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Unformatted text preview: Estimating
“Never underestimate the value of cold cash.”
—Gregory Nunn Saving Money?
Company X is a large multinational corporation with many facilities
throughout the United States and the rest of the world. Employees at a
variety of U.S. sites frequently are required to travel to the home office
in Headquarters City. On a typical day there may be a dozen or more
employees traveling to Headquarters City from any given satellite city site.
Company X has many corporate jets at airports throughout the United
States near the larger satellite cities. Senior executives routinely fly on these
corporate jets when traveling to Headquarters City. Middle-level managers
fly on commercial aircraft, usually located at a much greater distance from
the workplace. The reason for this is that the department of the traveling
employee is “billed” $800 if the corporate jet is used. This $800 expense
goes into the financial report of that department, which goes to corporate
headquarters. Managers can frequently find commercial airfares under
$300 for employees traveling to Headquarters City.
Because each department would rather be charged $300 a trip instead
of $800 when reporting its financial performance, only a few of the most
senior executives fly the corporate jets. This means that each corporate jet
typically has a dozen empty seats for its daily flights to Headquarters City.
It is clearly in the interest of each department manager to keep his or her
expenses down. Is it in the interests of the stockholders to have mostly empty
planes fly each day to Headquarters City? The cost of adding an additional 314 © V.Leach (http://www.fotolia.com/p/4594) passenger, or 12 additional passengers, to a corporate jet is almost zero. A
very small amount of additional fuel would be consumed. The stockholders
would save $300 for each additional person who took an otherwise-empty
seat on a corporate jet instead of flying on a commercial airline.
Consider the interests of the department managers and those of the
stockholders of Company X as you read Chapter 11. Chapter Overview
In Chapter 10, we applied capital budgeting decision methods, taking the cash flow
estimates as a given. In this chapter, we see how financial managers determine
which cash flows are incremental and, therefore, relevant to a capital budgeting
decision. We define incremental cash flows and distinguish incremental cash flows
from sunk costs. We also examine how financial managers estimate incremental
initial investment cash flows and incremental operating cash flows in the capital
budgeting decision. Finally, we explore how the financing cash flows of a capital
budgeting project are factored into the capital budgeting decision. Incremental Cash Flows
The capital budgeting process focuses on cash flows, not accounting profits.
Recall from our discussion in Chapter 1, it is cash flow that changes the value of
a firm. Cash outflows reduce the value of the firm, whereas cash inflows increase
the value of the firm.
315 Learning Objectives
After reading this chapter,
you should be able to:
1. Explain the difference
between incremental cash
flows and sunk costs.
2. Identify types of
incremental cash flows in a
capital budgeting project.
3. Explain why cash flows
associated with project
financings are not included
in capital budgeting
analysis. 316 Part III Capital Budgeting and Business Valuation In capital budgeting, incremental cash flows are the positive and negative cash flows
directly associated with a project. They occur if a firm accepts a project, but they do not
occur if the project is rejected.
For instance, suppose that the chief financial officer of Photon Manufacturing,
Mr. Sulu, is analyzing the cash flows associated with a proposed project. He finds that
the CEO hired a consultant to assess the proposed project’s environmental effects. The
consultant will be paid $50,000 for the work. Although the $50,000 fee is related to the
project, it is not an incremental cash flow because the money must be paid whether the
project is accepted or rejected. Therefore, the fee should not be included as a relevant
cash flow of the expansion project decision. Cash flows that have already occurred, or
will occur whether a project is accepted or rejected, are sunk costs.
Financial managers carefully screen out irrelevant cash flows, such as sunk costs,
from the capital budgeting decision process. If they include irrelevant cash flows in their
capital budgeting decision, then their calculations of a project’s payback period, net
present value (NPV), or internal rate of return (IRR) will be distorted and inaccurate.
The calculations may be so distorted that they lead to an incorrect decision about a
capital budgeting project. Types of Incremental Cash Flows
To accurately assess the value of a capital budgeting project, financial managers must
identify and estimate many types of incremental cash flows. The three main types of
incremental cash flows are initial investment cash flows, operating cash flows, and
shutdown cash flows. We examine these three types of incremental cash flows in the
sections that follow. Initial Investment Cash Flows
Generally, financial managers begin their incremental cash flow estimates by assessing
the costs of the initial investment. The negative cash flow associated with the initial
investment occurs only if the project is accepted. Initial investment cash flows include
the purchase price of the asset or materials to produce the asset, the installation and
delivery costs, and the additional investment in net working capital.
