Practice Questions Week 13

Q1. Project cash flow and timeline depiction

For each of the following projects, determine the cash flows, and depict the cash flows on a timeline.
a. A project that requires an initial investment of $120,000 and will generate annual operating cash
inflows of $25,000 for the next 18 years. In each of the 18 years, maintenance of the project will
require a $5,000 cash outflow.
b. A new machine with an installed cost of $85,000. Sale of the old machine will yield $30,000 after
taxes. Operating cash inflows generated by the replacement will exceed the operating cash inflows
of the old machine by $20,000 in each year of a six-year period. After six years, liquidation of the
new machine will yield $20,000 after taxes, which is $10,000 greater than the after-tax proceeds
expected from the old machine had it been retained and liquidated after six years.
c. An asset that requires an initial investment of $2 million and will yield annual operating cash
inflows of $300,000 for each of the next 10 years. Operating cash outlays will be $20,000 for each
year except year six, when an overhaul requiring an additional cash outlay of $500,000 will be
required. The asset’s liquidation value at the end of year 10 is expected to be zero.
Solution
a.
Year Cash Flow

This is a conventional cash flow pattern, where the cash inflows are of equal size, which is
referred to as an annuity.
b.

This is a conventional cash flow pattern, where the subsequent cash inflows vary, which is
referred to as a mixed stream.
c.

This is a nonconventional cash flow pattern, which has several cash flow series of equal size, which is
referred to as an embedded annuity. Note that the phrasing of the question leaves some ambiguity about
the cash outflow in year 6. The problem mentions a $500,000 outlay related to a necessary overhaul, but
students may argue that this is in addition to the regular $20,000 cash outlay. Thus, an argument could be
made that the year 6 cash outlay is –$520,000 rather than –$500,000 as shown here.
Q2. Replacement versus expansion cash flows
Stable Nuclear Corporation has estimated the cash flows over the five-year lives for two projects, A and
B. These cash flows are summarized in the table below.

a
After-tax cash inflow expected from liquidation.

a) If project A is a replacement for project B and the $38,000 initial investment shown for project B
is the after-tax cash inflow expected from liquidating it, what would be the net cash flows for this
replacement decision?
b) Instead, if project A is an expansion decision, what would be the net cash flows and how can it be
viewed as a special form of a replacement decision? Explain.

Solution
a.
Year Relevant Cash Flows
Initial investment ($22,000)
1 6,000
2 6,000
3 3,000
4 4,000
5 4,000

b. An expansion project is simply a replacement decision in which all cash flows from the old asset
are zero.

Q3. Sunk costs and opportunity costs

Luxottica Group spent two years and €1,000,000 to develop its new line of folding eyewear to replace an
older line. To begin manufacturing them, the company will have to invest €2,500,000 in new equipment.
The new eyewear line is expected to generate an increase in operating cash inflows of €1,100,000 per year
for the next eight years. The company has determined that the existing line could be sold to a competitor
for €300,000.
a) How should the €1,000,000 in development costs be classified?
b) How should the €300,000 sale price for the existing line be classified?
c) Depict all the known incremental cash flows on a timeline.

Solution
 a. The €1,000,000 in development costs should not be considered part of the decision to go ahead
with the new production. This money has already been spent and cannot be retrieved, so it is a
sunk cost.
b. The €300,000 sale price of the existing line is an opportunity cost. If Luxottica does not proceed
with the new line of eyewear, they will not receive the €300,000.
c.

Q4. Sunk and opportunity cash flows

Hans has been living in his current apartment in the Helmholtzkiez neighborhood in Berlin for the past 10
years. During that time, he has replaced the coffee maker for €300, the washing machine for €350, and has
had to make miscellaneous repair and maintenance expenditures of approximately €2,000. He has decided
to move to the Bergmannkiez neighborhood and rent the apartment for €1,200 per month. Advertising in a
real estate agency will cost €100. Hans also wants to paint the interior of the apartment, and this will cost
him about €400. The apartment should be ready to rent after that. In reviewing the financial situation, Hans
views all the expenditures as being relevant, so he plans to net out the estimated expenditures discussed
above from the rental income.
a) Does Hans understand the difference between sunk costs and opportunity costs? Explain the two
concepts to him.
b) Which of the expenditures should be classified as sunk cash flows, and which should be viewed as
opportunity cash flows?

Solution
a. Sunk costs or cash outlays are expenditures made in the past that have no effect on the cash flows
relevant to a current situation. The cash outlays made before Hans decided to rent out his apartment
would be classified as sunk costs. An opportunity cost or cash flow is one that can be realized from
an alternative use of an existing asset. Here, Hans has decided to rent out his apartment, and all the
costs associated with getting the apartment in “rentable” condition would be relevant.
b.

