CHAPTER 8
CAPITAL BUDGETING AND CASH FLOW
ANALYSIS
ANSWERS TO QUESTIONS:
1. a . Personnel managers -- the value of insurance programs and pension plans can be evaluated
using discounted cash flow techniques.
b. Research and development staffs -- investments in new product research and product
improvement research, having benefits that accrue over several years, can be evaluated using
the methodology of capital budgeting.
c. Advertising executives -- advertising campaigns normally generate benefits (increased sales)
that extend over several years. Hence investments in these campaigns can be evaluated using
capital budgeting methodology.
2. Mutually exclusive projects -- the acceptance of one precludes the acceptance of another, e.g., the
decision to buy one model of drillpress over a competing model.
Independent projects -- the acceptance of one project neither precludes the acceptance of another
nor requires the acceptance of another, e.g., the decision to buy a replacement truck for deliveries
is independent of the decision to buy a new data processing system.
Contingent projects -- the acceptance of one project requires ( is contingent upon) the acceptance
of another project, e.g., the decision to build additional brewery capacity may be contingent on the
decision to expand the company's marketing and distribution area.
3. Capital rationing is normally not consistent with shareholder wealth maximization, because some
potentially profitable projects (projects offering an expected return greater than the required
return) may not be undertaken.
4. The primary types of investment projects are projects generated by growth opportunities, projects
generated by cost-reduction opportunities, and legally mandated projects. In all cases the
appropriate framework for analysis is to compare the discounted benefits of the project with the
project's cost. If benefits exceed costs, then the project should be undertaken. Normally growth
opportunity projects will be riskier than cost-reduction projects, and hence a differential risk
analysis approach should be used.
5. The objective of capital budgeting analysis is to estimate the total change in the firm's cash flows
that result because a project is undertaken. Hence indirect effects on the costs and/or revenues
associated with a firm's other projects that occur as a result of the acceptance of a new project
101
102  CHAPTER 8/CAPITAL BUDGETING AND CASH FLOW ANALYSIS
should be considered when evaluating the cash flows from a new project.
6. The factors that should be considered when estimating a project's net investment include the new
project cost plus shipping and installation charges, required increases in working capital at
project inception, the net proceeds from the sale of old assets (in the case of replacement
decisions) and the taxes associated with the sale of the old asset and/or the purchase of the new
one.
7. Although depreciation itself is a noncash charge, it has the effect of reducing taxable net income
and hence reducing income taxes, which are a cash outflow. The effect of depreciation on cash
flows is equal to the amount of the depreciation times the firm's marginal tax rate.
8. If the old asset is sold for its book value there are no tax consequences. If the asset is sold for less
than book value, the difference may be charged as a loss against ordinary income. If the asset is
sold for more than book value but less than original cost, the difference is treated as ordinary
income and taxed at the ordinary tax rate. If an asset is sold for more than original cost, the
difference between book value and original cost is taxed as ordinary income and the difference
between the sale price of the asset and its original cost is taxed as a capital gain. Under current
tax laws the tax rate on capital gains is the same as the tax rate on ordinary income for most large
U.S. corporations.
9. Interest charges are considered in the discounting process of capital budgeting analysis. Hence to
consider their cash flow impact on a project would lead to double counting. Also, it is generally
incorrect to associate a particular method of financing with the investment decision for a project.
10. An asset expansion project requires a firm to invest funds in additional assets in order to increase
sales or reduce costs. Asset expansion projects frequently require a significant, incremental
investment in net working capital by the firm. Expansion projects are often more risky than
replacement investments because the revenues the project may generate are more uncertain.
Asset replacement investments involve the retiring of one asset and the replacement of that asset
with a more efficient one. Replacement investments usually do not require significant,
incremental net working capital investments.
11. The opportunity cost concept is considered in the capital budgeting process primarily through the
use of the appropriate required return used to evaluate a project. This required return (the riskadjusted discount rate) considers the returns (opportunities) that are available on other projects of
equivalent risk.
