Critical Thinking Questions

11.1 Do you agree or disagree with the following statement given the techniques discussed
in this chapter? We can calculate future cash flows precisely and obtain an exact
value for the NPV of an investment.

The statement is not true. Given the nature of the real business world, it is almost
certain that the cash flows generated by a project will differ from the forecasts used to
decide whether to proceed with the project. However, techniques discussed in this
chapter provide an important and useful framework that helps minimise errors and
ensures that forecasts are internally consistent.

11.2 What are the differences between forecast cash flows used in capital budgeting
calculations and past accounting earnings?

Cash flows used in capital budgeting calculations are forward looking; they are
incremental after-tax cash flows based on forecast. Accounting earnings are backward
looking; they represent a record of past performance and may not accurately reflect
cash flows.

11.3 Suppose that Melbane Ltd already has divisions in both Melbourne and Brisbane.
Melbane is now considering setting up a third division in Adelaide. This expansion
will require one senior manager from Melbourne and one from Brisbane to relocate to
Adelaide. Ignore relocation expenses. Is their annual compensation relevant to the
decision to expand?

The annual compensations of existing senior managers are not incremental to the new
investment and therefore are not relevant for capital budgeting analysis. This is
consistent with our Rule 1 for incremental cash flow calculations: Include cash flows
and only cash flows; do not include allocated costs unless they reflect cash flows.

11.4 RetroMusic Ltd is a producer of MP3 players which currently have either 20
gigabytes or 30 gigabytes of storage. Now the company is considering launching a
new production line making mini MP3 players with 5 gigabytes of storage. Analysts
forecast that RetroMusic will be able to sell 1 million such mini MP3 players if the
investment is taken. In making the investment decision, discuss what the company
should consider other than the sales of the mini MP3 players.

The company’s launch of the new mini MP3 players may reduce its current sales of
MP3 players of bigger storage. This impact has to be considered. This is consistent
with our Rule 2 for incremental cash flow calculations: Include the impact of the
project on cash flows from other product lines.
11.5 QualityLiving Ltd is a real estate investment company that builds and remodels
apartment buildings in northern Victoria. It is currently considering remodelling a
few idle buildings that it owns into luxury apartment buildings. The company bought
those buildings eight months ago. How should the market value of the buildings be
treated in evaluating this project?

Although the buildings are not currently in use, the company can sell them at their
market value rather than remodel them into apartments. Therefore, the market value
of the buildings is the opportunity cost of the project and should be considered as cash
outflow in the investment decision. This is consistent with our Rule 3 for incremental
cash flow calculations: Include all opportunity costs.

11.6 High-End Fashions Ltd bought a production line of ankle-length skirts last year at a
cost of $500,000. This year, however, miniskirts are hot in the market and ankle-
length skirts are completely out of fashion. High-End has the option to rebuild the
production line and use it to produce miniskirts, with a cost of $300,000 and expected
revenue of $700,000. How should the company treat the cost of $500,000 of the old
production line in evaluating the rebuilding plan?

The cost of the old production line occurred in the past. It cannot be changed whether
or not the company rebuilds it into the miniskirt production line. Therefore, High-End
should not consider the cost of $500,000. This is consistent with our Rule 4 for
incremental cash flow calculations: Forget sunk costs.

11.7 When two mutually exclusive projects have different lives, how can an analyst
determine which is better? What is the underlying assumption in this method?

When we choose from mutually exclusive projects with different lives, instead of
electing the project with higher NPV or lower net present value of costs, we should
choose the project with higher equivalent annual value, NPV perpetuity or lower
equivalent annual cost. The underlying assumption is that we will continue to operate
with the same equivalent annual revenue or equivalent annual cost in the future.

11.8 What is the opportunity cost of using an existing asset? Give an example of the
opportunity cost of using the excess capacity of a machine.

