 56.09%
(c) Find i* by plotting the NPW as a function of interest rate:
Project i*
A 56.09%
B 47.94%
C 8.32%
D 178.8%
E 24.21%
5.65
(a) Classification of investment projects:
Simple projects: A, B, and D
Nonsimple projects: C
(b)
Project A: i* 9.63%
Project B: i 27.6%
*
Project C: i 276.72%
*
Project D: i 86.69%
*
(c) Use the PW plot command provided in Cash Flow Analyzer, or you may use the
Excel’s Chart Wizard.
5.66
(a)
$50, 000 ($25, 000 $9, 000)( P / A, i,8) $10, 000( P / F , i,8) 0
Solving for i yields i* 28.45%
(b) With the geometric expense series
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
5-27
$50, 000 $25, 000( P / A, i,8) $9, 000( P / A1 , 7%, i,8)
$10, 000( P / F , i,8) 0
Solving for i yields i 24.48%
* *
(c) To maintain i 28.45%
*
PW (i ) $50, 000 $25, 000( P / A1 , g , 28.45%,8)
$9, 000( P / A1 , 7%, 28.45%,8) $10, 000( P / A, 28.45%,8)
0
Solving for g yields
g 2.7035%
5.67 *
(a) Rate of return calculation:
Project A: i 32.10%
*
Project B: i 25.53%
*
(b) i* 44.95%
PW Plot
$50,000.00
$40,000.00
$30,000.00
PW ($)
$20,000.00 A
$10,000.00 B
$0.00
($10,000.00) 0 5 10 15 20 25 30 35 40 45 50
($20,000.00)
Interest Rate (%)
5.68
(a) IRR = 69.81%
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94, 000 144, 000 72, 000
PW (i ) 120, 000 0
(1 i ) (1 i ) 2 (1 i )3
i* 69.81%
(b) Use the PW plot command provided in Cash Flow Analyzer, or you may use the
Excel’s Chart Wizard.
(c) Since IRR(69.81%) > MARR (15%), accept the project!
IRR Analysis
5.69 *
The present worth of the project cash flow is
PW (i ) $10 M $1.8M ( P / A, i,8) $1M ( P / F , i,8) 0
Since IRR 10.18% > MARR, accept the project
5.70 The present worth of the project cash flow is
PW (i ) $5, 000 $4,840( P / F , i, 2) $1,331( P / F , i,3) 0
Since IRR 10% = MARR, the project breaks even.
5.71
(a) Since IRR = 10% and PW(10%) = 0, we have,
PW (10%) $2, 000 $800( P / F ,10%,1) $900( P / F ,10%, 2)
X ( P / F ,10%,3) 0
X = $704
(b) Since IRR > 8%, the project is acceptable.
5.72 *
Let X be the annual rent per apartment unit. Then net cash flow table is:
N Capital Revenue Maintenance Manager Net Cash Flow
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
5-29
Investment
0 (12,500,000) -12,500,000
1 50 X -250,000 -80,000 50X - 330,000
2 50 X -300,000 -80,000 50X - 380,000
3 50 X -350,000 -80,000 50X - 430,000
4 50 X -400,000 -80,000 50X - 480,000
5 14,000,000 50 X -450,000 -80,000 50X - 13,470,000
PW (15%) 12,500, 000 (50 X 330, 000)( P / A,15%,5)
50, 000( P / G ,15%,5) 12,940, 000( P / F ,15%,5)
0
X * $41,373 per year or $3,448 per month
5.73 *
Let X be the annual savings in labour, then
PW (10%) $25, 000 ( X $3, 000)( P / A,10%, 6)
$5, 000( P / F ,10%, 6) 0
X = $8,092.15
5.74
Net cash flow table:
n Land Building Equipment Revenue Expenses Net Cash Flow
0 ($1.50) ($3) ($4.50)
1 ($4) ($4.00)
2 $3.50 ($1.40) $2.10
3 $3.68 ($1.47) $2.21
4 $3.86 ($1.54) $2.32
5 $4.05 ($1.62) $2.43
6 $4.25 ($1.70) $2.55
7 $4.47 ($1.79) $2.68
8 $4.69 ($1.88) $2.81
9 $4.92 ($1.97) $2.95
10 $5.17 ($2.07) $3.10
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11 $5.43 ($2.17) $3.26
12 $5.43 ($2.17) $3.26
13 $5.43 ($2.17) $3.26
14 $2 $1.40 $0.50 $5.43 ($2.17) $7.16
Rate of return calculation:
PW (i ) $4.5 $4( P / F , i,1) $2.1( P / F , i, 2)
$7.16( P / F , i,14) 0
i* 24.85%
Since this is a simple investment, IRR = 24.85%. At MARR = 15%, the project is
economically attractive.
5.75
(a)
PW (i ) $20 $8( P / F , i,1) $17( P / F , i, 2) $19( P / F , i,3)
$18( P / F , i, 4) $10( P / F , i,5) $3( P / F , i, 6)
0
This is a simple investment. Therefore, IRR i 60.52% .
*
Since IRR > MARR (18%), the product is worth marketing.
(b) IRR = 67.03%
(c) IRR = 48.07%
Short Case Studies
ST 5.1
(a) Analysis period of 40 years:
Without the “mothballing” cost:
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5-31
PW (i ) $1,500, 000 $138, 000( P / A1 , 0.05%, i, 40)
0
i* 8.94%
With the “mothballing” cost of $0.75 billion:
PW (i ) $1,500, 000 $138, 000( P / A1 , 0.05%, i, 40)
$750, 000( P / F , i, 40)
i 8.77%
*
For a 40-year analysis period, the drop of IRR with the mothballing cost is
only 1.9%, which is relatively insignificant.
(b) Analysis period of 25 years (unit: thousand $):
Without the “mothballing” cost:
PW (i ) $1,500, 000 ($207, 000 $69, 000)( P / A1 , 0.05%, i, 25)
0
i* 7.84%
With the “mothballing” cost of $0.75 billion:
PW (i ) $1,500, 000 ($207, 000 $69, 000)( P / A1 , 0.05%, i, 25)
$750, 000( P / F , i, 25)
0
i* 6.80%
For a 25-year analysis period, the drop of IRR with the mothballing
cost is about 13.27%, which is relatively significant.
ST 5.2 Assuming that the cost of your drainage pipe has experienced a 4%
annual inflation rate, I could estimate the cost of the pipe 20 years ago
as follow:
$4, 208( P / F , 4%, 20) $4, 208(1.04) 20 $1,920.48
If the pipe had a 50-year service life with a zero salvage value when it was placed in
service 20 years ago, the annual capital recovery cost to the owner would be as
follows: (I assumed the owner’s interest rate would be 5% per year. In other words,
the owner could invest his $1,920.48 at 5% annual interest, if he did not purchase the
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
5-32
pipe.)
CR (5%) $1,920, 48( A / P,5%,50)
$105.20 per year
You can view this number as the annual amount he would expect to recover from his
investment considering the cost of money. With only a 20-year’s usage, he still has
30 more years to go. So the unrecovered investment at the current point is
$105.20( P / A,5%,30) $1, 617.15.
The owner could claim this number, but the city’s interest rate could be different from
the owner’s, so there is some room for negotiation.
Assumed interest rate Claim cost
0% $1,152.24
3% $1,462.98
4% $1,545.89
5% $1,617.15
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
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Appendix 5A
Investment Classification and Calculation of i *
5A.1
(a) Cash flow sign rules:
Projects Number of Sign Changes Possible Number of i*
A 1 0, 1
B 1 0, 1
C 1 0, 1
D 1 0, 1
E 2 0, 1, 2
F 1 0, 1
(b) Use the PW plot command provided in Cash Flow Analyzer, or you may use the
Excel’s Chart Wizard.
(c)
Project A: i* 228.42%
Project B: i* 500%
Project C: i* 23.27%
Project D: i* 70.99%
Project E: i* 265.41%
Project F: i* 258.91%
Mixed Investments
5A.2
(a)
Project 1: i* 20%
Project 2: i 18%
*
Project 3: i 1 32.45%, i 2 92.45%
* *
(b) Investment classification:
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5-34
Project 1: simple and pure investment, IRR 20%
Project 2: simple and pure investment, IRR 18%
Project 3: nonsimple and mixed investment, IRR RIC 31.07% , using
MARR 12%.
PB(31.07%,12%)0 $1, 000
PB (31.07%,12%)1 $1, 000(1 0.3107) $1, 400 $89.30
PB(31.07%,12%)2 $89.30(1 0.12) 100 $0
(c) If MARR = 12%, all the projects are acceptable.
5A.3
(a)
$100 $24
$100 0
1 i (1 i ) 2
1
Let X , then,
(1 i )
$100 $100 X $24 X 2 0
X 1 0.8333, X 2 5
∴ i 20%
*
(b)
Simple projects: A,B, and D
Nonsimple projects: C and E
(c) Apply the cash flow sign rule:
Projects Number of Possible Number of Actual i
*
Sign Changes i*
A 1 0, 1 20%
B 1 0, 1 28.58%
C 2 0, 1, 2 14.63%,210.27%
D 1 0, 1 15.24%
E 2 0, 1, 2 12.63%,41.42%
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(d)
Project B: IRRB 28.59%
Project C: IRRC 15.70%
Project D: IRRD 15.24%
Project E: IRRE 11.24%
Note that since Projects C and E are mixed investments, we need to find the RIC for
both C and E by using external interest rate of 10%.
(e) Apply the net investment test: Project C = pure investment, Project D = pure
borrowing
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
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Project Balances
n
Project C ( i 14.63% ) Project D ( i 12.63% )
* *
0 –$5.0 $200
1 $5.8 $320
2 $36.4 –$148
3 0 –$665
4 –$539
5 0
5A.4
(a)
Project 1: i 612.695%
*
Project 2: i
*
1 14.64%, i*2 210.28%
Project 3: i* 100%
(b) Apply the net investment test:
Project 1:
PB(612.695%)0 $1, 600
PB (612.695%)1 $1, 600(1 6.12695) $10, 000 $1, 403.2
PB(612.695%) 2 $1, 403.2(1 6.12695) $10, 000 0
(–,–,0), a pure investment
Project 2:
PB (14.64%)0 $5, 000
PB (14.64%)1 $5, 000(1 0.1464) $10, 000 $4, 268
PB(14.64%) 2 $4, 268(1 0.1464) $30, 000 $34,892.80
PB (14.64%)3 $34,892.8(1 0.1464) $40, 000 0
(-,+,0), a mixed investment
Project 3:
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5-37
PB (100%)0 $1, 000
PB (100%)1 $1, 000(1 1) $4, 000 $2, 000
PB(100%) 2 $2, 000(1 1) $4, 000 0
(-,+,0), a mixed investment
(c)
Project 1: IRR1 612.695%, PW (12%) $15,300
Project 2: IRR2 RIC 2.04%, PW (12%) $623 0
Project 3: IRR3 RIC 57.14%, PW (12%) $617 0
(d) Only Project 1 is acceptable.
5A.5
(a) Simple investments: A and B (simple as well as pure)
(b) Mixed investments: C
(c) Project A: IRRA 23.24% , Project B: IRRB 21.11% , Project C:
IRRC 12.24% at an external rate of 12%
(d) All three projects are acceptable.
5A.6
(a) There are two sign changes in cash flow, indicating multiple i s.
*
i*1 20%, i*2 40%
Apply the net investment test:
PB(20%)0 $100
PB(20%)1 $100(1.2) $260 $140
PB(20%) 2 $140(1.2) $168 0
∴ (-,+,0), a mixed investment
(b) At an external interest rate of 12%, RIC = IRR = 10% < 12%.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
5-38
(c) The project is not acceptable.
5A.7
(a) i*1 15.99%, i*2 0%
(b) Since all projects pass the net investment test, all projects are pure investments.
(c) All projects are acceptable at MARR = 10%.
5A.8
(a) Project A: i*1 10%, i*2 100% , Project B: i*1 350.33%, i*2 80.83%
(b) Pure investment: C, mixed investments: A, B, D, and E
(c) Project A: IRRA 13.57% , Project B: IRRB 342.16% , Project C:
IRRC 18% , Project D: IRRD 31.07% , Project E: IRRE 19.66%
(d) All projects are acceptable at MARR = 12%.
5A.9
(a) Use the PW plot command provided in Cash Flow Analyzer.
From the plot, we get i*1 14.64%, i*2 210.27%
(b) Apply the net investment test:
PB(14.64%)0 $5, 000
PB(14.64%)1 $5, 000(1 0.1464) $10, 000 $4, 268
PB(14.64%)2 $4, 268(1 0.1464) $30, 000 $34,892.80
PB(14.64%)3 $34,892.8(1 0.1464) $40, 000 0
(-,+,+,0): The project is a mixed investment.
(c) Since RIC = IRR = 33.92% > 18%, the project is acceptable.
5A.10
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
5-39
(a) Apply the net investment test using i* 10%
PB(10%)0 $100, 000
PB(10%)1 $100, 000(1.1) $310, 000 $200, 000
PB(10%) 2 $200, 000(1.1) $220, 000 0
∴ (-,+,0), a mixed investment
(b) RIC = IRR = 6.29% <8%. So the project is not acceptable.
5A.11 (c)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
6-1
Chapter 6 Comparing Mutually Exclusive Alternatives
Mutually Exclusive Alternatives: PW Method
6.1
PW (12%) A $800 $1,500( P / F ,12%,1)
L $660( P / F ,12%,10)
$988.91
PW (12%) B $2, 635 $565( P / F ,12%,1)
L $840( P / F ,12%,10)
$1, 696.01
∴ Select Project B.
6.2
(a)
PW (15%) A $1,500 $1,350( P / F ,15%,1) L
$100( P / F ,15%, 4)
$467.52
PW (15%) B $1,500 $1, 000( P / F ,15%,1) L
$150( P / F ,15%, 4)
$586.26
Select Project B.
(b)
NFW (15%) D $1,500( F / P,15%,4) $450( F / A,15%, 4)
$376.49
NFW (15%) E $1,800( F / P,15%, 4) $600( F / A,15%, 4)
$152.18
Select Project D.
(c)
PW (15%)C $3, 000 $1, 000( P / F ,15%,1)
X ( P / F ,15%, 2)
$1,500( P / F ,15%,3) X ( P / F ,15%, 4)
1.3279 X $1,144.16
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6-2
To be acceptable, it must satisfy the following condition:
PW (15%)C 0
1.3279 X $1,144.16 0
X $861.63
(d)
PW (18%) D $1,500 $450( P / A,18%, 4)
$289.47 0
Yes, Project D is acceptable.
(e) If MARR < 10.40%, Project E is better. Otherwise, Project D is better.
6.3
(a)
PW (12%) A $14,500 $12,610( P / F ,12%,1) $12,930( P / F ,12%,2)
$12,300( P / F ,15%,3) $15,821.54
PW (12%) B $12,900 $11,210( P / F ,12%,1) $11,720( P / F ,12%,2)
$11,500( P / F ,12%,3) $14,637.51
∴ Select Project A.
(b)
FW (12%) A $15,821.54( F / P,12%,3) $22,228.13
FW (12%) B $14,637.51( F / P,12%,3) $20,564.65
∴ Select Project A.
6.4
(a)
PW (15%) A $6,000 $800( P / F ,15%,1) $14,000( P / F ,15%,2)
$5,281.66
PW (15%) B $8,000 $11,500( P / F ,15%,1) $400( P / F ,15%,2)
$2,302.46
∴ Select Project A.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
6-3
(b) PW(i) function for each alterative on the same chart between 0% and 50%:
Project A is preferred at all interest rates between 0% and 50%.
6.5
Method A:
$25, 000( A / F ,12%,5)
CE (12%) A $60, 000 $92, 791.67
0.12
Method B:
$180, 000( A / F ,12%,50)
CE (12%) B $150, 000 $150, 625.5
0.12
∴ Since CE(12%) values above represent cost, Method A is preferred.
6.6
Standard Lease Option:
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6-4
PW (0.5%)SL $5,500 $1,150( P / A, 0.5%, 24)
$1, 000( P / F , 0.5%, 24)
$30,560.10
Single Up-Front Option:
PW (0.5%)SU $31,500 $1, 000( P / F , 0.5%, 24)
$30, 612.82
∴ Select the standard lease option as you will save $52.72 in present worth.
6.7
Machine A:
PW (13%) $75, 200 ($6,800 $2, 400)( P / A,13%, 6)
$21, 000( P / F ,13%, 6)
$101,891
Machine B:
PW (13%) $44, 000 $11,500( P / A,13%, 6)
$89,971
∴ Machine B is a better choice.
*
6.8
(a)
Required HP to produce 10 HP:
Motor A: X 1 10 / 0.85 11.765 HP
Motor B: X 2 10 / 0.90 11.111 HP
Annual Energy Cost:
Motor A: 11.765(0.7457)(1,500)(0.07) $921.18
Motor B: 11.111(0.7457)(1,500)(0.07) $869.97
Present Worth:
*
An asterisk next to a problem number indicates that the solution is available to students
on the Companion Website.
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6-5
PW (8%) A $800 $921.18( P / A,8%,15)
$50( P / F ,8%,15)
$8, 669
PW (8%) B $1, 200 $869.97( P / A,8%,15)
$100( P / F ,8%,15)
$8, 614
∴ Motor B is preferred.
(b) With 2,000 operating hours:
PW (8%) A $800 $1,535.26( P / A,8%,15)
$50( P / F ,8%,15)
$13,925
PW (8%) B $1, 200 $1, 449.97( P / A,8%,15)
$100( P / F ,8%,15)
$13,579
∴ Motor B is still preferred.
6.9 Given: Required service period = infinite, analysis period = least common
multiple service periods (six years)
Project A:
PW (12%)cycle $20, 000 $17,500( P / F ,12%,1) $17, 000( P / F ,12%, 2)
$15, 000( P / F ,12%,3)
$19,854.00
PW (12%) total $19,854[1 ( P / F ,12%,3)]
$33,985.69
Project B:
PW (12%)cycle $25, 000 $25,500( P / F ,12%,1) $18, 000( P / F ,12%, 2)
$12,117.35
PW (12%) total $12,117.35[1 ( P / F ,12%, 2) ( P / F ,12%, 4)]
$29, 478.02
∴ Project A is preferred.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
6-6
6.10
(a) Without knowing the future replacement opportunities, we may assume that
both alternatives will be available in the future with the identical investments
and expenses. We further assume that the required service period will be
indefinite.
(b) With the common service period of 24 years,
Project A1:
PW (10%)cycle $900 $400( P / A,10%,3)
$200( P / F ,10%,3)
$1, 744.48
PW (10%) total $1, 744.48[1 ( P / A,33.10%, 7)]
$6,302.63
Note that the effective interest rate for a three-year cycle is
(1.10)3 1 33.10%
Project A2:
PW (10%)cycle $1,800 $300( P / A,10%,8)
$500( P / F ,10%,8)
$3,167.22
PW (10%) total $3,167.22[1 ( P / F ,10%,8)
( P / F ,10%,16)]
$5,334.03
∴ Project A2 is preferred.
(c)
PW (10%) A1 $1,744.48
PW (10%) A 2 $1,800 $300( P / A,10%,3) S ( P / F ,10%,3)
$2,546.06 0.7513S
Let PW (10%) A1 PW (10%) A 2 and solve for S.
S $1, 067
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
6-7
6.11
(a) Assuming a common service period of 15 years
Project B1:
PW (12%)cycle $18, 000 $2, 000( P / A,12%,5) $2, 000( P / F ,12%,5)
$24, 075
PW (12%) total $24, 075[1 ( P / A, 76.23%, 2)]
$45, 487
Note: (1.12) 5 1 76.23%
Project B2:
PW (12%) cycle $15,000 $2,100( P / A,12%,3) $1,000( P / F ,12%,3)
$19,332
PW (12%) total $19,332[1 ( P / A,40.49%,4)]
$54,826
Note: (1.12) 3 1 40.49%
∴ Select Project B1.
(b)
Project B1 with two replacement cycles:
PW (12%) $24, 075 $24, 075( P / F ,12%,5)
$37, 736
Project B2 with four replacement cycles where the fourth replacement ends
at the end of the first operating year:
PW (12%) $19,332[1 ( P / F ,12%,3) ( P / F ,12%, 6)]
[$15, 000 ($2,100 $6, 000)( P / F ,12%,1)]( P / F ,12%,9)
$47, 040
∴ Project B1 is still a better choice
6.12 Since only Model A is repeated in the future, we may have the following
sequence of replacement cycles:
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
6-8
Option 1: Purchase Model A now and repeat Model A forever.
Option 2: Purchase Model B now and replace it at the end of year 2 by
Model A. Then repeat Model A forever.
PW (15%) Model A $6, 000 $3,500( P / A,15%,3)
$1,991.29
A $1,991.29( A / P,15%,3)
$872.14
PW (15%)Model B $15, 000 $10, 000( P / A,15%, 2)
$1, 257.09
A $1, 257.09( A / P,15%, 2)
$773.26
(a)
Option 1:
$872.14
PW (15%) AAAL
0.15
$5,814.27
Option 2:
$872.14
PW (15%) BAAL $1, 257.09 ( P / F ,15%, 2)
0.15
$5, 653.51
∴ Option 1 is a better choice.
(b) Let S be the salvage value of Model A at the end of year 2.
$6, 000 $3,500( P / A,15%, 2) S ( P / F ,15%, 2) $1, 257.09
Solving for S yields
S $2, 072.50
6.13
Since either tower will have zero salvage value after 20 years, we may select
the analysis period of 35 years:
PW (11%) Bid A $137, 000 $2, 000( P / A,11%,35)
$154, 710
PW (11%)Bid B $128, 000 $3,300( P / A,11%,35)
$157, 222
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
6-9
∴ Bid A is a better choice.
If you assume an infinite analysis period, the present worth of each bid will
be:
[$137, 000 $2, 000( P / A,11%, 40)]( A / P,11%, 40)
PW (11%) Bid A
0.11
$157, 296
[$128, 000 $3,300( P / A,11%,35)]( A / P,11%,35)
PW (11%) Bid B
0.11
$161,367
∴ Bid A is still preferred.
6.14
(a)
PW (15%) A1 $15, 000 $9,500( P / F ,15%,1)
$12,500( P / F ,15%, 2) $7,500( P / F ,15%,3)
$7, 644.04
(b)
PW (15%) A 2 $25, 000 X ( P / F ,15%, 2)( P / F ,15%,1)
$9,300
X $24, 263
(c) Note that the net future worth of the project is equivalent to its terminal
project balance.
PB (15%)3 $7, 644.04( F / P,15%,3)
$11, 625.63
(d) Select Project A2.
6.15
(a) Project balances as a function of time are as follows:
Project Balances
n A D
0 –$2,500 –$5,000
1 –2,100 –6,000
2 –1,660 –7,100
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
6-10
3 –1,176 –3,810
4 –694 –1,191
5 –163 1,690
6 421 3,859
7 763 7,245
8 1,139
All figures above are rounded to nearest dollars.
(b) Knowing the relationship FW (i ) PB (i ) N ,
FW (10%) A $1,139
FW (10%) D $7, 245
(c) Assuming a required service period of eight years
PW (10%) B $7, 000 $1,500( P / A,10%,8)
$1, 000( P / F ,10%,1) $500( P / F ,10%, 2)
$1,500( P / F ,10%, 7) $1,500( P / F ,10%,8)
$17, 794
PW (10%)C $5, 000 $2, 000( P / A,10%, 7)
$3, 000( P / F ,10%,8)
$16,136
∴ Select Project C.
6.16
Option 1: Non-deferred plan
PW (12%)1 $200, 000 $21, 000( P / A,12%,8)
$304,320
Option 2: Deferred plan
PW (12%)2 $100, 000( P / F ,12%, 2) $6, 000( P / A,12%,3)( P / F ,12%, 2)
$160, 000( P / F ,12%,5) $15, 000( P / A,12%,3)( P / F ,12%,5)
$140, 000( P / F ,12%,8)
$258,982
∴ Option 2 is a better choice.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
6-11
*
6.17
Alternative A: Once-For-All Expansion
PW (15%) A $30M $0.40M ( P / A,15%, 25)
$0.85M ( P / F ,15%, 25)
$32,559,839
Alternative B: Incremental Expansion
PW (15%) B $10M $18M ( P / F ,15%,10)
$12 M ( P / F ,15%,15) $1.5M ( P / F ,15%, 25)
$0.25M ( P / A,15%, 25)
$0.10M ( P / A,15%,15)( P / F ,15%,10)
$0.10 M ( P / A,15%,10)( P / F ,15%,15)
$17, 700, 745
∴ Select Alternative B.
6.18
Option 1: Tank/tower installation
PW (12%)1 $164, 000
Option 2: Tank/hill installation with the pumping equipment replaced at the
end of 20 years at the same cost
PW (12%)2 ($120, 000 $12, 000)
($12, 000 $1, 000)( P / F ,12%, 20)
$1, 000( P / F ,12%, 40) $1, 000( P / A,12%, 40)
$141,373
∴ Option 2 is a better choice.
Unit-Cost Profit Calculation
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
6-12
*
6.19
Let T denote the total operating hours in full load.
Motor I (Expensive)
Annual power cost:
150
(0.746) (0.05) T $6.741T
0.83
Equivalent annual cost of operating the motor:
AEC (6%) I $4,500( A / P, 6%,10) $675 6.741T
$1, 286.41 $6.741T
Motor II (Less expensive):
Annual power cost:
150
(0.746) (0.05) T $6.9938T
0.80
Equivalent annual cost of operating the motor:
AEC (6%) II $3, 600( A / P, 6%,10) $540 6.9938T
$1, 026.11 6.9938T
Let AEC (6%) I AEC (6%) II and solve for T .
$1, 286.41 6.741T $1, 029.11 6.9938T
T 1, 017.8 hours per year
6.20
Option 1: Purchase units from John Holland
Unit cost $25 ($35, 000) / 20, 000 $23.25
Option 2: Make units in house
PW (15%)dm $63, 000( P / A1 ,5%,15%,5) $230, 241
PW (15%)dl $190,800( P / A1 , 6%,15%,5) $709, 491
PW (15%) vo $139, 050( P / A1 ,3%,15%,5) $490,888
AEC (15%) ($230, 241 $709, 491 $490,888)( A / P,15%,5) $70, 000
$496, 776
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
6-13
Unit cost $496, 776 / 20, 000 $24.84
∴ Option 1 is a better choice.
6.21
(a) Determine the unit profit of air sample test by the TEM (in-house).
Subcontract Option:
Unit profit $400 $300 $0.50 $1,500 /1, 000 $98
TEM Purchase Option:
AEC (15%) ($415, 000 $9,500)( A / P,15%,8) ($50, 000
$6, 000 $18, 000 $20, 000)
$188, 600
Unit cost $188, 600 /1, 000 $188.60
Unit profit $300 $188.60 $111.40
(b) Let X denote the break-even number of air samples per year.
$1,500 $188, 600
$400 ($300 $0.50 ) $300
X X
Solving for X yields
X 933.17 934 air samples per year
Note: If SEC’s goal is simply to minimize per unit cost of sampling, then the
break-even point would be calculated without including the revenue:
($300+$0.50+ ($1,500/X) = $188,600/X
Solving for X yields: X= 622.62 ≈ 623 air samples per year
Mutually Exclusive Alternatives: AE Method
6.22
(a)
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AE (15%) A $12, 000( A / P,15%, 4) [$9,120 $2, 280( A / G,15%, 4)]
$1,892.95
AE (15%) B $12, 000( A / P,15%, 4) $6,350
$2,146.82
(b) Process A: $1,892.95 / 2, 000 $0.9465 / hour
Process B: $2,146.82 / 2, 000 $1.0734 / hour
(c) Process B is a better choice.
*
6.23
Capital recovery cost for both motors:
CR (13%)CV $13, 000( A / P,13%, 20) $1,851
CR(13%)PE $15, 600( A / P,13%, 20) $2, 221
Annual operating cost for both motors:
18.650 kW $0.07 3,120 hrs
CV : $4,551
0.895 kWh year
18.650 kW $0.07 3,120 hrs
PE : $4,380
0.93 kWh year
(a) Savings per kWh:
AEC (13%)CV $1,851 $4,551 $6, 402
AEC (13%) PE $2, 221 $4,380 $6, 601
Comments: At 3,120 annual operating hours, it will cost the company an
additional $370, but energy savings are only $171, which results in a $199
loss from each motor. The total output power is 58,188 kWh per year (25
HP 0.746 kW/HP 3120 hrs/year). Therefore, the savings (losses) per
operating hour from switching from conventional motor to the PE is
($199 / yr)
($0.034) / kWh
58,188 kWh/yr
(b)
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$1,851 1.4587T $2, 221 1.4038T
0.0549T 370
T 6, 737 hours
6.24
New Lighting System Cost:
AEC (12%) $50, 000( A / P,12%, 20) ($8, 000 $3, 000)
$17, 694
Old Lighting System Cost:
AEC (12%) $20, 000
Annual savings from installing the new lighting system $2,306
6.25 Given: i 6% interest compounded monthly, the effective annual
interest (1.005)12 1 6.17% per year, effective semiannual
interest (1.005)6 1 3.04% per semiannual
Option 1: Buying a bond
AE (3.04%)1 $2, 000( A / P,3.04%, 6) $100 $2, 000( A / F ,3.04%, 6)
$39.20 per semiannual
AE (6.17%) $39.20( F / A,3.04%, 2)
$79.59 per year
Option 2: Buying and holding a growth stock for three years
AE (6.17%) 2 $2, 000( A / P, 6.17%,3) $2, 735.26( A / F , 6.17%,3)
$107.17
Option 3: Receiving $150 interest per year for three years
AE (6.17%)3 $2, 000( A / P, 6.17%,3) $150 $2, 000( A / F , 6.17%,3)
$126.60
∴ Making the personal loan is the best option.
6.26
Equivalent Annual Cost:
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AEC (13%) A ($1, 200, 000 $60, 000)( A / P,13%, 20)
(0.13)($60, 000) $50, 000 $40, 000
$260, 083
AEC (13%) B ($750, 000 $30, 000)( A / P,13%,10)
(0.13)($30, 000) $80, 000 $30, 000
$216,395
Processing cost per tonne:
C A $260, 083 /(20)(365) $35.63 per tonne
CB $216,395 /(20)(365) $29.64 per tonne
∴ Incinerator B is a better choice.
6.27
(a)
AE (15%) A [$2,500 $1, 000( P / F ,15%,1)
$400( P / F ,15%, 4)]( A / P,15%, 4)
$216.06
AE (15%) B [$4, 000 $100( P / F ,15%,1)]( A / P,15%, 4) $1,500
$129.40
∴ Project A is a better choice.
(b)
AE (15%) B $129.40
AE (15%)C [$5, 000 $200( P / A,15%, 2)]( A / P,15%, 4) $2, 000
$134.79
∴ Project C is a better choice.
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Life-Cycle Cost Analysis
6.28 Assumption: Jet Fuel Cost = $1.50/L
System A : Equivalent annual fuel cost: A1 = ($1.5/L)(160kL/1,000
hours)(2,000 hours) $480, 000 (assuming an end of-year convention)
AEC (10%)fuel [$480, 000( P / A1 , 6%,10%,3)]( A / P,10%,3)
$507, 494
AEC (10%) A ($100, 000 $10, 000)( A / P,10%,3)
(0.10)($10, 000) $507, 494
$544, 684
System B : Equivalent annual fuel cost: A1 = ($1.50/L)(128kL/1,000
hours)(2,000 hours = $384,400
AEC (10%)fuel [$384, 000( P / A1 , 6%,10%,3)]( A / P,10%,3)
$405,995
AEC (10%) B ($200, 000 $20, 000)( A / P,10%,3)
(0.10)($20, 000) $405,995
$480,376
Cost of owning and operating:
System A $544, 684 / 2, 000 $272.34 per hour
System B $480,376 / 2, 000 $240.19 per hour
∴ System B is a better choice.
6.29 Since the required service period is 12 years and the future replacement cost
for each truck remains unchanged, we can easily determine the equivalent
annual cost over a 12-year period by simply finding the annual equivalent cost
of the first replacement cycle for each truck.
Truck A: Four replacements are required.
AEC (12%) A ($15, 000 $5, 000)( A / P,12%,3)
(0.12)($5, 000) $3, 000
$7, 763.50
Truck B: Three replacements are required.
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AEC (12%) B ($20, 000 $8, 000)( A / P,12%, 4)
(0.12)($8, 000) $2, 000
$6,910.80
∴ Truck B is a more economical choice.
6.30
(a) Number of decision alternatives (required service period = five years):
Alternative Description
Buy Machine A and use it for four years.
A1
Then lease the machine for one year.
A2 Buy Machine B and use it for five years.
A3 Lease a machine for five years.
Buy Machine A and use it for four years.
A4 Then buy another Machine A and use it
for just one year.
Buy Machine A and use it for four years.
A5
Then buy Machine B and use it for one year.
Both A4 and A5 are feasible but may not be practical alternatives. To
consider these alternatives, we need to know the salvage values of the
machines after one-year use.
(b) With lease, the O&M costs will be paid by the leasing company:
For A1:
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PW (10%)1 $6,500 ($600 $100)( P / F ,10%, 4)
$800( P / A,10%, 4) $200( P / F ,10%,3)
$100( P / F ,10%, 2) ($3, 000 $100)( P / F ,10%,5)
$10,976
AEC (10%)1 $10,976( A / P,10%,5)
$2,895.44
For A2:
PW (10%) 2 $8,500 $1, 000( P / F ,10%,5)
$520( P / A,10%,5) $280( P / F ,10%, 4)
$10, 042
AEC (10%) 2 $10, 042( A / P,10%,5)
$2, 649
For A3:
AEC (10%)3 [$3, 000 $3, 000( P / A,10%, 4)]( A / P,10%,5)
$3,300
∴ A2 is a better choice.
*
6.31
Option 1:
AEC (18%)1 $125,000(300)( A / P,18%, 20)
$(0.08)(125,000)(300)( A / F ,18%, 20)
(0.01 0.473)(80,000,000)
$52,824,600
cost/kg $52,824,600 / 80,000,000
$66.0 cents/kg
Option 2:
AEC (18%) 2 ($0.10 0.473)(80,000,000)
$45,840,000
cost/kg $45.84 / 80
57.34 cents/kg
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∴ Option 2 is a better choice.
6.32 Given: Required service period indefinite, analysis period indefinite
Plan A: Incremental Investment Strategy:
Capital Investment :
AEC (10%)1 [$400, 000 $400, 000( P / F ,10%,15)]( A / P,10%, )
$49,576
Supporting Equipment:
AEC (10%) 2 [($75, 000 $75, 000 / 3.1772)( P / F ,10%,30)]
( A / P,10%, )
$565
Note that the effective interest rate for 15-year period is
(1 0.1)15 1 3.1772
Operating Cost:
AEC (10%)3 [$31, 000( P / A,10%,15)
$62, 000( P / A,10%,5)( P / F ,10%,15)]
$63, 000
[ $1, 000( P / G,10%, )]
0.10
( P / F ,10%, 20)]( A / P,10%, )
$40, 056
Note that ( P / G, i, ) 1/ i 2 or ( P / G,10%, ) 100
Total Equivalent Annual Worth:
AEC (10%) A $49,576 $565 $40, 056 $90,197
Plan B: One-Time Investment Strategy:
Capital Investment:
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AEC (10%)1 $550, 000( A / P,10%, )
$55, 000
Supporting Equipment:
$150, 000
AEC (10%) 2 ( A / P,10%, )
16.4494
$912
Note that the effective interest rate for 30-year period is
(1 0.1)30 1 16.4494
Operating Cost:
AEC (10%)3 [$35, 000( P / A,10%,15)
$55, 000( P / A,10%, )( P / F ,10%,15)]
( A / P,10%, )
$39, 788
Total Equivalent Annual Worth:
AEC (10%) B $55, 000 $912 $39, 788 $95,700
∴ Plan A is a better choice.
Design Economics
*
6.33
(a)
Energy Loss:
0.0042059 $3, 038.13
(24 365)($0.0825)
A A
Material Weight:
(60)(8894) A 533640 A
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Total Material Costs:
(533 640 A)(13) $693 7320 A
Capital Recovery Cost:
CR (11%) [$6937 320 A $2 533640 A]( A / P,11%, 25) $2 533640 A 0.11
5870040 A A / P,11%, 25 117400.8 A
814175 A
Total Equivalent Annual Cost:
3.03813
AEC (11%) $814175 A
A
Optimal Cross-Sectional Area:
dAEC (11%) 3.03813
$814175 0
dA A2
A 0.00193172m 2 19.3172 cm 2
(b) Minimum Annual Equivalent Total Cost:
AEC (11%)
2 3.03813 $3,145.52
0.00193172
(c) Graphs of the capital cost, energy-loss cost, and the total cost as a function of
the cross-sectional area A:
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Mixed Investments
6.34
(a) IRR for the incremental investment:
n Net Cash Flow
Project A Project B B-A
0 –$300 –$800 –$500
1 0 $1,150 $1,150
2 $690 $40 –$650
i* B A 0% or 30%
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Since this is a mixed incremental investment, we need to find the RIC using an
external interest rate of 15%.
RICB-A IRRB-A 16.95% 15%
∴ Project B is preferred.
(b) PW(i) function between 0% and 50%:
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Mutually Exclusive Alternatives: IRR Method
6.35
(a) Project A: IRR 11.71%
Project B: IRR 19.15%
(b) Only Project B is acceptable.
(c) Since Project A is not acceptable, select Project B.
6.36 Option 1:Buy a GIC.
Option 2: Purchase a bond, and assume that MARR 9%
Net Cash Flow
n Option 1 Option 2 Option 1 – Option 2
0 -$10,000 -$10,000 0
1 0 1,000 -1,000
2 0 1,000 -1,000
3 0 1,000 -1,000
4 0 1,000 -1,000
5 16,105 11,000 5,105
The rate of return on incremental investment is
i*1 2 10% 9%
∴ Option 1 is a better choice.
6.37 Determine the cash flow on incremental investment:
Net Cash Flow
n Project A Project B B-A
0 -$2,000 -$3,000 -$1,000
1 1,400 2,400 1,000
2 1,640 2,000 360
i* B A 28.11% 15%
∴ Select Project B.
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6.38
(a) IRR on the incremental investment:
Net Cash Flow
n Project A1 Project A2 A2 – A1
0 –10,000 –12,000 –$2,000
1 5,000 6,100 1,100
2 5,000 6,100 1,100
3 5,000 6,100 1,100
i* A 2 A1 29.92%
(b) Since it is a simple incremental investment, IRR A2-A1 29.92% 10% .
Therefore, select Project A2.
6.39
(a) IRR on the incremental investment:
Net Cash Flow
n
A1 A2 A2 – A1
0 -$15,000 -$20,000 -$5,000
1 7,500 8,000 500
2 7,500 15,000 7,500
3 7,500 5,000 -2,500
Since the incremental cash flow series portrays a nonsimple investment, we
need to find the RIC at 10%, which is RIC A 2 A1 7.36% 10% . So, select A1.
(b) We can verify the same result by applying the NPW criterion.
PW (10%) A1 15, 000 $7,500( P / A,10%,3)
$3, 651
PW (10%) A 2 20, 000 $8, 000( P / F ,10%,1) $15, 000( P / F ,10%2)
$5, 000( P / F ,10%,3)
$3, 426
∴ Select Project A1.
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6.40 Incremental cash flows ( Model A – Model B):
n A–B
0 –$2,376
1 0
2 0
3 0
4 2,500
IRR A B 1.28%
∴ If MARR 1.28%, Model A is a preferred.
*
6.41
IRR for Model A: 6.01%, IRR for Model B: 7.25%
∴ The best decision is “do-nothing.”
6.42
(a) The least common multiple project lives = six years → analysis period six
years
Net Cash Flow
n
Project A Project B B–A
0 –$100 –$200 –100
1 60 120 60
2 50 150-200 –100
3 50–100 120 170
4 60 150-200 –110
5 50 120 70
6 50 150 100
Since the incremental cash flow series indicates a nonsimple investment, but it
is a pure incremental investment.
IRRB A 15.98% 15%
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∴ So, select Project B.
(b) Incremental analysis between C and D:
Net Cash Flow
n
Project C Project D C–D
0 –$4,000 –$2,000 –$2,000
1 2,410 1,400 1,010
2 2,930 1,720 1,210
∴ IRR C D 7.03% , Project D is preferred.
(c) Incremental analysis between E and F:
Net Cash Flow
n
Project E Project F F –E
0 –$2,000 –$3,000 –$1,000
1 3,700 2,500 –1,200
2 1,640 1,500 –140
∴No IRR, Project E dominates Project F. Select E.
6.43 Let A0 = current practice, A1 just-in-time system, A2 stocks less supply
system.
Comparison Between A0 and A1:
n A0 A1 A1 – A0
0 0 -$2,500,000 -$2,500,000
1-8 -5,000,000 -2,900,000 2,100,000
i* A1 A0 IRR A1 A0 83.34% 10%
∴ A1 is a better choice.
Comparison Between A1 and A2:
n A2 A1 A2 – A1
0 -$5,000,000 -$2,500,000 -$2,500,000
1-8 -1,400,000 -2,900,000 1,500,000
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i* A 2 A1 IRR A 2 A1 58.49% 10%
∴ A2 is a better choice. That means that the stockless supply system is the final
choice.
6.44
(a)
Project A vs. Project B
Net Cash Flow
n
Project A Project B B–A
0 –$1,000 –$1,000 0
1 900 600 -$300
2 500 500 0
3 100 500 400
4 50 100 50
∴ i* B A IRR B A 21.27% 12% , select B.
Project B vs. Project C
Net Cash Flow
n
Project B Project C C–B
0 –$1,000 –$2,000 –$1,000
1 600 900 300
2 500 900 400
3 500 900 400
4 100 900 800
∴ i*C B IRR C B 26.32% 12% , select C.
(b)
$1, 000 $300( P / A, i, 4)
i 7.71%
(c) Since borrowing rate of return (BRR) is less than MARR, Project D is
acceptable.
(d)
Net Cash Flow
n
Project C Project E C–E
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0 –$2,000 –$1,200 –$800
1 900 400 500
2 900 400 500
3 900 400 500
4 900 400 500
∴ i*C E IRR C E 50.23% 12% , select C.
6.45
(a)
i1* 85.08%, i2* 48.11%, and i3* 44.31%
(b)
Project 1 vs. Project 2:
n Project 1 Project 2 2–1
0 –$1,000 –$5,000 –$4,000
1 500 7,500 7,000
2 2,500 600 –1,900
This is a nonsimple incremental investment. So we need to compute RIC at
15%.
RIC21 33.69% 15%
∴ Select Project 2.
Project 2 vs. Project 3:
n Project 2 Project 3 2–3
0 -$5,000 -$2,000 -$3,000
1 7,500 1,500 6,000
2 600 2,000 -1,400
This is another nonsimple incremental investment, so we need to calculate
RIC on the incremental investment.
RIC23 59.42% 15%
∴ Again, select Project 2.
6.46
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(a) IRRB 25.99%
(b) PW (15%) A $10, 000 $5,500( P / A,15%,3) $2,558
(c) Incremental Analysis:
Net Cash Flow
n Project A Project B B–A
0 –$10,000 –$20,000 –$10,000
1 5,500 0 –5,500
2 5,500 0 –5,500
3 5,500 40,000 34,500
∴ Since IRR B A 24.24% 15%, select Project B.
6.47 Select Model C. Note that all three projects would be acceptable individually,
as each project’s IRR exceeds the MARR. The incremental IRR of Model (C –
B) is 40%, indicating that Model C is preferred over Model B at MARR = 12%.
Similarly, the incremental IRR of Model (C – A) is 15%, which exceeds the
MARR. Therefore, Model C is again preferred.
6.48 All projects would be acceptable because individual ROR exceed the MARR.
Based on the incremental analysis, we observe the following relationships:
IRR A 2 A1 10% 15% (Select A1)
IRR A3 A1 18% 15% (Select A3)
IRR A3 A 2 23% 15% (Select A3)
∴ Therefore, A3 is the best alternative.
6.49 From the incremental rate of return table, we can deduce the following
relationships:
IRR A 2 A1 9% 15% (Select A1)
IRR A3 A 2 42.8% 15% (Select A3)
IRR A 4 A3 0% 15% (Select A3)
IRR A5 A 4 20.2% 15% (Select A5)
IRR A6 A5 36.3% 15% (Select A6)
It is necessary to determine the preference relationship among A1, A3, and A6.
IRR A3 A1 16.66% 15% (Select A3)
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IRR A6 A3 20.18% 15% (Select A6)
IRR A6 A1 18.24% 15% (Select A6)
∴ A6 is the best alternative.
6.50 For each power saw model, we need to determine the incremental cash flows
over the “by-hand” operation that will result over a 20-year service life.
Power Saw
Category Model A Model B Model C
Investment cost $4,000 $6,000 $7,000
Salvage value $400 $600 $700
Annual labour savings $1,296 $1,725 $1,944
Annual power cost $400 $420 $480
Net annual savings $896 $1,305 $1,464
Net Cash Flow
n Model A Model B Model C
0 -$4,000 -$6,000 -$7,000
1 896 1,305 1,464
2 896 1,305 1,464
20 400+896 600+1,305 700+1,464
IRR 22.03% 21.35% 20.46%
PW(10%) $3,688 $5,199 $5,568
Model A vs. Model B:
PW (i ) B A $2, 000 $409( P / A, i, 20) $200( P / F , i, 20)
0
IRR B A 19.97% 10%
∴ Select Model B.
Model B vs. Model C:
PW (i )C B $1, 000 $159( P / A, i, 20) $100( P / F , i, 20)
0
IRR C B 15.03% 10%
∴ Select Model C.
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Unequal Service Lives
6.51 With the least common multiple of six project years,
Net Cash Flow
n Project A Project B B–A
0 -$100 -$200 -$100
1 60 120 60
2 50 150-200 -100
3 50-100 120 170
4 60 150-200 -110
5 50 120 70
6 50 150 100
Since the incremental cash flow series is a nonsimple investment, we may
abandon the IRR analysis and use the PW decision rule.
PW (15%) B A $100 $60( P / F ,15%,1)
$100( P / F ,15%, 6)
$3.48
Since PW (15%) B A 0, or PW (15%) B PW (15%) A , select Project B.
Comments: Even though the incremental flow is a nonsimple, it has a unique rate
of return. As shown in Problem 7.39, this incremental cash flow series will pass the
net investment test, indicating that the incremental cash flow is a pure investment.
IRR B A 15.98% 15%
6.52
(a) Since there is not much information given regarding the future replacement
options and the required service period, we may assume that the required
service period is indefinite and both projects can be repeated at the same cost
in the future.
(b) The analysis period may be chosen as the least common multiple of project
lives, which is three years.
n A2 – A1
0 -$5,000
1 0
2 0
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3 15,000
IRR A 2 A1 44.195%
∴ The MARR must be less than 44.195% for Project A1 to be preferred.
Short Case Studies
ST6.1
Option 1: Process device A lasts only four years. You have a required
service period of six years. If you take this option, you must consider how you
will satisfy the rest of the required service period at the end of the project life.
One option would subcontract the remaining work for the duration of the
remaining required service period. If you select this subcontracting option
along with Device A, the equivalent net present worth would be
PW (12%)1 $100, 000 $60, 000( P / A,12%, 4)
$10, 000( P / F ,12%, 4)
$100, 000( P / A,12%, 2)( P / F ,12%, 4)
$383, 292
Option 2: This option creates no problem because its service life coincides
with the required service period.
PW (12%) 2 $150, 000 $50, 000( P / A,12%, 6)
$30, 000( P / F ,12%, 6)
$340,371
Option 3: With the assumption that the subcontracting option would be
available over the next six years at the same cost, the equivalent present worth
would be
PW (12%)3 $100, 000( P / A,12%, 6)
$411,141
With the restricted assumptions above, Option 2 appears to be the best
alternative.
Notes to Instructors: This problem is deceptively simple. However, it can make
the problem interesting with the following embellishments.
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• If the required service period is changed from six years to five years, what would
be the best course of action?
• If there are price differentials in the subcontracting option (say, $55,000 a year for
a six-year contract, $60,000 for a five-year contract, $70,000 a year for a four-
year contract, and $75,000 a year for any contract lasting less than four years),
what would be the best option?
• If both Processes A and B would be available in the subsequent years, but the
required investment and salvage value would be increasing at the annual rate of
10%, what would be the best course of action?
• If both Device A and B will be available in the subsequent years, but the required
investment and salvage value (as well as the O & M costs) would be decreasing at
the annual rate of 10%, what would be the best course of action?
ST6.2
Note to Instructors: This case problem requires several pieces of information. (1)
No minimum attractive rate return figure is given for Northern Electric. (2) What
would be a typical number of accidents in line construction work? (3) How does a
typical electric utility handle the nesting problems? If there is some cleaning cost,
how much and how often?
First, we may calculate the equivalent present value (cost) for each option
without considering the accident costs and nesting problems.
Design Options
Factors Option 1 Option 2 Option 3 Option 4
Cross Arm Triangular Horizontal Stand Off
Line
Investment:
Construction cost $495,243 $396,813 $402,016 $398,000
Accident cost
Annual cost:
Flashover repair $6,000 $3,000 $3,000 $3,000
Cleaning nest
Annual savings:
Inventory 0 $4,521 $4,521 $4,521
Assume that Northern Electrics’ required rate of return would be 12%. The
equivalent present value cost for each option is as follows:
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PW (12%)1 $495, 243 $6, 000( P / A,12%, 20)
$540, 060
PW (12%)2 $396,813 $3, 000( P / A,12%, 20)
$4,521( P / A,12%, 20)
$385, 452
PW (12%)3 $402, 016 $3, 000( P / A,12%, 20)
$4,521( P / A,12%, 20)
$398, 654
PW (12%)4 $398, 000 $3, 000( P / A,12%, 20)
$4,521( P / A,12%, 20)
$386, 639
It appears that the triangular design configuration be the most
economical.
If we consider the potential accident costs ($65,000 per accident) during line
construction work, it is likely to change the outcome. If we expect only a
couple of accidents, Option 2 still appears to be the best. However, if you
expect more than three accidents, the conventional cross-arm design appears
to be more economical. If the nest cleaning cost were factored into the
analysis, the accident cost would be reduced to the extent of the annual
cleaning cost, indicating the preference of the triangular design.
ST6.3
This case problem appears to be a trivial decision problem as one alternative
(laser blanking method) dominates the other (conventional method). The
problem of this nature (from an engineer’s point of view) involves more
strategic planning issues than comparing the accounting data. We will first
calculate the unit cost under each production method. Since all operating costs
are already given in dollars per part, we need to convert the capital expenditure
into the required capital recovery cost per unit.
Conventional method:
CR (16%) $106, 480( A / P,16%,10)
$22, 031 per year
$22, 031
Unit capital recovery cost
3, 000
$7.34 per year
Laser blanking method:
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CR(16%) $83, 000( A / P,16%,10)
$17,173 per year
$17,173
Unit capital recovery cost
3, 000
$5.72 per part
Blanking Method
Description Conventional Laser
Steel cost/part $14.98 $8.19
Transportation cost/part $0.67 $0.42
Blanking cost/part $0.50 $0.40
Capital cost/part $7.34 $5.72
Total unit cost $23.49 $14.73
It appears that the window frame production by the laser blanking
technique would save about $8.76 for each part produced. If Ford decides
to make the window frame in house, the part cost would range between
$14.73 and $23.49, depending upon the blanking method adopted. If Ford
relies on an outside supplier, the subcontracting work should be in this
cost range. If Ford were producing the window frames by the conventional
method, the die investment had already been made. In this case, one of the
important issues is to address if it is worth switching to the laser blanking
this time or later. If Ford decides to go with the laser blanking, it will take
six months to reach the required production volume. What option should
Ford exercise to meet the production need during this start-up period?
ST6.4
Given: annual energy requirement 66 Gg of steam, net proceeds from
demolishing the old boiler unit $1, 000
Annual Energy Requirement 66 2.32 153.12 TJ
(a) Annual fuel costs for each alternative:
Alternative 1:
153,12 TJ
Weight of dry coal
(0.75)(33.24 MJ/kg)
6,142 tonnes
Annual fuel cost 6,142 125
= $7,67,750
Alternative 2:
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153.12 TJ(0.94)
Natural Gas cost 40¢ / m3 3
(0.78)(39 MJ/m )
= $1,892,608
153.12 TJ(0.06)
Heating Oil cost $86¢4 / L
(0.81)(38.6 MJ/L)
= $252,702
Annual fuel cost = $1,892,608 + $252,702
= $2,145,310
(b) Unit cost per steam kg:
Alternative 1: Assuming a zero salvage value of the investment
AEC (10%) ($1, 770,300 $100, 000
$1, 000)( A / P,10%, 20)
$767, 750
$10, 71,970
$10, 71,970
Unit cost $1.62 ¢/kg
66×106 kg
Alternative 2:
AEC (10%) ($889, 200 $1, 000)( A / P,10%, 20)
$2,145,310
$2, 249, 638
$2, 249, 638
Unit cost 3.41 ¢/kg
66×106 kg
(c) Select Alternative 1.
ST6.5
(a) Assumptions Required:
There is no information regarding the analysis period; we will assume that the
firm will be in business for an indefinite period.
There is no information regarding the future plastics technology options; we
will assume that the best one available will be the technology introduced n
months from now.
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6-39
We will assume that the annual revenue/costs are spread evenly throughout
the year.
(b) Investment Decision:
Present Worth Analysis: First we will determine the equivalent present worth for
each option, and its value at MARR = 15%
Option 1:
PW(i)1 = -10 + [15/12 – 6/12](P/A,i,96) + 1(P/F,i,96)
PW(i)1 = -10 + 0.75(P/A,i,96) + 1(P/F,i,96)
PW(1%)1 = -10 + 46.15 + 0.38 = $36.53 M
Option 2:
PW(i)2 = {(0.1n – 10) + [(15/12 – 0.15n) – (6/12 + 0.05n)](P/A,i,96-n) +
[1+0.05n](P/F,i,96-n)}(P/F,i,n) + [15/12 – 6/12](P/A,i,n)
PW(i)2 = {(0.1n – 10) + [0.75 – 0.2n](P/A,i,96-n) + [1+0.05n](P/F,i,96-
n)}(P/F,i,n)) + 0.75(P/A,i,n)
Although Option 1 (switching now) bestows a great present worth ($36.53 M), it
can be seen that the best time to retrofit would be to wait the full 96 months,
which would yield a PW of $48.22 M. The worst time to retrofit would be after
41 months (–$186.43 M).
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n PW n PW n PW n PW n PW n PW
1 $24.64 17 -$116.43 33 -$179.01 49 -$180.47 65 -$134.77 81 -$53.08
2 $13.14 18 -$122.44 34 -$180.73 50 -$178.86 66 -$130.61 82 -$47.00
3 $2.02 19 -$128.16 35 -$182.22 51 -$177.08 67 -$126.32 83 -$40.81
4 -$8.72 20 -$133.57 36 -$183.48 52 -$175.12 68 -$121.90 84 -$34.52
5 -$19.09 21 -$138.69 37 -$184.51 53 -$172.98 69 -$117.34 85 -$28.13
6 -$29.09 22 -$143.53 38 -$185.31 54 -$170.68 70 -$112.65 86 -$21.64
7 -$38.73 23 -$148.08 39 -$185.90 55 -$168.20 71 -$107.83 87 -$15.06
8 -$48.01 24 -$152.36 40 -$186.27 56 -$165.56 72 -$102.89 88 -$8.38
9 -$56.95 25 -$156.36 41 -$186.43 57 -$162.75 73 -$97.82 89 -$1.61
10 -$65.54 26 -$160.09 42 -$186.39 58 -$159.79 74 -$92.63 90 $5.25
11 -$73.79 27 -$163.56 43 -$186.13 59 -$156.67 75 -$87.32 91 $12.20
12 -$81.70 28 -$166.76 44 -$185.67 60 -$153.39 76 -$81.90 92 $19.24
13 -$89.29 29 -$169.71 45 -$185.02 61 -$149.96 77 -$76.36 93 $26.36
14 -$96.55 30 -$172.41 46 -$184.17 62 -$146.38 78 -$70.70 94 $33.57
15 -$103.49 31 -$174.85 47 -$183.12 63 -$142.65 79 -$64.94 95 $40.85
16 -$110.12 32 -$177.05 48 -$181.89 64 -$138.78 80 -$59.06 96 $48.22
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
6-41
ST6.6
(a) Assumptions Required:
There is no information regarding the expected cash flows from the current
operation if Chiller Cooling decides to defer the introduction of the
absorption technology for three years. Therefore, we need to make an
explicit assumption of the expected cash flows for the first three years if
Chiller Cooling decides to defer the decision. Assume that the annual cash
flow during this period would be X.