Purchase Price, Installation, and Delivery Financial managers usually obtain quotes
on the purchase price and installation and delivery costs from suppliers. These figures,
then, can usually be estimated with a high degree of accuracy.
Changes in Net Working Capital Aside from the setup costs and purchase price of
a proposed capital budgeting project, a company may have to invest in changes in net
working capital. As explained in Chapter 4, net working capital is defined as current
assets (working capital) minus current liabilities. If a proposed capital budgeting project
will require a positive change in net working capital (the most likely scenario), the cash
outlay needed to finance this must be included in the cash flow estimates.
Recall that working capital consists of cash, accounts receivable, and inventory,
along with other current assets if any. Companies invest in these assets in much the
same way they invest in plant and equipment. Accepting a new project often triggers
an increased need for cash, accounts receivable, and inventory investments. Working
capital investments tie up cash the same way as investment in a new piece of equipment. Chapter 11 Estimating Incremental Cash Flows A company’s current liabilities—such as accounts payable, accrued wages, and
accrued taxes—may also be affected if a firm accepts a capital budgeting project. For
example, if a plant is expanded, the company may place larger orders with suppliers to
accommodate the increased production. The increase in orders is likely to lead to an
increase in accounts payable.
Increases in current liabilities create cash inflows. It is unlikely that current liabilities
will increase sufficiently to finance all the needed current asset buildup. This is the reason
that an investment in net working capital is almost always required.
Table 11-1 shows an example of the incremental changes in net working capital
that might occur with a proposed capital budgeting project for the McGuffin Company.
As Table 11-1 indicates, the McGuffin Company project has an estimated increase
of $27,000 in needed current assets and a $10,000 increase in new current liabilities,
resulting in a $17,000 change in needed net working capital. That is, the firm will have to
spend $17,000 to increase its net working capital by this amount—a negative cash flow.
Once financial managers estimate the initial investment incremental cash flows,
they analyze the operating cash flows of a capital budgeting project. We turn to those
cash flows next. Operating Cash Flows
Operating cash flows are those cash flows that the project generates after it is in operation.
For example, cash flows that follow a change in sales or expenses are operating cash
flows. Those operating cash flows incremental to the project under consideration are the
ones relevant to our capital budgeting analysis. Incremental operating cash flows also
include tax changes, including those due to changes in depreciation expense, opportunity
costs, and externalities.
Taxes The change in taxes that will occur if a project is accepted is part of the
incremental cash flow analysis. Tax effects are considered because a tax increase is
equivalent to a negative cash flow, and a tax decrease is equivalent to a positive cash
flow. In a capital budgeting decision, then, financial managers must examine whether and
how much tax the firm will pay on additional income that the proposed project generates
during a given period. They must also see whether and how much taxes will decrease if
the project increases the firm’s periodic operating expenses (such as payments for labor
and materials), thereby creating additional tax deductions.
Depreciation and Taxes Financial managers estimate changes in depreciation expense
as part of the incremental cash flow analysis because increases in depreciation expense
may increase a firm’s cash flow. How? Depreciation expense is deductible for tax
purposes. The greater the depreciation expense deduction, the less tax a firm must pay,
and the less cash it must give to the IRS. Financial managers estimate the amount of
depreciation expense a capital budgeting project will have, therefore, to see how much
the firm’s taxable income and taxes owed will decrease.
Incremental depreciation expense is the change in depreciation expense that results
from accepting a proposed capital budgeting project. Incremental depreciation expense
affects the change in taxes attributable to a capital budgeting project.
To illustrate how incremental depreciation expense changes taxes due, recall how
we converted after-tax net profits into operating cash inflows in Chapter 4. We added
all noncash charges (including depreciation) that were deducted as expenses on the 317 318 Part III Capital Budgeting and Business Valuation Table 11-1 Change in McGuffin Company Net Working Capital If New Project
Current Asset Changes Current Liability Changes $5,000 Increase in Cash $8,000 Increase in Accounts Payable $7,000 Increase in Receivables $2,000 Increase in Accruals $15,000 Increase in Inventory
Total Current Asset Changes: $27,000 Total Current Liability Changes: $10,000 Increase in Needed Net Working Capital (NWC): $27,000 – $10,000 = $17,000
Incremental Cash Flow Due to the Increase in NWC = –$17,000 firm’s income statement to net profits after taxes. Once the tax effects of a project’s
depreciation expense are calculated, we add this incremental depreciation expense back
to the project’s net profits after taxes.
