I WILL HELP THE STUDENTS TO PREPARE THE EXAMS , Exams of Finance

Download I WILL HELP THE STUDENTS TO PREPARE THE EXAMS and more Exams Finance in PDF only on Docsity! CHAPTER 8 Capital Budgeting Cash Flows ANSWERS TO REVIEW QUESTIONS 8-1 Capital budgeting is the process used to evaluate and select long-term investments consistent with the goal of owner wealth maximization. Capital expenditures are outlays made by the firm that are expected to produce benefits over the long term (a period greater than one year). Not all capital expenditures are made for fixed assets. An expenditure made for an advertising campaign may have long-term benefits. 8-2 The primary motives for making capital expenditures include: • Expansion - increasing the productive capacity of the firm, usually through the acquisition of fixed assets. • Replacement - replacing existing assets with new or more advanced assets which provide the same function. • Renewal - rebuilding or overhauling existing assets to improve efficiency. Other motives include expenditures for non-tangible projects that improve a firm's profitability, such as advertising, research and development, and product development. A firm may also be required by law to undertake pollution control and similar projects. Expansion and replacement involve the purchase of new assets as compared with renewal, where old assets are upgraded. 8-3 1. Proposal generation is the origination of proposed capital projects for the firm by individuals at various levels of the organization. 2. Review and analysis is the formal process of assessing the appropriateness and economic viability of the project in light of the firm's overall objectives. This is done by developing cash flows relevant to the project and evaluating them through capital budgeting techniques. Risk factors are also incorporated into the analysis phase. 3. Decision making is the step where the proposal is compared against predetermined criteria and either accepted or rejected. 4. Implementation of the project begins after the project has been accepted and funding is made available. 5. Follow-up is the post-implementation audit of expected and actual costs and revenues generated from the project to determine if the return on the proposal meets preimplementation projections. 8-4 a. Independent projects have cash flows unrelated to or independent of each other. Mutually exclusive projects have the same function as the other projects being considered. Therefore, they compete with one another; accepting one eliminates the others from further consideration. b. Firms under capital rationing have only a fixed amount of dollars available for the capital budget, whereas a firm with unlimited funds may accept all projects with a specified rate of return. c. The accept-reject approach evaluates capital expenditures using a predetermined minimum acceptance criterion. If the project meets the criterion, it's accepted and vice versa. With ranking, projects are ranked from best to worst based on some predetermined measure, such as rate of return. d. A conventional cash flow pattern consists of an initial outflow followed by a series of inflows. A nonconventional cash flow pattern is any pattern in which an initial outlay is not followed by a series of inflows. 