Another assumption we have to make is about the analysis period.
Assuming that the firm will be in business for an indefinite period, we also
need to make an explicit assumption regarding the future cooling technology.
Since there is no information about the future cooling technology options,
we may assume that the best cooling technology will be the absorption
technology that will be introduced three years from now. Therefore, if
Chiller Cooling decides to select Option 1, we could assume that, at the end
of eight years, Option 2 (the best cooling technology at that time) will be
adopted for an indefinite period.
(b) Investment Decision:
Present Worth Analysis: First, we will determine the equivalent present
worth for each option:
PW (i )1 $6 $9( P / A, i,8) $1( P / F , i,8)
[$5 $4( P / A, i,8) $2( P / F , i,8)]( A / P, i,8)
i
( P / F , i,8)
PW (i ) 2 X ( P / A, i,3)
[$5 $4( P / A, i,8) $2( P / F , i,8)]( A / P, i,8)
i
( P / F , i,3)
Now we can determine the value X that makes the two options economically
equivalent at an interest rate of 15%. In other words, if we evaluate the two
present worth functions at i 15% , we have
PW (15%)1 $41.31
PW (15%)2 2.2832 X $13.28
Letting PW (15%)1 PW (15%) 2 and solving for X gives
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
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X $12.28
As long as the current operation continues to generate annual net revenue of
$12.28 millions for three years, Option 2 is a better choice.
Rate of return analysis: The present worth analysis above indicates that, if
X $12.28 , the break-even rate of return on incremental investment is
i*1 2 15%
Therefore, the ultimate choice will depend on the level of annual revenues
generated during the first three years when the advanced cooling technology is
deferred. Clearly, if
X $12.28 , then i*1 2 15% , Option 1 is preferred.
ST6.7
n Current Pump(A) Larger Pump(B) B-A
0 $0 -$1,600,000 -$1,600,000
1 $10,000,000 $20,000,000 $10,000,000
2 $10,000,000 $0 -$10,000,000
IRR = 25%
400%
The incremental cash flows result in multiple rates of return (25% and 400%), so
we may abandon the rate of return analysis. Using the PW analysis,
PW (20%) $1.6 M $10 M ( P / F , 20%,1) $10 M ( P / F , 20%, 2)
$0.21 0
Reject the larger pump.
Return on Invested Capital:
PB (i, 20%)0 $1, 600, 000
PB(i, 20%)1 $1, 600, 000(1 i ) $10, 000, 000
8, 400, 000 1, 600, 000i
If i 525%, then PB(i, 20%)1 0 .
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
6-43
PB (i, 20%) 2 (8, 400, 000 1, 600, 000i)(1 0.20) $10, 000, 000
80, 000 1,920, 000i
0
i 4.17% 20%
If i 525%, then PB(i, 20%)1 0 , no RIC exists. So the RIC on the incremental
cash flows should be 4.17%, which indicates “Select a smaller pump.”
ST6.8
(a) Whenever you need to compare a set of mutually exclusive projects based
on the rate of return criterion, you should perform an incremental analysis.
In our example, the incremental cash flows would look like the following:
n B-A
0 -$10,000
1 +23,000
2 -13,200
This is a nonsimple investment with two rates of return.
i* B A 10% or 20%
We could abandon the IRR analysis and use the PW analysis to rank the
projects.
(b) If we plot the present worth as a function of interest rate, we will observe
the following:
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If MARR < 10% select Project A.
If 10% ≤ MARR 18.1%, select Project B.
If MARR > 18.1%, do nothing.
Return on Invested Capital: The true rate of return can be found as a function of
MARR.
Let i IRR and assume i 1.3
PB (i, MARR)0 $10, 000
PB(i, MARR)1 $10, 000(1 i ) $23, 000
$13, 000 10, 000i
PB(i, MARR) 2 ($13, 000 10, 000i)(1 MARR)
$13, 200
0
(Note that, if, i 1.3, there will be no feasible solution.) Rearranging the terms
in PB(i, MARR) 2 gives an expression of IRR as a function of MARR.
1.32
IRR 1.3
1 MARR
For example, at MARR 15%
IRR B A 15.3% 15%
∴ Project B (the higher cost investment) would be justified.
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7-1
Part 3
Analysis of Project Cash
Flows
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7-2
Chapter 7 Cost Concepts Relevant to Decision Making
Classifying Cost
7.1
Storage and material handling costs for raw materials: product cost (indirect
costs)
Gains or loss on disposal of factory equipment: period income (costs)
Lubricants for machinery and equipment used in production: product cost
(manufacturing overhead)
Depreciation of a factory building: product cost (manufacturing overhead)
Depreciation of manufacturing equipment: product cost (manufacturing
overhead)
Depreciation of the company president’s automobile: period cost
Leasehold costs for land on which factory buildings stand: period cost
Inspection costs of finished goods: product cost
Direct labour cost: product cost
Raw materials cost: product cost
Advertising expenses: period cost
Cost Behaviour
7.2 *
Wages paid to temporary workers: variable cost
Property taxes on factory building: fixed cost
Property taxes on administrative building: fixed cost
Sales commission: variable cost
Electricity for machinery and equipment in the plant: variable cost
Heat and air-conditioning for the plant: fixed cost
Salaries paid to design engineers: fixed cost
Regular maintenance on machinery and equipment: fixed cost
*
An asterisk next to a problem number indicates that the solution is available to students
on the Companion Website.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
7-3
Basic raw materials used in production: variable cost
Factory fire insurance: fixed cost
7.3
(a) 6
(b) 11
(c) 5, (Note: It is tempting to select “1,” but the graphs are drawn in cumulative
basis)
(d) 4
(e) 2
(f) 10
(g) 3
(h) 7
(i) 9
7.4
Output Level
Question
1,000 Units 2,000 Units
(a) Total manufacturing cost $98,000 $130,000
(b) Manufacturing cost per unit $98 $65
(c) Total variable costs $67,000 $104,000
(d) Total variable costs per unit $67 $52
(e) Total costs to be recovered $125,000 $162,000
Cost-Volume-Profit Relationships
7.5 *
(a) Total unit manufacturing costs if 30,000 units are produced: $21
Total mfg. costs $150, 000 $300, 000 $180, 000 $630, 000
Unit cost =$630, 000 / 30, 000 $21
(b) Total unit manufacturing costs if 40,000 units are produced: $20.33
Total mfg. costs $200, 000 $400, 000 $133,333 $80, 000 $813,333
Unit cost =$813,333 / 40, 000 $20.33
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7-4
(c) Break-even price with 30,000 units produced: $29.33
Total cost Mfg. cost + Selling & Admin
=$630,000+$250,000 $880, 000
Unit cost =$880, 000 / 30, 000 $29.33
7.6 *
(a) Break-even sales volume: $200,000
(b) Marginal contribution rate (MCR) = $20,000/$100,000 = 20%, which is
equivalent to the slope of the profit-loss function.
(c) Let R = break-even sales dollars; F = total fixed cost; V = variable cost per
unit; Q = sales price per unit
F F V V
R ; 1 0.2; 0.8;
1V MCR Q Q
Q
V V 1 0.8
1 1 1 0.1579;
0.95Q Q 0.95 0.95
$40, 000
R $253,333
0.1579
(d)
F 1.1F $44, 000
$44, 000
R $220, 000
0.2
(e)
V V
1 0.2; 0.8;
Q Q
1.06V
1 1 1.06(0.8) 0.1520;
Q
$40, 000
R $263,158
0.1520
(f)
$40, 000 $20, 000
$100, 000
0.2
7.7
(a) Total fixed cost to be recovered
(b) Sales volume & Profit/Loss
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7-5
(c) Profit = 0
(d) Profit per sales volume
(e) Break-even volume
7.8
(a)
No. Description No. Description
1. Profit (Loss) 6. Break even
2. Sales volume 7. Loss
3. Total manufacturing cost 8. Profit
4. Variable costs 9. Total revenue
5. Fixed costs 10. Marginal contribution
(b)
Unit Variable Contribution Fixed Net Income
Case Sales Margin per Unit
Sold Expenses Expenses (Loss)
A 9,000 $270,000 $162,000 $12 $90,000 $18,000
B 14,000 $350,000 $140,000 $15 $170,000 $40,000
C 20,000 $400,000 $280,000 $6 $85,000 $35,000
D 5,000 $100,000 $30,000 $14 $82,000 ($12,000)
Cost Concepts Relevant to Decision Making
7.9 Additional units ordered = 100
Labour cost = ($12)(5)(100) = $6,000
Material cost = ($14)(100) = $1,400
Overhead cost = (50%) ($6,000) = $3,000
Total cost = $6,000 + $1,400 + $3,000 = $10,400
Profit = (30%) ($10,400) = $3,120
∴ Unit price to quote = $10,400 + $3,120 = $13,520
7.10
(a) Product mix that must satisfy: A:B = 4:3, or 4B = 3A (or B = 0.75A)
Break-even formula: Total revenue = Total cost: 10A + 12(0.75)A = 5A +
10(0.75)A + 2,600; 6.5A = 2,600; A = 400 units and B = 300 units
(b) 10A + 12A = 5A + 10A + 2,600; A = 371.43 units
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
7-6
(c) Compute the marginal contribution rate (MCR) for each product: Product A =
$5, Product B= $2; with the assumption (A > 0 and B > 0), more preference
should be given to Product A
(d) Product A: MCR = $5 per unit; Production time = 0.5 hour per unit; profit per
hour = $10
Product B: MCR = $2 per unit; Production time = 0.25 hour per unit; profit
per hour = $8
Conclusion: Product A is more profitable, so it should be pushed first.
7.11
(a) Incremental cost
In-house O utscoring
Description O ption O ption
Soldering operation $4.80
Direct m aterials $7.50 $6.00
Direct labor $5.00 $4.25
M fg. O v erhead $4.00 $3.40
Fixed cost $0.20 $0.20
Unit cost $16.70 $18.65
The outsourcing option would cost $1.95 more for each unit. Note that the
fixed cost of $20,000 (or $0.20 per unit based on 100,000 production
volume) remains unchanged under either option.
(b) Break-even price = $4.80 - $1.95 = $2.85 per unit
Short Case Studies
ST 7.1
(a) Break-even volume:
six-day operation: capacity → 270 tonnes/day, 6 days, Q = $270/tonne
F = ($4,200)(6 days) = $25,200, V = [$7.56+($0.16)(1.2)(1000)] =
$199.56/tonne
F NV NQ
F $25, 200
Nb 357.75 tonnes
Q V $270 $199.56
seven-day operation: capacity → 270 tonnes/day, 7 days, Q = $270/tonne
F = ($4,200)(6 days) + $420 = $29,820,
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7-7
V = [$7.56(6/7) + $15.12(1/7) + ($0.16)(1.2)(1000)] = $200.64/tonne
F NV NQ
F $29,820
Nb 429.93 tonnes
Q V $270 $200.64
(b)
six-day operation:
V 199.56
MCR 1 1 0.2609
Q 270
seven-day operation:
V 200.64
MCR 1 1 0.2569
Q 270
(c)
$25, 200
Average total cost per tonne = $199.56 $215.12 / tonne
(270)(6)
Net profit margin before taxes = Sales – Costs = $270 – $215.12 =
$54.88/tonne
(d)
$420
Sunday profit margin = $270 [ $192 $15.12] $61.32 0
270
Yes, it could be economical for the mill to operate on Sunday. The incremental
profit margin for the seven-day operation is less than the six-day operation.
Although Sunday operation is not as profitable due to the increased labour and
fixed cost, the overall MCR is still positive.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
8-1
Chapter 8 Depreciation
Book Depreciation Methods
8.1 $45,000 – 2 × (45,000 – 5,000)/4 = $25,000
8.2 d = (1/4) × 2 = 0.5, D2 = 45,000(1 – 0.5) × 0.5 = $11,250
8.3 SOYD = 1 + 2 + 3 + 4 = 10; D1 = (4/10) × (45,000 – 5,000) = $16,000; D2 =
(3/10) × (40,000) = $12,000; B2 = 45,000 – 16,000 – 12,000 = $17,000
CCA or UCC Calculation
8.4 d = 0.2; Un = 30,000 × (1 – 0.2/2) × (1 – 0.2)n – 1 = 11,059; (n – 1) × ln(0.8) =
ln(0.4096); n = 5 years
Economic Depreciation
8.5 economic depreciation = $5,000 – $2,300 = $2,700
Cost Basis
8.6 Cost basis for flexible manufacturing cells:
Flexible manufacturing cells ($500,000 × 3) $1,500,000
Freight charges 25,000
Handling fee 12,000
Site preparation costs 35,000
Start-up and testing costs 18,000
Special wiring and material costs 1,500
Cost basis $1,591,500
(Note: Start-up and testing costs = $15 × 40 × 6 × 5 = $18,000)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
8-2
CCA or UCC Calculation
8.7 CCA Class 1 (d = 4%)
Year CCA UCC
0 $375,000
1 $7,500 367,500
2 14,700 352,800
3 14,112 338,688
4 13,548 325,140
5 13,005 312,135
Cost Basis
8.8 Trade-in allowance:
Old drill press (book value) $25,000
Less: Trade-in allowance 20,000
Unrecognized loss ($5,000)
Cost of new drill 95,000
Plus: Unrecognized loss on trade-in 5,000
Cost basis of new drill $100,000
Comments: If the old drill was sold on the market (instead of trade-in), there
would be no unrecognized loss. In that situation, the cost basis for the new drill
will be just $95,000.
8.9 Trade-in allowance:
Old lift-truck (book value) $6,000
Less: Trade-in allowance 10,000
Unrecognized gains ($4,000)
Cost of new lift-truck 35,000
Less: Unrecognized gains on trade-in 4,000
Cost basis of new truck $31,000
Comments: If the old truck was sold on the market (instead of trade-in), there
would be no unrecognized gains. In that situation, the cost basis for the new
truck will be just $35,000.
Book Depreciation Methods
8.10 d = (1/8) × 2.0 = 0.25; D3 = 0.25 × 150,000 × (1 – 0.25)2 = $21,094
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8-3
*
8.11
Given: Ρ = $60,000, S = $5,000, Ν = 8 years
DDB SL from Yr Dep’n With BV With
Annual Switching to Switching to
n Dep’n Book Value n to 8 SL SL
1 $15,000 $45,000 $6,875 $15,000 $45,000
2 $11,250 $33,750 $5,714 $11,250 $33,750
3 $8,438 $25,313 $4,792 $8,438 $25,313
4 $6,328 $18,984 $4,063 $6,328 $18,984
5 $4,746 $14,238 $3,496 $4,746 $14,238
6 $3,560 $10,679 $3,079 $3,560 $10,679
7 $2,670 $8,009 $2,839 $2,839 $7,839
8 $2,002 $6,007 $3,009 $2,839 $5,000
5(5 1)
8.12 (a) SOYD 15
2
(b) D1 = ($12,000 – $2,000) × (5/15) = $3,333
(c) The depreciation amounts in the first four years are (5/15), (4/15), (3/15),
and (2/15) respectively, for a total of (14/15). Therefore the total depreciation
for these four years is $10,000*(14/15) = $9,333. Therefore, B4 = $12,000-
$9,333 = $2,667.
Units-of-Production Method
8.13 Allowed depreciation amount
D = ($0.32)(55,000) = $17,600
$60, 000 $8, 000
8.14 D5,000hours (5, 000) $5, 200
50, 000
CCA or UCC Calculation
8.15
(a) Capital cost: $180,000 + $35,000 = $215,000
*
An asterisk next to a problem number indicates that the solution is available to students
on the Companion Website.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
8-4
Year CCA UCC
0 $215,000
1 $32,250 182,750
2 54,825 127,925
3 38,378 89,548
4 26,864 62,683
5 18,805 43,878
6 13,163 30,715
7 9,214 21,500
8 6,450 15,050
9 4,515 10,535
10 3,161 7,375
11 2,212 5,162
12 1,549 3,614
MACRS Depreciation
*
8.16
Given: I = $20,000, tax depreciation method = six-year MACRS property class
with half-year convention
200% DB SL MACRS
n Bn–1 Dn life Dn Dn
1 $20,000 $3,333 $3,333
2 $16,667 $5,556 5.5 $3,030 $5,556
3 $11,111 $3,704 4.5 $2,469 $3,704
4 $7,407 $2,649 3.5 $2,116 $2,649
5 $4,938 $1,646 2.5 $1,975 $1,975
6 $3,292 $549 1.5 $1,975 $1,975
7 0.5 $988
: Optimal time to switch
CCA or UCC Calculation
*
8.17
For Class 43, d = 30%
Year CCA UCC
0 $68,000
1 $10,200 57,800
2 17,340 40,460
3 12,138 28,322
4 8,497 19,825
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
8-5
5 5,948 13,878
8.18 This non-systems software belongs in Class 12 (see Table 8.1) with d = 100%.
It is subject to the 50% rule since it is NOT exempt (see Section 8.4.4).
Year CCA UCC
0 $10,000
1 $5,000 5,000
2 5,000 0
3 0 0
4 0 0
Cost Basis
8.19
Total property value with the warehouse:
Land Building
Original cost $65,000 $35,000
Adjustments to basis 35,000
Add: New warehouse 50,000
Demolition expense 5,000
Subtract: Building loss (35,000)
Adjusted cost basis $100,000 $55,000
Total value = $100,000 + $5,000 + $50,000 = $155,000
Note that the old house that was demolished has no value. This loss may be
deductible for tax purposes, but this should not be added to the cost basis of the
new asset for book depreciation. In general, the property’s entire basis is
allocated to the land only, if the company intends to demolish the building
when they acquire the property for business use. Then the cost basis is
increased by the net cost of demolition. (The demolition can be treated as a site
preparation expense.)
• Cost basis for book depreciation:
Cost basis = $5,000 + $50,000 = $55,000
Book Depreciation Methods
8.20 Depreciation allowances and book values: (a) depreciation rate = 1/N = 1/5 for
SL, (b) depreciation rate = 1/5 =20% for DB, (c) SOYD =15
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
8-6
SL DB SOYD
n Dn Bn Dn Bn Dn Bn
1 $18,000 $82,000 $20,000 $80,000 $30,000 $70,000
2 18,000 64,000 16,000 64,000 24,000 46,000
3 18,000 46,000 12,800 51,200 18,000 28,000
4 18,000 28,000 10,240 40,960 12,000 16,000
5 18,000 10,000 8,192 32,768 6,000 10,000
*
8.21
d = 1/7; SL calculated from period n to N, switch to straight-line when D(SL) >
D(DB).
n D(DB) D(SL) Β
0 $30,000
1 4,286* $3,143 25,714
2 3,673* 2,952 22,041
3 3,149* 2,808 18,892
4 2,699 2,723* 16,169
5 2,310 2,723* 13,446
6 1,921 2,723* 10,723
7 1,532 2,723* 8,000
*amount claimed in year n
8.22 Given: Ρ = $80,000, S = $22,000, Ν = 6 years
(a) D1 = $26,667, D2 = $17,778, D3 = $11,852
(b) DDB switching to SL
n Dn Bn
1 $26,667 $53,333
2 17,778 35,556
3 11,852 23,704
4 1, 704 22,000
5 0 22,000
6 0 22,000
Comments: If the regular DDB deduction is taken during the fourth year, B4
would be less than the salvage value. Therefore, it is necessary to adjust D4.
The number in the box represents the adjusted value.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
8-7
*
8.23
Given: Ρ = $20,000, Ν = 5 years, S = $3,000
n SL DDB SOYD
1 $3,400 $8,000 $5,667
2 3,400 4,800 4,533
3 3,400 2,880 3,400
4 3,400 1,320 2,267
5 3,400 0 1,133
8.24 Given: Ρ = $58,000, S = $8,000, N = 12 years
($58, 000 $8, 000)
(a) D $4,167
12
(b) D3 = $6,713
(c) D2 = $7,051
Units-of-Production Method
8.25
Truck A:
25, 000
D ($50, 000 $5, 000) $5, 625
200, 000
Truck Β:
12, 000
D ($25, 000 $2,500) $2, 250
120, 000
Truck C:
15, 000
D ($18,500 $1,500) $2,550
100, 000
Truck D:
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
8-8
20, 000
D ($35, 600 $3,500) $3, 210
200, 000
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
8-9
CCA or UCC Calculation
*
8.26
Given: Ρ = $32,000, S = $5,000, Ν = 8 years
n D(book) CCA
1 $3,375 $4,800
2 3,375 8,160
3 3,375 5,712
4 3,375 3,998
5 3,375 2,799
6 3,375 1,959
7 3,375 1,371
8 3,375 960
8.27 CCA Class 1 for buildings (d = 4%); 50% rule applies
(a) CCA1 = (0.04/2) × 120,000 = $2,400 (Note: The land is not depreciable.)
(b) UCC4 = 120,000 × (1 – 0.04/2)(1 – 0.04)4 – 1 = $104,045
8.28 The spindle machine became available for use on “the second taxation year
after the date the property was acquired,” which is 2008. Since the spindle
machine became available for use more than 358 days after acquisition, it is
exempt from the 50% rule. Class 43: d = 30%
n CCAn UCCn
2006 $34,000
2008 $10,200 23,800
2009 7,140 16,660
2010 4,998 11,662
2011 3,499 8,163
2012 2,449 5,714
8.29 For Book depreciation: d = 1/6; D6 = 7,500(1 – 1/6)6 = $2,512
For Tax depreciation: d = 20%, 50% rule applies
CCA6 = 7,500 × 0.20 × (1 – 0.2/2)(1 – 0.2)4 = $553
UCC6 = 7,500 × (1 – 0.2/2)(1 – 0.2)5 = $2,219
8.30
Book depreciation:
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
8-10
Asset Type
Year Lathe Truck Building Photocopier
1 $7,500 $2,530 $14,000 $13,333
2 6,250 2,875 14,000 10,666
(a) Tax depreciation: All four assets are subject to 50% rule
Asset Type
Year Lathe Truck Building Photocopier
1 $6,750 $3,750 $16,000 $4,000
2 11,475 6,375 31,360 7,200
(b) Book depreciation for lathe:
n Dn n Dn
1 $7,500 7 $2,512
2 6,250 8 2,093
3 5,208 9 1,866
4 4,340 10 1,866
5 3,617 11 1,866
6 3,014 12 1,866
*
8.31
Type of Asset I II III IV
Dep. methods SL DDB SOYD UP
End of year 7 4 3 3
Initial cost ($) 10,000 18,000 90, 000 30,000
Salvage value ($) 2,000 2,000 7,000 0
Book value ($) 3,000 2,320 23, 600 15, 000
Depreciable life 8 years 5 years 5 years 90,000 km
Dep. amount ($) 1, 000 1,555 16,600 5, 000
Accum. Dep. (S) 7, 000 15,680 66,400 15, 000
8.32
Given: Ρ = $147,000, Ν = 10 years, S = $27,000, units produced = 250,000,
working hours = 30,000 hrs
(a) Straight-Line
$147, 000 $27, 000
D2009 $12, 000
10
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
8-11
(b) Units-of-Production Method
23, 450
D2009 ($147, 000 $27, 000) $11, 256
250, 000
(c) Working Hours
2, 450
D2009 ($120, 000) $9,800
30, 000
(d) Sum-Of-the-Year’s-Digits
10
D2009 ($147, 000 $27, 000) $21,818
55
(e) Declining Balance
1
D2009 ($147, 000) $14, 700
10
(f) Double Declining Balance
2
D2009 ($147, 000) $29, 400
10
8.33 All of these assets are subject to the 50% rule. CCA may be claimed starting in
the year when each asset becomes available for use.
Car Arc Welder Freezer
Capital cost $15,000 $12,000 $8,000
Available-for-use 2005 2005 2006
CCA Class 10 43 8
DB rate d = 30% d = 30% d = 20%
2005 $2,250 $1,800
2006 3,825 3,060 $800
2007 2,678 2,142 1,440
2008 1,874 1,499 1,152
2009 1,312 1,050 922
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8-12
8.34 Class 16: CCA rate = 40%; 50% rule applies
CCA - Schedule 8 Column Labels
2 3 5 6 7 8 12 13
UUC UCC 50% Reduced UCC
Yr Start Acquisitions Dispositions (unreduced) rule UCC CCA End
1 $0 $296,000 $0 $296,000 $148,000 $148,000 $59,200 $236,800
2 $236,800 $54,000 $0 $290,800 $27,000 $263,800 $105,520 $185,280
3 $185,280 $142,000 $58,000 $269,280 $42,000 $227,280 $90,912 $178,368
4 $178,368 $0 $32,000 $146,368 $0 $146,368 $58,547 $87,821
8.35
Depreciation Method
A SOYD
Β DDB
C CCA
D DDB with conversion to SL
MACRS Depreciation
8.36 Let P denote the cost basis for the equipment.
B3 P ( D1 D2 D3 ) P
P (0.1428 0.2449 0.1749) P
P 0.5626 P
0.4374($145, 000)
$63, 423
Revisions to Depreciable Property
8.37 Referring to Example 8.11, we must calculate the prorated portion, which is the
lesser of:
(a) one fifth of the capital cost: $22,000/5 = $4,400
or (b) the number, N, of 12-month periods from the start of the year when the
improvement was made to the end of the original lease = 7 (Note: Lease
renewal is not applicable.)
(Capital cost)/N – $22,000/7 = $3,142
The lesser of these is $3,143, with only half claimable in the first year. The
allowable CCA for the first three years after the leasehold improvement:
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8-13
CCA1 = $1,571 CCA2 = $3,142 CCA3 = $3,142
8.38
(a) D = ($1,200,000 – $400,000)/ 25 = $32,000/year
(b) B = $400,000 + $125,000 = $525,000
(c) Original estimate of depreciable life: ($1,200,000 – $0)/N = $32,000
Ν = 37.5 years
Remaining years after repairs = (37.5 – 25) + 10 = 22.5 years
Depreciation over the coming year: D = $525,000/22.5 = $23,333
8.39
(a) Book depreciation amount for 2011:
B2009 $140,000 3($14,000)
$98,000
revised depreciation basis $98, 000 $25, 000
$123, 000
revised useful life 12 years
D2011 $123, 000 /12 $10, 250
(b) Class 43: CCA rate = 30%
Moulding Machine Overhaul
Year CCA UCC CCA UCC Total CCA
$140,000
2006 $21,000 119,000 $21,000
2007 35,700 83,300 35,700
2008 24,990 58,310 $25,000 24,990
2009 17,493 40,817 $3,750 21,250 21,243
2010 12,245 28,572 6,375 14,875 18,620
2011 8,572 20,000 4,463 10,413 13,034
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
8-14
Short Case Studies
ST 8.1
CCA – Schedule 8 Column Labels
2 3 5 6 7 8 9 12 13
YEAR 1 UUC UCC 50% Reduced CCA UCC
Class Start Acquisitions Dispositions (unreduced) rule UCC Rate CCA End
8 $0 $7,000 $0 $7,000 $3,500 $3,500 20% $700 $6,300
10 $0 $13,000 $0 $13,000 $6,500 $6,500 30% $1,950 $11,050
12 $0 $3,200 $0 $3,200 $1,600 $1,600 100% $1,600 $1,600
50 $0 $3,500 $0 $3,500 $1,750 $1,750 55% $963 $2,538
TOTAL = $5,213
YEAR 2
8 $6,300 $0 $0 $6,300 $0 $6,300 20% $1,260 $5,040
10 $11,050 $0 $0 $11,050 $0 $11,050 30% $3,315 $7,735
12 $1,600 $1,000 $0 $2,600 $500 $2,100 100% $2,100 $500
50 $2,538 $4,000 $0 $6,538 $2,000 $4,538 55% $2,496 $4,042
TOTAL = $9,171
YEAR 3
8 $5,040 $2,500 $1,000 $6,540 $750 $5,790 20% $1,158 $5,382
10 $7,735 $20,000 $6,000 $21,735 $7,000 $14,735 30% $4,421 $17,315
12 $500 $0 $0 $500 $0 $500 100% $500 $0
50 $4,042 $0 $0 $4,042 $0 $4,042 55% $2,223 $1,819
TOTAL = $8,302
YEAR 4
8 $5,382 $0 $0 $5,382 $0 $5,382 20% $1,076 $4,306
10 $17,315 $0 $0 $17,315 $0 $17,315 30% $5,194 $12,120
12 $0 $0 $0 $0 $0 $0 100% $0 $0
50 $1,819 $2,000 $500 $3,319 $750 $2,569 55% $1,413 $1,906
TOTAL = $7,684
ST 8.2
(a) Book depreciation schedule: SL depreciation rate = ($79,500 – $4,500)/12
= $6,250 each year (including 2008)
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8-15
(b) Cost basis = $79,500; Class 43 CCA rate = 30%
n CCAn UCCn
2005 $11,925 $67,575
2006 20,273 47,303
2007 14,191 33,112
2008 9,934 23,178
Comments: The accessories costing $2,000 that were incurred in 2007 do
not change the depreciation schedule. This type of regular maintenance gets
treated as current expenses.
ST 8.3 Given: P = $63,000 + $2,000 = $65,000, N = 10 years, and S = $4,000
Book depreciation expense for 2004:
$65, 000 $4, 000
D2004 $6,100
10
Year Dn Bn
2004 $6,100 $58,900
2005 $6,100 $52,800
new depreciation basis $52,800 $6, 000 $58,800
remaining useful life 11years
salvage value $4, 000
Book depreciation expense for 2006:
$58,800 $4, 000
D2006 $4,982
11
B2006 $58,800 $4,982 $53,818
new depreciation basis $53,818 $3, 000 $56,818
remaining useful life 10 years
salvage value $6, 000
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
8-16
Book depreciation expense for 2007:
$56,818 $6, 000
D2007 $5, 082
10
B2007 $56,818 $5, 082 $51, 736
Comments: Whenever any repairs or improvements increase the value of
the asset (increased salvage value) or extend the life of the asset, these costs
should be a part of the depreciation basis.
ST 8.4
(a) Book depreciation methods:
Straight-line method:
Cumulative
n Dn Bn Dn
1 $12,000 $53,000 $12,000
2 12,000 41,000 24,000
3 12,000 29,000 36,000
4 12,000 17,000 48,000
5 12,000 5,000 60,000
DDB method:
Cumulative
n Dn Bn Dn
1 $26,000 $39,000 $26,000
2 15,600 23,400 41,600
3 9,360 14,040 50,960
4 5,616 8,424 56,576
5 3,424 5,000 60,000
SOYD method:
Cumulative
n Dn Bn Dn
1 $20,000 $45,000 $20,000
2 16,000 29,000 36,000
3 12,000 17,000 48,000
4 8,000 9,000 56,000
5 4,000 5,000 60,000
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8-17
(b) Class 43 CCA rate = 30%
n CCAn UCCn
0 $65,000
1 $9,750 55,250
2 16,575 38,675
3 11,603 27,073
4 8,122 18,951
5 5,685 13,266
(c) Since we don't have the market value after three years, we may assume
that the salvage value equals the trade-in value.
CCA4 = (UCC3 – sales + purchases/2)*d
= (27,073 – 10,000 + 82,000/2)*0.3
= 17,422
UCC4 = UCC3 – CCA4 = 27,073 – 17,422 = $9,651
ST 8.5 No solution provided; see Canada Revenue Agency website
www.cra-arc.gc.ca for Canada Customs and Revenue Agency
Interpretation Bulletins.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
9-1
Chapter 9 Corporate Income Taxes
Note: Unless otherwise specified, tax rates from Tables 9.1 and 9.2 are used in the
solutions.
Corporate Income Taxes
9.1 (b)
Gains, Losses, Disposal Tax Effect
9.2 UCC with 50% rule = 0.85(0.7)4$50,000 = $10,204
Corporate Income Taxes
9.3 Taxable income = $200,000 – $84,000 – $4,000 = $112,000; net income =
(1 – 0.30)$112,000 = $78,400
9.4 Net cash generated = $78,400 + $4,000 = $82,400
9.5 Since all of these expenses are tax deductible, both companies have the same
taxable income of $240,000.
9.6
(a) Taxable income:
$2,500,000 – $1,280,000 – $128,000 = $1,092,000
(b) Income tax calculation using data from Tables 9.1 and 9.2 (Saskatchewan):
Combined small business tax rate on $400,000 taxable income = 11.0% +
4.5% = 15.5%
Combined manufacturing tax rate on remaining $692,000 = 19.5% + 10% =
29.5%
Income taxes = 0.155($400,000) + 0.295($692,000) = $266,140
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
9-2
Gains, Losses, Disposal Tax Effect
*
9.7
(a) Disposed of in year 3:
UCC 2 0.85(0.70) 2 $60, 000
$24,990
loss $20, 000 $24,990
($4,990)
(b) Disposed of in year 5:
UCC 4 0.85(0.70) 4 $60, 000
$12, 245
loss $10, 000 $12, 245
($2, 245)
(c) Disposed of in year 6:
UCC5 0.85(0.70)5 $60, 000
$8,571
loss $5, 000 $8,571
($3,571)
*
9.8
UCC 4 0.85(0.70) 4 $300, 000
$61, 225
(a) If sold at $10,000:
loss $10, 000 $61, 225
($51, 225)
disposal tax effect $51, 225(0.34)
$17, 416
*
An asterisk next to a problem number indicates that the solution is available to students
on the Companion Website.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
9-3
(b) If sold at $125,460:
gain $125, 460 $61, 225
$64, 235
disposal tax effect $64, 235(0.34)
$21,839
(c) If sold at $200,000:
gain $200, 000 $61, 225
$138, 775
disposal tax effect $138, 775
$47,183
9.9
(a) Taxable operating income:
Gross revenue $ 1,250,000
Expenses:
Labour 350,000
Material 185,000
CCA 32,500
Rental 57,200
Taxable income 625,300
(b) Taxable gains:
$23,000 – $20,000 = $3,000
(c) Total taxes:
Alberta-based small business combined tax rate = 11.0% + 3.0% = 14.0%
Alberta-based nonmanufacturing combined tax rate = 19.5% + 10% = 29.5%
income taxes 0.14 $400, 000 0.295 225,300 tax on gains
$122, 464 0.295 $3, 000 $123,349
(d) Disposal tax effect:
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
9-4
–(0.295)($3,000) = –$885
9.10 Given: Ρ = $50,000, Ν = 10 years, S = $1,000
(a) SL depreciation:
$50,000 $1,000
D $4,900
10
B2011 $35,300 3($4,900) $35, 400
(b) DDB method:
D2011 = $6,400
(c) Optimal time to switch: in year 7
(d) SOYD
45
D2014 ($50, 000 $1, 000) $40, 091
55
(e) Taxable gain:
UCC3 $0.85(0.70)3 ($50, 000)
$14,578
disposal tax effect $0.35(14,578 $30, 000)
$5,398
Incremental & Marginal Tax Rates
9.11
(a) Marginal tax rates:
Existing taxable income already exceeds small business maximum of
$400,000 (small business tax rate = 11.0% + 5.5% = 16.5%). Therefore,
marginal tax rates before and after venture = 19.5% + 14.0 % = 33.5%
(b) Average tax rates:
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
9-5
Without the project = ($400,000/$450,000) × 16.5% + ($50,000/$450,000) ×
33.5% = 18.39%
With the project = ($400,000/$600,000) × 16.5% + ($150,000/$600,000) ×
33.5% = 19.38%
9.12 Marginal tax rate = Average tax rate = 33.5%
9.13
(a) Economic depreciation for the milling machine:
$200,000 – $30,000 = $170,000
(b) Marginal tax rates with the project (assume O&M costs are unchanged):
Marginal tax rate Combined manufacturing tax rate
19.5% 13.0% 32.5%
(c) Average tax rate:
Small business rate on first $400,000 = 11.0% + 5.0% = 16.0%
Combined
Project Taxable Taxable
n Revenue CCAn Income Income
1 $80,000 $30,000 $50,000 $520,000
2 80,000 51,000 29,000 499,000
3 80,000 35,700 44,300 514,300
4 80,000 24,990 55,010 525,010
5 80,000 17,493 62,507 532,507
6 80,000 12,245 67,755 537,755
Combined Combined Average
Taxable Income Tax
n Income Taxes Rate
1 $520,000 $103,000 19.81%
2 499,000 96,175 19.27%
3 514,300 101,148 19.67%
4 525,010 104,628 19.93%
5 532,507 107,065 20.11%
6 537,755 108,770 20.23%
9.14 Incremental tax rate calculation:
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
9-6
Combined small business tax rate for Alberta = 11.0% + 3.0% = 14.0%
Combined nonmanufacturing tax rate for Alberta =19.5% + 10.0% =
29.5%
Year 1 Year 2
Revenue $200,000 $200,000
Operating costs 100,000 100,000
CCA 7,500 12,750
Taxable income $92,500 $87,250
Year 1 Year 2
Taxable income without project $350,000 $350,000
Income taxes @ 14.0% 49,000 49,000
Taxable income with project 442,500 437,250
Income taxes @ 14.0% on first
$400,000 and 29.5% thereafter 68,538 66,989
Incremental taxable income 92,500 87,250
Incremental income taxes 19,538 17,989
Incremental tax rate 21.1% 20.6%
9.15 (a) and (b) B.C. combined manufacturing tax rate = 19.5% + 11.5% = 31.0%
Economic Condition
Taxable Income Good Fair Poor
before expansion $2,000,000 $2,000,000 $2,000,000
due to expansion 2,000,000 500,000 (100,000)
after expansion 4,000,000 2,500,000 1,900,000
Income taxes $1,544,800 $965,500 $733,780
Marginal tax rate 31.0% 31.0% 31.0%
Incremental tax rate 31.0% 31.0% 31.0%
Average tax rate 31.0% 31.0% 31.0%
Comments: Note that all tax rates over the project life remain unchanged
because there is no small business deduction with a public company.
9.16 Taxable income from project during year 1:
Combined small business tax rate in Quebec = 11.0% + 8.0% = 19.0%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
9-7
CCA1 0.15($100, 000)
$15, 000
taxable income $50, 000 $15, 000
$35, 000
(a) Increment in income tax due to the project during year 1:
Without With Project
Project Project Alone
Taxable income $95,000 $130,000 $35,000
Income taxes 18,050 24,700 ?
increment in income taxes = $24,700 – $18,050 = $6, 650
(b) Incremental tax rate:
$6,650/$35,000 = 19.0%
The marginal tax rate is 19.0% also.
9.17 Incremental tax calculations:
(a) Additional taxable income due to project:
Year
1 2 3
Annual revenue $80,000 $80,000 $80,000
Operating cost 20,000 20,000 20,000
CCA 7,500 12,750 8,925
Taxable income $52,500 $47,250 $51,075
(b) Additional income tax calculation:
Combined small business tax rate for Ontario = 16.5%
Combined manufacturing tax rate for Ontario = 31.5%
Year 1 Without With Project
Project Project Alone
Taxable income $ 500,000 $ 552,500 $ 52,500
income taxes 97,500 114,038 16,538
Year 2 Without With Project
Project Project Alone
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
9-8
Taxable income 500,000 547,250 47,250
income taxes 97,500 112,384 14,884
Year 3 Without With Project
Project Project Alone
Taxable income 500,000 551,075 51,075
income taxes 97,500 113,589 16,089
(c) Capital gain taxes:
UCC 0.85(0.70) 2 $50, 000
$20,825
disposal tax effect 0.315($20,825 $10, 000)
$3, 410
9.18 (a) and (b):
Property
n Un–1 Taxes
1 $3,500,000 $42,000
2 2,975,000 35,700
3 2,082,500 24,990
4 1,457,750 17,493
5 1,020,425 12,245
6 714,297 8,572
7 500,008 6,000
8 350,005 4,200
Total $151,200
Investment Tax Credits
9.19
Year 1: Building: eligible for 10% ITC (Atlantic Provinces)
ITC1 (bldg) = 0.10 × $3,500,000 = $350,000
CCA1(bldg@4%) = ½ (0.04) × $3,500,000 = $70,000
UCC1(bldg) = $3,430,000
Equipment: SR&ED investment eligible for ITCs as a CPCC
Calculate the Expenditure Limit (EL) based on the previous year’s
taxable income to determine the ITC rate:
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
9-9
EL = $3,000,000 – 10×($525,000–$400,000) = $1,750,000
ITC1 (equip) = 0.35 × $1,750,000 + 0.20 × $1,250,000 =
$862,500
CCA1(equip@20%) = ½ (0.20) × $1,750,000 = $175,000
UCC1(equip) = $1,575,000
Net Effect in the First Year:
The taxable income is lowered by the sum of the two CCA
amounts: $245,000
The sum of the two ITC amounts can be deducted from taxes
owing: $1,212,500
Year 2: Building: The beginning UCC must be lowered by the year 1 ITC:
CCA2(bldg@4%) = (0.04) × ($3,430,000–$350,000)= $123,200
UCC2(bldg) = $3,430,000–$350,000–$123,200 = $2,956,800
Equipment: The beginning UCC must be lowered by the year 1
ITC:
CCA2(equip@20%) = (0.20) × ($1,575,000–$862,500)=
$142,500
UCC2(equip) = $1,575,000–$862,500–$142,500 = $570,000
Net Effect in the Second Year:
The taxable income is lowered by the sum of the two CCA
amounts: $265,700
9.20 Total planned expenditures = $975,000
Maximum amount eligible for ITC = 20 spaces × $40,000/space = $800,000
The company applies the maximum credit to the asset with the higher CCA
rate (the furnishings) to get the maximum benefit:
ITC(furnishings) = 0.25 × $75,000 = $18,750
ITC(building) = 0.25 × $725,000 = $181,250
Year 1: Building:
CCA1(bldg@4%) = ½ (0.04) × $900,000 = $18,000
UCC1(bldg) = $882,000
Furnishings:
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
9-10
CCA1(furn@20%) = ½ (0.20) × $75,000 = $7,500
UCC1(furn) = $67,500
Net Effect in the First Year:
The taxable income is lowered by the sum of the two CCA
amounts: $25,500
The sum of the two ITC amounts can be deducted from taxes
owing: $200,000
Year 2: Building: The beginning UCC must be lowered by the Year 1 ITC:
CCA2(bldg@4%) = (0.04) × ($882,000–$181,250)= $28,030
UCC2(bldg) = $882,000–$181,250–$28,030 = $672,720
Furnishings: The beginning UCC must be lowered by the Year 1
ITC:
CCA2(furn@20%) = (0.20) × ($67,500–$18,750)= $9,750
UCC2(furn) = $67,500–$18,750–$9,750 = $39,000
Net Effect in the Second Year:
The taxable income is lowered by the sum of the two CCA
amounts: $37,780
Corporate Income Taxes
9.21
(a) Taxable income:
Revenues: $1,450,000
Expenses:
Labour 550,000
Materials 185,000
CCA 32,500
Rental 45,000
Total taxable income $1,162,500
(b) Taxable gain:
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
9-11
gain proceeds from old equipment UCC
$23, 000 $20, 000
$3, 000
(c) Marginal and average tax rates:
Combined small business tax rate on $400,000 taxable income =
11.0% + 5.0% = 16.0%
Combined nonmanufacturing tax rate on $762,500 = 19.5% + 16.0% =
35.5%
Income taxes = 0.16($400,000) + 0.355($762,500) = $334,688
Effective tax rate = $334,688/$1,162,500 = 28.79%
Marginal tax rate = 35.5%
(d) Net cash flow:
Taxable income $1,162,500
Income taxes 334,688
Net income $827,812
Adjustment:
Add CCA 32,500
Add proceed from
equipment sale 23,000
Subtract gains tax
@ 35.5% (1,065)
Net cash flow $882,247
Gains, Losses, Disposal Tax Effect
9.22
(a) CCA:
Building (Class 1 asset, d = 4%, placed in service in February):
CCA building $400, 000(0.04 / 2)
$8, 000
Equipment (Class 43 asset, d = 30%)
CCA equipment $200, 000(0.30 / 2)
$30, 000
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
9-12
Total CCA allowed:
CCA total $8, 000 $30, 000
$38, 000
(b) Tax liability:
Sales revenue $1,500,000
Expenses:
Cost of goods sold 600,000
Bond interest 50,000
CCA 38.000
Taxable income $812,000
Income taxes 324.800
Net income $487,200
Short Case Studies
ST 9.1
(a) Economic depreciation:
economic depreciation = $4,000 – $2,500 = $1,500
(b) Cost basis:
depreciation base = $14,000 + $800 + $200 = $15,000
(c) Taxable gains and gains taxes:
U 3 $0.85(0.70) 2 $4, 000
$1, 666
disposal tax effect $0.40(1, 666 $2,500)
$334
(d) Capital gains:
U 3 $1, 666
disposal tax effect 0.40($1, 666 $4, 000) 0.40(1/ 2)($4, 000 $5, 000)
$1,134
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
9-13
(e) Book value at the end of year 3 under 175% DB:
B3 = $1,420
(f) Optimal time to switch: during the fourth year
ST 9.2 (a) and (b) Additional annual taxable income due to expansion:
Since the taxable income before and after the expansion is less than
$400,000, the marginal and average tax rates are the small business value.
Combined small business tax rate for Nova Scotia = 11.0% + 5.0% =
16.0%
(c) PW of income taxes:
CCA schedules: base = $20,000, d = 20%
n CCA
1 $2,000
2 3,600
3 2,880
Incremental income taxes over a three-year period:
Operating Year
Year l Year 2 Year 3
Revenue $30,000 $30,000 $30,000
Expense 10,000 10,000 10,000
CCA 2,000 3,600 2,880
Taxable income $18,000 $16,400 $17,120
Income taxes 2,880 2,624 2,739
Equivalent cost of income taxes:
PW (10%) $2,880( P / F , 10%, 1) 2,624( P / F ,10%, 2) 2,739( P / F ,10%,3)
$6,845
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
9-14
ST 9.3
(a) Incremental operating income:
Operating Year
Year l Year 2 Year 3 Year 4 Year 5
Revenue $15,000,000 $15,000,000 $15,000,000 $15,000,000 $15,000,000
Expenses:
Mfg. cost 6,000,000 6,000,000 6,000,000 6,000,000 6,000,000
O&M costs 1,200,000 1,200,000 1,200,000 1,200,000 1,200,000
CCA 750,000 1,275,000 892,500 624,750 437,325
Taxable 7,050,000 6,525,000 6,907,500 7,175,250 7,362,675
income
Income 2,467,500 2,283,750 2,417,625 2,511,337 2,576,936
taxes(35%)
Net income 4,582,500 4,241,250 4,489,875 4,663,912 4,785,739
(b) Gains or losses:
U 5 0.85(0.70) 4 × $5,000,000
$1,020,425
disposal tax effect 0.35($ 1,020,425 $1,600,000)
$202,851
ST 9.4 (a)
Combined tax rates for Alberta, small business = 14.0% on first $400K,
manufacturing rate = 29.5%
(b) Gains or losses:
• Plant:
U 8 0.9(0.80)7 $10,000,000
$1,887,436
disposal tax effect 0.3662($1,887,436 $6,000,000)
$1,506,021
• Equipment:
U 8 0.85(0.70)7 $40,000,000
$280,046
disposal tax effect 0.3662($280,046 $4,000,000)
$1,362,247
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
9-15
(c)
Income Statement (in thousands of dollars)
1 2 3 4 5 6 7 8
Revenue 30,000.0 30,000.0 30,000.0 30,000.0 30,000.0 30,000.0 30,000.0 30,000.0
Expenses
Mfg cost 9,000.0 9,000.0 9,000.0 9,000.0 9,000.0 9,000.0 9,000.0 9,000.0
Operating
cost 12,000.0 12,000.0 12,000.0 12,000.0 12,000.0 12,000.0 12,000.0 12,000.0
CCA
Plant 1,000.0 1,800.0 1,440.0 1,152.0 921.6 737.3 589.8 471.9
Equipment 6,000.0 10,200.0 7,140.0 4,998.0 3,498.6 2,449.0 1,714.3 1,200.0
Taxable
income 2,000.0 -3,000.0 420.0 2,850.0 4,579.8 5,813.7 6,695.9 7,328.1
Income taxes 528.0 -823.0(1) 61.9 778.8 1,289.0 1,653.0 1,913.3 2,099.8
Net income 1,472.0 -2,177.0 358.1 2,071.3 3,290.8 4,160.7 4,782.6 5,228.3
(1) As a start-up company, Diamonid may not be able to use this year’s loss against other taxable
income in the company. So there is no simple answer about what marginal tax rate applies to this
loss, as it may be carried forward to future years. For simplicity, the same marginal tax rates are
used as for the other years.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-1
Chapter 10 Developing Project Cash Flows
Generating Net Cash Flows
10.1
dB= 4% t= 35%
dE= id=
dO= MARR= 15%
tCG= 17.5% N= 5
Year 0 1 2 3 4 5
Income Statement
Revenues 2,965,524 2,965,524 2,965,524 2,965,524 2,965,524
Expenses
Materials
Labour
Overhead
O&M 330,000 380,000 430,000 480,000 530,000
Debt interest - - - - -
CCA
Building @dB 250,000 490,000 470,400 451,584 433,521
Machines @dE - - - - -
Others @dO - - - - -
Taxable income 2,385,524 2,095,524 2,065,124 2,033,940 2,002,003
Income taxes @t 834,933 733,433 722,793 711,879 700,701
Net income 1,550,590 1,362,090 1,342,330 1,322,061 1,301,302
Cash Flow Statement
Operating activities
Net income 1,550,590 1,362,090 1,342,330 1,322,061 1,301,302
CCA 250,000 490,000 470,400 451,584 433,521
Investment activities
Land
Building (12,500,000) 14,000,000
Machines
Others
Disposal tax effect
Land -
Building (995,927)
Machines -
Others -
Financing activities
Principal portion - - - - -
Net cash flow (12,500,000) 1,800,590 1,852,090 1,812,730 1,773,645 14,738,896
PE(MARR) = -
AE(MARR) = -
IRR= 15.00%
The rent per apartment is $2,965,524/50 = $59,310.48/year.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-2
*
10.2
dB= t= 35%
dE= 30% id=
dO= MARR=
tCG= N= 7
Year 0 1 2 3 4 5 6 7
Income Statement
Revenues 120,000 120,000 120,000 120,000 120,000 120,000 120,000
Expenses
Materials
Labour
Overhead
O&M
Debt interest - - - - - - -
CCA
Building @dB - - - - - - -
Machines @dE 27,750 47,175 33,023 23,116 16,181 11,327 7,929
Others @dO - - - - - - -
Taxable income 92,250 72,825 86,978 96,884 103,819 108,673 112,071
Income taxes @t 32,288 25,489 30,442 33,909 36,337 38,036 39,225
Net income 59,963 47,336 56,535 62,975 67,482 70,638 72,846
Cash Flow Statement
Operating activities
Net income 59,963 47,336 56,535 62,975 67,482 70,638 72,846
CCA 27,750 47,175 33,023 23,116 16,181 11,327 7,929
Investment activities
Land
Building
Machines (185,000) 40,000
Others
Disposal tax effect
Land -
Building -
Machines (7,525)
Others -
Financing activities
Principal portion - - - - - - -
Net cash flow (185,000) 87,713 94,511 89,558 86,091 83,663 81,964 113,250
PE(MARR) = $ 451,750
AE(MARR) = $ 64,536
IRR= 44.87%
*
An asterisk next to a problem number indicates that the solution is available to students
on the Companion Website.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-3
10.3
dB= t= 40%
dE= 30% id=
dO= MARR= 15%
tCG= N= 6
Year 0 1 2 3 4 5 6
Income Statement
Revenues 25,000 25,000 25,000 25,000 25,000 25,000
Expenses
Materials
Labour
Overhead
O&M 7,000 7,000 7,000 7,000 7,000 7,000
Debt interest - - - - - -
CCA
Building @dB - - - - - -
Machines @dE 8,250 14,025 9,818 6,872 4,811 3,367
Others @dO - - - - - -
Taxable income 9,750 3,975 8,183 11,128 13,189 14,633
Income taxes @t 3,900 1,590 3,273 4,451 5,276 5,853
Net income 5,850 2,385 4,910 6,677 7,914 8,780
Cash Flow Statement
Operating activities
Net income 5,850 2,385 4,910 6,677 7,914 8,780
CCA 8,250 14,025 9,818 6,872 4,811 3,367
Investment activities
Land
Building
Machines (55,000) -
Others
Disposal tax effect
Land -
Building -
Machines 3,143
Others -
Financing activities
Principal portion - - - - - -
Net cash flow (55,000) 14,100 16,410 14,727 13,549 12,724 15,290
PE(MARR) = $ 35 Yes, buy the machine.