The following example, illustrated in Table 11-2, demonstrates how to estimate the
incremental depreciation expense of a capital budgeting project. Suppose your firm is
considering a project that is expected to earn $100,000 in cash sales in year 1. Suppose
that, in addition to the sales increase, the project is expected to increase cash operating
expenses by $50,000 and new depreciation expense will be $10,000. Assume your firm’s
marginal tax rate is 40 percent. First, compute the net operating cash flows from the
project for this year, as shown in Table 11-2.
Compare line 3 and line 7 in Table 11-2. Note that once we used the new project
incremental depreciation expense of $10,000 to make the tax change calculations,
we added the $10,000 depreciation expense back to the new project’s after-tax net
income to calculate the incremental operating cash flow for this year from the new
project. The incremental depreciation expense affected cash flow only because of its
effect on taxes.
Opportunity Costs Sometimes accepting a capital budgeting project precludes other
opportunities for the firm. For instance, if an industrial mixer already owned by a toy
company is used to make a new product called Slime #4, then that mixer will not be
available to make the Slime #2 currently produced in that mixer. The forgone benefits
of the alternative not chosen are opportunity costs.
Opportunity costs are incremental cash flows that financial managers consider
in a capital budgeting decision. In our example, the opportunity cost comes from
the lost use of the industrial mixer for other products our firm makes. If our cash
flows decrease by $30,000 due to the decrease in sales of Slime #2 that we can no
longer make, then this $30,000 is the opportunity cost of choosing to produce the
new product, Slime #4.
Externalities In estimating incremental operating cash flows, financial managers
consider the effect a capital budgeting project might have on cash flows related to other
parts of the business. Externalities are the positive or negative effects on existing projects
if a new capital budgeting project is accepted. Chapter 11 319 Estimating Incremental Cash Flows Table 11-2 Net Operating Cash Flows for New Project
1. New Project Sales (cash inflow) $ 100,000 2. New Project Cash Operating Expenses (cash outflow) – 50,000 3. New Project Depreciation Expense (noncash expense) – 10,000 4. Net New Project Taxable Income
5. Taxes on New Project Income (40%) (cash outflow)
6. Net New Project After-Tax Income 40,000
24,000 7. Plus Depreciation Expense (added back) + 10,000 8. Net Incremental Cash Flow $ 34,000 For instance, suppose that a tennis ball manufacturer decides to start making tennis
racquets but does not want to hire any additional managers. The current managers may
become overworked because the expansion project requires manager time and oversight.
This is a negative externality. Existing projects suffer due to manager inattention, but
it is difficult to measure the size of those incremental costs.
On the other hand, the new racquet project may give the company more visibility than
it had before and increase sales of its existing tennis ball business, thereby leading to an
increase in cash flows. Because these cash flows from the increased tennis ball sales are
incremental to the tennis racquet project under consideration, they should be considered
in the capital budgeting analysis. This is a positive externality. Here again, however, the
costs associated with the positive externalities are likely to be difficult to measure.
If the impact of externalities can be measured, they should be incorporated in the
capital budgeting analysis. If the cost of externalities cannot be measured precisely—as
is likely the case—most firms use a subjective analysis of externalities before making
a project’s final accept or reject decision. For example, if the NPV of a project is only
slightly greater than zero, company officials may reject the project if they believe
significant unmeasured negative externalities are present. Shutdown Cash Flows
Financial managers estimate the shutdown cash flows that are expected to occur at the
end of the useful life of a proposed capital budgeting project. Shutdown cash flows may
include those from the project’s salvage value, taxes tied to the sale of the used asset,
and the reduction of net working capital.
If a project is expected to have a positive salvage value at the end of its useful life,
there will be a positive incremental cash flow at that time. However, this salvage value
incremental cash flow must be adjusted for tax effects.
Four possible tax scenarios may occur when the used asset is sold, depending on
the asset’s sale price. First, the asset may be sold for more than its purchase price. In
this instance, the difference between the purchase and the sale price is taxed at the
capital gains tax rate. (The capital gain is the portion of the sale price that exceeds the
purchase price.) In addition, the purchase price minus depreciation book value is taxed
at the ordinary income rate.
Second, the asset may be sold for less than the purchase price but for more than its
depreciation book value. The amount that the sales price exceeds the depreciation book
value is ordinary income, so it is taxed at the ordinary income tax rate. . 320 Part III Capital Budgeting and Business Valuation Table 11-3 Tax Effects of the Sale of an Asset at the End of Its Useful Life
Type of Sale
The asset is sold for more than its purchase
price. Tax Effect
This difference is taxed at the capital
gains rate. In addition, the purchase price
minus the depreciation book value is
ordinary income and is taxed at
the ordinary rate. The asset is sold for less than its purchase
price but for more than its depreciation
book value. The sales price minus the depreciation
book value is ordinary income and is
taxed at the ordinary income tax rate. The asset is sold for its depreciation book
value. There is no tax effect. The asset is sold for less than its
depreciation book value. The depreciation book value minus the
sales price is an ordinary loss and reduces
the firm’s tax liability by that amount times
the ordinary income tax rate. Third, the asset may be sold for its depreciation book value. In that case the asset
sale has no tax effects.
