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CHAPTER 8: CAPITAL BUDGETING

DECISIONSPART II
Problems
1. Stockholm Company is considering the sale of a machine with the following
characteristics.
Book value
Remaining useful life
Annual straight-line depreciation
Current market value

\$120,000
5 years
\$ 24,000
\$ 70,000

If the company sells the machine its cash operating expenses will increase by
\$30,000 per year due to an operating lease. The tax rate is 40%.
a. Find the cash flow from selling the machine.
b. Calculate the increase in annual net cash outflows as a result of selling the
machine.
SOLUTION:
a. Cash flow from sale: \$90,000 (\$70,000 + 40% tax savings on the \$50,000 tax loss)
b. Increase in annual cash outflows: \$27,600 (\$30,000 pretax cost increase - \$2,400
decrease in income taxes; the \$30,000 increase in cash costs is partially offset by
losing a \$24,000 depreciation deduction)
2. Pepin Company is considering replacing a machine that has the following
characteristics.
Book value
Remaining useful life
Annual straight-line depreciation
Current market value

\$100,000
5 years
\$ ???
\$ 60,000

The replacement machine would cost \$150,000, have a five-year life, and save
\$50,000 per year in cash operating costs. It would be depreciated using the straightline method. The tax rate is 40%.
a. Find the net investment required to replace the existing machine.

b. Compute the increase in annual income taxes if the company replaces the
machine.
c. Compute the increase in annual net cash flows if the company replaces the
machine.
SOLUTION:
a. Net investment: \$74,000 [\$150,000 - \$60,000 - 40%(\$100,000 - 60,000)]
b. Increase in income taxes: \$16,000 [40% x (\$50,000 pretax flow - \$30,000
depreciation + \$20,000 lost depreciation)]
c. Increase in cash flows: \$34,000 (\$50,000 - \$16,000 increase in income taxes)
3. Cable Company is considering the purchase of a machine with the following
characteristics.
Cost
Useful life
Expected annual cash cost savings

\$100,000
10 years
\$30,000

Cable's income tax rate is 40% and its cost of capital is 12%. Cable expects to use
straight-line depreciation for tax purposes.
a. Compute the expected increase in annual net cash flow for this project.
b. Compute the profitability index for the project.
c. How would the profitability index for this project be affected if Cable were to use
MACRS depreciation for tax purposes and the machine fell into the 7-year
MACRS class? (increase decrease not affected) Circle the appropriate
SOLUTION:
a. Increase in annual net cash flow: \$22,000 [\$30,000 - (40% x (\$30,000 - \$10,000)]
b. Profitability index: 1.24 [(\$22,000 x 5.65)/\$100,000]
c. Effect on profitability index: Increase (PI would increase because the tax shield of
depreciation would occur earlier and so be more valuable when considering the time
value of money.)

4. Frank Co. has the opportunity to introduce a new product. Frank expects the product
to sell for \$60 and to have per-unit variable costs of \$35 and annual cash fixed costs
of \$4,000,000. Expected annual sales volume is 275,000 units. The equipment
needed to bring out the new product costs \$6,000,000, has a four-year life and no
salvage value, and would be depreciated on a straight-line basis. Frank's cost of
capital is 14% and its income tax rate is 40%.
a. Compute the annual net cash flows for the investment.
b. Compute the NPV of the project.
c. Suppose that some of the 275,000 units expected to be sold would be to customers
who currently buy another of Frank's products, the X-10, which has a \$12 perunit contribution margin. Find the sales of X-10 that can Frank lose per year and
still have the investment in the new product return at least the 14% cost of
capital.
d. Suppose that selling the new product has no complementary effects but that
Frank's production engineers anticipate some production problems in making the
new product and are not confident of the \$35 estimate of per-unit variable costs
for the new product. Find the amount by which Frank's estimate of per-unit
variable cost could be in error and the investment still have a return at least equal
to the 14% cost of capital.
SOLUTION:
a. Annual net cash flows: \$2,325,000 [\$2,875,000 pretax - 40% x (\$2,875,000 \$1,500,000 depreciation)]
pretax income = 275,000 x (\$60 - \$35) - \$4,000,000 = \$2,875,000
b. NPV: \$775,050 [(\$2,325,000 x 2.914) - \$6,000,000]
c. Allowable loss of X-10 sales, approximately 36,941 units [(\$775,050/2.914)/60%]/12
d. Allowable error in per-unit VC, \$1.61
{[(\$775,050/2.914)/60%]/275,000 units}
5. Zenex is considering the purchase of a machine. Data are as follows:
Cost
Useful life

\$240,000
10 years

Annual straight-line depreciation

Expected annual savings in cash
operation costs
Additional working capital needed

???

