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Capital Budgeting and Estimating Cash Flows
“Data! data! data!” he cried impatiently. “I can’t make
bricks without clay.”
SHERLOCK HOLMES
IN THE COOPER BEECHES
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ANSWERS TO QUESTIONS
1. Tax depreciation is a noncash charge against operating income that lowers taxable income.
So we need to deduct it as we determine the incremental effect that the project has on
2.
Initial Cash Outflow Depreciable
Basis
a. Market value of old machine Subtract (if sold); any taxes due to
sale of old machine would be added
Ignore
b. Additional investment in
inventory Add Ignore
3. Sunk costs must be ignored because they do not affect incremental cash flows. With capital
4. If the required return is the cost of capital where the expectation of investors includes an
5. It is implied that a project is regarded as more important, the larger it is. As a result,
increasing levels of approvals are necessary and more information frequently is required as
6. The product expansion project will produce new future cash revenues, but will also involve
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SOLUTIONS TO PROBLEMS
1. Relevant cash flows:
a. Initial cash outflow
()
0
$60,000
1 2 3 4 5
b. Savings $20,000 $20,000 $20,000 $20,000 $20,000
2. a. Relevant cash flows:
(a) Initial cash outflow
()
0
$60,000
3
5
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b. Relevant cash flows: (Note: net cash flows for years 1–4 remain the same as in part a.
above.)
0
5
3. a. b.
Amount of cash outflow:
Time of cash
outflow Rockbuilt Bulldog
Net cost savings of
Rockbuilt over
Bulldog truck
0 ($74,000) ($59,000) ($15,000)
1 (2,000) (3,000) 1,000
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4. Incremental cash inflows:
End of Year
1 2 3 4
a. Savings $12,000 $12,000 $12,000 $12,000
b. Depreciation, new 19,998 26,670 8,886 4,446
c. Depreciation, old 4,520 0 0 0
Cost of “new” machine $60,000
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5. Incremental cash inflows:
End of Year
1 2 3 4
a. Savings $12,000 $12,000 $12,000 $12,000
b. Depreciation, new 20,665 27,559 9,182 4,594
c. Depreciation, old 4,520 0 0 0
Cost of “new” machine $60,000
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SOLUTIONS TO SELF-CORRECTION PROBLEMS
1. Incremental cash inflows:
END OF YEAR
1 2 3 4
1. Savings $100,000 $100,000 $100,000 $100,000
2. Depreciation, new 96,000 153,600 92,160 55,296
END OF YEAR
5 6 7 8
1. Savings $100,000 $100,000 $100,000 $100,000
2. Depreciation, new 55,296 27,648 0 0
Incremental cash outflow at time 0 (i.e., initial cash outflow):
Cost – Sale of old machines – Tax savings on book loss
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2. Incremental cash inflows:
END OF YEAR
1 2 3 4
1. Labour savings $150,000 $150,000 $150,000 $150,000
2. Incremental maintenance 6,000 6,000 6,000 6,000
Incremental cash outflow at time 0 (i.e., initial cash outflow):