Fourth, the asset may be sold for less than its depreciation book value. The
amount by which the depreciation book value exceeds the sales price is an ordinary
loss. The firm’s tax liability is reduced by the amount of the loss times the ordinary
income tax rate.
The situation is summarized in Table 11-3. Financing Cash Flows
Suppose a company planned to borrow or sell new common stock to raise part or
all of the funds needed for a proposed capital budgeting project. The company
would receive a cash inflow on receipt of the loan or the sale of new common stock.
Conversely, the company must make the interest and principal payments on the loan,
or may make dividend payments to stockholders. Financing cash flows are the cash
outflows that occur as creditors are paid interest and principal, and stockholders are
If a capital budgeting project is rejected, financing cash flows will not occur, so they
are relevant cash flows in the capital budgeting decision. However, as we saw in Chapter
10, financing costs are factored into the discount rate (required rate of return) in the NPV
calculation. Those costs are also included in the hurdle rate of the IRR decision rule.
Therefore, to avoid double counting, we do not include financing costs in our operating
incremental cash flow estimates when we make capital budgeting decisions. If we did
include financing costs as part of the incremental operating cash flows, then the NPV
or IRR analysis would be distorted. That distortion could lead in turn to a poor capital
Figure 11-1 summarizes the cash flow estimation process and its role in capital
budgeting. Chapter 11 Estimating Incremental Cash Flows 321 Estimate Initial
Cash Flows during
the Project’s Life
Cash Flows Estimate Cash Flows
at the End of the
Project’s Life Carry Cash Flows to the Capital
Budgeting Evaluation Process Screen Out
Cash Flows Incremental Cash Flows of an Expansion Project
To practice capital budgeting cash flow estimation, let’s examine a proposed expansion
project. An expansion project is one in which the company adds a project and does not
replace an existing one. Imagine a company called Photon Manufacturing, which makes
torpedoes. It is considering a project to install $3 million worth of new machine tools
in its main plant. The new tools are expected to last for five years. Photon operations
management and marketing experts estimate that during those five years the tools will
result in a sales increase of $800,000 per year.
The Photon Manufacturing CEO has asked Mr. Sulu, the company CFO, to identify
all incremental cash flows associated with the project, and to calculate the project’s NPV
and IRR. Based on the incremental cash flow analysis and Sulu’s recommendation, the
company will make an accept or reject decision about the project.
Sulu’s first step is to identify the relevant (incremental) cash flows associated with the
project. He begins with the initial investment in the project, then looks at the operating
cash flows, and finally the shutdown cash flows.
Initial Investment Cash Flows The cash flows that will occur as soon as the project
is implemented (at t0) make up the project’s initial investment. The initial investment
includes the cash outflows for the purchase price, installation, delivery, and increase in
net working capital.
Sulu knows that its tool supplier gave Photon a bid of $3 million to cover the cost of
the new tools, including setup and delivery. Photon inventory and accounting specialists
estimate that if the tools are purchased, inventory will need to increase by $40,000,
accounts receivable by $90,000, and cash by $10,000. This is a $140,000 increase in
current assets (working capital).
Also, Photon experts estimate that if the tools are purchased, accounts payable
will increase by $20,000 as larger orders are placed with suppliers, and accruals
(wages and taxes) will increase by $10,000—a $30,000 increase in current liabilities.
Subtracting the increases in current liabilities from the increases in current assets Figure 11-1 The Cash
Flow Estimation Process 322 Part III Capital Budgeting and Business Valuation Table 11-4 Photon Manufacturing Expansion Project Initial Investment
Incremental Cash Flows at t0
Cost of Tools and Setup
+ Investment in Additional NWC
= Total Initial Cash Outlay $3,000,000
$3,110,000 ($140,000 – $30,000) results in a $110,000 increase in net working capital associated
with the expansion project.
Sulu concludes after extensive research that he has found all the initial investment
incremental cash flows. Those cash flows are summarized in Table 11-4.
Operating Cash Flows Now Sulu examines the operating cash flows, those cash
flows expected to occur from operations during the five-year period after the project
is implemented (at t1 through t ). The Photon expansion project operating cash flows
reflect changes in sales, operating expenses, and depreciation tax effects. We assume
these cash flows occur at the end of each year.
