Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
11-14 a. Cost of new machine ($775,000)
b. Recovery Depreciable Depreciation Depreciation Change in
1 2 3 4 5
Old depreciation 90,000 90,000 90,000 90,000 90,000
Old tax shield 31,500 31,500 31,500 31,500 31,500
shield
c. CFt = (Operating expenses)(1 – T) + (Depreciation)(T).
0 1 2 3 4 5
After tax cost savings 120,250 120,250 120,250 120,250 120,250
*The salvage value of the new machine is calculated as: Book value = 7.41%(775,000) =
d. A time line of the cash flows looks like this:
012345
||||||
Since the NPV is positive, the project should be accepted. To buy the new machine
e. 1. If the expected life of the old machine decreases, the new machine will look better
as cash flows attributable to the new machine would increase. On the other hand, a
Answers and Solutions: 11 - 1
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
12%
2. The higher capital cost should be used in the analysis.
11-15 a. Expected annual cash flows:
Project A: Probable
Probability Cash Flow = Cash Flow
Project B: Probable
Probability Cash Flow = Cash Flow
Coefficient of variation:
CV =
NPV Expected
=
valueExpected
deviation Standard
NPV
Project A:
σA =
$474.34. = (0.2)
)
($750 + (0.6)
)
($0 + (0.2)
)
(-$750 222
Project B:
σB=
(0.2)
)
($10,350 + (0.6)
)
(-$900 + (0.2)
)
(-$7,650 222
= $5,797.84.
CVA = $474.34/$6,750 = 0.0703.
CVB = $5,797.84/$7,650 = 0.7579.
Answers and Solutions: 11 - 2
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
b. Project B is the riskier project because it has the greater variability in its probable
Project B: With a financial calculator, input the appropriate cash flows into the cash
c. The portfolio effects from Project B would tend to make it less risky than otherwise.
11-16 a. First, note that with symmetric probability distributions, the middle value of each
distribution is the expected value. Therefore,
Expected Values
Sales (units) 200
Sales price $13,500
in the problem.
0 =
8
1t t
)IRR1(
000,900$
- $4,000,000.
Using a financial calculator, input the following: CF0 = -4000000, CF1 = 900000, and
Nj = 8, to solve for IRR = 15.29%.
Expected IRR = 15.29% ≈ 15.3%.
Answers and Solutions: 11 - 3
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
Assuming complete independence between the distributions, and normality, it would
b. Using a financial calculator, input the following: CF0 = -4000000, CF1 = 900000, Nj
c. (1) a. Calculate developmental costs. The 44 random number value, coming
(2) a. Estimate unit sales. The 16 indicates sales of 100 units.
(3) Repeat the process for Year 2. Sales will be 200 with a random number of 79;
(4) Repeat the process for Year 3. Sales will be 100 units with a random number of
(5) a. 0 =
321
)IRR1(
000,510$
)IRR1(
000,780$
)IRR1(
000,510$
- $4,000,000
IRR = -31.55%.
Answers and Solutions: 11 - 4
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
Alternatively, with a financial calculator, input the following: CF0 =
b. NPV =
321
)15.1(
000,510$
)15.1(
000,780$
)15.1(
000,510$
- $4,000,000.
With a financial calculator, input the following: CF0 = -4000000, CF1 =
510000, CF2 = 780000, CF3 = 510000, and I/YR = 15 to solve for NPV =
-$2,631,396.40.
The results of this run are very bad because the project’s life is so
Answers and Solutions: 11 - 5
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
(6) & (7) The computer would store NPVs and IRRs for the different trials, then
display them as frequency distributions:
Probability
of occurrence
X
Probability
of occurrence
X
XX
The distribution would be reasonably symmetrical because all the input
data were from symmetrical distributions. One often finds, however, that
Answers and Solutions: 11 - 6
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
11-17 a. The resulting decision tree is:
NPV
t = 0 t = 1 t = 2 t = 3 P NPV Product
The NPV of the top path is:
3
)12.1(
000,000,3$
-
2
)12.1(
000,000,1$
-
1
)12.1(
000,500$
- $10,000 = $881,718.
Using a financial calculator, input the following: CF0 = -10000,
CF
3
Answers and Solutions: 11 - 7
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
CVNPV =
779,117$
060,445$
= 3.78.
Since the CV is 3.78 for this project, while the firm’s average project has a CV of 1.0 to
2.0, this project is of high risk.
SOLUTION TO SPREADSHEET PROBLEM
11-18 The detailed solution for the problem is available in the file Ch 11 P18 Build a Model
Solution.xlsx at the textbook’s Web site.
Answers and Solutions: 11 - 8
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
MINI CASE
Shrieves Casting Company is considering adding a new line to its product mix, and the
capital budgeting analysis is being conducted by Sidney Johnson, a recently graduated MBA.
The production line would be set up in unused space in Shrieves’ main plant. The
machinery’s invoice price would be approximately $200,000, another $10,000 in shipping
charges would be required, and it would cost an additional $30,000 to install the equipment.
The machinery has an economic life of 4 years, and Shrieves has obtained a special tax ruling
that places the equipment in the MACRS 3-year class. The machinery is expected to have a
salvage value of $25,000 after 4 years of use.
The new line would generate incremental sales of 1,250 units per year for 4 years at an
incremental cost of $100 per unit in the first year, excluding depreciation. Each unit can be
sold for $200 in the first year. The sales price and cost are both expected to increase by 3%
per year due to inflation. Further, to handle the new line, the firm’s net working capital
would have to increase by an amount equal to 12% of sales revenues. The firm’s tax rate is
40%, and its overall weighted average cost of capital, which is the risk-adjusted cost of
capital for an average project (r), is 10%.
a. Define “incremental cash flow.”
a. 1. Should you subtract interest expense or dividends when calculating project cash
flow?
Answer: The cash flow statement should not include interest expense or dividends. The return
required by the investors furnishing the capital is already accounted for when we
a. 2. Suppose the firm had spent $100,000 last year to rehabilitate the production line
site. Should this cost be included in the analysis? Explain.
Answers and Solutions: 11 - 9
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
a. 3. Now assume that the plant space could be leased out to another firm at $25,000
per year. Should this be included in the analysis? If so, how?
Answer: If the plant space could be leased out to another firm, then if Shrieves accepts this
project, it would forgo the opportunity to receive $25,000 in annual cash flows. This
a. 4. Finally, assume that the new product line is expected to decrease sales of the firm’s
other lines by $50,000 per year. Should this be considered in the analysis? If so,
how?
Answer: If a project affects the cash flows of another project, this is an “externality” that must be
considered in the analysis. If the firm's sales would be reduced by $50,000, then the net
Answers and Solutions: 11 - 10
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