AE(MARR) = $ 9
IRR= 15.02%
The machine should be bought because its PE(MARR) is greater than 0.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-4
*
10.4
dB= 4% t= 40%
dE= 30% id=
dO= MARR=
tCG= 20% N= 5
Year 0 1 2 3 4 5
Income Statement
Revenues 2,200,000 2,200,000 2,200,000 2,200,000 2,200,000
Expenses
Materials
Labour
Overhead
O&M 1,280,000 1,280,000 1,280,000 1,280,000 1,280,000
Debt interest - - - - -
CCA
Building @dB 10,000 19,600 18,816 18,063 17,341
Machines @dE 75,000 127,500 89,250 62,475 43,733
Others @dO - - - - -
Taxable income 835,000 772,900 811,934 839,462 858,927
Income taxes @t 334,000 309,160 324,774 335,785 343,571
Net income 501,000 463,740 487,160 503,677 515,356
Cash Flow Statement
Operating activities
Net income 501,000 463,740 487,160 503,677 515,356
CCA 85,000 147,100 108,066 80,538 61,073
Investment activities
Land (100,000) 115,000
Building (500,000) 575,000
Machines (500,000) 50,000
Others
Disposal tax effect
Land (3,000)
Building (48,528)
Machines 20,817
Others -
Financing activities
Principal portion - - - - -
Net cash flow (1,100,000) 586,000 610,840 595,226 584,215 1,285,718
PE(MARR) = $2,562,000
AE(MARR) = $ 512,400
IRR= 51.28%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-5
10.5
Year: 1 2 3 4 5
Total distance/year (m): 2000 2000 2000 2000 2000
Production rate (m/hr) 5 5 5 4.5 4
Required hours/year: 400 400 400 444 500
Operating cost/year: 6000 6000 6000 6667 7500
dB= t= 34%
dE= 30% id=
dO= MARR=
tCG= N= 5
Year 0 1 2 3 4 5
Income Statement
Revenues - - - -
Expenses
Materials/Labour
Overhead
O&M 6,000 6,000 6,000 6,667 7500
Debt interest - - - - -
CCA
Building @dB - - - - -
Machines @dE 27,000 45900 32,130 22,491 55,744
Others @dO - - - - -
Taxable income (33,000) (51,900) (38,130) (29,158) (23,244)
Income taxes @t (11,220) (17,646) (12,964) (9,914) (7,903)
Net income (21,780) (34,254) (25,166) (19,244) (15,341)
Cash Flow Statement
Operating activities
Net income (21,780) (34,254) (25,166) (19,244) (15,341)
CCA 27,000 45,900 32,130 22,491 15,744
Investment activities
Land
Building
Machines (180,000) 40,000
Others
Disposal tax effect
Land -
Building -
Machines (1,110)
Others -
Financing activities
Principal portion - - - - -
Net cash flow (180,000) 5,220 11,646 6,964 3,247 39,293
PE(MARR) = $ (113,630)
AE(MARR) = $ (22,726)
IRR= -21.47%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-6
*
10.6
dB= t= 35%
dE= 45% id=
dO= MARR= 13%
tCG= N= 5
Year 0 1 2 3 4 5
Income Statement
Revenues 52,000 52,000 52,000 52,000 52,000
Expenses
Materials
Labour
Overhead
O&M 32,000 12,000 12,000 12,000 12,000
Debt interest - - - - -
CCA
Building @dB - - - - -
Machines @dE 23,400 36,270 19,949 10,972 6,034
Others @dO - - - - -
Taxable income (3,400) 3,730 20,052 29,028 33,966
Income taxes @t (1,190) 1,306 7,018 10,160 11,888
Net income (2,210) 2,425 13,033 18,868 22,078
Cash Flow Statement
Operating activities
Net income (2,210) 2,425 13,033 18,868 22,078
CCA 23,400 36,270 19,949 10,972 6,034
Investment activities
Land
Building
Machines (104,000) -
Others
Disposal tax effect
Land -
Building -
Machines 2,581
Others -
Financing activities
Principal portion - - - - -
Net cash flow (104,000) 21,190 38,695 32,982 29,840 30,693
PE(MARR) = $ 2,874
AE(MARR) = $ 817
IRR= 14.09%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-7
10.7
dB= t= 40%
dE= 45% id=
dO= MARR= 12%
tCG= N= 5
Year 0 1 2 3 4 5
Income Statement
Revenues 20,160 20,160 20,160 20,160 20,160
Expenses
Materials
Labour
Overhead
O&M 10,000 10,000 10,000 10,000 10,000
Debt interest - - - - -
CCA
Building @dB - - - - -
Machines @dE 4,163 6,452 3,549 1,952 1,073
Others @dO - - - - -
Taxable income 5,998 3,708 6,611 8,208 9,087
Income taxes @t 2,399 1,483 2,645 3,283 3,635
Net income 3,599 2,225 3,967 4,925 5,452
Cash Flow Statement
Operating activities
Net income 3,599 2,225 3,967 4,925 5,452
CCA 4,163 6,452 3,549 1,952 1,073
Investment activities
Land
Building
Machines (18,500) 1,850
Others
Disposal tax effect
Land -
Building -
Machines (215)
Others -
Financing activities
Principal portion - - - - -
Net cash flow (18,500) 7,761 8,677 7,515 6,877 8,160
PE(MARR) = $ 9,696
AE(MARR) = $ 2,690
IRR= 31.79%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-8
10.8
dB= t= 40%
dE= 20% id=
dO= MARR= 12%
tCG= N= 6
Year 0 1 2 3 4 5 6
Income Statement
Revenues 300,000 300,000 300,000 300,000 300,000 300,000
Expenses
Materials 50,000 50,000 50,000 50,000 50,000 50,000
Labour 80,000 80,000 80,000 80,000 80,000 80,000
Overhead
O&M - - - - -
Debt interest - - - - - -
CCA
Building @dB - - - - - -
Machines @dE 12,000 21,600 17,280 13,824 11,059 8,847
Others @dO - - - - - -
Taxable income 158,000 148,400 152,720 156,176 158,941 161,153
Income taxes @t 63,200 59,360 61,088 62,470 63,576 64,461
Net income 94,800 89,040 91,632 93,706 95,364 96,692
Cash Flow Statement
Operating activities
Net income 94,800 89,040 91,632 93,706 95,364 96,692
CCA 12,000 21,600 17,280 13,824 11,059 8,847
Investment activities
Land
Building
Machines (120,000) -
Others
Disposal tax effect
Land -
Building -
Machines 14,156
Others -
Financing activities
Principal portion - - - - - -
Net cash flow (120,000) 106,800 110,640 108,912 107,530 106,424 119,695
PE(MARR) = $ 330,446
AE(MARR) = $ 80,373
IRR= 88.28%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-9
10.9
dB= t= 40%
dE= 30% id=
dO= MARR=
tCG= N= 5
Year 0 1 2 3 4 5
Income Statement
Revenues 250,000 250,000 250,000 250,000 250,000
Expenses
Materials - - - -
Labour - - - -
Overhead
O&M 50,000 50,000 50,000 50,000 50,000
Debt interest - - - - -
CCA
Building @dB - - - - -
Machines @dE 45,000 76,500 53,550 37,485 26,240
Others @dO - - - - -
Taxable income 155,000 123,500 146,450 162,515 173,761
Income taxes @t 62,000 49,400 58,580 65,006 69,504
Net income 93,000 74,100 87,870 97,509 104,256
Cash Flow Statement
Operating activities
Net income 93,000 74,100 87,870 97,509 104,256
CCA 45,000 76,500 53,550 37,485 26,240
Investment activities
Land
Building
Machines (300,000) 5,000
Others
Disposal tax effect
Land -
Building -
Machines 22,490
Others -
Financing activities
Principal portion - - - - -
Net cash flow (300,000) 138,000 150,600 141,420 134,994 157,986
PE(MARR) = $ 423,000
AE(MARR) = $ 84,600
IRR= 38.32%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-10
10.10
dB= t= 35%
dE= 35% id=
dO= MARR= 10%
tCG= N= 9
Year 0 1 2 3 4 5 6 7 8 9
Income Statement
Revenues 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000
Expenses
Materials - - - - - - - -
Labour - - - - - - - -
Overhead
O&M - - - - - - - -
Debt interest - - - - - - - - -
CCA
Building @dB - - - - - - - - -
Machines @dE 8,750 14,438 9,384 6,100 3,965 2,577 1,675 1,089 708
Others @dO - - - - - - - - -
Taxable income 1,250 (4,438) 616 3,900 6,035 7,423 8,325 8,911 9,292
Income taxes @t 438 (1,553) 215 1,365 2,112 2,598 2,914 3,119 3,252
Net income 813 (2,884) 400 2,535 3,923 4,825 5,411 5,792 6,040
Cash Flow Statement
Operating activities
Net income 813 (2,884) 400 2,535 3,923 4,825 5,411 5,792 6,040
CCA 8,750 14,438 9,384 6,100 3,965 2,577 1,675 1,089 708
Investment
activities
Land
Building
Machines (50,000) -
Others
Disposal tax effect
Land -
Building -
Machines 460
Others -
Financing activities
Principal portion - - - - - - - - -
Net cash flow (50,000) 9,563 11,553 9,785 8,635 7,888 7,402 7,086 6,881 7,208
PE(MARR) = $ 469
AE(MARR) = $ 82
IRR= 10.26%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-11
*
10.11
dB= t= 40%
dE= 30% id=
dO= MARR= 15%
tCG= N= 5
Year 0 1 32 4 5
Income Statement
Revenues 130,000 130,000 130,000 130,000 130,000
Expenses
Materials - - - -
Labour - - - -
Overhead
O&M 20,000 20,000 20,000 20,000 20,000
Debt interest - - - - -
CCA
Building @dB - - - - -
Machines @dE 45,017 76,529 53,570 37,499 26,249
Others @dO - - - - -
Taxable income 64,983 33,471 56,430 72,501 83,751
Income taxes @t 25,993 13,388 22,572 29,000 33,500
Net income 38,990 20,083 33,858 43,501 50,250
Cash Flow Statement
Operating activities
Net income 38,990 20,083 33,858 43,501 50,250
CCA 45,017 76,529 53,570 37,499 26,249
Investment activities
Land
Building
Machines (300,113) -
Others
Disposal tax effect
Land -
Building -
Machines 24,499
Others -
Financing activities
Principal portion - - - - -
Net cash flow (300,113) 84,007 96,612 87,428 81,000 100,999
PE(MARR) = $ -
AE(MARR) = $ -
IRR= 15.00%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-12
Investment in Working Capital
*
10.12
dB= 4% t= 40%
dE= 30% id=
dO= 0% MARR= 15%
tCG= 20% N= 10
Year 0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues 875,000 875,000 875,000 875,000 875,000 875,000 875,000 875,000 875,000 875,000
Expenses
Materials - - - - - - - - -
Labour - - - - - - - - -
Overhead
O&M 425,000 425,000 425,000 425,000 425,000 425,000 425,000 425,000 425,000 425,000
Debt interest - - - - - - - - - -
CCA
Building @dB 30,000 58,800 56,448 54,190 52,022 49,942 47,944 46,026 44,185 42,418
Machines @dE 75,000 127,500 89,250 62,475 43,733 30,613 21,429 15,000 10,500 7,350
Others @dO - - - - - - - - - -
Taxable income 345,000 263,700 304,302 333,335 354,245 369,446 380,627 388,974 395,315 400,232
Income taxes @t 138,000 105,480 121,721 133,334 141,698 147,778 152,251 155,589 158,126 160,093
Net income 207,000 158,220 182,581 200,001 212,547 221,667 228,376 233,384 237,189 240,139
Cash Flow Statement
Operating activities
Net income 207,000 158,220 182,581 200,001 212,547 221,667 228,376 233,384 237,189 240,139
CCA 105,000 186,300 145,698 116,665 95,755 80,554 69,373 61,026 54,685 49,768
Investment activities
Land (250,000) 500,000
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-13
Building (1,500,000) 700,000
Machines (500,000) 50,000
Others (150,000) 150,000
Disposal tax effect
Land (50,000)
Building 127,210
Machines (13,140)
Others -
Financing activities
Principal portion - - - - - - - - - -
Net cash flow (2,400,000) 312,000 344,520 328,279 316,666 308,302 302,222 297,749 294,411 291,874 1,753,977
PE(MARR) = $ (462,642)
AE(MARR) = $ (92,182)
IRR= 10.65%
With working capital: PE(15%) = - $462,642, Not justified
Without working capital: PE(15%) = - $349,720, Still not justified
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-14
10.13
dB= t= 35%
dE= 30% id=
dO= 0% MARR= 18%
tCG= N= 6
Year 0 1 2 3 4 5 6
Income Statement
Revenues 55,800 55,800 55,800 55,800 55,800 55,800
Expenses
Materials - - - - -
Labour - - - - -
Overhead
O&M 8,120 8,120 8,120 8,120 8,120 8,120
Debt interest - - - - - -
CCA
Building @dB - - - - - -
Machines @dE 9,825 16,703 11,692 8,184 5,729 4,010
Others @dO - - - - - -
Taxable income 37,855 30,978 35,988 39,496 41,951 43,670
Income taxes @t 13,249 10,842 12,596 13,824 14,683 15,284
Net income 24,606 20,135 23,392 25,672 27,268 28,385
Cash Flow Statement
Operating activities
Net income 24,606 20,135 23,392 25,672 27,268 28,385
CCA 9,825 16,703 11,692 8,184 5,729 4,010
Investment activities
Land
Building
Machines (65,500) 3,000
Others (10,000) 10,000
Disposal tax effect
Land -
Building -
Machines 2,225
Others -
Financing activities
Principal portion - - - - - -
Net cash flow (75,500) 34,431 36,838 35,084 33,856 32,997 47,621
PE(MARR) = $ 51,015
AE(MARR) = $ 14,586
IRR= 41.36%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-15
10.14 All in '000 dollars
dB= 4% t= 40%
dE= 30% id=
dO= 0% MARR= 20%
tCG= N= 10
1 2 3
Year -2 -1 0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues 45,000 49,500 54,450 59,895 65,885 72,473 65,226 58,703 52,833 47,550
Expenses
Materials - - - - - - - - -
Labour - - - - - - - - -
Overhead
O&M 500 2,500 2,000 36,000 39,600 43,560 47,916 52,708 57,978 52,181 46,962 42,266 38,040
Debt interest - - - - - - - - - -
CCA
Building @dB 40 78 75 72 69 67 64 61 59 57
Machines @dE 450 765 536 375 262 184 129 90 63 44
Others @dO - - - - - - - - - -
Taxable income (500) (2,500) (2,000) 8,510 9,057 10,279 11,532 12,845 14,244 12,853 11,589 10,445 9,409
Income taxes @t (200) (1,000) (800) 3,404 3,623 4,112 4,613 5,138 5,698 5,141 4,636 4,178 3,764
Net income (300) (1,500) (1,200) 5,106 5,434 6,168 6,919 7,707 8,547 7,712 6,954 6,267 5,646
Cash Flow Statement
Operating activities
Net income (300) (1,500) (1,200) 5,106 5,434 6,168 6,919 7,707 8,547 7,712 6,954 6,267 5,646
CCA - - - 490 843 611 447 332 250 192 151 122 101
Investment activities
Land
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-16
Building (2,000) 1,000
Machines (3,000) 300
Others (4,500) (450) (495) (545) (599) (659) 725 652 587 528 4,755
Disposal tax effect
Land -
Building 143
Machines (79)
Others
Financing activities
Principal portion - - - - - - - - - -
Net cash flow (300) (1,500) (10,700) 5,146 5,782 6,234 6,767 7,380 9,522 8,556 7,692 6,917 11,865
PE(MARR) = $ 9,162 at the beginning of the first R&D year
AE(MARR) = $ 2,021 each year over 13 years
IRR= 45.31% considering all net cash flows during the 13 years
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-17
Effects of Borrowing
10.15
dB= 4% t= 35%
dE= id= 10%
dO= MARR= 15%
tCG= 17.5% N= 5
Year 0 1 2 3 4 5
Income Statement
Revenues 1,896,945 1,896,945 1,896,945 1,896,945 1,896,945
Expenses
Materials
Labour
Overhead
O&M 330,000 380,000 430,000 480,000 530,000
Debt interest 1,250,000 1,045,253 820,032 572,288 299,770
CCA
Building @dB 250,000 490,000 470,400 451,584 433,521
Machines @dE - - - - -
Others @dO - - - - -
Taxable income 66,945 (18,308) 176,513 393,073 633,654
Income taxes @t 23,431 (6,408) 61,780 137,576 221,779
Net income 43,514 (11,900) 114,734 255,497 411,875
Cash Flow Statement
Operating activities
Net income 43,514 (11,900) 114,734 255,497 411,875
CCA 250,000 490,000 470,400 451,584 433,521
Investment activities
Land
Building (12,500,00) 14,000,000
Machines
Others
Disposal tax effect
Land -
Building (995,927)
Machines -
Others -
Financing activities
Principal portion 12,500,000 (2,047,469) (2,252,215) (2,477,437) (2,725,181) (2,997,699)
Net cash flow - (1,753,954) (1,774,116) (1,892,303) (2,018,099) 10,851,771
PE(MARR) = $130,509
AE(MARR) = $38,933
IRR= 16.08%
Annual rent per apartment needed = $ 37,939
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-18
*
10.16
dB= t= 35%
dE= 30% id= 10%
dO= MARR=
tCG= N= 7
Year 0 1 2 3 4 5 6 7
Income Statement
Revenues 120,000 120,000 120,000 120,000 120,000 120,000 120,000
Expenses
Materials
Labour
Overhead
O&M
Debt interest 18,500 14,800 11,100 7,400 3,700
CCA
Building @dB - - - - - - -
Machines @dE 27,750 47,175 33,023 23,116 16,181 11,327 7,929
Others @dO - - - - - - -
Taxable income 73,750 58,025 75,878 89,484 100,119 108,673 112,071
Income taxes @t 25,813 20,309 26,557 31,319 35,042 38,036 39,225
Net income 47,938 37,716 49,320 58,165 65,077 70,638 72,846
Cash Flow Statement
Operating activities
Net income 47,938 37,716 49,320 58,165 65,077 70,638 72,846
CCA 27,750 47,175 33,023 23,116 16,181 11,327 7,929
Investment activities
Land
Building
Machines (185,000) 40,000
Others
Disposal tax effect
Land -
Building -
Machines (7,525)
Others -
Financing activities
Principal portion 185,000 (37,000) (37,000) (37,000) (37,000) (37,000)
Net cash flow - 38,688 47,891 45,343 44,281 44,258 81,964 113,250
PE(MARR) = $ 415,675
AE(MARR) = $ 59,382
IRR= Undefined
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-19
10.17
dB= t= 40%
dE= 30% id= 11%
dO= MARR=
tCG= N= 5
Year 0 1 2 3 4 5
Income Statement
Revenues 250,000 250,000 250,000 250,000 250,000
Expenses
Materials - - - -
Labour - - - -
Overhead
O&M 50,000 50,000 50,000 50,000 50,000
Debt interest 16,500 13,851 10,910 7,645 4,022
CCA
Building @dB - - - - -
Machines @dE 45,000 76,500 53,550 37,485 26,240
Others @dO - - - - -
Taxable income 138,500 109,649 135,540 154,870 169,739
Income taxes @t 55,400 43,860 54,216 61,948 67,895
Net income 83,100 65,790 81,324 92,922 101,843
Cash Flow Statement
Operating activities
Net income 83,100 65,790 81,324 92,922 101,843
CCA 45,000 76,500 53,550 37,485 26,240
Investment activities
Land
Building
Machines (300,000) 5,000
Others
Disposal tax effect
Land -
Building -
Machines 22,490
Others -
Financing activities
Principal portion 150,000 (24,086) (26,735) (29,676) (32,940) (36,564)
Net cash flow (150,000) 104,014 115,555 105,198 97,467 119,009
PE(MARR) = $ 391,243 Annual Loan Payment = $ 40,586
AE(MARR) = $ 78,249
IRR= 65.93%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-20
10.18
dB= t= 40%
dE= 100% id= 10%
dO= MARR= 15%
tCG= N= 2
Year 0 1 2
Income Statement
Revenues 30,000 30,000
Expenses
Materials
Labour
Overhead
O&M 5,000 5,000
Debt interest 1,000 524
CCA
Building @dB - -
Machines @dE 10,000 10,000
Others @dO - -
Taxable income 14,000 14,476
Income taxes @t 5,600 5,790
Net income 8,400 8,686
Cash Flow Statement
Operating activities
Net income 8,400 8,686
CCA 10,000 10,000
Investment activities
Land
Building
Machines (20,000) 8,000
Others
Disposal tax effect
Land -
Building -
Machines (3,200)
Others -
Financing activities
Principal portion 10,000 (4,762) (5,238)
Net cash flow (10,000) 13,638 18,248
PE(MARR) = $15,657 Annual loan payment = $5,762
AE(MARR) = $9,631
IRR= 119.51%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-21
10.19
dB= t= 40%
dE= 30% id= 9%
dO= MARR= 18%
tCG= N= 10
Year 0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues 135,000 135,000 135,000 135,000 135,000 135,000 135,000 135,000 135,000 135,000
Expenses
Materials
Labour
Overhead
O&M
Debt interest 13,500 9,000 4,500
CCA
Building @dB - - - - - - - - - -
Machines @dE 30,000 51,000 35,700 24,990 17,493 12,245 8,572 6,000 4,200 2,940
Others @dO - - - - - - - - - -
Taxable income 91,500 75,000 94,800 110,010 117,507 122,755 126,428 129,000 130,800 132,060
Income taxes @t 36,600 30,000 37,920 44,004 47,003 49,102 50,571 51,600 52,320 52,824
Net income 54,900 45,000 56,880 66,006 70,504 73,653 75,857 77,400 78,480 79,236
Cash Flow Statement
Operating activities
Net income 54,900 45,000 56,880 66,006 70,504 73,653 75,857 77,400 78,480 79,236
CCA 30,000 51,000 35,700 24,990 17,493 12,245 8,572 6,000 4,200 2,940
Investment activities
Land
Building
Machines (200,000) 20,000
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-22
Others
Disposal tax effect
Land -
Building -
Machines (5,256)
Others -
Financing activities
Principal portion 150,000 (50,000) (50,000) (50,000)
Net cash flow (50,000) 34,900 46,000 42,580 90,996 87,997 85,898 84,429 83,400 82,680 96,920
PE(MARR) = $241,597
AE(MARR) = $53,759
IRR= 92.24% Yes, justified
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-23
10.20
dB= t= 35%
dE= 30% id= 10%
dO= MARR= 18%
tCG= N= 5
Year 0 1 2 3 4 5
Income Statement
Revenues - - - -
Expenses
Materials
Labour
Overhead
O&M
Debt interest 84,000 70,241 55,106 38,458 20,145
CCA
Building @dB - - - - -
Machines @dE 315,000 535,500 374,850 262,395 183,677
Others @dO - - - - -
Taxable income (399,000) (605,741) (429,956) (300,853) (203,821)
Income taxes @t (139,650) (212,009) (150,485) (105,298) (71,337)
Net income (259,350) (393,732) (279,471) (195,554) (132,484)
Cash Flow Statement
Operating activities
Net income (259,350) (393,732) (279,471) (195,554) (132,484)
CCA 315,000 535,500 374,850 262,395 183,677
Investment activities
Land
Building
Machines (2,100,000) 210,000
Others
Disposal tax effect
Land -
Building -
Machines 76,502
Others -
Financing activities
Principal portion 840,000 (137,590) (151,349) (166,484) (183,132) (201,445)
Net cash flow (1,260,000) (81,940) (9,581) (71,105) (116,291) 136,250
PE(MARR) = $(1,380,024) Annual loan payment = $ 221,590
AE(MARR) = $(441,301)
IRR= Undefined
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-24
10.21
dB= t= 36%
dE= 30% id= 12%
dO= MARR= 15%
tCG= N= 6
Year 0 1 2 3 4 5 6
Income Statement
Revenues 10,000 10,000 10,000 10,000 10,000 10,000
Expenses
Materials
Labour
Overhead
O&M
Debt interest 4,800 4,209 3,546 2,804 1,973 1,042
CCA
Building @dB - - - - - -
Machines @dE 6,000 10,200 7,140 4,998 3,499 2,449
Others @dO - - - - - -
Taxable income (800) (4,409) (686) 2,198 4,528 6,509
Income taxes @t (288) (1,587) (247) 791 1,630 2,343
Net income (512) (2,821) (439) 1,407 2,898 4,165
Cash Flow Statement
Operating activities
Net income (512) (2,821) (439) 1,407 2,898 4,165
CCA 6,000 10,200 7,140 4,998 3,499 2,449
Investment activities
Land
Building
Machines (40,000) 3,000
Others
Disposal tax effect
Land -
Building -
Machines 977
Others -
Financing activities
Principal portion 40,000 (4,929) (5,521) (6,183) (6,925) (7,756) (8,687)
Net cash flow - 559 1,858 518 (520) (1,359) 1,905
PE(MARR) = $2,082 Annual loan payment = $ 9,729
AE(MARR) = $550
IRR= Undefined IRR does not exist. Cannot use the IRR method.
Acceptable based on the PE criterion.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-25
Generalized Cash Flow Method
*
10.22
dB= t= 40%
dE= 30% id= 10%
dO= MARR= 14%
tCG= N= 8
Year 0 1 2 3 4 5 6 7 8
Income Statement
Revenues 40,000 40,000 40,000 40,000 40,000 40,000 40,000 40,000
Expenses
Materials
Labour
Overhead
O&M 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000
Debt interest 4,000 3,650 3,265 2,842 2,377 1,865 1,301 682
CCA
Building @dB - - - - - - - -
Machines @dE 16,500 28,050 19,635 13,745 9,621 6,735 4,714 3,300
Others @dO - - - - - - - -
Taxable income 14,500 3,300 12,100 18,413 23,002 26,401 28,984 31,018
Income taxes @t 5,800 1,320 4,840 7,365 9,201 10,560 11,594 12,407
Net income 8,700 1,980 7,260 11,048 13,801 15,840 17,391 18,611
Cash Flow Statement
Operating activities
Net income 8,700 1,980 7,260 11,048 13,801 15,840 17,391 18,611
CCA 16,500 28,050 19,635 13,745 9,621 6,735 4,714 3,300
Investment activities
Land
Building
Machines (110,000) 10,000
Others
Disposal tax effect
Land -
Building -
Machines (920)
Others -
Financing activities
Principal portion 40,000 (3,498) (3,848) (4,232) (4,656) (5,121) (5,633) (6,196) (6,816)
Net cash flow (70,000) 21,702 26,182 22,662 20,137 18,301 16,942 15,908 24,175
PE(MARR) = $28,459 Annual loan payment = $7,498
AE(MARR) = $6,135
IRR= 26.00%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-26
10.23 (a) Without debt financing
dB= t= 35% Lease cost
dE= 15% id= Beginning?
dO= MARR= 9% 0
tCG= N= 5
Year 0 1 2 3 4 5
Input Data:
Revenues 1,500 1,500 1,500 1,500 1,500
Expenses
Materials
Labour
Overhead
O&M - - - -
Investments
Land
Building
Machines 6,000 2,000
Others
Borrowed Money:
Calculated Entries:
Debt principal: - - - - - -
Debt interest - - - - - -
CCA
Building @dB - - - - - -
Machines @dE 450 833 708 601 511
Others @dO - - - - - -
Disposal tax effect
Land -
Building -
Machines 314
Others -
Cash Flow Elements:
Revenue (1-t): 975 975 975 975 975
- Costs (1-t): - - - - -
+ Beginning adjust? - - - - - -
- Interest (1-t): - - - - -
+ t × CCA: 158 291 248 211 179
Investments (6,000) 2,314
Debts: - - - - - -
Net Cash Flow: (6,000) 1,133 1,266 1,223 1,186 3,468
PE(MARR) = $143
AE(MARR) = $37
IRR= 9.77%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-27
10.23 (b) With debt financing
dB= t= 35% Lease cost
dE= 15% id= 9% Beginning?
dO= MARR= 9% 0
tCG= N= 5
Year 0 1 2 3 4 5
Input Data:
Revenues 1,500 1,500 1,500 1,500 1,500
Expenses
Materials
Labour
Overhead
O&M - - - -
Investments
Land
Building
Machines 6,000 2,000
Others
Borrowed Money: 6,000
Calculated Entries:
Debt principal: 1,003 1,093 1,191 1,298 1,415
Debt interest 540 450 351 244 127
CCA
Building @dB - - - - -
Machines @dE 450 833 708 601 511
Others @dO - - - - -
Disposal tax effect
Land -
Building -
Machines 314
Others -
Cash Flow Elements:
Revenue (1-t): 975 975 975 975 975
- Costs (1-t): - - - - -
+ Beginning adjust? - - - - - -
- Interest (1-t): (351) (292) (228) (159) (83)
+ t × CCA: 158 291 248 211 179
Investments (6,000) 2,314
Debts: 6,000 (1,003) (1,093) (1,191) (1,298) (1,415)
Net Cash Flow: - (221) (119) (197) (272) 1,970
PE(MARR) = $633 Annual loan payment = $1,543
AE(MARR) = $163
IRR= 40.72%
(c) The option with debt financing is better. Its PE value is $633, larger than the one
without debt financing (PE of $143).
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-28
*
10.24
dB= t= 40% Lease cost
dE= 30% id= 10% Beginning?
dO= MARR 12% 0
tCG= = 5
N=
Year 0 1 2 3 4 5
Input Data:
Revenues 60,000 60,000 60,000 60,000 60,000
Expenses
Materials
Labour
Overhead
O&M - - - -
Investments
Land
Building
Machines 150,000 50,000
Others
Borrowed Money: 150,000
Calculated Entries:
Debt principal: 24,570 27,027 29,729 32,702 35,972
Debt interest 15,000 12,543 9,840 6,867 3,597
CCA
Building @dB - - - - -
Machines @dE 22,500 38,250 26,775 18,743 13,120
Others @dO - - - - -
Disposal tax effect
Land -
Building -
Machines (7,755)
Others -
Cash Flow Elements:
Revenue (1-t): 36,000 36,000 36,000 36,000 36,000
- Costs (1-t): - - - - -
+ Beginning adjust? - - - - - -
- Interest (1-t): (9,000) (7,526) (5,904) (4,120) (2,158)
+ t × CCA: 9,000 15,300 10,710 7,497 5,248
Investments (150,000) 42,245
Debts: 150,000 (24,570) (27,027) (29,729) (32,702) (35,972)
Net Cash Flow: - 11,430 16,748 11,077 6,674 45,362
PE(MARR) = $61,422 Annual loan payment = $39,570
AE(MARR) = $17,039
IRR= Undefined
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-29
10.25 All numbers in '000 dollars
dB= t= 38% Lease cost
dE= 25% id= 12% Beginning?
dO= MARR= 18% 0
tCG= N= 15
Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Input Data:
Revenues 35,000 35,000 35,000 35,000 35,000 35,000 35,000 35,000 35,000 35,000 35,000 35,000 35,000 35,000 35,000
Expenses
Materials
Labour
Overhead
O&M 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000
Investments
Land
Building
Machines 62,000 9,300
Others
Borrowed Money: 55,800
Calculated Entries:
Debt principal: 55,800
Debt interest 6,696 6,696 6,696 6,696 6,696 6,696 6,696 6,696 6,696 6,696
CCA
Building @dB - - - - - - - - - - - - - - -
Machines @dE 7,750 13,563 10,172 7,629 5,722 4,291 3,218 2,414 1,810 1,358 1,018 764 573 430 322
Others @dO - - - - - - - - - - - - - - -
Disposal tax effect
Land -
Building -
Machines (3,167)
Others -
Cash Flow Elements:
Revenue (1-t): 21,700 21,700 21,700 21,700 21,700 21,700 21,700 21,700 21,700 21,700 21,700 21,700 21,700 21,700 21,700
- Costs (1-t): (12,400) (12,400) (12,400) (12,400) (12,400) (12,400) (12,400) (12,400) (12,400) (12,400) (12,400) (12,400) (12,400) (12,400) (12,400)
+ Beginning adjust? - - - - - - - - - - - - - - - -
- Interest (1-t): (4,152) (4,152) (4,152) (4,152) (4,152) (4,152) (4,152) (4,152) (4,152) (4,152) - - - - -
+ t × CCA: 2,945 5,154 3,865 2,899 2,174 1,631 1,223 917 688 516 387 290 218 163 122
Investments (62,000) 6,133
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-30
Debts: 55,800 - - - - - - - - - (55,800) - - - -
Net Cash Flow: (6,200) 8,093 10,302 9,014 8,047 7,323 6,779 6,371 6,066 5,836 (50,136) 9,687 9,590 9,518 9,463 15,556
PE(MARR) = $24,980 Yes, its PE is greater than 0 at MARR = 18%.
AE(MARR) = $4,906
IRR: 139.95%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-31
Comparing Mutually Exclusive Alternatives
10.26 Option 1: Retained earnings
dB= t= 39% Lease cost
dE= 30% id= Beginning?
dO= MARR= 18% 0
tCG= N= 6
Year 0 1 2 3 4 5 6
Input Data:
Revenues 174,000 174,000 174,000 174,000 174,000 174,000
Expenses
Materials
Labour
Overhead
O&M 22,000 22,000 22,000 22,000 22,000 22,000
Investments
Land
Building
Machines 220,000 30,000
Others 25,000 25,000
Borrowed Money:
Calculated Entries:
Debt principal: - - - - - -
Debt interest - - - - - -
CCA
Building @dB - - - - - -
Machines @dE 33,000 56,100 39,270 27,489 19,242 13,470
Others @dO - - - - - -
Disposal tax effect
Land -
Building -
Machines 557
Others -
Cash Flow Elements:
Revenue (1-t): 106,140 106,140 106,140 106,140 106,140 106,140
- Costs (1-t): (13,420) (13,420) (13,420) (13,420) (13,420) (13,420)
+ Beginning adjust? - - - - - - -
- Interest (1-t): - - - - - -
+ t × CCA: 12,870 21,879 15,315 10,721 7,504 5,253
Investments (245,000) 55,557
Debts: - - - - - - -
Net Cash Flow: (245,000) 105,590 114,599 108,035 103,441 100,224 153,530
PE(MARR) = $146,575
AE(MARR) = $41,907
IRR= 38.75%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-32
10.26 Option 2: Amortized loan
dB= t= 39% Lease cost
dE= 30% id= 12% Beginning?
dO= MARR= 18% 0
tCG= N= 6
Year 0 1 2 3 4 5 6
Input Data:
Revenues 174,000 174,000 174,000 174,000 174,000 174,000
Expenses
Materials
Labour
Overhead
O&M 22,000 22,000 22,000 22,000 22,000 22,000
Investments
Land
Building
Machines 220,000 30,000
Others 25,000 25,000
Borrowed Money: 220,000
Calculated Entries:
Debt principal: 27,110 30,363 34,006 38,087 42,658 47,776
Debt interest 26,400 23,147 19,503 15,423 10,852 5,733
CCA
Building @dB - - - - - -
Machines @dE 33,000 56,100 39,270 27,489 19,242 13,470
Others @dO - - - - - -
Disposal tax effect
Land -
Building -
Machines 557
Others -
Cash Flow Elements:
Revenue (1-t): 106,140 106,140 106,140 106,140 106,140 106,140
- Costs (1-t): (13,420) (13,420) (13,420) (13,420) (13,420) (13,420)
+ Beginning adjust? - - - - - - -
- Interest (1-t): (16,104) (14,120) (11,897) (9,408) (6,620) (3,497)
+ t × CCA: 12,870 21,879 15,315 10,721 7,504 5,253
Investments (245,000) 55,557
Debts: 220,000 (27,110) (30,363) (34,006) (38,087) (42,658) (47,776)
Net Cash Flow: (25,000) 62,376 70,117 62,132 55,946 50,947 102,257
PE(MARR) = $205,038 Annual loan pay: $53,510
AE(MARR) = $58,623
IRR= 255.17%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-33
10.26 Option 3: Leasing
dB= t= 39% Lease cost
dE= 30% id= Beginning?
dO= MARR= 18% 1
tCG= N= 6
Year 0 1 2 3 4 5 6
Input Data:
Revenues 174,000 174,000 174,000 174,000 174,000 174,000
Expenses
Materials
Labour
Overhead 22,000 22,000 22,000 22,000 22,000 22,000
O&M 55,000 55,000 55,000 55,000 55,000 55,000
Investments
Land
Building
Machines
Others 25,000 25,000
Borrowed Money:
Calculated Entries:
Debt principal: - - - - - -
Debt interest - - - - - -
CCA
Building @dB - - - - - -
Machines @dE - - - - - -
Others @dO - - - - - -
Disposal tax effect
Land -
Building -
Machines -
Others -
Cash Flow Elements:
Revenue (1-t): 106,140 106,140 106,140 106,140 106,140 106,140
- Costs (1-t): (46,970) (46,970) (46,970) (46,970) (46,970) (13,420)
+ Beginning adjust? (55,000) 21,450
- Interest (1-t): - - - - - -
+ t × CCA: - - - - - -
Investments (25,000) 25,000
Debts: - - - - - - -
Net Cash Flow: (80,000) 59,170 59,170 59,170 59,170 59,170 139,170
PE(MARR) = $156,588
AE(MARR) = $44,770
IRR= 73.96%
Conclusion: Option 2 is the best with the highest PE value. Buy the machine via borrowing.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-34
*
10.27 Option 1: Leasing
dB= t= 40% Lease
dE= id= cost
dO= MARR= 12% Beginnin
tCG= N= 30 g?
1
Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
Input Data:
Revenues - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
Expenses
Materials
Labour
Overhead - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
O&M 84,000 84,000 84,000 84,000 84,000 84,000 84,000 84,000 84,000 84,000 84,000 84,000 84,000 84,000 84,000 84,000 84,000 84,000 84,000 84,000 84,000 84,000 84,000 84,000 84,000 84,000 84,000 84,000 84,000 84,000
Investments
Land
Building
Machines
Others
Borrowed Money:
Calculated Entries:
Debt principal: - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
Debt interest - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
CCA
Building @dB - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
Machines @dE - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
Others @dO - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
Disposal tax effect
Land -
Building -
Machines -
Others -
Cash Flow Elements:
Revenue (1-t): - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
- Costs (1-t): (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) -
+ Beginning adjust? (84,000) 33,600
- Interest (1-t): - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
+ t × CCA: - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
Investments - -
Debts: - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
Net Cash Flow: (84,000) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) 33,600
PE(MARR) = $(487,178)
AE(MARR) = $(60,480)
IRR= Undefined
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-35
*
10.27 Option 2: Purchase
dB= 4% t= 40% Lease cost
dE= id= Beginning
dO= MARR= 12% ?
tCG= N= 30 1
Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
Input Data:
Revenues - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
Expenses
Materials
Labour
Overhead 42,500 42,500 42,500 42,500 42,500 42,500 42,500 42,500 42,500 42,500 42,500 42,500 42,500 42,500 42,500 42,500 42,500 42,500 42,500 42,500 42,500 42,500 42,500 42,500 42,500 42,500 42,500 42,500 42,500 42,500
O&M (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000) (60,000)
Investments
Land 150,000 150,000
Building 700,000 70,000
Machines
Others
Borrowed Money:
Calculated Entries:
Debt principal: - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
Debt interest - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
CCA
Building @dB 14,000 27,440 26,342 25,289 24,277 23,306 22,374 21,479 20,620 19,795 19,003 18,243 17,513 16,813 16,140 15,495 14,875 14,280 13,709 13,160 12,634 12,129 11,643 11,178 10,731 10,301 9,889 9,494 9,114 8,749
Machines @dE - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
Others @dO - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
Disposal tax effect
Land -
Building 55,994
Machines -
Others -
Cash Flow Elements:
Revenue (1-t): - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
- Costs (1-t): 10,500 10,500 10,500 10,500 10,500 10,500 10,500 10,500 10,500 10,500 10,500 10,500 10,500 10,500 10,500 10,500 10,500 10,500 10,500 10,500 10,500 10,500 10,500 10,500 10,500 10,500 10,500 10,500 10,500 (25,500)
+ Beginning adjust? 60,000 (24,000)
- Interest (1-t): - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
+ t × CCA: 5,600 10,976 10,537 10,115 9,711 9,322 8,950 8,592 8,248 7,918 7,601 7,297 7,005 6,725 6,456 6,198 5,950 5,712 5,483 5,264 5,054 4,851 4,657 4,471 4,292 4,121 3,956 3,797 3,646 3,500
Investments (850,000) 275,994
Debts: - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
Net Cash Flow: (790,000) 16,100 21,476 21,037 20,615 20,211 19,822 19,450 19,092 18,748 18,418 18,101 17,797 17,505 17,225 16,956 16,698 16,450 16,212 15,983 15,764 15,554 15,351 15,157 14,971 14,792 14,621 14,456 14,297 14,146 229,994
PE(MARR) = $(632,662
)
AE(MARR) = $(78,541)
IRR= -0.43%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-36
*
10.27 Option 3: Remodelling
dB= 4% t= 40% Lease cost
dE= id= Beginning?
dO= MARR= 12% 1
tCG= N= 30
Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
Input Data:
Revenues - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
Expenses
Materials
Labour
Overhead 33,000 33,000 33,000 33,000 33,000 33,000 33,000 33,000 33,000 33,000 33,000 33,000 33,000 33,000 33,000 33,000 33,000 33,000 33,000 33,000 33,000 33,000 33,000 33,000 33,000 33,000 33,000 33,000 33,000 33,000
O&M 9,000 9,500 10,000 10,500 11,000 11,500 12,000 12,500 13,000 13,500 14,000 14,500 15,000 15,500 16,000 16,500 17,000 17,500 18,000 18,500 19,000 19,500 20,000 20,500 21,000 21,500 22,000 22,500 23,000 23,500
Investments
Land 60,000
Building 300,000 60,000
Machines
Others
Borrowed Money:
Calculated Entries:
Debt principal: - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
Debt interest - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
CCA
Building @dB 6,000 11,760 11,290 10,838 10,404 9,988 9,589 9,205 8,837 8,484 8,144 7,818 7,506 7,205 6,917 6,641 6,375 6,120 5,875 5,640 5,415 5,198 4,990 4,790 4,599 4,415 4,238 4,069 3,906 3,750
Machines @dE - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
Others @dO - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
Disposal tax effect
Land -
Building 11,998
Machines -
Others -
Cash Flow Elements:
Revenue (1-t): - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
- Costs (1-t): (25,500) (25,800) (26,100) (26,400) (26,700) (27,000) (27,300) (27,600) (27,900) (28,200) (28,500) (28,800) (29,100) (29,400) (29,700) (30,000) (30,300) (30,600) (30,900) (31,200) (31,500) (31,800) (32,100) (32,400) (32,700) (33,000) (33,300) (33,600) (33,900) (19,800)
+ Beginning adjust? (9,000) (200) (200) (200) (200) (200) (200) (200) (200) (200) (200) (200) (200) (200) (200) (200) (200) (200) (200) (200) (200) (200) (200) (200) (200) (200) (200) (200) (200) (200) 9,400
- Interest (1-t): - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
+ t × CCA: (300,000) 2,400 4,704 4,516 4,335 4,162 3,995 3,836 3,682 3,535 3,393 3,258 3,127 3,002 2,882 2,767 2,656 2,550 2,448 2,350 2,256 2,166 2,079 1,996 1,916 1,840 1,766 1,695 1,627 1,562 1,500
Investments 131,998
Debts: - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
Net Cash Flow: ( 309,000) (23,300) (21,296) (21,784) (22,265) (22,738) (23,205) (23,664) (24,118) (24,565) (25,007) (25,442) (25,873) (26,298) (26,718) (27,133) (27,544) (27,950) (28,352) (28,750) (29,144) (29,534) (29,921) (30,304) (30,684) (31,060) (31,434) (31,805) (32,173) (32,538) 123,097
PE(MARR) = $(500,353)
AE(MARR) = $(62,116)
IRR= Undefined
Conclusion: Option 1 (leasing) is the best as it has the least negative PE value.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-37
10.28 Option 1: Plant A All numbers in '000 dollars
dB= t= 39% Lease cost
dE= 30% id= Beginning?
dO= MARR= 12%
tCG= N= 20
0
Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Input Data:
Revenues - - - - - - - - - - - - - - - - -
Expenses
Materials
Labour
Overhead - - - - - - - - - - - - - - - - - - -
O&M 1,964 1,964 1,964 1,964 1,964 1,964 1,964 1,964 1,964 1,964 1,964 1,964 1,964 1,964 1,964 1,964 1,964 1,964 1,964 1,964
Investments
Land
Building -
Machines 8,530 853
Others
Borrowed Money:
Calculated Entries:
Debt principal: - - - - - - - - - - - - - - - - - - - -
Debt interest - - - - - - - - - - - - - - - - - - - -
CCA
Building @dB - - - - - - - - - - - - - - - - - - -
Machines @dE 1,280 2,175 1,523 1,066 746 522 366 256 179 125 88 61 43 30 21 15 10 7 5 4
Others @dO - - - - - - - - - - - - - - - - - - - -
Disposal tax effect
Land -
Building -
Machines (329)
Others -
Cash Flow Elements:
Revenue (1-t): - - - - - - - - - - - - - - - - - - - -
- Costs (1-t): (1,198) (1,198) (1,198) (1,198) (1,198) (1,198) (1,198) (1,198) (1,198) (1,198) (1,198) (1,198) (1,198) (1,198) (1,198) (1,198) (1,198) (1,198) (1,198) (1,198)
+ Beginning adjust? - - - - - - - - - - - - - - - - - - - -
- Interest (1-t): - - - - - - - - - - - - - - - - - - -
+ t x CCA: 499 848 594 416 291 204 143 100 70 49 34 24 17 12 8 6 4 3 2 1
Investments (8,530) 524
Debts: - - - - - - - - - - - - - - - - - - - - -
Net Cash Flow: (8,530) (699) (350) (604) (782) (907) (994) (1,055) (1,098) (1,128) (1,149) (1,164) (1,174) (1,181) (1,186) (1,190) (1,192) (1,194) (1,195) (1,196) (673)
PE(MARR) = $(15,176) Power needs/year = 50,000,000 kWh
AE(MARR) = $(2,032) Unit power cost = $ 0.0406 /kwh
IRR= Undefined
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-38
10.28 Option 2: Plant B All numbers in '000 dollars
dB= t= 39% Lease cost
dE= 30% id= Beginning?
dO= MARR= 12%
tCG= N= 20
0
Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Input Data:
Revenues - - - - - - - - - - - - - - - - - - -
Expenses
Materials
Labour
Overhead - - - - - - - - - - - - - - - - - - -
O&M 1,744 1,744 1,744 1,744 1,744 1,744 1,744 1,744 1,744 1,744 1,744 1,744 1,744 1,744 1,744 1,744 1,744 1,744 1,744 1,744
Investments
Land
Building -
Machines 9,498 950
Others
Borrowed Money:
Calculated Entries:
Debt principal: - - - - - - - - - - - - - - - - - - - -
Debt interest - - - - - - - - - - - - - - - - - - - -
CCA
Building @dB - - - - - - - - - - - - - - - - - - - -
Machines @dE 1,425 2,422 1,695 1,187 831 582 407 285 199 140 98 68 48 34 23 16 11 8 6 4
Others @dO - - - - - - - - - - - - - - - - - - - -
Disposal tax effect
Land -
Building -
Machines (367)
Others -
Cash Flow Elements:
Revenue (1-t): - - - - - - - - - - - - - - - - - - - -
- Costs (1-t): (1,064) (1,064) (1,064) (1,064) (1,064) (1,064) (1,064) (1,064) (1,064) (1,064) (1,064) (1,064) (1,064) (1,064) (1,064) (1,064) (1,064) (1,064) (1,064) (1,064)
+ Beginning adjust? - - - - - - - - - - - - - - - - - - - - -
- Interest (1-t): - - - - - - - - - - - - - - - - - - - -
+ t × CCA: 556 945 661 463 324 227 159 111 78 54 38 27 19 13 9 6 4 3 2 2
Investments (9,498) 583
Debts: - - - - - - - - - - - - - - - - - - - - -
Net Cash Flow: (9,498) (508) (119) (403) (601) (740) (837) (905) (953) (986) (1,009) (1,026) (1,037) (1,045) (1,051) (1,055) (1,057) (1,059) (1,061) (1,064) (479)
PE(MARR) = $(14,880)
AE(MARR) = $(1,992) Unit power cost = $ 0.0398 /kWh
IRR= Undefined
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-39
10.28 Option 3: Plant C All numbers in '000 dollars
dB= t= 39% Lease cost
dE= 30% id= Beginning?
dO= MARR= 12% 0
tCG= N= 20
Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Input Data:
Revenues - - - - - - - - - - - - - - - - - - -
Expenses
Materials
Labour
Overhead - - - - - - - - - - - - - - - - - - -
O&M 1,632 1,632 1,632 1,632 1,632 1,632 1,632 1,632 1,632 1,632 1,632 1,632 1,632 1,632 1,632 1,632 1,632 1,632 1,632 1,632
Investments
Land
Building -
Machines 10,546 1,055
Others
Borrowed Money:
Calculated Entries:
Debt principal: - - - - - - - - - - - - - - - - - - - -
Debt interest - - - - - - - - - - - - - - - - - - - -
CCA
Building @dB - - - - - - - - - - - - - - - - - - - -
Machines @dE 1,582 2,689 1,882 1,318 922 646 452 316 221 155 109 76 53 37 26 18 13 9 6 4
Others @dO - - - - - - - - - - - - - - - - - - - -
Disposal tax effect
Land -
Building -
Machines (407)
Others -
Cash Flow Elements:
Revenue (1-t): - - - - - - - - - - - - - - - - - - - -
- Costs (1-t): (996) (996) (996) (996) (996) (996) (996) (996) (996) (996) (996) (996) (996) (996) (996) (996) (996) (996) (996) (996)
+ Beginning adjust? - - - - - - - - - - - - - - - - - - - - -
- Interest (1-t): - - - - - - - - - - - - - - - - - - - -
+ t × CCA 617 1,049 734 514 360 252 176 123 86 60 42 30 21 15 10 7 5 3 2 2
Investments (10,546) 647
Debts: - - - - - - - - - - - - - - - - - - - - -
Net Cash Flow: (10,546) (379) 53 (261) (482) (636) (744) (819) (872) (909) (935) (953) (966) (975) (981) (985) (988) (991) (992) (993) (347)
PE(MARR) = $(15,13
5)
AE(MARR) = $(2,026) Unit power cost = $0.0405 /kWh
IRR = Undefined
Conclusion: Plant B is the best as it has the lowest cost per kWh of power generated.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-40
Lease-Versus-Buy Decisions
10.29 Option 1: Leasing
dB= t= 40% Lease cost
dE= id= Beginning?
dO= MARR= 15% 1
tCG= N= 4
Year 0 1 2 3 4
Input Data:
Revenues - - -
Expenses
Materials
Labour
Overhead - - -
O&M 11,000 11,000 11,000 11,000
Investments
Land
Building -
Machines -
Others
Borrowed Money:
Calculated Entries:
Debt principal: - - - -
Debt interest - - - -
CCA
Building @dB - - - -
Machines @dE - - - -
Others @dO - - - -
Disposal tax effect
Land -
Building -
Machines -
Others -
Cash Flow Elements:
Revenue (1-t): - - - -
- Costs (1-t): (6,600) (6,600) (6,600) -
+ Beginning adjust? (11,000) - - - 4,400
- Interest (1-t): - - - -
+ t × CCA: - - - -
Investments - -
Debts: - - - - -
Net Cash Flow: (11,000) (6,600) (6,600) (6,600) 4,400
PE(MARR) = $(23,554)
AE(MARR) = $(8,250)
IRR= Undefined
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-41
10.29 Option 2: Buying
dB= t= 40% Lease cost
dE= 30% id= 12% Beginning?
dO= MARR= 15% 0
tCG= N= 4
Year 0 1 2 3 4
Input Data:
Revenues - - -
Expenses
Materials
Labour
Overhead - - -
O&M 1,200 1,200 1,200 1,200
Investments
Land
Building -
Machines 41,000 10,000
Others
Borrowed Money: 41,000
Calculated Entries:
Debt principal: 8,579 9,608 10,761 12,052
Debt interest 4,920 3,891 2,738 1,446
CCA
Building @dB - - - -
Machines @dE 6,150 10,455 7,319 5,123
Others @dO - - - -
Disposal tax effect
Land -
Building -
Machines 781
Others -
Cash Flow Elements:
Revenue (1-t): - - - -
- Costs (1-t): (720) (720) (720) (720)
+ Beginning adjust? - - - - -
- Interest (1-t): (2,952) (2,334) (1,643) (868)
+ t × CCA: 2,460 4,182 2,927 2,049
Investments (41,000) 10,781
Debts: 41,000 (8,579) (9,608) (10,761) (12,052)
Net Cash Flow: - (9,791) (8,480) (10,196) (809)
PE(MARR) = $(22,093) Annual loan payment 13,499
AE(MARR) = $(7,738)
IRR= Undefined
Conclusion: Buying is better as it has a less negative PE value.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-42
*
10.30 The buy option
dB= t= 40% Lease cost
dE= 30% id= 10% Beginning?
dO= MARR= 15% 0
tCG= N= 4
Year 0 1 2 3 4
Input Data:
Revenues 200,000 200,000 200,000 200,000
Expenses
Materials
Labour
Overhead 10,000 10,000 10,000 10,000
O&M 40,000 40,000 40,000 40,000
Investments
Land
Building -
Machines 130,000 20,000
Others
Borrowed Money: 130,000
Calculated Entries:
Debt principal: 28,011 30,812 33,894 37,283
Debt interest 13,000 10,199 7,118 3,728
CCA
Building @dB - - - -
Machines @dE 19,500 33,150 23,205 16,244
Others @dO - - - -
Disposal tax effect
Land -
Building -
Machines 7,161
Others -
Cash Flow Elements:
Revenue (1-t): 120,000 120,000 120,000 120,000
- Costs (1-t): (30,000) (30,000)(30,000) (30,000)
+ Beginning adjust? - - - - -
- Interest (1-t): (7,800) (6,119) (4,271) (2,237)
+ t × CCA: 7,800 13,260 9,282 6,497
Investments (130,000) 27,161
Debts: 130,000 (28,011) (30,812) (33,894) (37,283)
Net Cash Flow: - 61,989 66,328 61,118 84,138
PE(MARR) = $192,349 Annual loan payment: 41,011
AE(MARR) = $67,373
IRR= Undefined
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-43
*
10.30 The lease option
dB= t= 40% Lease cost
dE= id= Beginning?
dO= MARR= 15% 1
tCG= N= 4
Year 0 1 2 3 4
Input Data:
Revenues 200,000 200,000 200,000 200,000
Expenses
Materials
Labour
Overhead 40,000 40,000 40,000 40,000
O&M 44,000 44,000 44,000 44,000
Investments
Land
Building -
Machines
Others
Borrowed Money:
Calculated Entries:
Debt principal: - - - -
Debt interest - - - -
CCA
Building @dB - - - -
Machines @dE - - - -
Others @dO - - - -
Disposal tax effect
Land -
Building -
Machines -
Others -
Cash Flow Elements:
Revenue (1-t): 120,000 120,000 120,000 120,000
- Costs (1-t): (50,400) (50,400) (50,400) (24,000)
+ Beginning adjust? (44,000) - - - 17,600
- Interest (1-t): - - - -
+ t × CCA: - - - -
Investments - -
Debts: - - - - -
Net Cash Flow: (44,000) 69,600 69,600 69,600 113,600
PE(MARR) = $179,864 -
AE(MARR) = $63,000
IRR= 158.18%
Conclusion: The buy option is better because its PE value is larger.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-44
10.31 The borrow-and-purchase option
dB= t= 40% Lease cost
dE= 30% id= 10% Beginning?
dO= MARR= 15% 0
tCG= N= 4
Year 0 1 2 3 4
Input Data:
Revenues - - -
Expenses
Materials
Labour
Overhead - - -
O&M 12,000 12,000 12,000 12,000
Investments
Land
Building -
Machines 200,000 20,000
Others
Borrowed Money: 200,000
Calculated Entries:
Debt principal: 43,094 47,404 52,144 57,358
Debt interest 20,000 15,691 10,950 5,736
CCA
Building @dB - - - -
Machines @dE 30,000 51,000 35,700 24,990
Others @dO - - - -
Disposal tax effect
Land -
Building -
Machines 15,324
Others -
Cash Flow Elements:
Revenue (1-t): - - - -
- Costs (1-t): (7,200) (7,200) (7,200) (7,200)
+ Beginning adjust? - - - - -
- Interest (1-t): (12,000) (9,414) (6,570) (3,441)
+ t × CCA: 12,000 20,400 14,280 9,996
Investments (200,000) 35,324
Debts: 200,000 (43,094) (47,404) (52,144) (57,358)
Net Cash Flow: - (50,294) (43,618) (51,634) (22,680)
PE(MARR) = $(123,633) Annual debt payment: $63,094
AE(MARR) = $(43,304)
IRR= Undefined
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-45
10.31 The lease option
dB= t= 40% Lease cost
dE= id= Beginning
dO= MARR= 15% ?
tCG= N= 4 0
Year 0 1 2 3 4
Input Data:
Revenues - - -
Expenses
Materials
Labour
Overhead - - -
O&M 70,000 70,000 70,000 70,000
Investments
Land
Building -
Machines
Others
Borrowed Money:
Calculated Entries:
Debt principal: - - - -
Debt interest - - - -
CCA
Building @dB - - - -
Machines @dE - - - -
Others @dO - - - -
Disposal tax effect
Land -
Building -
Machines -
Others -
Cash Flow Elements:
Revenue (1-t): - - - -
- Costs (1-t): (42,000) (42,000) (42,000) (42,000)
+ Beginning adjust? - - - - -
- Interest (1-t): - - - -
+ t × CCA: - - - -
Investments - -
Debts: - - - - -
Net Cash Flow: - (42,000) (42,000) (42,000) (42,000)
PE(MARR) = $(119,909) -
AE(MARR) = $(42,000)
IRR= Undefined
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-46
10.32 The buy option
dB= t= 35% Lease cost
dE= 30% id= 12.6% Beginning?