The opportunity cost of using an existing asset in a project is the present value of the
change in the company’s cash flows that is attributed to the fact that this asset is being
used in the project. For example, by using the excess capacity of a machine, you may
accelerate the wear and tear of the machine and hence will need to replace it sooner.
The present value of the added annualised costs is the opportunity cost of using the
excess capacity.
11.9 You are providing financial advice to an oyster farmer who will be harvesting his last
crop of farm-raised oysters. His current oyster crop is very young and will therefore
grow and become more valuable as their weight increases. Describe how you would
determine the appropriate time to harvest the entire crop of oysters.

Assuming that the price of oysters is directly (and linearly) related to the weight of
the oysters, then the optimal point in time to harvest the oysters would be where the
rate of weight increase is no longer greater than the opportunity cost of capital for the
oyster farmer. Alternatively, the appropriate time is when the value increase of the
oyster is no longer greater than the opportunity cost of capital.
CHALLENGING
11.20 You are the CFO of SlimBody Ltd a retailer of the exercise machine Bodyslim and
related accessories. Your company is considering opening up a new store in Perth.
The store will have a life of 20 years. It will generate annual sales of 5,000 exercise
machines, and the price of each machine is $2,500. The annual sales of accessories
will be $600,000, and the operating expenses of running the store, including labour
and rent, will amount to 50 percent of the revenues from the exercise machines. The
initial investment in the store will equal $30 million and will be fully depreciated on a
straight-line basis over the 20-year life of the store. Your company will need to invest
$2 million in additional working capital immediately, and recover it at the end of the
investment. Your company’s tax rate is 30 percent. The opportunity cost of opening
up the store is 10 percent. What are the incremental cash flows from this project at the
beginning of the project as well as in years 1-19 and 20? Should you approve it?

Solution:

Step One: Initial outlay = $30,000,000 + $2,000,000 (WC requirement) =

$32,000,000
Step Two: ΔNR for years 1- 20: $2,500 x 5,000 machines = $12,500,000 plus
$600,000 = $13,100,000
Step Three: ΔOpExp for years 1- 20: $1,250 x 5,000 machines = $6,250,000
Step Four: ΔD&A for years 1- 20: $30,000,000 / 20 years = $1,500,000 / year
Step Five: Plug information into the text book template as below.
Step Six: Yr 20 recapture of WC requirements that were funded in year 0.
Yrs 1-19 Yr 20

ΔNR
1 3 , 1 0 0 , 0 0 0 1 3 , 1 0 0 , 0 0 0

Δ O p E x - 6 2 5 0 0 0 0 - 6 2 5 0 0 0 0

Δ E B I T D A 6 , 8 5 0 , 0 0 0 6 , 8 5 0 , 0 0 0

Δ D & A - 1 5 0 0 0 0 0 - 1 5 0 0 0 0 0

Δ E B I T 5 , 3 5 0 , 0 0 0 5 , 3 5 0 , 0 0 0

( 1 - t ) 0 . 7 0 . 7

Δ N O P A T 3 , 7 4 5 , 0 0 0 3 , 7 4 5 , 0 0 0

Δ D & A 1 , 5 0 0 , 0 0 0 1 , 5 0 0 , 0 0 0

Δ C F O 5 , 2 4 5 , 0 0 0 5 , 2 4 5 , 0 0 0

Δ C a p E x - 3 0 , 0 0 0 , 0 0 0 0 0

Δ A W C - 2 , 0 0 0 , 0 0 0 0 2 , 0 0 0 , 0 0 0

Δ F C F - 3 2 , 0 0 0 , 0 0 0 5 , 2 4 5 , 0 0 0 7 , 2 4 5 , 0 0 0

Therefore the NPV of the project is:

NPV = -32,000,000+5,245,000*(((1.1)20-1)/ ((1.1)20*0.1))+2,000,000/(1.1)20
=12,950,929
You should approve the project since it has a positive NPV.