8-5 Capital budgeting projects should be evaluated using incremental after-tax cash flows, since after-tax cash flows are what is available to the firm. When evaluating a project, concern is placed only on added cash flows expected to result from its implementation. Expansion decisions can be treated as replacement decisions in which all cash flows from the old assets are zero. Both expansion and replacement decisions involve purchasing new assets. Replacement decisions are more complex because incremental cash flows deriving from the replacement must be determined. 8-6 The three components of cash flow for any project are 1. initial investment, 2. operating cash flows, and 3. terminal cash flows. 8-7 Sunk costs are costs that have already been incurred and thus the money has already been spent. Opportunity costs are cash flows that could be realized from the next best alternative use of an owned asset. Sunk costs are not relevant to the investment decision because they are not incremental. These costs will not change no matter what 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 structure but to utilize the owned asset for its alternative purpose. 8-8 To minimize long-term currency risk, companies can finance a foreign investment in local capital markets so that the project's revenues and costs are in the local currency rather than dollars. Techniques such as currency futures, forwards, and options market instruments protect against short-term currency risk. Financial and operating strategies that reduce political risk include structuring the investment as a joint venture with a competent and well-connected local partner; and using debt rather than equity financing, since debt service payments are legally enforceable claims while equity returns such as dividends are not. Chapter 8 Capital Budgeting Cash Flows 0 Year 1 2 3 4 5 -20,000 -40,000 F 0 D C Initial Investment -60,000 SOLUTIONS TO PROBLEMS Note: The MACRS depreciation percentages used in the following problems appear in Chapter 3, Table 3.2. The percentages are rounded to the nearest integer for ease in calculation. For simplification, five-year-lived projects with 5 years of cash inflows are used throughout this chapter. Projects with usable lives equal to the number of years cash inflows are also included in the end-of-chapter problems. It is important to recall from Chapter 3 that, under the Tax Reform Act of 1986, MACRS depreciation results in n + 1 years of depreciation for an n-year class asset. This means that in actual practice projects will typically have at least one year of cash flow beyond their recovery period. 8-1 LG 1: Classification of Expenditures a. Operating expenditure b. Capital expenditure c. Capital expenditure d. Operating expenditure e. Capital expenditure f. Capital expenditure g. Capital expenditure h. Operating expenditure 8-2 LG 2: Basic Terminology Situation A Situation B Situation C a. mutually exclusive mutually exclusive independent b. unlimited unlimited capital rationing c. ranking accept-reject ranking d. conventional nonconventional conventional (2&4) nonconventional (1&3) 8-3 LG 3: Relevant Cash Flow Pattern Fundamentals a. Year Cash Flow Initial investment ($120,000) 1-18 $25,000 - $5,000 = $ 20,000 0 1 2 3 16 17 18 -120,000 20,000 20,000 20,000 ----------------- 20,000 20,000 20,000 b. Initial investment ($85,000 - $30,000) = ($55,000) 1-5 = $ 20,000 6 $20,000 + $20,000 - $10,000 = $ 30,000 0 1 2 3 4 5 6 -55,000 20,000 20,000 20,000 20,000 20,000 30,000 c. Initial investment ($2,000, 000) 1-5 $300,000 - $20,000 = $ 280,000 6 $300,000 - $500,000 = ($ 200,000) 7-10 $300,000 - $20,000 = $ 280,000 0 1 2 5 6 7 10 -2,000,000 280,000 280,000 F 0B 7 F 0 B 7 F 0 B 7 F 0 B 7 F 0 B 7 F 0 B 7 280,000 -200,000 280,000 F 0 B 7 F 0 B 