dO= MARR= 13% 0
tCG= N= 3
Year 0 1 2 3
Input Data:
Revenues -
Expenses
Materials
Labour
Overhead -
O&M -
Investments
Land
Building -
Machines 18,000 5,800
Others
Borrowed Money: 18,000
Calculated Entries:
Debt principal: 5,304 5,972 6,724
Debt interest 2,268 1,600 847
CCA
Building @dB - - -
Machines @dE 2,700 4,590 3,213
Others @dO - - -
Disposal tax effect
Land -
Building -
Machines 594
Others -
Cash Flow Elements:
Revenue (1-t): - - -
- Costs (1-t): - - -
+ Beginning adjust? - - - -
- Interest (1-t): (1,474) (1,040) (551)
+ t × CCA: 945 1,607 1,125
Investments (18,000) 6,394
Debts: 18,000 (5,304) (5,972) (6,724)
Net Cash Flow: - (5,833) (5,405) 243
PE(MARR) = $(9,226) Loan pay/yr: $7,572
AE(MARR) = $(3,908)
IRR= Undefined
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-47
10.32 The lease option
dB= t= 35% Lease cost
dE= id= Beginning?
dO= MARR= 13% 1
tCG= N= 3
Year 0 1 2 3
Input Data:
Revenues -
Expenses
Materials
Labour
Overhead -
O&M 5,100 5,100 5,100
Investments
Land
Building -
Machines
Others 500 500
Borrowed Money:
Calculated Entries:
Debt principal: - - -
Debt interest - - -
CCA
Building @dB - - -
Machines @dE - - -
Others @dO - - -
Disposal tax effect
Land -
Building -
Machines -
Others -
Cash Flow Elements:
Revenue (1-t): - - -
- Costs (1-t): (3,315 (3,315) -
)
+ Beginning adjust? (5,100) - - 1,785
- Interest (1-t): - - -
+ t × CCA: - - -
Investments (500) 500
Debts: - - - -
Net Cash Flow: (5,600) (3,315) (3,315) 2,285
PE(MARR) = $(9,546) -
AE(MARR) = $(4,043)
IRR= Undefined
Conclusion: The buy option is better with a higher PE value.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-48
10.33 The lease option
dB= t= 40% Lease cost
dE= id= Beginning?
dO= MARR 15% 1
tCG= = 3
N=
Year 0 1 2 3
Input Data:
Revenues -
Expenses
Materials
Labour
Overhead -
O&M 15,000 15,000 15,000
Investments
Land
Building -
Machines
Others
Borrowed Money:
Calculated Entries:
Debt principal: - - -
Debt interest - - -
CCA
Building @dB - - -
Machines @dE - - -
Others @dO - - -
Disposal tax effect
Land -
Building -
Machines -
Others -
Cash Flow Elements:
Revenue (1-t): - - -
- Costs (1-t): (9,000) (9,000) -
+ Beginning adjust? (15,000) - - 6,000
- Interest (1-t): - - -
+ t × CCA: - - -
Investments - -
Debts: - - - -
Net Cash Flow: (15,000) (9,000) (9,000) 6,000
PE(MARR) = $(25,686) -
AE(MARR) = $(11,250)
IRR= Undefined
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-49
10.33 The buy option
dB= t= 40% Lease cost
dE= 30% id= 12% Beginning?
dO= MARR= 15% 0
tCG= N= 3
Year 0 1 2 3
Input Data:
Revenues -
Expenses
Materials
Labour
Overhead -
O&M 5,000 5,000 5,000
Investments
Land
Building -
Machines 80,000 50,000
Others
Borrowed Money: 80,000
Calculated Entries:
Debt principal: 23,708 26,553 29,739
Debt interest 9,600 6,755 3,569
CCA
Building @dB - - -
Machines @dE 12,000 20,400 14,280
Others @dO - - -
Disposal tax effect
Land -
Building -
Machines (6,672)
Others -
Cash Flow Elements:
Revenue (1-t): - - -
- Costs (1-t): (3,000) (3,000) (3,000)
+ Beginning adjust? - - - -
- Interest (1-t): (5,760) (4,053) (2,141)
+ t × CCA: 4,800 8,160 5,712
Investments (80,000) 43,328
Debts: 80,000 (23,708) (26,553) (29,739)
Net Cash Flow: - (27,668) (25,446) 14,160
PE(MARR) = $(33,990) Loan pay/yr: $33,308
AE(MARR) = $(14,887)
IRR= Undefined
Conclusion: The lease option is much better.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-50
*
10.34 The buy option
dB= t= 30% Lease cost
dE= 20% id= 12% Beginning?
dO= MARR= 10% 0
tCG= N= 5
Year 0 1 2 3 4 5
Input Data:
Revenues 10,000 10,000 10,000 10,000 10,000
Expenses
Materials
Labour
Overhead - - - -
O&M 2,500 2,500 2,500 2,500 2,500
Investments
Land
Building -
Machines 25,000 5,000
Others
Borrowed Money: 25,000
Calculated Entries:
Debt principal: 3,935 4,407 4,936 5,529 6,192
Debt interest 3,000 2,528 1,999 1,407 743
CCA
Building @dB - - - - -
Machines @dE 2,500 4,500 3,600 2,880 2,304
Others @dO - - - - -
Disposal tax effect
Land -
Building -
Machines 1,265
Others -
Cash Flow Elements:
Revenue (1-t): 7,000 7,000 7,000 7,000 7,000
- Costs (1-t): (1,750) (1,750) (1,750) (1,750) (1,750)
+ Beginning adjust? - - - - - -
- Interest (1-t): (2,100) (1,769) (1,399) (985) (520)
+ t × CCA: 750 1,350 1,080 864 691
Investments (25,000) 6,265
Debts: 25,000 (3,935) (4,407) (4,936) (5,529) (6,192)
Net Cash Flow: - (35) 423 (6) (399) 5,494
PE(MARR) = $3,452 Annual debt payment: $6,935
AE(MARR) = $911
IRR= N/A
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-51
*
10.34 The lease option
dB= t= 30% Lease cost
dE= id= Beginning?
dO= MARR= 10% 1
tCG= N= 5
Year 0 1 2 3 4 5
Input Data:
Revenues 10,000 10,000 10,000 10,000 10,000
Expenses
Materials
Labour
Overhead 2,500 2,500 2,500 2,500 2,500
O&M 3,500 3,500 3,500 3,500 3,500
Investments
Land
Building -
Machines
Others
Borrowed Money:
Calculated Entries:
Debt principal: - - - - -
Debt interest - - - - -
CCA
Building @dB - - - - -
Machines @dE - - - - -
Others @dO - - - - -
Disposal tax effect
Land -
Building -
Machines -
Others -
Cash Flow Elements:
Revenue (1-t): 7,000 7,000 7,000 7,000 7,000
- Costs (1-t): (4,200) (4,200) (4,200) (4,200) (1,750)
+ Beginning adjust? (3,500) - - - - 1,050
- Interest (1-t): - - - - -
+ t × CCA: - - - - -
Investments - -
Debts: - - - - - -
Net Cash Flow: (3,500) 2,800 2,800 2,800 2,800 6,300
PE(MARR) = $9,287 -
AE(MARR) = $2,450
IRR= 80.00%
Conclusion: The lease option is better with a higher PE value.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-52
10.35 Buy and lease out
dB= t= 35% Lease cost
dE= 40% id= Beginning?
dO= MARR= 10% 1
tCG= N= 3
Year 0 1 2 3
Input Data:
Revenues -
Expenses
Materials
Labour
Overhead -
O&M (14,431) (14,431) (14,431)
Investments
Land
Building -
Machines 53,000 22,000
Others (1,500) (1,500)
Borrowed Money:
Calculated Entries:
Debt principal: - - -
Debt interest - - -
CCA
Building @dB - - -
Machines @dE 10,600 16,960 10,176
Others @dO - - -
Disposal tax effect
Land -
Building -
Machines (2,358)
Others -
Cash Flow Elements:
Revenue (1-t): - - -
- Costs (1-t): 9,380 9,380 -
+ Beginning adjust? 14,431 - - (5,051)
- Interest (1-t): - - -
+ t × CCA: 3,710 5,936 3,562
Investments (51,500) 18,142
Debts: - - - -
Net Cash Flow: (37,069) 13,090 15,316 16,653
PE(MARR) = - -
AE(MARR) = -
IRR= 10.00%
Conclusion: Charge $14,431 at the beginning of each year for three years.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-53
Short Case Studies
ST10.1 (a) and (b) All numbers in '000 dollars
dB= 4% t= 40%
dE= 30% id=
dO= MARR= 15%
tCG= 20% N= 12%
Year 0 1 2 3 4 5 6 7 8 9 10 11 12
Income Statement
Revenues 51,000 51,000 51,000 51,000 85,000 85,000 85,000 136,000 136,000 136,000 136,000 136,000
Expenses
Materials
Labour
Overhead
O&M 36,000 36,000 36,000 36,000 60,000 60,000 60,000 96,000 96,000 96,000 96,000 96,000
Debt interest - - - - - - - - - - - -
CCA
Building @dB 800 1,568 1,505 1,445 1,387 1,332 1,279 1,227 1,178 1,131 1,086 1,042
Machines @dE 14,250 24,225 16,958 11,870 8,309 5,816 4,071 2,850 1,995 1,397 978 684
Others @dO - - - - - - - - - - - -
Taxable income (50) (10,793) (3,463) 1,685 15,304 17,852 19,650 35,923 36,827 37,472 37,937 38,273
Income taxes @t (20) (4,317) (1,385) 674 6,121 7,141 7,860 14,369 14,731 14,989 15,175 15,309
Net income (30) (6,476) (2,078) 1,011 9,182 10,711 11,790 21,554 22,096 22,483 22,762 22,964
Cash Flow Statement
Operating activities
Net income (30) (6,476) (2,078) 1,011 9,182 10,711 11,790 21,554 22,096 22,483 22,762 22,964
CCA 15,050 25,793 18,463 13,315 9,696 7,148 5,350 4,077 3,173 2,528 2,063 1,727
Investment activities
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-54
Land (5,000) 8,000
Building (40,000) 30,000
Machines (95,000) 10,000
Others
Disposal tax effect
Land (600)
Building (1,992)
Machines (3,361)
Others -
Financing activities
Principal portion - - - - - - - - - - - -
Net cash flow (140,000) 15,020 19,317 16,385 14,326 18,879 17,859 17,140 25,631 25,269 25,011 24,825 66,737
PE(MARR) = $(30,264)
AE(MARR) = $(5,583)
IRR= 10.55%
(c) The project should be rejected as its IRR is lower than the MARR of 15%.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-55
ST10.2 Morgantown Mining Company
(a) Unit-production method
(Units are thousand dollars)
0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues (savings) $9,500 $9,500 $9,500 $9,500 $9,500 $9,500 $9,500 $9,500 $9,500 $9,500
Expenses:
O&M $2,400 $2,400 $2,400 $2,400 $2,400 $2,400 $2,400 $2,400 $2,400 $2,400
Depreciation $1,880 $1,880 $1,880 $1,880 $1,880 $1,880 $1,880 $1,880 $1,880 $1,880
Taxable Income $5,220 $5,220 $5,220 $5,220 $5,220 $5,220 $5,220 $5,220 $5,220 $5,220
Income Taxes (40%) $2,088 $2,088 $2,088 $2,088 $2,088 $2,088 $2,088 $2,088 $2,088 $2,088
Net Income $3,132 $3,132 $3,132 $3,132 $3,132 $3,132 $3,132 $3,132 $3,132 $3,132
Cash Flow Statement
Operating Activities:
Net Income $3,132 $3,132 $3,132 $3,132 $3,132 $3,132 $3,132 $3,132 $3,132 $3,132
Depreciation $1,880 $1,880 $1,880 $1,880 $1,880 $1,880 $1,880 $1,880 $1,880 $1,880
Investment Activities:
Investment ($19,300)
Salvage $500
Gains Tax
Working capital ($2,500) $2,500
Net Cash Flow ($21,800) $5,012 $5,012 $5,012 $5,012 $5,012 $5,012 $5,012 $5,012 $5,012 $8,012
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-56
(b) Seven-year MACRS
(Units are thousand dollars)
0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues (savings) $9,500 $9,500 $9,500 $9,500 $9,500 $9,500 $9,500 $9,500 $9,500 $9,500
Expenses:
O&M $2,400 $2,400 $2,400 $2,400 $2,400 $2,400 $2,400 $2,400 $2,400 $2,400
Depreciation $2,758 $4,727 $3,376 $2,411 $1,723 $1,722 $1,723 $861 $0 $0
Taxable Income $4,342 $2,373 $3,724 $4,689 $5,377 $5,378 $5,377 $6,239 $7,100 $7,100
Income Taxes (40%) $1,737 $949 $1,490 $1,876 $2,151 $2,151 $2,151 $2,496 $2,840 $2,840
Net Income $2,605 $1,424 $2,235 $2,814 $3,226 $3,227 $3,226 $3,744 $4,260 $4,260
Cash Flow Statement
Operating Activities:
Net Income $2,605 $1,424 $2,235 $2,814 $3,226 $3,227 $3,226 $3,744 $4,260 $4,260
Depreciation $2,758 $4,727 $3,376 $2,411 $1,723 $1,722 $1,723 $861 $0 $0
Investment Activities:
Investment ($19,300)
Salvage $500
Gains Tax ($200)
Working capital ($2,500) $2,500
Net Cash Flow ($21,800) $5,363 $6,151 $5,610 $5,224 $4,949 $4,949 $4,949 $4,604 $4,260 $7,060
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-57
ST10.3 (a) Equity financing
dB= t= 40%
dE= 30% id=
dO= MARR= 20%
tCG= N= 6
Year 0 1 2 3 4 5 6
Income Statement
Revenues 349,000 349,000 349,000 349,000 349,000 349,000
Expenses
Materials 140,000 140,000 140,000 140,000 140,000 140,000
Labour
Overhead 20,000
O&M 36,000 36,000 36,000 36,000 36,000 36,000
Debt interest - - - - - -
CCA
Building @dB - - - - - -
Machines @dE 36,000 61,200 42,840 29,988 20,992 14,694
Others @dO - - - - - -
Taxable income 117,000 111,800 130,160 143,012 152,008 158,306
Income taxes @t 46,800 44,720 52,064 57,205 60,803 63,322
Net income 70,200 67,080 78,096 85,807 91,205 94,984
Cash Flow Statement
Operating activities
Net income 70,200 67,080 78,096 85,807 91,205 94,984
CCA 36,000 61,200 42,840 29,988 20,992 14,694
Investment activities
Land
Building
Machines (240,000) 30,000
Others
Disposal tax effect
Land -
Building -
Machines 1,715
Others -
Financing activities
Principal portion - - - - - -
Net cash flow (240,000) 106,200 128,280 120,936 115,795 112,197 141,392
PE(MARR) = $155,853 -
AE(MARR) = $46,866
IRR= 43.31%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-58
ST 10.3 (b) Debt financing
dB= t= 40%
dE= 30% id= 13%
dO= MARR= 20%
tCG= N= 6
Year 0 1 23 4 5 6
Income Statement
Revenues 349,000 349,000 349,000 349,000 349,000 349,000
Expenses
Materials 140,000 140,000 140,000 140,000 140,000 140,000
Labour
Overhead 20,000
O&M 36,000 36,000 36,000 36,000 36,000 36,000
Debt interest 31,200 27,451 23,215 18,428 13,019 6,907
CCA
Building @dB - - - - - -
Machines @dE 36,000 61,200 42,840 29,988 20,992 14,694
Others @dO - - - - - -
Taxable income 85,800 84,349 106,945 124,584 138,989 151,399
Income taxes @t 34,320 33,740 42,778 49,833 55,596 60,560
Net income 51,480 50,609 64,167 74,750 83,394 90,839
Cash Flow Statement
Operating activities
Net income 51,480 50,609 64,167 74,750 83,394 90,839
CCA 36,000 61,200 42,840 29,988 20,992 14,694
Investment activities
Land
Building
Machines (240,000) 30,000
Others
Disposal tax effect
Land -
Building -
Machines 1,715
Others -
Financing activities
Principal portion 240,000 (28,837) (32,586) (36,822) (41,608) (47,018) (53,130)
Net cash flow - 58,643 79,224 70,185 63,130 57,368 84,118
PE(MARR) = $226,173 Annual debt payment $60,037
AE(MARR) = $68,011
IRR= Undefined
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-59
ST 10.3 (c) Lease financing
dB= t= 40% Lease cost
dE= id= Beginning?
dO= MARR= 20% 1
tCG= N= 6
Year 0 1 2 3 4 5 6
Input Data:
Revenues 349,000 349,000 349,000 349,000 349,000 349,000
Expenses
Materials 140,000 140,000 140,000 140,000 140,000 140,000
Labour 20,000
Overhead 36,000 36,000 36,000 36,000 36,000 36,000
O&M 62,560 62,560 62,560 62,560 62,560 62,560
Investments
Land
Building
Machines
Others
Borrowed Money:
Calculated Entries:
Debt principal: - - - - - -
Debt interest - - - - - -
CCA
Building @dB - - - - - -
Machines @dE - - - - - -
Others @dO - - - - - -
Disposal tax effect
Land -
Building -
Machines -
Others -
Cash Flow Elements:
Revenue (1-t): 209,400 209,400 209,400 209,400 209,400 209,400
- Costs (1-t): (155,136) (143,136) (143,136) (143,136) (143,136) (105,600)
+ Beginning adjust? (62,560) - - - - - 25,024
- Interest (1-t): - - - - - -
+ t × CCA: - - - - - -
Investments - -
Debts: - - - - - - -
Net Cash Flow: (62,560) 54,264 66,264 66,264 66,264 66,264 128,824
PE(MARR) = $168,75
3
AE(MARR) = $50,745
IRR= 96.34%
Conclusion: The debt financing option is the best with the highest PE value.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-60
ST 10.4 (a) Option 1: Lease
dB= t= 35% Lease cost
dE= id= Beginning?
dO= MARR= 15% 1
tCG= N= 10
Year 0 1 2 3 4 5 6 7 8 9 10
Input Data:
Revenues - - - - - - - - -
Expenses
Materials 1,660 1,660 1,660 1,660 1,660 1,660 1,660 1,660 1,660 1,660
Labour 58,683 58,683 58,683 58,683 58,683 58,683 58,683 58,683 58,683 58,683
Overhead 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000
O&M 11,782 11,782 11,782 11,782 11,782 11,782 11,782 11,782 11,782 11,782
Investments
Land
Building
Machines
Others
Borrowed Money:
Calculated Entries:
Debt principal: - - - - - - - - - -
Debt interest - - - - - - - - - -
CCA
Building @dB - - - - - - - - - -
Machines @dE - - - - - - - - - -
Others @dO - - - - - - - - - -
Disposal tax effect
Land -
Building -
Machines -
Others -
Cash Flow Elements:
Revenue (1-t): - - - - - - - - - -
- Costs (1-t): (53,381) (53,381) (53,381) (53,381) (53,381) (53,381) (53,381) (53,381) (53,381) (45,723)
+ Beginning adjust? (11,782) - - - - - - - - - 4,124
- Interest (1-t): - - - - - - - - - -
+ t × CCA: - - - - - - - - - -
Investments - -
Debts: - - - - - - - - - - -
Net Cash Flow: (11,782) (53,381) (53,381) (53,381) (53,381) (53,381) (53,381) (53,381) (53,381) (53,381) (41,599)
PE(MARR) = $(276,778
)
AE(MARR) = $(55,149)
IRR= Undefined
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
10-61
ST 10.4 (a) Option 2: Buy
dB= t= 35% Lease cost
dE= 30% id= 10% Beginning?
dO= MARR= 15% 1
tCG= N= 10
Year 0 1 2 3 4 5 6 7 8 9 10
Input Data:
Revenues - - - - - - - - -
Expenses
Materials
Labour
Overhead
O&M 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000
Investments
Land
Building
Machines 209,000 -
Others
Borrowed Money: 209,000
Calculated Entries:
Debt principal: 34,234 37,657 41,423 45,565 50,122
Debt interest 20,900 17,477 13,711 9,569 5,012
CCA
Building @dB - - - - - - - - -
Machines @dE 31,350 53,295 37,307 26,115 18,280 12,796 8,957 6,270 4,389 3,072
Others @dO - - - - - - - - -
Disposal tax effect
Land -
Building -
Machines 2,509
Others -
Cash Flow Elements:
Revenue (1-t): - - - - - - - - - -
- Costs (1-t): (13,000) (13,000) (13,000) (13,000) (13,000) (13,000) (13,000) (13,000) (13,000) -
+ Beginning adjust? (20,000) - - - - - - - - - 7,000
- Interest (1-t): (13,585) (11,360) (8,912) (6,220) (3,258) - - - - -
+ t × CCA: 10,973 18,653 13,057 9,140 6,398 4,479 3,135 2,195 1,536 1,075
Investments (209,000) 2,509
Debts: 209,000 (34,234) (37,657) (41,423) (45,565) (50,122) - - - - -
Net Cash Flow: (20,000) (49,846) (43,364) (50,278) (55,645) (59,981) (8,521) (9,865) (10,805) (11,464) 10,584
PE(MARR) = $(202,396) Annual debt pay: $55,134
AE(MARR) = $(40,328)
IRR= Undefined
(b) The buy option is better because its PE value is less negative.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-1
Part 4
Special Topics in
Engineering Economics
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-2
Chapter 11 Replacement Decisions
Sunk Costs, Opportunity Costs, and Cash Flows
11.1
(a) Purchase price = $18,000
Market value = $7,000
Sunk cost = $11,000
(b) Opportunity cost = $7,000
(c) Operating the truck for two years
MARR= 15%
N= 2
year: 0 1 2
Cost: -1,500 -3,000 -3,500
SV: -7,000 3,000
Net: -8,500 -3,000 -500
NPV: -$11,486.77
AEC: $7,065.70
(d) Operating the truck for five years:
MARR= 15%
N= 5
year: 0 1 2 3 4 5
Cost: -1,500 -3,000 -3,500 -3,800 -4,500 -9,800
SV: -7,000 0
Net: -8,500 -3,000 -3,500 -3,800 -4,500 -9,800
NPV: -$23,698.98
AEC: $7,069.77
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-3
11.2
(a) Opportunity cost = $35,000
(b) Assume the operating cost of the defender is $30,000 per year. Then the
operating cost of the challenger is $0 each year. Keeping the defender for two
years:
MARR= 12%
N= 2
year: 0 1 2
Cost: -30,000 -30,000
SV: -35,000 12,000
Net: -35,000 -30,000 -18,000
NPV: -$76,135.20
AEC: $45,049.06
(c) Using the challenger for eight years:
MARR= 12%
N= 8
year: 0 1 2 3 4 5 6 7 8
Cost:
SV: -175,000 5,000
Net: -175,000 0 0 0 0 0 0 0 5,000
-
NPV: $172,980.58
AEC: $34,821.48
(d) Since AEC of defender is larger than AEC of challenger, replace the defender
now.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-4
*
11.3
(a) Initial cash outlay for the new machine = $130,000
(b) Cash flows for defender over five years:
MARR= 15%
N= 5
year: 0 1 2 3 4 5
Revenue:
Cost:
SV: -10,000 0
Net: -10,000 0 0 0 0 0
NPV: -$10,000.00
AEC: $2,983.16
(c) Using the challenger for seven years:
MARR= 15%
N= 7
year: 0 1 2 3 4 5 6 7
Revenue: 50,000 50,000 50,000 50,000 50,000 50,00050,000
Cost:
SV: -130,000 30,000
Net: -130,000 50,000 50,000 50,000 50,000 50,000 50,00080,000
NAP: $89,299.10
AEC: -$21,463.96
The defender has an AEC of $2,983.16. The challenge has a positive AE of $21,463.96.
Replace the defender now.
*
An asterisk next to a problem number indicates that the solution is available to students
on the Companion Website.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-5
11.4 (a)
Defender:
MARR= 15%
N= 5
year: 0 1 2 3 4 5
Revenue:
Cost:
SV: -10,000 5,000
Net: -10,000 0 0 0 0 5,000
NPV: -$7,514.12
AEC: $2,241.58
Challenger:
MARR= 15%
N= 5
year: 0 1 2 3 4 5
Revenue: 30,000 30,000 30,000 30,000 30,000
Cost:
SV: -85,000 0
Net: -85,000 30,000 30,000 30,000 30,000 30,000
NPV: $15,564.65
AEC: -$4,643.18
(b) Since defender has an AEC of $2,241.58 while challenger has an AE of $4,643.18,
replace the defender now.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-6
11.5
Defender: Annual profit = $(19 – 12)*3,000 = $21,000
MARR= 12%
N= 3
year: 0 1 2 3
Revenue: 21,000 21,000 21,000
Cost:
SV: -6,500 1,200
Net: -6,500 21,000 21,000 22,200
NPV: $44,792.59
AEC: -$18,649.35
Challenger: Annual profit = $(19 – 11)*3,000 = $24,000
MARR= 12%
N= 5
year: 0 1 2 3 4 5
Revenue: 24,000 24,000 24,000 24,000 24,000
Cost:
SV: -35,500 6,300
Net: -35,500 24,000 24,000 24,000 24,000 30,300
NPV: $54,589.42
AEC: -$15,143.64
The defender has an AE value of $18,649.35, which is larger than the AE value of
$15,143.64 of the challenger. Keep the defender for now.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-7
Economic Service Life
11.6
Defender:
MARR= 12%
Year OC MV AEOC CR AEC
0 7,900
1 3,200 4,300 3,200 4,548 7,748
2 3,700 3,300 3,436 3,118 6,554
3 4,800 1,100 3,840 2,963 6,803
4 5,850 0 4,261 2,601 6,862
The defender's economic life is two years with AEC = $6,554.
Challenger:
MARR= 12%
N= 10
year: 0 1 2 3 4 5 6 7 8 9 10
Revenue:
-
Cost: -1,000 -1,000 -1,000 -1,000 -1,000 -1,000 -1,000 -1,000 -1,000 1,000
SV: -32,000 2,500
Net: -32,000 -1,000 -1,000 -1,000 -1,000 -1,000 -1,000 -1,000 -1,000 -1,000 1,500
NPV: -$36,845
AEC: $6,521
Since the AEC of the defender is larger, replace it now.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-8
11.7 Challenger:
(a)
MARR= 12%
Year OC MV AEOC CR AEC AE
0 7,500 0
1 -4,000 4,200 -4,000 4,200 200 -200
2 -3,400 2,940 -3,717 3,051 -666 666
3 -2,710 2,058 -3,419 2,513 -906 906
4 -1,917 1,441 -3,104 2,168 -936 936
5 -1,004 1,008 -2,774 1,922 -852 852
6 45 706 -2,426 1,737 -689 689
7 1,252 494 -2,062 1,594 -467 467
The economic life is four years with the largest AE of $936.
(b)
Interest rate Economic life Maximum AE value
1% 3 years 1503
5% 3 years 1290
10% 4 years 1033
12% 4 years 936
15% 4 years 788
20% 4 years 534
25% 4 years 270
30% 5 years 14
40% 5 years -515
The maximum annual revenue at its economic service life varies inversely with the
interest rate.
The economic service life increases as the interest rate increases in our example. As the
interest rate increases, the capital cost will also increase. However, the annual equivalent
revenue will decrease. Thus, the net effect is that the marginal increase in the capital cost
is less than the decrease in the annual equivalent revenue, resulting in extending the
service life.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-9
*
11.8
(a)
MARR= 10%
Year OC MV AEOC CR AEC
0 18,000
1 2,500 14,400 2,500 5,400 7,900
2 3,250 11,520 2,857 4,886 7,743
3 4,225 9,216 3,270 4,454 7,724
4 5,493 7,373 3,749 4,090 7,839
5 7,140 5,898 4,305 3,782 8,087
At 10%, the economic life is three years with AEC = $7,724.
(b)
MARR= 20%
Year OC MV AEOC CR AEC
0 18,000
1 2,500 14,400 2,500 7,200 9,700
2 3,250 11,520 2,841 6,545 9,386
3 4,225 9,216 3,221 6,013 9,234
4 5,493 7,373 3,644 5,580 9,224
5 7,140 5,898 4,114 5,226 9,340
At 20%, the economic life is four years with AEC = $9,224.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-10
Replacement Decisions With an Infinite Planning Horizon and No Technological Change
*
11.9
Defender:
MARR= 8%
N= 6
year: 0 1 2 3 4 5 6
Revenue:
Cost: -2000 -2000 -2000 -2000 -2000 -2000
SV: -6,000 1500
Net: -6,000 -2000 -2000 -2000 -2000 -2000 -500
NPV: -$14,300.50
AEC: $3,093.42
Challenger:
MARR= 8%
N= 12
year: 0 1 2 3 4 5 6 7 8 9 10 11 12
Revenue:
Cost: -1000 -1000 -1000 -1000 -1000 -1000 -1000 -1000 -1000 -1000 -1000 -1000
SV: -23,000 500
Net: -23,000 -1000 -1000 -1000 -1000 -1000 -1000 -1000 -1000 -1000 -1000 -1000 -500
NPV: -$30,337.52
AEC: $4,025.64
Keep using the defender. The economic advantage is: $932.22 per year = $4025.64 – $3093.42
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-11
11.10
Defender:
MARR= 15%
N= 3
year: 0 1 2 3
Revenue:
Cost: -3,000 -4,500 -6,000
SV: -4,000 1,000
Net: -4,000 -3,000 -4,500 -5,000
NPV: -$13,298.92
AEC: $5,824.62
Challenger:
MARR= 15%
N= 3
year: 0 1 2 3
Revenue:
Cost: -2,000 -3,000 -4,000
SV: -7,000 2,000
Net: -7,000 -2,000 -3,000 -2,000
NPV: -$12,322.59
AEC: $5,397.01
Replace the defender because the challenger has a lower AEC value.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-12
11.11
(a) Opportunity cost = $0
(b) Incremental cash flows:
MARR= 10%
N= 5
year: 0 1 2 3 4 5
Revenue: 3,000 3,000 3,000 3,000 3,000
Cost:
SV: -11,000 0
Net: -11,000 3,000 3,000 3,000 3,000 3,000
NPV: $372.36
AEC: -$98.23
IRR: 11.3%
(c) Incremental IRR = 11.3% > MARR = 10%. Buy the new machine.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-13
11.12
Defender:
MARR= 15%
N= 5
year: 0 1 2 3 4 5
Revenue: 10,000 10,000 10,000 10,000 10,000
Cost: -7,000 -7,000 -7,000 -7,000 -7,000
SV: -2,000
Net: -2,000 3,000 3,000 3,000 3,000 3,000
NPV: $8,056.47
AEC: -$2,403.37
Challenger:
MARR= 15%
N= 5
year: 0 1 2 3 4 5
Revenue: 11,500 11,500 11,500 11,500 11,500
Cost: -5,000 -5,000 -5,000 -5,000 -5,000
SV: -15,000 2,000
Net: -15,000 6,500 6,500 6,500 6,500 8,500
NPV: $7,783.36
AEC: -$2,321.90
The new machine should not be purchased now because it has an AE value of $2,321.90,
which is lower than the AE value of $2,403.37 of the defender.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-14
11.13
Defender:
MARR= 14%
N= 5
year: 0 1 2 3 4 5
Revenue:
Cost: -20,000 -20,000 -20,000 -20,000 -20,000
SV: -901,05.12 0
Net: -901,05.12 -20,000 -20,000 -20,000 -20,000 -20,000
NPV: -$158,766.74
AEC: $46,246.14
Challenger:
MARR= 14%
N= 10
year: 0 1 2 3 4 5 6 7 8 9 10
Revenue:
Cost: -5,000 -5,000 -5,000 -5,000 -5,000 -5,000 -5,000 -5,000 -5,000 -5,000
SV: -220,000 18,000
Net: -220,000 -5,000 -5,000 -5,000 -5,000 -5,000 -5,000 -5,000 -5,000 -5,000 13,000
NPV: -$241,225.19
AEC: $46,246.14
If the resale value of the old machine is $90,105.12, the two options would have the same AEC value.
If it is lower than $90,105.12, the defender is better; otherwise, the challenger is better.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-15
*
11.14
Defender:
MARR= 12%
N= 10
year: 0 1 2 3 4 5 6 7 8 9
Revenue:
Cost: -18,000 -18,000 -18,000 -18,000 -18,000 -18,000 -18,000 -18,000 -18,000 -18
SV: -60,000
Net: -60,000 -18,000 -18,000 -18,000 -18,000 -18,000 -18,000 -18,000 -18,000 -18,000 -18
NPV: -$161,704
AEC: $28,619
Challenger:
MARR= 12%
N= 10
year: 0 1 2 3 4 5 6 7 8 9
Revenue:
Cost: -4,000 -4,000 -4,000 -4,000 -4,000 -4,000 -4,000 -4,000 -4,000 -4
SV: -180,000 20
Net: -180,000 -4,000 -4,000 -4,000 -4,000 -4,000 -4,000 -4,000 -4,000 -4,000 16
NPV: -$196,161
AEC: $34,717
The AEC of the new process is $34,717, higher than the AEC of the current process of
$28,619. Keep the current process.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-16
11.15
Defender:
MARR= 12%
N= 5
year: 0 1 2 3 4 5
Revenue:
Cost: -8,700 -8,700 -8,700 -8,700 -8,700
SV: -8,500 0
Net: -8,500 -8,700 -8,700 -8,700 -8,700 -8,700
NPV: -$39,862
AEC: $11,058
Challenger:
MARR= 12%
N= 5
year: 0 1 2 3 4 5
Revenue:
Cost: -4,200 -4,700 -5,200 -5,700 -6,200
SV: -52,000 12,000
Net: -52,000 -4,200 -4,700 -5,200 -5,700 5,800
NPV: -$63,529
AEC: $17,624
Keep the defender as it has a lower AEC value.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-17
11.16
MARR= 10%
Year OC MV AEOC CR AEC AE
0 20,000
1 -23,620 17,000 -23,620 5,000 -18,620 18,620
2 -20,620 14,450 -22,191 4,643 -17,549 17,549
3 -17,170 12,283 -20,674 4,332 -16,343 16,343
4 -13,203 10,440 -19,064 4,060 -15,005 15,005
Year: 0 1
Market: -20,000 17,000
Revenue: 23,620
Net: -20,000 40,620
IRR= 103.10%
(a) The economic life is one year.
(b) The IRR with a one-year replacement cycle is 103.10%.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-18
11.17
Defender:
MARR= 10%
Year OC MV AEOC CR AEC
0 2,000
1 3,800 1,500 3,800 700 4,500
2 3,800 1,200 3,800 581 4,381
3 3,800 960 3,800 514 4,314
4 3,800 768 3,800 465 4,265
5 3,800 614 3,800 427 4,227
The defender's economic life is five years with AEC = $4,227.
Challenger:
MARR= 10%
N= 12
year: 0 1 2 3 4 5 6 7 8 9 10 11 12
Revenue: 6,000 6,000 6,000 6,000 6,000 6,000 6,000 6,000 6,000 6,000 6,000 6,000
Cost: -3,000-3,000-3,000-3,000-3,000 -3,000 -3,000-3,000 -3,000-3,000 -3,000 -3,000
SV: -49,000 3,000
Net: -49,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 6,000
NPV: -$27,603
AEC: $4,051
Replace the defender as the challenger has a lower AEC value.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-19
11.18
Option 1: Keep the old sprayer
MARR= 12%
N= 10
year: 0 1 2 3 4 5 6 7 8 9 10
Revenue:
Cost: -27000 -27000 -27000 -27000 -27000 -27000 -27000 -27000 -27000 -27000
SV: -55000 5000
Net: -55000 -27000 -27000 -27000 -27000 -27000 -27000 -27000 -27000 -27000 -22000
NPV: -$205,946
AEC: $36,449
Option 2: Sell the old sprayer
MARR= 12%
N= 10
year: 0 1 2 3 4 5 6 7 8 9 10
Revenue:
Cost: -24000 -24000 -24000 -24000 -24000 -24000 -24000 -24000 -24000 -24000
SV: -85000 9000
Net: -85000 -24000 -24000 -24000 -24000 -24000 -24000 -24000 -24000 -24000 -15000
NPV: -$217,708
AEC: $38,531
Option 1 is better as its AEC is lower.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-20
Replacement Problems With a Finite Planning Horizon
11.19
MARR= 12%
N= 10
year: 0 1 2 3 4 5 6 7 8 9 10
Cost: 2550 2550 3250 3250 3250 3250 3250 3250 4280 4280 #1
NPV: $17,883
Cost: 3250 3250 3250 3250 3250 3250 3250 3250 3250 3250 #2
NPV: $18,363
Cost: 2700 2700 2700 3250 3250 3250 3250 3250 3250 5850 #3
NPV: $17,879
Cost: 2700 2700 2700 3250 3250 3250 3550 3550 3550 3550 #4
NPV: $17,504
Cost: 3350 3350 3350 3350 3250 3250 3250 3250 3250 3250 #5
NPV: $18,667
The five options considered above are:
Challenger
Option # Defender years years
1 2 3, 3, 2
2 1 3, 3, 3
3 3 3, 3, 1
4 3 3, 4
5 4 3, 3
It seems that Option 4 has the lowest PEC value of $17,504.
This option says, Keep defender for three years, replace it with a challenger for three
years, replace that with another challenger for four years.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-21
11.20
Note: We aim to maximize the net present value (NPV) in this problem.
MARR= 12%
N= 10
year: 0 1 2 3 4 5 6 7 8
Revenue:
Revenue: 13850 13850 13850 13650 13650 13650 13050 13050 #1
NPV: $67,775
Revenue: 13550 13550 13650 13650 13650 13650 13650 13650 #2
NPV: $67,639
Revenue: 13450 13650 13650 13650 13650 13650 13650 12350 #3
NPV: $67,105
Revenue: 13250 13250 13250 13250 13650 13650 13650 12350 #4
NPV: $66,068
Revenue: 13250 13250 13250 13250 13450 13450 13450 13450 #5
NPV: $66,207
The five options considered above are:
Defender Challenger
Option # years years
1 3 3, 2
2 2 3, 3
3 1 3, 3, 1
4 4 3, 1
5 4 4
Since the values given are AE values, it seems that Option 1 is the best with the highest
NPV value.
This option says, Keep defender for three years, use a challenger for three years, and use
another challenger for two years.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-22
11.21
Defender:
MARR= 11%
N= 6
year: 0 1 2 3 4 5 6
Revenue:
Cost: -4000 -4000 -4000 -4000 -4000 -4000
SV: -12000 2000
Net: -12000 -4000 -4000 -4000 -4000 -4000 -2000
NPV: -$27,853
AEC: $6,584
Challenger:
MARR= 11%
N= 6
year: 0 1 2 3 4 5 6
Revenue:
Cost: -2000 -2000 -2000 -2000 -2000 -2000
SV: -13000 -9000 4000
Net: -13000 -2000 -2000 -11000 -2000 -2000 2000
NPV: -$25,903
AEC: $6,123
The challenger should replace the defender now as it has a lower PEC value of $25,903.
Note: The SV value under year 3 is calculated as -$13,000 + $4,000 = -$9,000.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-23
11.22
Based on the calculations given in Problem 11.21, the same conclusion can be made as
the challenger has a lower AEC value of $6,123.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-24
Replacement Analysis With Tax Considerations
11.23
(a) Sunk cost can be defined as the past cost.
The original purchase price of $18,000 is a sunk cost.
(b) The opportunity cost of keeping the defender is the net market value today.
From (c), we see that it is equal to $7,000 + $199 = $7,199
(c) Keeping defender for two years:
Original Price= 18,000 t= 40%
Current Age= 3MARR= 15%
UCC= 7,497 N= 2
dE= 30%
Year 0 1 2
Income Statement
Revenues - -
Expenses
O&M 1,500 3,000 3,500
Overhaul
CCA @dE 2,249 1,574
Taxable income (1,500) (5,249) (5,074)
Income taxes @ t (600) (2,100) (2,030)
Net income (900) (3,149) (3,045)
Cash Flow Statement
Operating activities
Net income (900) (3,149) (3,045)
CCA - 2,249 1,574
Investment activities
Investment & Salvage (7,000) 3,000
Disposal tax effect (199) 269
Net cash flow (8,099) (900) 1,799
PE(MARR) = $ (7,521)
AE(MARR) = $ (4,626)
(d) Keeping defender for five years
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-25
Original Price= 18,000 t= 40%
Current Age= 3MARR= 15%
UCC= 7,497 N= 5
dE= 30%
Year 0 1 2 3 4 5
Income Statement
Revenues - - - - -
Expenses
O&M 3,000 3,500 3,800 4,500 4,800
Overhaul 1,500 5,000
CCA @dE 2,249 1,574 1,102 771 540
Taxable income (1,500) (5,249) (5,074) (4,902) (5,271) (10,340)
Income taxes @ t (600) (2,100)(2,030) (1,961) (2,109) (4,136)
Net income (900) (3,149) (3,045) (2,941) (3,163) (6,204)
Cash Flow
Statement
Operating activities
Net income (900) (3,149) (3,045) (2,941) (3,163) (6,204)
CCA - 2,249 1,574 1,102 771 540
Investment activities
Investment &
Salvage (7,000) -
Disposal tax effect (199) 504
Net cash flow (8,099) (900) (1,470) (1,839) (2,391) (5,160)
PE(MARR) = $ (15,135)
AE(MARR) = $ (4,515)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-26
11.24
(a) Opportunity cost = 23,058
(b)
Original Price= 150,000 t= 40%
Current Age= 10 MARR= 12%
UCC= 5,145 N= 2
dE= 30%
Year 0 1 2
Income Statement
Revenues - -
Expenses
O&M 30,000 30,000
Overhaul
CCA @dE 1,544 1,080
Taxable income (31,544) (31,080)
Income taxes @ t (12,617) (12,432)
Net income (18,926) (18,648)
Cash Flow Statement
Operating activities
Net income (18,926) (18,648)
CCA 1,544 1,080
Investment activities
Investment & Salvage (35,000) 12,000
Disposal tax effect 11,942 (3,792)
Net cash flow (23,058) (17,383) (9,359)
PE(MARR) = $ (46,039)
AE(MARR) = $ (27,241)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-27
(c)
t= 40%
MARR= 12%
N= 8
dE= 30%
Year 0 1 2 3 4 5 6 7 8
Income Statement
Revenues - - - - - - - -
Expenses
O&M - - - - - - - -
CCA @dE 26,250 44,625 31,238 21,866 15,306 10,714 7,500 5,250
Taxable income (26,250) (44,625) (31,238) (21,866) (15,306) (10,714) (7,500) (5,250)
Income taxes @ t (10,500) (17,850) (12,495) (8,747) (6,123) (4,286) (3,000) (2,100)
Net income (15,750) (26,775) (18,743) (13,120) (9,184) (6,429) (4,500) (3,150)
Cash Flow Statement
Operating activities
Net income (15,750) (26,775) (18,743) (13,120) (9,184) (6,429) (4,500) (3,150)
CCA 26,250 44,625 31,238 21,866 15,306 10,714 7,500 5,250
Investment activities
Investment & Salvage (175,000) 5,000
Disposal tax effect 2,900
Net cash flow (175,000) 10,500 17,850 12,495 8,747 6,123 4,286 3,000 10,000
PE(MARR) = $ (125,901)
AE(MARR) = $ (25,344)
(d) The defender's AE value is -$27,241 while the challenger's AE value is -
$25,344.
The defender should be replaced by the challenger now.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-28
11.25
(a) Initial cash outlay for the new machine = $130,000
(b)
Defender
Original Price= 100,000 t= 40%
Current Age= 3 MARR= 15%
UCC= 41,650 N= 5
dE= 30%
Year 0 1 2 3 4 5
Income Statement
Revenues - - - - -
Expenses
O&M - - - - -
Overhaul
CCA @dE 12,495 8,747 6,123 4,286 3,000
Taxable income (12,495) (8,747) (6,123) (4,286) (3,000)
Income taxes @ t (4,998) (3,499) (2,449) (1,714) (1,200)
Net income (7,497) (5,248) (3,674) (2,571) (1,800)
Cash Flow Statement
Operating activities
Net income (7,497) (5,248) (3,674) (2,571) (1,800)
CCA 12,495 8,747 6,123 4,286 3,000
Investment activities
Investment &
Salvage (10,000) -
Disposal tax effect (12,660) 2,800
Net cash flow (22,660) 4,998 3,499 2,449 1,714 4,000
PE(MARR) = $ (11,089)
AE(MARR) = $ (3,308)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-29
Challenger:
t= 40%
MARR= 15%
N= 7
dE= 30%
Year 0 1 2 3 4 5 6 7
Income Statement
Revenues 50,000 50,000 50,000 50,000 50,000 50,000 50,000
Expenses
O&M - - - - - - -
CCA @dE 19,500 33,150 23,205 16,244 11,370 7,959 5,572
Taxable income 30,500 16,850 26,795 33,757 38,630 42,041 44,428
Income taxes @ t 12,200 6,740 10,718 13,503 15,452 16,816 17,771
Net income 18,300 10,110 16,077 20,254 23,178 25,224 26,657
Cash Flow Statement
Operating activities
Net income 18,300 10,110 16,077 20,254 23,178 25,224 26,657
CCA 19,500 33,150 23,205 16,244 11,370 7,959 5,572
Investment activities
Investment & Salvage (130,000) 30,000
Disposal tax effect (6,800)
Net cash flow (130,000) 37,800 43,260 39,282 36,497 34,548 33,184 55,429
PE(MARR) = $ 34,637
AE(MARR) = $ 8,325
The defender has an AE value of -$3,308, while the challenger has a positive AE value of
$8,325. The defender should be replaced by the challenger now.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-30
11.26 (a) Defender:
Original Price= 50,000 t= 35%
Current Age= 3 MARR= 15%
UCC= 28,800 N= 5
dE= 20%
Year 0 1 2 3 4 5
Income Statement
Revenues - - - - -
Expenses
O&M 30,000 30,000 30,000 30,000 30,000
Overhaul
CCA @dE 5,760 4,608 3,686 2,949 2,359
Taxable income (35,760) (34,608) (33,686) (32,949) (32,359)
Income taxes @ t (12,516) (12,113) (11,790) (11,532) (11,326)
Net income (23,244) (22,495) (21,896) (21,417) (21,034)
Cash Flow
Statement
Operating activities
Net income (23,244) (22,495) (21,896) (21,417) (21,034)
CCA 5,760 4,608 3,686 2,949 2,359
Investment activities
Investment &
Salvage (10,000) 5,000
Disposal tax effect (6,580) 1,553
Net cash flow (16,580) (17,484) (17,887) (18,210) (18,468) (12,121)
PE(MARR) = $ (73,867)
AE(MARR) = $ (22,036)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-31
(b) Challenger:
t= 35%
MARR= 15%
N= 5
dE= 20%
Year 0 1 2 3 4 5
Income Statement
Revenues - - - - -
Expenses
O&M - - - - -
CCA @dE 8,500 15,300 12,240 9,792 7,834
Taxable income (8,500) (15,300) (12,240) (9,792) (7,834)
Income taxes @ t (2,975) (5,355) (4,284) (3,427) (2,742)
Net income (5,525) (9,945) (7,956) (6,365) (5,092)
Cash Flow Statement
Operating activities
Net income (5,525) (9,945) (7,956) (6,365) (5,092)
CCA 8,500 15,300 12,240 9,792 7,834
Investment activities
Investment & Salvage (85,000) -
Disposal tax effect 10,967
Net cash flow (85,000) 2,975 5,355 4,284 3,427 13,709
PE(MARR) = $ (66,772)
AE(MARR) = $ (19,919)
(c)
The company should replace the defender because the challenger has a less negative AE
value.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-32
11.27 (a) Defender:
Original Price= 50,000 t= 40%
Current Age= 4 MARR= 12%
UCC= 14,578 N= 3
dE= 30%
Year 0 1 2 3
Income Statement
Revenues 57,000 57,000 57,000
Expenses
O&M 36,000 36,000 36,000
Overhaul
CCA @dE 4,373 3,061 2,143
Taxable income 16,627 17,939 18,857
Income taxes @ t 6,651 7,175 7,543
Net income 9,976 10,763 11,314
Cash Flow Statement
Operating activities
Net income 9,976 10,763 11,314
CCA 4,373 3,061 2,143
Investment activities
Investment & Salvage (6,500) 1,200
Disposal tax effect (3,231) 1,520
Net cash flow (9,731) 14,349 13,825 16,177
PE(MARR) = $ 25,616
AE(MARR) = $ 10,665
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-33
(b) Challenger:
t= 40%
MARR= 12%
N= 5
dE= 30%
Year 0 1 2 3 4 5
Income Statement
Revenues 57,000 57,000 57,000 57,000 57,000
Expenses
O&M 33,000 33,000 33,000 33,000 33,000
CCA @dE 5,325 9,053 6,337 4,436 3,105
Taxable income 18,675 14,948 17,663 19,564 20,895
Income taxes @ t 7,470 5,979 7,065 7,826 8,358
Net income 11,205 8,969 10,598 11,739 12,537
Cash Flow Statement
Operating activities
Net income 11,205 8,969 10,598 11,739 12,537
CCA 5,325 9,053 6,337 4,436 3,105
Investment activities
Investment & Salvage (35,500) 6,300
Disposal tax effect 378
Net cash flow (35,500) 16,530 18,021 16,935 16,174 22,320
PE(MARR) = $ 28,623
AE(MARR) = $ 7,940
(c)
The defender has an AE value of $10,665 while the challenger has an AE value of
$7,940. Keep the defender for now.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-34
Economic Service Life
11.28 (a) Defender:
Tax
Initial Price= $25,000 rate= 35%
Current age= 4 MARR= 12%
CCA Rate= 30%
Current UCC: $7,289
Holding Market Undeprec A/T PE of O&M A/T PE of Cum. Capital Cum. Total Total
Period Value Capital Market Market Cost O&M O&M PE of Cost PE of PE AE
N Cost Value Value Cost Cost O&M Allowance CCA Cost Cost
Cost Credit
0 $7,900 $7,289 $7,686 $7,686 $0 $0 $0 $0
1 4,300 5,102 4,581 4,090 3,200 2,080 1,857 1,857 $2,187 $683 $4,770 $5,342
2 3,300 3,571 3,395 2,706 3,700 2,405 1,917 3,774 1,531 1,110 7,644 4,523
3 1,100 2,500 1,590 1,132 4,800 3,120 2,221 5,995 1,071 1,377 11,172 4,652
4 0 1,750 613 389 5,850 3,803 2,417 8,412 750 1,544 14,164 4,663
The remaining economic life of the defender is two years with AEC = $4,523.
The cost of keeping the defender for the third year is: $4,957 = NSV_2(1+12%) – NSV_3 – t*CCA_3 +OC_3(1–t)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-35
(b) Challenger:
t= 35%
MARR= 12%
N= 10
dE= 30%
Year 0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues - - - - - - - - - -
Expenses
O&M 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000
CCA @dE 4,800 8,160 5,712 3,998 2,799 1,959 1,371 960 672 470
Taxable income (5,800) (9,160) (6,712) (4,998) (3,799) (2,959) (2,371) (1,960) (1,672) (1,470)
Income taxes @ t (2,030) (3,206) (2,349) (1,749) (1,330) (1,036) (830) (686) (585) (515)
Net income (3,770) (5,954) (4,363) (3,249) (2,469) (1,923) (1,541) (1,274) (1,087) (956)
Cash Flow Statement
Operating activities
Net income (3,770) (5,954) (4,363) (3,249) (2,469) (1,923) (1,541) (1,274) (1,087) (956)
CCA 4,800 8,160 5,712 3,998 2,799 1,959 1,371 960 672 470
Investment activities
Investment & Salvage (32,000) 2,500
Disposal tax effect (491)
Net cash flow (32,000) 1,030 2,206 1,349 749 330 36 (170) (314) (415) 1,524
$
PE(MARR) = (27,543)
AE(MARR) = $ (4,875)
The AEC of the defender is $4,523, which is smaller than the AEC of the challenger of $4,875. Don't replace the defender now.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-36
(c) The defender will be kept for at least two years. Now consider keeping it for the third year.
As shown in (a), C3 = $4,957, which is larger than the AEC of the challenger.
The defender should be replaced at the end of year 2.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-37
*
11.29 (a)
Tax
Initial Price= $10,000 rate= 40%
Current age= 0 MARR= 15%
CCA Rate= 40%
Holding Undeprec A/T PV of A/T PV of Cum. PV Capital Cum. PV
Period Market Capital Market Market O&M O&M O&M of O&M Cost of CCA Total PV Total AE
N Value Cost Value Value Cost Cost Cost Cost Allowance Credit Cost Cost
0 10,000 10000 $ 10,000 $ 10,000 0$ - $ - $ -
1 5,300 8000 $ 6,380 $ 5,548 1500 $ 900 $ 783 $ 783 2000 $ 696 $ 4,539 $5,220
2 3,900 4800 $ 4,260 $ 3,221 2100 $ 1,260 $ 953 $ 1,735 3200 $ 1,664 $ 6,851 $4,214
3 2,800 2880 $ 2,832 $ 1,862 2900 $ 1,740 $ 1,144 $ 2,879 1920 $ 2,168 $ 8,849 $3,876
4 1,800 1728 $ 1,771 $ 1,013 3800 $ 2,280 $ 1,304 $ 4,183 1152 $ 2,432 $ 10,738 $3,761
5 1,400 1037 $ 1,255 $ 624 4800 $ 2,880 $ 1,432 $ 5,615 691 $ 2,569 $ 12,422 $3,706*
6 600 622 $ 609 $ 263 5900 $ 3,540 $ 1,530 $ 7,145 415 $ 2,641 $ 14,241 $3,763
The economic life is five years with AEC = $3,706.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-38
*
(b)
Tax
Initial Price= $10,000 rate= 40%
Current age= 0 MARR= 5%
CCA Rate= 40%
Undeprec A/T PV of A/T PV of Cum. PV Capital Cum. PV
Holding Market Capital Market Market O&M O&M O&M of O&M Cost of CCA Total PV Total AE
Period N Value Cost Value Value Cost Cost Cost Cost Allowance Credit Cost Cost
0 10,000 10,000 $ 10,000 $ 10,000 0$ - $ - $ -
1 5,300 8,000 $ 6,380 $ 6,076 1,500 $ 900 $ 857 $ 857 2,000 $ 762 $ 4,019 $4,220
2 3,900 4,800 $ 4,260 $ 3,864 2,100 $ 1,260 $ 1,143 $ 2,000 3,200 $ 1,923 $ 6,213 $3,341
3 2,800 2,880 $ 2,832 $ 2,446 2,900 $ 1,740 $ 1,503 $ 3,503 1,920 $ 2,586 $ 8,470 $3,110
4 1,800 1,728 $ 1,771 $ 1,457 3,800 $ 2,280 $ 1,876 $ 5,379 1,152 $ 2,965 $ 10,956 $3,090*
5 1,400 1,037 $ 1,255 $ 983 4,800 $ 2,880 $ 2,257 $ 7,635 691 $ 3,182 $ 13,470 $3,111
6 600 622 $ 609 $ 454 5,900 $ 3,540 $ 2,642 $ 10,277 415 $ 3,306 $ 16,517 $3,254
The economic life is four years with AEC = $3,090.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-39
11.30 (a)
Tax
Initial Price= $20,000 rate= 40%
Current age= 0 MARR= 10%
CCA Rate=
Holding Undeprec A/T PE of A/T PE of Cum. PE Capital Cum. PE Total Total
Period Market Capital Market Market O&M O&M O&M of O&M Cost of CCA PE AE
N Value Cost Value Value Cost Cost Cost Cost Allowance Credit Cost Cost
0 $20,000 $20,000 $20,000 $20,000 $0 $0 $0 $0
1 10,000 17,500 13,000 11,818 3,000 1,800 1,636 1,636 $2,500 $909 $8,909 $9,800
2 8,000 15,000 10,800 8,926 5,000 3,000 2,479 4,116 $2,500 1,736 13,455 7,752
3 6,000 12,500 8,600 6,461 7,000 4,200 3,156 7,271 $2,500 2,487 18,323 7,368*
4 4,000 10,000 6,400 4,371 9,000 5,400 3,688 10,959 $2,500 3,170 23,418 7,388
5 2,000 7,500 4,200 2,608 11,000 6,600 4,098 15,058 $2,500 3,791 28,659 7,560
6 0 5,000 2,000 1,129 13,000 7,800 4,403 19,460 $2,500 4,355 33,976 7,801
The economic life is three years with AEC = $7,368.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-40
(b)
Tax
Initial Price= $20,000 rate= 40%
Current age= 0 MARR= 25%
CCA Rate=
Cum. Cum.