Alternative Solution:
Incremental cash flows in year 0 is:
ΔFCF0 = -30,000,000-2,000,000= -32,000,000
Annual incremental cash flows through the life of the investment are:
ΔFCFt = (2,500*2,500+600,000)*(1-0.3)+0.3*1,500,000 = 5 ,245,000
Additional incremental cash flows at the end of the project are:
 2,000,000
Therefore the NPV of the project is:
NPV = -32,000,000+5,245,000*(((1.1)20-1)/ ((1.1)20*0.1))+2,000,000/(1.1)20
=12,950,929
You should approve the project since it has a positive NPV.

11.21 Blue Mountain Lumber Ltd is considering purchasing a new wood saw that costs
$50,000. The saw will generate revenues of $100,000 per year for five years. The cost of
materials and labour needed to generate these revenues will total $60,000 per year, and other
cash expenses will be $10,000 per year. The machine is expected to sell for $1,000 at the end
of its five-year life and will be depreciated on a straight-line basis over five years to zero.
Blue Mountain’s tax rate is 30 percent, and its opportunity cost of capital is 10 percent.
Should the company purchase the saw? Explain why or why not.

Solution:
Step One: Initial outlay = $50,000
Step Two: ΔNR for years 1- 5: $100,000
Step Three: ΔOpExp for years 1- 5: $60,000 + $10,000 = $70,000
Step Four: ΔD&A for years 1- 5: $50,000 / 5 years = $10,000 / year
Step Five: Plug into the text book template as below.
Step Six: Yr 5: Capital recovery = $1,000 – (.30 x 1,000 gain on sale) = $700.

Yr 0 Yrs 1-4 Yr 5
∆NR 100,000 100,000
∆OpEx -70,000 -70,000
∆EBITDA 30,000 30,000
∆D&A -10,000 -10,000
∆EBIT 20,000 20,000
(1-t) 0.70 0.70
∆NOPAT 14000 14000
∆D&A 10,000 10,000
∆CFO 24000 24000
∆CapEx -50,000 700
∆AWC 0 0 0
∆FCF -50000 24000 24700

Therefore, NPV of investment is:

-50,000+24,000 /(1.1)1+24,000 /(1.1)2+24,000 /(1.1)3+24,000 /(1.1)4
+(24,000 +700)/(1.1)5= $41,414
Therefore the company should buy the machine.

Alternatively:
The annual operating cash flows from year 1 to 5 are:
(100,000-60,000-10,000)*(1-0.3)+0.3*10,000=24,000
The after-tax terminal value in year 5 is:
1,000 -(0.3)(1,000-0) = 700
 Therefore, NPV of investment is:
-50,000+24,000 /(1.1)1+ 24,000 /(1.1)2+ 24,000 /(1.1)3+24,000 /(1.1)4
+(24,000 + 700 )/(1.1)5=$41,414
Therefore the company should buy the machine.

11.22 A beauty product company is developing a new fragrance named Scent Forever.
There is a probability of 0.5 that consumers will love Scent Forever and, in this case
annual sales will be 1 million bottles; a probability of 0.4 that consumers will find the
smell acceptable and annual sales will be 200,000 bottles; and a probability of 0.1 that
consumers will find the smell weird and annual sales will be only 50,000 bottles. The
selling price is $38, and the variable cost is $8 per bottle. Fixed production costs will
be $1 million per year, and depreciation costs are $1.2 million. Assume that the tax
rate is 30 percent. What are the expected annual incremental cash flows from the new
fragrance?

Solution:

Step One: Expected sales units: (.5)1,000,000 + (.4)200,000 + (.1)50,000 = 585,000

units
Step Two: ΔNR: 585,000 units x $38 = $22,230,000
Step Three: ΔOpExp: 585,000 units x $8 + $1,000,000 = $5,680,000
Step Four: ΔD&A: $1,200,000
Step Five: Plug into the text book template as below.