Q5. Book value

Find the book value for each of the assets shown in the following table, assuming that MACRS depreciation
is being used. (See Table 4.2 on the last page for the applicable depreciation percentages.)
Solution

Book value
Installed Accumulated Book
Asset Cost Depreciation Value
A $ 890,000 $ 462,800 $427,200
B 67,000 46,230 20,770
C 34,000 11,220 22,780
D 4,280,000 2,696,400 1,583,600
E 753,000 534,630 218,370

Q6. Change in net working capital calculation

MSF Manufacturing is considering the purchase of a new machine to improve its production efficiency.
The company has total current assets of $865,000 and total current liabilities of $673,000. As a result of
the proposed replacement, the following changes are anticipated in the levels of the current asset and
current liability accounts noted.

a) Using the information given, calculate any change in net working capital that is expected to result
from the proposed replacement plan.
b) Explain why a change in these current accounts would be relevant in determining the initial
investment for the proposed capital expenditure.
c) Would the change in net working capital enter into any of the other cash flow components that
make up the project’s relevant cash flows? Explain.
Solution
a.
Current Assets Current Liabilities
 Cash +$43,500 Accounts payable +$230,000
Accounts receivable +378,000 Accruals +38,000
Inventory −69,000
Net change $352,500 $268,000
Net working capital = current assets − current liabilities = $352,500 = $268,000 = $84,500
b. An analysis of the purchase of the new machine reveals an increase in net working capital. This
increase should be treated as an initial outlay and is the cost of acquiring the new machine.
c. Yes, in computing the terminal cash flow, the net working capital increase should be reversed

Q7. Calculating initial cash flow

Miller Dental Inc. is considering replacing its laser checking system, which was purchased three years ago
at a cost of $568,000. The system can be sold today for $253,000. It is being depreciated using MACRS
and a five-year recovery period (see Table 4.2 on the last page). A new laser checking system will cost
$870,000 to purchase and install. Replacement of the laser checking system would not involve any change
in net working capital. Assume a 20% tax rate.
a) Calculate the book value of the existing laser checking system.
b) Calculate the after-tax proceeds of its sale for $253,000.
c) Calculate the initial cash flow associated with the replacement project. Change in net working
capital calculation
Solution
a. Book value = $568,000 × (1 – 0.20 – 0.32 – 0.19) = $568,000 × 0.29 = $164,720
b. Sales price of old equipment $253,000
Book value of old equipment 164,720
Recapture of depreciation $ 88,280
Taxes on recapture of depreciation (20% tax rate) = $88,280  0.20 = $17,656
After-tax proceeds = $253,000 − $17,656 = $235,344
c. Cost of new machine $ 870,000
Less sales price of old machine $(253,000)
Plus tax on recapture of depreciation $ 17,656
Initial investment $ 634,656

Q8. Initial cash flow: Basic calculation

Sony Pacific Music Corporation is considering the purchase of a new sound board, used in recording
studios to improve sound effects. The existing sound board was purchased three years ago at an installed
cost of $23,500; it was being depreciated under MACRS, using a five-year recovery period. (See Table 4.2
on the last page for the applicable depreciation percentages.) The existing sound board is expected to have
a usable life of at least 4 more years. The new sound board costs $38,800 and requires $5,400 in installation
costs; it will be depreciated using a five-year recovery period under MACRS. The existing sound board
can currently be sold for $27,300 without incurring any removal or cleanup costs. The firm is subject to a
20% tax rate. Calculate the initial cash flow associated with the proposed purchase of a new sound board.
Solution
Installed cost of new asset =
Cost of new asset $38,800
+ Installation costs 5,400
Total installed cost (depreciable value) $44,200
After-tax proceeds from sale of old asset =
Proceeds from sale of old asset ($27,300)
+ Tax on sale of old asset 4,097
Total after-tax proceeds—old asset ($23,203)

Initial investment $20,997

Book value of existing machine = $23,500  (1 − (0.20 + 0.32 + 0.19)) = $ 6,815

Recaptured depreciation = $23,500 − $6,815 = $16,685
Capital gain = $27,300 − $23,500 = $ 3,800
Tax on recaptured depreciation = $16,685  (0.20) = $ 3,337
Tax on capital gain = $ 3,800  (0.20) = $ 760
Total tax = $ 4,097

Q9. Operating cash inflows

A firm is considering renewing its equipment to meet increased demand for its product. The cost of
equipment modifications is $1.9 million plus $100,000 in installation costs. The firm will depreciate the
equipment modifications under MACRS, using a five-year recovery period. (See Table 4.2 for the
applicable depreciation percentages.) Additional sales revenue from the renewal should amount to
$1,200,000 per year, and additional operating expenses and other costs (excluding depreciation and
interest) will amount to 40% of the additional sales. The firm is subject to a tax rate of 21%. (Note: Answer
the following questions for each of the next six years.)
a) What net incremental earnings before interest, taxes, depreciation, and amortization will result
from the renewal?
b) What net incremental operating profits after taxes will result from the renewal?
c) What net incremental operating cash flows will result from the renewal?
Solution
a. Additional sales revenue = $1,200,000
Operating expenses and other costs = 40% × $1,200,000 = $480,000
Incremental earnings before depreciation and tax = $1,200,000 − $480,000
= $720,000 each year
b. PBDT = Profits before depreciation and taxes NPAT = Net profits after taxes
NPBT = Net profits before taxes
Year (1) (2) (3) (4) (5) (6)
 PBDT $720,000 $720,000 $720,000 $720,000 $720,000 $720,000
Depr. 400,000 640,000 380,000 240,000 240,000 100,000
NPBT 320,000 80,000 340,000 480,000 480,000 620,000
Tax 67,200 16,800 71,400 100,800 100,800 130,200
NPAT 252,800 63,200 268,600 379,200 379,200 489,800