Undeprec A/T PE of A/T PE of PE of Capital PE of Total Total
Holding Market Capital Market Market O&M O&M O&M O&M Cost CCA PE AE
Period N Value Cost Value Value Cost Cost Cost Cost Allowance Credit Cost Cost
0 $20,000 $20,000 $20,000 $20,000 $0 $0 $0 $0
1 10,000 17,500 13,000 10,400 3,000 1,800 1,440 1,440 $2,500 $800 $10,240 $12,800
2 8,000 15,000 10,800 6,912 5,000 3,000 1,920 3,360 $2,500 1,440 15,008 10,422
3 6,000 12,500 8,600 4,403 7,000 4,200 2,150 5,510 $2,500 1,952 19,155 9,813
4 4,000 10,000 6,400 2,621 9,000 5,400 2,212 7,722 $2,500 2,362 22,739 9,629
5 2,000 7,500 4,200 1,376 11,000 6,600 2,163 9,885 $2,500 2,689 25,819 9,601*
6 0 5,000 2,000 524 13,000 7,800 2,045 11,930 $2,500 2,951 28,454 9,641
The economic life is six years with AEC = $9,601.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-41
(c)
Tax
Initial Price= 20,000 rate= 40%
Current age= 0 MARR= 0%
CCA Rate=
Cum. Cum.
Holding Undeprec A/T PE of A/T PE of PE of Capital PE of Total Total
Period Market Capital Market Market O&M O&M O&M O&M Cost CCA PE AE
N Value Cost Value Value Cost Cost Cost Cost Allowance Credit Cost Cost
0 20000 20000 20000 20000 0 0 0 0
1 10000 17500 13000 13000 3000 1800 1800 1800 2500 1000 7800 7800
2 8000 15000 10800 10800 5000 3000 3000 4800 2500 2000 12000 6000
3 6000 12500 8600 8600 7000 4200 4200 9000 2500 3000 17400 5800*
4 4000 10000 6400 6400 9000 5400 5400 14400 2500 4000 24000 6000
5 2000 7500 4200 4200 11000 6600 6600 21000 2500 5000 31800 6360
6 0 5000 2000 2000 13000 7800 7800 28800 2500 6000 40800 6800
The economic life is three years with AEC = $5,800.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-42
*
11.31 (a)
Tax
Initial Price= $18,000 rate= 40%
Current age= 0 MARR= 10%
CCA Rate= 15%
Holding Undeprec A/T PE of A/T PE of Cum. PE Capital Cum. PE
Period Market Capital Market Market O&M O&M O&M of O&M Cost of CCA Total Total
N Value Cost Value Value Cost Cost Cost Cost Allowance Credit PE Cost AE Cost
0 $18,000 $18,000 $18,000 $18,000 $0 $0 $0 $0
1 14,400 16,650 15,300 13,909 2,500 1,500 1,364 1,364 $1,350 $491 $4,964 $5,460
2 11,520 14,153 12,573 10,391 3,250 1,950 1,612 2,975 2,498 1,317 9,268 5,340
3 9,216 12,030 10,341 7,770 4,225 2,535 1,905 4,880 2,123 1,955 13,156 5,290*
4 7,373 10,225 8,514 5,815 5,493 3,296 2,251 7,131 1,804 2,447 16,868 5,321
5 5,898 8,691 7,015 4,356 7,140 4,284 2,660 9,791 1,534 2,828 20,606 5,436
The economic life is three years with AEC of $5,290.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-43
*
(b)
Tax
Initial Price= $18,000 rate= 40%
Current age= 0 MARR= 20%
CCA Rate= 15%
Cum.
Undeprec A/T PE of A/T PE of Cum. PE Capital PE of Total Total
Holding Market Capital Market Market O&M O&M O&M of O&M Cost CCA PE AE
Period N Value Cost Value Value Cost Cost Cost Cost Allowance Credit Cost Cost
0 $18,000 $18,000 $18,000 $18,000 $0 $0 $0 $0
1 14,400 16,650 15,300 12,750 2,500 1,500 1,250 1,250 $1,350 $450$6,050$7,260
2 11,520 14,153 12,573 8,731 3,250 1,950 1,354 2,604 2,498 1,14410,729 7,023
3 9,216 12,030 10,341 5,985 4,225 2,535 1,467 4,071 2,123 1,63514,451 6,860
4 7,373 10,225 8,514 4,106 5,493 3,296 1,589 5,661 1,804 1,98317,5726,788*
5 5,898 8,691 7,015 2,819 7,140 4,284 1,722 7,382 1,534 2,23020,333 6,799
The economic life is four years with AEC of $6,788.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-44
11.32 (a)
Defender:
Original Price= 130,000 t= 40%
Current Age= 7 MARR= 10%
UCC= 13,000 N= 10
dE= 30%
Year 0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues - - - - - - - - - -
Expenses
O&M - - - - - - - - -
Overhaul
CCA @dE 3,900 2,730 1,911 1,338 936 655 459 321 225 157
Taxable income (3,900) (2,730) (1,911) (1,338) (936) (655) (459) (321) (225) (157)
Income taxes @ t (1,560) (1,092) (764) (535) (375) (262) (184) (128) (90) (63)
Net income (2,340) (1,638) (1,147) (803) (562) (393) (275) (193) (135) (94)
Cash Flow Statement
Operating activities
Net income (2,340) (1,638) (1,147) (803) (562) (393) (275) (193) (135) (94)
CCA 3,900 2,730 1,911 1,338 936 655 459 321 225 157
Investment activities
Investment & Salvage - -
Disposal tax effect (5,200) 147
Net cash flow (5,200) 1,560 1,092 764 535 375 262 184 128 90 210
PE(MARR) = $ (1,286)
AE(MARR) = $ (209)
Defender has an AEC of $209.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-45
Challenger:
t= 40%
MARR= 10%
N= 10
dE= 30%
Year 0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues 30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,00030,000
Expenses
O&M - - - - - - - - - -
CCA @dE 24,000 40,800 28,560 19,992 13,994 9,796 6,857 4,800 3,3602,352
Taxable income 6,000 (10,800) 1,440 10,008 16,006 20,204 23,143 25,200 26,64027,648
Income taxes @ t 2,400 (4,320) 576 4,003 6,402 8,082 9,257 10,080 10,65611,059
Net income 3,600 (6,480) 864 6,005 9,603 12,122 13,886 15,120 15,98416,589
Cash Flow Statement
Operating activities
Net income 3,600 (6,480) 864 6,005 9,603 12,122 13,886 15,120 15,98416,589
CCA 24,000 40,800 28,560 19,992 13,994 9,796 6,857 4,800 3,3602,352
Investment activities
Investment & Salvage (160,000) -
Disposal tax effect 2,195
Net cash flow (160,000) 27,600 34,320 29,424 25,997 23,598 21,918 20,743 19,920 19,34421,136
PE(MARR) = $ (3,368)
AE(MARR) = $ (548)
Challenger has an AEC of $548, which is larger than that of the defender. Don`t replace the defender now.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-46
(b)
Defender:
Original Price= 130,000 t= 40%
Current Age= 7 MARR= 10%
UCC= 13,000 N= 10
dE= 30%
Year 0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues - - - - - - - - - -
Expenses
O&M - - - - - - - - -
Overhaul
CCA @dE 3,900 2,730 1,911 1,338 936 655 459 321 225 157
Taxable income (3,900) (2,730) (1,911) (1,338) (936) (655) (459) (321) (225) (157)
Income taxes @ t (1,560) (1,092) (764) (535) (375) (262) (184) (128) (90) (63)
Net income (2,340) (1,638) (1,147) (803) (562) (393) (275) (193) (135) (94)
Cash Flow Statement
Operating activities
Net income (2,340) (1,638) (1,147) (803) (562) (393) (275) (193) (135) (94)
CCA 3,900 2,730 1,911 1,338 936 655 459 321 225 157
Investment activities
Investment & Salvage (45,000) -
Disposal tax effect 12,800 147
Net cash flow (32,200) 1,560 1,092 764 535 375 262 184 128 90 210
$
PE(MARR) = (28,286)
AE(MARR) = $ (4,603)
Defender has an AEC value of $4,603, much higher than that of the challenger of $548. Replace the defender now.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-47
(c)
Challenger:
t= 40%
MARR= 10%
N= 12
dE= 30%
Year 0 1 2 3 4 5 6 7 8 9 10 11 12
Income Statement
Revenues 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000
Expenses
O&M - - - - - - - - - - - -
CCA @dE 24,000 40,800 28,560 19,992 13,994 9,796 6,857 4,800 3,360 2,352 1,646 1,152
Taxable income (9,000) (25,800) (13,560) (4,992) 1,006 5,204 8,143 10,200 11,640 12,648 13,354 13,848
Income taxes @ t (3,600) (10,320) (5,424) (1,997) 402 2,082 3,257 4,080 4,656 5,059 5,341 5,539
Net income (5,400) (15,480) (8,136) (2,995) 603 3,122 4,886 6,120 6,984 7,589 8,012 8,309
Cash Flow Statement
Operating activities
Net income (5,400) (15,480) (8,136) (2,995) 603 3,122 4,886 6,120 6,984 7,589 8,012 8,309
CCA 24,000 40,800 28,560 19,992 13,994 9,796 6,857 4,800 3,360 2,352 1,646 1,152
Investment activities
Investment & Salvage (160,000) -
Disposal tax effect 1,076
Net cash flow (160,000) 18,600 25,320 20,424 16,997 14,598 12,918 11,743 10,920 10,344 9,941 9,659 10,537
PE(MARR) = $ (52,773)
AE(MARR) = $ (7,745)
The challenger has an AEC value of $7,745, higher than that of the defender of $4,603 in (b). Don’t replace the defender now.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-48
11.33 (a)
Defender Model A:
Original Price= 160,000 t= 40%
Current Age= 2 MARR= 10%
UCC= 95,200 N= 8
dE= 30%
Year 0 1 2 3 4 5 6 7 8
Income Statement
Revenues - - - - - - - -
Expenses
O&M - - - - - - -
Overhaul
CCA @dE 28,560 19,992 13,994 9,796 6,857 4,800 3,360 2,352
Taxable income (28,560) (19,992) (13,994) (9,796) (6,857) (4,800) (3,360) (2,352)
Income taxes @ t (11,424) (7,997) (5,598) (3,918) (2,743) (1,920) (1,344) (941)
Net income (17,136) (11,995) (8,397) (5,878) (4,114) (2,880) (2,016) (1,411)
Cash Flow Statement
Operating activities
Net income (17,136) (11,995) (8,397) (5,878) (4,114) (2,880) (2,016) (1,411)
CCA 28,560 19,992 13,994 9,796 6,857 4,800 3,360 2,352
Investment activities
Investment & Salvage - -
Disposal tax effect (38,080) 2,195
Net cash flow (38,080) 11,424 7,997 5,598 3,918 2,743 1,920 1,344 3,136
PE(MARR) = $ (9,264)
AE(MARR) = $ (1,736)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-49
Challenger Model B:
t= 40%
MARR= 10%
N= 10
dE= 30%
Year 0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues 75,000 75,000 75,000 75,000 75,000 75,000 75,000 75,000 75,000 75,000
Expenses
O&M - - - - - - - - - -
CCA @dE 60,000 102,000 71,400 49,980 34,986 24,490 17,143 12,000 8,400 5,880
Taxable income 15,000 (27,000) 3,600 25,020 40,014 50,510 57,857 63,000 66,600 69,120
Income taxes @ t 6,000 (10,800) 1,440 10,008 16,006 20,204 23,143 25,200 26,640 27,648
Net income 9,000 (16,200) 2,160 15,012 24,008 30,306 34,714 37,800 39,960 41,472
Cash Flow Statement
Operating activities
Net income 9,000 (16,200) 2,160 15,012 24,008 30,306 34,714 37,800 39,960 41,472
CCA 60,000 102,000 71,400 49,980 34,986 24,490 17,143 12,000 8,400 5,880
Investment activities
Investment & Salvage (400,000) -
Disposal tax effect 5,488
Net cash flow (400,000) 69,000 85,800 73,560 64,992 58,994 54,796 51,857 49,800 48,360 52,840
PE(MARR) = $ (8,420)
AE(MARR) = $ (1,370)
Model A (defender) has an AEC of $1,736 while Model B (challenger) has an AEC of $1,370. Replace the defender now.
(b) It is rather difficult to predict what technological advances would be made on typical equipment in the future. If the
industrial engineer had expected a more efficient lathe to be available in one or two years, he could defer the replacement
decision. Since Model A was already placed in service, the amount of $150,000 expended is a sunk cost, and it should not
be considered in future replacement decisions.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-50
*
11.34 Defender:
Original Price= 21,000 t= 30%
Current Age= 4 MARR= 8%
UCC= 6,123 N= 6
dE= 30%
Year 0 1 2 3 4 5 6
Income Statement
Revenues - - - - - -
Expenses
O&M 2,000 2,000 2,000 2,000 2,000 2,000
Overhaul
CCA @dE 1,837 1,286 900 630 441 309
Taxable income (3,837) (3,286) (2,900) (2,630) (2,441) (2,309)
Income taxes @ t (1,151) (986) (870) (789) (732) (693)
Net income (2,686) (2,300) (2,030) (1,841) (1,709) (1,616)
Cash Flow Statement
Operating activities
Net income (2,686) (2,300) (2,030) (1,841) (1,709) (1,616)
CCA 1,837 1,286 900 630 441 309
Investment activities
Investment & Salvage (6,000) 1,500
Disposal tax effect (37) (234)
Net cash flow (6,037) (849) (1,014) (1,130) (1,211) (1,268) (41)
PE(MARR) = $ (10,368)
AE(MARR) = $ (2,243)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-51
*
Challenger:
t= 30%
MARR= 8%
N= 12
dE= 30%
Year 0 1 2 3 4 5 6 7 8 9 10 11 12
Income Statement
Revenues - - - - - - - - - - - -
Expenses
O&M 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000
CCA @dE 3,450 5,865 4,106 2,874 2,012 1,408 986 690 483 338 237 166
Taxable income (4,450) (6,865) (5,106) (3,874) 3,012) (2,408) (1,986) (1,690) (1,483) 1,338) (1,237) (1,166)
Income taxes @ t (1,335) (2,060) (1,532) (1,162) (904) (722) (596) (507) (445) (401) (371) (350)
Net income (3,115) (4,806) (3,574) (2,712) (2,108) (1,686) (1,390) (1,183) (1,038) (937) (866) (816)
Cash Flow Statement
Operating activities
Net income (3,115)(4,806) (3,574) (2,712) (2,108) (1,686) (1,390) (1,183) (1,038) (937) (866) (816)
CCA 3,450 5,865 4,106 2,874 2,012 1,408 986 690 483 338 237 166
Investment activities
Investment & Salvage (23,000) 500
Disposal tax effect (34)
Net cash flow (23,000) 335 1,060 532 162 (96) (278) (404) (493) (555) (599) (629) (184)
PE(MARR) = $ (22,881)
AE(MARR) = $ (3,036)
Challenger`s AEC of $3,036 is larger than that of the defender, $2,243. Don’t replace the defender now.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-52
11.35 (a) Defender:
Original Price= 8,000 t= 40%
Current Age= 5MARR= 15%
UCC= 2,215 N= 3
dE= 25%
Year 0 1 2 3
Income Statement
Revenues - - -
Expenses
O&M 3,000 4,500 6,000
Overhaul
CCA @dE 554 415 311
Taxable income (3,554) (4,915) (6,311)
Income taxes @ t (1,421) (1,966) (2,525)
Net income (2,132) (2,949) (3,787)
Cash Flow Statement
Operating activities
Net income (2,132) (2,949) (3,787)
CCA 554 415 311
Investment activities
Investment & Salvage (4,000) 1,000
Disposal tax effect 714 (26)
Net cash flow (3,286) (1,579) (2,534) (2,502)
PE(MARR) = $ (8,219)
AE(MARR) = $ (3,600)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-53
(b) Challenger:
t= 40%
MARR= 15%
N= 3
dE= 25%
Year 0 1 2 3
Income Statement
Revenues - - -
Expenses
O&M 2,000 3,000 4,000
CCA @dE 875 1,531 1,148
Taxable income (2,875) (4,531) (5,148)
Income taxes @ t (1,150) (1,813) (2,059)
Net income (1,725) (2,719) (3,089)
Cash Flow Statement
Operating activities
Net income (1,725) (2,719) (3,089)
CCA 875 1,531 1,148
Investment activities
Investment & Salvage (7,000) 2,000
Disposal tax effect 578
Net cash flow (7,000) (850) (1,188) 638
PE(MARR) = $ (8,218)
AE(MARR) = $ (3,599)
Defender’s AEC of $3,600 is larger than that of the challenger of $3,599. Replace the
defender now. Actually, there is hardly any difference between the two AEC values. It
does not make much economic difference whether the defender is replaced right now.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-54
11.36 (a): Opportunity cost = $2,000 as calculated in (b) under disposal tax effect
(b)
Defender:
Original Price= t= 40%
Current Age= MARR= 10%
UCC= 5,000 N= 5
dE= 30%
Year 0 1 2 3 4 5
Income Statement
Revenues - - - - -
Expenses
O&M 3,000 3,000 3,000 3,000 3,000
Overhaul
CCA @dE 1,500 1,050 735 515 360
Taxable income (4,500) (4,050) (3,735) (3,515) (3,360)
Income taxes @ t (1,800) (1,620) (1,494) (1,406) (1,344)
Net income (2,700) (2,430) (2,241) (2,109) (2,016)
Cash Flow Statement
Operating activities
Net income (2,700) (2,430) (2,241) (2,109) 2,016)
CCA 1,500 1,050 735 515 360
Investment activities
Investment & Salvage - -
Disposal tax effect (2,000) 336
Net cash flow (2,000) (1,200) (1,380) (1,506) (1,594) (1,320)
PE(MARR) = $ (7,271)
AE(MARR) = $ (1,918)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-55
Challenger:
t= 40%
MARR= 10%
N= 5
dE= 30%
Year 0 1 2 3 4 5
Income Statement
Revenues - - - - -
Expenses
O&M - - - - -
CCA @dE 1,650 2,805 1,964 1,374 962
Taxable income (1,650) (2,805) (1,964) (1,374) (962)
Income taxes @ t (660) (1,122) (785) (550) (385)
Net income (990) (1,683) (1,178) (825) (577)
Cash Flow Statement
Operating activities
Net income (990) (1,683) (1,178) (825) (577)
CCA 1,650 2,805 1,964 1,374 962
Investment activities
Investment & Salvage (11,000) -
Disposal tax effect 898
Net cash flow (11,000) 660 1,122 785 550 1,283
PE(MARR) = $ (7,711)
AE(MARR) = $ (2,034)
The defender`s AEC is $1,918, smaller than the challenger`s AEC of $2,034. Don’t
replace the defender now.
(c) Incremental cash flows
Year: 0 1 2 3 4 5
Net cash flows: -9000 1860 2502 2291 2144 2603
IRR= 8.14%
The incremental IRR is lower than MARR of 10%. Reject the challenger.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-56
*
11.37 (a)
Defender:
Original Price= 11,000 t= 40%
Current Age= 7MARR= 15%
UCC= 1,100 N= 5
dE= 30%
Year 0 1 2 3 4 5
Income Statement
Revenues 10,000 10,000 10,000 10,000 10,000
Expenses
O&M 7,000 7,000 7,000 7,000 7,000
Overhaul
CCA @dE 330 231 162 113 79
Taxable income 2,670 2,769 2,838 2,887 2,921
Income taxes @ t 1,068 1,108 1,135 1,155 1,168
Net income 1,602 1,661 1,703 1,732 1,752
Cash Flow Statement
Operating activities
Net income 1,602 1,661 1,703 1,732 1,752
CCA 330 231 162 113 79
Investment activities
Investment & Salvage (2,000) -
Disposal tax effect 360 74
Net cash flow (1,640) 1,932 1,892 1,865 1,845 1,906
PE(MARR) = $ 4,699
AE(MARR) = $ 1,402
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-57
*
Challenger:
t= 40%
MARR= 15%
N= 5
dE= 30%
Year 0 1 2 3 4 5
Income Statement
Revenues 11,500 11,500 11,500 11,500 11,500
Expenses
O&M 5,000 5,000 5,000 5,000 5,000
CCA @dE 2,250 3,825 2,678 1,874 1,312
Taxable income 4,250 2,675 3,823 4,626 5,188
Income taxes @ t 1,700 1,070 1,529 1,850 2,075
Net income 2,550 1,605 2,294 2,775 3,113
Cash Flow Statement
Operating activities
Net income 2,550 1,605 2,294 2,775 3,113
CCA 2,250 3,825 2,678 1,874 1,312
Investment activities
Investment & Salvage (15,000) 2,000
Disposal tax effect 425
Net cash flow (15,000) 4,800 5,430 4,971 4,650 6,849
PE(MARR) = $ 2,612
AE(MARR) = $ 779
The defender’s AE value is $1,402, which is larger than the challenger's AE value of
$779. Keep the defender for now.
(b) Using Goal Seek on the spreadsheet of the defender, we find that when the
current market value of the defender is $5,480, the two options are equivalent.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-58
11.38 Challenger:
t= 40%
MARR= 14%
N= 10
dE= 30%
Year 0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues - - - - - - - - -
Expenses
O&M 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000
CCA @dE 33,000 56,100 39,270 27,489 19,242 13,470 9,429 6,600 4,620 3,234
Taxable income 38,000) (61,100) (4,270) (32,489) (24,242) (18,470) (14,429) (11,600) (9,620) (8,234)
Income taxes @ t (15,200) (24,440) (17,708) (12,996) (9,697) (7,388) (5,771) (4,640) (3,848) (3,294)
Net income (22,800) (36,660) (26,562) (19,493) (14,545) (11,082) (8,657) (6,960) (5,772) (4,940)
Cash Flow Statement
Operating activities
Net income (22,800) (36,660) (26,562) (19,493) (14,545) (11,082) (8,657) (6,960) (5,772) (4,940)
CCA 33,000 56,100 39,270 27,489 19,242 13,470 9,429 6,600 4,620 3,234
Investment activities
Investment & Salvage (220,000) 18,000
Disposal tax effect (4,182)
Net cash flow (220,000) 10,200 19,440 12,708 7,996 4,697 2,388 771 (360) 1,152) 12,112
PE(MARR) = $ (176,160)
AE(MARR) = $ (33,772)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-59
Defender:
Original Price= 100,000 t= 40%
Current Age= 10 MARR= 14%
UCC= 3,430 N= 5
dE= 30%
Year 0 1 2 3 4 5
Income Statement
Revenues - - - -
Expenses
O&M 20,000 20,000 20,000 20,000 20,000
Overhaul
CCA @dE 1,029 720 504 353 247
Taxable income (21,029) (20,720) (20,504) (20,353) (20,247)
Income taxes @ t (8,412) (8,288) (8,202) (8,141) (8,099)
Net income (12,617) (12,432) (12,303) (12,212) (12,148)
Cash Flow Statement
Operating activities
Net income (12,617) (12,432) (12,303) (12,212) (12,148)
CCA 1,029 720 504 353 247
Investment activities
Investment & Salvage (123,911) -
Disposal tax effect 48,192 231
Net cash flow (75,719) (11,588) (11,712) (11,798) (11,859) (11,671)
PE(MARR) = $ (115,942)
AE(MARR) = $ (33,772)
If the current resale value of the defender is $123,911, the two options are equivalent.
This would not be possible as the defender was bought 10 years ago for only $100,000.
Thus, the defender is much better than the challenger.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-60
11.39 (a)
Find the economic life of the defender
Tax
Initial Price= $35,000 rate= 35%
Current age= 5 MARR= 18%
CCA Rate= 30%
Current UCC: $7,143
Holding Period Market Undeprec A/T PE of O&M A/T PE of Cum. PE Capital Cum. PE Total PE Total AE
N Value Capital Market Market Cost O&M O&M of O&M Cost of CCA Cost Cost
Cost Value Value Cost Cost Cost Allowance Credit
0 $8,000 $7,143 $7,700 $7,700 $0 $0 $0 $0
1 5,200 5,000 5,130 4,347 6,000 3,900 3,305 3,305 $2,143 $636 $6,022 $7,106
2 3,500 3,500 3,500 2,514 7,000 4,550 3,268 6,573 1,500 1,013 10,747 6,864
3 1,200 2,450 1,638 997 10,000 6,500 3,956 10,529 1,050 1,236 15,996 7,357
The economic life of the defender is two years with AEC of $6,864.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-61
(a)
Find the AEC of the challenger
t= 35%
MARR= 18%
N= 10
dE= 30%
Year 0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues - - - - - - - - - -
Expenses
O&M 1,500 1,500 1,500 1,500 1,500 1,500 1,500 1,500 1,500 1,500
CCA @dE 6,375 10,838 7,586 5,310 3,717 2,602 1,821 1,275 893 625
Taxable income (7,875) (12,338) (9,086) (6,810) (5,217) (4,102) (3,321) (2,775) (2,393) (2,125)
Income taxes @ t (2,756) (4,318) (3,180) (2,384) (1,826) (1,436) (1,163) (971) (837) (744)
Net income (5,119) (8,019) (5,906) (4,427) (3,391) (2,666) (2,159) (1,804) (1,555) (1,381)
Cash Flow Statement
Operating activities
Net income (5,119) (8,019) (5,906) (4,427) (3,391) (2,666) (2,159) (1,804) (1,555) (1,381)
CCA 6,375 10,838 7,586 5,310 3,717 2,602 1,821 1,275 893 625
Investment activities
Investment & Salvage (42,500) 3,500
Disposal tax effect (715)
Net cash flow (42,500) 1,256 2,818 1,680 884 326 (64) (337) (529) (663) 2,029
PE(MARR) = $ (37,823)
AE(MARR) = $ (8,416)
The AEC of the defender is $6,864, which is smaller than the AEC of the challenger of $8,416. Don’t replace the defender now.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-62
(b) For the third year of the defender
Year 2 3
A/T OC: 6,500
NMV: 3500 1638
t*CCA: 368
Net: -3500 -4,494
FV: -8624
The cost of keeping the defender for the third year is $8,624, higher than the AEC of the challenger.
Thus, the defender should not be kept for the third year; that is, it should be replaced at the end of year 2.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-63
*
11.40 Defender:
Original Price= 90,000 t= 40%
Current Age= 10 MARR= 12%
UCC= 10,872 N= 10
dE= 20%
Year 0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues - - - - - - - - -
Expenses
O&M 18,000 18,000 18,000 18,000 18,000 18,000 18,000 18,000 18,000 18,000
Overhaul
CCA @dE 2,174 1,739 1,392 1,113 891 712 570 456 365 292
Taxable income (20,174) (19,739) (19,392) (19,113) (18,891) (18,712) 18,570) (18,456) (18,365) (18,292)
Income taxes @ t (8,070) (7,896) (7,757) (7,645) (7,556) (7,485) (7,428) (7,382) (7,346) (7,317)
Net income (12,105) (11,844) (11,635) (11,468) (11,334) (11,227) (11,142) (11,074) (11,019) (10,975)
Cash Flow Statement
Operating activities
Net income (12,105) (11,844) (11,635) 11,468) (11,334) 11,227) 11,142) 11,074) 11,019) 10,975)
CCA 2,174 1,739 1,392 1,113 891 712 570 456 365 292
Investment activities
Investment & Salvage (60,000) -
Disposal tax effect 19,651 467
Net cash flow 40,349) (9,930) 10,104) 10,243) 10,355) 10,444) 10,515) 10,572) 10,618) 10,654) 10,216)
PE(MARR) = $ (98,597)
AE(MARR) = $ (17,450)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-64
*
Challenger:
t= 40%
MARR= 12%
N= 10
dE= 20%
Year 0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues - - - - - - - - - -
Expenses
O&M 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000
CCA @dE 18,000 32,400 25,920 20,736 16,589 13,271 10,617 8,493 6,795 5,436
Taxable income 22,000) 36,400) 29,920) 24,736) 20,589) 17,271) 14,617) 12,493) 10,795) 9,436)
Income taxes @ t (8,800) 14,560) 11,968) (9,894) (8,236) (6,908) 5,847) 4,997) 4,318) 3,774)
Net income 13,200) 21,840) 17,952) 14,842) 12,353) 10,363) 8,770) 7,496) 6,477) 5,661)
Cash Flow Statement
Operating activities
Net income 13,200) 21,840) 17,952) 14,842) 12,353) 10,363) (8,770) (7,496) (6,477) 5,661)
CCA 18,000 32,400 25,920 20,736 16,589 13,271 10,617 8,493 6,795 5,436
Investment activities
Investment & Salvage (180,000) 20,000
Disposal tax effect 697
Net cash flow (180,000) 4,800 10,560 7,968 5,894 4,236 2,908 1,847 997 318 20,472
PE(MARR) = $ (146,057)
AE(MARR) = $ (25,850)
The AEC of the defender is $17,450, lower than the AEC of the challenger $25,850.
Keep the defender for now.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-65
11.41 Defender:
Original Price= 55,000 t= 35%
Current Age= 8 MARR= 12%
UCC= 3850 N= 5
dE= 30%
Year 0 1 2 3 4 5
Income Statement
Revenues - - - -
Expenses
O&M 8,700 8,700 8,700 8,700 8,700
Overhaul
CCA @dE 1,155 809 566 396 277
Taxable income (9,855) (9,509) (9,266) (9,096) (8,977)
Income taxes @ t (3,449) (3,328) (3,243) (3,184) (3,142)
Net income (6,406) (6,181) (6,023) (5,913) (5,835)
Cash Flow Statement
Operating activities
Net income (6,406) (6,181) (6,023) (5,913) (5,835)
CCA 1,155 809 566 396 277
Investment activities
Investment & Salvage (8,500) -
Disposal tax effect 1,627 226
Net cash flow (6,873) (5,251) (5,372) (5,457) (5,516) (5,331)
PE(MARR) = $(26,258)
AE(MARR) = $ (7,284)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-66
Challenger:
t= 35%
MARR= 12%
N= 5
dE= 30%
Year 0 1 2 3 4 5
Income Statement
Revenues - - - - -
Expenses
O&M 4,200 4,700 5,200 5,700 6,200
CCA @dE 7,800 13,260 9,282 6,497 4,548
Taxable income (12,000) (17,960) (14,482) (12,197) (10,748)
Income taxes @ t (4,200) (6,286) (5,069) (4,269) (3,762)
Net income (7,800) (11,674) (9,413) (7,928) (6,986)
Cash Flow Statement
Operating activities
Net income (7,800) (11,674) (9,413) (7,928) (6,986)
CCA 7,800 13,260 9,282 6,497 4,548
Investment activities
Investment & Salvage (52,000) 12,000
Disposal tax effect (486)
Net cash flow (52,000) - 1,586 (131) (1,431) 9,076
PE(MARR) = $ (46,588)
AE(MARR) = $ (12,924)
The AEC of the defender is $7,284. The AEC of the challenger is $12,924.
The defender has a lower AEC value. Keep the defender for now.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-67
11.42
Find the economic life of the defender
Tax
Initial Price= $24,000 rate= 40%
Current age= 4 MARR= 10%
CCA Rate= 30%
Current UCC: $6,997
Undeprec A/T PE of A/T PE of Cum. PE Capital Cum. PE
Holding Market Capital Market Market O&M O&M O&M of O&M Cost of CCA Total PE Total AE
Period N Value Cost Value Value Cost Cost Cost Cost Allowance Credit Cost Cost
0 $2,000 $6,997 $3,999 $3,999 $0 $0 $0 $0
1 1,500 4,898 2,859 2,599 3,800 2,280 2,073 2,073 $2,099 $763 $2,709 $2,980
2 1,200 3,429 2,091 1,728 3,800 2,280 1,884 3,957 1,469 1,249 4,978 2,868
3 960 2,400 1,536 1,154 3,800 2,280 1,713 5,670 1,029 1,558 6,957 2,797
4 768 1,680 1,133 774 3,800 2,280 1,557 7,227 720 1,755 8,698 2,744
5 614 1,176 839 521 3,800 2,280 1,416 8,643 504 1,880 10,241 2,701*
The economic life is five years with AEC of $2,701.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-68
Find the AEC of the challenger
t= 40%
MARR= 10%
N= 12
dE= 30%
Year 0 1 2 3 4 5 6 7 8 9 10 11 12
Income Statement
Revenues 6,000 6,000 6,000 6,000 6,000 6,000 6,000 6,000 6,000 6,000 6,000 6,000
Expenses
O&M 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000
CCA @dE 7,350 12,495 8,747 6,123 4,286 3,000 2,100 1,470 1,029 720 504 353
Taxable income (4,350) (9,495) (5,747) (3,123) (1,286) (0) 900 1,530 1,971 2,280 2,496 2,647
Income taxes @ t (1,740) (3,798) (2,299) (1,249) (514) (0) 360 612 788 912 998 1,059
Net income (2,610) (5,697) (3,448) (1,874) (771) (0) 540 918 1,183 1,368 1,497 1,588
Cash Flow Statement
Operating activities
Net income (2,610) (5,697) (3,448) (1,874) (771) (0) 540 918 1,183 1,368 1,497 1,588
CCA 7,350 12,495 8,747 6,123 4,286 3,000 2,100 1,470 1,029 720 504 353
Investment activities
Investment & Salvage (49,000) 3,000
Disposal tax effect (871)
Net cash flow (49,000) 4,740 6,798 5,299 4,249 3,514 3,000 2,640 2,388 2,212 2,088 2,002 4,071
PE(MARR) = $ (22,104)
AE(MARR) = $ (3,244)
Defender has an AEC of $2,701. Challenger has an AEC of $3,244. The defender’s cost is lower. Keep the defender for now.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-69
11.43 * Option 1:
Defender:
Original Price= t= 40%
Current Age= 10 MARR= 12%
UCC= 4,000 N= 10
dE= 30%
Year 0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues - - - - - - - - - -
Expenses
O&M 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000
Overhaul
CCA @dE 1,200 840 588 412 288 202 141 99 69 48
Taxable income (16,200) (15,840) (15,588) (15,412) (15,288) (15,202) (15,141) (15,099) (15,069) (15,048)
Income taxes @ t (6,480) (6,336) (6,235) (6,165) (6,115) (6,081) (6,056) (6,040) (6,028) (6,019)
Net income (9,720) (9,504) (9,353) (9,247) (9,173) (9,121) (9,085) (9,059) (9,042) (9,029)
Cash Flow Statement
Operating activities
Net income (9,720) (9,504) (9,353) (9,247) (9,173) (9,121) (9,085) (9,059) (9,042) (9,029)
CCA 1,200 840 588 412 288 202 141 99 69 48
Investment activities
Investment & Salvage (6,000) -
Disposal tax effect 800 45
Net cash flow (5,200) (8,520) (8,664) (8,765) (8,835) (8,885) (8,919) (8,944) (8,960) (8,972) (8,935)
PE(MARR) = $ (54,905)
AE(MARR) = $ (9,717)
*
Challenger:
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-70
t= 40%
MARR= 12%
N= 10
dE= 30%
Year 0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues - - - - - - - - - -
Expenses
O&M 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000
CCA @dE 7,350 12,495 8,747 6,123 4,286 3,000 2,100 1,470 1,029 720
Taxable income (19,350) (24,495) (20,747) (18,123) (16,286) (15,000) (14,100) (13,470) (13,029) (12,720)
Income taxes @ t (7,740) (9,798) (8,299) (7,249) (6,514) (6,000) (5,640) (5,388) (5,212) (5,088)
Net income (11,610) (14,697) (12,448) (10,874) (9,771) (9,000) (8,460) (8,082) (7,817) (7,632)
Cash Flow Statement
Operating activities
Net income (11,610) (14,697) (12,448) (10,874) (9,771) (9,000) (8,460) (8,082) (7,817) (7,632)
CCA 7,350 12,495 8,747 6,123 4,286 3,000 2,100 1,470 1,029 720
Investment activities
Investment & Salvage (49,000) 5,000
Disposal tax effect (1,328)
Net cash flow (49,000) (4,260) (2,202) (3,701) (4,751) (5,486) (6,000) (6,360) (6,612) (6,788) (3,240)
PE(MARR) = $ (75,404)
AE(MARR) = $ (13,345)
*
Option 2:
Challenger:
t= 40%
MARR= 12%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-71
N= 10
dE= 30%
Year 0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues - - - - - - - - - -
Expenses
O&M 24,000 24,000 24,000 24,000 24,000 24,000 24,000 24,000 24,000 24,000
CCA @dE 12,750 21,675 15,173 10,621 7,435 5,204 3,643 2,550 1,785 1,250
Taxable income (36,750) (45,675) (39,173) (34,621) (31,435) (29,204) (27,643) (26,550) (25,785) (25,250)
Income taxes @ t (14,700) (18,270) (15,669) (13,848) (12,574) (11,682) (11,057) (10,620) (10,314) (10,100)
Net income (22,050) (27,405) (23,504) (20,772) (18,861) (17,523) (16,586) (15,930) (15,471) (15,150)
Cash Flow Statement
Operating activities
Net income (22,050) (27,405) (23,504) (20,772) (18,861) (17,523) (16,586) (15,930) (15,471) (15,150)
CCA 12,750 21,675 15,173 10,621 7,435 5,204 3,643 2,550 1,785 1,250
Investment activities
Investment & Salvage (85,000) 9,000
Disposal tax effect (2,434)
Net cash flow (85,000) (9,300) (5,730) (8,331) (10,152) (11,426) (12,318) (12,943) (13,380) (13,686) (7,334)
PE(MARR) = $ (141,533)
AE(MARR) = $ (25,049)
Option 1 has a combined AEC of $23,062; Option 2 has an AEC of $25,049.
Option 1 is cheaper and better.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-72
11.44
Find the economic life of the defender
Tax
Initial Price= $9,000 rate= 30%
Current age= 6 MARR= 12%
CCA Rate= 30%
Current UCC: $1,286
Holding Market Undeprec A/T PE of O&M A/T PE of Cum. PE Capital Cum. PE Total PE Total AE
Period N Value Capital Market Market Cost O&M O&M of O&M Cost of CCA Cost Cost
Cost Value Value Cost Cost Cost Allowance Credit
0 $1,500 $1,286 $1,436 $1,436 $0 $0 $0 $0
1 1,200 900 1,110 991 1,900 1,330 1,188 1,188 $386 $103 $1,529 $1,712
2 1,000 630 889 709 2,300 1,610 1,283 2,471 270 168 3,030 1,793
3 500 441 482 343 2,700 1,890 1,345 3,816 189 208 4,700 1,957
4 0 309 93 59 3,100 2,170 1,379 5,195 132 233 6,339 2,087
5 0 216 65 37 3,400 2,380 1,350 6,546 93 249 7,695 2,135
The defender's economic life is one year with AEC = $1,712.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-73
Challenger:
t= 30%
MARR= 12%
N= 5
dE= 30%
Year 0 1 2 3 4 5
Income Statement
Revenues - - - - -
Expenses
O&M 1,100 1,300 1,500 1,700 1,800
CCA @dE 825 1,403 982 687 481
Taxable income (1,925) (2,703) (2,482) (2,387) (2,281)
Income taxes @ t (578) (811) (745) (716) (684)
Net income (1,348) (1,892) (1,737) (1,671) (1,597)
Cash Flow Statement
Operating activities
Net income (1,348) (1,892) (1,737) (1,671) (1,597)
CCA 825 1,403 982 687 481
Investment activities
Investment & Salvage (5,500) 1,000
Disposal tax effect 37
Net cash flow (5,500) (523) (489) (755) (984) (79)
PE(MARR) = $ (7,564)
AE(MARR) = $ (2,098)
The defender’s AEC is $1,712. The challenger's AEC is $2,098. The defender costs less.
Keep the defender for now.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-74
11.45
Defender:
Original Price= 15,000 t= 30%
Current Age= 2MARR= 11%
UCC= 9,844 N= 6
dE= 25%
Year 0 1 2 3 4 5 6
Income Statement
Revenues - - - - - -
Expenses
O&M 4,000 4,000 4,000 4,000 4,000 4,000
Overhaul
CCA @dE 2,461 1,846 1,384 1,038 779 584
Taxable income (6,461) (5,846) (5,384) (5,038) (4,779) (4,584)
Income taxes @ t (1,938) (1,754) (1,615) (1,511) (1,434) (1,375)
Net income (4,523) (4,092) (3,769) (3,527) (3,345) (3,209)
Cash Flow Statement
Operating activities
Net income (4,523) (4,092) (3,769) (3,527) (3,345) (3,209)
CCA 2,461 1,846 1,384 1,038 779 584
Investment activities
Investment & Salvage (12,000) 2,000
Disposal tax effect 647 (74)
Net cash flow (11,353) (2,062) (2,246) (2,385) (2,489) (2,566) (699)
PE(MARR) = $(20,313)
AE(MARR) = $ (4,802)
The defender's AEC is $4,802. Its PEC is $20,313 for six years.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-75
Challenger :
t= 30%
MARR= 11%
N= 3
dE= 25%
Year 0 1 2 3
Income Statement
Revenues - - -
Expenses
O&M 2,000 2,000 2,000
CCA @dE 1,625 2,844 2,133
Taxable income (3,625) (4,844) (4,133)
Income taxes @ t (1,088) (1,453) (1,240)
Net income (2,538) (3,391) (2,893)
Cash Flow Statement
Operating activities
Net income (2,538) (3,391) (2,893)
CCA 1,625 2,844 2,133
Investment activities
Investment & Salvage (13,000) 4,000
Disposal tax effect 720
Net cash flow (13,000) (913) (547) 3,959
PE(MARR) = $ (11,371)
AE(MARR) = $ (4,653)
The challenger's AEC is $4,653, smaller than the defender's AEC of $4,802.
Replace the defender now.
The challenger's PEC is $19,685 for six years, lower than the PEC of the defender, $20,313.
The challenger is better. Each challenger has a three-year life cycle. The total PEC of the
challenger over six years (two life cycles) is $11,371 (1 + (1+11%)-3) = $19,685.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-76
ST11.1
Defender:
Original Price= 250,000 t= 30%
Current Age= 5 MARR= 20%
UCC= 125,000 N= 10
dE= S-L Methodwith N = 10 and S = 0
Year 0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues - - - - - - - - - -
Expenses
O&M 45,000 45,000 45,000 45,000 45,000 45,000 45,000 45,000 45,000 45,000
Overhaul
CCA-Present Facility 25,000 25,000 25,000 25,000 25,000 - - - - -
CCA-Upgrade Facility 10,400 10,400 10,400 10,400 10,400 10,400 10,400 10,400 10,400 10,400
Taxable income (80,400) (80,400) (80,400) (80,400) (80,400) (55,400) (55,400) (55,400) (55,400) (55,400)
Income taxes @ t (24,120) (24,120) (24,120) (24,120) (24,120) (16,620) (16,620) (16,620) (16,620) (16,620)
Net income (56,280) (56,280) (56,280) (56,280) (56,280) (38,780) (38,780) (38,780) (38,780) (38,780)
Cash Flow Statement
Operating activities
Net income (56,280) (56,280) (56,280) (56,280) (56,280) (38,780) (38,780) (38,780) (38,780) (38,780)
CCA-Present Facility 25,000 25,000 25,000 25,000 25,000 - - - - -
CCA-Upgrade Facility 10,400 10,400 10,400 10,400 10,400 10,400 10,400 10,400 10,400 10,400
Investment activities
Present Facility - -
Disposal tax effect (37,500) -
Upgrade Facility (104,000) -
Disposal tax effect -
Net cash flow (141,500) (20,880) (20,880) (20,880) (20,880) (20,880) (28,380) (28,380) (28,380) (28,380) (28,380)
PE(MARR) = $ (238,053)
AE(MARR) = $ (56,781)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-77
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-78
ST11.1 (a)
Challenger:
t= 30%
MARR= 20%
N= 10
dE= S-L Method with S = 0 and N = 10
Year 0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues - - - - - - - - - -
Expenses
O&M 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000
CCA @dE 32,500 32,500 32,500 32,500 32,500 32,500 32,500 32,500 32,500 32,500
Taxable income (42,500) (42,500) (42,500) (42,500) (42,500) (42,500) (42,500) (42,500) (42,500) (42,500)
Income taxes @ t (12,750) (12,750) (12,750) (12,750) (12,750) (12,750) (12,750) (12,750) (12,750) (12,750)
Net income (29,750) (29,750) (29,750) (29,750) (29,750) (29,750) (29,750) (29,750) (29,750) (29,750)
Cash Flow Statement
Operating activities
Net income (29,750) (29,750) (29,750) (29,750) (29,750) (29,750) (29,750) (29,750) (29,750) (29,750)
CCA 32,500 32,500 32,500 32,500 32,500 32,500 32,500 32,500 32,500 32,500
Investment activities
Investment & Salvage (325,000) -
Disposal tax effect -
Net cash flow (325,000) 2,750 2,750 2,750 2,750 2,750 2,750 2,750 2,750 2,750 2,750
PE(MARR) = $ (313,471)
AE(MARR) = $ (74,770)
Defender's AEC is $56,781. Challenger's AEC is $74,770. Defender costs less.
Keep the defender for now.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-79
(b) If environmental impact is taken into account, it might be better to install the new facility. It is also quite possible that
the government of Kazakhstan would impose some huge fines upon discovering the environmental damage caused by
the defending facility. This type of issues needs to be addressed before making any final decision.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-80
ST11.2
(a) It is assumed that the current FMS manufacturing technology would prevail
for several years with no major cost and productivity improvement. Therefore,
if the present system is kept for the remaining useful life, it will be replaced
by the current FMS technology with the same investment and O&M costs.
(b)
Defender:
Original Price= t= 40%
Current Age= MARR= 15%
UCC= 110000 N= 5
dE= 30%
Year 0 1 2 3 4 5
Income Statement
Revenues - - - - -
Expenses
O&M 105,000 115,000 125,000 135,000 145,000
Overhaul
CCA @dE 33,000 23,100 16,170 11,319 7,923
Taxable income (138,000) (138,100) (141,170) (146,319) (152,923)
Income taxes @ t (55,200) (55,240) (56,468) (58,528) (61,169)
Net income (82,800) (82,860) (84,702) (87,791) (91,754)
Cash Flow Statement
Operating activities
Net income (82,800) (82,860) (84,702) (87,791) (91,754)
CCA 33,000 23,100 16,170 11,319 7,923
Investment activities
Investment & Salvage (140,000) -
Disposal tax effect 12,000 7,395
Net cash flow (128,000) (49,800) (59,760) (68,532) (76,472) (76,436)
PE(MARR) = $ (343,278)
AE(MARR) = $ (102,405)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-81
Challenger:
t= 40%
MARR= 15%
N= 10
dE= 30%
Year 0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues 664,243 664,243 664,243 664,243 664,243 664,243 664,243 664,243 664,243 664,243
Expenses
O&M 45,000 47,000 49,000 51,000 53,000 55,000 57,000 59,000 61,000 63,000
CCA @dE 345,000 586,500 410,550 287,385 201,170 140,819 98,573 69,001 48,301 33,811
Taxable income 274,243 30,743 204,693 325,858 410,074 468,424 508,670 536,242 554,942 567,432
Income taxes @ t 109,697 12,297 81,877 130,343 164,029 187,370 203,468 214,497 221,977 226,973
Net income 164,546 18,446 122,816 195,515 246,044 281,055 305,202 321,745 332,965 340,459
Cash Flow Statement
Operating activities
Net income 164,546 18,446 122,816 195,515 246,044 281,055 305,202 321,745 332,965 340,459
CCA 345,000 586,500 410,550 287,385 201,170 140,819 98,573 69,001 48,301 33,811
Investment activities
Investment & Salvage (2,300,000) 120,000
Disposal tax effect (16,443)
Net cash flow (2,300,000) 509,546 604,946 533,366 482,900 447,214 421,873 403,775 390,746 381,266 477,827
PE(MARR) = $ 138,058
AE(MARR) = $ 27,508
Defender's AE value is -$102,405. Challenger's AE value is +$27,508. Replace the defender with the challenger now.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-82
ST11.3
Find the economic life of the defender
Tax
Initial Price= $200,000 rate= 40%
Current age= 8 MARR= 16%
CCA Rate= 30%
Current UCC: $14,000
Holding Undeprec A/T PE of A/T PE of Cum. PE Capital Cum. PE Total Total
Period Market Capital Market Market O&M O&M O&M of O&M Cost of CCA PE AE
N Value Cost Value Value Cost Cost Cost Cost Allowance Credit Cost Cost
0 $0 $14,000 $5,600 $5,600 $0 $0 $0 $0
1 0 9,800 3,920 3,379 67,500 40,500 34,914 34,914 $4,200 $1,448 $35,686 $41,396
2 0 6,860 2,744 2,039 67,875 40,725 30,265 65,179 2,940 2,322 66,418 41,376
3 0 4,802 1,921 1,231 68,306 40,984 26,257 91,436 2,058 2,850 92,955 41,389
4 0 3,361 1,345 743 68,802 41,281 22,799 114,235 1,441 3,168 115,925 41,429
5 0 2,353 941 448 69,373 41,624 19,817 134,052 1,008 3,360 135,844 41,488
The defender's economic life is two years with AEC = $41,376.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-83
(a) and (b) Challenger:
t= 40%
MARR= 16%
N= 10
dE= 30%
dB= 10%
Year 0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues 57,895 57,895 57,895 57,895 57,895 57,895 57,895 57,895 57,895 57,895
Expenses
O&M 35,000 35,000 35,000 35,000 35,000 35,000 35,000 35,000 35,000 35,000
CCA @dE 22,710 38,607 27,025 18,917 13,242 9,270 6,489 4,542 3,179 2,226
CCA @dB 2,360 4,484 4,036 3,632 3,269 2,942 2,648 2,383 2,145 1,930
Taxable income (2,175) (20,196) (8,166) 346 6,384 10,684 13,759 15,970 17,571 18,739
Income taxes @ t (870) (8,078) (3,266) 138 2,554 4,273 5,503 6,388 7,028 7,496
Net income (1,305) (12,118) (4,899) 207 3,830 6,410 8,255 9,582 10,543 11,244
Cash Flow Statement
Operating activities
Net income (1,305) (12,118) (4,899) 207 3,830 6,410 8,255 9,582 10,543 11,244
CCA-Equip 22,710 38,607 27,025 18,917 13,242 9,270 6,489 4,542 3,179 2,226
CCA-Bldg 2,360 4,484 4,036 3,632 3,269 2,942 2,648 2,383 2,145 1,930
Investment activities
Equipment (151,400) 5,570
Building (47,200) -
Disposal tax effect-Equip (151)
Disposal tax effect-Bldg 6,949
Net cash flow (198,600) 23,765 30,973 26,161 22,757 20,341 18,622 17,392 16,507 15,867 27,767
PE(MARR) = $ (86,783)
AE(MARR) = $ (17,955)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-84
Defender's AEC = $41,376. Challenger's AEC = $17,955. Challenger costs much less.
Replace the defender with the challenger.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-85
ST11.4 Option 1:
Defender for eight more years
Original Price= 120,000 t= 40%
Current Age= 6 MARR= 12%
UCC= 17,143 N= 8
dE= 30%
Year 0 1 2 3 4 5 6 7 8
Income Statement
Revenues - - - - - - - -
Expenses
O&M 31,986 32,785 33,663 34,630 35,692 36,,861 38,147 39,562
Overhaul
CCA @dE 5,143 3,600 2,520 1,764 1,235 864 605 424
Taxable income (37,129) (36,385) (36,183) (36,394) (36,927) (37,725) (38,752) (39,986)
Income taxes @ t (14,852) (14,554) (14,473) (14,558) (14,771) (15,090) (15,501) (15,994)
Net income (22,277) (21,831) (21,710) (21,836) (22,156) (22,635) (23,251) (23,991)
Cash Flow Statement
Operating activities
Net income (22,277) (21,831) (21,710) (21,836) (22,156) (22,635) (23,251) (23,991)
CCA 5,143 3,600 2,520 1,764 1,235 864 605 424
Investment activities
Investment & Salvage (40,000) -
Disposal tax effect 9,143 395
Net cash flow (30,857) (17,134) (18,231) (19,190) (20,072) (20,921) (21,771) (22,646) (23,172)
PE(MARR) = $(129,609)
AE(MARR) = $ (26,091)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-86
Option 2:
Defender for one more year and switch to a brand new machine
Original Price= 120,000 t= 40%
Current Age= 6 MARR= 12%
UCC= 17,143 N= 1
dE= 30%
Year 0 1
Income Statement
Revenues -
Expenses
O&M 31986
Overhaul
CCA @dE 5,143
Taxable income (37,129)
Income taxes @ t (14,852)
Net income (22,277)
Cash Flow Statement
Operating activities
Net income (22,277)
CCA 5,143
Investment activities
Investment & Salvage (40,000) 30,000
Disposal tax effect 9,143 (7,200)
Net cash flow (30,857) 5,666
PE(MARR) = $ (25,799)
AE(MARR) = $ (28,894)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-87
Option 3:
Challenger: Buy the Used Equipment
t= 40%
MARR= 12%
N= 8
dE= 30%
Year 0 1 2 3 4 5 6 7 8
Income Statement
Revenues 36,000 36,000 36,000 36,000 36,000 36,000 36,000 36,000
Expenses
O&M 26,500 26,950 27,445 27,990 28,590 29,245 29,950 30,745
CCA @dE 23,730 40,341 28,239 19,767 13,837 9,686 6,780 4,746
Taxable income (14,230) (31,291) (19,684) (11,757) (6,427) (2,931) (730) 509
Income taxes @ t (5,692) (12,516) (7,873) (4,703) (2,571) (1,172) (292) 204
Net income (8,538) (18,775) (11,810) (7,054) (3,856) (1,759) (438) 305
Cash Flow Statement
Operating activities
Net income (8,538) (18,775) (11,810) (7,054) (3,856) (1,759) (438) 305
CCA 23,730 40,341 28,239 19,767 13,837 9,686 6,780 4,746
Investment activities
Investment & Salvage (158,200) -
Disposal tax effect 4,430
Net cash flow (158,200) 15,192 21,566 16,428 12,713 9,981 7,927 6,342 9,481
PE(MARR) = $ (91,293)
AE(MARR) = $ (18,377)
Challenger: The Brand-New Equipment
t= 40%
MARR= 12%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-88
N= 8
dE= 30%
Year 0 1 2 3 4 5 6 7 8
Income Statement
Revenues 36,000 36,000 36,000 36,000 36,000 36,000 36,000 36,000
Expenses
O&M 25,350 25,755 26,201 26,691 27,231 27,821 28,455 29,171
CCA @dE 31,568 53,665 37,565 26,296 18,407 12,885 9,019 6,314
Taxable income (20,918) (43,420) (27,766) (16,987) (9,638) (4,705) (1,474) 516
Income taxes @ t (8,367) (17,368) (11,106) (6,795) (3,855) (1,882) (590) 206
Net income (12,551) (26,052) (16,659) (10,192) (5,783) (2,823) (885) 310
Cash Flow Statement
Operating activities
Net income (12,551) (26,052) (16,659) (10,192) (5,783) (2,823) (885) 310
CCA 31,568 53,665 37,565 26,296 18,407 12,885 9,019 6,314
Investment activities
Investment & Salvage (210,450) -
Disposal tax effect 5,893
Net cash flow (210,450) 19,017 27,613 20,906 16,104 12,624 10,062 8,135 12,516
PE(MARR) = $ (125,348)
AE(MARR) = $ (25,233)
(a) If the service life is very long, the best option is to replace the current equipment with the used equipment right now and use it
for eight years.