7 280,000 8-4 LG 3: Expansion versus Replacement Cash Flows a. Year Relevant Cash Flows Initial investment ($28,000) 1 4,000 2 6,000 3 8,000 4 10,000 5 4,000 b. An expansion project is simply a replacement decision in which all cash flows from the old asset are zero. 8-5 LG 3: Sunk Costs and Opportunity Costs a. The $1,000,000 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. Chapter 8 Capital Budgeting Cash Flows b. The $250,000 sale price of the existing line is an opportunity cost. If Masters Golf Products does not proceed with the new line of clubs they will not receive the $250,000. c. Cash Flows -$1,800,000 $750,000 $750,000 $750,000 $750,000 $750,000 + $ 250,000 |—————|—————|—————|———— F 0B 7 F 0 B 7 F 0 B 7 F 0 B 7 F 0 B 7———|—————|—> 0 1 2 3 9 10 End of Year 8-6 LG 3: Sunk Costs and Opportunity Costs a. Sunk cost - The funds for the tooling had already been expended and would not change, no matter whether the new technology would be acquired or not. b. Opportunity cost - The development of the computer programs can be done without additional expenditures on the computers; however, the loss of the cash inflow from the leasing arrangement would be a lost opportunity to the firm. c. Opportunity cost - Covol will not have to spend any funds for floor space but the lost cash inflow from the rent would be a cost to the firm. d. Sunk cost - The money for the storage facility has already been spent, and no matter what decision the company makes there is no incremental cash flow generated or lost from the storage building. e. Opportunity cost - Foregoing the sale of the crane costs the firm $180,000 of potential cash inflows. 8-7 LG 4: Book Value Installed Accumulated Book Asset Cost Depreciation Value A $ 950,000 $ 674,500 $275,500 B 40,000 13,200 26,800 C 96,000 79,680 16,320 D 350,000 70,000 280,000 E 1,500,000 1,170,000 330,000 8-8 LG 4: Book Value and Taxes on Sale of Assets a. Book value = $80,000 - (.71 x $80,000) Installed cost of new asset: Cost of new asset $24,000 $24,000 $24,000 $24,000 + Installation cost 2,000 2,000 2,000 2,000 Total installed-cost $26,000 $26,000 $26,000 $26,000 After-tax proceeds from sale of old asset Proceeds from sale of old asset (11,000) (7,000) (2,900) (1,500) + Tax on sale of old asset* 3,240 1,640 0 (560) Total after-tax proceeds ( 7,760) (5,360) (2,900) (2,060) Initial investment $18,240 $20,640 $23,100 $23,940 Book value of existing machine = $10,000 x [1 - (.20 -.32 -.19)] = $2,900 * Tax Calculations: a. Recaptured depreciation = $10,000 - $2,900 = $7,100 Capital gain = $11,000 - $10,000 = $1,000 Tax on ordinary gain = $7,100 x (.40) = $2,840 Tax on capital gain = $1,000 x (.40) = 400 Total tax = $3,240 b. Recaptured depreciation = $7,000 - $2,900 = $4,100 Tax on ordinary gain = $4,100 x (.40) = $1,640 c. 0 tax liability d. Loss on sale of existing asset = $1,500 - $2,900 = ($1,400) Tax benefit = - $1,400 x (.40) = $ 560 8-14 LG 4: Calculating Initial Investment a. Book value = ($61,000 x .31) = $18,910 Chapter 8 Capital Budgeting Cash Flows b. Sales price of old equipment $35,000 Book value of old equipment 18,910 Recapture of depreciation $ 16,090 Taxes on recapture of depreciation = $16,090 x .40 = $6,436 Sale price of old roaster $35,000 Tax on recapture of depreciation (6,436) After-tax proceeds from sale of old roaster $28,564 c. Changes in current asset accounts Inventory $ 50,000 Accounts receivable 70,000 Net change $120,000 Changes in current liability accounts Accruals $ (20,000) Accounts payable 40,000 Notes payable 