Capital Budgeting Cash Flows
Capital Budgeting Cash Flows
Instructor’s Resources
Instructor’s Resources
Overview
Overview
This chapter expands upon the capital budgeting techniques presented in the last chapter (Chapter 10). This chapter expands upon the capital budgeting techniques presented in the last chapter (Chapter 10). Shareholder wealth maximization relies upon selection of projects that have positive net present values. Shareholder wealth maximization relies upon selection of projects that have positive net present values. The most important and difficult aspect of the
The most important and difficult aspect of the capital budgeting process is developing good estimates ofcapital budgeting process is developing good estimates of the relevant cash flows. Chapter 11 focuses on
the relevant cash flows. Chapter 11 focuses on the basics of determining relevant after-tax cash the basics of determining relevant after-tax cash flows of aflows of a project, from the initial cas
project, from the initial cash outlay to annual cash sth outlay to annual cash stream of costs and benefits anream of costs and benefits and terminal cash flow. Itd terminal cash flow. It also describes the special concerns facing capital budgeting for the
also describes the special concerns facing capital budgeting for the multinational compmultinational company. The textany. The text highlights how capital budgeting will be a critical aspect of the
highlights how capital budgeting will be a critical aspect of the professional life and personal life ofprofessional life and personal life of students upon graduation.
students upon graduation.
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Question
The chapter opener talked about ExxonMobil’s considerable investment in long
The chapter opener talked about ExxonMobil’s considerable investment in long-term projects and-term projects and the sometimes difficult task of having projects come in on budget. How are
the sometimes difficult task of having projects come in on budget. How are project cash flowsproject cash flows affected by budget overruns? In the capital budgeting process, how should financial managers affected by budget overruns? In the capital budgeting process, how should financial managers account for the potential of budget overruns?
account for the potential of budget overruns? It is critical to have
It is critical to have the best estimate of project cash flows pothe best estimate of project cash flows po ssible when making a project accept/rejectssible when making a project accept/reject decision. Depending upon the scope of a project, financial
decision. Depending upon the scope of a project, financial managers may need to draw managers may need to draw information frominformation from many areas of a
many areas of a corporation including research and development, marketing, operations, human resources,corporation including research and development, marketing, operations, human resources, and within the various departments dealing with corporate finance. It may be
and within the various departments dealing with corporate finance. It may be possible to get some of thepossible to get some of the information directly from the project managers if they have
information directly from the project managers if they have done some of the legwork already.done some of the legwork already. Budget overruns mean higher than expected costs, and therefore
Budget overruns mean higher than expected costs, and therefore lower than expected cash flows. Lowerlower than expected cash flows. Lower than expected cash flows mean lower than
than expected cash flows mean lower than expected capital budgeting outcomes (e.g., lower NPVs, PIs,expected capital budgeting outcomes (e.g., lower NPVs, PIs, IRRs, etc.). If
IRRs, etc.). If financial managers do not adequately account for possible budget overruns in the capitalfinancial managers do not adequately account for possible budget overruns in the capital budg
budgeting eting process process they athey are unlire unlikely kely to fullto fully maximy maximize firm ize firm value. value. ChapteChapter 12 cor 12 considernsiders the us the uncertaincertainty ofnty of cash flows in more detail and
cash flows in more detail and discusses some of the methods used by fdiscusses some of the methods used by financial managers to account forinancial managers to account for the uncertainty of cash flows. In particular,
the uncertainty of cash flows. In particular, ExxonMobil could generate a range or distribution of capitalExxonMobil could generate a range or distribution of capital budg
budgeting eting outcomoutcomes for pes for projects rojects that hthat have unave uncertain certain cash cash flows flows due to due to possibpossible budle budget ovget overruns. erruns. ExxonExxonMobilMobil should calculate NPVs using cash flows that assume no budget overrun a
should calculate NPVs using cash flows that assume no budget overrun a nd a variety of possible budgetnd a variety of possible budget overruns and then calculate an expected average NPV
overruns and then calculate an expected average NPV where the weights reflect the probably of eacwhere the weights reflect the probably of eachh budget outcome.
Answers to Review Questions
Answers to Review Questions
1.
1. Capital buCapital budgeting dgeting projects projects should should be evalube evaluated usinated usingg incremental after-tax cash flowsincremental after-tax cash flows, since after-tax, since after-tax cash flows are what is
cash flows are what is available to the firm. When evaluating a available to the firm. When evaluating a project, concern is placed only onproject, concern is placed only on added cash flows expected to result from
added cash flows expected to result from its implementation. Expansion decisions can be treatedits implementation. Expansion decisions can be treated as replacement decisions in which all cash
as replacement decisions in which all cash flows from the old assets aflows from the old assets are zero. Both expansion andre zero. Both expansion and replacement decisions involve purchasing new assets. Replacement decisions are more complex replacement decisions involve purchasing new assets. Replacement decisions are more complex because incremental cash flow
because incremental cash flows resulting from the replacems resulting from the replacement must be determined.ent must be determined. 2.
2. The three components The three components of cash flow foof cash flow for any project are r any project are (1) initial inv(1) initial investment, (2) operating estment, (2) operating cash flows,cash flows, and (3) terminal cash flows.
and (3) terminal cash flows. 3.
3. Sunk costsSunk costs are costs that are costs that have already been incurred and thus the money has have already been incurred and thus the money has already been spent.already been spent. Opportunity costs
Opportunity costs are cash flows that could be realized from the next best alternative use of an owned are cash flows that could be realized from the next best alternative use of an owned asset. Sunk costs are not
asset. Sunk costs are not relevant to the investment decision because they are not incremental. Theserelevant to the investment decision because they are not incremental. These costs will not change no matter
costs will not change no matter what the final accept/reject decision. Opportunity costs are a relevantwhat the final accept/reject decision. Opportunity costs are a relevant cost. These cash flows could be realized if the decision is made not to change the current asset
cost. These cash flows could be realized if the decision is made not to change the current asset structure but to utilize the owned asset for
structure but to utilize the owned asset for this alternative purpose.this alternative purpose. 4.
4. To minimize long-To minimize long-term currency risk, comterm currency risk, companies can finance a panies can finance a foreign investmforeign investment in local capient in local capitaltal markets so that the project’s revenues and costs are in the local currency rather than dollars. markets so that the project’s revenues and costs are in the local currency rather than dollars. Techniques such as currency futures, forwards, and
Techniques such as currency futures, forwards, and options market instruments protect against short-options market instruments protect against short-term currency risk. Financial and operating strategies that r
term currency risk. Financial and operating strategies that r educe political risk include structuring theeduce political risk include structuring the investment as a joint venture with a
investment as a joint venture with a competent and well-connected local partner, and using debtcompetent and well-connected local partner, and using debt rather than equity financing, since debt service payments are
rather than equity financing, since debt service payments are legally enforceable claims while equitylegally enforceable claims while equity returns such as dividends are not.
returns such as dividends are not. 5. a. The
5. a. The cost of the new asset cost of the new asset is the purchase price. is the purchase price. (Outflow)(Outflow) b.
b. Installation Installation costscosts are any added are any added costs necessary to get an asset into costs necessary to get an asset into operation. (Outflow)operation. (Outflow) c.
c. Proceeds Proceeds from sale ofrom sale of old assef old asset t are cash are cash inflows resulting from the sale of an inflows resulting from the sale of an existing asset,existing asset, reduced by any removal costs. (Inflow)
reduced by any removal costs. (Inflow) d.