a. Cash Flow = NPAT + depreciation

Cash (1) (2) (3) (4) (5) (6)

flow $652,800 $703,200 $648,600 $619,200 $619,200 $589,800

Q10. Terminal cash flow

Various lives and sale prices Looner Industries is currently analyzing the purchase of a new machine that
costs $160,000 and requires $20,000 in installation costs. Net working capital will increase immediately
by $30,000, but those funds will be recovered at the end of the machine’s life. The firm plans to
depreciate the machine under MACRS, using a five-year recovery period (see Table 4.2), and expects to
sell it to net $10,000 before taxes at the end of its usable life. The firm is subject to a 21% tax rate.
a) Calculate the terminal cash flow for a usable life of (1) three years, (2) five years, and (3) seven
years.
b) Discuss the effect of usable life on terminal cash flows, using your findings in part a.
c) Assuming a five-year usable life, calculate the terminal cash flow if the machine were sold to net
(1) $9,000 or (2) $170,000 (before taxes) at the end of five years.
d) Discuss the effect of sale price on terminal cash flow, using your findings in part c.
Solution
a.
After-tax proceeds from sale of new asset = 3-Year* 5-Year* 7-Year*
Proceeds from sale of proposed asset $10,000 $10,000 $10,000
 Tax on sale of proposed asset* +8,862 −210 −2,100
Total after-tax proceeds—new $18,862 $9,790 $ 7,900
+ Change in net working capital +30,000 +30,000 +30,000
Terminal cash flow $48,862 $39,790 $37,900
*
1. Book value of asset = [1− (0.20 + 0.32 + 0.19)]  $180,000 = $52,200
Proceeds from sale = $10,000. So, $10,000 − $52,200= ($42,200) loss
$42,200  (0.21) = $8,862 tax benefit
2. Book value of asset = [1 − (0.20 + 0.32 + 0.19 + 0.12 + 0.12)]  $180,000 = $9,000
$10,000 − $9,000 = $1,000 recaptured depreciation. So $1,000  (0.21) = $210 tax liability
3. Book value of asset = $0
$10,000 − $0 = $10,000 recaptured depreciation. So $10,000  (0.21)= $2,100 tax liability
b. The shorter the usable life, the higher the asset’s book value and the lower the tax bill due from
selling the old asset (or, the higher the tax benefit from selling the old asset at a loss). This is
why the terminal cash flow is higher as the usable life gets shorter.
c.
(1) (2)
 After-tax proceeds from sale of new asset =
Proceeds from sale of new asset $ 9,000 $170,000
+ Tax on sale of proposed asset* 0 −33,810
Total after-tax proceeds—new $ 9,000 $136,190
+ Change in net working capital +30,000 +30,000
Terminal cash flow $39,000 $166,190
1. Book value of the asset = $180,000  0.05 = $9,000; no taxes are due
2. Tax = ($170,000 − $9,000)  0.21 = $33,810.
d. The higher the sale price, the higher the terminal cash flow.

Q11. Terminal cash flow: Replacement decision

Russell Industries is considering replacing a fully depreciated machine that has a remaining useful life of
10 years with a newer, more sophisticated machine. The new machine will cost $200,000 and will require
$30,000 in installation costs. It will be depreciated under MACRS, using a five-year recovery period (see
Table 4.2 for the applicable depreciation percentages). A $25,000 increase in net working capital will be
required to support the new machine. The firm’s managers plan to evaluate the potential replacement
over a four-year period. They estimate that the old machine could be sold at the end of four years to net
$15,000 before taxes; the new machine at the end of four years will be worth $75,000 before taxes.
Calculate the terminal cash flow at the end of year four that is relevant to the proposed purchase of the
new machine. The firm is subject to a 21% tax rate.
Solution
After-tax proceeds from sale of new asset =
Proceeds from sale of new machine $75,000
−Tax on sale of new machinel (7,539)
Total after-tax proceeds—new asset $67,461
−After-tax proceeds from sale of old asset
Proceeds from sale of old machine (15,000)
+ Tax on sale of old machine2 3,150
Total after-tax proceeds—old asset (11,850)
+ Change in net working capital 25,000
Terminal cash flow Year 4 $80,611
1
Book value of new machine at end of year 4:
[1 − (0.20 + 0.32+ 0.19 + 0.12)  ($230,000)] = $39,100
$75,000 − $39,100 = $35,900 recaptured depreciation
$35,900  (0.21) = $7,539 tax liability

2
Book value of old machine at end of year 4:$0
$15,000 − $0 = $15,000 recaptured depreciation
$15,000  (0.21) = $3,150 tax benefit
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