CHAPTER 8/CAPITAL BUDGETING AND CASH FLOW ANALYSIS  103
SOLUTIONS TO PROBLEMS:
1. a. After tax operating cash flow (assuming straight-line depreciation):
Revenues
$200.0 MM
Total operating expenses
$130.0 MM
Depreciation
$15.0 MM
Operating earnings before tax
$55.0 MM
Tax @ 40%
22.0 MM
Operating earnings after tax
$33.0 MM
Depreciation
$15.0 MM
After tax operating cash flow
$48.0 MM
After tax operating cash flow (assuming accelerated depreciation):
Revenues
$200.0 MM
Total operating expenses
Depreciation
$25.0 MM
Operating earnings before tax $45.0 MM
Tax @ 40 %
18.0 MM
Operating earnings after tax
$27.0 MM
Depreciation
$130.0 MM
$25.0 MM
After tax operating cash flow $52.0 MM
b. The income statement reported to the stockholders will be the same as the cash flow statement
shown in part (a) above under the straight-line depreciation assumption, except that the
income statement ends with the item "Operating earnings after tax" of $33 million. The after
tax operating cash flow is affected by the tax depreciation charged by the firm, not the book
depreciation. In this case tax depreciation is accelerated, hence the after tax operating cash
flow is $52 million. The income statement of the firm would show $18 million of current
income tax expense and $4 million of deferred income tax expense.
104  CHAPTER 8/CAPITAL BUDGETING AND CASH FLOW ANALYSIS
2. Annual depreciation amount = Installed cost / Number of years over which the asset is
depreciated
= ($50,000 + $1,000) / 10
= $5,100
3. a. Projects A,B D,E, and G should be adopted because they offer returns which equal or exceed
the acceptability criterion.
b. A capital budgeting funds constraint could eliminate some of the less promising projects, such
as D and E, depending on the level of funds available. Projects would be eliminated in reverse
order of profitability in order to meet the constraint.
c. If these projects differed with respect to risk, the expected project return would have to be
compared to the risk-adjusted required rate of return - which could be above or below 10%.
4. a. NINV = $100,000 + $2,500 + $20,000
= $122,500
b. Annual depreciation = $102,500/8
= $12,812.50
5. Net investment = $100,000 (There are no tax consequences assumed to be associated with this
purchase.)
Annual net cash flow:
Annual depreciation = $100,000/12 = $8,333
NCF = (_R - _O - _Dep)(1 - T) + _Dep
NCF = [$0 - (-$15,000) - $8,333](1 - 0.4) + $8,333 = $12,333
CHAPTER 8/CAPITAL BUDGETING AND CASH FLOW ANALYSIS  105
6. a.
Year
Cash Outlay
PVIF0.12,t
Present Value of Cash Outlays
0
$4,000,000
1.000
$4,000,000
1
2,000,000
0.893
1,786,000
2
500,000
0.797
398,500
$6,184,500
b. $6,500,000
7. Net investment: $1,200,000
Net cash flows: (in thousands of dollars)
Years
R
-_O
-_Dep
_OEBT
-T
_OEAT
NCF
1-10
$400
$200
$120
$80
$32
$48
$168
8. Net investment calculation:
Installed cost
Plus: Net working capital increase
Less: Proceeds from sale of old assets
$600,000
20,000
-250,000
Plus: Tax on sale of machine 1
($100,000 - $95,000) x .40
2,000
Plus: Tax on sale of machine 2
($150,000 - $75,000) x .40
Net Investment
30,000
$402,000
106  CHAPTER 8/CAPITAL BUDGETING AND CASH FLOW ANALYSIS
9. a. Sale for $15,000:
Current book value of asset = $15,000 ($30,000 original cost less 5 years of depreciation at
$3,000 per year). Hence the sale of the old machine for $15,000 (book value) has no tax
consequences.
b. Sale for $5,000:
Tax loss on sale: $15,000 - $5,000 = $10,000
Tax saving on tax loss: .4($10,000) = $4,000
c. Sale for $26,000:
Recapture of depreciation: $26,000 - $15,000 = $11,000
Tax on depreciation recapture: .4($11,000) = $4,400
d. Sale for $32,000:
Recapture of depreciation: $30,000 - $15,000 = $15,000
Tax on depreciation recapture: .4($15,000) = $6,000
Capital gain on sale: $32,000 - $30,000 = $2,000
Capital gains tax: .40($2,000) = $800
10. Calculation of net investment:
Installed cost of new computer
$160,000
Less: Proceeds from sale of old computer
20,000
Plus: Tax on sale of old computer (.4)($20,000)
Net investment
8,000
$148,000
Net cash flows:
Depreciation computed on basis of installed cost ($160,000).
Year
R
-O
-Dep
OEBT
-T
1-10
$32,000
-$2,000
$16,000
$18,000
$7,200 $10,800
OEAT
NCF
$26,800
CHAPTER 8/CAPITAL BUDGETING AND CASH FLOW ANALYSIS  107
11. Installed cost of ACE generator:
Cost
$250,000 Delivery and installation
50,000 Installed cost $300,000
Depreciation computed based on installed cost ($300,000).