d. Tax on sale of old asset Tax on sale of old asset is incurred when the is incurred when the replaced asset is sold due to replaced asset is sold due to recaptured depreciation,recaptured depreciation, capital gain, or capital loss. (May be an inflow or an outflow)
capital gain, or capital loss. (May be an inflow or an outflow) e. The
e. The change in net working capital change in net working capital is the difference between the is the difference between the change in current assets and thechange in current assets and the change in current liabilities. (May be an
change in current liabilities. (May be an inflow or an outflow)inflow or an outflow) 6. The
6. The book valuebook value of an asset of an asset is its strict accounting value.is its strict accounting value. Book value
Book value installed cost of asset installed cost of asset – – accumulated depreciation accumulated depreciation
Gains and losses in the sale of an asset may have tax consequences, and hence are both key forms of Gains and losses in the sale of an asset may have tax consequences, and hence are both key forms of taxable income. More specifically, taxable income may arise
taxable income. More specifically, taxable income may arise from (1) capital gain: portion of salefrom (1) capital gain: portion of sale price above initial purch
price above initial purchase price, taxed at the ordinary rate; ase price, taxed at the ordinary rate; (2) recaptured depreciation: p(2) recaptured depreciation: portion ofortion of sale price in excess
sale price in excess of book value that represents a recovery of of book value that represents a recovery of previously taken depreciation, taxed atpreviously taken depreciation, taxed at the ordinary rate; and (3) loss on the sale of an asset: amount by which sale price is less than book the ordinary rate; and (3) loss on the sale of an asset: amount by which sale price is less than book value, taxed at the
value, taxed at the ordinary rate and deducted from ordinary income if ordinary rate and deducted from ordinary income if the asset is depreciable andthe asset is depreciable and used in business. If the asset
used in business. If the asset is not depreciable or is not used is not depreciable or is not used in business, it is also taxed at in business, it is also taxed at thethe ordinary rate but is deductible only against capital gains.
7.
7. The asset may The asset may be sold (1) for mbe sold (1) for more than its boore than its book value, (2) for ok value, (2) for the amount of the amount of its book its book value, orvalue, or (3) at a price below book value. In the first case, taxes arise from the amount by which the sa
(3) at a price below book value. In the first case, taxes arise from the amount by which the sa le pricele price exceeded the book value. In the second case, no taxes would be required. In the third case, a tax exceeded the book value. In the second case, no taxes would be required. In the third case, a tax credit would occur.
credit would occur. 8.
8. The depreciable vThe depreciable value of an asset alue of an asset is the instalis the installed cost of led cost of a new asset and a new asset and is based on is based on the depreciablethe depreciable cost of the new
cost of the new project, including installatioproject, including installation cost.n cost. 9.
9. Depreciation is used to decrease the firm’s total tax liability and then is added back to net profits afterDepreciation is used to decrease the firm’s total tax liability and then is added back to net profits after taxes to determine cash flow. Ta
taxes to determine cash flow. Table 11.6 and Equation 3.4 (refer to ble 11.6 and Equation 3.4 (refer to the text) are equivalent ways ofthe text) are equivalent ways of expressing operating cash flows. The earnings before interest and taxes in Table
expressing operating cash flows. The earnings before interest and taxes in Table 11.6 is the same as11.6 is the same as the EBIT terminology in Equation 3.4. Both
the EBIT terminology in Equation 3.4. Both models then take out taxes and add models then take out taxes and add back in depreciation.back in depreciation. 10.
10. To calculate inTo calculate incremental operating cacremental operating cash inflow for sh inflow for both the existinboth the existing situation g situation and the proposand the proposeded project, the depreciation on
project, the depreciation on assets is added back to thassets is added back to the after-tax profits to get the cash flowe after-tax profits to get the cash flowss associated with each alternative. The difference between the cash
associated with each alternative. The difference between the cash flows of the proposed and presentflows of the proposed and present situation, the incremental after-tax cash flows, are the
situation, the incremental after-tax cash flows, are the relevant operating cash flows used inrelevant operating cash flows used in evaluating the proposed project.
evaluating the proposed project. 11. The
11. The terminal cash flowterminal cash flow is the cash is the cash flow resulting from termination and liquidation of a project at theflow resulting from termination and liquidation of a project at the end of its economic life.
end of its economic life. The form of calculating terminal The form of calculating terminal cash flows is shown below:cash flows is shown below: Terminal Cash Flow Calculation:
Terminal Cash Flow Calculation: After-tax
After-tax proceeds from proceeds from
sale of new asset sale of new asset
– – After-tax After-tax proceeds from proceeds from sale of old asset sale of old asset
Change in Change in net working net working capital capital = = Terminal Terminal cash cash flow flow Extended Presentation: Extended Presentation: Proceeds from Proceeds from sale of new asset sale of new asset
Tax on sale of Tax on sale of new asset new asset – – Proceeds from Proceeds from sale of old asset sale of old asset
Tax on sale of Tax on sale of old asset old asset Change in Change in net working net working capital capital == Terminal Terminal cash cash flow flow 12. The
12. The relevant cash flowsrelevant cash flows necessary for a necessary for a conventional capital budgeting project are the incrementalconventional capital budgeting project are the incremental after-tax cash flows attributable to the proposed project: the initial investment, the operating cash after-tax cash flows attributable to the proposed project: the initial investment, the operating cash inflows, and the terminal cash flow. The
inflows, and the terminal cash flow. The initial investment is the initial outlay required, taking intoinitial investment is the initial outlay required, taking into account the installed cost of the new asset, proceeds from the sale of the old asset, tax on the sale of account the installed cost of the new asset, proceeds from the sale of the old asset, tax on the sale of the old asset, and any
the old asset, and any change in net working capital. The operating cash inflows are change in net working capital. The operating cash inflows are the additionalthe additional cash flows received as a
cash flows received as a result of implementing a proposal. Terminal cash flow represents the result of implementing a proposal. Terminal cash flow represents the after- after-tax cash flows expected to result from
tax cash flows expected to result from the liquidation of the project at the end the liquidation of the project at the end of its life. These threeof its life. These three components represent the positive or negative cash flow impact if
components represent the positive or negative cash flow impact if the firm implements the project,the firm implements the project, and are depicted in the
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Changes May Influence Future Investments in China
Changes May Influence Future Investments in China
Although China has been actively campaigning for foreign investment, how do you think having Although China has been actively campaigning for foreign investment, how do you think having a communist government affects its foreign investment?
a communist government affects its foreign investment? Having a communist government has a negative affect on
Having a communist government has a negative affect on foreign direct investment (FDI). As in allforeign direct investment (FDI). As in all investments abroad, FDI in China entails high travel and
investments abroad, FDI in China entails high travel and communications expenses. The differences ofcommunications expenses. The differences of political system and cu
political system and culture that exist between lture that exist between the country of the investothe country of the investor and the host country wr and the host country will alsoill also cause problems with foreign direct investment in China. Due to
cause problems with foreign direct investment in China. Due to its control of the economy, the communistits control of the economy, the communist party has more control over em
party has more control over employment, raw materials, and repatriatioployment, raw materials, and repatriation of revenues to a parent firm thn of revenues to a parent firm thanan found in non-communist countries. There is also the chance that
found in non-communist countries. There is also the chance that a company may lose a company may lose ownership of itsownership of its overseas operations to a Chinese company. Hence, foreign f
overseas operations to a Chinese company. Hence, foreign f irms often partner with Chinese firms irms often partner with Chinese firms in theirin their development efforts, but this requires coordination and raises the costs of FDI in
development efforts, but this requires coordination and raises the costs of FDI in China.China.
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A Question of Accuracy
A Question of Accuracy
What would your options be when faced with the
What would your options be when faced with the demands of an imperial demands of an imperial chief executive officerchief executive officer (CEO) who expects you t
(CEO) who expects you to “make it work”? Brainstorm several options.o “make it work”? Brainstorm several options.
There is a chance that you may be working for an “imperial CEO” at some point in your career. This may There is a chance that you may be working for an “imperial CEO” at some point in your career. This may be by cho
be by choice or by ice or by chance. chance. While the While the “make “make it work” mit work” mandate maandate may seem y seem like an olike an o rder to do anything itrder to do anything it takes to accomplish your job, you are
takes to accomplish your job, you are under no obligation to do anything unethical or illegal. If that is under no obligation to do anything unethical or illegal. If that is thethe only way to accomplish the job, the best approach is to ask your superior directly, “Is (this) what you want only way to accomplish the job, the best approach is to ask your superior directly, “Is (this) what you want me to do?”