(b) If the service life is eight years, the best option is still the same.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-89
ST11.5
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-90
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-91
(c)
Economic life of defender
Tax
Initial Price= $375,000 rate= 40%
Current age= 6 MARR= 15%
CCA Rate= 30%
Current UCC: $53,572
Holding Undeprec A/T PE of A/T PE of Cum. PE Capital Cum. PE Total Total
Period Market Capital Market Market O&M O&M O&M of O&M Cost of CCA PE AE
N Value Cost Value Value Cost Cost Cost Cost Allowance Credit Cost Cost
0 $75,000 $53,572 $66,429 $66,429 $0 $0 $0 $0
1 60,000 37,501 51,000 44,348 113,328 67,997 59,128 59,128 $16,072 $5,590 $75,618 $86,961
2 50,000 26,250 40,500 30,624 113,328 67,997 51,415 110,543 11,250 8,993 137,355 84,489
3 30,000 18,375 25,350 16,668 109,632 65,779 43,251 153,794 7,875 11,064 192,491 84,306
4 30,000 12,863 23,145 13,233 109,632 65,779 37,609 191,403 5,513 12,325 232,274 81,358
5 10,000 9,004 9,602 4,774 105,936 63,562 31,601 223,005 3,859 13,092 271,568 81,013
The defender's economic life is five years with AEC = $81,013.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-92
(c)
Economic life of challenger
Initial Price= $400,000 Tax rate= 40%
Current age= 0 MARR= 15%
CCA Rate= 30%
Holding Undeprec A/T PV of A/T PV of Cum. PV Capital Cum. PV Total Total
Period Market Capital Market Market O&M O&M O&M of O&M Cost of CCA PV AE
N Value Cost Value Value Cost Cost Cost Cost Allowance Credit Cost Cost
0 400,000 400000 $400,000 $400,000 0$ - $ - $ -
1 300,000 340000 $316,000 $274,783 84900 $ 50,940 $ 44,296 $ 44,296 60000 $ 20,870 $148,643 $170,940
2 240,000 238000 $239,200 $180,870 87900 $ 52,740 $ 39,879 $ 84,175 102000 $ 51,720 $251,585 $154,754
3 190,000 166600 $180,640 $118,774 87267 $ 52,360 $ 34,428 $118,602 71400 $ 70,499 $329,330 $144,239
4 150,000 116620 $136,648 $ 78,129 92933 $ 55,760 $ 31,881 $150,483 49980 $ 81,929 $390,425 $136,752
5 115,000 81634 $101,654 $ 50,540 95467 $ 57,280 $ 28,478 $178,962 34986 $ 88,887 $439,535 $131,120
Challenger's economic life is five years with AEC = $131,120.
Keep the defender for now.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-93
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-94
(d) Economic life of defender
Tax
Initial Price= $375,000 rate= 40%
Current age= 6 MARR= 15%
CCA Rate= 30%
Current UCC: $53,572
Holding Undeprec A/T PE of A/T PE of Cum. PE Capital Cum. PE Total Total
Period Market Capital Market Market O&M O&M O&M of O&M Cost of CCA PE AE
N Value Cost Value Value Cost Cost Cost Cost Allowance Credit Cost Cost
0 $75,000 $53,572 $66,429 $66,429 $0 $0 $0 $0
1 60,000 37,501 51,000 44,348 125,831 75,499 65,651 65,651 $16,072 $5,590 $82,142 $94,463
2 50,000 26,250 40,500 30,624 136,228 81,737 61,805 127,456 11,250 8,993 154,268 94,893
3 30,000 18,375 25,350 16,668 139,714 83,828 55,119 182,574 7,875 11,064 221,271 96,912
4 30,000 12,863 23,145 13,233 144,944 86,966 49,723 232,298 5,513 12,325 273,168 95,681
5 10,000 9,004 9,602 4,774 144,864 86,918 43,214 275,511 3,859 13,092 324,074 96,676
The defender's economic life is one year with AEC = $94,463.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
11-95
(d) Economic life of challenger
Initial Price= $400,000 Tax rate= 40%
Current age= 0 MARR= 15%
CCA Rate= 30%
Holding Undeprec A/T PV of A/T PV of Cum. PV Capital Cum. PV Total Total
Period Market Capital Market Market O&M O&M O&M of O&M Cost of CCA PV AE
N Value Cost Value Value Cost Cost Cost Cost Allowance Credit Cost Cost
0 400,000 400000 $400,000 $400,000 0$ - $ - $ -
1 300,000 340000 $316,000 $274,783 94725 $ 56,835 $ 49,422 $ 49,422 60000 $ 20,870 $153,770 $176,835
2 240,000 238000 $239,200 $180,870 106275 $ 63,765 $ 48,216 $ 97,637 102000 $ 51,720 $265,047 $163,035
3 190,000 166600 $180,640 $118,774 111832 $ 67,099 $ 44,119 $141,756 71400 $ 70,499 $352,483 $154,380
4 150,000 116620 $136,648 $ 78,129 123888 $ 74,333 $ 42,500 $184,256 49980 $ 81,929 $424,198 $148,582
5 115,000 81634 $101,654 $ 50,540 131573 $ 78,944 $ 39,249 $223,505 34986 $ 88,887 $484,078 $144,408
Challenger's economic life is five yeas with AEC = $144,408.
Still keep the defender for now.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
12-1
Chapter 12 Capital-Budgeting Decisions
Methods of Financing
12.1
(a) Equity financing:
Let X denote the number of shares to be sold. The total flotation cost would be
(0.06)($25) X $1.5 X
To net $10 million,
25 X 1.5 X $10,000,000
23.5 X $10,000,000
X 425,532 shares
Flotation cost = $1.5(425,532) = $638,298
(b) Debt financing:
$10, 000, 000
Flotation cost = $10, 000, 000 $193, 680
1 0.019
Number of bond = $10,193,680 / $1,000 = 10,194 units
Annual interest = (10,194) ($1,000) (0.12) = $1,223,280
12.2 *
(a) Equal repayment of the principal:
Repayment
n Loan Balance
Interest Principal
0 $300,000
1 $36,000 $50,000 $250,000
2 $30,000 $50,000 $200,000
3 $24,000 $50,000 $150,000
4 $18,000 $50,000 $100,000
5 $12,000 $50,000 $50,000
6 $6,000 $50,000 $0
(b) Equal repayment of the interest:
n Repayment Loan Balance
*
An asterisk next to a problem number indicates that the solution is available to students
on the Companion Website.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
12-2
Interest Principal
0 $300,000
1 $36,000 $0 $300,000
2 $36,000 $0 $300,000
3 $36,000 $0 $300,000
4 $36,000 $0 $300,000
5 $36,000 $0 $300,000
6 $36,000 $300,000 $0
(c) Equal annual installment:
A $300, 000( A / P,12%, 6) $72,968
Repayment
n Loan Balance
Interest Principal
0 $300,000
1 $36,000 $36,968 $263,032
2 $31,564 $41,404 $221,628
3 $26,595 $46,372 $175,256
4 $21,031 $51,937 $123,319
5 $14,798 $58,169 $65,150
6 $7,818 $65,150 $0
12.3
(a) Equity financing
End of Year 0 1 2 3 4
Income Statement
Revenues/Savings $100,000 $100,000 $100,000 $100,000
Expenses
CCA 30,000 51,000 35,700 24,990
Taxable income 70,000 49,000 64,300 75,010
Income taxes (35%) 24,500 17,150 22,505 26,254
Net Income $45,500 $31,850 $41,795 $48,757
Cash Flow Statement
Operating activities
Net income $45,500 $31,850 $41,795 $48,757
CCA 30,000 51,000 35,700 24,990
Investment activities
Investment and Salvage (200,000) 30,000
Disposal tax effects 9,909
Net cash flow ($200,000) $75,500 $82,850 $77,495 $113,655
3
UCC4 = $200,000(0.85)(0.7) = $58,310 ; G= ($58,310 - 30,000)(0.35) = $9,909
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
12-3
PW(10%) = $72,958
AE(10%) = $23,016
(b) Debt financing
End of Year 0 1 2 3 4
Income Statement (Bank
A)
Revenues/Savings $100,000 $100,000 $100,000 $100,000
Expenses
CCA 30,000 51,000 35,700 24,990
Interest (10%) 20,000 15,000 10,000 5,000
Taxable income 50,000 34,000 54,300 70,010
Income taxes (35%) 17,500 11,900 19,005 24,504
Net Income $32,500 $22,100 $35,295 $45,507
Cash Flow Statement
Operating activities
Net income $32,500 $22,100 $35,295 $45,507
CCA 30,000 51,000 35,700 24,990
Investment activities
Investment and Salvage (200,000) 30,000
Disposal tax effects 9,909
Financing
Loan repayment 200,000 (50,000) (50,000) (50,000) (50,000)
Net cash flow $0 $12,500 $23,100 $20,995 $60,405
4
UCC5 = $200,000(0.85)(0.7) = $58,310 ; G= ($58,310 - 30,000)(0.35) = $9,909
PW(10%) = $87,486
AE(10%) = $27,599
End of Year 0 1 2 3 4 5
Income Statement
Revenues/Savings $100,000 $100,000 $100,000 $100,000
Expenses
CCA 30,000 51,000 35,700 24,990
Interest (10%) 20,000 16,724 13,121 9,157 4,796
Taxable income 50,000 32,276 51,179 65,853 (4,796)
Income taxes (35%) 17,500 11,297 17,913 23,049 (1,679)
Net Income $32,500 $20,979 $33,267 $42,805 (3,118)
Cash Flow Statement
Operating activities
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
12-4
Net income $32,500 $20,979 $33,267 $42,805 (3,118)
CCA 30,000 51,000 35,700 24,990
Investment activities
Investment and Salvage (200,000) 30,000
Disposal tax effects 9,909
Financing
Loan repayment 200,000 (32,759) (36,035) (39,639) (43,603) (47,963)
Prepayment (46,437)
Net cash flow $0 $29,741 $35,944 $29,328 $17,663 (51,081)
UCC5 = $200,000(0.85)(0.7)4 = $58,310 ; G= ($58,310 - 30,000)(0.35) =
$9,909
PW(10%) = $90,841
AE(10%) = $28,658
Comments: The project terminates after four years where the bank financing from
Bank B extends over five years. Since the bank financing is related to the proposed
project, any unpaid future expenses after the project must be charged against the
revenue from the proposed project. This adjustment is shown under the
prepayment in the amount of $46,437, which is the equivalent cost in year 4 for
the future expense (net cash flow) in the amount of $51,081 at the firm’s MARR.
(c) Best course of action: Adopt Bank B’s repayment plan
12.4
(a) The total flotation costs to raise $65 million:
Common stock:
Amount of common stock ($65, 000, 000)(0.45)
$29, 250, 000
$29, 250, 000
Flotation cost = $29, 250, 000 $1, 410,377
1 0.046
Preferred stock:
Amount of preferred stock ($65, 000, 000)(0.10)
$6,500, 000
$6,500, 000
Flotation cost = $6,500, 000 $572,905
1 0.081
Bond:
Amount of bond ($65, 000, 000)(0.45)
$29, 250, 000
$29, 250, 000
Flotation cost = $29, 250, 000 $425,314
1 0.014
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
12-5
∴ Total flotation costs = $2,398,596
(b) Number of shares or (bonds) to be sold to raise $65 million:
Common stock:
X S (1 0.046)($32) $29, 250, 000
X S 958,137 shares
Preferred stock:
X P (1 0.081)($55) $6,500, 000
X P 128,598 shares
Bond:
X B (1 0.014)($980) $29, 250, 000
X B 30, 271 units
(c) Cash requirement to meet financing costs:
Common stock:
Annual cash dividends ($2 / share)(958,137 shares)
$1,916, 274
Preferred stock:
Annual cash dividends (0.06)($15 / share)(128,598shares)
$115, 738
Bond:
Borrowing amount (30, 271)($1, 000)
$30, 271, 000
Annual interest = ($30,271,000)(0.12) = $3,632,520
∴ Total annual cash requirement = $5,664,532
Cost of Capital
12.5 After-tax cost of debt:
(a)
(0.12)(1 0.25) 0.09 or 9%
(b)
(0.14)(1 0.34) 0.0924 or 9.24%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
12-6
(c)
(0.15)(1 0.40) 0.09 or 9%
12.6 In the absence of bond maturity date, we need to assume that the 13% yield to
maturity represents the before-tax cost of debt after considering both the
flotation cost as well as bond discounting. Let kb 13% . Then we compute the
after-tax cost of debt as follows:
(0.13)(1 0.38) 8.06%
12.7 Cost of retaining earnings:
$1
kr 0.12 17.56%
$18
12.8
(a) Flotation costs in percentage:
15
fc 1 16.67%
18
(b) Cost of new common stock:
$1.10
ke 0.10 18.80%
$15(1 0.1667)
12.9
ie 0.22
id (0.13)(1 0.40) 0.078
k (0.078)(0.45) (0.22)(0.55)
0.1561
12.10 Given: ke 0.30, k p 0.12
ie (55 / 70)(0.30) (15 / 70)(0.12) 0.2614
id (1 0.40)[(0.3333)(0.14) (1 0.3333)(0.12)] 0.07602
k (0.07602)(0.30) (0.2614)(0.70)
0.2058
*
12.11
Given: ie 18%, id (0.12)(1 0.36) 0.0768
k (0.4)(0.0768) (0.6)(0.18) 13.87%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
12-7
(a) Net equity flow method: PW (18%) $36,306 0 , accept the project.
End of Year 0 1 2 3 4 5
Income Statement
Revenue $90,000 $90,000 $90,000 $90,000 $90,000
Expenses
O&M 10,000 10,000 10,000 10,000 10,000
Interest payment 9,600 8,089 6,396 4,501 2,378
CCA 30,000 51,000 35,700 24,990 17,493
Taxable income 40,400 20,911 37,904 50,509 60,129
Income taxes (36%) 14,544 7,528 13,645 18,183 21,647
Net Income $25,856 $13,383 $24,258 $32,326 $38,483
Cash Flow Statement
Operating activities
Net income $25,856 $13,383 $24,258 $32,326 $38,483
CCA 30,000 51,000 35,700 24,990 17,493
Investment activities
Investment and Salvage (200,000) 50,000
Disposal tax effects (3,306)
Financing activities
Borrowed funds 80,000
Principal repayment (12,593) (14,104) (15,796) (17,692) (19,815)
Net cash flow ($120,000) $43,263 $50,279 $44,162 $39,624 $82,855
(b) Cost of capital method: PW (13.87%) $41, 704 0 , accept the project.
End of Year 0 1 2 3 4 5
Income Statement
Revenue $90,000 $90,000 $90,000 $90,000 $90,000
Expenses
O&M 10,000 10,000 10,000 10,000 10,000
CCA 30,000 51,000 35,700 24,990 17,493
Taxable income 50,000 29,000 44,300 55,010 62,507
Income taxes (36%) 18,000 10,440 15,948 19,804 22,503
Net Income $32,000 $18,560 $28,352 $35,206 $40,004
Cash Flow Statement
Operating activities
Net income $32,000 $18,560 $28,352 $35,206 $40,004
CCA 30,000 51,000 35,700 24,990 17,493
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
12-8
Investment and Salvage (200,000) 50,000
Disposal tax effects (3,306)
Net cash flow ($200,000) $62,000 $69,560 $64,052 $60,196 $104,192
12.12
(a) Net equity flow method:
End of Year 0 1 2 3 4 5
Income Statement
Revenue $45,000 $45,000 $45,000 $45,000 $45,000
Expenses
Interest payment 9,000 7,665 6,130 4,365 2,335
CCA 15,000 25,500 17,850 12,495 8,747
Taxable income 21,000 11,835 21,020 28,140 33,919
Income taxes (30%) 6,300 3,550 6,306 8,442 10,176
Net Income $14,700 $8,284 $14,714 $19,698 $23,743
Cash Flow Statement
Operating activities
Net income $14,700 $8,284 $14,714 $19,698 $23,743
CCA 15,000 25,500 17,850 12,495 8,747
Investment activities
Investment and Salvage (100,000) 30,000
Disposal tax effects (2,877)
Financing activities
Borrowed funds 60,000
Principal repayment (8,899) (10,234) (11,769) (13,534) (15,564)
Net cash flow ($40,000) $20,801 $23,551 $20,795 $18,659 $44,048
PW 20% $32, 423
ie 20%, id (0.15)(1 0.30) 0.105
(b) Cost of capital method:
k (0.60)(0.105) (0.40)(0.20) 14.30%
End of Year 0 1 2 3 4 5
Income Statement
Revenue $45,000 $45,000 $45,000 $45,000 $45,000
Expenses
CCA 15,000 25,500 17,850 12,495 8,747
Taxable income 30,000 19,500 27,150 32,505 36,254
Income taxes (30%) 9,000 5,850 8,145 9,752 10,876
Net Income $21,000 $13,650 $19,005 $22,754 $25,377
Cash Flow Statement
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
12-9
Operating activities
Net income $21,000 $13,650 $19,005 $22,754 $25,377
CCA 15,000 25,500 17,850 12,495 8,747
Investment and Salvage (100,000) 30,000
Disposal tax effects (2,877)
Net cash flow ($100,000) $36,000 $39,150 $36,855 $35,249 $61,247
PW 14.3% $38,189
12.13
(a) Using ie 15% : Select Machine B.
Machine A
End of Year 0 1 2 3 4 5 6
Income Statement
Revenue $20,000 $20,000 $20,000 $20,000 $20,000 $20,000
Expenses
O&M 8,000 8,000 8,000 8,000 8,000 8,000
Interest payment 1,200 1,044 873 685 478 250
CCA $6,000 $10,200 $7,140 $4,998 $3,499 $2,449
Taxable income 4,800 756 3,987 6,317 8,023 9,300
Income taxes (35%) 1,680 264 1,395 2,211 2,808 3,255
Net Income $3,120 $491 $2,591 $4,106 $5,215 $6,045
Cash Flow Statement
Operating activities
Net income $3,120 $491 $2,591 $4,106 $5,215 $6,045
CCA 6,000 10,200 7,140 4,998 3,499 2,449
Investment activities
Investment and Salvage (40,000) 4,000
Disposal tax effects 600
Financing activities
Borrowed funds 12,000
Principal repayment (1,555) (1,711) (1,882) (2,070) (2,277) (2,505)
Net cash flow ($28,000) $7,565 $8,980 $7,849 $7,034 $6,437 $10,590
PW(15%) = $2,329
Machine B
End of Year 0 1 2 3 4 5 6
Income Statement
Revenue $28,000 $28,000 $28,000 $28,000 $28,000 $28,000
Expenses
O&M 10,000 10,000 10,000 10,000 10,000 10,000
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
12-10
Interest payment 1,800 1,567 1,310 1,028 717 376
CCA $9,000 $15,300 $10,710 $7,497 $5,248 $3,674
Taxable income 7,200 1,133 5,980 9,475 12,035 13,951
Income taxes (35%) 2,520 397 2,093 3,316 4,212 4,883
Net Income $4,680 $737 $3,887 $6,159 $7,823 $9,068
Cash Flow Statement
Operating activities
Net income $4,680 $737 $3,887 $6,159 $7,823 $9,068
CCA 9,000 15,300 10,710 7,497 5,248 3,674
Investment activities
Investment and Salvage (60,000) 8,000
Disposal tax effects 200
Financing activities
Borrowed funds 18,000
Principal repayment (2,333) (2,566) (2,823) (3,105) (3,416) (3,757)
Net cash flow ($42,000) $11,347 $13,470 $11,774 $10,551 $9,655 $17,184
PW(15%) = $4,056
(b) Using k 0.31 0.35 0.1 0.7 0.15 12.45% : Select machine B.
Machine A
End of Year 0 1 2 3 4 5 6
Income Statement
Revenue $20,000 $20,000 $20,000 $20,000 $20,000 $20,000
Expenses
O&M 8,000 8,000 8,000 8,000 8,000 8,000
CCA $6,000 $10,200 $7,140 $4,998 $3,499 $2,449
Taxable income 6,000 1,800 4,860 7,002 8,501 9,551
Income taxes (35%) 2,100 630 1,701 2,451 2,975 3,343
Net Income $3,900 $1,170 $3,159 $4,551 $5,526 $6,208
Cash Flow Statement
Operating activities
Net income $3,900 $1,170 $3,159 $4,551 $5,526 $6,208
CCA 6,000 10,200 7,140 4,998 3,499 2,449
Investment activities
Investment and Salvage (40,000) 4,000
Disposal tax effects 600
Net cash flow ($40,000) $9,900 $11,370 $10,299 $9,549 $9,025 $13,257
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
12-11
PW(12.45%) = $2,587
Machine B
End of Year 0 1 2 3 4 5 6
Income Statement
Revenue $28,000 $28,000 $28,000 $28,000 $28,000 $28,000
Expenses
O&M 10,000 10,000 10,000 10,000 10,000 10,000
CCA $9,000 $15,300 $10,710 $7,497 $5,248 $3,674
Taxable income 9,000 2,700 7,290 10,503 12,752 14,326
Income taxes (35%) 3,150 945 2,552 3,676 4,463 5,014
Net Income $5,850 $1,755 $4,739 $6,827 $8,289 $9,312
Cash Flow Statement
Operating activities
Net income $5,850 $1,755 $4,739 $6,827 $8,289 $9,312
CCA 9,000 15,300 10,710 7,497 5,248 3,674
Investment activities
Investment and Salvage (60,000) 8,000
Disposal tax effects 200
Net cash flow ($60,000) $14,850 $17,055 $15,449 $14,324 $13,537 $21,186
PW(12.45%) = $4,523
(c) Both methods provide consistent solutions.
Capital Budgeting
12.14 Based on the investment opportunity curve below, the firm’s optimal capital
budget would be $177 million, with no restriction on the firm’s debt limit.
However, with a budget limit of $100 million, the firm may select Projects 5
and 3 first. Since these two projects alone consume $95 million, the firm may
have two choices about utilizing the remaining $5 million funds. First choice is
to find any projects whose rates of return exceed the cost of capital. Project 4
comes close to meeting this requirement. However, the firm’s borrowing rate is
18%, which is greater than the rate of return from Project 4. Therefore, the
projects that should be included in the $100 million budget would be Projects 5
and 3. If money has to be raised from outside, the firm should raise only $95
million.
Rate of Return
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
12-12
90%
5 80%
3
40%
2 32% 30%
7 6 22%
1 15% Borrowing rate (18%)
4
Lending (12%)
12.15
(a) Present worth analysis: With no budget restriction, select alternatives 1, 2, 3, 4,
7, 13, and 14. The total NPW from the projects is $2,194.
j PW(8%) j PW(8%)
1 $303 8 -$208
2 $500 9 -$165
3 $661 10 -$27
4 $46 11 -$1,017
5 -$66 12 -$248
6 -$814 13 $126
7 $47 14 $512
(b) With a budget limit of $1,800, select alternatives 1, 2, 3, 4, 13, and 14. The
total amount of investment required is $1,756.
Short Case Studies
ST 12.1 Their financial data for Year 2010:
Number of Shares 1,000,000
Long-Term Debts 12,000,000
Interest Paid 1,200,000
Assets 5,000,000
Earning before Tax 3,500,000
* Stock Price per Share 18 Total Equity 18,000,000
* Earning per Share 2.1 Total Earning 2,100,000
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
12-13
* Dividends per Share 1.9 Total Dividend 1,900,000
(a) From the table, the future net cash flow is
$18, 000, 000 $5, 000, 000 $13, 000, 000
(b) From the table, the tax rate is
$2,100, 000
1 0.4
$3,500, 000
(c)
MARR with known source of financing = Cost of equity
Increase in share price over the four years plus the dividends each year, divided
by the starting share price:
1
(18 8) 1.1 1.2 1.5 1.9 4
ie 1 18.36%
8
MARR with unknown source of financing = Cost of capital
Cost of Debt 10% (40% of assets)
Cost of Equity 18.36% (60% of assets)
Tax Rate 40%
∴ k (0.1 (1 0.4) 0.4) (0.1836 0.6) 13.42%
(d) Assuming that the company funds the new project by maintaining the same
debt to equity ratio. To raise the $10,080,00 needed (for equipment and
installation), they have to borrow $4,032,000 and issue 336,000 stocks (at $18
per share), which will increase their equity $6,048,000 for the project. At 11%,
the flotation costs of $665,280 are deducted as an expense.
End of Year 0 1 2
Income Statement
Revenue $44,000,000 $44,000,000
Cost of Goods Sold 35,200,000 26,400,000
Interest 403,200 403,200
CCA $1,512,000 $2,570,400
Taxable income 6,884,800 14,626,400
Income taxes (40%) 2,753,920 5,850,560
Net Income $4,130,880 $8,775,840
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
12-14
Cash Flow Statement
Operating activities
Net income $4,130,880 $8,775,840
CCA 1,512,000 2,570,400
Investment activities
Investment and Salvage (10,080,000) 3,600,000
Disposal tax effects 959,040
Finance 4,032,000 (4,032,000)
Stock issue fee ($665,280)
Net cash flow ($6,713,280) $5,642,880 $11,873,280
NPW (18.36%) 6,529,815
(18, 000, 000 6,529,815)
∴ Most likely stock price = $18.36 / share
(1, 000, 000 336, 000)shares
(e) Three different ways to finance the project are considered. In case of debt
financing, the interests are at the end of each year and the principal is fully
repaid in a lump sum at the end of the fifth year. Based on the analyses, the
potential stock price of each case would be as follows:
100% Equity Current Mixed 100% Debt
Methods
Financing Financing Financing
Stock price 39.86 48.03 67.15
Comments Pessimistic Most likely Optimistic
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
12-15
100% Equity Financing
End of Year 0 1 2 3 4 5 6 7 8
Income Statement
Revenue $44,000,000 $44,000,000 $44,000,000 $44,000,000 $44,000,000 $44,000,000 $44,000,000 $44,000,000
Cost of Goods Sold 35,200,000 26,400,000 26,400,000 26,400,000 26,400,000 26,400,000 26,400,000 26,400,000
Interest
CCA $1,512,000 $2,570,400 $1,799,280 $1,259,496 $881,647 $617,153 $432,007 $302,405
Taxable income 7,288,000 15,029,600 15,800,720 16,340,504 16,718,353 16,982,847 17,167,993 17,297,595
Income taxes (40%) 2,915,200 6,011,840 6,320,288 6,536,202 6,687,341 6,793,139 6,867,197 6,919,038
Net Income $4,372,800 $9,017,760 $9,480,432 $9,804,302 $10,031,012 $10,189,708 $10,300,796 $10,378,557
Cash Flow Statement
Operating activities
Net income $4,372,800 $9,017,760 $9,480,432 $9,804,302 $10,031,012 $10,189,708 $10,300,796 $10,378,557
CCA 1,512,000 2,570,400 1,799,280 1,259,496 881,647 617,153 432,007 302,405
Investment activities
Investment and
Salvage (10,080,000)
Disposal tax effects
Finance
Stock issue fee ($1,108,800)
Net cash flow ($11,188,800) $5,884,800 $11,588,160 $11,279,712 $11,063,798 $10,912,659 $10,806,861 $10,732,803 $10,680,962
Discounted to time 0 ($11,188,800) $4,971,979 $8,271,983 $6,802,848 $5,637,604 $4,698,059 $3,930,837 $3,298,346 $17,753,139
PW(18.36%) = $44,175,997
(18, 000, 000 44,175,997)
∴ Stock price = $39.86/share
(1, 000, 000 560, 000)shares
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
12-16
Current Mixed Financing
End of Year 0 1 2 3 4 5 6 7 8
Income Statement
Revenue $44,000,000 $44,000,000 $44,000,000 $44,000,000 $44,000,000 $44,000,000 $44,000,000 $44,000,000
Cost of Goods Sold 35,200,000 26,400,000 26,400,000 26,400,000 26,400,000 26,400,000 26,400,000 26,400,000
Interest 403,200 403,200 403,200 403,200 403,200
CCA $1,512,000 $2,570,400 $1,799,280 $1,259,496 $881,647 $617,153 $432,007 $302,405
Taxable income 6,884,800 14,626,400 15,397,520 15,937,304 16,315,153 16,982,847 17,167,993 17,297,595
Income taxes (40%) 2,753,920 5,850,560 6,159,008 6,374,922 6,526,061 6,793,139 6,867,197 6,919,038
Net Income $4,130,880 $8,775,840 $9,238,512 $9,562,382 $9,789,092 $10,189,708 $10,300,796 $10,378,557
Cash Flow Statement
Operating activities
Net income $4,130,880 $8,775,840 $9,238,512 $9,562,382 $9,789,092 $10,189,708 $10,300,796 $10,378,557
CCA 1,512,000 2,570,400 1,799,280 1,259,496 881,647 617,153 432,007 302,405
Investment activities
Investment and
Salvage (10,080,000)
Disposal tax effects
Finance 4,032,000 (4,032,000)
Stock issue fee ($665,280)
Net cash flow ($6,713,280) $5,642,880 $11,346,240 $11,037,792 $10,821,878 $6,638,739 $10,806,861 $10,732,803 $10,680,962
Discounted to time 0 ($6,713,280) $4,767,584 $8,099,293 $6,656,945 $5,514,333 $2,858,074 $3,930,837 $3,298,346 $17,753,139
PW(18.36%) = $46,165,273
(18, 000, 000 46,165, 273)
∴ Stock price = $48.03 / share
(1, 000, 000 336, 000)shares
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
12-17
100% Debt Financing
End of Year 0 1 2 3 4 5 6 7 8
Income Statement
Revenue $44,000,000 $44,000,000 $44,000,000 $44,000,000 $44,000,000 $44,000,000 $44,000,000 $44,000,000
Cost of Goods Sold 35,200,000 26,400,000 26,400,000 26,400,000 26,400,000 26,400,000 26,400,000 26,400,000
Interest 1,008,000 1,008,000 1,008,000 1,008,000 1,008,000
CCA $1,512,000 $2,570,400 $1,799,280 $1,259,496 $881,647 $617,153 $432,007 $302,405
Taxable income 6,280,000 14,021,600 14,792,720 15,332,504 15,710,353 16,982,847 17,167,993 17,297,595
Income taxes (40%) 2,512,000 5,608,640 5,917,088 6,133,002 6,284,141 6,793,139 6,867,197 6,919,038
Net Income $3,768,000 $8,412,960 $8,875,632 $9,199,502 $9,426,212 $10,189,708 $10,300,796 $10,378,557
Cash Flow Statement
Operating activities
Net income $3,768,000 $8,412,960 $8,875,632 $9,199,502 $9,426,212 $10,189,708 $10,300,796 $10,378,557
CCA 1,512,000 2,570,400 1,799,280 1,259,496 881,647 617,153 432,007 302,405
Investment activities
Investment and
Salvage (10,080,000)
Disposal tax effects
Finance 10,080,000 (10,080,000)
Stock issue fee
Net cash flow $0 $5,280,000 $10,983,360 $10,674,912 $10,458,998 $227,859 $10,806,861 $10,732,803 $10,680,962
Discounted to time 0 $0 $4,460,993 $7,840,259 $6,438,090 $5,329,426 $98,097 $3,930,837 $3,298,346 $17,753,139
PW(18.36%) = $49,149,187
(18, 000, 000 49,149,187)
∴ Stock price = $67.15 / share
(1, 000, 000)shares
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
12-18
ST 12.2
(a) There are 36 mutually exclusive alternatives without considering the budget
and engineering-hour constraints. Projects 1 and 2 are mutually exclusive
projects; Projects 5 and 6 or keeping the current supplier are mutually
exclusive; Project 3 is contingent on Project 2.
1 1,5 1,7 1,4,6 1,5,7 1,4,5,7
2 2,5 2,7 2,4,6 2,5,7 2,4,5,7
2,3 2,3,5 2,3,7 2,3,4,6 2,3,5,7 2,3,4,5,7
1,4 1,6 1,4,5 1,4,7 1,6,7 1,4,6,7
2,4 2,6 2,4,5 2,4,7 2,6,7 2,4,6,7
2,3,4 2,3,6 2,3,4,5 2,3,4,7 2,3,6,7 2,3,4,6,7
(b) There are 10 feasible alternatives with the budget and time restrictions:
1 1 6 2,6
2 2 7 2,7
3 1,4 8 1,4,7
4 1,5 9 1,5,7
5 1,7 10 2,6,7
(c) Without knowing the exact cash flow sequences for each project over the
project life, it is not feasible to determine the optimal capital budget.
ST 12.3
(a) Select A and C with FW(10%) = $4,894. Since $500 is left over after selecting
A and C, we could lend out the leftover funds at 10% for three periods.
Therefore, the total amount available for lending at the end of period 3 is
calculated as follows:
F $4,894 $500( F / P,10%,3)
$5,559.60
(b) Select B and C. The total amount available for lending at the end of period 3 is
$5,740.
(c) With a budget limit of $3,500, the reasonable MARR should be the lending
rate of 10%. (You select A and C and have $500 available for lending.)
ST 12.4
(a) The debt repayment schedule for the loan from the equipment manufacturer:
Loan Repayment
n Loan Balance
Interest Principal
0 $2,000,000
1 $200,000 $125,491 $1,874,509
2 $187,451 $138,040 $1,736,469
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
12-19
3 $173,647 $151,844 $1,584,625
4 $158,463 $167,028 $1,417,597
5 $141,760 $183,731 $1,233,866
6 $123,387 $202,104 $1,031,762
7 $103,176 $222,315 $809,447
8 $80,945 $244,546 $564,901
9 $56,490 $269,001 $295,901
10 $29,590 $295,901 $0
(b) The flotation costs and the number of common stocks to raise $8,500,000:
$8,500, 000
Flotation cost = $8,500, 000 $749,184
1 0.081
$8,500, 000
Number of shares = 205,537 shares
(1 0.081)($45)
(c) The flotation costs and the number of $1,000 bonds to raise $10.5 million:
$10,500, 000
Flotation cost = $10,500, 000 $203,364
1 0.019
$10,500, 000
Number of bonds = 11,893units
(1 0.019)($900)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
12-20
ST 12.5 (a) The net cash flow from the cogeneration project with bond financing
End of Year 0 1 2 3 4 5 6 7 8 9 10 11 12
(all units in thousands of dollars)
Income Statement
Revenue
Electricity bill $6,120.0 $6,120.0 $6,120.0 $6,120.0 $6,120.0 $6,120.0 $6,120.0 $6,120.0 $6,120.0 $6,120.0 $6,120.0 $6,120.0
Excess power 480.0 480.0 480.0 480.0 480.0 480.0 480.0 480.0 480.0 480.0 480.0 480.0
Expenses
O&M 500.0 500.0 500.0 500.0 500.0 500.0 500.0 500.0 500.0 500.0 500.0 500.0
Misc. 1,000.0 1,000.0 1,000.0 1,000.0 1,000.0 1,000.0 1,000.0 1,000.0 1,000.0 1,000.0 1,000.0 1,000.0
Standby Power 6.4 6.4 6.4 6.4 6.4 6.4 6.4 6.4 6.4 6.4 6.4 6.4
Fuel 1,280.0 1,280.0 1,280.0 1,280.0 1,280.0 1,280.0 1,280.0 1,280.0 1,280.0 1,280.0 1,280.0 1,280.0
Overhauls 1,600.0 1,600.0 1,600.0
CCA on Unit 500.0 950.0 855.0 769.5 692.6 623.3 561.0 504.9 454.4 408.9 368.0 331.2
CCA on Inter. Equip. 75.0 127.5 89.3 62.5 43.7 30.6 21.4 15.0 10.5 7.4 5.1 3.6
Interest (9%) 1,070.4 1,070.4 1,070.4 1,070.4 1,070.4 1,070.4 1,070.4 1,070.4 1,070.4 1,070.4 1,070.4 1,070.4
Taxable income 2,168.23 1,665.73 198.98 1,911.26 2,006.95 489.32 2,160.84 2,223.36 678.35 2,326.94 2,370.04 2,408.38
Income taxes (36%) 780.56 599.66 71.63 688.05 722.50 176.16 777.90 800.41 244.21 837.70 853.21 867.02
Net Income 1,387.67 1,066.07 127.35 1,223.20 1,284.45 313.17 1,382.93 1,422.95 434.14 1,489.24 1,516.82 1,541.37
Cash Flow Statement
Operating activities
Net income $1,388 $1,066 $127 $1,223 $1,284 $313 $1,383 $1,423 $434 $1,489 $1,517 $1,541
CCA on Unit 500 950 855 770 693 623 561 505 454 409 368 331
CCA on Inter. Equip. 75 128 89 62 44 31 21 15 11 7 5 4
Investment and Salvage
Unit (10,000) 975
Inter Equip. (500) 25
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
12-21
Disposal tax effects 716
Loan/repayment 10,500 (11,893)
Net cash flow $0 $1,963 $2,144 $1,072 $2,055 $2,021 $967 $1,965 $1,943 $899 $1,906 $1,890 ($8,301)
PW(27%) = $5,629.625 thousands
(b) The maximum annual lease amount that ACC is willing to pay is $909.528. (By Excel goal.)
End of Year 0 1 2 3 4 5 6 7 8 9 10 11 12
(all units in thousands of dollars)
Income Statement
Revenue
Electricity bill $6,120.0 $6,120.0 $6,120.0 $6,120.0 $6,120.0 $6,120.0 $6,120.0 $6,120.0 $6,120.0 $6,120.0 $6,120.0 $6,120.0
Excess power 480.0 480.0 480.0 480.0 480.0 480.0 480.0 480.0 480.0 480.0 480.0 480.0
Expenses
O&M 500.0 500.0 500.0 500.0 500.0 500.0 500.0 500.0 500.0 500.0 500.0 500.0
Misc. 1,000.0 1,000.0 1,000.0 1,000.0 1,000.0 1,000.0 1,000.0 1,000.0 1,000.0 1,000.0 1,000.0 1,000.0
Standby Power 6.4 6.4 6.4 6.4 6.4 6.4 6.4 6.4 6.4 6.4 6.4 6.4
Fuel 1,280.0 1,280.0 1,280.0 1,280.0 1,280.0 1,280.0 1,280.0 1,280.0 1,280.0 1,280.0 1,280.0 1,280.0
Overhauls 1,600.0 1,600.0 1,600.0
Lease 909.5 909.5 909.5 909.5 909.5 909.5 909.5 909.5 909.5 909.5 909.5 909.5
Taxable income 2,904.07 2,904.07 1,304.07 2,904.07 2,904.07 1,304.07 2,904.07 2,904.07 1,304.07 2,904.07 2,904.07 2,904.07
Income taxes (36%) 1,045.47 1,045.47 469.47 1,045.47 1,045.47 469.47 1,045.47 1,045.47 469.47 1,045.47 1,045.47 1,045.47
Net Income 1,858.61 1,858.61 834.61 1,858.61 1,858.61 834.61 1,858.61 1,858.61 834.61 1,858.61 1,858.61 1,858.61
Cash Flow Statement
Operating activities
Net income $1,859 $1,859 $835 $1,859 $1,859 $835 $1,859 $1,859 $835 $1,859 $1,859 $1,859
Net cash flow $0 $1,859 $1,859 $835 $1,859 $1,859 $835 $1,859 $1,859 $835 $1,859 $1,859 $1,859
PW(27%) = $5,629.625 thousands
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
13-1
Chapter 13 Economic Analysis in the Public Sector
Cost-Effectiveness Analysis
13.1 Cost-effectiveness of the alternatives:
Type of Treatment Cost-Effectiveness
Antibiotic A 12,000/75 =160
Antibiotic B 168.75
Antibiotic C 180.49
∴ The best treatment option is Antibiotic A.
13.2
The summary of three mutually exclusive alternatives CER:
Incremental
Strategy Cost Effectiveness Cost-Effectiveness
CER
Nothing $0 0 years 0 0
Simple $5,000 5 years 1,000 1,000
Complex $50,000 5.5 years 9,091 90,000
Since there is no clear dominance, we can draw a cost-effective diagram.
Life-Year 6
5
4
3
2
1
0
$0 $10,000 $20,000 $30,000 $40,000 $50,000 $60,000
Investment cost
Budget Available ($) Treatment Option to be Implemented
Less than $5,000 As much of Simple treatment as budget
allows
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
13-2
$5,000 100% of Simple treatment
$5,000 - $50,000 Simple treatment and as much of
Complex treatment as budget allows
$50,000 or larger 100% of Complex treatment
Valuation of Benefits and Costs
13.3
(a) • User’s benefits:
- Prevention (or retardation) of highway corrosion: resulting in lower highway
maintenance cost. This lower maintenance cost implies lower users’ taxes
on gasoline and so forth.
- Prevention of rust on vehicles: resulting in lower repair and maintenance
costs and higher resale value of vehicles.
- Prevention of corrosion to utility lines and damages to water supplies:
resulting in lower utility rates.
- Prevention of damages to vegetation and soil surrounding areas: increasing
land values and agriculture yields.
Users’ costs:
- Paying higher taxes.
- Unknown environmental damages due to using CMA
(b) The province of Quebec may declare certain sections of highway for
experimental purpose. CMA may be used exclusively for a designated area
and road salts for another area for an extended period time. Then it
investigates the impact of CMA on vegetation yields, which can be compared
with those of areas from road salt use. The difference in vegetation yields may
be quantified in terms of market value and so forth.
13.4 This is an open-end type question. (No solution is given.)
13.5 This is an open-end type question. (No solution is given.)
Benefit-Cost Analysis
13.6
(a) BC (i ) analysis:
Design A:
I $400, 000
C ' $50, 000( P / A,8%,15) $427,974
B $85, 000
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
13-3
Design B:
I $300, 000
C ' $80, 000( P / A,8%,15) $684, 758
B $85, 000
Incremental analysis: Fee collections in the amount of $85,000 will be the
same for both alternatives. Therefore, we will not be able to compute the
BC (i ) ratio. If this happens, we may select the best alternative based on either
the least cost ( I C ' ) criterion or the incremental B 'C (i ) criterion. Using the
B 'C (i ) criterion,
B C ' 0 ($427,974 $684, 758)
B 'C (8%) A B 2.57 1
I $100, 000
∴Select Design A.
(b) Incremental analysis (A – C):
B C ' 0 ($427,974 $556,366)
B 'C (8%) AC 2.57 1
I $50, 000
∴Select Design A.
13.7
Building X:
BX $1,960, 000( P / A,10%, 20) $16, 686, 656
C X $8, 000, 000 $240, 000( P / A,10%, 20)
$4,800, 000( P / F ,10%, 20)
$9,329,984
$16, 686, 656
BC (10%) X 1.79 1
$9,329,984
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
13-4
Building Y:
BY $1,320, 000( P / A,10%, 20) $11, 237,952
CY $12, 000, 000 $180, 000( P / A,10%, 20)
$7, 200, 000( P / F ,10%, 20)
$12, 462,528
$11, 237,952
BC (10%)Y 0.90 1
$12, 462,528
Since Building Y is not desirable at the outset, we don’t need to conduct an
incremental analysis. Building X becomes the better choice.
*
13.8
Incremental BC (i ) analysis:
Present Proposals Incremental
Worth A1 A2 A3 A3-A1 A2-A1
B $400 $700 $500 $100 $300
I $100 $300 $200 $100 $200
C $100 $200 $150 $50 $100
BC (i ) 2 1.4 1.43 0.67 1
∴ Select either A1 or A2.
13.9 Incremental BC (i ) analysis
Present Design Incremental
Worth A B C C-B A-B
B $7,824 $7,070 $5,656 -$1,414 $754
I $2,440 $880 $1,600 $720 $1,560
C’ $3,865 $3,394 $2,922 -$472 $471
BC (i ) 1.24 1.65 1.25 -5.7 0.37
∴ Select Design B.
13.10
The benefit-cost ratio for each alternative:
Alternative A:
*
An asterisk next to a problem number indicates that the solution is available to students
on the Companion Website.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
13-5
B ($1, 000, 000 $250, 000 $350, 000 $100, 000)( P / A,10%,50)
$16,855,160
C $8, 000, 000 $200, 000( P / A,10%,50)
$9,982,960
$16,855,160
BC (10%) A 1.69 1
$9,982,960
Alternative B:
B ($1, 200, 000 $350, 000 $450, 000 $200, 000)( P / A,10%,50)
$21,812,560
C $10, 000, 000 $250, 000( P / A,10%,50)
$12, 478, 700
$21,812,560
BC (10%) B 1.75 1
$12, 478, 700
Alternative C:
B ($1,800, 000 $500, 000 $600, 000 $350, 000)( P / A,10%,50)
$32, 223,100
C $15, 000, 000 $350, 000( P / A,10%,50)
$18, 470,180
$32, 223,100
BC (10%)C 1.74 1
$18, 470,180
(a) Select the best alternative based on BC (i ) :
$21,812,560 $16,855,100
BC (10%) B A
$12, 478, 700 $9,982,960
1.99 1 ( Select B)
$32, 223,100 $21,812,560
BC (10%)C B
$18, 470,180 $12, 478, 700
1.74 1 ( Select C )
Comments: You could select the best alternative based on B 'C (i ) :
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
13-6
A B C
B $16,855,160 $21,812,560 $32,223,100
I $8,000,000 $10,000,000 $15,000,000
C' $1,982,960 $2,478,700 $3,470,180
B'C(i) 1.86 1.93 1.92
13.11
Option 1 – The “long” route:
user's annual cost 22 km × $0.25 km × 400,000 cars
$2, 200, 000
sponsor's annual cost $21, 000, 000( A / P,10%, 40) $140, 000
$2, 288,300
Option 2 – Shortcut:
user's annual cost 10 km × $0.25 km × 400,000 cars
$1, 000, 000
sponsor's annual cost $45, 000, 000( A / P,10%, 40) $165, 000
$4, 768,500
Incremental analysis (Option 2 – Option 1):
Incremental user's benefit $2, 200, 000 $1, 000, 000
$1, 200, 000
$1, 200, 000
BC (10%) 21
$4, 768,500 $2, 288,300
0.48 1
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
13-7
∴ Assuming that there is no do-nothing alternative, select Option 1.
13.12
Multiple alternatives:
Projects PW of Benefits PW of Costs Net PW B/C Ratio
A1 $40 $85 -$45 0.47
A2 $150 $110 $40 1.36
A3 $70 $25 $45 2.80
A4 $120 $73 $47 1.64
Since the BC ratio for Project A1 is less than 1, we delete it from our comparison.
Incremental Analysis
A4 vs. A3:
$120 $70
BC (10%) A 4 A3
$73 $25
1.04 1
Select A4.
A2 vs. A4:
$150 $120
BC (10%) A 2 A 4
$110 $73
0.81 1
Select A4.
Short Case Studies
ST 13.1 Capital allocation decision, assuming that the government will be able to
raise the required funds at 10% interest:
Region Project PW(10%) Investment
1 $1,606,431 $980,000
2 $3,438,531 $3,500,000
I
3 $2,682,758 $2,800,000
4 $2,652,473 $1,400,000
5 $1,672,473 $2,380,000
6 $5,258,050 $5,040,000
II
7 $4,130,824 $2,520,000
8 $2,958,052 $4,900,000
III 9 $552,475 $1,365,000
10 $4,459,032 $2,100,000
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
13-8
11 $1,166,557 $1,170,000
12 $1,788,245 $1,120,000
13 $5,066,566 $2,800,000
14 $2,338,635 $1,690,000
IV
15 $1,213,846 $975,000
16 $1,899,946 $1,462,500
(a) $6 million to each region:
Region Projects NPW
I 1,2,4 $7,697,488
II 5,7 $5,803,297
III 9,10,11,12 $5,966,309
IV 13,14,16 $9,305,147
(b) $15 million to Regions I & II and $9 million to regions III & IV:
Region Projects NPW Investment
I & II 2,4,5,6,7 $17,152,400 $14,840,000
III & IV 10,12,13,14,15 $12,866,320 $8,685,000
ST 13.2 Given i 8% , g 10% , garbage amount/day = 300 tonnes
(a) The operating cost of the current system in terms of $/tonne of solid waste:
Annual garbage collection required (assuming 365 days):
Total amount of garbage = 300 tonnes × 365 days
= 109,500 tonnes
Equivalent annual operating and maintenance cost:
PW (8%) $905, 400( P / A1 ,10%,8%, 20)
$20, 071,500
AEC (8%) $20, 071,500( A / P,8%, 20)
$2, 044,300
Operating cost per tonne:
$2,044,300
cost per tonne= =$18.67/tonne
109,500
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
13-9
(b) The economics of each solid-waste disposal alternative in terms of $/tonne:
Site 1:
AEC (8%)1 $4, 053, 000( A / P,8%, 20) $342, 000 ($13, 200 $87, 600)
$653, 000
$653,000
cost per tonne =$5.96/tonne
109,500
Site 2:
AEC (8%)2 $4,384, 000( A / P,8%, 20) $480, 000 ($14, 700 $99,300)
$812,520
$812,520
cost per tonne =$7.42/tonne
109,500
Site 3:
AEC (8%)3 $4, 764, 000( A / P,8%, 20) $414, 000 ($15,300 $103,500)
$780, 424
$780,424
cost per tonne =$7.13/tonne
109,500
Site 4:
AEC (8%)2 $5, 454, 000( A / P,8%, 20) $408, 000 ($17,100 $119, 400)
$827, 000
$827,000
cost per tonne $7.55/tonne
109,500
∴ Site 1 is the most economical choice.
ST 13.3
(a) Let’s define the following variables to compute the equivalent annual cost.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
13-10
Ala initial land cost
Aeq initial equipment cost
Ast initial structure cost
Apu initial pumping equipment cost
Aen initial annual energy cost in today's dollars
Alb initial annual labour cost in today's dollars
Aen initial annual repair cost in today's dollars
Land:
PW (10%)land Ala Ala (1.03 /1.1)120
$0.99963 Ala
Equipment: Let’s define the following additional variables.
I15 n replacement cost in year 15n
S15 n salvage value in year 15n
C15 n net replacement cost in year 15n
where n 1, 2,3, 4,5, 6, and 7
The total replacement cost over the analysis period is calculated as follows:
I15 Aeq (1.05)15 2.07893 Aeq
S15 0.5 Aeq
C15 (2.07893 0.5) Aeq 1.57893 Aeq
C15 n (1.57893 Aeq )(1.05)15( n 1)
S15 n 0.5 Aeq (1.05)15 n
7
PW (10%)equipment Aeq C15 n S120
n 1
7 (1.57893 Aeq )(1.05)15( n 1) 0.5 Aeq (1.05)120
Aeq
n 1 (1.1)15 n (1.1)120
1.745 Aeq
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
13-11
Structure:
1 1 0.6 Ast
PW (10%) structure Ast (0.40) Ast
(1.1)
40
(1.1)80 (1.1)120
1.00902 Ast
Pumping:
PW (10%) pumping 1.745 Apu
Energy:
120
PW (10%)energy Aen (1.05 /1.1) j 20.92302 Aen
j 1
Labour:
120
PW (10%)labour Alb (1.04 /1.1) j 17.3113 Alb
j 1
Repair:
120
PW (10%)repair Are (1.02 /1.1) j 12.748 Are
j 1
Present worth of the life-cycle cost:
PW (10%) 0.99963 Ala 1.745 Aeq 1.00902 Ast 1.745 Apu
20.92302 Aen 17.3113 Alb 12.748 Are
Option
Parameters
2 3 4 5
Ala $2,400,000 $49,000 $49,000 $400,000
Aeq $500,000 $500,000 $400,000 $175,000
Ast $700,000 $2,100,000 $2,463,000 $1,750,000
Apu $100,000 0 0 $100,000
Aen $200,000 $125,000 $100,000 $50,000
Alb $95,000 $65,000 $53,000 $37,000
Are $30,000 $20,000 $15,000 $5,000
PW(10%) $10,364,300 $7,036,290 $6,433,460 $4,395,790
AEC(10%) $1,036,440 $703,637 $643,353 $439,584
∴ Option 5 is the least cost alternative.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
13-12
(b)
Cost / L = $439,584 / 8,000,000(365)
= $0.0151 ¢/L
Monthly charge
$439,854 1600 L
8, 000, 000 L 12 months
$7.33 / month
ST 13.4
(a) Users’ benefits and disbenefits:
Users’ benefits
(1) Reduced travel time.
(2) Reduced fuel consumption.
(3) Reduced air pollution.
(4) Reduced number of accidents.
Users’ disbenefits: Increased automobile purchase and maintenance costs.
(b) Sponsors’ cost:
Development costs associated with computerized dashboard navigational
systems, roadside sensors, and automated steering and speed controls.
Implementation and maintenance costs.
Public promotional and educational costs.
(c) On a national level, the sponsors’ costs are estimated to be as follows:
R&D costs = $2.5 billion
Implementation costs = $18 billion
Maintenance costs = $4 billion per year
Comments: However, the users’ benefits are sketchy, except the level of
reduction possible in the area of travel time, fuel consumption, and air pollution.
Ask the students to quantify these in dollar terms by consulting various
government publications on public transportation. Once these figures are
estimated, the benefit-cost ratio can be easily derived.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
14-1
Part 5
Handling Risk and
Uncertainty
14-2
Chapter 14 Inflation and Its Impact on Project Cash Flows
Measure of Inflation
14.1
(a) Ottawa-Gatineau:
74.2(1 + ƒ)12 = 95.2
ƒ = 2.0985%
F = 100(1+ 0.020985)12
F = 128.30
Toronto:
78.9 (1 + ƒ)12 = 98.9
ƒ = 1.9006%
F = 100(1+ 0.019006)12
F = 125.35
Thunder Bay:
84.2 (1 + ƒ)12 = 102.7
ƒ = 1.6689%
F = 100(1+ 0.016689)12
F = 121.97
(b)
Ottawa-Gatineau Toronto Thunder Bay
January 2009 94.04 100.00 106.72
February 2009 97.34 103.42 113.05
March 2009 102.41 107.35 110.39
April 2009 102.53 107.98 111.79
May 2009 113.18 119.65 124.46
June 2009 119.65 125.22 136.12
14-3
July 2009 113.43 119.01 135.36
August 2009 118.76 124.59 134.60
September 2009 114.70 120.79 132.70
October 2009 116.10 121.17 125.35
November 2009 120.03 124.33 128.01
December 2009 115.72 119.65 122.56
January 2010 120.66 125.35 130.16
14.2
(a) Average price index:
92.0(1 f ) 4 117.3
f 6.262%
(b) Price index (2010 = 117.3(1+0.06262)5 = 158.92
(c)
2001 100.0
2002 102.2
2003 104.9
2004 123.8
2005 127.5
14.3
100(1 0.05)(1 0.08) 113.40
100( F / P, f , 2) 113.40
f 6.4894%
14.4
(a) Given: ƒ = 3.14%, N = 75
F = 1(1 + 0.0314)-75
F = (1.0314)-75
F = $0.0963
F = 9.63¢
(b) Given: ƒ = 3.14%, F = 0.5
0.5 = 1(1 + 0.0314)-N
14-4
0.5 = (1.0314)-N
-N log 1.0314 = log 0.5
N = -log 0.5 / log 1.0314
N = 22.42 years
72
Comments: If you use the Rule of 72, you may find 22.93 years , which
3.14
is very close to the actual value.
