SELF-TEST QUESTIONS

8.1 Capital budgeting for project X

Based on the following information for project X, should we undertake the venture? To
answer, use the three-step approach. Calculate the tax effect (the taxable income), the cash
flows and then the NPV created by undertaking the venture. All cash flows will need to be
identified and finally the total cash flow will be discounted at the appropriate rate of 20 per
cent. Use a 30 per cent tax rate throughout and assume that tax is paid in the year income
is earned. For help, look back at our earlier examples.

Project X is an up-market LCD television. We think we can sell 500 units per year at a
price of $10,000 each. Variable costs per television will be 70 per cent of revenue, and the
product should have a 4-year life before progress makes it dated. We required a 20 per
cent return on new products such as this one.

Fixed costs for the project will be $610,000 per year. Further, we will need to invest a total
of $1,100,000 in manufacturing equipment. This equipment may be depreciated at 15 per
cent diminishing value. In 4 years, the equipment will be worth half of what we paid for it.

Yr.0 ($) Yr.1 ($) Yr.2 ($) Yr.3 ($) Yr. 4 ($)
Step 1: Calculate Taxable Income
Sales 5,000,000 5,000,000 5,000,000 5,000,000
Variable costs (3,500,000) (3,500,000) (3,500,000) (3,500,000)
Fixed costs (610,000) (610,000) (610,000) (610,000)
Depreciation (165,000) (140,250) (119,213) (101,331)
Loss on sale (24,207)
Taxable Income 725,000 749,750 770,787 764,462

Step 2: Calculate the Tax Paid

and Net Cash Flow
Tax Paid (217,500) (224,925) (231,236) (229,339)
Cash flows after adjustment 890,000 890,000 890,000 890,000
Salvage Value 550,000
Outlay (Initial cost of investment) (1,100,000)
Net Cash Flow (1,100,000) 672,500 665,075 658,764 1,210,661

Step 3: Discount Net Cash Flow $887,348

to calculate NPV

This project appears quite profitable.

Extra notes:
Cash flow adjustments = Sales – variable costs – fixed costs

8.2 Spending money to save money?

We’re contemplating a new, mechanized welding system to replace our current manual
system. It will cost $600,000 to get the new system. The cost will be depreciated straight-line
to zero over its 4-year expected life. The system will actually be worth $100,000 at the end
of four years.

We think the new system will save us $180,000 pre-tax in labour costs. The tax rate is 30
per cent. What are the NPV and return on buying the new system? The required return is
15 per cent.

Yr.0 ($) Yr.1 ($) Yr.2 ($) Yr.3 ($) Yr. 4 ($)
Step 1: Calculate Taxable Income
Labour savings 180,000 180,000 180,000 180,000
Depreciation (150,000) (150,000) (150,000) (150,000)
Gain on sales 100,000
Taxable Income 30,000 30,000 30,000 130,000

Step 2: Calculate the Tax Paid

and Net Cash Flow
Tax Paid (9,000) (9,000) (9,000) (39,000)
Labour savings 180,000 180,000 180,000 180,000
Salvage Value 100,000
Outlay (Initial cost of investment) (600,000)
Net Cash Flow (600,000) 171,000 171,000 171,000 241,000

Step 3: Discount Net Cash Flow

to calculate NPV -$71,776

 The project is rejected because the NPV less than 0, which does not appear to be profitable.
 QUESTIONS AND PROBLEMS
3. Calculating cash flows
Proposed new home delivery services have projected sales of $1,131,000, costs of $928,000,
and truck depreciation of $150,000. The tax rate is 30 per cent. Calculate the cash flow
assuming that tax is paid in the year of income.

Step 1: Calculate Taxable Income $

Sales 1,131,000
Costs (928,000)
Cash flow after adjustment 203,000
Depreciation (150,000)
Taxable Income 53,000

Step 2: Calculate the Tax Paid and Net Cash Flow

Tax Paid (15,900)
Cash flow after adjustment 203,000
Net Cash Flow 187,100

5. NPV application
A new freezer costs $16,000. This cost will be depreciated prime cost to zero over 5 years.
The freezer will actually be worthless in 5 years. The new freezer would save us $6,000 per
year before taxes and operating costs. If we require a 10 per cent return, what is the NPV
of the purchase? Assume a tax rate of 30 per cent and that tax is paid in the year of income.