\$ 80,000
\$100,000

Zenex's cutoff rate is 12% and its tax rate is 40%.

a. Compute the annual net cash flows for the investment.
b. Compute the NPV of the project.
c. Compute the profitability index of the project.
SOLUTION:
a. Annual net cash flows: \$57,600 [\$80,000 pretax - 40% x (\$80,000 - \$24,000
depreciation)]
b. NPV: \$17,640 [(\$57,600 x 5.650) - \$240,000 - \$100,000 + (\$100,000 x .322)]
c. PI: 1.052 {[(\$57,600 x 5.650) + (\$100,000 x .322)]/(\$240,000 + \$100,000)}
6. Darwin Company is considering the sale of a machine with the following
characteristics.
Book value
Remaining useful life
Annual straight-line depreciation
Current market value

\$110,000
5 years
\$ ???
\$120,000

If the company sells the machine its cash operating expenses will increase by
\$20,000 per year. The tax rate is 40%.
a. Find the cash flow from selling the machine.
b. Calculate the increase in annual net cash outflows as a result of selling the
machine.
SOLUTION:
a. Cash flow from sale: \$116,000 (\$120,000 - 40% tax on the \$10,000 tax gain)
b. Increase in annual cash outflows: \$20,800 (\$20,000 pretax cost increase + \$800
increase in income taxes; the \$20,000 increase in cash costs is more than offset by

losing a \$22,000 depreciation deduction)

7. Rusk Company is considering replacing a machine that has the following
characteristics.
Book value
Remaining useful life
Annual straight-line depreciation
Current market value

\$200,000
4 years
\$ ???
\$160,000

The replacement machine would cost \$300,000, have a four-year life, and save
\$37,500 per year in cash operating costs. It would be depreciated using the straightline method. The tax rate is 40%.
a. Find the net investment required to replace the existing machine.
b. Compute the increase in annual income taxes if the company replaces the
machine.
c. Compute the increase in annual net cash flows if the company replaces the
machine.
SOLUTION:
a. Net investment: \$124,000 [\$300,000 - \$160,000 - 40% x (\$200,000 - 160,000)]
b. Increase in income taxes: \$5,000 [40% x (\$37,500 pretax flow - \$75,000
depreciation + \$50,000 lost depreciation)]
c. Increase in cash flows: \$32,500 (\$37,500 - \$5,000 increase in income taxes)
8. Zmolek Company is considering the purchase of a machine costing \$700,000 with a
useful life of 10 years. Annual cash cost savings are expected to be \$200,000.
Zmolek's income tax rate is 40% and its cost of capital is 12%. Zmolek expects to
use straight-line depreciation for tax purposes.
a. Compute the expected increase in annual net cash flow for this project.
b. Compute the profitability index for the project.
SOLUTION:
a. Increase in annual net cash flow: \$148,000 [\$200,000 - 40% x (\$200,000 -

\$70,000)]
b. Profitability index: 1.19 [(\$148,000 x 5.65)/\$700,000]
9. Racine Co. has the opportunity to introduce a new product. Racine expects the
project to sell for \$200 and to have per-unit variable costs of \$130 and annual cash
fixed costs of \$6,000,000. Expected annual sales volume is 125,000 units. The
equipment needed to bring out the new product costs \$7,200,000, has a four-year
life and no salvage value, and would be depreciated on a straight-line basis.
Working capital of \$500,000 would be necessary to support the increased sales.
Racine's cost of capital is 12% and its income tax rate is 40%.
a. Compute the NPV of this opportunity.
b. Compute the profitability index of this opportunity.
SOLUTION:
a. NPV: negative \$184,310
Annual cash flow: \$2,370,000 = 60% x [125,000 x (\$200 - \$130)]
- 60% x \$6,000,000 + 40% x \$7,200,000/4
NPV: [(\$2,370,000 x 3.037) - \$7,200,000 - 500,000 + (\$500,000 x .636)]
b. PI: 0.976 [(\$2,370,000 x 3.037 + 500,000 x .636)/(\$7,200,000 + 500,000)]
10. Seiler is considering the purchase of a machine. Data are as follows:
Cost
Useful life
Annual straight-line depreciation
Expected annual savings in cash
operation costs
Additional working capital needed

\$2,000,000
8 years
\$ ???
\$
\$

750,000
500,000

Seiler's cutoff rate is 12% and its tax rate is 40%.

a. Compute the annual net cash flows for the investment.
b. Compute the NPV of the project.
c. Compute the profitability index of the project.

SOLUTION:
a. Annual net cash flows: \$550,000 [\$750,000 - 40% x (\$750,000 - \$250,000
depreciation)]
b. NPV: \$434,400 [(\$550,000 x 4.968) - \$2,000,000 - \$500,000 + (\$500,000 x .404)]
c. PI: 1.17 {[(\$550,000 x 4.968) + (\$500,000 x .404)]/(\$2,000,000 + \$500,000)}