Current book value of generator: $300,000 less first two years of depreciation = $300,000 $60,000 - $60,000 = $180,000
Tax loss on sale of generator: $180,000 book value less actual salvage proceeds of $79,550 =
$100,450
Tax saving on loss from sale of generator = .4($100,450) = $40,180
After-tax proceeds from sale:
Actual sales proceeds
$79,550
Plus: Tax saving on loss from sale
40,180
Plus: Recovery of working capital
25,000
$144,730
12. a
Net investment calculation:
Installed cost of equipment, etc
Plus: Net working capital
Net investment
$200,000
200,000
$400,000
108  CHAPTER 8/CAPITAL BUDGETING AND CASH FLOW ANALYSIS
b. Net cash flows:
Depreciation is computed on the basis of installed cost = $200,000
Year R
-O
-Dep
OEBT
-Tax
OEAT
NCF
1
$1,000,000 $700,000 $40,000 $260,000
$104,000 $156,000
$196,000
2
1,080,000
749,000
40,000
291,000
116,400
174,600
214,600
3
1,166,400
801,430
40,000
324,970
129,988
194,982
234,982
4
1,259,712
857,530
40,000
362,182
144,873
217,309
257,309
5
1,360,489
917,557
40,000
402,932
161,173
241,759
281,759
6
1,469,328
981,786
0
487,542
195,017
292,525
292,525
7
1,586,874
1,050,511 0
536,363
214,545
321,818
321,818
8
1,713,824
1,124,047 0
589,777
235,911
353,866
353,866
9
1,850,930
1,202,730 0
648,200
259,280
388,920
388,920
10 1,999,005
1,286,921 0
712,084
284,834
427,250
427,250*
* In addition to these operating cash flows, year 10 NCFs are increased by after-tax proceeds from
the salvage of equipment and fixtures of $6,000 and the recovery of the $200,000 net working
capital investment. This yields total NCF for year 10 of $633,250.
CHAPTER 8/CAPITAL BUDGETING AND CASH FLOW ANALYSIS  109
13. Net investment = $100,000
Net cash flows:
Year
R
-O
-D
OEBT
-T
OEAT NCF
1
0
-$15,000
$14,290
$710
$284
$426
2
0
-15,000
24,490
-9,490
-3,796 -5,694
18,796
3
0
-15,000
17,490
-2,490
-996
-1,494
15,996
4
0
-15,000
12,490
2,510
1,004
1,506
13,996
5
0
-15,000
8,930
6,070
2,428
3,642
12,572
6
0
-15,000
8,920
6,080
2,432
3,648
12,568
7
0
-15,000
8,930
6,070
2,428
3,642
12,572
8
0
-15,000
4,460
10,540
4,216
6,324
10,784
9
0
-15,000
0
15,000
6,000
9,000
9,000
10
0
-15,000
0
15,000
6,000
9,000
9,000
11
0
-15,000
0
15,000
6,000
9,000
9,000
12
0
-15,000
0
15,000
6,000
9,000
9,000
14. Calculation of net investment:
Installed cost of new computer
Less: Proceeds from sale of old computer
Plus: Tax on sale of old computer (.4)($20,000)
Net investment
$160,000
20,000
8,000
$148,000
$14,716
110  CHAPTER 8/CAPITAL BUDGETING AND CASH FLOW ANALYSIS
Net cash flows:
Depreciation computed on basis of installed cost ($160,000).
Year
R
-O
-D
OEBT
-T
1
$32,000
-$2,000
$22,864
$11,136
$4,454.4 $6,681.6
$29,545.6
2
32,000
-2,000
39,184
-5,184
-2,073.6 -3,110.4
36,073.6
3
32,000
-2,000
27,984
6,016
2,406.4 3,609.6
31,593.6
4
32,000
-2,000
19,984
14,016
5,606.4 8,409.6
28,393.6
5
32,000
-2,000
14,288
19,712
7,884.8 11,827.2
26,115.2
6
32,000
-2,000
14,272
19,728
7,891.2 11,836.8
26,108.8
7
32,000
-2,000
14,288
19,712
7,884.8 11,827.2
26,115.2
8
32,000
-2,000
7,136
26,864
10,745.6 16,118.4
23,254.4
9
32,000
-2,000
0
34,000
13,600 20,400
20,400
10
32,000
-2,000
0
34,000
13,600 20,400
20,400
15. Net investment:
Land
$100,000
Building
100,000
Equipment
250,000
Installation
40,000
Shipping
10,000
Year 0 Net working capital
70,000
Equals: NINV
$570,000
Year 20 NCF:
EBIT*
Less: Tax
OEAT
$210,700
84,280
126,420
OEAT
NCF
CHAPTER 8/CAPITAL BUDGETING AND CASH FLOW ANALYSIS  111
Plus: Depreciation (building)
5,000
Plus: Recovery of net working capital**
150,000
Plus: After-tax land salvage ***
160,000
Plus: After-tax building salvage ****
90,000
Equals: Net Cash Flow
$531,420
* $100,000(FVIF.04,19)