Sulu learns from the vice president of sales that cash sales are expected to increase by
$800,000 per year because the new tools will increase manufacturing capacity. If purchased,
the tools will be used to perform maintenance on other equipment at Photon, so operating
expenses (other than depreciation) are expected to decrease by $100,000 per year.
Depreciation is a noncash expense, but remember that Sulu must use
depreciation to compute the change in income tax that Photon must pay. After taxes
are computed, Sulu then will add back the change in depreciation in the operating
cash flow analysis.
To calculate depreciation expense, Sulu looks at MACRS depreciation rules and finds
that the new manufacturing tools are in the three-year asset class. According to the MACRS
rules, 33.3 percent of the new tools’ $3 million cost will be charged to depreciation expense
in the tools’ first year of service, 44.5 percent in the second year, 14.8 percent in the third
year, and 7.4 percent in the fourth year.1 Now Sulu summarizes the incremental operating
cash flows for the Photon capital budgeting project in Table 11-5.
Sulu is not quite through yet. He must include in his analysis additional shutdown
cash flows that occur at t5, the end of the project’s life.
Shutdown Cash Flows Photon company experts estimate that the actual economic life
of the tools will be five years, after which time the tools should have a salvage value of
$800,000. Under MACRS depreciation rules, assets are depreciated to zero at the end of
their class life, so at t5 the book value of the new tools is zero. Therefore, if the tools are
sold at the end of year 5 for their salvage value of $800,000, Photon Manufacturing will
realize a taxable gain on the sale of the tools of $800,000 ($800,000 – $0 = $800,000).
The income tax on the gain at Photon’s marginal tax rate of 40 percent will be $800,000
× .40 = $320,000. Depreciation expenses for the tools are spread over four years instead of three because the MACRS depreciation rules apply a
half-year convention—all assets are assumed to be purchased and sold halfway through the first and last years, respectively. If
an asset with a three-year life is assumed to be purchased halfway through year 1, then the three years will be complete halfway
through year 4. 1 Chapter 11 323 Estimating Incremental Cash Flows Table 11-5 Photon Manufacturing Expansion Project Incremental Operating Cash Flows, Years 1–5
t1 t2 t3 t4 t5 + Change in Sales + 800,000 800,000 800,000 800,000 800,000 + Reduction in Nondepreciation
Operating Expenses + 100,000 100,000 100,000 100,000 100,000 – Change in Depreciation Exp. – 999,000 1,335,000 444,000 222,000 0 = Change in Operating Income = (99,000 ) (435,000 ) 456,000 678,000 900,000 – Tax on New Income (See Note) – (39,600 ) (174,000 ) 182,400 271,200 360,000 (59,400 ) = Change in Earnings After Taxes = (261,000 ) 273,600 406,800 540,000 + Add Back Change in Dep. Expense + 999,000 1,335,000 444,000 222,000 0 = Net Incremental Operating
Cash Flow = 939,600 1,074,000 717,600 628,800 540,000 Note: Taxes at t1 and t2 are negative amounts, which means earnings after taxes on the lines above for those years is increased by the amount of the taxes saved. Operating losses in year 1
of $99,000 and in year 2 of $435,000 cause a decrease in the taxes Photon owes during years 1 and 2 of $39,600 and $174,000, respectively due to the value of the offset of these
amounts against taxable income elsewhere in the company. The net amount of cash that Photon will receive from the sale of the tools is the
salvage value minus the tax paid:
$800,000 Salvage Value – 320,000 Taxes Paid $480,000 Net Proceeds The net proceeds from the tool sale at the end of year 5, then, are $480,000.
Finally, if the new tools are sold at t5, Sulu concludes (based on sales department
information) that Photon’s sales will return to the level they were before the new tools
were installed. Consequently, there will be no further need for the additional investment
in net working capital that was made at t0. When the $110,000 investment in net working
capital is recaptured,2 that amount is recovered in the form of a positive cash flow.
The additional incremental cash flows from the sale of the tools and the change in
net working capital are summarized in Table 11-6.
Cash Flow Summary and Valuation Tables 11-4, 11-5, and 11-6 contain all the
incremental cash flows associated with Photon Manufacturing’s proposed expansion
project. Sulu’s next step is to summarize the total incremental net cash flows occurring
at each point in time in one table. Table 11-7 shows the results.
Table 11-7 contains the bottom-line net incremental cash flows associated with
Photon’s proposed expansion project. The initial cash flow at t0 is –$3,110,000. The
operating cash flows from t1 to t5 total $4,490,000. The sum of all the incremental positive
and negative cash flows for the project is $1,380,000.