*prime cost = straight-line depreciation

*worthless = no salvage value

Yr.0 ($) Yr.1 ($) Yr.2 ($) Yr.3 ($) Yr. 4 ($) Yr. 5 ($)
Step 1: Calculate Taxable
Income
Savings 6,000 6,000 6,000 6,000 6,000
Depreciation (3,200) (3,200) (3,200) (3,200) (3,200)
Taxable Income 2,800 2,800 2,800 2,800 2,800

Step 2: Calculate the Tax Paid

and Net Cash Flow
Tax Paid (840) (840) (840) (840) (840)
Operating cost savings 6,000 6,000 6,000 6,000 6,000
Outlay (Initial cost of
(16,000)
investment)
Net Cash Flow (16,000) 5,160 5,160 5,160 5,160 5,160

Step 3: Discount Net Cash

Flow to calculate NPV $3,560.46

8. NPV application
Homesaver Ltd believes it can sell 10,000 home smoke detectors per year at $30 each. They
cost $20 each to manufacture (variable cost). Fixed production costs will run to $30,000 per
year. The necessary equipment costs $150,000 to buy and will be depreciated prime cost to
zero over the 5-year life of the project. The actual value will be $10,000 in 5 years. The
discount rate is 12 per cent, and the tax rate is 30 per cent. What do you think of the
proposal?

Yr.0 ($) Yr.1 ($) Yr.2 ($) Yr.3 ($) Yr. 4 ($) Yr. 5 ($)
Step 1: Calculate Taxable
Income
Sales 300,000 300,000 300,000 300,000 300,000
Variable cost (200,000) (200,000) (200,000) (200,000) (200,000)
Fixed cost (30,000) (30,000) (30,000) (30,000) (30,000)
Cash flow after adjustment 70,000 70,000 70,000 70,000 70,000
Depreciation (30,000) (30,000) (30,000) (30,000) (30,000)
Gain on disposal 10,000
Taxable Income 40,000 40,000 40,000 40,000 50,000

Step 2: Calculate the Tax Paid

and Net Cash Flow
Tax Paid (12,000) (12,000) (12,000) (12,000) (15,000)
Cash flow after adjustment 70,000 70,000 70,000 70,000 70,000
Salvage Value 10,000
Outlay (Initial cost of
(150,000)
investment)
Net Cash Flow (150,000) 58,000 58,000 58,000 58,000 65,000
Step 3: Discount Net Cash
Flow to calculate NPV 63,049.01

9. Cash flows and IRR

Party Supplies is contemplating the purchase of a $900,000 computer-based customer
order management system. The system will be depreciated prime cost to zero over its 5-
year life. It will be worth $300,000 at that time. The firm would save $600,000 before taxes
in the first year and $400,000 thereafter in order processing costs. The relevant tax rate is
30 per cent and tax is paid in the year of income. What is the IRR on this investment? And
the net present value if the discount rate is 20% or 40%?

Yr.0 ($) Yr.1 ($) Yr.2 ($) Yr.3 ($) Yr. 4 ($) Yr. 5 ($)
Step 1: Calculate Taxable
Income
Savings 600,000 400,000 400,000 400,000 400,000
Depreciation (180,000) (180,000) (180,000) (180,000) (180,000)
Gain on disposal 300,000
Taxable Income 420,000 220,000 220,000 220,000 520,000

Step 2: Calculate the Tax Paid

and Net Cash Flow
Tax Paid (126,000) (66,000) (66,000) (66,000) (156,000)
Savings 600,000 40,000 40,000 40,000 40,000
Salvage Value 300,000
Outlay (Initial cost of
(900,000)
investment)
Net Cash Flow (900,000) 474,000 334,000 334,000 334,000 544,000

Step 3: Discount Net Cash

Flow to calculate NPV

IRR 34.50%
NPV when I = 20% 299,925.41
NPV when I = 40% -81,209.02

10. Calculating AEC

You are evaluating two different audio systems. Loudsound costs $45,000, has a 3-year life,
and costs $5,000 per year to operate. The Mellowmaster costs $65,000, has a 5-year life, and
costs $4,000 per year to operate. The relevant discount rate is 12 per cent. Ignoring
depreciation and taxes, compute the AEC for both. Which do we prefer?

