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CHAPTER 6
Making Investment Decisions with the Net Present Value Rule
Answers to Practice Questions
1.
See the table below.
We begin with the cash flows given in the text, Table 6.6,
line 8, and utilize the following relationship from Chapter 3:
Real cash flow = nominal cash flow/(1 + inflation rate)
t
Here, the nominal rate is 20 percent, the expected inflation rate is 10 percent,
and the real rate is given by the following:
(1 + r
nominal
)
= (1 + r
real
)
×
(1 + inflation rate)
1.20
= (1 + r
real
)
×
(1.10)
r
real
= 0.0909 = 9.09%
As can be seen in the table, the NPV is unchanged (to within a rounding error).
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Net Cash Flows/Nominal
12,600 1,484
2,947
6,323
10,534 9,985
5,757
3,269
Net Cash Flows/Real
12,600 1,349
2,436
4,751
7,195 6,200
3,250
1,678
NPV of Real Cash Flows (at 9.09%) = $3,804
2.
No, this is not the correct procedure.
The opportunity cost of the land is its value
in its best use, so Mr. North should consider the $45,000 value of the land as an
outlay in his NPV analysis of the funeral home.
3. Unfortunately, there is no simple adjustment to the discount rate that will resolve the
issue of taxes.
Mathematically:
1.15
0.35)
/(1
C
1.10
C
1
1

≠
and
2
2
2
2
1.15
0.35)
(1
/
C
1.10
C

≠
46
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Even when capital budgeting calculations are done in real terms, an inflation
forecast is still required because:
a.
Some real flows depend on the inflation rate, e.g., real taxes and real
proceeds from collection of receivables; and,
b.
Real discount rates are often estimated by starting with nominal rates and
“taking out” inflation, using the relationship:
(1 + r
nominal
)
= (1 + r
real
)
×
(1 + inflation rate)
5.
Investment in working capital arises as a forecasting issue only because accrual
accounting recognizes sales when made, not when cash is received (and costs
when incurred, not when cash payment is made).
If cash flow forecasts
recognize the exact timing of the cash flows, then there is no need to also include
investment in working capital.
6. If the $50,000 is expensed at the end of year 1, the value of the tax shield is:
$16,667
1.05
$50,000
0.35
=
×
If the $50,000 expenditure is capitalized and then depreciated using a fiveyear
MACRS depreciation schedule, the value of the tax shield is:
$15,306
1.05
.0576
1.05
.1152
1.05
.1152
1.05
.192
1.05
.32
1.05
.20
$50,000]
[0.35
6
5
4
3
2
=
+
+
+
+
+
×
×
If the cost can be expensed, then the tax shield is larger, so that the aftertax
cost is smaller.
7.
a.
$3,810
1.08
26,000
,000
100
NPV
5
1
t
t
A
=
+

=
∑
=
NPV
B
= Investment + PV(aftertax cash flow) + PV(depreciation tax shield)
∑
=
+

×
+

=
5
1
t
t
B
1.08
.35)
0
(1
26,000
100,000
NPV
[
]
+
+
+
+
+
×
×
6
5
4
3
2
1.08
0.0576
1.08
0.1152
1.08
0.1152
1.08
0.192
1.08
0.32
1.08
0.20
100,000
0.35
NPV
B
= $4,127
47
Another, perhaps more intuitive, way to do the Company B analysis is to
first calculate the cash flows at each point in time, and then compute the
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This note was uploaded on 10/19/2009 for the course FINANCE finance mb taught by Professor Myers during the Spring '09 term at NUCES  Lahore.
 Spring '09
 myers
 Corporate Finance, Net Present Value

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