978-1305632295 Chapter 11 Solution Manual Part 3

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

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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

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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

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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

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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

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(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

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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

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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

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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

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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

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