15,000 Net change $ 35,000 Change in net working capital $ 85,000 d. Cost of new roaster $130,000 Less after-tax proceeds from sale of old roaster 28,564 Plus change in net working capital 85,000 Initial investment $186,436 8-15 LG 4: Depreciation Depreciation Schedule Year Depreciation Expense 1 $68,000 x .20 = $13,600 2 68,000 x .32 = 21,760 3 68,000 x .19 = 12,920 4 68,000 x .12 = 8,160 5 68,000 x .12 = 8,160 6 68,000 x .05 = 3,400 8-16 LG 5: Incremental Operating Cash Inflows a. Incremental profits before tax and depreciation = $1,200,000 - $480,000 = $720,000 each year b. 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 128,000 32,000 136,000 192,000 192,000 248,000 NPAT 192,000 48,000 204,000 288,000 288,000 372,000 c. Cash flow $592,000 $688,000 $584,000 $528,000 $528,000 $472,000 (NPAT + depreciation) PBDT = Profits before depreciation and taxes NPBT = Net profits before taxes NPAT = Net profits after taxes 8-17 LG 5: Incremental Operating Cash Inflows–Expense Reduction Year (1) (2) (3) (4) (5) (6) Incremental expense savings $16,000 $16,000 $16,000 $16,000 $16,000 $0 Incremental profits before dep. and taxes* $16,000 $16,000 $16,000 $16,000 $16,000 $0 Depreciation 9,600 15,360 9,120 5,760 5,760 2,400 Net profits before taxes 6,400 640 6,880 10,240 10,240 -2,400 Taxes 2,560 256 2,752 4,096 4,096 -960 Net profits after taxes 3,840 384 4,128 6,144 6,144 -1,440 Operating cash inflows** 13,440 15,744 13,248 11,904 11,904 960 * Incremental profits before depreciation and taxes will increase the same amount as the decrease in expenses. ** Net profits after taxes plus depreciation expense. Chapter 8 Capital Budgeting Cash Flows Inflows $ 164 $ 390 $ 283 $ 197 $ 195 $ 111 8-20 LG 6: Terminal Cash Flows–Various Lives and Sale Prices 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 F 0 B 1 Tax on sale of proposed asset* + 16,880 - 400 - 4,000 Total after-tax proceeds-new $26,880 $ 9,600 $ 6,000 + Change in net working capital + 30,000 + 30,000 + 30,000 Terminal cash flow $ 56,800 $39,600 $ 36,000 * (1) Book value of asset = [1- (.20 +.32 +.19) x ($180,000)] = $52,200 Proceeds from sale = $10,000 $10,000 - $52,200 = ($42,200) loss $42,200 x (.40) = $16,880 tax benefit (2) Book value of asset = [1 - (.20 +.32 +.19 +.12 +.12) x ($180,000)] = $9,000 $10,000 - $9,000 = $1,000 recaptured depreciation $1,000 x (.40) = $400 tax liability (3) Book value of asset = $0 $10,000 - $0 = $10,000 recaptured depreciation $10,000 x (.40) = $4,000 tax liability b. If the usable life is less than the normal recovery period, the asset has not been depreciated fully and a tax benefit may be taken on the loss; therefore, the terminal cash flow is higher. 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 (64,400) + Change in net working capital + 30,000 + 30,000 Terminal cash flow $ 39,000 $135,600 * (1) Book value of the asset = $180,000 x .05 = $9,000; no taxes are due (2) Tax = ($170,000 - $9,000) x 0.4 = $64,400. d. The higher the sale price, the higher the terminal cash flow. 8-21 LG 6: Terminal Cash Flow–Replacement Decision After-tax proceeds from sale of new asset = Proceeds from sale of new machine $75,000 - Tax on sale of new machine l (14,360) Total after-tax proceeds-new asset $60,640 - After- tax proceeds from sale of old asset Proceeds from sale of old machine (15,000) + Tax on sale of old machine 2 6,000 Total after-tax proceeds-old asset ( 9,000 ) + Change in net working capital 25,000 Terminal cash flow $76,640 l Book value of new machine at end of year.4: [1 - (.20 + .32+.19 + .12) x ($230,000)] = $39,100 $75,000 - $39,100 = $35,900 recaptured depreciation $35,900 x (.40) = $14,360 tax liability 2 Book value of old machine at end of year 4: $0 $15,000 - $0 = $15,000 recaptured depreciation $15,000 x (.40) = $ 6,000 tax benefit 8-22 LG 4, 5, 6: Relevant Cash Flows for a Marketing Campaign Marcus Tube Calculation of Relevant Cash Flow ($000) Calculation of Net Profits after Taxes and Operating Cash Flow: With Marketing Campaign 2004 2005 2006 2007 2008 Sales $20,500 $21,000 $21,500 $22,500 $23,500 CGS (@ 80%) 16,400 16,800 17,200 18,000 18,800 Gross Profit $ 4,100 $ 4,200 $ 4,300 $ 4,500 $ 4,700 Less: Operating Expenses General and Administrative (10% of sales) $ 2,050 $ 2,100 $ 2,150 $ 2,250 $ 2,350 Marketing Campaign 150 150 150 150 150 Depreciation 500 500 500 500 500 Total operating expenses 2,700 2,750 2,800 2,900 3,000 Net profit before taxes $1,400 $1,450 $1,500 $1,600 $1,700 Less: Taxes 40% 560 580 600 640 680 Net profit after taxes $ 840 $ 870 $ 900 $ 960 $1,020 +Depreciation 500 500 500 500 500 Operating CF $1,340 $1,370 $1,400 $1,460 $1,520 Without Marketing Campaign Years 2004 - 2008 Net profit after taxes $ 900 +Depreciation 500 Operating cash flow $ 1,400 Relevant Cash Flow ($000) With Without Incremental Year Marketing Campaign Marketing Campaign Cash Flow 2004 $1,340 $1,400 $(60) 2005 1,370 1,400 (30) 2006 1,400 1,400 -0- 2007 1,460 1,400 60 2008 1,520 1,400 120 8-23 LG 4, 5: Relevant Cash Flows–No Terminal Value a. Installed cost of new asset Cost of new asset $76,000 Profits Before Operating Depreciation Depre- Net Profits Net Profits Cash Year and Taxes ciation Before Taxes Taxes After Taxes Inflows New Grinder 1 $43,000 $22,000 $21,000 $ 8,400 $12,600 $34,600 2 43,000 35,200 7,800 3,120 4,680 39,880 3 43,000 20,900 22,100 8,840 13,260 34,160 4 43,000 13,200 29,800 11,920 17,880 31,080 5 43,000 13,200 29,800 11,920 17,880 31,080 6 --0- 5,500 -5,500 -2,200 -3,300 2,200 Existing Grinder 1 $26,000 $11,400 $14,600 $5,840 $ 8,760 $20,160 2 24,000 7,200 16,800 6,720 10,080 17,280 3 22,000 7,200 14,800 5,920 8,880 16,080 4 20,000 3,000 17,000 6,800 10,200 13,200 5 18,000 -0- 18,000 7,200 10,800 10,800 6 -0- -0- -0- -0- -0- -0- Calculation of Incremental Cash Inflows Incremental Operating Year New Grinder Existing Grinder Cash Flow 1 $34,600 $20,160 $14,440 2 39,880 17,280 22,600 3 34,160 16,080 18,080 4 31,080 13,200 17,880 5 31,080 10,800 20,280 6 2,200 -0- 2,200 c. Terminal Cash Flow: After-tax proceeds from sale of new asset = Proceeds from sale of new asset $29,000 - Tax on sale of new asset* ( 9,400) Total proceeds from sale of new asset 19,600 - After-tax proceeds from sale of old asset = Proceeds from sale of old asset 0 + Tax on sale of old asset 0 Total proceeds from sale of old asset 0 + Change in net working capital 12,000 Terminal cash flow $31,600 * Book value of asset at end of year 5 = $ 5,500 $29,000 - $5,500 = $23,500 recaptured depreciation $23,500 x .40 = $ 9,400 d. Year 5 Relevant Cash Flow: Operating cash flow $20,280 Terminal cash flow 31,600 Total inflow $51,880 0 1 2 3 4 5 6 -68,480 14,400 22,600 18,080 17,880 51,880 2,200 8-25 LG 4, 5, 6: Integrative–Determining Relevant Cash Flows a. Initial investment: A B Installed cost of new asset Cost of new asset $40,000 $54,000 + Installation costs 8,000 6,000 Total proceeds, sale of new asset 48,000 60,000 - After-tax proceeds from sale of old asset Proceeds from sale of old asset (18,000) (18,000) + Tax on sale of old asset * 3,488 3,488 Total proceeds, sale of old