Actual versus Constant Dollars
14.5 Given: i 12%, f 5% , 10 annuity payments in actual dollars
P $4,500( P / A,12%,10)
$25, 426
Comments: Since the annuity payments are made in actual dollars, we use the
market interest rate to find its equivalent lump sum amount in today’s dollars.
14.6 Given: i 15%, f 8%, maintenance costs are given in constant dollars,
i ' 6.48%
P $25, 000( P / F , 6.48%,1) $30, 000( P / F , 6.48%, 2)
$32, 000( P / F , 6.48%,3) $35, 000( P / F , 6.48%, 4)
$40, 000( P / F , 6.48%,5)
$132,894
A $132,894( A / P,15%,5)
$39, 644
14.7 Given: i 16%, f 4%
n Actual Dollars Constant Dollars
0 $1,500 $1,500(P/F,4%,0) = $1,500
4 2,500 2,500(P/F,4%,4) = 2,137
5 3,500 3,500(P/F,4%,5) = 2,877
7 4,500 4,500(P/F,4%,7) = 3,420
14-5
14.8 Given:P $25, 000, i 1% per month, f 0.5% per month
th
The 20 payment in actual dollars:
A20 $25, 000( A / P,1%, 48) $658.35
The 20th payment in constant dollars:
A '20 $658.35( P / F , 0.5%, 20) $595.85
14.9
(a) Constant-dollar analysis: we need to find the inflation-free interest rate.
i f
i' 5.607%
1 f
Then find the equivalent present worth of this geometric series at i ' .
P $7, 000( P / A1 ,8%,5.607%, 4)
$27, 428
(b) Actual-dollar analysis
Net Cash Flow Conversion Net Cash Flow
Period
in Constant $ Factor in Actual $
1 $7,000 (1 0.07)1 $7,490
2 7,560 (1 0.07) 2 8,655
3 8,165 (1 0.07)3 10,002
4 8,818 (1 0.07) 4 11,559
P $7, 490( P / F ,13%,1) $8, 655( P / F ,13%, 2)
$10, 002( P / F ,13%,3) $11,559( P / F ,13%, 4)
$27, 428
Comments: As an alternative way of finding the equivalent cash flows in
actual dollars, we may use the compound growth rate (geometric growth and
inflation):
g (1 0.08)(1 0.07) 1
15.56%
P $7, 000(1.07)( P / A1 ,15.56%,13%, 4)
$27, 428
14-6
14.10 Given: i 9%, f 3.8% , we find the inflation-free interest rate as follows:
i ' (0.09 0.038) /(1 0.038) 5.01%
First compute the equivalent present worth of the constant dollar series at i ' :
P $1, 000( P / A,5.01%, 4)
$3,545.13
Then we compute the equivalent annual payment in actual dollars using i:
A $3,545.13( A / P,9%, 4)
$1, 094.27
14.11 Given: i 12%, f 6% , bond interest rate = 9% compounded semiannually,
face value = $1,000
The 16th interest payment in actual dollars:
I16 $1, 000(0.045) $45
The 16th interest payment (8th year) in constant dollars:
I '16 $45( P / F , 6%,8) $28.23
Equivalence Calculation Under Inflation
14.12 Given: i 1% per month, f 0.5% per month, P = $20,000, N = 60 months
0.01 0.005
i'
1 0.005
0.4975%
A ' $20, 000( A / P, 0.4975%, 60)
$386.38
14.13 Given: i ' 6%, f 5%, N 5 years, A $1.5 million in constant dollars
Market interest rate:
i 0.06 0.05 (0.06)(0.05) 11.3%
14-7
Actual dollar analysis:
Period Net Cash Net Cash Flow Equivalent
Flow in Actual $ Present Worth
in Constant $
1 $1,500,000 $1,575,000 $1,415,094
2 1,500,000 1,653,750 1,334,995
3 1,500,000 1,736,438 1,259,429
4 1,500,000 1,823,259 1,188,140
5 1,500,000 1,914,422 1,120,887
P $1,575, 000( P / F ,11.3%,1)
L $1,914, 422( P / F ,11.3%,5)
$6,318,545
14.14 Given: i 0.75% per month, f 0.5% per month,
P $5, 000, N 24 months, down payment = $1,000
(a) Inflation-free interest rate:
0.0075 0.005
i' 0.2488% per month
1 0.005
(b) Equal monthly payment in constant dollars:
A ' $5, 000( A / P, 0.2488%, 24)
$214.87
14.15 Given: i 6% compounded monthly, f 5% compounded annually, number
of months to deposit = 240 months, number of annual withdrawals = 10, first
withdrawal = six months after retirement
Effective inflation rate per semiannual: Since the first withdrawal is made after
six months from retirement, it is necessary to calculate the effective inflation
rate per semiannual.
1.05 1/ 2
f ( ) 1 2.4695% per semiannual
1
Annual withdrawals in actual dollars: On semiannual basis, the first withdrawal
will be made after 41 semiannual periods. Then we can calculate the equivalent
amount of this first withdrawal in actual dollars as follows:
14-8
A41 $40, 000( F / P, 2.4695%, 41) $108, 753
The second withdrawal will be made after 43 semiannual periods. The
equivalent amount of this second withdrawal in actual dollars is
A43 $40, 000( F / P, 2.4695%, 43) $114,190
The remaining withdrawals in actual dollars are
A45 $40, 000( F / P, 2.4695%, 45) $119,990
A47 $40, 000( F / P, 2.4695%, 47) $125,895
A49 $40, 000( F / P, 2.4695%, 49) $132,189
A51 $40, 000( F / P, 2.4695%,51) $138, 799
A53 $40, 000( F / P, 2.4695%,53) $145, 739
A55 $40, 000( F / P, 2.4695%,55) $153, 026
A57 $40, 000( F / P, 2.4695%,57) $160, 677
A59 $40, 000( F / P, 2.4695%,59) $168, 711
$168,711
$160,677
$108,753
(240 months)
0 20 Years
21 22 29 30
Monthly Deposits (A)
Equivalence calculation: To find the required equal monthly deposit amount (A),
we establish the following equivalence relationship:
A( F / A, 0.5%, 240)( F / P, 0.5%, 6) $180, 753
$114,190( P / F , 6.168%,1)
$119,900( P / F , 6.168%, 2)
14-9
M
$168, 711( P / F , 6.168%,9)
$1, 035, 236
A $1, 035, 236 / 476.08
= $2,174.52 per month
*
14.16
Given : i 2% per quarter, f 6% per year
(a)
Actual dollar analysis:
A( F / A, 2%,160) $600, 000( F / P, 6%, 40)
$6,171, 431
A $5, 420.69
Constant dollar analysis: Given: i 2% per quarter and f =6% per year, we
need to find the inflation free interest rate (i ') per quarter. In doing so, we first
compute the equivalent inflation rate per quarter.
(1 f ) 4 1 6%
f 1.4674% per quarter
i f 0.02 0.014674
i' 0.525%
1 f 1 0.014674
Now, we can establish the following equivalence relationship:
A '( F / A, 0.525%,160) $600, 000
A ' $2, 402.41
(b)
Effective annual interest rate:
ia (1 0.08 / 4) 4 1 8.243%
Equivalent value of $600,000 in actual dollars at the end of 63rd birthday:
*An asterisk next to a problem number indicates that the solution is available to students on the Companion
Website.
14-10
$600, 000( F / P, 6%, 40) $6,171, 431
Conversion of a gradient series to an equivalent uniform series:
A G ( A / G,8.243%, 40)
$1, 000(10.3746)
$10,374
Amount of the first deposit ( A1 ) :
( A1 $10,374)( F / A,8.243%, 40) $6,171, 431
276.21A1 3,306, 026
A1 $11,969
14.17 Given: i 3% per year, f 2% per year
(a) Frosh-year expense in actual dollars:
$20, 000( F / P, 2%,10) $24,380
(b) Equivalent single-sum amount at n 0
i f 0.03 0.02
i'
1 f 1 0.02
0.009804
P [$20, 000( P / A,9.804%,3) $20.000]*( P / F , 0.9804%,10)
$71,513.78
(c) Required annual deposit in actual dollars:
A $71514( A / P,3%,10) $8,381
Effects of Inflation on Project Cash Flows
14.18 Consider the following project’s after-tax cash flow and the expected annual
general inflation rate during the project period:
End of Cash Flow Expected General
Year in Actual Dollars Inflation Rate
0 -$45,000
14-11
1 $26,000 6.5%
2 $26,000 7.7%
3 $26,000 8.1%
(a) The average annual general inflation rate:
(1 0.065)(1 0.077)(1 0.081) 1.2399
(1 f )3 1.2399
f 7.4312%
(b) Constant dollars:
Actual Constant
n
Dollars Dollars
0 -$45,000 -$45,000
1 $26,000 26,000(0.9390) = 24,414
2 $26,000 26,000(0.8718) = 22,667
3 $26,000 26,000(0.8065) = 20,969
Conversion factors:
( P / F , 6.5%,1) 0.9390
( P / F , 7.7%,1)( P / F , 6.5%,1) 0.8718
( P / F ,8.1%,1)( P / F , 7.7%,1)( P / F , 6.5%,1) 0.8065
(c) The project is still profitable under inflationary economy.
P $45, 000 $24, 414( P / F ,5%,1)
$22, 667( P / F ,5%, 2) $20,969( P / F ,5%,3)
$16,925 0
14-12
14.19 (a) and (b)
0 1 2
Income Statement
$114,000 $114,000
Revenues
Expenses
O & M $56,490 $59,315
CCA $8,250 $14,025
Interest $5,000 $7,381
Taxable Income $44,260 $33,280
Income Taxes $17,704 $13,312
Net Income $26,556 $19,968
Cash Flow Statement
Operating Activities
Net Income $26,556 $19,968
CCA $8,250 $14,025
Investment Activities
Investment/Salvage ($55,000) $29,768
Disposal Tax Effect $1,183
Working Capital ($12,000) ($600) $12,600
Loan Repayment $50,000 ($23,810) ($26,190)
Net Cash Flow (Actual) ($17,000) $10,396 $51,353
Net Cash Flow (Constant) ($17,000) $9,901 $46,578
PW(18%), Actual Dollars: $28,691
PW(18%), Constant Dollars: $24,843
14-13
14.20 * (a)
0 1 2 3 4 5 6
Income Statement
$152,250 $159,863 $167,856 $185,061 $194,314
Revenues $176,248
Expenses
$104,655 $109,888
O & M $86,100 $90,405 $94,925 $99,672
CCA $27,000 $41,850 $23,018 $12,660 $6,963 $3,830
Interest $10,800 $10,800
Taxable Income $28,350 $16,808 $49,913 $63,917 $73,443 $80,596
Income Taxes $11,340 $6,723 $19,965 $25,567 $29,377 $32,239
Net Income $17,010 $10,085 $29,948 $38,350 $44,066 $48,358
Cash Flow Statement
Operating Activities
Net Income $17,010 $10,085 $29,948 $38,350 $44,066 $48,358
CCA $27,000 $41,850 $23,018 $12,660 $6,963 $3,830
Investment Activities
($120,000
Investment/Salvage ) $20,101
Disposal Tax Effect ($6,168)
Working Capital
$120,000 ($120,000
Loan Repayment )
Net Cash Flow (Actual) $0 $44,010 ($68,066) $52,965 $51,010 $51,029 $66,121
PW(18%), Actual Dollars: $93,758
PW(12.38%), Actual Dollars: $115,856
14-14
* (b)
0 1 2 3 4 5 6
Income Statement
$145,000 $145,000 $145,000 $145,000
Revenues $145,000 $145,000
Expenses
O & M $82,000 $82,000 $82,000 $82,000 $82,000 $82,000
CCA $27,000 $41,850 $23,018 $12,660 $6,963 $3,830
Interest $10,800 $10,800
Taxable Income $25,200 $10,350 $39,983 $50,340 $56,037 $59,170
Income Taxes $10,080 $4,140 $15,993 $20,136 $22,415 $23,668
Net Income $15,120 $6,210 $23,990 $30,204 $33,622 $35,502
Cash Flow Statement
Operating Activities
Net Income $15,120 $6,210 $23,990 $30,204 $33,622 $35,502
CCA $27,000 $41,850 $23,018 $12,660 $6,963 $3,830
Investment Activities
Investment/Salvage ($120,000) $15,000
Disposal tax effect ($4,128)
Working Capital
Loan Repayment $120,000 ($120,000)
Net Cash Flow (Constant) $0 $42,120 ($71,940) $47,007 $42,864 $40,585 $50,204
PW(18%), Constant Dollars: $71,085
PW(12.38%), Constant Dollars: $88,074
(c) Present value gain (or loss) due to inflation:
0.18 0.05
i 12.38%
1 0.05
PW (12.38%) no inflation $88, 074
PW (18%) with inflation $93, 758
present value gain = $93,758 - $88,074
=$5,684
(d) Present value gain due to borrowing:
14-15
Net Financing Cost Net
n Principal Interest (A/T) Loan Flow
0 +$120,000 +$120,000
1 -(1-0.4)(10,800) -$6,480
2 -$120,000 -(1-0.4)(10,800) -$126,480
PW (18%) Loan $120, 000 $6, 480( P / F ,18%,1)
$126, 480( P / F ,18%, 2)
$23, 673
Comments: The present value gain is possible here due to the fact that the
firm was able to finance the project at a lower interest rate than its MARR. In
practice, the lenders would raise their lending rates under inflationary
economy, so that it is not likely to realize a significant gain.
14-16
14.21 (a)
0 1 2 3 4 5
Income Statement
Revenues $15,750 $18,743 $16,207 $17,017 $17,868
Expenses
O & M $0 $0 $0 $0 $0
CCA $2,000 $3,600 $2,880 $2,304 $1,843
Interest $2,000 $3,396 $731
Taxable Income $11,750 $11,747 $12,596 $14,713 $16,025
Income Taxes $4,700 $4,699 $5,038 $5,885 $6,410
Net Income $7,050 $7,048 $7,557 $8,828 $9,615
Cash Flow Statement
Operating Activities
Net Income $7,050 $7,048 $7,557 $8,828 $9,615
CCA $2,000 $3,600 $2,880 $2,304 $1,843
Investment Activities
Investment/Salvage ($20,000) $2,553
Disposal Tax Effect $1,928
Working Capital
Loan Repayment $20,000 ($6,042) ($6,647) ($7,311)
Net Cash Flow (Actual) $0 $3,008 $4,001 $3,126 $11,132 $15,939
PW(20%), Actual Dollars: $18,868
PW(14.29%), Actual Dollars: $22,490
14-17
(b)
0 1 2 3 4 5
Income Statement
Revenues $15,000 $17,000 $14,000 $14,000 $14,000
Expenses:
O&M $0 $0 $0 $0 $0
CCA $2,000 $3,600 $2,880 $2,304 $1,843
Interest $2,000 $3,396 $731
Taxable Income $11,000 $10,004 $10,389 $11,696 $12,157
Income Taxes $4,400 $4,002 $4,156 $4,678 $4,863
Net Income $6,600 $6,002 $6,233 $7,018 $7,294
Cash Flow Statement
Operating Activities
Net Income $6,600 $6,002 $6,233 $7,018 $7,294
CCA $2,000 $3,600 $2,880 $2,304 $1,843
Investment Activities
Investment/Salvage ($20,000) $2,000
Disposal Tax Effect $2,149
Working Capital
Loan Repayment $20,000 ($6,042) ($6,647) ($7,311)
Net Cash Flow (Constant) $0 $2,558 $2,955 $1,802 $9,322 $13,286
PW(20%), Constant Dollars: $15,062
PW(14.29%), Constant Dollars: $17,987
(c) Present Value Gain: $881
14-18
14.22 (a) and (b)
0 1 2 3
Income Statement
$84,000 $88,200
Revenues $92,610
Expenses
O & M
$22,500 $38,250
CCA $26,775
Interest
$61,500 $49,950
Taxable Income $65,835
$24,600 $19,980
Income Taxes $26,334
$36,900 $29,970
Net Income $39,501
Cash Flow Statement
Operating Activities
$36,900 $29,970
Net Income $39,501
$22,500 $38,250
CCA $26,775
Investment Activities
($150,000
Investment/Salvage ) $80,000
Disposal Tax Effect ($7,010)
Working Capital ($10,000) ($800) ($864) $11,664
Loan Repayment
($160,000 $58,600 $67,356 $150,930
Net Cash Flow (Actual) )
Net Cash Flow (Constant ($160,000 $55,283 $59,947 $126,724
) )
PW(20%), Actual Dollars: $22,952
PW(20%), Constant Dollars: $1,034
14-19
Rate of Return Analysis Under Inflation
14.23 (a)
0 1 2 3 4 5 6 7 8
Income Statement
Revenues $20,000 $20,000 $20,000 $20,000 $20,000 $20,000 $20,000 $20,000
Expenses
O&M $8,000 $8,000 $8,000 $8,000 $8,000 $8,000 $8,000 $8,000
CCA $7,500 $12,750 $8,925 $6,248 $4,373 $3,061 $2,143 $1,500
Interest
Taxable Income $4,500 ($750) $3,075 $5,753 $7,627 $8,939 $9,857 $10,500
Income Taxes $1,575 ($263) $1,076 $2,013 $2,669 $3,129 $3,450 $3,675
Net Income $2,925 ($488) $1,999 $3,739 $4,957 $5,810 $6,407 $6,825
Cash Flow Statement
Operating Activities
Net Income $2,925 ($488) $1,999 $3,739 $4,957 $5,810 $6,407 $6,825
CCA $7,500 $12,750 $8,925 $6,248 $4,373 $3,061 $2,143 $1,500
Investment Activities
Investment/Salvage ($50,000) $5,000
Disposal Tax Effect ($525)
Working Capital ($10,000) $10,000
Net Cash Flow (Actual) ($60,000) $10,425 $12,263 $10,924 $9,987 $9,331 $8,871 $8,550 $22,800
PW(12.38%), Actual Dollars: ($4,709)
IRR(%) = 10.20%
14-20
(b)
0 1 2 3 4 5 6 7 8
Income Statement
Revenues $21,600 $23,328 $25,194 $27,210 $29,387 $31,737 $34,276 $37,019
Expenses
O&M $8,480 $8,989 $9,528 $10,100 $10,706 $11,348 $12,029 $12,751
CCA $7,500 $12,750 $8,925 $6,248 $4,373 $3,061 $2,143 $1,500
Interest
Taxable Income $5,620 $1,589 $6,741 $10,862 $14,308 $17,328 $20,105 $22,768
Income Taxes $1,967 $556 $2,359 $3,802 $5,008 $6,065 $7,037 $7,969
Net Income $3,653 $1,033 $4,382 $7,061 $9,300 $11,263 $13,068 $14,799
Cash Flow Statement
Operating Activities
Net Income $3,653 $1,033 $4,382 $7,061 $9,300 $11,263 $13,068 $14,799
CCA $7,500 $12,750 $8,925 $6,248 $4,373 $3,061 $2,143 $1,500
Investment Activities
Investment/Salvage ($50,000) $7,387
Disposal Tax Effect ($1,361)
Working Capital ($10,000) ($800) ($864) ($933) ($1,008) ($1,088) ($1,175) ($1,269) $17,138
Loan Repayment
Net Cash Flow (Constant) ($60,000) $10,353 $12,919 $12,374 $12,300 $12,585 $13,149 $13,941 $39,464
PW(18%), Constant Dollars: ($2,826)
IRR' (%) = 16.70%
14-21
14.24 (a) and (b)
0 1 2 3 4 5 6
Income Statement
Revenues $30,000 $35,000 $55,000 $70,000 $70,000 $60,000
Expenses
Rental $9,600 $9,600 $9,600 $9,600 $9,600 $9,600
O & M $15,000 $21,000 $25,000 $30,000 $30,000 $30,000
CCA $4,583 $8,403 $7,002 $5,835 $4,863 $4,052
Interest
Taxable Income $817 ($4,003) $13,398 $24,565 $25,537 $16,348
Income Taxes $245 ($1,201) $4,019 $7,369 $7,661 $4,904
Net Income $572 ($2,802) $9,378 $17,195 $17,876 $11,443
Cash Flow Statement
Operating Activities
Net Income $572 ($2,802) $9,378 $17,195 $17,876 $11,443
CCA $4,583 $8,403 $7,002 $5,835 $4,863 $4,052
Investment Activities
Investment/Salvage ($55,000) $13,401
Disposal Tax Effect $2,058
Working Capitol
Loan Repayment
Net Cash Flow (Actual) ($55,000) $5,155 $5,601 $16,381 $23,031 $22,739 $30,955
Net Cash Flow (Constant) ($55,000) $4,910 $5,080 $14,150 $18,947 $17,816 $23,099
PW(10%), Actual Dollars: $13,945
PW10%), Constant Dollars: $1,336
IRR'(%) = 10.65%
14-22
14.25
(a) Real after-tax yield on bond investment:
Provincial bond:
0.09 1 0.5 0.03
iprovincial 1.456%
1 0.03
Corporate bond:
10000
PE 10000 1200 1 0.5 P / A, i,5
1 /
5
i 6.000%
1 0.06
ccorporate 1 2.913%
1 0.03
The corporate bond provides a greater return on investment.
(b) Given z 6% f 3%
0.06 1 0.5 0.03
isavings 0%
1 0.03
Since both iprovincial and icorporate
are 0%, both investments are better than the
savings account. Moreover, since icorporate i provincial , the corporate bond is clearly
the best choice out of the three.
14-23
14.26 (a), (b), and (c)
Engine A 0 1 2 3 4 5
Income Statement
Revenues
Expenses
O&M ($216,000) ($233,280) ($251,942) ($272,098) ($293,866)
CCA $12,500 $21,875 $16,406 $12,305 $9,229
Interest
Taxable Income ($228,500) ($255,155) ($268,349) ($284,402) ($303,094)
Income Taxes ($91,400) ($102,062) ($107,339) ($113,761) ($121,238)
Net Income ($137,100) ($153,093) ($161,009) ($170,641) ($181,856)
Cash Flow Statement
Operating Activities
Net Income ($137,100) ($153,093) ($161,009) ($170,641) ($181,856)
CCA $12,500 $21,875 $16,406 $12,305 $9,229
Investment Activities
Investment/Salvage ($100,000) $40,000
Disposal Tax Effect ($4,926)
Working Capital
Loan Repayment
Net Cash Flow (Constant) ($100,000) ($124,600) ($131,218) ($144,603) ($158,337) ($137,554)
PW(20%), Constant Dollars: ($510,277)
FW(20%), Constant Dollars: ($1,269,733)
AE(20%), Constant Dollars: ($170,626)
14-24
(a), (b), and (c) cont’d
Engine B 0 1 2 3 4 5
Income Statement
Revenues
Expenses:
O & M ($138,240) ($149,299) ($161,243) ($174,143) ($188,074)
CCA $25,000 $43,750 $32,813 $24,609 $18,457
Interest
Taxable Income ($163,240) ($193,049) ($194,056) ($198,752) ($206,531)
Income Taxes ($65,296) ($77,220) ($77,622) ($79,501) ($82,612)
Net Income ($97,944) ($115,830) ($116,433) ($119,251) ($123,919)
Cash Flow Statement
Operating activities
Net income ($97,944) ($115,830) ($116,433) ($119,251) ($123,919)
CCA $25,000 $43,750 $32,813 $24,609 $18,457
Investment Activities
Investment/Salvage ($200,000) $80,000
Disposal Tax Effect ($9,852)
Working Capital
Loan Repayment
Net Cash Flow (Constant) ($200,000) ($72,944) ($72,080) ($83,621) ($94,642) ($35,313)
PW(20%), Constant Dollars: ($419,066)
FW(20%), Constant Dollars: ($1,042,771)
AE(20%), Constant Dollars: ($140,127)
Solution: Choose Engine B.
14-25
14.27 (a) and (b)
0 1 2
Income Statement
$126,000 $132,300
Revenues
Expenses
O & M $62,400 $64,896
CCA $9,000 $15,300
Interest
Taxable Income $54,600 $52,104
Income Taxes $16,380 $15,631
Net Income $38,220 $36,473
Cash Flow Statement
Operating Activities
Net Income $38,220 $36,473
CCA $9,000 $15,300
Investment Activities
Investment/Salvage ($60,000) $40,000
Disposal Tax Effect ($1,290)
Working Capital ($5,000) ($200) $5,200
Loan Repayment
Net Cash Flow (Actual) ($65,000) $47,020 $95,683
Net Cash Flow (Constant
) ($65,000) $43,537 $82,033
PW(15%), Actual Dollars: $48,237
PW(15%), Constant Dollars: $34,887
IRR(%) = 62.77%
IRR'(%) = 50.72%
(c) Given f 8%, i 15%
0.15 0.08
i 6.48% (Inflation-free MARR)
1 0.08
Since IRR’ (50.72%) > 6.48%, the project is a profitable one.
14-26
14.28 (a) and (b)
0 1 2 3 4 5 6
Income Statement
Revenues $84,800 $89,888 $95,281 $100,998 $107,058 $113,482
Expenses
O & M
CCA $15,000 $25,500 $17,850 $12,495 $8,747 $6,123
Interest
Taxable Income $69,800 $64,388 $77,431 $88,503 $98,312 $107,359
Income Taxes $27,920 $25,755 $30,973 $35,401 $39,325 $42,944
Net Income $41,880 $38,633 $46,459 $53,102 $58,987 $64,415
Cash Flow Statement
Operating Activities
Net Income $41,880 $38,633 $46,459 $53,102 $58,987 $64,415
CCA $15,000 $25,500 $17,850 $12,495 $8,747 $6,123
Investment Activities
Investment/Salvage ($100,000) $42,556
Disposal Tax Effect ($11,308)
Working Capital
Loan Repayment
Net Cash Flow (Actual) ($100,000) $56,880 $64,133 $64,309 $65,597 $67,733 $101,786
Net Cash Flow (Constant) ($100,000) $53,660 $57,078 $53,995 $51,959 $50,614 $71,755
PW(18%), Actual Dollars: $134,549
PW(18%), Constant Dollars: $94,834
IRR(%) = 59.24%
IRR'(%) = 50.22%
14-27
(c)
0 1 2 3 4 5 6
Income Statement
Revenues $84,800 $89,888 $95,281 $100,998 $107,058 $113,482
Expenses
O & M
CCA $15,000 $25,500 $17,850 $12,495 $8,747 $6,123
Interest $12,000 $10,521 $8,865 $7,010 $4,933 $2,606
Taxable Income $57,800 $53,867 $68,566 $81,493 $93,379 $104,753
Income Taxes $23,120 $21,547 $27,426 $32,597 $37,352 $41,901
Net Income $34,680 $32,320 $41,140 $48,896 $56,027 $62,852
Cash Flow Statement
Operating Activities
Net Income $34,680 $32,320 $41,140 $48,896 $56,027 $62,852
CCA $15,000 $25,500 $17,850 $12,495 $8,747 $6,123
Investment Activities
Investment/Salvage ($100,000) $42,556
Disposal Tax Effect ($11,308)
Working Capital
Loan Repayment $100,000 ($12,323) ($13,801) ($15,457) ($17,312) ($19,390) ($21,717)
Net Cash Flow (Actual) $0 $37,357 $44,019 $43,532 $44,078 $45,384 $78,505
Net Cash Flow (Constant) $0 $35,243 $39,177 $36,551 $34,914 $33,914 $55,343
PW(18%), Actual Dollars: $161,421
FW(18%), Actual Dollars: $435,766
AE(18%), Actual Dollars: $46,152
PW(18%), Constant Dollars: $133,582
FW(18%), Constant Dollars: $360,611
AE(18%), Constant Dollars: $38,192
14-28
(d)
0 1 2 3 4 5 6
Income Statement
Revenues $80,000 $80,000 $80,000 $80,000 $80,000 $80,000
Expenses:
O & M
CCA $15,000 $25,500 $17,850 $12,495 $8,747 $6,123
Interest
Taxable Income $65,000 $54,500 $62,150 $67,505 $71,254 $73,877
Income Taxes $26,000 $21,800 $24,860 $27,002 $28,501 $29,551
Net Income $39,000 $32,700 $37,290 $40,503 $42,752 $44,326
Cash Flow Statement
Operating Activities
Net Income $39,000 $32,700 $37,290 $40,503 $42,752 $44,326
CCA $15,000 $25,500 $17,850 $12,495 $8,747 $6,123
Investment Activities
Investment/Salvage ($100,000) $30,000
Disposal Tax Effect ($6,286)
Working Capital
Loan Repayment
Net Cash Flow (Actual) ($100,000) $54,000 $58,200 $55,140 $52,998 $51,499 $74,163
PW(11.32%) Actual Dollars: $139,049; IRR(%) = 51.19%; Present Value Loss = $139,049 - $134,549 = ($4,500)
(e) Required additional before-tax annual revenue in actual dollars (equal amount) to make-up the inflation loss.
$4500( A / P,18%, 6)
$2,144
1 0.40
14-29
Short Case Studies
ST14.1 (a) and (b)
0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues $80,000 $80,000 $80,000 $80,000 $80,000 $80,000 $80,000 $80,000 $80,000 $80,000
Expenses
O & M $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000
Labour $15,000 $15,000 $15,000 $15,000 $15,000 $15,000 $15,000 $15,000 $15,000 $15,000
Material $9,000 $9,000 $9,000 $9,000 $9,000 $9,000 $9,000 $9,000 $9,000 $9,000
Energy $4,500 $4,500 $4,500 $4,500 $4,500 $4,500 $4,500 $4,500 $4,500 $4,500
CCA
Equipment $16,500 $28,050 $19,635 $13,745 $9,621 $6,735 $4,714 $3,300 $2,310 $1,617
Tools $5,000 $5,000 $0 $0 $0 $5,000 $5,000 $0 $0 $0
Taxable Income $27,000 $15,450 $28,865 $34,756 $38,879 $36,765 $38,786 $45,200 $46,190 $46,883
Income Taxes $9,450 $5,408 $10,103 $12,164 $13,608 $12,868 $13,575 $15,820 $16,166 $16,409
Net Income $17,550 $10,043 $18,762 $22,591 $25,271 $23,897 $25,211 $29,380 $30,023 $30,474
Cash Flow Statement
Operating Activities
Net Income $17,550 $10,043 $18,762 $22,591 $25,271 $23,897 $25,211 $29,380 $30,023 $30,474
CCA $21,500 $33,050 $19,635 $13,745 $9,621 $11,735 $9,714 $3,300 $2,310 $1,617
Investment Activities
Investment/Salvage
Equipment ($110,000) $10,000
Tools ($10,000) $300
Replacement ($10,000) $300
14-30
Disposal Tax Effect
Equipment ($2,179)
Tools ($105) ($105)
Working Capitol
Net Cash Flow (Actual) ($120,000) $39,050 $43,093 $38,397 $36,336 $25,087 $35,632 $34,925 $32,680 $32,334 $40,107
PW(11.32%), Actual Dollars: $91,127
FW(11.32%), Actual Dollars: $266,323
AE(11.32%), Actual Dollars: $24,935
IRR(%) = 28.52%
14-31
(c) and (d)
0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues $85,600 $91,592 $98,003 $104,864 $112,204 $120,058 $128,463 $137,455 $147,077 $157,372
Expenses
Operating costs $3,090 $3,183 $3,278 $3,377 $3,478 $3,582 $3,690 $3,800 $3,914 $4,032
Labour $15,750 $16,538 $17,364 $18,233 $19,144 $20,101 $21,107 $22,162 $23,270 $24,433
Material $9,360 $9,734 $10,124 $10,529 $10,950 $11,388 $11,843 $12,317 $12,810 $13,322
Energy $4,635 $4,774 $4,917 $5,065 $5,217 $5,373 $5,534 $5,700 $5,871 $6,048
CCA
Equipment $16,500 $28,050 $19,635 $13,745 $9,621 $6,735 $4,714 $3,300 $2,310 $1,617
Tools $5,000 $5,000 $0 $0 $0 $5,000 $5,000 $0 $0 $0
Taxable Income $31,265 $24,313 $42,685 $53,917 $63,794 $67,879 $76,574 $90,175 $98,901 $107,920
Income Taxes $10,943 $8,510 $14,940 $18,871 $22,328 $23,758 $26,801 $31,561 $34,615 $37,772
Net Income $20,322 $15,804 $27,745 $35,046 $41,466 $44,121 $49,773 $58,614 $64,286 $70,148
Cash Flow Statement
Operating Activities
Net Income $20,322 $15,804 $27,745 $35,046 $41,466 $44,121 $49,773 $58,614 $64,286 $70,148
CCA $21,500 $33,050 $19,635 $13,745 $9,621 $11,735 $9,714 $3,300 $2,310 $1,617
Investment Activities
Investment/Salvage
Equipment ($110,000) $10,000
Tools ($10,000) $300
Replacement ($10,000) $300
Disposal Tax Effect
Equipment ($2,179)
Tools ($105) ($105)
Working Capital
14-32
Net Cash Flow (Actual) ($120,000) $41,822 $48,854 $47,380 $48,790 $41,282 $55,856 $59,488 $61,914 $66,596 $79,781
Net Cash Flow (Constant) ($120,000) $39,455 $43,480 $39,781 $38,646 $30,849 $39,376 $39,563 $38,846 $39,418 $44,549
PW(18%), Actual Dollars: $108,671
FW(18%), Actual Dollars: $568,764
AE(18%), Actual Dollars: $24,181
IRR(%) = 38.52%
PW(18%), Constant Dollars: $57,032
FW(18%), Constant Dollars: $298,494
AE(18%), Constant Dollars: $12,690
IRR'(%) = 30.68%
(e) Economic loss (or gain) in present worth due to inflation = $108,671 – $91,127 = $17,544
14-33
ST14.2 (a) and (b)
2011 2012 2013 2014
-2 -1 0 1
Income Statement
Revenues
Sales Unit $2,000
Unit Price $95,000
$190,000,000
Sales Volume
Expenses
Fixed Costs $5,000,000
$114,000,000
Variable Costs
CCA
Building $100,000
Equipment $1,200,000
Amortization $250,000
Taxable Income $69,450,000
Income Taxes $27,780,000
Net Income $41,670,000
Cash Flow Statement
Operating Activities
Net Income $41,670,000
CCA $1,300,000
Amortization $250,000
Investment Activities
Investment/Salvage
Opportunity Cost* ($600,000)
14-34
Land ($1,500,000)
Building ($1,000,000) ($4,000,000)
Equipment ($8,500,000)
Disposal Tax Effect
Land
Building
Equipment
Working Capital ($1,000,000) ($1,425,000)
Loan Repayment
Net Cash Flow (Actual) ($2,100,000) ($1,000,000) ($13,500,000) $41,795,000
Net Cash Flow (Constant) ($1,227,827) ($556,837) ($7,159,338) $21,109,315
14-35
(a) and (b) cont’d.
2015 2016 2017 2018 2019
2 3 4 5 6
Income Statement
Revenues
Sales Unit $2,000 $2,000 $2,000 $2,000 $2,000
Unit Price $99,750 $104,738 $109,974 $115,473 $121,247
Sales Volume $199,500,000 $209,475,000 $219,948,750 $230,946,188 $242,493,497
Expenses
Fixed Costs $5,250,000 $5,512,500 $5,788,125 $6,077,531 $6,381,408
Variable Costs $119,700,000 $125,685,000 $131,969,250 $138,567,713 $145,496,098
CCA
Building $196,000 $188,160 $180,634 $173,408 $166,472
Equipment $2,040,000 $1,428,000 $999,600 $699,720 $489,804
Amortization $250,000 $250,000 $250,000 $250,000 $250,000
Taxable Income $72,064,000 $76,411,340 $80,761,141 $85,177,815 $89,709,715
Income Taxes $28,825,600 $30,564,536 $32,304,457 $34,071,126 $35,883,886
Net Income $43,238,400 $45,846,804 $48,456,685 $51,106,689 $53,825,829
Cash Flow Statement
Operating Activities
Net Income $43,238,400 $45,846,804 $48,456,685 $51,106,689 $53,825,829
CCA $2,236,000 $1,616,160 $1,180,234 $873,128 $656,276
Amortization $250,000 $250,000 $250,000 $250,000 $250,000
Investment Activities
Investment/Salvage
Opportunity Cost*
Land $2,000,000
14-36
Building $3,000,000
Equipment $1,500,000
Disposal Tax Effect
Land ($560,000)
Building $398,130
Equipment $57,150
Working Capital ($1,496,250) ($1,571,063) ($1,649,616) ($1,732,096) ($8,874,025)
Loan Repayment
Net Cash Flow (Actual) $44,228,150 $46,141,902 $48,237,303 $50,497,721 $52,253,361
Net Cash Flow (Constant) $21,274,496 $21,138,137 $21,045,775 $20,982,846 $20,678,429
PW(20%), Constant Dollars: $60,509,246
IRR(%) = 148.68%
IRR' (%) = 136.83%
Note: If the firm decides not to invest in the project, the firm could write off the R&D expenditure.
This results in an opportunity cost in the amount of (0.40)($1,500,000) = $600,000.
15-1
Chapter 15 Project Risk and Uncertainty
Sensitivity Analysis
*
15.1
(a) and (b) Project cash flows based on most likely estimates:
total CCA $60,218
UCC4 $24,782
G 0.4($30,000 24,782) $2,087
After-tax Net Cash Flow
(a) (b)
Without With
n Working Capital Working Capital
0 –$85,000 –$87,000
1 24,300 24,300
2 27,870 27,870
3 25,269 25,269
4 51,361 53,361
PW(15%) $3,185 $2,238
The project is acceptable in either situation.
(c) Required annual savings (X):
$85,000 (0.6X)(P /A, 20%, 4) + $5,100(P /F , 20%, 1) +
$8,670(P /F , 20%, 2) + $6,069(P /F , 20%, 3) +
$32,161(P /F , 20%, 4)
X $35,865
15.2
Project’s IRR if the investment is made now:
PW (i ) $500,000 $200,000(P / A, i, 5) 0
i 28.65%
Let X denote the additional after-tax annual cash flow:
*
An asterisk next to a problem number indicates that the solution is available to students
on the Companion Website.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-2
PW (28.65%) $500, 000 X ( P /A, 28.65%, 4)( P /F , 28.65%, 1) 0
X $290, 240
15.3
(a) Economical building height:
0% < i < 20%: The optimal building height is five floors.
20% < i < 30%: The optimal building height is two floors.
Net Cash Flows
n 2 Floors 3 Floors 4 Floors 5 Floors
0 ($500,000) ($750,000) ($1,250,000) ($2,000,000)
1 199,100 169,200 149,200 378,150
2 199,100 169,200 149,200 378,150
3 199,100 169,200 149,200 378,150
4 199,100 169,200 149,200 378,150
5 799,100 1,069,100 2,149,200 3,378,150
Sensitivity Analysis
PW(i) as a Function of Interest Rate
Best
i(%) Floor Plan
5 $832,115 $687,643 $963,010 $1,987,770 5
6 787,037 635,190 873,001 1,834,680 5
7 744,141 585,370 787,722 1,689,448 5
8 703,298 538,023 706,879 1,551,593 5
9 664,388 493,002 630,199 1,420,666 5
10 627,298 450,168 557,428 1,296,250 5
11 591,924 409,393 488,330 1,177,957 5
12 558,167 370,556 422,686 1,065,427 5
13 525,937 333,545 360,291 958,321 5
14 495,148 298,257 300,953 856,326 5
15 465,720 264,594 244,495 759,148 5
16 437,580 232,465 190,751 666,513 5
17 410,657 201,784 139,565 578,166 5
18 384,885 172,472 90,792 493,867 5
19 360,205 144,454 44,298 413,393 5
20 336,557 117,661 (46) 336,533 2
21 313,889 92,027 (42,357) 263,091 2
22 292,150 67,490 (82,746) 192,883 2
23 271,292 43,993 (121,319) 125,737 2
24 251,271 21,482 (158,173) 61,490 2
25 232,044 (95) (193,399) (9) 2
26 213,572 (20,784) (227,084) (58,903) 2
27 195,817 (40,632) (259,308) (115,327) 2
28 178,745 (59,679) (290,148) (169,407) 2
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-3
29 162,323 (77,967) (319,674) (221,261) 2
30 146,519 (95,532) (347,955) (271,002) 2
(b) Effects of overestimation on resale value:
Net Present Worth
Number of Floors
Resale 2 3 4 5
Value
Base $465,720 $264,594 $244,495 $759,148
10% error 435,890 219,898 145,060 609,995
Difference $29,831 $44,696 $99,435 $149,153
15.4
(a) Defender:
0 1 2 3 4 5 6
Revenue
Expenses
O&M 5,000 5,000 5,000 5,000 5,000 5,000
CCA 3,499 2,449 1,714 1,200 840 588
Taxable income (8,499) (7,449) (6,714) (6,200) (5,840) (5,588)
Income taxes (3,399) (2,980) (2,686) (2,480) (2,336) (2,235)
Net income (5,099) (4,469) (4,029) (3,720) (3,504) (3,353)
Cash Flow Statement
Operating activities
Net income (5,099) (4,469) (4,029) (3,720) (3,504) (3,353)
CCA 3,499 2,449 1,714 1,200 840 588
Investment activities:
Salvage (6000) (500)
Disposal tax effect (2265) 749
Net Cash Flow (8265) (1601) (2020) (2314) (2520) (2664) (2516)
UCC0 = $40,000(1 – 0.15)(1 – 0.30)3 = $11,662
Challenger:
0 1 2 3 4 5 6
Revenues
Expenses:
O&M $1,000 $1,000 $1,000 $1,000 $1,000 $1,000
CCA 3,750 6,375 4,463 3,124 2,187 1,531
Taxable income (4,750) (7,375) (5,463) (4,124) (3,187) (2,531)
Income taxes (40%) (1,900) (2,950) (2,185) (1,650) (1,275) (1,012)
Net income ($2,850) ($4,425) ($3,278) ($2,474) ($1,912) ($1,518)
Cash Flow Statement
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-4
Operating activities:
Net income ($2,850) ($4,425) ($3,278) ($2,474) ($1,912) ($1,518)
CCA 3,750 6,375 4,463 3,124 2,187 1,531
Investment activities:
Investment ($25,000)
Salvage 2,000
Disposal tax effect 629
Net cash flow ($25,000) $900 $1,950 $1,185 $650 $275 $2,641
Incremental cash flows:
Net Cash Flow Incremental
Challenger Defender Cash Flow
n C D (C‐D)
0 ‐25000 ‐8265 ‐16735
1 900 ‐1601 2501
2 1950 ‐2020 3970
3 1185 ‐2314 3499
4 650 ‐2520 3169
5 275 ‐2664 2939
6 2641 ‐2516 5157
PW(10%) = ‐19575 ‐17924 ‐1651
IRR = 6.77%
The defender should be retained.
(b) Sensitivity analysis: If the operating costs of the defender inflate by 9% per
year, it becomes preferable to replace with the challenger now. (IRRC – D =
14.75%; PW(10%)C – D = $2,719)
(c) Break-even trade-in value: Let X denote the change (positive or negative) in
sale price for the defender which would result in the same PW for the
defender and challenger. At time 0, the firm would receive X dollars more
(or less) for the defender, and the immediate disposal tax effect would be
altered by –t × X (so if X is positive more tax is owed, and vice versa if X is
negative):
PWD + (1 – t)X = PWC
Therefore:
X = ( –19,575 + 17,924)/0.6 = –$2,752
So if the current sale price were –$6,000 – $2,752 = –$8,752, we would be
indifferent to replacing the defender now.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-5
15.5
(a)
Option 1: Copper wire:
cost per metre $5.55
cost per pair $0.043
number of pairs 2,000
lengths 8,000 metres
first cost ($5.55 + $0.043 × 2,000) × 8,000 metres $732,400
annual cost 0.184 × $732,400 $134,761.60
PW (15%)1 $1,617,242
Option 2: Fibre optics:
Requirements:
1 repeater, 21 modulators in central office, 21 modulators in field
ribbon cost $74,568
terminator cost $240,000
repeater cost $15,000
modulating system cost $1,428,000
total first cost $1,757,568
annual cost modulators $178,500
annual cost ribbon $13,273
total annual cost $191,773
PW (15%)2 $3,016,746
Option 1 is the better choice since PW1 > PW2.
(b) Either 16 km or 40 km of transmission distance:
16 km:
PW (15%)1 $3,234,484
PW (15%)2 $3,193,465
Option 2 is the better choice by a slight margin.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-6
40 km:
PW (15%)1 $8,086,210
PW (15%)2 $3,723,622
Option 2 is the better choice.
*
15.6
(a) With infinite planning horizon: We assume that both machines will be
available in the future with the same cost. (Select Model A.)
Model A:
t = 0.3 d = 0.3
MARR = 0.1 n = 8
Year 0 1 2 3 4 5 6 7 8
Income Statement
Revenue
O&M cost 700 700 700 700 700 700 700 700
CCA 900 1,530 1,071 750 525 367 257 180
Taxable income (1,600) (2,230) (1,771) (1,450) (1,225) (1,067) (957) (880)
Income tax (480) (669) (531) (435) (367) (320) (287) (264)
Net income (1,120) (1,561) (1,240) (1,015) (857) (747) (670) (616)
Cash Flow Statement
Cash from operations:
Net income (1,120) (1,561) (1,240) (1,015) (857) (747) (670) (616)
CCA 900 1,530 1,071 750 525 367 257 180
Investment (6,000)
Salvage 500
Disposal tax effect (24)
Working capital
Net cash flow (6,000) (220) (31) (169) (265) (333) (380) (413) 40
Undepreciated capital cost 6,000 420
PW = $(7,148)
AE = $(1,340)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-7
Model Β:
t = 0.3 d = 0.3
MARR = 0.1 n = 10
Year 0 1 2 3 4 5 6 7 S 9 10
Income Statement
Revenue
O&M cost 520 520 520 520 520 520 520 520 520 520
CCA 1,275 2,168 1,517 1,062 743 520 364 255 179 125
Taxable income (1,795) (2,688) (2,037) (1,582) (1,263) (1,040) (884) (775) (699) (645)
Income tax (539) (806) (611) (475) (379) (312) (265) (233) (210) (193)
Net income (1,257) (1,881) (1,426) (1,107) (884) (728) (619) (543) (489) (451)
Cash Flow
Statement
Cash from
operations:
Net income (1,257) (1,881) (1,426) (1,107) (884) (728) (619) (543) (489) (451)
CCA 1,275 2,168 1,517 1,062 743 520 364 255 179 125
Investment (8,500)
Salvage 1,000
Disposal tax effect (213)
Working capital
Net cash flow (8,500) 19 286 91 (45) (141) (208) (255) (287) (310) 461
Undepreciated 8,500 292
capital cost
PW = $(8,633)
AE = $(1,405)
Model A is a better choice since it is cheaper.
(b) Break-even annual O&M costs for machine A: Let X denote a before-tax
annual operating cost for model.
PW (10%) A $6,000 + ($270 0.7X)(P /F , 10%, 1) + ... +
($459 0.7X )(P /F , 10%, 8)
$4,533 3.734X
AE (10%) A $850 0.7X
Let ΑΕ(10%)Α = AE(10%)B, and solve for X.
$850 0.7X $1,405
X $793 per year
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-8
(c) With a shorter service life:
Net Cash Flow
n Model A Model B
0 –$6,000 –$8,500
1 –220 19
2 –31 286
3 –169 91
4 –265 –45
5 2,135 2,829
PW(10%) –$5,208 –$6,452
Model A is still preferred over Model B.
15.7 (a) and (b):
Alternative #1
OR = 7915748 Labour = 261040 O&M = 1092000 Changed = 1
MARR = 0.18 t = 0.4 d = 0.3 n = 8
Year 0 1 2 3 4 5 6 7 8
Income
Statement
Revenue 7,915,748 7,915,748 7,915,748 7,915,748 7,915,748 7,915,748 7,915,748 7,915,748
Labour cost 261,040 261,040 261,040 261,040 261,040 261,040 261,040 261,040
O&M cost 1,092,000 1,092,000 1,092,000 1,092,000 1,092,000 1,092,000 1,092,000 1,092,000
CCA 321,905 547,239 383,067 268,147 187,703 131,392 91,974 64,382
Taxable income 6,240,803 6,015,469 6,179,641 6,294,561 6,375,005 6,431,316 6,470,734 6,498,326
Income tax 2,496,321 2,406,188 2,471,856 2,517,824 2,550,002 2,572,526 2,588,293 2,599,330
Net income 3,744,482 3,609,281 3,707,784 3,776,736 3,825,003 3,858,790 3,882,440 3,898,996
Cash Flow
Statement
Cash from
operations:
Net income 3,744,482 3,609,281 3,707,784 3,776,736 3,825,003 3,858,790 3,882,440 3,898,996
CCA 321,905 547,239 383,067 268,147 187,703 131,392 91,974 64,382
Investment (2,146,036)
Salvage 62,000 169,000
Disposal tax (24,800) (7,510)
effect
Net cash flow (2,108,836) 4,066,387 4,156,520 4,090,852 4,044,884 4,012,706 3,990,182 3,974,415 4,124,868
Undepreciated
capital cost 2,146,036 150,225
PW = $14,475,648
AE = $3,550,071
IRR = 1.938%
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-9
Alternative #2
OR = 7455084 Labour = 422080 O&M = 1560000 Changed = 1
MARR = 0.18 t = 0.4 d = 0.3 n = 8
Year 0 1 2 3 4 5 6 7 8
Income Statement
Revenue 7,455,084 7,455,084 7,455,084 7,455,084 7,455,084 7,455,084 7,455,084 7,455,084
Labour cost 422,080 422,080 422,080 422,080 422,080 422,080 422,080 422,080
O&M cost 1,560,000 1,560,000 1,560,000 1,560,000 1,560,000 1,560,000 1,560,000 1,56,0000
CCA 168,036 285,662 199,963 139,974 97,982 68,587 48,011 33,608
Taxable income 5,304,968 5,187,342 5,273,041 5,333,030 5,375,022 5,404,417 5,424,993 5,439,396
Income tax 2,121,987 2,074,937 2,109,216 2,133,212 2,150,009 2,161,767 2,169,997 2,175,758
Net income 3,182,981 3,112,405 3,163,824 3,199,818 3,225,013 3,242,650 3,254,996 3,263,638
Cash Flow Statement
Cash from operations:
Net income 3,182,981 3,112,405 3,163,824 3,199,818 3,225,013 3,242,650 3,254,996 3,263,638
CCA 168,036 285,662 199,963 139,974 97,982 68,587 48,011 33,608
Investment (1,120,242)
Salvage 62,000 54,000
Disposal tax effect (24,800) 9,767
Net cash flow (1,083,042) 3,351,017 3,398,067 3,363,788 3,339,792 3,322,995 3,311,237 3,303,007 3,361,013
Undepreciated
capital cost 1,120,242 78,418
PW = $12,577,327
AE = $3,084,519
IRR = 3.102%
Sensitivity graphs:
This figure shows that the PW is not very sensitive to operating costs (labour or O&M).
While it’s somewhat sensitive to MARR, this is not a significant issue as it’s the
company that sets their threshold for rate of return. The present worth is quite sensitive to
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-10
sales level; however, Alternative 1 remains feasible even for a drop in sales of 30%.
Similar charts can be prepared for Alternative 2, and for the difference in their PWs.
15.8 Sensitivity graph:
Break-Even Analysis
15.9
PW of net investment:
P0 = –$2,200,000 – $600,000 – $400,000 = –$3,200,000
PW of after-tax revenue:
P1 $4,000(365)X (1 0.31)(P /A, 10%, 25)
$9,144,210X
PW of after-tax operating costs:
P2 ($230,000 + $170,000X )(1 0.31)(P/A, 10%, 25)
$1,440,526 1,064,737X
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-11
• PW of tax savings due to capital cost allowance:
CCA on CCA on CCA Tax Savings
n Building Furniture Total (t = 31%)
1 $44,000 $40,000 $84,000 $26,040
2 86,240 72,000 158,240 49,054
3 82,790 57,600 140,390 43,521
4 79,479 46,080 125,559 38,923
5 76,300 36,864 113,164 35,081
6 73,248 29,491 102,739 31,849
7 70,318 23,593 93,911 29,112
8 67,505 18,874 86,379 26,778
9 64,805 15,099 79,904 24,770
10 62,213 12,080 74,292 23,031
11 59,724 9,664 69,388 21,510
12 57,335 7,731 65,066 20,170
13 55,042 6,185 61,227 18,980
14 52,840 4,948 57,788 17,914
15 50,726 3,958 54,685 16,952
16 48,697 3,167 51,864 16,078
17 46,750 2,533 49,283 15,278
18 44,880 2,027 46,906 14,541
19 43,084 1,621 44,706 13,859
20 41,361 1,297 42,658 12,224
21 39,707 1,038 40,744 12,631
22 38,118 830 38,948 12,074
23 36,594 664 37,258 11,550
24 35,130 531 35,661 11,055
25 33,725 425 34,150 10,586
P3 $26,040(P / F , 10%, 1) + $49,054(P / F , 10%, 2) + ... +
$10,586(P / F , 10%, 25)
$258,260
PW of net proceeds from sale of capital assets:
Disposal Capital
Property Cost Salvage Undepreciated Tax Effect Gains Tax Net
(Asset) Base Value Capital Cost G = t × (U 0.75 × t × salvage
– S) (S – P)
Furniture $400,000 $0 $1,700 $527 None $527
Building 2,200,000 0 809,391 250,911 None 250,911
Land 600,000 2,031,813 600,000 None (332,897) 1,698,916
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-12
net proceeds from sale $527 + $250,911 + $1,698,354
$1,950,354
P4 $1,950,354(P/F , 10%, 25)
$180,010
PW (10%) P0 + P1 + P2 + P3 + P4
$4,202,256 + 8,079,473X
0
X 52.01%
15.10 Useful life of the old bulb: 13,870/(19 × 365) = 2 years
Therefore, the new bulb would last for four years. Let X denote the price for
the new light bulb. With an analysis period of four years, we can compute
the present equivalent for each option as follow:
PW (15%)old (1 0.40) $61.90 [1 (P /F , 15%, 2)]
$65.23
PW (15%) new (1 0.40)(X $16)
The break-even price for the new bulb will be
0.6X 9.6 $65.23
X $92.72
Since the new light bulb costs only $60, it is a good bargain.
*
15.11
PW of net investment:
P0 = –$250,000
PW of after-tax rental revenue (where X is the annual rental income):
P1 X (1 0.30)(P / A, 15%, 20)
$4.3815X
PW of after-tax operating costs:
P2 (1 0.30)$12,000(P/A, 15%, 20)
$52,578
PW of the investment and tax effects:
n CCA–Building Tax Savings (30%)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-13
1 $5,000 $1,500
2 9,800 2,940
3 9,408 2,822
4 9,032 2,710
5 8,670 2,601
6 8,324 2,497
7 7,991 2,397
8 7,671 2,301
9 7,364 2,209
10 7,070 2,121
11 6,787 2,036
12 6,515 1,955
13 6,255 1,876
14 6,005 1,801
15 5,764 1,729
16 5,534 1,660
17 5,312 1,594
18 5,100 1,530
19 4,896 1,469
20 4,700 1,410
Total CCA = 137,197
P3 $1,500(P / F , 15%, 1) + $2,940(P / F , 15%, 2) + +
$1,410(P / F , 15%, 20 )
$14,324
PW of net proceeds from sale of building:
total CCA $139,137
undepreciated capital cost $250,000 $139,137 $112,803
salvage value $250,000(1.05)20 $663,324
disposal tax effect 0.30($112,803 $250,000) 0.75 × 0.30 ×
($663,324 $250,000) $134,157
net proceeds from sale $663,324 $134,157 $529,167
P4 $529,167(P /F , 15%, 20) $32,332
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-14
The break-even rental:
PW (10%) P0 + P1 + P2 + P3 + P4
$255,922 + $4.3815X
0
X $58,410
15.12 Let X denote the additional annual revenue (above $16,000) for Model A
that is required to break even.