If the answer is that you should break the law
If the answer is that you should break the law or do something unethical, you may have three viable optionsor do something unethical, you may have three viable options other than doing something that you should not do. One option is to seek the guidance of your “mentor” if other than doing something that you should not do. One option is to seek the guidance of your “mentor” if you have one in the company. He or she may be able to intervene on your behalf. Another option is to take you have one in the company. He or she may be able to intervene on your behalf. Another option is to take the matter over your boss’s head (in
the matter over your boss’s head (in the case of a the case of a CEO, that would be the board CEO, that would be the board of directors). The thirdof directors). The third option is to evaluate your career options. You
option is to evaluate your career options. You may be better served working elsewhere. Remay be better served working elsewhere. Realistically, byalistically, by offering opposition to an “imperial CEO,” you may be limiting your career in your present company. offering opposition to an “imperial CEO,” you may be limiting your career in your present company. However, do not immediately assume that “do whatever it takes” or “make it work” automatically includes However, do not immediately assume that “do whatever it takes” or “make it work” automatically includes anything unethical or illegal. The CEO may j
anything unethical or illegal. The CEO may just be stating that more resources or ust be stating that more resources or effort need to be put effort need to be put intointo solving the problem.
solving the problem.
Answers to Warm-Up
Answers to Warm-Up Exercises
Exercises
E11-1.
E11-1. Categorizing a firm’s expendituresCategorizing a firm’s expenditures Answer:
Answer: In this case, the In this case, the tuition reimbursement should be categorized as a capital expenditure since thetuition reimbursement should be categorized as a capital expenditure since the outlay of funds is expected to produce benefits over a period of time greater than 1 year. outlay of funds is expected to produce benefits over a period of time greater than 1 year. E11-2.
E11-2. Classification Classification of of project project costs costs and and cash cash flowsflows Answer:
Answer: $3.5 billion already spent$3.5 billion already spent — — sunk cost (irrelevant)sunk cost (irrelevant) $350 million incremental cash outflow
$350 million incremental cash outflow — — relevant cash flowrelevant cash flow $15 million per year cash
$15 million per year cash inflowinflow — — relevant cash flowrelevant cash flow $450 million for satellites
$450 million for satellites — — opportunity cost and relevant cash flowopportunity cost and relevant cash flow E11-3.
E11-3. Finding Finding the the initial initial investmentinvestment Answer:
Answer: $20,000 Purchase price of new $20,000 Purchase price of new machinerymachinery
$3,000 Installation costs$3,000 Installation costs
$4,500 After-tax proceeds from sale of $4,500 After-tax proceeds from sale of old machineryold machinery $18,500 Initial investment
$18,500 Initial investment E11-4.
E11-4. Book Book value value and and recaptured recaptured depreciationdepreciation Answer:
Answer: Book valueBook value $175,000 $175,000 $124, 250 $124, 250 $50,750 $50,750 Recaptured depreciation
Recaptured depreciation $110,000 $110,000 $50, 750 $50, 750 $59,250 $59,250 E11-5.
E11-5. Initial Initial investmentinvestment Answer:
Answer: Initial investmentInitial investment purchase price purchase price installation costs installation costs – – after-tax proceeds from sale of old after-tax proceeds from sale of old asset
asset change in net change in net working capitalworking capital
Solutions to Problems
Solutions to Problems
Note
Note:: The MACRS depreciation percentages used in the The MACRS depreciation percentages used in the following problems appear in Chapter 4,following problems appear in Chapter 4,
Table 4.2. The percentages are
Table 4.2. The percentages are rounded to the nearest integer for ease rounded to the nearest integer for ease in calculation.in calculation. For simplification, 5-year-lived projects with 5 years of cash
For simplification, 5-year-lived projects with 5 years of cash inflows are typically used throughout thisinflows are typically used throughout this chapter. Projects with usable lives equal to the number
chapter. Projects with usable lives equal to the number of years of cash of years of cash inflows are also included in theinflows are also included in the end-of-chapter problems. It is important to recall from Chapter
end-of-chapter problems. It is important to recall from Chapter 4 that under the Tax Ref4 that under the Tax Reform Act of 1986,orm Act of 1986, MACRS depreciation results in
MACRS depreciation results in nn 1 years of depreciation for an 1 years of depreciation for an nn-year class asset. This means that in-year class asset. This means that in actual practice projects will typically have at least one year
actual practice projects will typically have at least one year of cash flow beyond their recovery period.of cash flow beyond their recovery period. P11-1.
P11-1. Classification Classification of of expendituresexpenditures LG 2; Basic
LG 2; Basic a.
a. Operating Operating expenditureexpenditure — — lease expires within one yearlease expires within one year b.
b. Capital expenditureCapital expenditure — — patent rights exis patent rights exist for many yearst for many years c.
c. Capital Capital expenditureexpenditure — — research and development benefits last many yearsresearch and development benefits last many years d.
d. Operating Operating expenditureexpenditure — — marketable securities mature in under one yearmarketable securities mature in under one year e.
e. Capital Capital expenditureexpenditure — — machine will last over one yearmachine will last over one year f.
f. Capital Capital expenditureexpenditure — — building tool w building tool will last over one yearill last over one year g.
g. Capital Capital expenditureexpenditure — — building will building will last for more than one yearlast for more than one year h.
h. Operating Operating expenditureexpenditure — — market changes require obtaining another report within a yearmarket changes require obtaining another report within a year P11-2.
P11-2. Relevant cash Relevant cash flow and flow and timeline detimeline depictionpiction LG 1, 2; Intermediate
LG 1, 2; Intermediate a.
a.
Year
Year Cash FlowCash Flow
This is a conventional cash flow patt
This is a conventional cash flow pattern, where the cash inflows are of equal ern, where the cash inflows are of equal size, which is referred tosize, which is referred to as an annuity.
as an annuity.
b. b.
This is a conventional cash flow p
This is a conventional cash flow pattern, where the subsequent cash inflows attern, where the subsequent cash inflows vary, which is referred tovary, which is referred to as a mixed stream.
c. c.
This is a nonconventional cash flow pattern,
This is a nonconventional cash flow pattern, which has several cash flow series of equal size, which has several cash flow series of equal size, which iswhich is referred to as an embedded annuity.
referred to as an embedded annuity.
P11-3.
P11-3. Expansion Expansion versus versus replacement creplacement cash flowash flowss LG 3; Intermediate
LG 3; Intermediate a.
a.
Year
Year Relevant CashRelevant Cash Flows Flows Initial
Initial investment investment ($28,000)($28,000)
1 4,000 1 4,000 2 6,000 2 6,000 3 8,000 3 8,000 4 10,000 4 10,000 5 4,000 5 4,000 b.
b. An expansion project An expansion project is simply a replacement decisis simply a replacement decision in which all cash fion in which all cash flows from the oldlows from the old asset are zero.
asset are zero. P11-4.
P11-4. Sunk costs Sunk costs and opand opportunity portunity costscosts LG 2; Basic
LG 2; Basic a.
a. The $1,000The $1,000,000 develop,000 development costs ment costs should nshould not be ot be considered considered part of part of the decisithe decision to on to go aheadgo ahead with the new production. This money has already been spent
with the new production. This money has already been spent and cannot be retrieved so it and cannot be retrieved so it is ais a sunk cost.
sunk cost. b.
b. The $250,000 sale price of The $250,000 sale price of the existing line is an opthe existing line is an opportunity cost. Iportunity cost. If Masters Golf Productsf Masters Golf Products does not proceed with the new line
does not proceed with the new line of clubs they will not receive the of clubs they will not receive the $250,000.$250,000. c.
c.
P11-5.
