Chapter 13

Capital Budgeting: Estimating Cash Flow

and Analyzing Risk
ANSWERS TO END-OF-CHAPTER QUESTIONS
13-3

Since the cost of capital includes a premium for expected inflation, failure to adjust cash
flows means that the denominator, but not the numerator, rises with inflation, and this
lowers the calculated NPV.

13-4

Capital budgeting analysis should only include those cash flows which will be affected by
the decision. Sunk costs are unrecoverable and cannot be changed, so they have no bearing
on the capital budgeting decision. Opportunity costs represent the cash flows the firm gives
up by investing in this project rather than its next best alternative, and externalities are the
cash flows (both positive and negative) to other projects that result from the firm taking on
this project. These cash flows occur only because the firm took on the capital budgeting
project; therefore, they must be included in the analysis.

13-5

When a firm takes on a new capital budgeting project, it typically must increase its
investment in receivables and inventories, over and above the increase in payables and
accruals, thus increasing its net operating working capital. Since this increase must be
financed, it is included as an outflow in Year 0 of the analysis. At the end of the projects
life, inventories are depleted and receivables are collected. Thus, there is a decrease in
NOWC, which is treated as an inflow.

13-6

Scenario analysis analyzes a limited number of outcomes. Although the base case scenario
may be the most likely, or expected outcome, the bad and good scenarios are frequently
worst case and best case scenarios, that is, when everything goes bad together, or
everything goes right together. It is unlikely that everything will go wrong all at once, or
everything will go right all at once and so scenario analysis can tend to overestimate the
riskiness of a project. Simulation analysis, on the other hand, allows the variables being
simulated to either vary together or independently, as the modeler sees fit. With enough
runs of the simulation, this procedure should provide a reasonably accurate description of
the possible outcomes. Note, however, that if the project is big and its failure could threaten
the viability of the firm, then evaluating a worst case scenario may very well be important!
A simulation may only identify that worst case outcome infrequently and with a scenario
analysis you can specify the worst case and see if it drags the company down.

13-7

The costs associated with financing are reflected in the weighted average cost of capital.
To include interest expense in the capital budgeting analysis would double count the
cost of debt financing.

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

13-1

a. Equipment
NWC Investment
Initial investment outlay

$ 17,000,000
5,000,000
$22,000,000

b. No, last years $150,000 expenditure is considered a sunk cost and does not represent
an incremental cash flow. Hence, it should not be included in the analysis.
c. The potential sale of the building represents an opportunity cost of conducting the project in
that building. Therefore, the possible after-tax sale price must be charged against the
project as a cost.
13-2

13-3

Operating Cash Flows: t = 1

Sales revenues
Operating costs
Depreciation
Operating income before taxes
Taxes (40%)
Operating income after taxes
Add back depreciation
Operating cash flow

$18,000,000
9,000,000
4,000,000
$ 5,000,000
2,000,000
$ 3,000,000
4,000,000
$ 7,000,000

Equipment's original cost

Depreciation (80%)
Book value

$12,000,000
9,000,000
$ 3,000,000

Gain on sale = $4,000,000 - $3,000,000 = $1,000,000.

Tax on gain = $1,000,000(0.4) = $400,000.
AT net salvage value = $4,000,000 - $400,000 = $3,600,000.
13-4

Cash outflow = $40,000.

Increase in annual after-tax cash flows: CF = $9,000.
Place the cash flows on a time line:
0
1
10%
|
|
-110,000
19,000

2
|
19,000

10
|
19,000

With a financial calculator, input the appropriate cash flows into the cash flow register,
input I/YR = 10, and then solve for NPV = $6,746.78. Thus, Chen should purchase the
new machine.

13-5

a. The applicable depreciation values are as follows for the two scenarios:
Year
1
2
3
4

Scenario 1
(Straight Line)
$425,000
425,000
425,000
425,000

Scenario 2
(MACRS)
$566,610
755,650
251,770
125,970

b. To find the difference in net present values under these two methods, we must
determine the difference in incremental cash flows each method provides. The
depreciation expenses cannot simply be subtracted from each other, as there are tax
ramifications due to depreciation expense. The full depreciation expense is subtracted
from Revenues to get operating income, and then taxes due are computed Then,
depreciation is added to after-tax operating income to obtain the projects operating
cash flow. Therefore, if the tax rate is 40%, only 60% of the depreciation expense is
actually subtracted out during the after-tax operating income calculation and the full
depreciation expense is added back to calculate operating income. So, there is a tax
benefit associated with the depreciation expense that amounts to 40% of the
depreciation expense. Therefore, the differences between depreciation expenses under
each scenario should be computed and multiplied by 0.4 to determine the benefit
provided by the depreciation expense.

Year
1
2
3
4

Depreciation Expense
Difference (2 1)
$141,610
330,650
-173,230
-299,030

Depreciation Expense
Diff. 0.4 (MACRS)
$56,644
132,260
-69,292
-119,612

Now to find the difference in NPV to be generated under these scenarios, just enter the
cash flows that represent the benefit from depreciation expense and solve for net
present value based upon a WACC of 10%.
CF0 = 0; CF1 = 56644; CF2 = 132260; CF3 = -69292; CF4 = -119612; and I/YR = 10.
Solve for NPV = $27,043.62
So, all else equal the use of the accelerated depreciation method will result in a higher
NPV (by $27,043.62) than would the use of a straight-line depreciation method.
c. If Wendys boss has a bonus plan that depends on net income instead of cash flow, then
he will make a larger bonus in the first 2 years of the project if they use straight line
depreciation, and a smaller bonus in the last two years. This is despite the fact that
accelerated depreciation is better economically for the firm. The fault lies in the bonus
plan. Paying managers a bonus based on net income can lead to decisions that are not in
the best interest of the companys shareholders, like this one.
13-6

a. The net cost is $1,118,000:

Price
($1,080,000)
Modification
(22,500)
Increase in NWC
(15,500)
Cash outlay for new machine ($1,118,000)
b. The operating cash flows follow:
1. After-tax savings
2. Depreciation tax savings
Net cash flow

Year 1
Year 2 Year 3
$247,000 $247,000 $28,600
128,612 171,521 57,148
$375,612 $418,512 $304,148

Notes:
1. The after-tax cost savings is $380,000(1 - T) = $380,000(0.65)
= $247,000
2. The depreciation expense in each year is the depreciable basis, $1,102,500, times
the MACRS allowance percentages of 0.3333, 0.4445, and 0.1481 for Years 1, 2,
and 3, respectively. Depreciation expense in Years 1, 2, and 3 is $367,463,

$490,061, and $163,280. The depreciation tax savings is calculated as the tax rate
(35%) times the depreciation expense in each year.
c. The terminal year cash flow is $473,343:
Salvage value
Tax on SV*
Return of NWC

$605,000
(183,157)
15,500
$437,343

BV in Year 4 = $1,102,500(0.0741) = $81,695.

*Tax on SV = ($605,000 - $81,695)(0.35) = $183,157.
d. The project has an NPV of $78,790; thus, it should be accepted.
Year Net Cash Flow PV @ 12%
0 ($1,118,000)
($1,118,000)
1
375,612
335,368
2
418,512
333,643
3
741,491
527,779
NPV =
$ 78,790
Alternatively, with a financial calculator, input the appropriate cash flows into the
cash flow register, input I/YR = 12, and then solve for NPV = $78,790.
13-7

a. The net cost is $89,000:

Price
Modification
Change in NWC

($70,000)
(15,000)
(4,000)
($89,000)

b. The operating cash flows follow:

Year 1 Year 2 Year 3
After-tax savings $15,000 $15,000 $15,000
Depreciation shield 11,332 15,113
5,035
Net cash flow
$26,332 $30,113 $20,035
Notes:
1. The after-tax cost savings is $25,000(1 T) = $25,000(0.6)
= $15,000.
2. The depreciation expense in each year is the depreciable basis, $85,000, times the
MACRS allowance percentage of 0.3333, 0.4445, and 0.1481 for Years 1, 2 and
3, respectively. Depreciation expense in Years 1, 2, and 3 is $28,331, $37,783,
and $12.589. The depreciation shield is calculated as the tax rate (40%) times the
depreciation expense in each year.
c. The additional end-of-project cash flow is $24,519:
Salvage value
Tax on SV*
Return of NWC

$30,000
(9,481)
4,000
$24,519

*Tax on SV = ($30,000 - $6,299)(0.4) = $9,481.

Note that the remaining BV in Year 4 = $85,000(0.0741) = $6299.
d. The project has an NPV of -$6,700. Thus, it should not be accepted.
Year
0
1
2
3

Net Cash Flow

($89,000)
26,332
30,113
44,555

With a financial calculator, input the following: CF0 = -89000, CF1 = 26332, CF2 =
30113, CF3 = 44555, and I/YR = 10 to solve for NPV = -$6,700.18.

13-8

a. Sales = 1,000($138)
Cost = 1,000($105)
Net before tax
Taxes (34%)
Net after tax

$138,000
105,000
$ 33,000
11,220
$ 21,780

Not considering inflation, NPV is -$4,800. This value is calculated as

-$150,000 +

$21,780
= -$4,800.
0.15

Considering inflation, the real cost of capital is calculated as follows:

(1 + rr)(1 + i) = 1.15
(1 + rr)(1.06) = 1.15
rr = 0.0849057.
Thus, the NPV considering inflation is calculated as
-$150,000 +

$21,780
= $106,520.
0.0849057

After adjusting for expected inflation, we see that the project has a positive NPV and
should be accepted. This demonstrates the bias that inflation can induce into the
capital budgeting process: Inflation is already reflected in the denominator (the cost
of capital), so it must also be reflected in the numerator.
A more straightforward way to calculate the present value without having to calculate
a real required rate of return is to use the constant growth formula, instead. Here, the
present value of all of the future cash flows is:
CF0 1 g 21,780 1.06
256,520
rg
.15.06
so the NPV = 256,520 150,000 = 106,520, which is the same answer wed have
gotten above if in calculating the real required rate of return we had used enough
decimal places.
PV0

b. If part of the costs were fixed, and hence did not rise with inflation, then sales
revenues would rise faster than total costs. However, when the plant wears out and
must be replaced, inflation will cause the replacement cost to jump, necessitating a
sharp output price increase to cover the now higher depreciation charges. Note that if
you wanted to value this perpetuity with a fixed component and a growing
component, the total cash flows would no longer grow at a constant rate and so the
constant growth formula couldnt be used as we did in part (a). Instead, you would
need to either calculate a real required rate of return, as we did in the first part of the
solution to (a), or better, split the cash flows into two parts: a growing part that grows
at 6% and a non-growing part. Use the constant growth formula on the growing part
with g = 6%, and use the constant growth formula on the non-growing part with g =
0%.
13-11 E(NPV) = 0.05(-$70) + 0.20(-$25) + 0.50($12) + 0.20($20) + 0.05($30)
= -$3.5 + -$5.0 + $6.0 + $4.0 + $1.5
= $3.0 million.
NPV= [0.05(-$70 - $3)2 + 0.20(-$25 - $3)2 + 0.50($12 - $3)2
+ 0.20($20 - $3)2 + 0.05($30 - $3)2]0.5
= $23.622 million.
CVNPV =

$23.622
= 7.874.
$3.0