asset (14,512) (14,512) + Change in working capital 4,000 6,000 Initial investment $37,488 $51,488 * Book value of old asset: [1 - (.20 + .32 + .19)] x ($32,000) = $9,280 b. Calculation of Operating Cash Inflows Profits Before Operating Depreciation Depre- Net Profits Net Profits Cash Year and Taxes ciation Before Taxes Taxes After Taxes Inflows Hoist A 1 $21,000 $ 9,600 $11,400 $4,560 $6,840 $16,440 2 21,000 15,360 5,640 2,256 3,384 18,744 3 21,000 9,120 11,880 4,752 7,128 16,248 4 21,000 5,760 15,240 6,096 9,144 14,904 5 21,000 5,760 15,240 6,096 9,144 14,904 6 -0- 2,400 -2,400 -960 -1,440 960 Hoist B 1 $22,000 $12,000 $10,000 $4,000 $6,000 18,000 2 24,000 19,200 4,800 1,920 2,880 22,080 3 26,000 11,400 14,600 5,840 8,760 20,160 4 26,000 7,200 18,800 7,520 11,280 18,480 5 26,000 7,200 18,800 7,520 11,280 18,480 6 -0- 3,000 -3,000 -1,200 -1,800 1,200 Existing Hoist 1 $14,000 $3,840 $10,160 $4,064 $6,096 $9,936 2 14,000 3,840 10,160 4,064 6,096 9,936 3 14,000 1,600 12,400 4,960 7,440 9,040 4 14,000 -0- 14,000 5,600 8,400 8,400 5 14,000 --0- 14,000 5,600 8,400 8,400 6 -0- -0- -0- -0- -0- -0- Calculation of Incremental Cash Inflows Incremental Cash Flow Year Hoist A Hoist B Existing Hoist Hoist A Hoist B 1 $16,440 $18,000 $9,936 $6,504 $ 8,064 2 18,744 22,080 9,936 8,808 12,144 3 16,248 20,160 9,040 7,208 11,120 4 14,904 18,480 8,400 6,504 10,080 5 14,904 18,480 8,400 6,504 10,080 6 960 1,200 -0- 960 1,200 c. Terminal Cash Flow: (A) (B) After-tax proceeds form sale of new asset Proceeds from sale of new asset $12,000 $20,000 - Tax on sale of new asset l (3,840) (6,800) Total proceeds-new asset 8,160 13,200 - After-tax proceeds from sale of old asset Calculation of Incremental Cash Inflows Incremental Cash Flow Year Alternative 1 Alternative 2 Existing Alt. 1 Alt. 2 1 $ 126,300 $150,100 $100,000 $26,300 $50,100 2 186,000 215,200 150,000 36,000 65,200 3 235,980 239,420 200,000 35,980 39,420 4 293,460 266,340 250,000 43,460 16,340 5 353,460 335,940 320,000 33,460 15,940 6 1,800 2,200 -0- 1,800 2,200 c. Terminal Cash Flow: Alternative 1 Alternative 2 After-tax proceeds from sale of new asset = Proceeds from sale of new asset $8,000 $25,000 - Tax on sale of new assetl (1,400) (7,800) Total proceeds, sale of new asset 6,600 17,200 - After-tax proceeds from sale of old asset = Proceeds from sale of old asset (2,000) cant sold renew Alt1 (2,000) + Tax on sale of old asset2 800 800 Total proceeds, sale of old asset (1,200) (1,200) + Change in working capital 15,000 22,000 Terminal cash flow $21,600 $38,000 1 Book value of Alternative 1 at end of year 5:= $4,500 $8,000 - $4,500 = $3,500 recaptured depreciation $3,500 x (.40) = $1,400 tax Book value of Alternative 2 at end of year 5:= $5,500 $25,000 - $5,500 = $19,500 recaptured depreciation $19,500 x (.40) = $7,800 tax 2 Book value of old asset at end of year 5: = $0 $2,000 - $0 = $2,000 recaptured depreciation $2,000 x (.40) = $800 tax Alternative 1 Year 5 Relevant Cash Flow: Operating Cash Flow: $33,460 Terminal Cash Flow 20,400 Total Cash Inflow $53,860 Alternative 2 Year 5 Relevant Cash Flow: Operating Cash Flow: $15,940 Terminal Cash Flow 38,000 Total Cash Inflow $53,940 d. Alternative 1 Cash Flows -$105,000 $26,300 $36,000 $35,980 $43,460 $53,860 $1,800 | | | | | | | 0 1 2 3 4 5 6 End of Year Alternative 2 Cash Flows -$120,000 $50,100 $65,200 $39,420 $16,340 $53,940 $2,200 | | | | | | | 0 1 2 3 4 5 6 End of Year e. Alternative 2 appears to be slightly better because it has the larger incremental cash flow amounts in the early years.