Now Sulu is ready to compute the NPV, IRR, and MIRR of the expansion project
based on the procedures described in Chapter 10. Current assets, in the amount by which they exceed current liabilities, are sold and not replaced because they are no longer
needed. 2 324 Part III Capital Budgeting and Business Valuation Table 11-6 Photon Manufacturing Expansion Project Shutdown Cash Flows at t5
Salvage Value 800,000 – Taxes on Salvage Value – 320,000 = Net Cash Inflow from Sale of Tools = 480,000 + Cash from Reduction in NWC + 110,000 = Total Additional Cash Flows at t5 = 590,000 Assuming that Photon’s discount rate is 10 percent, Sulu computes the NPV of the
project using Equation 10-1 as follows:
Initial Investment at t0: $3,110,000
Net Incremental Cash Flows:
t1 t2 t3 t4 t5 $939,600 $1,074,000 $717,600 $628,800 $1,130,000 $1,130, 000 $939, 600 $1, 074, 000 $717, 600 $628,800 NPV= 1 + 2 +
3 + 4 + 5 − $3,110, 000 (1 + .10) (1 + .10) (1 + .10) (1 + .10) (1 + .10) = $628,800
$1, 074, 000
− $3,110, 000
1.331 = $854,182 + $887, 603 + $539,144 + $429, 479 +$701, 641 − $3,110, 000
= $302, 049 Assuming a discount rate of 10 percent, the NPV of the project is $302,049.
Next, Sulu uses Equation 10-2 and the trial-and-error method described in Chapter
10 to find the IRR of the project: CF5 CF1 CF2 CF3 CF4 NPV = 0 = 1 + 2 + 3 + 4 + 5 − Initial Investment (1 + k ) (1 + k ) (1 + k ) (1 + k ) (1 + k ) $1,130, 000 $939, 600 $1, 074, 000 $717, 600 $628,800 0= 1 + 2 +
3 + 4 + 5 − $3,110, 000 (1 + k ) (1 + k ) (1 + k ) (1 + k ) (1 + k ) trial rate = 13.78%: $1,130, 000 $939, 600 $1, 074, 000 $717, 600 $628,800 0= 1 + 2 + 3 + 4 + 5 − $3,110, 000 (1 + .1378) (1 + .1378) (1 + .1378) (1 + .1378) (1 + .1378) $939, 600 $1, 074, 000 $717, 600 $628,800 $1,130, 000 0= +
+ − $3,110, 000 1.1378 1.294589 1.472983 1.67596 1.90691 0 = $825,804.18 + $829, 607.03 + $487,174.61 + $375,187.89 + $592, 582.47 − $3,110, 000
0 = $356.17, which is close enough for our purposes. Therefore IRR = .1378, or 13.78%. Chapter 11 325 Estimating Incremental Cash Flows Table 11-7 Photon Manufacturing Expansion Project Summary of Incremental Cash Flows
t0 (3,000,000) t2 t3 t4 t5 939,600 For Purchase and Setup t1 1,074,000 717,600 628,800 540,000 (110,000) For Additional NWC
From Operating Cash Flows
From Salvage Value Less Taxes 480,000
110,000 From Reducing NWC
Net Incremental Cash Flows (3,110,000) 939,600 1,074,000 717,600 Finally, Sulu uses the method described in Chapter 10 to find the MIRR of the
FV of Cash Flow at t5 If Reinvested
@ 10% Cost of Capital
(per Equation 8-1a) Time Cash Flow t1 $ 939,600 x (1 + .10)4 = $ 1,375,668 t2 $ 1,074,000 x (1 + .10)3 = $ 1,429,494 t3 $ 717,600 x (1 + .10)2 = $ 868,296 t4 $ 628,800 x (1 + .10)1 = $ 691,680 t5 $ 1,130,000 x (1 + .10)0 = $ 1,130,000
Terminal Value: $ 5,495,138
Initial Investment: $ 3,110,000 MIRR per Equation 8-6: 1 $5, 495,138 5
k= −1 $3,110, 000 k = .121, therefore MIRR = .121, or 12.1% Because the project’s NPV of $302,049 is positive, the IRR of 13.78 percent exceeds
the required rate of return of 10 percent, and the MIRR of 12.1 percent exceeds the
required rate of return, Sulu will recommend that Photon proceed with the expansion
In this discussion we examined how a firm determines the incremental costs of an
expansion project, and the project’s NPV, IRR, and MIRR. We turn next to replacement
projects and their incremental costs. Asset Replacement Decisions
Often a company considers replacing existing equipment with new equipment. A
replacement decision is a capital budgeting decision to purchase a new asset and
replace and retire an old asset, or to keep the old asset. Financial managers identify
the differences between the company’s cash flows with the old asset versus the
company’s cash flows if the new asset is purchased and the old asset retired. As
illustrated in Figure 11-2, these differences are the incremental cash flows of the
proposed new project. 628,800 1,130,000 326 Part III Capital Budgeting and Business Valuation
Cash flows that will occur if old
asset is maintained The relevant cash flows in the
The difference in cash flows
between the two alternatives Figure 11-2 Comparing Cash Flows:
Replacing an Asset vs.