P11-5. Sunk costs Sunk costs and opand opportunity portunity costscosts LG 2; Intermediate
LG 2; Intermediate a.
a. Sunk Sunk costcost — — The funds for the tooling had already been The funds for the tooling had already been expended and would not change, noexpended and would not change, no matter whether the new technology would be acquired or
matter whether the new technology would be acquired or not.not. b.
b. Opportunity costOpportunity cost — — The development of the computer programs can be The development of the computer programs can be done withoutdone without additional expenditures on the computers; however, the loss of the cash
additional expenditures on the computers; however, the loss of the cash inflow from theinflow from the leasing arrangement would be a lost opportunity to the firm.
c.
c. Opportunity costOpportunity cost — — Covol will not have to spend any funds for Covol will not have to spend any funds for floor space but the lost cashfloor space but the lost cash inflow from the rent would be a cost to the firm.
inflow from the rent would be a cost to the firm. d.
d. Sunk Sunk costcost — — The money for the storage facility has The money for the storage facility has already been spent, and no matter already been spent, and no matter whatwhat decision the company makes there is no
decision the company makes there is no incremental cash flow generated or lost from theincremental cash flow generated or lost from the storage building.
storage building. e.
e. Opportunity costOpportunity cost — — Forgoing the sale of the crane Forgoing the sale of the crane costs the firm $180,000 of potential cashcosts the firm $180,000 of potential cash inflows.
inflows. P11-6.
P11-6. Personal finance: Personal finance: Sunk and Sunk and opportunity opportunity cash flowscash flows LG 2; Intermediate
LG 2; Intermediate a.
a. The The sunk sunk costs costs or cor cash ouash outlays tlays are expendare expenditures itures that that have have been mbeen made in ade in the the past past and and have nhave noo effect on the cash flows
effect on the cash flows relevant to a current situation. The cash relevant to a current situation. The cash outlays done before Davidoutlays done before David and Ann decided to rent
and Ann decided to rent out their home would be classified as sunk costs. out their home would be classified as sunk costs. An opportunityAn opportunity cost or cash flow is one that can be realized from an alternative use of an existing asset. cost or cash flow is one that can be realized from an alternative use of an existing asset. Here, David and Ann have dec
Here, David and Ann have decided to rent out their home, and ided to rent out their home, and all the costs associated withall the costs associated with getting the home in “rentable” condition would be relevant.
getting the home in “rentable” condition would be relevant. b.
b. Sunk costs (cash flows):Sunk costs (cash flows): Replace water heater Replace water heater Replace dish washer Replace dish washer
Miscellaneous repairs and maintenance Miscellaneous repairs and maintenance Opportunity costs cash flows:
Opportunity costs cash flows: Rental income
Rental income Advertising Advertising
House paint and power wash House paint and power wash P11-7.
P11-7. Book Book valuevalue LG 3; Basic LG 3; Basic Asset Asset Installed Installed Cost Cost Accumulated Accumulated Depreciation Depreciation Book Book Value Value A A $ $ 950,000 950,000 $ $ 674,500 674,500 $275,500$275,500 B B 40,000 40,000 13,200 13,200 26,80026,800 C C 96,000 96,000 79,680 79,680 16,32016,320 D D 350,000 350,000 70,000 70,000 280,000280,000 E E 1,500,000 1,500,000 1,170,000 1,170,000 330,000330,000 P11-8.
P11-8. Book value Book value and taxes and taxes on sale oon sale of assetsf assets LG 3, 4; Intermediate
LG 3, 4; Intermediate a.
a. Book Book valuevalue $80,000 $80,000 (0.71 (0.71 $80,000) $80,000)
$23,200 $23,200 b. b. Sale Price Sale Price Capital Capital Gain Gain Tax on Tax on Capital Gain Capital Gain Depreciation Depreciation Recovery Recovery Tax on Tax on Recovery Recovery Total Total Tax Tax $100,000 $20,000 $100,000 $20,000 $8,000 $8,000 $56,800 $56,800 $22,720 $22,720 $30,720$30,720 56,000 56,000 0 0 0 0 32,800 32,800 13,120 13,120 13,12013,120 23,200 23,200 0 0 0 0 0 0 0 0 00 15,000 15,000 0 0 0 0 (8,200) (8,200) (3,280) (3,280) (3,280)(3,280)
P11-9.
P11-9. Tax Tax calculationscalculations
LG 3, 4; Intermediate LG 3, 4; Intermediate Current book value
Current book value $200,000 $200,000 [(0.52 [(0.52 ($200,000)] ($200,000)] $96,000 $96,000
(a) (b) (c) (d)
(a) (b) (c) (d)
Capital
Capital gain gain $ $ 20,000 20,000 $ $ 0 0 $0 $0 $ $ 00 Recaptured
Recaptured depreciation depreciation 104,000 104,000 54,000 54,000 0 0 (16,000)(16,000) Tax
Tax on on capital capital gain gain 8,000 8,000 0 0 0 0 00 Tax on depreciation
Tax on depreciation Recovery
Recovery 41,600 41,600 21,600 21,600 0 0 (6,400)(6,400) Total
Total tax tax $ $ 49,600 49,600 $21,600 $21,600 $0 $0 ($6,400)($6,400) P11-10.
P11-10. Change in Change in net working capital net working capital calculationcalculation LG 3; Basic
LG 3; Basic a.
a.
Current
Current Assets Assets Current Current LiabilitiesLiabilities Cash
Cash $15,000$15,000 Accounts payableAccounts payable $90,000$90,000 Accounts receivable
Accounts receivable 150,000150,000 AccrualsAccruals 40,00040,000 Inventory
Inventory 10,00010,000 Net change
Net change $155,000 $155,000 $130,000$130,000 Net working capital
Net working capital current assets current assets current liabilities current liabilities
NWC NWC $155,000 $155,000 $130,000 $130,000
NWC NWC $25,000 $25,000 b.
b. Analysis of the purchase oAnalysis of the purchase of a new machine reveals an increase in nf a new machine reveals an increase in net working capital. Thiet working capital. Thiss increase should be treated as an
increase should be treated as an initial outlay and is a cost of initial outlay and is a cost of acquiring the new machine.acquiring the new machine. c.
c. Yes, in Yes, in computing computing the terminathe terminal cash l cash flow, tflow, the net he net working working capital capital increase shincrease should ould bebe reversed.
reversed. P11-11. Calculatin
P11-11. Calculating g initial investmentinitial investment LG 3, 4; Intermediate LG 3, 4; Intermediate a.
a. Book Book valuevalue $325,000 $325,000 (1 (1 0.20 – 0.20 – 0.32) 0.32) $325,000 $325,000 0.48 0.48 $156,000$156,000 b.
b. Sales price of old equipment Sales price of old equipment $200,000$200,000 Book
Book value value of of old old equipment equipment 156,000156,000 Recapture
Recapture of of depreciation depreciation $ $ 44,00044,000 Taxes on recapture of depreciation
Taxes on recapture of depreciation $44,000 $44,000 0.40 0.40 $17,600 $17,600 After-tax proceeds
After-tax proceeds $200,000 $200,000 $17,600 $17,600 $182,400 $182,400 c. Co
c. Cost st of of new new machine machine $ $ 500,000500,000 Less
Less sales sales price price of of old old machine machine (200,000)(200,000) Plus
Plus tax tax on on recapture recapture of of depreciation depreciation 17,60017,600 Initial
P11-12. Initial investment
P11-12. Initial investment — — basic calculation basic calculation LG 3, 4; Intermediate
LG 3, 4; Intermediate Installed cost of new asset Installed cost of new asset
Cost
Cost of of new new asset asset $ $ 35,00035,000
Installation Installation costs costs 5,0005,000 Total
Total installed installed cost cost (depreciable (depreciable value) value) $40,000$40,000 After-tax proceeds from sale of
After-tax proceeds from sale of old assetold asset
Proceeds
Proceeds from from sale sale of of old old asset asset ($25,000)($25,000)
Tax Tax on on sale sale of of old old asset asset 7,6807,680 Total after-tax proceeds
Total after-tax proceeds — — old old asset asset ($17,320)($17,320) Initial
Initial investment investment $22,680$22,680 Book value of existing machine
Book value of existing machine $20,000 $20,000 (1 (1 (0.20 (0.20 0.32 0.32 0.19)) 0.19)) $5,800 $5,800 Recaptured depreciation
Recaptured depreciation $20,000 $20,000 $5,800 $5,800 $14,200 $14,200 Capital gain
Capital gain $25,000 $25,000 $20,000 $20,000 $5,000 $5,000 Tax on recaptured depreciation
Tax on recaptured depreciation $14,200 $14,200 (0.40) (0.40) $5,680 $5,680 Tax on capital gain
Tax on capital gain $5,000 $5,000 (0.40) (0.40) 2,000 2,000 Total tax
Total tax $7,680$7,680 P11-13.
