Chapter Eight

Investment decision rules

Answers to Problems
Evaluating projects with different lives

28. Utopia Tours is choosing between two bus models. One is more expensive to
purchase and maintain, but lasts much longer than the other. Its discount
rate is 11%. It plans to continue with one of the two models for the
foreseeable future. Based on the costs of each model shown below, which
one should it choose?

Plan: Compute the NPV and the EAA of each bus. Choose the bus with the lowest costs.

Execute: The timeline of the investment opportunity is:

0 1 2 3 4 5 6 7

Old Reliable: –200 –4 –4 –4 –4 –4 –4 –4

Short and Sweet: –100 –2 –2 –2 –2
4, 000  1 
NPVOld Reliable  200, 000   1  $218, 849
0.11  1.117 
EAA Old Reliable  1 
218, 849  1  1.117   EAA Old Reliable  $46, 443
0.11  
2, 000  1 
NPV Short and Sweet  100, 000  1  $106,205
0.11  1.114 
EAA Short and Sweet  1 
106,205   1  EAA Short and Sweet  $34,233
0.11  1.114 

Evaluate: The annual cost of the Short and Sweet bus is less, so they should buy this bus.

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Corporate Finance/3e
29. Hassle-Free Web is bidding to provide web-page hosting services for Hotel
Lisbon. Hotel Lisbon pays its current provider $10 000 per year for hosting its
web page and handling transactions on it, etc. HassleFree figures that it will
need to purchase equipment worth $15 000 up-front and then spend $2000
per year on monitoring, updates and bandwidth to provide the service for
three years. If Hassle-Free’s cost of capital is 10%, can it bid less than $10
000 per year to provide the service and still increase its value by doing so?

Plan: Compute the NPV and the EAA of this investment opportunity. Determine the lowest value
enhancing bid.

Execute: The timeline of the investment opportunity is:

0 1 2 3

–15 –2 –2 –2
2, 000  1 
NPV  15, 000   1  $19, 974
0.10  1.103 
EAA  1 
19, 974  1  EAA  $8, 032
0.10  1.103 

Evaluate: Hassle-free could bid as little as $8032 per year and increase its value.

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Corporate Finance/3e
Chapter Nine
Fundamentals of capital budgeting
Answers to Problems
Note: All problems in this chapter are available in MyLab Finance. An asterisk (*) indicates problems
with a higher level of difficulty.

Forecasting incremental earnings

1. Planet Enterprises is purchasing a $10 million machine. It will cost $50 000 to
transport and install the machine. The machine has a depreciable life of five years
and will have no salvage value. If Planet uses straight-line depreciation, what are the
depreciation expenses associated with this machine?
Plan: We can compute the total capitalisation of the machine by adding the total cost of
transporting and installing the machine to the initial cost of purchasing the machine, and this will
provide us with the total cost of the machine that we must appreciate over the 5 years of the
machine’s life. In order to compute the annual depreciation expense of the machine we can then
take the total capitalization of the machine and divide it by the depreciable life of the machine.
Execute:
Capitalisation of machine: $10,050,000
Annual depreciation expense: 10,050,000/5 = $2,010,000
Evaluate: Rather than expensing the $10,050,000 it costs to buy, ship and install the machine
in the year it was bought, accounting principles require you to depreciate the $10,050,000 over
the depreciable life of the equipment. Assuming the equipment has a 5-year depreciable life and
that we use the straight-line method, we would expense $10,050,000/5 = $2,010,000 per year
for five years. The idea is to match the cost of acquiring the machine to the timing of the revenues
it generates.

2. The machine in Problem 1 will generate incremental revenue of $4 million per year
along with incremental costs of $1.2 million per year. If Planet’s marginal tax rate is
30%, what are the incremental earnings associated with the new machine?
Plan: We need four items to calculate incremental earnings: (1) incremental revenues, (2)
incremental costs, (3) depreciation and (4) marginal tax rate.
Execute:
Incremental earnings = (Revenues – Costs – Depreciation)  (1 – tax rate)
= (4 – 1.2 – 2.01) × 1 – 0.30) = $553,000

Evaluate: These incremental earnings are an intermediate step on the way to calculating the
incremental cash flows that would form the basis of any analysis of the project. The cost of the
equipment does not affect earnings in the year it is purchased, but does so through the
depreciation expense in the following five years. Note that the depreciable life, which is based on
accounting rules, does not have to be the same as the economic life of the asset—the period
over which it will have value.

3. You are upgrading to better production equipment for your firm’s only product. The
new equipment will allow you to make more of your product in the same amount of

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Corporate Finance/3e
 time. Thus, you forecast that total sales will increase next year by 20% over the
current amount of 100 000 units. If your sales price is $20 per unit, what is the
incremental revenue next year from the upgrade?