Figure 11-2 illustrates how
firms compare the difference
between the cash flows of
replacing an old asset with
a new one or keeping the
old asset. Cash flows that will occur if old asset is retired and replaced with new asset Real Options
Externalities and opportunity costs are not the only elements of the capital budgeting
decision that are difficult to reduce to an incremental cash flow estimate. Many projects
have options embedded in them that add to the value of the project and, therefore, of
the firm. For example, a project may provide management with the option to revise
a capital budgeting project at a later date. This characteristic is called a real option.
It is a real option because it is related to a real asset such as a piece of equipment or
a new plant. You may already be familiar with financial options (calls and puts) that
give the holder the opportunity to buy or sell financial assets such as stocks or bonds
at a later date. Real options are similar except that their value is related to the value
of real assets rather than to the value of financial assets. Note that the word option
indicates that the future alternative does not have to be taken. It will be taken only if
it is seen as adding value.
The flexibility that is provided by a real option to revise a project at a later date has
value. This option may be to expand a project, to abandon it, to create another project
that is an offshoot of the current project, or something else. For example, a restaurant
with room to expand is more valuable than one that is confined to its original fixed space,
other things being equal. A project that can be shut down before its scheduled useful life
if it turns out to be a failure is more valuable, other things being equal, than a similar
failed project that must continue operating while it is losing money. An investment
in a research laboratory that might develop a wonderful new drug that is completely
unknown to us now is more valuable, other things being equal, than an investment in
another project that has no potential future spin-offs. Chapter 11 327 Estimating Incremental Cash Flows The Super Marg Mexican Restaurant Analysis
t0 t1 t2 t3 t4 t9 $110,000 $110,000
$75,000 C A –$250,000 B P = .6 E P=1 $40,000 P = .25
P = .25 D $100,000 $100,000 $100,000 $90,000 $90,000 $90,000 $75,000 $75,000 $75,000 $75,000 $40,000 $40,000 $40,000 –$20,000 –$20,000 –$20,000 –$20,000 P = .1
–$20,000 P = .5 $40,000 P=0 P = .3 P = .25 $110,000 P=0
P=1 $0 $0 Traditional NPV and IRR analysis often overlooks the value that may come from
real options because this value cannot be reduced to a simple incremental cash flow
estimate. Faced with this difficulty, managers usually omit from capital budgeting
analysis real options that are part of a project. This causes the NPV and IRR figures to
be understated. As a result, the value real options add to the firm and the increase in the
project rates of return they provide are not recognized.
The NPV process can be modified to reflect the value that real options add to the
firm. This involves computing the traditional NPV and then adding today’s value of
any real options that may be present. The following paragraphs illustrate the mechanics
of the process.
Real options can be incorporated into the capital budgeting process by using decision
trees. Decision trees show the different paths a project could take, including the various
options that may be available. Each place at which the decision tree branches is called
a node. There are two kinds of nodes, decision nodes and outcome nodes.
• A decision node is one that shows the alternatives available for management at that point in time. • An outcome node is one that shows the various things that can happen once a decision path is chosen. Let’s go through an NPV analysis using a decision tree and real options to illustrate
how the process works. Suppose that Jason and Jennifer are business partners who
think their hometown of Fort Fun would support a new Mexican restaurant, which they
have decided to call Super Marg. Figure 11-3 shows the decision tree for Super Marg
Mexican Restaurant. In Figure 11-3, A, C, and D are decision nodes, whereas B and E
are outcome nodes.
Jason and Jennifer’s first expenditure is the $250,000 investment required to build
the restaurant. This initial cash outflow is shown at the left side of Figure 11-3. This
is decision node A. Once the new restaurant is built, customers will determine how $0 $0 Path 1
Path 6 Path 7 Figure 11-3 A Real
Options Decision Tree 328 Part III Interactive Module
Go to www.textbookmedia.
com and find the free
companion material for this
book. Follow the instructions
there. Why does oil in the
ground have a positive value
even if it currently costs $40
per barrel to retrieve oil
that has a current market
price of $30 per barrel?
