P11-27. Integrative—determining relevant cash flows
LG 3, 4, 5, 6; Challenge
a.
Initial Investment A B
Installed cost of new asset
*Book value of old asset: [1 (0.20 0.32 0.19)] ($32,000) $9,280
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b.
Calculation of Operating Cash Flows
Year
Profits before
Depreciation
and Taxes
Depre-ciatio
n
Net Profits
before
Taxes Taxes
Net Profits
after
Taxes
Operating
Cash
Inflows
Hoist A
1 $21,000 $9,600 $11,400 $4,560 $6,840 $16,440
Hoist B
1 $22,000 $12,000 $10,000 $4,000 $6,000 18,000
Existing Hoist
1 $14,000 $3,840 $10,160 $4,064 $6,096 $9,936
Calculation of Incremental Cash Flows
Incremental Cash Flow
Year Hoist A Hoist B Existing Hoist Hoist A Hoist B
1 $16,440 $18,000 $9,936 $6,504 $8,064
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Chapter 11 Capital Budgeting Cash Flows 227
c. Terminal cash flow:
(A) (B)
After-tax proceeds form sale of new asset
1Book value of Hoist A at end of year 5 $2,400
Year 5 relevant cash flow—Hoist A:
Year 5 relevant cash flow—Hoist B:
d.
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Chapter 11 Capital Budgeting Cash Flows 228
P11-28. Integrative—complete investment decision
LG 1, 2, 3, 4, 5, 6; Challenge
a. Initial investment:
Installed cost of new press
After-tax proceeds from sale of old asset
Taxes on sale of existing press* 480,000
*Book value $0
b.
Calculation of Operating Cash Flows
Year Revenues Expenses Depreciation
Net Profits
before Taxes Taxes
Net Profits
after Taxes
Cash
Flow
1 $1,600,000 $800,000 $440,000 $360,000 $144,000 $216,000 $656,000
d. PV of cash inflows:
Year CF PVIF11%,nPV
1 $656,000 0.901 $ 591,056
1 2 3 4 5 6
$656,000 $761,600 $647,200 $585,600 $585,600 $44,000
$0 $1,480,000
(1 IRR) (1 IRR) (1 IRR) (1 IRR) (1 IRR) (1 IRR)
= + + + + + –
+ + + + + +
IRR 35%
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Chapter 11 Capital Budgeting Cash Flows 229
e. The NPV is a positive $959,289, and the IRR of 35% is well above the cost of capital of 11%. Based
P11-29. Integrative—investment decision
LG 1, 2, 3, 4, 5, 6; Challenge
a. Initial investment:
Installed cost of new asset
Installation costs 150,000
After-tax proceeds from sale of old asset
Tax on sale of existing machine* (79,600)
Increase in net working capital 25,000
*Book value $384,000
Calculation of Operating Cash Flows
New Machine
Year
Reduction in
Operating Costs Depreciation
Net Profits
before Taxes Taxes
Net Profits
after Taxes
Cash
Flow
1 $350,000 $270,000 $80,000 $32,000 $48,000 $318,000
Existing Machine
Year Depreciation
Net Profits
before Taxes Taxes
Net Profits
after Taxes
Cash
Flow
1 $152,000 $152,000 $60,800 $91,200 $60,800
Incremental Operating Cash Flows
Year New Machine Existing Machine Incremental Cash Flow
1 $318,000 $60,800 $257,200
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Chapter 11 Capital Budgeting Cash Flows 230
Terminal cash flow:
After-tax proceeds from sale of new asset
Tax on sale of new asset* (53,000)
After-tax proceeds from sale of old asset 0
Change in net working capital 25,000
*Book value of new machine at the end of year 5 is $67,500
b. CF0 $1,110,400, CF1 257,200, CF2 $344,400, CF3 $274,200,
c.
1 2 3 4 5
$257,200 $344,400 $274,200 $258,800 $446,800
$0 $1,110,400
(1 IRR) (1 IRR) (1 IRR) (1 IRR) (1 IRR)
= + + + + –
+ + + + +
IRR 12.2%
Calculator solution: 12.24%
d. Because the NPV 0 and the IRR cost of capital, the new machine should be purchased.
e. 12.24%. The criterion is that the IRR must equal or exceed the cost of capital; therefore, 12.24% is the
P11-30. Ethics problem
LG 2; Intermediate
The person who came up with the idea for a new investment may have a selfish interest in seeing the
Case
Case studies are available on www.myfinancelab.com.
Developing Relevant Cash Flows for Clark Upholstery Company’s Machine Renewal
or Replacement Decision
Clark Upholstery is faced with a decision to either renew its major piece of machinery or to replace the machine.
The case tests the students’ understanding of the concepts of initial investment and relevant cash flows.
a. Initial Investment:
Alternative 1 Alternative 2
Installed cost of new asset
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Chapter 11 Capital Budgeting Cash Flows 231
Installation costs 0 10,000
After-tax proceeds from sale of old asset
Tax on sale of old asset* 0 8,000
Change in working capital 15,000 22,000
*Book value of old asset 0
b.
Calculation of Operating Cash Inflows
Year
Profits before
Depreciation
and Taxes Depre-ciation
Net Profits
before Taxes Taxes
Net Profits
after Taxes
Operating
Cash
Inflows
Alternative 1
1 $198,500 $18,000 $180,500 $72,200 $108,300 $126,300
Alternative 2
1 $235,500 $22,000 $213,500 $85,400 $128,100 $150,100
Calculation of Incremental Cash Inflows
Incremental Cash Flow
Year Alternative 1 Alternative 2 Existing Alt. 1 Alt. 2
1 $126,300 $150,100 $100,000 $26,300 $50,100
3 235,980 239,420 200,000 35,980 39,420
4 293,460 266,340 250,000 43,460 16,340
After-tax proceeds from sale of old asset
Tax on sale of old asset** 800 800
Change in working capital 15,000 22,000
*Book value of Alternative 1 at end of year 5: $4,500
Book value of Alternative 2 at end of year 5: $5,500
** Book value of old asset at end of year 5: $0
Alternative 1
Year 5 relevant cash flow: Operating cash flow: $33,460
Alternative 2
Year 5 relevant cash flow: Operating cash flow: $15,940
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Chapter 11 Capital Budgeting Cash Flows 233
d. Alternative 1
e. Alternative 2 appears to be slightly better because it has the larger incremental cash flow amounts
Spreadsheet Exercise
The answer to Chapter 11’s Damon Corporation spreadsheet problem is located on the Instructor’s Resource
Center at www.pearsonhighered.com/irc under the Instructor’s Manual.
Group Exercise
Group exercises are available on www.myfinancelab.com.
Capital investment is revisited in this chapter. A long-term investment project will be detailed across this and the
The first task is to design two mutually exclusive investment projects. The design should focus on why these
A payback period, net present value, and internal rate of return are estimated for both projects. If the projects have
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