CHAPTER 6 CASE #1 C-1
CHAPTER 6, Case #1
BETHESDA MINING
To analyze this project, we must calculate the incremental cash flows generated by the project. Since
net working capital is built up ahead of sales, the initial cash flow depends in part on this cash
outflow. So, we will begin by calculating sales. Each year, the company will sell 500,000 tons under
contract, and the rest on the spot market. The total sales revenue is the price per ton under contract
times 500,000 tons, plus the spot market sales times the spot market price. The sales per year will be:
Year 1 Year 2 Year 3 Year 4
The current aftertax value of the land is an opportunity cost. The initial outlay for net working
capital is the required net working capital percentage times Year 1 sales, or:
Initial net working capital = .05($52,240,000) = $2,612,000
So, the cash flow today is:
Now we can calculate the OCF each year. The OCF is:
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Sales $52,240,000 $56,860,000 $60,710,000 $49,930,000
VC 19,220,000 21,080,000 22,630,000 18,290,000
Years 5 and 6 are of particular interest. Year 5 has an expense of $2.7 million to reclaim the land, and
it is the only expense for the year. Taxes that year are a credit, an assumption given in the case. In
Year 6, the charitable donation is irrelevant in itself since it is required for the company to donate the
CHAPTER 6 CASE #1 C-2
land in order to receive the necessary permits. However, the donation of the land does mean that the
company will receive a tax credit on the donation of the land, so this tax credit is relevant.
Next, we need to calculate the net working capital cash flow each year. NWC is 5 percent of next
year’s sales, so the NWC requirement each year is:
Year 1 Year 2 Year 3 Year 4
The last cash flow we need to account for is the salvage value. The fact that the company is keeping
the equipment for another project is irrelevant. The aftertax salvage value of the equipment should
be used as the cost of equipment for the new project. In other words, the equipment could be sold
after this project. Keeping the equipment is an opportunity cost associated with that project. The
book value of the equipment is the original cost, minus the accumulated depreciation, or:
And the aftertax salvage value of the equipment is:
So, the net cash flows each year, including the operating cash flow, net working capital, and aftertax
salvage value, are:
Time Cash flow
0 –$104,112,000
1 22,858,090
2 28,289,990
3 27,920,490
CHAPTER 6 CASE #1 C-3
PI = ($22,858,090 / 1.12 + $28,289,990 / 1.122 + $27,920,490 / 1.123 + $70,697,830 / 1.124
The NPV is:
NPV = –$104,112,000 + $22,858,090 / 1.12 + $28,289,990 / 1.122 + $27,920,490 / 1.123
The equation for IRR is:
0 = –$104,112,000 + $22,858,090 / (1 + IRR) + $28,289,990 / (1 + IRR)2 + $27,920,490 / (1 + IRR)3
Using a spreadsheet or financial calculator, the IRR for the project is:
CHAPTER 6, Case #2
GOODWEEK TIRES, INC.
The cash flow to start the project is the $160 million equipment cost and the $9 million required for
net working capital, yielding a total cash outflow today of $169 million. The research and
development costs and the marketing test are sunk costs.
We can calculate the future cash flows on a nominal basis or a real basis. Since the depreciation is
given in nominal values, we will calculate the cash flows in nominal terms. The same solution can be
To analyze this project, we must calculate the incremental cash flows generated by the project. We
will calculate the real cash flows, although using nominal cash flows will result in the same NPV.
CHAPTER 6 CASE #1 C-4
Year 1 Year 2 Year 3 Year 4
Automobiles sold 6,200,000 6,355,000 6,513,875 6,676,722
The tires will be sold in each market at a different price. The price will increase each year at the rate
calculated earlier, so the price each year will be:
Year 1 Year 2 Year 3 Year 4
Multiplying the number of tires sold in each market by the respective price in that market, the
revenue each year will be:
Year 1 Year 2 Year 3 Year 4
OEM market $111,848,000 $119,553,838 $127,790,574 $136,594,786
Now we can calculate the incremental cash flows each year. We will calculate the nominal cash
flows. Doing so, we find:
Year 1 Year 2 Year 3 Year 4
Revenue $270,568,000 $288,381,366 $307,369,292 $327,609,346
Variable costs 153,352,000 163,530,185 163,915,828 167,627,528
Mkt. and general costs 43,000,000 44,397,500 45,840,419 47,330,232
Net working capital is a percentage of sales, so the net working capital requirements will change
every year. The net working capital cash flows will be:
Year 1 Year 2 Year 3 Year 4
CHAPTER 6 CASE #1 C-5
Beginning $9,000,000 $40,585,200 $43,257,205 $46,105,394
The book value of the equipment is the original cost minus the accumulated depreciation. The book
value of equipment each year will be:
Year 1 Year 2 Year 3 Year 4
Since the market value of the equipment is $54 million, the equipment is sold at a gain to book
value, so the sale will incur the taxes of:
And the aftertax salvage value of the equipment is:
So, the net cash flows each year, including the operating cash flow, net working capital, and aftertax
salvage value, are:
Time Cash flow
0 –$169,000,000
1 22,090,000
So, the payback period for the project is:
Payback period = 3 + $18,722,959 / $180,683,545
Payback period = 3.10 years
The discounted cash flows are:
Time Discounted cash flow
0 –$169,000,000
The required return for the project is in nominal terms, so the profitability index is:
CHAPTER 6 CASE #1 C-6
Profitability index = ($22,090,000/1.134 + $61,273,803/1.1342 + $66,913,238/1.1343 +
$180,683,545/1.1344) / $169,000,000
Using a spreadsheet or financial calculator, the IRR for the project is:
IRR = 24.04%
In the final analysis, the company should accept the project since the NPV is positive.