∆NR 22,230,000
- ∆OpEx -5,680,000
= ∆EBITDA 16,550,000
- ∆D&A -1,200,000
= ∆EBIT 15,350,000
x (1-t) 0.70
= ∆NOPAT 10,745,000
+ ∆D&A 1,200,000
= ∆CFO 11,945,000
- ∆CapEx 0
- ∆AWC 0
= ∆FCF 11,945,000

Alternatively, the expected annual incremental cash flows are:

(((0.5*1,000,000+0.4*200,000+0.1*50,000)*(38-8))-1,000,000)*(1-
0.3)+1,200,000*0.3 = 11,945,000
11.23 Great Fit Ltd is a company that makes clothing. The company has a product line that
produces women’s tops of regular sizes. The same machine could be used to produce
petite sizes as well. However, the remaining life of the machines will be reduced from
4 more years to 2 more years if the petite size production is added. The cost of
identical machines with a life of 8 years is $2 million. Assume the opportunity cost of
capital is 8 percent. What is the opportunity cost of adding petite sizes?

Solution:

The opportunity cost is the incremental costs of the machine in year 3 and year 4 if
petite sizes are in production. The EAC of the machine is:
EAC=2,000,000*0.08*((1.08)8)/((1.08)8-1)=348,029.52
The present value of such cost in year 3 and year 4 is:
NPV=348,029.52/(1.08)3+348,029.52/(1.08)4=532,089.14

11.24 Biotech Partners Ltd has been farming a new strain of radioactive-material-eating
bacteria that the electrical utility industry can use to help dispose of its nuclear waste.
Two opposing factors affect Biotech’s decision of when to harvest the bacteria. The
bacteria are currently growing at a 22 percent annual rate, but due to known
competition from other top companies, Biotech analysts estimate that the price for the
bacteria will decline according to the scale below. If the opportunity cost of capital is
10 percent, then when should Biotech harvest the entire bacteria colony at one time?

Year Change in Price Due to Competition (5)

1 5%
2 -2
3 -8
4 -10
5 -15
6 -25

Solution:

Change in revenue:
Yr 1 (1.05)(1.22) = 1.2810 or 28.1%
Yr 2 (0.98)(1.22) = 1.1956 or 19.56%
Yr 3 (0.92)(1.22) = 1.1224 or 12.24%
Yr 4 (0.9)(1.22) = 1.0980 or 9.80%
Yr 5 (0.85)(1.22) = 1.037 or 3.70%
Yr 6 (0.75)(1.22) =- 0.9150 or -8.50%
Since the change in revenue is higher for the first two years, Biotech should sell its
bacteria colony at the beginning of the third year or at the end of the second year.
11.25 ACME manufacturing is considering replacing an existing production line with a new
line that has a greater output capacity and operates with less labour than the existing
line. The new line would cost $1 million, have a 5-year life, and would be depreciated
using the straight-line depreciation method over 5 years. At the end of 5 years, the
new line could be sold as scrap for $200,000 (in year 5 dollars). Because the new line
is more automated, it would require fewer operators, resulting in a saving of $40,000
per year before tax and unadjusted for inflation (in today’s dollars). Additional sales
with the new machine are expected to result in additional net cash inflows, before tax,
of $60,000 per year (in today’s dollars). If ACME invests in the new line, a one-time
investment of $10,000 in additional working capital will be required. The tax rate is
30 percent, the opportunity cost of capital is 10 percent, and the annual rate of
inflation is 3 percent. What is the NPV of the new production line?