P11-13. Initial investment at Initial investment at various sale pricesvarious sale prices LG 3, 4; Intermediate
LG 3, 4; Intermediate
(a)
(a) (b) (b) (c) (c) (d)(d) Installed cost of new asset:
Installed cost of new asset: Cost
Cost of of new new asset asset $24,000 $24,000 $24,000 $24,000 $24,000 $24,000 $24,000$24,000
Installation cost Installation cost 2,000 2,000 2,000 2,000 2,000 2,000 2,0002,000 Total
Total installed installed cost cost 26,000 26,000 26,000 26,000 26,000 26,000 26,00026,000 After-tax proceeds from sale
After-tax proceeds from sale of old asset
of old asset
Proceeds from sale Proceeds from sale
of
of old old asset asset (11,000) (11,000) (7,000) (7,000) (2,900) (2,900) (1,500)(1,500)
Tax on sale of old asset Tax on sale of old asset** 3,240 3,240 1,640 1,640 0 0 (560)(560)
Total
Total after-tax after-tax proceeds proceeds (7,760) (7,760) (5,360) (5,360) (2,900) (2,900) (2,060)(2,060) Initial
Initial investment investment $18,240 $18,240 $20,640 $20,640 $23,100 $23,100 $23,940$23,940 Book value of existing machine
Book value of existing machine $10,000 $10,000 [1 [1 (0.20 (0.20 0.32 0.320.19)]0.19)] $2,900 $2,900
*
* Tax Tax Calculations:Calculations:
a.
a. Recaptured Recaptured depreciationdepreciation $10,000 $10,000 $2,900 $2,900 $7,100$7,100 Capital gain
Capital gain $11,000 $11,000 $10,000 $10,000 $1,000 $1,000 Tax on ordinary gain
Tax on ordinary gain $7,100 $7,100 (0.40) (0.40) $2,840 $2,840 Tax on capital gain
Tax on capital gain $1,000 $1,000 (0.40) (0.40) 400400 Total tax
Total tax $3,240$3,240
b.
b. Recaptured depreciationRecaptured depreciation $7,000 $7,000 $2,900 $2,900 $4,100 $4,100 Tax on ordinary gain
Tax on ordinary gain $4,100 $4,100 (0.40) (0.40) $1,640 $1,640 c.
d.
d. Loss Loss on on sale sale of of existing existing assetasset $1,500 $1,500 $2,900 $2,900 ($1,400) ($1,400) Tax benefit
Tax benefit $ 1,400$ 1,400 (0.40) (0.40) $ $ 560560
P11-14. Calculatin
P11-14. Calculating g initial investmentinitial investment LG 3, 4; Challenge
LG 3, 4; Challenge a.
a. Book Book valuevalue ($60,000 ($60,000 0.31) 0.31) $18,600 $18,600 b.
b. Sales price of old equipmenSales price of old equipment t $35,000$35,000 Book
Book value value of of old old equipment equipment 18,60018,600 Recapture
Recapture of of depreciation depreciation $16,400$16,400 Taxes on recapture of depreciation
Taxes on recapture of depreciation $16,400 $16,400 0.40 0.40 $6,560 $6,560 Sale
Sale price price of of old old roaster roaster $35,000$35,000 Tax
Tax on on recapture recapture of of depreciation depreciation (6,560)(6,560) After-tax
After-tax proceeds proceeds from from sale of sale of old old roaster roaster $28,440$28,440 c.
c. Changes Changes in in current current asset asset accountsaccounts Inventory
Inventory $ $ 50,00050,000 Accounts
Accounts receivable receivable 70,00070,000 Net change
Net change $ 120,000$ 120,000 Changes in current
Changes in current liability accountsliability accounts
Accruals $ (20,000) Accruals $ (20,000) Accounts
Accounts payable payable 40,00040,000 Notes payable
Notes payable 15,00015,000 Net change
Net change $ 35,000$ 35,000 Change
Change in in net net working working capital capital $ $ 85,00085,000 d.
d. Cost Cost of of new new roaster roaster $130,000$130,000 Less after-tax proceeds from sale of old roaster
Less after-tax proceeds from sale of old roaster 28,44028,440 Plus
Plus change change in in net net working working capital capital 85,00085,000 Initial
Initial investment investment $186,560$186,560 P11-15. Depreciation P11-15. Depreciation LG 5; Basic LG 5; Basic Depreciation Schedule Depreciation Schedule Year
Year Depreciation Depreciation ExpenseExpense 1 1 $68,000$68,000 0.200.20 $13,600$13,600 2 2 68,00068,000 0.320.32 21,76021,760 3 3 68,00068,000 0.190.19 12,92012,920 4 4 68,00068,000 0.120.12 8,1608,160 5 5 68,00068,000 0.120.12 8,1608,160 6 6 68,00068,000 0.050.05 3,4003,400
P11-16.
P11-16. Incremental operating Incremental operating cash inflowscash inflows LG 5; Intermediate
LG 5; Intermediate a.
a. Incremental profits Incremental profits before before depreciation depreciation and and taxtax $1,200,000 $1,200,000 $480,000 $480,000
$720,000 each year $720,000 each year b. b. Year Year (1) (1) (2) (2) (3) (3) ((4) 4) (5) (5) (6)(6) PBDT PBDT $720$720,00,000 0 $720,000 $720,000 $720$720,000 ,000 $720,000 $720,000 $720,000 $720,000 $720,000$720,000 Depr. Depr. 400,000 400,000 640,00640,000 0 380,000 380,000 240,000 240,000 240,000 240,000 100,000100,000 NPBT NPBT 320,000 320,000 80,000 80,000 340,000 340,000 480,000 480,000 480,000 480,000 620,000620,000 Tax Tax 128,000 128,000 32,000 32,000 136,000 136,000 192,000 192,000 192,000 192,000 248,000248,000 NPAT NPAT 192,000 192,000 48,000 48,000 204,000 204,000 288,000 288,000 288,000 288,000 372,000372,000 c. c. Cash Cash flow flow (1) (1) $592,000 $592,000 (2) (2) $688,000 $688,000 (3) (3) $584,000 $584,000 (4) (4) $528,000 $528,000 (5) (5) $528,000 $528,000 (6) (6) $472,000 $472,000 (NPAT
(NPAT depreciation) depreciation) PBDT
PBDT Profits before depreciation and taxesProfits before depreciation and taxes NPBT
NPBT Net profits before taxes Net profits before taxes NPAT
NPAT Net profits after taxes Net profits after taxes P11-17.
P11-17. Personal finance: Personal finance: Incremental operating cash Incremental operating cash inflowsinflows LG 5; Challenge
LG 5; Challenge
Richard and Linda Thomson Richard and Linda Thomson Incremental Operating Cash Flows Incremental Operating Cash Flows Replacement of John Deere Riding
Replacement of John Deere Riding MowerMower Year
Year 1 1 Year Year 2 2 Year Year 3 3 Year Year 4 4 Year Year 5 5 Year Year 66 Savings
Savings from from new new and and improved improved mower mower $500 $500 $ 500 $ 500 $500 $500 $500 $500 $500$500 — — Annual
Annual maintenance maintenance cost cost 120 120 120 120 120 120 120 120 120 120 00 Depreciation
Depreciation** 360 360 576 576 342 342 216 216 216 216 9090
Savings
Savings (loss) (loss) before before taxes taxes 20 20 (196) (196) 38 38 164 164 164 164 (90)(90) Taxes
Taxes (40%) (40%) 8 8 (78) (78) 15 15 66 66 66 66 (36)(36) Savings
Savings (loss) (loss) after after taxes taxes 12 12 (118) (118) 23 23 98 98 98 98 (54)(54) Depreci
Depreciation ation 360 360 576 576 342 342 216 216 216 216 9090 Incremental
Incremental operating operating cash cash flow flow $372 $372 $ $ 458 458 $365 $365 $314 $314 $314 $314 $ $ 3636
*
*MACRS Depreciation ScheduleMACRS Depreciation Schedule
Year
Year Base Base MACRS MACRS DepreciationDepreciation Year Year 1 1 $1,800 $1,800 20.0% 20.0% $360$360 Year Year 2 2 1,800 1,800 32.0% 32.0% 576576 Year Year 3 3 1,800 1,800 19.0% 19.0% 342342 Year Year 4 4 1,800 1,800 12.0% 12.0% 216216 Year Year 5 5 1,800 1,800 12.0% 12.0% 216216 Year Year 6 6 1,800 1,800 5.0% 5.0% 9090
P11-18.