AEC for Loudsound:

Cash: I = 12% , NPV = -$57,009.16
CMPD: N = 3 , I = 12% , PV = -$57,009.16
AEC = PMT = $23,735.71

AEC for Mellowmaster:

Cash: I = 12% , NPV = -$79,419.10
CMPD: N = 5 , I = 12% , PV = -$79,419.10
AEC = PMT = $22,031.63

Mellowmaster will be chosen as it has lower AEC.

12. AEC
Metal Ltd is looking at producing power boards. The company is considering alternative
production methods. The costs and lives associated with each are:

Method 1 ($) Method 2 ($)

Year 0 -90,000 -80,000
Year 1 -2,000 -8,000
Year 2 -2,000 -8,000
Year 3 -2,000 -8,000
Year 4 -8,000

Assuming that Metal will not replace the equipment when it wears out, which should it
buy? If it is going to replace it, which should it buy (r = 10%)? Ignore depreciation and
taxes in answering.
AEC for Method 1:
Cash: I = 10% , NPV = -$94,973.70
CMPD: N = 3 , I = 10% , PV = -$94,973.70
AEC = PMT = $38,190.33

AEC for Method 2:

Cash: I = 10% , NPV = -$105,358.92
CMPD: N = 4 , I = 10% , PV = -$105,358.92
 AEC = PMT = $33,237.66
 If Metal Ltd is going to replace it, we prefer method 2 because it has a lower annual
equivalent cost. However, if Metal Ltd is not replacing, method 1 has the lower cost (NPV =
$94,973.70) but no chips will be produced in year 4.

14. NPV application

Skite Ltd is thinking about replacing an old computer with a new one. The old one cost
$50,000; the new one will cost $35,000. The new machine will be depreciated prime cost to
zero over its 5-year life. It will probably be worth about $5,000 after 5 years.

The old computer is being depreciated at a rate of $5,000 per year. It will be completely
written off in 5 years. If Skite does not replace it now, it will have to replace it in 5 years.
Skite can sell it now for $12,000. In five years, it will probably be worth nothing. The new
machine will save $6,000 per year in cooling costs. The tax rate is 30 per cent, tax is paid in
the year of income, and the discount rate is 10 per cent. Should Skite purchase the new
computer?

*Always remember, when you have old and new equipment, the new equipment is the outlay.

Useful life of old machine = $50,000 / $5,000 = 10 years

Yr.0 ($) Yr.1 ($) Yr.2 ($) Yr.3 ($) Yr. 4 ($) Yr. 5 ($)
Step 1: Calculate Taxable
Income
Savings 6,000 6,000 6,000 6,000 6,000
Depreciation (new) (7,000) (7,000) (7,000) (7,000) (7,000)
Depreciation (old) 5,000 5,000 5,000 5,000 5,000
Gain / loss on disposal* (13,000) 5,000
Taxable Income (13,000) 4,000 4,000 4,000 4,000 9,000

Step 2: Calculate the Tax Paid

and Net Cash Flow
Tax Paid 3,900 (1,200) (1,200) (1,200) (1,200) (2,700)
Savings 6,000 6,000 6,000 6,000 6,000
Salvage Value 12,000 5,000
Outlay (Initial cost of
(35,000)
investment)
Net Cash Flow (19,100) 4,800 4,800 4,800 4,800 8,300

Step 3: Discount Net Cash

Flow to calculate NPV 1,269

*Depreciation Old New

Cost $50,000 $35,000
Acc. depreciation $25,000 $35,000
Book value $25,000 $0
Salvage value $12,000 $5,000
(Loss) / Gain on disposal ($13,000) $5,000