** Sum of year 0, 1, and 2 working capital requirements
*** $100,000 tax free plus $100,000 capital gain taxed at 40%
**** $100,000 recapture of depreciation plus $50,000 capital gain, both taxed at 40%.
16. Net investment:
Cost of store
$7,000,000
Cost of fixtures
700,000
Installation of fixtures
50,000
Present land value
500,000
Initial working capital
600,000
Net investment
$8,850,000
17. Net investment = Machine cost + Initial working capital
= $1,000,000 + $50,000 = $1,050,000
MACRS Depreciation:
Year 1 $1,000,000 x 14.29% = $142,900
NCF1 = (R - O - Dep)(1 - T) + Dep - NWC
= [($300,000 - $25,000) - ($50,000 - $5,000)
- $142,900] (1 - 0.4) + $142,900 - $25,000
112  CHAPTER 8/CAPITAL BUDGETING AND CASH FLOW ANALYSIS
= $170,160
NCF10 = (R - O - Dep)(1 - T) + Dep - NWC
+ Salvage value (1 - T)
= [($300,000 - $25,000) - ($50,000 - $5,000) - $0](1 - 0.4)
+ $0 -(-$85,000) + $50,000 (1 - 0.4)
= $253,000
18. NCF10 = (R - O - Dep)(1 - T) + Dep - NWC
+ after-tax cash flow from sale of assets
= [$700,000 - $200,000 - $0] (1 - 0.4) + $0
- (-$400,000) + [$1,800,000
- ($1,800,000 - $1,000,000) (0.4)]
+ ($1,000,000) (1 - 0.4)
= $2,780,000
19. Net investment = $900,000 + $100,000 = $1,000,000
MACRS Depreciation:
Year 1 $1,000,000 x 14.29% = $142,900
Year 2 $1,000,000 x 24.49% = $244,900
NCF = (R - O - Dep) (1 - T) + Dep - NWC
NCF1 = ($0 - $300,000 - $142,900) (1 - 0.4) + $142,900 = -$122,840
NCF2 = ($800,000 - $300,000 - $244,900) (1 - 0.4) + $244,900 - $50,000
= $347,960
20. NCF10 = (R - O - Dep) (1 - T) + Dep - NWC + AT Salvage
= ($225,000 - $170,000 - 0)(1 - 0.4) + 0 - ($-85,000)
CHAPTER 8/CAPITAL BUDGETING AND CASH FLOW ANALYSIS  113
+ $50,000 (1 - 0.4)
= $148,000
21. After-tax operating cash flow
= (R - O - Dep) (1 - T) + Dep - NWC
= ($50 million - $25 million - $10 million)(1 - 0.34)
+ $10 million - ($5 million - $2 million)
= $16.9 million
22. Net working capital investments = $5,000 + $3,000 + $2,000 = $10,000
Book value at the beginning of year 8 = $100,000 (0.0446) = $4,460
Year 7 revenues = $25,000(FVIF.05,5)(0.9) = $25,000(1.276)(0.9) = $28,710
Year 7 cash costs = $10,000 (FVIF.10,6) = $10,000(1.772) = $17,720
Year 7 depreciation = $100,000(0.0893) = $8,930
NCF7 = ($28,710 - $17,720 - $8,930)(1 - 0.4) + $8,930 + $10,000 + [$4,460 + ($10,000 $4,460)(1 - 0.4)] = $27,950
23. Year 3 NCF:
Revenues
$2,420,000
Less: Operating expenses
898,880
Less: Depreciation
150,000
Equals: Operating income before tax
Less: Tax @ 40 percent rate
Equals: Operating income after tax
$1,371,120
548,448
$ 822,672
Add back: Depreciation
150,000
Less: Increase in net working capital
85,000
114  CHAPTER 8/CAPITAL BUDGETING AND CASH FLOW ANALYSIS
Equals: Net cast flow in year 3
$887,672