P11-18. Incremental operating Incremental operating cash inflowscash inflows — — expense reductionexpense reduction LG 5; Intermediate LG 5; Intermediate Year Year (1) (1) (2) (2) (3) (3) (4) (4) (5) (5) (6)(6) Incremental Incremental expense
expense savings savings $16,000 $16,000 $16,000 $16,000 $16,000 $16,000 $16,000 $16,000 $16,000 $16,000 $ $ 00 Incremental profits
Incremental profits before dep. and taxes
before dep. and taxes** 16,000 16,000 16,000 16,000 16,000 16,000 16,000 16,000 16,000 16,000 00
Depreciation Depreciation 9,600 9,600 15,360 15,360 9,120 9,120 5,760 5,760 5,760 5,760 2,4002,400 Net profits Net profits before taxes before taxes 6,400 6,400 640 640 6,880 6,880 10,240 10,240 10,24010,240 2,4002,400 Taxes Taxes 2,560 2,560 256 256 2,752 2,752 4,096 4,096 4,0964,096 960960 Net profits Net profits after
after taxes taxes 3,840 3,840 384 384 4,128 4,128 6,144 6,144 6,1446,144 1,4401,440 Operating cash
Operating cash inflows
inflows**** 13,440 13,440 15,744 15,744 13,248 13,248 11,904 11,904 11,904 11,904 960960
*
*Incremental profits before depreciatiIncremental profits before depreciation and taxes will increase the on and taxes will increase the same amount as the decrease same amount as the decrease in expenses.in expenses. **
** Net profits after taxes plus depreciation expense. Net profits after taxes plus depreciation expense.
P11-19.
P11-19. Incremental operating Incremental operating cash inflowscash inflows LG 5; Intermediate LG 5; Intermediate a. a. Year Revenue Year Revenue Expenses Expenses (excluding (excluding depreciation depreciation and interest) and interest) Profits before Profits before Depreciation Depreciation and Taxes and Taxes Depre-ciation ciation Net Net Profits Profits before before Taxes Taxes Taxes Taxes Net Net Profits Profits after Tax after Tax Operating Operating Cash Cash Inflows Inflows New Lathe New Lathe 1 1 $40,000 $40,000 $30,000 $30,000 $10,000 $10,000 $2,000 $2,000 $8,000 $8,000 $3,200 $3,200 $4,800 $4,800 $6,800$6,800 2 2 41,000 41,000 30,000 30,000 11,000 11,000 3,200 3,200 7,800 7,800 3,120 3,120 4,680 4,680 7,8807,880 3 3 42,000 42,000 30,000 30,000 12,000 12,000 1,900 1,900 10,100 10,100 4,040 4,040 6,060 6,060 7,9607,960 4 4 43,000 43,000 30,000 30,000 13,000 13,000 1,200 1,200 11,800 11,800 4,720 4,720 7,080 7,080 8,2808,280 5 5 44,000 44,000 30,000 30,000 14,000 14,000 1,200 1,200 12,800 12,800 5,120 5,120 7,680 7,680 8,8808,880 6 6 0 0 0 0 0 0 500 500 (500) (500) (200) (200) (300) (300) 200200 Old Lathe Old Lathe 1 1 – – 5 5 $35,000 $35,000 $25,000 $25,000 $10,000 $10,000 0 0 $10,000 $10,000 $4,000 $4,000 $6,000 $6,000 $6,000$6,000 b.
b. Calculation of incremental Calculation of incremental cash inflowscash inflows Year
Year New New Lathe Lathe Old Old Lathe Lathe Incremental Incremental Cash Cash FlowsFlows 1 1 $6,800 $6,800 $6,000 $6,000 $800$800 2 2 7,880 7,880 6,000 6,000 1,8801,880 3 3 7,960 7,960 6,000 6,000 1,9601,960 4 4 8,280 8,280 6,000 6,000 2,2802,280 5 5 8,880 8,880 6,000 6,000 2,8802,880 6 6 200 200 0 0 200200
c. c.
P11-20.
P11-20. Determining incremental operating cash Determining incremental operating cash flowsflows LG 5; Intermediate LG 5; Intermediate Year Year 1 2 3 4 5 6 1 2 3 4 5 6 Revenues: (000) Revenues: (000) New buses New buses $1,850 $1,850 $1,850 $1,850 $1,830 $1,830 $1,825 $1,825 $1,815 $1,815 $1,800$1,800 Old
Old buses buses 1,800 1,800 1,800 1,800 1,790 1,790 1,785 1,785 1,775 1,775 1,7501,750 Incremental
Incremental revenue revenue $50 $50 $50 $50 $40 $40 $40 $40 $40 $40 $50$50 Expenses: (000)
Expenses: (000) New buses
New buses $460 $460 $460 $460 $468 $468 $472 $472 $485 $485 $500$500 Old
Old buses buses 500 500 510 510 520 520 520 520 530 530 535535 Incremental
Incremental expense expense $ $ (40) (40) $ $ (50) (50) $ $ (52) (52) $ $ (48) (48) $ $ (45) (45) $ $ (35)(35) Depreciation: (000)
Depreciation: (000) New buses
New buses $ 600 $ 600 $ 960 $ 960 $ 570 $ 570 $ 360 $ 360 $ 360 $ 360 $ 150$ 150 Old
Old buses buses 324 324 135 135 0 0 0 0 0 0 00 Incremental
Incremental depr. depr. $276 $276 $825 $825 $570 $570 $360 $360 $360 $360 $150$150 Incremental depr. tax
Incremental depr. tax savings
savings @40% @40% 110 110 330 330 228 228 144 144 144 144 6060 Net Incremental Cash Flows
Net Incremental Cash Flows Cash flows: (000) Cash flows: (000) Revenues Revenues $50 $50 $50 $50 $40 $40 $40 $40 $40 $40 $50$50 Expenses Expenses 40 40 50 50 52 52 48 48 45 45 3535 Less
Less taxes taxes @40% @40% (36) (36) (40) (40) (37) (37) (35) (35) (34) (34) (34)(34) Depr.
Depr. tax tax savings savings 110 110 330 330 228 228 144 144 144 144 6060 Net operating cash
Net operating cash inflows
inflows $164 $164 $390 $390 $283 $283 $197 $197 $195 $195 $111$111 P11-21.
P11-21. Terminal cash Terminal cash flowsflows — — various lives and sale pricesvarious lives and sale prices LG 6; Challenge
LG 6; Challenge a.
a.
After-tax proceeds from sale of new asset
After-tax proceeds from sale of new asset 3-Year3-Year** 5-Year5-Year** 7-Year7-Year**
Proceeds
Proceeds from from sale sale of of proposed proposed asset asset $10,000 $10,000 $10,000 $10,000 $10,000$10,000
Tax on sale of proposed asset Tax on sale of proposed asset** 16,88016,880 400400 4,0004,000
Total after-tax proceeds
Total after-tax proceeds — — new new $26,880 $26,880 $9,600 $9,600 $ $ 6,0006,000
Change in net Change in net working capitalworking capital 30,00030,000 30,00030,000 30,00030,000 Terminal
*
*1. 1. Book Book value value of of assetasset [1 [1 (0.20 (0.20 0.32 0.32 0.19)] 0.19)] $180,000 $180,000 $52,200 $52,200
Proceeds from sale
Proceeds from sale $10,000 $10,000 $10,000
$10,000 $52,200 $52,200 ($42,200) loss ($42,200) loss $42,200
$42,200 (0.40) (0.40) $16,880 tax benefit $16,880 tax benefit 2.