Generalized cash flows for Model A:
Cash flow elements 0 1 2 3 4 5 6
Investment ($80,000)
(0.40)CCAn $4,800 $8,160 $5,712 $3,998 $2,799 $1,959
–(0.60)O&Mn (13,200) (13,200) (13,200) (13,200) (13,200) (13,200)
+(0.60)Rn 9,600 9,600 9,600 9,600 9,600 9,600
+0.6X +0.6X +0.6X +0.6X +0.6X +0.6X
Net salvage 16,572
Net cash flow ($80,000) $1,200 $4,560 $2,112 $398 ($801) $14,931
+0.6X +0.6X +0.6X +0.6X +0.6X +0.6X
PW (20%) A $80,000 + 0.6X (P /A, 20%, 6) + $1,200(P /F , 20%, 1) + ... +
$14,931(P / F , 20%, 6)
$69,741 + 1.9953X
Generalized cash flows for Model B:
Cash flow elements 0 1 2 3 4 5 6
Investment ($52,000)
(0.40)CCAn $3,120 $5,304 $3,713 $2,599 $1,819 $1,273
–(0.60)O&Mn (10,200) (10,200) (10,200) (10,200) (10,200) (10,200)
+(0.60)Rn 0 0 0 0 0 0
Net salvage 11,971
Net cash flow ($52,000) ($7,080) ($4,896) ($6,487) ($7,601) ($8,381) ($3,045)
PW (20%) B $52,000 $7,080(P/F , 20%, 1) + ... + $3,045(P/F , 20%, 6)
$71,068
Now let PW(20%)Α = PW(20%)B and solve for X.
$69,741 + 1.9953X $71,068
X $665
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-15
The required break-even annual revenue for Model A is then
$16,000 + X = $15,335
15.13 Let X denote the number of copies to break even.
A/T annual revenue (0.6)[$0.20 + ($1.00 $0.20)]X
0.60X
A/T O&M cost (0.60)[$1,200,000(12) $0. 40X ]
$8,640,000 0.24X
CCA tax savings 0.4[$180,000(P /F , 13%, 1) + ... +
$17,640(P /F , 13%, 10)](A/P, 13%, 10)
$57,542
net salvage value 0.40($41,161 $200,000) + $200,000
$136,464
CR(13%) $1,200,000(A/P, 13%, 10) + $136,464(A/F , 13%, 10)
$213,739
AE (13%) 0.60X $8,640,000 0.24X + $57,542 $213,739
0
X 24,433,880 copies per year
or 81,446 copies per day (300 days per year)
Probabilistic Analysis
15.14
PW (12%)light $8,000,000 + $1,300,000(P /A, 12%, 3)
$4,800,000
PW (12%) moderate $8,000,000 + $2,500,000(P /A, 12%, 4)
$406,627
PW (12%) high $8,000,000 + $4,000,000(P /A, 12%, 4)
$4,149,000
E[PW (12%)] $4,800,000(0.20) $406,627(0.40) + $4,149,000(0.40)
$536,947
Yes, the company should make this investment.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-16
15.15
(a) The PW distribution for Project 1:
Event (x, y) Joint Probability PW (10%)
($20,$10) 0.24 $8,000
($20,$20) 0.36 $16,000
($40,$ 10) 0.16 $32,000
($40,$20) 0.24 $64,000
(b) The mean and variance of the NPW for Project 1:
E[PW (10%)]1 $8,000(0.24) + $16,000(0.36) + $32,000(0.16)
+$64,000(0.24)
$28,160
Var[PW (10%)]1 (8,000 28,160) 2 (0.24) + (16,000 28,160) 2 (0.36)
+ (32,000 28,160) 2 (0.16) + (64,000 28,160) 2 (0.24)
461,414,400
(c) The mean and variance of the NPW for Project 2:
E[PW (10%)]2 $8,000(0.24) + $16,000(0.20) + $32,000(0.36)
+ $64,000(0.20)
$32,000
Var[PW (10%)]2 (8,000 32,000) 2 (0.24) + (16,000 32,000) 2 (0.20)
+ (32,000 32,000) 2 (0.36) + (64,000 32,000) 2 (0.20)
394,240,000
(d) Project 2 is preferred over Project 1 because its mean is greater than that of
Project 1 but its variance is smaller than that of Project 1.
15.16
(a) Expected value criterion: Assume that the inventor’s opportunity cost rate is
7.5%.
Option 1:
E[R]1 = $2,450(0.25) + $2,000(0.45) + $1,675(0.30) $150(F/P, 7.5%, 1)
$1,854
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-17
Option 2:
E[R]2 = $25,000(0.075) = $1,875
Option 2 is the better choice based on the principle of expected value
maximization.
(b) We need to make an explicit assumption about the reliability of the
investment firm. If the investment firm tells the investor with certainty that
the bond’s yield will be $2,450, the investor’s strategy would be to
purchase the bond. After paying $150 brokerage fee (which is worth about
$161 at 7.5% at the end of year 1), his net gain is $2,289. If the investment
firm tells him otherwise, his best strategy would be to buy the GIC. Before
receiving the perfect information from the investment firm, he can calculate
the expected profit with perfect information. This is done by summing for
each possible state; the probability that a particular state will occur
multiplied by the maximum net gain achievable for that state.
expected net gain ($2,289 $1,875)(0.25) + $0(0.45) + $0(0.30)
$104
The investor should not solicit professional advice at any expense higher
than $104(P/F, 7.5%, 1) = $96 in today’s dollars.
15.17 Let X denote the annual revenue in constant dollars and Y the annual general
inflation rate. Then Ζ is defined as (1 + Y).
(a) PW as a function of X and Z:
Cash Element End of Period
0 1 2
Investment –$9,000
Salvage value 4,000Z2
Disposal tax effect 0.40(5,355 – 4,000Z2)
(0.4)CCAn 540 2,142
(0.6)Rn 0.6XZ 0.6XZ2
Working capital –2,000 2,000(1 – Z) 2,000Z
Net cash flow –$11,000 2,540 – 2,000Z + 0.6XZ 4,284 + 0.6XZ2 + 2,000Z + 2,400Z2
Note that the market interest rate is a random variable as the general
inflation rate becomes a random variable. There are nine joint events for X
and Y. For a joint event where X = 10,000 and Y = 0.05 (i.e., Ζ = 1.05), we
first calculate the market interest rate and then evaluate the PE function at
this market interest rate.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-18
i i f if
0.10 + 0.05 + (0.10)(0.05)
15.5%
PW (15.5%) $11,000 [2,540 2,000(1.05) 0.6(10,000)(1.05)]
( P /F , 15.5%, 1) [4, 284 0.6(10,000)(1.05) 2 2,000(1.05)
2, 400(1.05) 2 ]( F /P, 15.5%, 2)
$6,563
The PW(X, Y) for the remaining joint events are shown in the table below.
(b) We calculate the weighted PW of every possible event that equals p(X) ×
p(Y) × PW(X, Y), and then sum them to give the expected Present
Equivalent (see table below).
(c) The equation and results for the variance calculation are provided in the last
column of the table below.
Annual Revenue Ζ Inflation Rate Y Weighted Weighted Deviation
PW
Value p(X) Value p(Y) i PW(i) p(X)p(Y)PW p(X)p(Y)[PW – E(PW)]2
$10,000 0.30 3.0% 0.25 13.3% $6,762 $507 20,348,629
10,000 0.30 5.0 0.50 15.5 6,563 984 38,372,866
10,000 0.30 7.0 0.25 17.7 6,374 478 20,420,712
20,000 0.40 3.0 0.25 13.3 17,176 1,718 23,290,614
20,000 0.40 5.0 0.50 15.5 16,976 3,395 36,902,530
20,000 0.40 7.0 0.25 17.7 16,787 1,679 23,409,391
30,000 0.30 3.0 0.25 13.3 27,589 2,069 16,672,348
30,000 0.30 5.0 0.50 15.5 27,390 4,108 24,846,999
30,000 0.30 7.0 0.25 17.7 27,200 2,040 16,737,602
E(PW)= $16,979 var(PW) = $221,001,691
Comparing Risky Projects
15.18
E[PW ]1 ($2,000)(0.20) + ($3,000)(0.60) + ($3,500)(0.20) $1,000
$1,900
E[PW ]2 ($1,000)(0.30) + ($2,500)(0.40) + ($4,500)(0.30) $800
$1,850
Project 1 is preferred over Project 2.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-19
(b) Var[PW ]1 (2,000 1,900) 2 (0.20) + (3,000 1,900) 2 (0.60) +
(3,500 1,900) 2 (0.20)
1,240,000
Var[PW ]2 (1,000 1,850) 2 (0.30) + (2,500 1,850) 2 (0.40)
(4,500 1,850) 2 (0.30)
2,492,500
Project 1 is still preferred because Var[PW]1 < Var[PW]2 and E[PW]1 >
Ε[PW]2.
15.19
(a) Mean and variance calculations:
E[PW ]1 ($100,000)(0.20) + ($50,000)(0.40) + (0)(0.40)
$40,000
E[PW ]2 ($40,000)(0.30) + ($10,000)(0.40) + ( $10,000)(0.30)
$13,000
Var[PW ]1 (100,000 40,000) 2 (0.20) + (50,000 40,000) 2
(0.40) + (0 40,000) 2 (0.40)
1,400,000,000
Var[PW ]2 (40,000 13,000) 2 (0.30) + (10,000 13,000) 2 (0.40) +( 10,000 13,000) 2 (0.30)
381,000,000
It is not a clear case because El > E2 but also Var1 > Var2. If she makes her
decision based solely on the principle of maximization of expected value,
she may prefer Contract A.
(b) Assuming that both contracts are statistically independent from each other,
Joint Event Joint
(PWA > PWB) Probability
($100,000, $40,000) (0.20)(0.30) = 0.06
($100,000, $10,000) (0.20)(0.40) = 0.08
($100,000, –$10,000) (0.20)(0.30) = 0.06
($50,000, $40,000) (0.40)(0.30) = 0.12
($50,000, $10,000) (0.40)(0.40) = 0.16
($50,000, –$10,000) (0.40)(0.30) = 0.12
($0, –$10,000) (0.40)(0.30) = 0.12
0.72
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-20
15.20
(a)
Machine A:
CR(10%) A = ($60,000 $22,000)(A / P, 10%, 6) + (0.10)($22,000)
$10,924
E[AE (10%)] A = ($5,000)(0.20) + ($8,000)(0.30) + ($10,000)(0.30) +
($12,000)(0.20) + $10,924
$19,725
Var[AE (10%)]A (15,924 19,725) 2 (0.20) + (18,924 19,725) 2 (0.30) +
(20,924 19,725) 2 (0.30) + (22,924 19,725) 2 (0.20)
5,560,000
Machine Β:
CR(10%) B $35,000(A / P, 10%, 4)
$11,042
E[AE (10%)]B ($8,000)(0.10) + ($10,000)(0.30) + ($12,000)(0.40) +
($14,000)(0.20) + $11,042
$22,442
Var[AE (10%)]B (19,042 22,442) 2 (0.10) + (21,042 22,442) 2 (0.30) +
(23,042 22,442) 2 (0.40) + (25,042 22,442) 2 (0.20)
3,240,000
(b) Prob[AE(10%)A > ΑΕ(10%)B]:
Joint Event Joint
(O&MA, O&MB) (AEA > AEB) Probability
($10,000, $8,000) ($20,924, $19,042) (0.30)(0.10) = 0.03
($12,000, $8,000) ($22,924, $19,042) (0.20)(0.10) = 0.02
($12,000, $10,000) ($22,924, $21,042) (0.20)(0.30) = 0.06
0.11
15.21
(a) Mean and variance calculation (Note: For a random variable Y, which can
be expressed as a linear function of another random variable X (say, Y = aX,
where a is a constant), the variance of Y can be calculated as a function of
variance of X, Var[Y] = a2Var[X].)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-21
E[PW ]A $5,000 + $4,000(P /F , 15%, 1) $4,000 (P /F , 15%, 2)
$1,502.83
E[PW ]B $10,000 + $6,000(P /F , 15%, 1) + $8,000(P /F , 15%, 2)
$1,266.54
Var[PW ]A 1,0002 + (P /F , 15%, 1)21,0002 + (P /F , 15%, 2) 21,5002
3,042,588
Var[PW ]B 2,0002 + (P /F , 15%, 1) 21,5002 + (P /F , 15%, 2) 2 2,0002
7,988,336
(b) Comparing risky projects
Project A Project Β
E[PW] $1,503 $1,267
Var[PW] 3,042,688 7,988,336
Project A is preferred over Project B because Var[PW]A < Var[PW]B and
E[PW]A > E[PW]B.
Decision Tree Analysis
15.22
(a) Let’s define the symbols:
P: Party is taking place
NP: No party is planned
TP: Tipster says “P”
TNP: Tipster says “NP”
Then
P(NP TP) P (TP) P (NP)P (TP|NP)
(0.4)(0.2) 0.08
(b)
Optimal decision without sample information:
EMV = (0.6)(100) + (0.4)(–50) = 40 points
Raid the dormitories.
Joint probabilities:
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-22
P(P TP) P (P)P (TP/P) (0.60)(0.40) = 0.24
P(P TNP) P (P)P (TNP/P) (0.60)(0.60) 0.36
P(NP TP) P (NP)P (TP/NP) (0.40)(0.20) 0.08
P(NP TNP) P (NP)P (TNP/NP) (0.40)(0.80) 0.32
Marginal probabilities:
P(TP) P(P TP) + P(NP TP)
0.24 + 0.08 0.32
P(TNP) P(P TNP) + P (NP TNP)
0.36 + 0.32 0.68
State of Nature Tipster Says Marginal
Ρ NP Probability
P 0.24 0.36 0.6
Actual NP 0.08 0.32 0.4
Marginal Probability 0.32 0.68 1
Revised probabilities after receiving the tips:
P (P TP) 0.24
P(P/TP) 0.75
P (TP) 0.32
P (NP TP) 0.08
P(NP/TP) 0.25
P(TP) 0.32
P (P TNP) 0.36
P (P/TNP) 0.5294
P(TNP) 0.68
P (NP TNP) 0.32
P (NP/TNP) 0.4706
P(TNP) 0.68
Optimal decision after receiving the tips: The tipster’s information has
no value, even though it costs nothing. Do not reply on the tips.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-23
* Decision Tree
(c) EVPI = 60 – 40 = 20
Comments: Note that if a party is planned, “raid” and earn 100 points. If no
party is planned, do not raid and earn no points. The expected profit with perfect
information is
EPPI = (0.6)(100) + (0.4)(0) = 60 points
15.23
(a) Given:
Tax rate 40%
Year 1 CCA1 = (0.04/2)($500,000)
CCA Year 2 CCA2 = 0.04($490,000)
Year 15 CCA15 = 0.04($288,219)
UCC15 $276,690
Salvage Value $100,000
Net proceeds from sale (S + G) $170,676
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-24
Case 1: With high demand,
PW (15%) $500,000 + 0.6($1,000,000)(P /A, 15%, 15)
+ 0.4($10,000)(P /F , 15%, 1) + ...
+0.4($11,529) (P /F , 15%, 15) $170,676(P /F , 15%, 15)
$3,065,893
Case 2: With medium demand, PW(15%) = $1,311,682
Case 3: With lower demand, PW(15%) = $723,203
EMVopen (0.3)($3,065,893) + (0.4)($1,311,682) + (0.3)( $723,203)
$1,227,480
EMVdo not open = 0
Open the store.
EVPI = EPPI – EMV = $216,961
EPPI (0.3)($3,065,893) + (0.4)(1,311,682) + (0.3)(0)
$1,444,441
(b) Investment decision with sample information. Let’s define the symbols.
Η = High demand
Μ = Medium demand
L = Low demand
SH = Survey predicts a “H” demand.
SM = Survey predicts an “M” demand.
SL = Survey predicts a “L” demand.
Joint/marginal probabilities:
P(H SH) P (H)P (SH/H) (0.30)(0.70) 0.21
P(H SM) P(H)P(SM/H) (0.30)(0.25) 0.075
P(H SL) P (H)P (SL/H) (0.30)(0.05) 0.015
P(L SL) P (L)P (SL/L) (0.30)(0.75) 0.225
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-25
Marginal probabilities:
P(SH) P(H SH) + P(M SH) + P(L SH)
0.24 + 0.08 + 0.15 0.305
P (SM) 0.075 + 0.24 + 0.06 0.375
P(SL) 0.015 + 0.08 + 0.215 0.320
State of Nature Survey Says Marginal
High Medium Low Probability
High 0.21 0.075 0.015 0.3
Actual Medium 0.08 0.24 0.08 0.4
Low 0.015 0.06 0.225 0.3
Marginal Probability 0.305 0.375 0.320 1
Revised probabilities after seeing the survey results:
P(H SH) 0.21
P(H/SH) 0.6885
P(SH) 0.305
P(M SH) 0.08
P (M/SH) 0.2623
P(SH) 0.305
P(L SL) 0.225
P(L/SL) 0.7031
P(SL) 0.320
Optimal decision: Take a survey. With either “High” or “Low” result
from the survey, open the store. Otherwise, do not open the store.
The expected monetary value after taking the survey is $1,238,252.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-26
*Decision Tree (Problem 15.23)
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-27
Short Case Studies
ST15.1 Discussion: In Virginia, one investment group came tantalizingly close to
cornering the market on all possible combinations of six numbers from 1
to 44. State lottery officials say that the group bought 5 million of the
possible 7 million tickets (precisely 7,059,052). Each ticket cost $1 each.
The lottery had a more than $27 million jackpot.
44!
C (44, 6) 7, 059, 052
6!(44 6)!
Economic Logic: If the jackpot is big enough, provided nobody else
buys a winning ticket, it makes economic sense to buy one lottery ticket
for every possible combination of numbers and be sure to win. A group
in Australia apparently tried to do this in the February 15 (1992)
Virginia Lottery drawing.
The Cost: Since 7,059,052 combinations of numbers are possible3 and
each ticket costs $1, it would cost $7,059,052 to cover every
combination. The total remains the same regardless of the size of the
jackpot.
The Risk: The first prize jackpot is paid out in 20 equal yearly
installments, so the actual payoff on all prizes is $2,261,565 the first
year and $1,350,368 per year for the next 19 years. If more than one
first prize-winning ticket is sold, the prize is shared so that the
maximum payoff depends on an ordinary player not buying a winning
ticket. Since Virginia began its lottery in January 1990, 120 of the 170
drawings have not yielded a first-prize winner.
Solution
In the Virginia game, 7,059,052 combinations of numbers are possible.
The following table summarizes the winning odds for various prizes for a
one ticket-only purchase.
Number of Prizes Prize Category Winning Odds
1 First prize 0.0000001416
228 Second prizes 0.0000323
10,552 Third prizes 0.00149
168,073 Fourth prizes 0.02381
So a person who buys one ticket has odds of 1 in slightly more than 7
million. Holding more tickets increases the odds of winning, so that 1,000
tickets have odds of 1 in 7,000 and 1 million tickets have odds of 1 in 7.
Since each ticket costs $1, it would receive at least a share in the jackpot
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-28
and many of the second, third, and fourth place prizes. Together these
combined prizes (second through fourth) were worth $911,197 payable in
one lump sum. Suppose that the Australia group bought all the tickets
(7,059,052). We may consider two separate cases.
Case 1: If none of the prizes were shared, the rate of return on this
lottery investment, with prizes paid at the end of each year, would be
PW (i ) $7,059,052 + $911,197 (P/F, i, 1)
+$1,350,368(P/A, i, 20)
0
i* 20.94%
The first-prize payoff over 20 years is equivalent to putting the same
$7,059,052 in a more conventional investment that pays a guaranteed
20.94% return before taxes for 20 years, a rate available only from
speculative investments with fairly high risk. (If the prizes are paid at
the beginning of each year, the rate of return would be 27.88 %.)
Case 2: If the first prize is shared with one other ticket, the rate of return
on this lottery investment would be 8.87%. (With the prizes paid at the
beginning of each year, the rate of return would be 10.48%.) Certainly,
if the first prize is shared by more than one, the rate of return would be
far less than 8.87%.
ST15.2 Since the amount of annual labour savings is the same for alternatives, this
labour savings factor is not considered in the following analysis.
(a) After-tax cash flows:
After-Tax Cash Flows
n Lectra System Tex System
0 ($136,150) ($195,500)
1 115,204 145,165
2 120,922 153,376
3 116,756 147,393
4 113,839 143,206
5 111,798 140,274
6 130,149 158,394
PW(12%) 347,935 412,146
AE(12%) 84,627 100,244
Based on the most-likely estimates, the Tex system is the better choice.
(b) Let X and Y denote the annual material savings for the Lectra system and
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-29
Tex system, respectively.
After-Tax Cash Flows
n Lectra System Tex System
0 –$136,150 –$195,500
1 0.6X – 22,796 0.6Y – 19,235
2 0.6X – 17,078 0.6Y – 11,024
3 0.6X – 21,244 0.6Y – 17,007
4 0.6X – 24,161 0.6Y – 21,194
5 0.6X – 26,202 0.6Y – 24,126
6 0.6X – 7,851 0.6Y – 6,006
Lectra System:
AE (12%) Lectra $53,373 + 0.6X
E[X ] $224,000
Var[X ] = 899,000,000
E[AE (12%)]Lectra $53,373 + 0.6E[X ]
$81,027
Var[AE (12%)]Lectra (0.6) 2Var[X ]
323,640,000
Tex System:
AE (12%)Tex $64,156 + 0.6Y
E[Y ] $259,400
Var[Y] 1,718,440,000
E[AE (12%)]Tex $64,156 + 0.6E[Y ]
$91,484
Var[AE (12%)]Tex (0.6) 2Var[Y ]
618,638,400
(c) Probabilistic analysis:
Variable Savings Probability AE(12%)
$150,000 0.25 $36,627
X 230,000 0.40 84,627
270,000 0.35 108,627
200,000 0.30 55,844
Y 274,000 0.50 100,244
312,000 0.20 123,044
Joint Event Joint
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
15-30
(X, Y) (AELectra>AETex) Probability
(230,000, 200,000) ($84,627, $55,844) (0.40)(0.30) = 0.120
(270,000, 200,000) ($108,627, $55,844) (0.35)(0.30) = 0.105
(270,000, 274,000) ($108,627, $100,244) (0.35)(0.50) = 0.175
0.400
ST15.3 (a) Project cash flows:
Year 0 1 2 3 4 5 6 7 8-19 20
Income Statement
Revenues:
Steam sales 1,550,520 1,550,520 1,550,520 1,550,520 1,550,520 1,550,520 1,550,520 1,550,520 1,550,520
Tipping fee 976,114 895,723 800,275 687,153 553,301 395,161 208,585
Expenses:
O&M costs 832,000 832,000 832,000 832,000 832,000 832,000 832,000 832,000 832,000
Interest (11.5%) 805,000 805,000 805,000 805,000 805,000 805,000 805,000 805,000 805,000
Taxable income 889,634 809,243 713,795 600,673 466,821 308,681 122,105 (86,480) (86,480)
Income taxes (0%)
Net income 889,634 809,243 713,795 600,673 466,821 308,681 122,105 (86,480) (86,480)
Cash Flow
Statement
Cash from
operations:
Net income 889,634 809,243 713,795 600,673 466,821 308,681 122,105 (86,480) (86,480)
Investment/salvage:
Equipment (6,688,800) 300,000
Financing:
Loan payment 6,688,800 (7,000,000)
Net cash flow 0 889,634 809,243 713,795 600,673 466,821 308,681 122,105 (86,480) (6,786,480)
PW(10%) = $1,639,723
(b) Let X denote the steam charge per tonne. Then
annual steam charge = 1,061,962(X)(365)/1,000 = 387,616X
n Revenue Expenses
1 $387,616X –$660,886
2 $387,616X –$741,277
3 $387,616X –$836,725
4 $387,616X –$949,847
5 $387,616X –$1,083,699
6 $387,616X –$1,241,830
7 $387,616X –$1,428,415
8–19 $387,616X –$1,637,000
20 $387,616X –$8,337,000
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15-31
AE (10%) $387,616X [$660,886(P / F , 10%,1) ...
$8,337,000(P /F , 10%, 20)](A / P, 10%, 20)
$387,616X $1,357,918
0
X $3.503 per tonne
(c) Sensitivity graph
ST15.4
(a) Project cash flows based on most likely estimates:
MARR = 0.18 t = 0.38 d = 0.3 n = 8
Year 0 1 2 3 4 5 6 7 8
Income Statement
Revenue (Savings):
Telephone bill 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000
Deadhead kilometres 1,250 1,250 1,250 1,250 1,250 1,250 1,250 1,250
Expenses:
CCA 1,500 2,550 1,785 1,250 875 612 429 300
Taxable income 2,750 1,700 2,465 3,001 3,375 3,638 3,821 3,950
Income tax 1,045 646 937 1,140 1,283 1,382 1,452 1,501
Net income 1,705 1,054 1,528 1,860 2,093 2,255 2,369 2,449
Cash Flow Statement
Cash from operations:
Net income 1,705 1,054 1,528 1,860 2,093 2,255 2,369 2,449
CCA 1,500 2,550 1,785 1,250 875 612 429 300
Investment (10,000)
Salvage 0
Disposal tax effect 266
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15-32
Net cash flow (10,000) 3,205 3,604 3,313 3,110 3,967 2,868 2,798 3,015
PW(18%) = $2,965
AE(18%) = $727
IRR = 0.2749
(b) Sensitivity analysis:
Percentage Savings Savings
Deviation in T.B. PW(18%) in DM PW(18%)
–30.00% $2,100,000 $689,000 $875,000 $2,017,000
–20.00 2,400,000 1,448,000 1,000,000 2,333,000
–10.00 2,700,000 2,206,000 1,125,000 2,649,000
0.00 3,000,000 2,965,000 1,250,000 2,965,000
10.00 3,300,000 3,723,000 1,375,000 3,281,000
20.00 3,600,000 4,482,000 1,500,000 3,597,000
30.00 3,900,000 5,240,000 1,625,000 3,913,000
(c) Sensitivity graph:
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15-33
ST15.5
(a) Incremental project cash flows (FMS – CMT):
Income Statement (FMS – CMT)
0 1 2 3 4 5
Revenues:
Savings in VLC $462,400 $462,400 $462,400 $462,400 $462,400
Savings in VMC 233,920 233,920 233,920 233,920 233,920
Savings in AOC 1,200,000 1,200,000 1,200,000 1,200,000 1,200,000
Savings in ATC 170,000 170,000 170,000 170,000 170,000
Savings in AIC 109,500 109,500 109,500 109,500 109,500
Expenses:
Equipment in CCA 975,000 1,657,500 1,160,250 812,175 568,523
Taxable income 1,200,820 518,320 1,015,570 1,363,645 1,607,298
Income taxes (40%) 480,328 207,328 406,228 545,458 642,919
Net income $720,492 $310,992 $609,342 $818,187 $964,379
Cash Flow Statement
Cash flow operation:
Net income $720,492 $310,992 $609,342 $818,187 $964,379
CCA 975,000 1,657,500 1,160,250 812,175 568,523
Equipment ($6,500,000)
Disposal tax effect
Net cash flow ($6,500,000) $1,695,492 $1,968,492 $1,769,582 $1,630,362 $1,532,901
n 6 7 8 9 10
Revenues:
Savings in VLC $462,400 $462,400 $462,400 $462,400 $462,400
Savings in VMC 233,920 233,920 233,920 233,920 233,920
Savings in AOC 1,200,000 1,200,000 1,200,000 1,200,000 1,200,000
Savings in ATC 170,000 170,000 170,000 170,000 170,000
Savings in AIC 109,500 109,500 109,500 109,500 109,500
Expenses:
Equipment in CCA 397,966 278,576 195,003 136,502 95,552
Taxable income 1,777,854 1,897,244 1,980,817 2,039,318 2,080,268
Income taxes (40%) 711,142 758,898 792,327 815,727 832,107
Net income $1,066,713 $1,138,346 $1,188,490 $1,223,591 $1,248,161
Cash Flow Statement
Cash flow operation:
Net income $1,066,713 $1,138,346 $1,188,490 $1,223,591 $1,248,161
CCA 397,966 278,576 195,003 136,502 95,552
Equipment 500,000
Disposal tax effect ($110,819)
Net cash flow $1,464,678 $1,416,922 $1,383,493 $1,360,093 $1,732,894
ΡW (15%) = $1,753,756
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15-34
(b) and (c) Sensitivity analysis:
(d) Best and worse scenarios:
Best case: Material cost = $1.00 per part, annual inventory cost =
$25,000
PW(15%)FMS – CMT = $1,937,141
Worst case: Material cost = $1.40 per part, annual inventory cost =
$100,000
PW(15%)FMS – CMT = $1,056,046
(e) Mean and variance analysis:
E[PW(15%)FMS – CMT]:
Calculation of the mean of PE Distribution
Event Joint Weighted
No. VMC Prob. AIC Prob. Prob. PW(15%) PW
1 1.0 0.25 25,000 0.1 0.025 1,937,145 48,429
2 1.1 0.3 25,000 0.1 0.03 1,773,332 53,200
3 1.2 0.2 25,000 0.1 0.02 1,609,520 32,190
4 1.3 0.2 25,000 0.1 0.02 1,445,707 28,914
5 1.4 0.05 25,000 0.1 0.005 1,281,894 6,409
6 1.0 0.25 31,000 0.3 0.075 1,919,077 143,931
7 1.1 0.3 31,000 0.3 0.09 1,755,265 157,974
8 1.2 0.2 31,000 0.3 0.06 1,591,452 95,487
9 1.3 0.2 31,000 0.3 0.06 1,427,639 85,658
10 1.4 0.05 31,000 0.3 0.015 1,263,827 18,957
11 1.0 0.25 50,000 0.2 0.05 1,861,863 93,093
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15-35
12 1.1 0.3 50,000 0.2 0.06 1,698,051 101,883
13 1.2 0.2 50,000 0.2 0.04 1,534,238 61,370
14 1.3 0.2 50,000 0.2 0.04 1,370,425 54,817
15 1.4 0.05 50,000 0.2 0.01 1,206,613 12,066
16 1.0 0.25 80,000 0.2 0.05 1,771,526 88,576
17 1.1 0.3 80,000 0.2 0.06 1,607,713 96,463
18 1.2 0.2 80,000 0.2 0.04 1,443,900 57,756
19 1.3 0.2 80,000 0.2 0.04 1,280,088 51,204
20 1.4 0.05 80,000 0.2 0.01 1,116,275 11,163
21 1.0 0.25 100,000 0.2 0.05 1,711,300 85,565
22 1.1 0.3 100,000 0.2 0.06 1,547,488 92,849
23 1.2 0.2 100,000 0.2 0.04 1,383,675 55,347
24 1.3 0.2 100,000 0.2 0.04 1,219,862 48,794
25 1.4 0.05 100,000 0.2 0.01 1,056,050 10,561
E[PW] = 1,592,657
Var[PW(15%) FMS – CMT]:
Calculation of the variance of PW Distribution
E[PW] = 1,592,657
Event Joint Weighted PW(PW – μ)2
No. VMC Prob. AIC Prob. Prob. PW (15%)
1 1.0 0.25 25,000 0.1 0.025 1,937,145 2,966,799,554
2 1.1 0.3 25,000 0.1 0.03 1,773,332 979,303,669
3 1.2 0.2 25,000 0.1 0.02 1,609,520 5,687,215
4 1.3 0.2 25,000 0.1 0.02 1,445,707 431,886,050
5 1.4 0.05 25,000 0.1 0.005 1,281,894 482,868,210
6 1.0 0.25 31,000 0.3 0.075 1,919,077 7,991,251,230
7 1.1 0.3 31,000 0.3 0.09 1,755,265 2,379,722,550
8 1.2 0.2 31,000 0.3 0.06 1,591,452 87,121
9 1.3 0.2 31,000 0.3 0.06 1,427,639 1,633,856,419
10 1.4 0.05 31,000 0.3 0.015 1,263,827 1,621,937,534
11 1.0 0.25 50,000 0.2 0.05 1,861,863 3,623,593,522
12 1.1 0.3 50,000 0.2 0.06 1,698,051 666,473,714
13 1.2 0.2 50,000 0.2 0.04 1,534,238 136,511,182
14 1.3 0.2 50,000 0.2 0.04 1,370,425 1,975,482,473
15 1.4 0.05 50,000 0.2 0.01 1,206,613 1,490,299,699
16 1.0 0.25 80,000 0.2 0.05 1,771,526 1,599,705,958
17 1.1 0.3 80,000 0.2 0.06 1,607,713 13,600,988
18 1.2 0.2 80,000 0.2 0.04 1,443,900 885,145,802
19 1.3 0.2 80,000 0.2 0.04 1,280,088 3,907,975,190
20 1.4 0.05 80,000 0.2 0.01 1,116,275 2,269,398,099
21 1.0 0.25 100,000 0.2 0.05 1,711,300 703,808,072
22 1.1 0.3 100,000 0.2 0.06 1,547,488 122,414,314
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15-36
23 1.2 0.2 100,000 0.2 0.04 1,383,675 1,746,939,053
24 1.3 0.2 100,000 0.2 0.04 1,219,862 5,559,044,481
25 1.4 0.05 100,000 0.2 0.01 1,056,050 2,879,470,724
V[PW] = 46,073,262,826
SS[PW] = 214,647
(f) In no situation would the FMS be a more expensive instrument option
than the CMT.
Copyright © 2012 Pearson Canada Inc., Toronto, Ontario.
16‐1
Part 6
Personal Investment Analysis
and Strategy
16‐2
Chapter 16 Principles of Investing and Personal Income Tax
Income Taxes on Ordinary Income
16.1
a) Annual Espresso Expenditure = €2 × 365 days/year = €730 = $949
15 Years Dollars = $730 x 15 years = €10,950 = $14,235
b) After-Tax Income = $57,000 × (1 – 31.68%) = $38,942.40
Percentage of After-Tax Income = $949 / $38,942.40 = 2.437%
c) Pre-Tax Dollars = $57,000 × 2.437% = $1,389.05
Bond Investments After Tax
16.2
Marginal Tax Rate = 36%
Face Value = $2,000
Purchase Price = $1,800.00
Semiannual Interest Payments = ½($2,000 × 9%) = $90
Income Tax on Interest = 36% × $90 = $64.80
Capital Gains Tax on Sale = ($2,000 – $1,800) × 18% = $36
PW = –$1,800 + $90(P/A, i½, 12) – $64.80(P/A, ia, 6) + ($2,000 – $36)(P/F, i½, 12) = 0
Where i½ is the semiannual interest rate and ia = (1 + i½)2 – 1
Semiannual Rate (i½) = 3.8457%
After-Tax Annual Rate of Return (ia) = 7.8393%
Stock Investments After Tax
*
16.3
Total Capital Gains = ($175 – $45.50) × 1,000 shares = $129,500
Total Dividends = 10 years × 1,000 shares × $0.1 = $1,000
Note: Only her Capital Gains are taxed because her $10,000 salary + $100 dividend
income is less than the lowest federal bracket ($10,320) and the lowest provincial bracket
in Quebec ($13,069).
*
An asterisk next to a problem number indicates that the solution is available to students on the
Companion Website.
16‐3
Federal Bracket Rate Remaining Tax
$10,320 – $40,726 7.50% $119,180 $2,280.45
$40,726 – $81,452 11.00% $88,774 $4,479.86
$81,452 – $126,264 13.00% $48,048 $5,825.56
$126,264 and up 14.50% $3,236 $469.22
TOTAL FEDERAL: $13,055.09
Provincial Bracket (PEI) Rate Remaining Tax
$7,708 – $31,984 4.90% $121,792 $1,189.52
$31,984 – $63,969 6.90% $97,516 $2,206.97
$63,969 – $98,143 8.35% $65,531 $2,853.53
$98,143 and up 9.19% $31,357 $2,881.71
TOTAL PROVINCIAL: $9,131.73
Total Tax = $22,186.82
Total Proceeds = $129,500 + $1,000 – $22,186.82 = $108,313.18
Bond Investments After Tax
16.4
a) Marginal Tax Rate = 38.67%
Semiannual Interest Payments = ½($1,000 × 12%) = $60
Income Tax on Interest = 38.67% × $120 = $46.40
PW = –$1,000 + $60(P/A, i½, 60) – $46.40(P/A, ia, 30) + $1,000(P/F, i½, 60) = 0
Semiannual Rate (i½) = 3.7222%
After-Tax Annual Rate of Return (ia) = 7.5829%
b) The YTM of newly issued bonds for the investor is:
r = 9% × (1 – 38.67%) = 5.5197% per year compounded semiannually
i½ = 2.7599% per 6 months
ia = (1 + 2.7599%)2 – 1 = 5.5959% per year
c) To find the maximum price the investor is willing to pay, we need to use i½ =
2.7599% to analyze the cash flows of buying the bond on January 1, 2008.
P = $60(P/A, 2.7599%, 46) – $46.40(P/A, 5.5959%, 23) + $1,000(P/F, 2.7599%, 46)
P = $1,246.23
d) Capital Gains when redeemed = ½ × 38.67% ($1,000 – $922.38) = $15.01
PW = –$922.38 + $60(P/A, i½, 45) – $46.40(P/A, ia, 23) (1 + i½)
+ $60 × 38.67% (1 + i½)-1 + ($1,000 – $15.01)(P/F, i½, 45) = 0
16‐4
Semiannual Rate (i½) = 4.0922%
After-Tax Annual Rate of Return (ia) = 8.3519%
e) Current Yield = $120(1 – 38.67%) / $922.38 = 7.9789%
16.5
Marginal Tax Rate = 34.75%
Income Tax on Interest = 34.75% × $95 = $33.01
Semiannual Rate (i½) = (1 + 7%)½ – 1 = 3.4408%
Semiannual Coupon Payments = ½($1,000 × 9.5%) = $47.50
PW = -$1,010 + $47.50(P/A, 3.4408%, 6) – $33.01(P/A, 7%, 3)
+ [S – ½ × 34.75% × (S – $1,010)](P/F, 7%, 3) = 0
S = $1,037.54
16.6
Marginal Tax Rate = 35%
Income Tax on Interest = 35% × $80 = $28
Semiannual Rate (i½) = (1 + 10%)½ – 1 = 4.8809%
Semiannual Interest Payments = ½($1,000 × 8%) = $40
PW = –$920 + $40(P/A, 4.8809%, 8) – $28(P/A, 10%, 4)
+ [S – ½ × 35% × (S – $920)](P/F, 10%, 4) = 0
S = $1,134.04
16‐5
16.7
a) Purchase Price = $30(P/A, 4.5%, 10) + $1,000(P/F, 4.5%, 10) = $881.31
b) Marginal Tax Rate = 43.41%
Income Tax on Interest = 43.41% × $60 = $26.05
PW = -$881.31 + $30(P/A, i½, 10) – $26.05(P/A, ia, 5)
+ [$1,000 – ½ × 43.41% × ($1,000 – $881.31)](P/F, i½, 10) = 0
Semiannual Rate (i½) = 2.8725%
After-Tax Annual Rate of Return (ia) = 5.8275%
c) This 5.8275% is the after-tax ROR. It is lower than the required before-tax ROR
because we have to pay tax on any bond investment income in capital gains and
interest.
16.8
Marginal Tax Rate = 29.7%
Bond #1
PW = –$513.60 + [$1,000 – ½ × 29.7% × ($1,000 – $513.60)](P/F, ia, 5) = 0
Semiannual Rate (i½) = 6.0917%
After-Tax Annual Rate of Return (ia) =12.5545%
Bond #2
Income Tax on Interest = 29.7% × $113 × 2 = $67.12
PW = –$1,000 + $113(P/A, i½, 10) – $67.12(P/A, ia, 5) + $1,000(P/F, i½, 10) = 0
Semiannual Rate (i½) = 8.0741%
After-Tax Annual Rate of Return (ia) = 16.8002%
∴ The second bond would provide a higher yield.
16‐6
16.9 *
Marginal Tax Rate = 32.5%
Semiannual Interest Payments = ½($1,000 × 15%) = $75
Income Tax on Interest = 32.5% × $150 = $48.75
PW = –$1,298.68 + $75(P/A, i½, 24) – $48.75(P/A, ia, 12)
+ [$1,000 – ½ × 32.5% × ($1,000 – $1,298.68)](P/F, i½, 24) = 0
Semiannual Rate (i½) = 3.3973%
After-Tax Annual Rate of Return (ia) = 6.9101%
16.10
a) Marginal Tax Rate = 36.0%
Semiannual Rate (i½) = 9%(1 – 36%) / 2 = 2.8800%
After-Tax Annual Rate of Return (ia) = 5.8429%
Income Tax on Interest = 36% × $200 = $72
Alpha Bond
PW = –Pα + $100(P/A, 2.8800%, 30) – $72(P/A, 5.8429%, 15)
+ [$1,000 – ½ × 36% × ($1,000 – Pα)](P/F, 5.8429%, 15) = 0
Pα = $1,770.07
Beta Bond
PW = –Pβ + $100(P/A, 2.8800%, 2) – $72(P/A, 5.8429%, 1)
+ [$1,000 – ½ × 36% × ($1,000 – Pβ)](P/F, 5.8429%, 1) = 0
Pβ = $1,082.48
b)
Alpha Bond
Pα = $100(P/A, 2.8800%, 30) + $1,000(P/F, 5.8429%, 15)
Pα = $1,895.89
Beta Bond
Pβ = $100(P/A, 2.8800%, 2) + $1,000(P/F, 5.8429%, 1)
Pβ = $1,103.00
16‐7
16.11
Marginal Tax Rate = 34.8%
Income Tax on Interest = 34.8% × $87.50 = $30.45
a) PW = –$1,108 + $87.5(P/A, ia, 4) – $30.45(P/A, ia, 4)
+ [$1,000 – ½ × 34.8% × ($1,000 – $1,108)](P/F, ia, 4) = 0
After-Tax Annual Rate of Return (ia) = 3.2311%
b)
ia = {1 + ½ [9.5% × (1 – 34.8%)]}2 – 1 = 6.2899%
PW = –$1,035 + $87.5(P/A, 6.2899%, 4) – $30.45(P/A, 6.2899%, 4)
+ [$1,000 – ½ × 34.8% × ($1,000 – $1,035)](P/F, 6.2899%, 4)
PW = –$50.36 < 0
∴ No
16.12
Marginal Tax Rate = 36.5%
a) Semiannual Rate (i½) = 9%(1 – 36.5%) /2 = 2.8575%
After-Tax Annual Rate of Return (ia) = 5.7967%
PW = –P + $60(P/A, 2.8575%, 26) – $43.80(P/A, 5.7967%, 13)
+ [$1,000 – ½ × 36.5% × ($1,000 – P)](P/F, 5.7967%, 13) = 0
P = $1,195.89
b) Semiannual Rate (i½) = 13%(1 – 36.5%) /2 = 4.1275%
After-Tax Annual Rate of Return (ia) = 8.4254%
PW = –P + $60(P/A, 4.1275%, 26) – $43.80(P/A, 8.4254%, 13)
+ [$1,000 – ½ × 36.5% × ($1,000 – P)](P/F, 8.4254%, 13) = 0
P = $954.00
c) After-Tax Current Yield = $120(1 – 36.5%) / $783.58 = 9.7246%
16‐8
Stock Investments After Tax
16.13 *
Dividend Tax Rate = 18.71%
Tax Payment on Dividends = 50¢ × 18.71% = 9.355¢/share/year
Marginal Tax Rate = 43.41%
Capital Gains Tax (End of Year 5) = ½(43.41%)($42.20 – $20.20) = $4.82
PW = –$20.20 + 0.50(1 – 18.71%)(P/A, ia, 5) + ($42.40 – $4.82)(P/F, ia, 5) = 0
After-Tax Annual Rate of Return (ia) = 14.8202%
16.14
Marginal Tax Rate = 43.41%
Dividend Tax Rate = 18.71%
The Trojan:
PW = –$1,020 + $65(P/A, i½, 20) – $ 56.43(P/A, ia, 10)
+ [$1,000 – ½ × 43.41% × ($1,000 – $1,020)](P/F, i½, 20) = 0
Semiannual Rate (i½) = 3.6014%, After-Tax Annual Rate of Return (ia) = 7.3326%
The Greek:
PW = –$980 + $50(P/A, i½, 20) – $43.41(P/A, ia, 10)
+ [$1,000 – ½ × 43.41% × ($1,000 – $980)](P/F, i½, 20) = 0
Semiannual Rate (i½) = 2.9793%, After-Tax Annual Rate of Return (ia) = 6.0475%
The Hera:
Capital Gains Tax = ½(43.41%)($30 – $10) = $4.34
PW = –$10 + 0.10(1 – 18.71%)(P/A, ia, 10) + ($30 – $4.34)(P/F, ia, 10) = 0
After-Tax Annual Rate of Return (ia) = 10.4354%
The Zeus:
Capital Gains Tax = ½(43.41%)($50 – $15) = $7.60
PW = –$15 + 0.02(1 – 18.71%)(P/A, ia, 10) + ($50 – $7.60)(P/F, ia, 10) = 0
After-Tax Annual Rate of Return (ia) = 11.0219%
∴ The Zeus provides the highest after-tax rate of return.
Bond Investments After Tax
16.15
16‐9
a)
iSU3 yr 3 (1.01)(1.02)(1.03) 1 1.9967% / year
b)
iSU5 yr 5 (1.01)(1.02)(1.03)(1.0375)(1.0425) 1 2.7932% / year
(c) For the three-year term, the fixed rate savings bonds clearly provides a better
annual return. Since there is no five-year term for the fixed rate bonds, the
comparison is more difficult. However, if we assume a hypothetical five-year
fixed rate term would provide a rate that is the average of the three-year and
seven-year terms equivalent to 3.125%, then the fixed rate term would be superior
in this instance as well.
Stock Investments
16.16
Price Buy Sell Cash
$10,000.00
$4.00 2500 $0.00
$3.64 625 $2,275.00
$3.28 750 $4,735.00
$2.82 1675 $11.50
$3.72 2800 $10,427.50
∴ Dilan made $427.50
Dollar Cost Averaging
16.17
Date Price Shares
September 1, 2009 $81.21 12.31
October 1, 2009 $72.81 13.73
16‐10
November 2, 2009 $60.15 16.63
December 1, 2009 $62.61 15.97
January 4, 2010 $68.74 14.55
February 1, 2010 $68.06 14.69
March 1, 2010 $73.47 13.61
April 1, 2010 $69.05 14.48
May 3, 2010 $72.19 13.85
June 1, 2010 $62.27 16.06
July 2, 2010 $51.11 19.57
August 3, 2010 $56.77 17.61
a) Total Stocks = 183.07
b) Break-Even Price = $66.54
Stock Investments
16.18
Date Price Shares Investment
January 4, 2010 $59.15 1,000 $59,150
February 1, 2010 $57.23 2,000 $114,460
March 1, 2010 $53.98 3,000 $161,940
April 1, 2010 $57.74 4,000 $230,960
May 3, 2010 $50.19 5,000 $250,950
June 1, 2010 $36.25 6,000 $217,500
July 1, 2010 $29.39 7,000 $205,730
August 2, 2010 $39.42 8,000 $315,360
Total Shares = 36,000
Total Investment = $1,556,050
Break-Even Price = $43.22
16‐11
Income Taxes on Ordinary Income
16.19
Year 0 1 2 3 4 5
Bank $100,000 $101,500 $103,023 $104,568 $106,136 $107,728
Income $200,000 $201,500 $203,023 $204,568 $206,136 $207,728
Federal Bracket Rate Remain Tax Remain Tax Remain Tax Remain Tax Remain Tax
$10,320 - $40,726 15.0% $191,180 $4,560.90 $192,703 $4,560.90 $194,248 $4,560.90 $195,816 $4,560.90 $197,408 $4,560.90
$40,726 - $81,452 22.0% $160,774 $8,959.72 $162,297 $8,959.72 $163,842 $8,959.72 $165,410 $8,959.72 $167,002 $8,959.72
$81,452 - $126,264 26.0% $120,048 $11,651.12 $121,571 $11,651.12 $123,116 $11,651.12 $124,684 $11,651.12 $126,276 $11,651.12
$126,264 $999,999 29.0% $75,236 $21,818.44 $76,759 $22,259.97 $78,304 $22,708.11 $79,872 $23,162.98 $81,464 $23,624.68
TOTAL FEDERAL: $46,990.18 $47,431.71 $47,879.85 $48,334.72 $48,796.42 $239,432.88
Nunavut Bracket Rate Remain Tax Remain Tax Remain Tax Remain Tax Remain Tax
$11,644 - $38,832 4.0% $189,856 $1,087.52 $191,379 $1,087.52 $192,924 $1,087.52 $194,492 $1,087.52 $196,084 $1,087.52
$38,832 - $77,664 7.0% $162,668 $2,718.24 $164,191 $2,718.24 $165,736 $2,718.24 $167,304 $2,718.24 $168,896 $2,718.24
$77,664 - $126,264 9.0% $123,836 $4,374.00 $125,359 $4,374.00 $126,904 $4,374.00 $128,472 $4,374.00 $130,064 $4,374.00
$126,264 $999,999 11.5% $75,236 $8,652.14 $76,759 $8,827.23 $78,304 $9,004.94 $79,872 $9,185.32 $81,464 $9,368.41
TOTAL NUNAVUT: $16,831.90 $17,006.99 $17,184.70 $17,365.08 $17,548.17 $85,936.84
TOTAL COMBINED: $63,822.08 $64,438.69 $65,064.55 $65,699.80 $66,344.58 $325,369.71
NWT Bracket Rate Remain Tax Remain Tax Remain Tax Remain Tax Remain Tax
$12,664 - $36,885 5.9% $188,836 $1,429.04 $190,359 $1,429.04 $191,904 $1,429.04 $193,472 $1,429.04 $195,064 $1,429.04
$36,885 - $73,772 8.6% $164,615 $3,172.28 $166,138 $3,172.28 $167,683 $3,172.28 $169,251 $3,172.28 $170,843 $3,172.28
$73,772 - $119,936 12.2% $127,728 $5,632.01 $129,251 $5,632.01 $130,796 $5,632.01 $132,364 $5,632.01 $133,956 $5,632.01
$119,936 $999,999 14.1% $81,564 $11,459.74 $83,087 $11,673.65 $84,632 $11,890.77 $86,200 $12,111.15 $87,792 $12,334.83
TOTAL
YELLOWKNIFE: $21,693.07 $21,906.98 $22,124.10 $22,344.48 $22,568.16 $110,636.80
TOTAL
YELLOWKNIFE-
NUNAVUT: $4,861.17 $4,899.99 $4,939.40 $4,979.40 $5,020.00 $24,699.96
16‐12
Bond Investments After Tax
16.20
a) Muspelheim Rate of Return:
PW = –$10 + $0.20(P/A, ia, 5) + $45(P/F, ia, 5) = 0
Rate = 36.30%
Niflheim Rate of Return:
PW = –$5 + $0.10(P/A, ia, 5) + $15(P/F, ia, 5) = 0
Rate = 25.93%
∴ Muspelheim has a higher rate of return
b) Alberta Capital Gains Tax Rate @130k = 19.50%
Muspelheim Rate of Return:
PW = –$10 + $0.20[(1 – 3.68%)(P/F, ia, 1) + (1 – 3.68%)(P/F, ia, 2) + (1 – 10.21%)(P/F, ia, 3)
+ (1 – 10.21%)(P/F, ia, 4) + (1 – 14.56%)(P/F, ia, 5)]+ [$45 – (19.5% × $35)](P/F, ia, 5) =
0
Rate = 31.90%
Niflheim Rate of Return:
PW = –$5 + $0.10[(1 – 3.68%)(P/F, ia, 1) + (1 – 3.68%)(P/F, ia, 2) + (1 – 10.21%)(P/F, ia, 3)
+ (1 – 10.21%)(P/F, ia, 4) + (1 – 14.56%)(P/F, ia, 5)]+ [$45 – (19.5% × $15)](P/F, ia, 5) =
0
Rate = 23.79%
∴ Muspelheim has a higher rate of return
c) British Columbia Capital Gains Tax Rate @95k = 19.15%
Muspelheim Rate of Return:
PW = –$10 + $0.20[(1 – 3.68%)(P/F, ia, 1) + (1 – 3.68%)(P/F, ia, 2) + (1 – 12.07%)(P/F, ia, 3)
+ (1 – 12.07%)(P/F, ia, 4) + (1 – 12.07%)(P/F, ia, 5)]+ [$45 – (19.15% × $35)](P/F, ia, 5)
=0
Rate = 31.98%
Niflheim Rate of Return:
PW = –$5 + $0.10[(1 – 3.68%)(P/F, ia, 1) + (1 – 3.68%)(P/F, ia, 2) + (1 – 12.07%)(P/F, ia, 3)
+ (1 – 12.07%)(P/F, ia, 4) + (1 – 12.07%)(P/F, ia, 5)]+ [$45 – (19.15% × $15)](P/F, ia, 5)
=0
Rate = 23.86%
∴ Muspelheim has a higher rate of return
16‐13
Stock Investments After Tax
16.21
a) Share-Price % Gain = [($20.50 – $13.85)/$13.85]*100% = 48.014%
b) Distribution RoR with Purchase Price = (12*0.15)/$13.85 = 12.996%
c) Distribution RoR with Sale Price = (12*0.15)/$20.50 = 8.780%
Federal Bracket Rate Remaining Tax
$10,320 – $40,726 15.0% $77,680 $2,280.45
$40,726 – $81,452 22.0% $47,274 $5,200.14
$81,452 – $126,264 26.0% $6,548 $851.24
TOTAL FEDERAL: $8,331.83
Provincial Bracket
(Yukon) Rate Remaining Tax
$10,320 – $40,726 7.04% $77,680 $1,070.29
$40,726 – $80,595 9.68% $47,274 $2,288.06
$80,595 – $81,452 10.16% $7,405 $376.17
$81,452 – $126,264 12.01% $6,548 $393.21
TOTAL PROVINCIAL: $4,127.73
d) Total Income Taxes: $12,459.56
Combined Dividend Rate = 10.87%
(Federal Dividend Rate = 10.20% + Provincial Dividend Rate = 0.67%)
Combined Capital Gains Rate = 19.01%
(Federal Capital Gains Rate = 13.00% + Provincial Capital Gains Rate = 6.01%)
For 2009:
Distributions = $6,000 (4 Months)
Distribution Tax = $6,000 × 10.87% = $652.20
Capital Gains = $0S
TOTAL: $13,111.76
For 2010:
Distributions = $10,500 (7 Months)
Distribution Tax = $10,500 × 10.87% = $1,141.35
Capital Gains = ($20.50 – $13.85) × 10,000 = $66,500
Capital Gains Tax = $66,500 × 19.01% = $12,641.65
TOTAL: $26,242.56
TOTAL TAXES: $39,354.33
16‐14
Registered Retirement Savings Plans
16.22
Annual Withdrawal Upon Retirement = $40,000/75% = $53,333.33
First Withdrawal at Year 65: F65 = $53,333.33 (F/P, 4.2%, 35) = $225,096.58
Total Money Withdrawn During Retirement:
P65 = $225,096.58(P/A, 4.2%, 10%, 19) = $2,494,326.48
A = $2,494,326.48(A/F, 14.2%, 35) = $3,428.56
∴ Odin should invest $3,428.56 into his RRSPs on an annual basis.
Short Case Studies
ST16.1
No solution provided.
ST16.2
a) See GIC Taxes by Province graph
b) See Capital Gains Taxes by Province graph
c) See Dividend Taxes by Province graph
d) See Portfolio of Taxes by Province graph
16‐15
16‐16
16‐17
16‐18
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