Solution:

11.31 t= 0.3 rate = 0.1

Buy the New Line
0 1 2 3 4 5
(Revenue -
Op Exp)(1-t) $72,100 $74,263 $76,491 $78,786 $81,149

Tax x Deprec $60,000 $60,000 $60,000 $60,000 $60,000

-
$1,000,00 $200,00
Cap Exp 0 0

-
Tax on Salvage $60,000

Add WC -$10,000 $10,000

-
$1,010,00 $132,10 $134,26 $136,49 $138,78 $291,14
Net Cash Flows 0 0 3 1 6 9

-
PV of Net Cash $1,010,00 $120,09 $110,96 $102,54 $180,78
Flows 0 1 1 8 $94,793 1

Net Present
Value -$400,827
11.26 The alternative to investing in the new production line in Problem 11.25 is to overhaul
the existing line, which currently has both a book value and a salvage value of $0. It
would cost $300,000 to overhaul the existing line, but this expenditure would extend
its useful life to 5 years. The line would have a $0 salvage value at the end of 5 years.
The overhaul outlay would be capitalised and depreciated using straight-line method
of depreciation over 5 years. Should ACME replace or renovate the existing line?

t= 0.3 rate = 0.1

Renovate Old Line
0 1 2 3 4 5
(Revenue -
Op Ex)(1-t)

Tax x Deprec $18,000 $18,000 $18,000 $18,000 $18,000

Cap Exp -$300,000

Tax on Salvage

Add WC

Net Cash Flows -$300,000 $18,000 $18,000 $18,000 $18,000 $18,000

PV of Net Cash
Flows -$300,000 $16,364 $14,876 $13,524 $12,294 $11,177

Net Present
Value -$231,766

Renovating the old line is less costly.

11.27 FITCO is considering the purchase of new equipment. The equipment costs $350,000,
and an additional $110,000 is needed to install it. The equipment will be depreciated
straight-line to zero over a 5-year life. The equipment will generate additional annual
revenues of $265,000, and it will have annual cash operating expenses of $83,000.
The equipment will be sold for $85,000 after 5 years. An inventory investment of
$73,000 is required during the life of the investment. The company tax rate is 30
percent, and its cost of capital is 10 percent. What is the project NPV?
A. $100,753
B. $120,359
C. $136,844
D. $153,666

Solution:
C is correct.
Outlay = FCInv + NWCInv – Sal0 + T(Sal0 – B0)
Outlay = (350,000 + 110,000) + 73,000 – 0 + 0 = $533,000
The installed cost is $350,000 + $110,000 = $460,000, so the
annual depreciation is $460,000/5 = $92,000. The annual after-
tax operating cash flow for Years 1–5 is
CF = (S – C – D)(1 – T) + D = (265,000 – 83,000 – 92,000)(1 – 0.30) +
92,000
CF = $155,000
The terminal year after-tax non-operating cash flow in Year 5 is
TNOCF = Sal5 + NWCInv – T(Sal5 – B5) = 85,000 + 73,000 –
0.30(85,000 – 0)
TNOCF = $132,500
The NPV is
5
155,000 132,500
NPV  533,000   t
  $136,844
t 1 1.10 1.10 5
11.28 After estimating a project’s NPV, the analyst is advised that the fixed capital outlay
will be revised upward by $100,000. The fixed capital outlay is depreciated straight-
line over an 8-year life. The tax rate is 30 percent and the required rate of return is 10
percent. No changes in cash operating revenues, cash operating expenses, or salvage
value are expected. What is the effect on the project NPV?
A. $100,000 decrease
B. $79,994 decrease
C. $59,988 decrease
D. No change

Solution:
B is correct. The additional annual depreciation is $100,000/8 = $12,500. The
depreciation tax savings is 0.30 ($12,500) = $3,750. The change in project NPV is
8
3,750
 100,000    $79,994
t 1 (1.10) t

11.29 When assembling the cash flows to calculate an NPV or IRR, the project’s after-tax
interest expenses should be subtracted from the cash flows for
A. the NPV calculation, but not the IRR calculation.
B. the IRR calculation, but not the NPV calculation.
C. both the NPV calculation and the IRR calculation.
D. neither the NPV calculation nor the IRR calculation.

Solution:
D is correct. Financing costs are not subtracted from the cash flows for either the NPV
or the IRR. The effects of financing costs are captured in the discount rate used.