2. Book Book value value of of assetasset [1 [1 (0.20 (0.20 0.32 0.32 0.19 0.19 0.12 0.12 0.12)] 0.12)] $180,000 $180,000 $9,000 $9,000 $10,000
$10,000 $9,000 $9,000 $1,000 recaptured depreciation $1,000 recaptured depreciation $1,000
$1,000 (0.40) (0.40) $400 tax liability $400 tax liability 3.
3. Book Book value value of of assetasset $0 $0 $10,000
$10,000 $0 $0 $10,000 recaptured depreciation $10,000 recaptured depreciation $10,000
$10,000 (0.40) (0.40) $4,000 tax liability $4,000 tax liability b.
b. If the usable life is less than If the usable life is less than the normal recovery period, the assthe normal recovery period, the asset has not been depreciatedet has not been depreciated fully and a tax benefit may be taken on the loss; therefore, the terminal cash flow is higher. fully and a tax benefit may be taken on the loss; therefore, the terminal cash flow is higher. c.
c.
(1)
(1) (2)(2) After-tax proceeds from sale of new asset
After-tax proceeds from sale of new asset
Proceeds
Proceeds from from sale sale of of new new asset asset $ $ 9,000 9,000 $170,000$170,000
Tax on sale of proposed asset Tax on sale of proposed asset** 0 0 (64,400)(64,400)
Change in net working capital Change in net working capital 30,00030,000 30,00030,000 Terminal
Terminal cash cash flow flow $39,000 $39,000 $135,600$135,600 1.
1. Book Book value value of of the the assetasset $180,000 $180,000 0.05 0.05 $9,000; no taxes are due $9,000; no taxes are due 2. Tax
2. Tax ($170,000 ($170,000 $9,000) $9,000) 0.4 0.4 $64,400. $64,400. d.
d. The higThe higher the her the sale psale price, the rice, the higher higher the termthe terminal cash inal cash flow.flow. P11-22.
P11-22. Terminal cash Terminal cash flowflow — — replacement decisionreplacement decision LG 6; Challenge
LG 6; Challenge
After-tax proceeds from sale of new asset After-tax proceeds from sale of new asset
Proceeds
Proceeds from from sale sale of of new new machine machine $75,000$75,000
Tax on sale of new machine Tax on sale of new machinell (14,360)(14,360)
Total after-tax proceeds
Total after-tax proceeds — — new new asset asset $60,640$60,640
After-tax proceeds from sale of old asset After-tax proceeds from sale of old asset Proceeds
Proceeds from from sale sale of of old old machine machine (15,000)(15,000)
Tax on sale of old machine Tax on sale of old machine22 6,0006,000
Total after-tax proceeds
Total after-tax proceeds — — old old asset asset (9,000)(9,000)
Change Change in in net net working working capital capital 25,00025,000 Terminal
Terminal cash cash flow flow $76,640$76,640
1
1 Book Book value value of of new new machine machine at at end end of of year year 4:4:
[1
[1 (0.20 (0.20 0.32 0.32 0.19 0.19 0.12) 0.12) ($230,000)] ($230,000)] $39,100 $39,100 $75,000
$75,000 $39,100 $39,100 $35,900 recaptured depr$35,900 recaptured depreciationeciation $35,900
$35,900 (0.40) (0.40) $14,360 tax liabil$14,360 tax liabilityity
2
2 Book value of old machine at end of year 4:Book value of old machine at end of year 4:
$0 $0 $15,000
$15,000 $0 $0 $15,000 recaptured depr$15,000 recaptured depreciationeciation $15,000
P11-23.
P11-23. Relevant cash flows fRelevant cash flows for a marketing caor a marketing campaignmpaign LG 3, 4, 5, 6;
LG 3, 4, 5, 6; ChallengeChallenge
Marcus Tube Marcus Tube
Calculation of Relevant Cash Flow Calculation of Relevant Cash Flow
($000) ($000) Calculation of Net Profits after Taxes
Calculation of Net Profits after Taxes and Operating Cash Flow:and Operating Cash Flow: with Marketing Campaign
with Marketing Campaign 2013 2013 2014 2014 2015 2015 2016 2016 20172017 Sales Sales $20,500 $20,500 $21,000 $21,000 $21,500 $21,500 $22,500 $22,500 $23,500$23,500 CGS CGS (@ (@ 80%) 80%) 16,400 16,400 16,800 16,800 17,200 17,200 18,000 18,000 18,80018,800 Gross
Gross profit profit $ $ 4,100 4,100 $ $ 4,200 4,200 $ $ 4,300 4,300 $ $ 4,500 4,500 $ $ 4,7004,700 Less: Operating expenses
Less: Operating expenses General and General and administrative administrative (10% (10% of of sales) sales) $ $ 2,050 2,050 $ $ 2,100 2,100 $ $ 2,150 2,150 $ $ 2,250 2,250 $ $ 2,3502,350 Marketing
Marketing campaign campaign 150 150 150 150 150 150 150 150 150150 Depreciation Depreciation 500 500 500 500 500 500 500 500 500500 Total operating Total operating expenses expenses 2,700 2,700 2,750 2,750 2,800 2,800 2,900 2,900 3,0003,000 Net profit Net profit before taxes before taxes $ 1,400 $ 1,400 $ 1,450 $ 1,450 $ 1,500 $ 1,500 $ 1,600 $ 1,600 $ 1,700$ 1,700 Less:
Less: Taxes Taxes 40% 40% 560 560 580 580 600 600 640 640 680680 Net profit
Net profit after
after taxes taxes $ $ 840 840 $ $ 870 870 $ $ 900 900 $ $ 960 960 $ $ 1,0201,020
Depreciation Depreciation 500 500 500 500 500 500 500 500 500500 Operating
Operating CF CF $ $ 1,340 1,340 $ $ 1,370 1,370 $ $ 1,400 1,400 $ $ 1,460 1,460 $ $ 1,5201,520
Without Marketing Campaign Without Marketing Campaign
Years 2013
Years 2013 – – 20172017 Net profit after taxes
Net profit after taxes $ 900$ 900
Depreciation Depreciation 500500 Operating
Operating cash cash flow flow $1,400$1,400 Relevant Cash Flow Relevant Cash Flow
($000) ($000) Year Year With Marketing With Marketing Campaign Campaign Without Marketing Without Marketing Campaign Campaign Incremental Incremental Cash Flow Cash Flow 2013 2013 $1,340 $1,340 $1,400 $1,400 $(60)$(60) 2014 2014 1,370 1,370 1,400 1,400 (30)(30) 2015 2015 1,400 1,400 1,400 1,400 00 2016 2016 1,460 1,460 1,400 1,400 6060 2017 2017 1,520 1,520 1,400 1,400 120120
P11-24.
P11-24. Relevant cash Relevant cash flowsflows — — no terminal valueno terminal value LG 3, 4, 5;
LG 3, 4, 5; ChallengeChallenge a.
a. Installed Installed cost cost of of new new assetasset Cost
Cost of of new new asset asset $76,000$76,000
Installation Installation costs costs 4,0004,000 Total
Total cost cost of of new new asset asset $80,000$80,000
After-tax proceeds from sale of old aAfter-tax proceeds from sale of old assetsset Proceeds
Proceeds from from sale sale of of old old asset asset (55,000)(55,000)
Tax on sale of old assetTax on sale of old asset** 16,20016,200
Total
Total proceeds, proceeds, sale sale of of old old asset asset (38,800)(38,800) Initial
Initial investment investment $41,200$41,200
*
* Book value of old machine:Book value of old machine:
[1
[1 (0.20 (0.20 0.32 0.32 0.19)] 0.19)] $50,000 $50,000 $14,500 $14,500 $55,000
$55,000 $14,500 $14,500 $40,500 $40,500 gain gain on on assetasset $35,500 recaptured depreciation
$35,500 recaptured depreciation 0.40 0.40 $14,200 $14,200 $5,000 capital gain
$5,000 capital gain 0.40 0.40 2,0002,000 Total tax on sale of asset
Total tax on sale of asset $16,200 $16,200
b. b.