Plan: We can compute the incremental revenues by taking the percentage increase in sales of
the 100,000 units multiplied by the $20 sales price per unit.

Execute: Incremental revenues = (0.20 × 100,000) × 20 = $400,000.

Evaluate: A new product typically has lower sales initially, as customers gradually become aware
of the product. Sales will then accelerate, plateau, and ultimately decline as the product nears
obsolescence or faces increased competition. Similarly, the average selling price of a product and
its cost of production will generally change over time. Prices and costs tend to rise with the
general level of inflation in the economy.

Determining incremental free cash flow

7. You have a depreciation expense of $500 000 and a tax rate of 30%. What is your
depreciation tax shield?

Plan: The depreciation tax shield is equal to the depreciation expense multiplied by the tax rate.

Execute:
Depreciation tax shield = Depreciation expense  Tax Rate
= $500,000  0.3= = $150,000

Evaluate: Each dollar of depreciation expense “shields” a dollar of income from tax. At a tax
rate of 30% on a dollar of income, the total reduction in your taxes is $150,000.

13. Oakdale Enterprises is deciding whether to expand its production facilities. Although
long-term cash flows are difficult to estimate, management has projected the
following cash flows for the first two years (in millions of dollars) (see MyLab Finance
for the data in Excel format):

The firm’s marginal corporate tax rate is 30%.

a. What are the incremental earnings for this project for years 1 and 2?

b. What are the free cash flows for this project for the first two years?

Plan: We need four items to calculate incremental earnings: (1) incremental revenues, (2)
incremental costs, (3) depreciation and (4) the marginal tax rate.

Earnings include non-cash charges, such as depreciation, but do not include the cost of capital
investment. To determine the project’s free cash flow from its incremental earnings, we must
adjust for these differences. We need to add back depreciation to the incremental earnings to
recognize the fact that we still have the cash flow associated with it.

Execute:

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Corporate Finance/3e
 Solution: Note—we have assumed any incremental cost of goods sold is included as part of
operating expenses.
a. Year 1 2
Incremental earnings forecast ($000s)
1 Sales 125.0 160.0
2 Operating expenses (40.0) (60.0)
3 Depreciation (25.0) (36.0)
4 EBIT 60.0 64.0
5 Income tax at 30% (18.0) (19.2)
6 Unlevered net profit 42.0 44.8

b. Free Cash Flow ($000s) 1 2

7 Plus: Depreciation 25.0 36.0
8 Less: Capital expenditures (30.0) (40.0)
9 Less: Increases in NWC (2.0) (8.0)
10 Free cash flow 35.0 32.8

Evaluate: These incremental earnings are an intermediate step on the way to calculating the
incremental cash flows that would form the basis of any analysis of the project. Earnings are an
accounting measure of the firm’s performance. They do not represent real profits, and a firm
needs cash. Thus, to evaluate a capital budgeting decision, we must determine its consequences
for the firm’s available cash.

Other effects on incremental free cash flows

22. Home Builder Supply, a retailer in the home improvement industry, currently
operates seven retail outlets in New South Wales. Management is contemplating
building an eighth retail store across town from its most successful retail outlet. The
company already owns the land for this store, which currently has an abandoned
warehouse located on it. Last month, the marketing department spent $10 000 on
market research to determine the extent of customer demand for the new store. Now
Home Builder Supply must decide whether to build and open the new store. Which of
the following should be included as part of the incremental earnings for the proposed
new retail store?

a. the original purchase price of the land where the store will be located;

b. the cost of demolishing the abandoned warehouse and clearing the land;

c. the loss of sales in the existing retail outlet, if customers who previously drove
across town to shop at the existing outlet become customers of the new store
instead;

d. the $10 000 in market research spent to evaluate customer demand;

e. construction costs for the new store;

f. the value of the land if sold;

g. interest expense on the debt borrowed to pay the construction costs.

a. No, this is a sunk cost and will not be included directly. (But see part (f) below.)
b. Yes, this is a cost of opening the new store.

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 c. Yes, this loss of sales at the existing store should be deducted from the sales at the new
store to determine the incremental increase in sales that opening the new store will generate
for HBS.
d. No, this is a sunk cost.
e. This is a capital expenditure associated with opening the new store. These costs will therefore
increase HBS’s depreciation expenses.
f. Yes, this is an opportunity cost of opening the new store. (By opening the new store, HBS
forgoes the after-tax proceeds it could have earned by selling the property. This loss is equal
to the sale price less the tax owed on the capital gain from the sale, which is the difference
between the sale price and the book value of the property. The book value equals the initial
cost of the property less accumulated depreciation.)
g. While these financing costs will affect HBS’s actual earnings, for capital budgeting purposes
we calculate the incremental earnings without including financing costs to determine the
project’s unlevered net profit.

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Corporate Finance/3e