Calculation of Operating Cash Flow Calculation of Operating Cash Flow Year Year (1) (1) (2) (2) (3) (3) (4) (4) (5) (5) (6)(6) Old Machine Old Machine PBDT PBDT $14,000 $14,000 $16,000 $16,000 $20,000 $20,000 $18,000 $18,000 $14,000 $14,000 $ $ 00 Depreciation Depreciation 6,000 6,000 6,000 6,000 2,500 2,500 0 0 0 0 00 NPBT NPBT $ 8,000 $ 8,000 $10,000 $10,000 $17,500 $17,500 $18,000 $18,000 $14,000 $14,000 00 Taxes Taxes 3,200 3,200 4,000 4,000 7,000 7,000 7,200 7,200 5,600 5,600 00 NPAT NPAT $ 4,800 $ 4,800 $ 6,000 $ 6,000 $10,500 $10,800 $10,500 $10,800 $ 8,400 $ 8,400 $ 0$ 0 Depreciation Depreciation 6,000 6,000 6,000 6,000 2,500 2,500 0 0 0 0 00 Cash
Cash flow flow $10,800 $10,800 $12,000 $12,000 $13,000 $13,000 $10,800 $10,800 $ $ 8,400 8,400 $ $ 00 New Machine New Machine PBDT PBDT $30,000 $30,000 $30,000 $30,000 $30,000 $30,000 $30,000 $30,000 $30,000 $30,000 $ $ 00 Depreciation Depreciation 16,000 16,000 25,600 25,600 15,200 15,200 9,600 9,600 9,600 9,600 4,0004,000 NPBT NPBT $14,000 $14,000 $ 4,400 $ 4,400 $14,800 $14,800 $20,400 $20,400 $20,400$20,400 $4,000$4,000 Taxes Taxes 5,600 5,600 1,760 1,760 5,920 5,920 8,160 8,160 8,1608,160 1,6001,600 NPAT NPAT $ 8,400 $ 8,400 $ 2,640 $ 2,640 $ 8,880 $ 8,880 $12,240 $12,240 $12,240$12,240 $2,400$2,400 Depreciation Depreciation 16,000 16,000 25,600 25,600 15,200 15,200 9,600 9,600 9,600 9,600 4,0004,000 Cash
Cash flow flow $24,400 $24,400 $28,240 $28,240 $24,080 $24,080 $21,840 $21,840 $21,840 $21,840 $1,600$1,600 Incremental
Incremental After-tax After-tax cash
c. c.
P11-25. Integrative
P11-25. Integrative — — determining relevant cash flowsdetermining relevant cash flows LG 3, 4, 5, 6;
LG 3, 4, 5, 6; ChallengeChallenge a.
a. Initial investment:Initial investment:
Installed cost of new asset Installed cost of new asset
Cost
Cost of of new new asset asset $105,000$105,000
Installation Installation costs costs 5,0005,000 Total
Total cost cost of of new new asset asset $110,000$110,000
After-tax proceeds from sale of old asset After-tax proceeds from sale of old asset
Proceeds
Proceeds from from sale sale of of old old asset asset (70,000)(70,000)
Tax on sale of old asset Tax on sale of old asset** 16,48016,480
Total
Total proceeds proceeds from from sale sale of of old old asset asset (53,520)(53,520)
Change Change in in working working capital capital 12,00012,000 Initial
Initial investment investment $ $ 68,48068,480
*
* Book Book value value of of old old asset:asset:
[1
[1 (0.20 (0.20 0.32)] 0.32)] $60,000 $60,000 $28,800 $28,800 $70,000
$70,000 $28,800 $28,800 $41,200 gain on sale of asset $41,200 gain on sale of asset $31,200 recaptured depreciation
$31,200 recaptured depreciation 0.40 0.40 $12,480 $12,480 $10,000 capital gain
$10,000 capital gain 0.40 0.40 4,0004,000 Total tax of sale of asset
Total tax of sale of asset $16,480 $16,480 b.
b.
Calculation of Operating Cash Inflows Calculation of Operating Cash Inflows
Year Year Profits before Profits before Depreciation Depreciation and
and Taxes Taxes DepreciationDepreciation
Net Profits Net Profits before
before Taxes Taxes TaxesTaxes
Net Profits Net Profits after Taxes after Taxes Operating Operating Cash Cash Inflows Inflows New Grinder New Grinder 1 1 $43,000 $43,000 $22,000 $22,000 $21,000 $21,000 $8,400 $8,400 $12,600 $12,600 $34,600$34,600 2 2 43,000 43,000 35,200 35,200 7,800 7,800 3,120 3,120 4,680 4,680 39,88039,880 3 3 43,000 43,000 20,900 20,900 22,100 22,100 8,840 8,840 13,260 13,260 34,16034,160 4 4 43,000 43,000 13,200 13,200 29,800 29,800 11,920 11,920 17,880 17,880 31,08031,080 5 5 43,000 43,000 13,200 13,200 29,800 29,800 11,920 11,920 17,880 17,880 31,08031,080 6 6 0 0 5,5005,500 5,5005,500 2,2002,200 3,300 3,300 2,2002,200 Existing Grinder Existing Grinder 1 1 $26,000 $26,000 $11,400 $11,400 $14,600 $14,600 $5,840 $5,840 $8,760 $8,760 $20,160$20,160 2 2 24,000 24,000 7,200 7,200 16,800 16,800 6,720 6,720 10,080 10,080 17,28017,280 3 3 22,000 22,000 7,200 7,200 14,800 14,800 5,920 5,920 8,880 8,880 16,08016,080 4 4 20,000 20,000 3,000 3,000 17,000 17,000 6,800 6,800 10,200 10,200 13,20013,200 5 5 18,000 18,000 0 0 18,000 18,000 7,200 7,200 10,800 10,800 10,80010,800 6 6 0 0 0 0 0 0 0 0 0 0 00
Calculation of Incremental Cash Inflows Calculation of Incremental Cash Inflows Year
Year New New Grinder Existing Grinder Existing GrinderGrinder
Incremental Operating Incremental Operating Cash Flow Cash Flow 1 1 $34,600 $34,600 $20,160 $20,160 $14,440$14,440 2 2 39,880 39,880 17,280 17,280 22,60022,600 3 3 34,160 34,160 16,080 16,080 18,08018,080 4 4 31,080 31,080 13,200 13,200 17,88017,880 5 5 31,080 31,080 10,800 10,800 20,28020,280 6 6 2,200 2,200 0 0 2,2002,200 c.
c. Terminal Terminal cash cash flow:flow:
After-tax proceeds from sale of
After-tax proceeds from sale of new assetnew asset
Proceeds
Proceeds from from sale sale of of new new asset asset $29,000$29,000
Tax on sTax on sale of new ale of new assetasset** (9,400)(9,400)
Total
Total proceeds proceeds from from sale sale of of new new asset asset 19,60019,600
After-tax proceeds froAfter-tax proceeds from sale of old asm sale of old assetset
Proceeds
Proceeds from from sale sale of of old old asset asset 00
Tax on Tax on sale sale of of old old asset asset 00 Total
Total proceeds proceeds from from sale sale of of old old asset asset 00
Change Change in in net net working working capital capital 12,00012,000 Terminal
Terminal cash cash flow flow $31,600$31,600
*
* Book Book value value of aof asset sset at enat end od of yf year ear 55 $5,500 $5,500
$29,000
$29,000 $5,500 $5,500 $23,500 $23,500 recaptured recaptured depreciationdepreciation $23,500
$23,500 0.40 0.40 $9,400 $9,400
d.
d. Year Year 5 5 relevant relevant cash cash flow:flow: Operating
Operating cash cash flow flow $20,280$20,280 Terminal
Terminal cash cash flow flow 31,60031,600 Total
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