See how real options can
add to the value of a capital
budgeting project. successful it is. According to Jason and Jennifer’s estimates, the probability is .3 that
it will be a smash hit, .6 that it will be moderately successful, and .1 that it will be a
bomb. Outcome node B shows these three possibilities. Note that all the probabilities
associated with a node must sum to 1.0. If the restaurant is a smash hit, operating cash
flows of $75,000 in year 1 are expected. If it is a smash hit, Jason and Jennifer will
expand the business after one year of operation, making an additional investment of
$50,000 at t2. Decision node C indicates where the management decision to expand the
business would be made. Paths 1, 2, and 3 show the possible outcomes if the business
is expanded. Path 4 indicates the path that would not be taken if the expansion option
is pursued. Jason and Jennifer can do better than this if the restaurant is a smash hit.
After expansion, the probability is .25 that subsequent operating cash flows will
be $110,000, .50 that they will be $100,000, and .25 that they will be $90,000. Each
of these cash flow streams would continue for seven years, until t9. Outcome node E in
Figure 11-3 shows these three possibilities.
If the restaurant is moderately successful, operating cash flows of $40,000 per year
for nine years are expected. Path 5 shows this cash flow stream. If the restaurant is a
bomb, an operating cash flow of –$20,000 at t1 is expected. This outcome would cause
Jason and Jennifer to abandon the business after one year. Decision node D shows this
abandonment option. Note that the probability is 1.0 that Jason and Jennifer will abandon
the project if cash flows in t1 are –$20,000. Path 6 shows the negative cash flows from
t2 to t9 that are avoided if the project is abandoned. Path 7 shows the $0 cash flows that
are preferred to the –$20,000 cash flows that would have occurred.
Once all the decisions, outcomes, and probabilities are plotted on the decision
tree, the net present value and joint probability of each path can be computed. Note in
Figure 11-3 that there are seven possible paths the operation can take. The probabilities
associated with each possible path are multiplied together to give a joint probability
for that path. The sum of the joint probabilities is 1.0. When the net present value for
each path is multiplied by its joint probability and these results added, the expected net
present value for the entire deal is obtained.
Table 11-8 shows the NPV calculations for the Super Marg Restaurant project,
assuming that Jason and Jennifer’s required rate of return is 10 percent. The NPV of
each of the seven paths is calculated using Equation 10-1a. In the far right-hand column
of Table 11-8, the NPVs of each path are multiplied by the joint probability of that path
occurring to give a composite score for each path called the product. The sum of the
products, $15,161, is the expected NPV of the project. Because the expected NPV is
greater than zero, the project would be accepted. Note that Path 5 has a higher probability
than any of the other six paths and it has a negative NPV. The overall expected NPV is
positive, however, due to the very good outcomes from Paths 1–3. Capital Budgeting and Business Valuation What’s Next
In this chapter, we learned how financial managers estimate incremental cash flows as
part of the capital budgeting process. We described the difference between sunk costs
and incremental cash flows. We also discussed various types of incremental cash flows.
In Chapter 12 we examine business valuation. ($250,000) ($250,000) Path 6 Path 7 $75,000 ($250,000) ($250,000) Path 4 Path 5 $75,000 ($250,000) Path 3 ($20,000) ($20,000) $40,000 $75,000 ($250,000) $75,000 ($250,000) Path 2 t1 Path 1 t0 t2 $0 ($20,000) $40,000 $75,000 ($50,000) ($50,000) ($50,000) Real Options NPV Analysis $0 ($ 20,000) $ 40,000 $ 75,000 $ 90,000 $100,000 $110,000 t3 $0 ($ 20,000) $ 40,000 $ 75,000 $ 90,000 $100,000 $110,000 t4 t5 $0 ($ 20,000 ) $ 40,000 $ 75,000 $ 90,000 $100,000 $110,000 Cash Flows $0 ($ 20,000) $ 40,000 $ 75,000 $ 90,000 $100,000 $110,000 t6 Table 11-8 Real Options NPV Analysis for the Super Marg Mexican Restaurant $ 40,000 $ 75,000 $ 90,000 $100,000 $110,000 t8 $0 $0 ($ 20,000) ($ 20,000 ) $ 40,000 $ 75,000 $ 90,000 $100,000 $110,000 t7 $0 ($ 20,000) $ 40,000 $ 75,000 $ 90,000 $100,000 $110,000 t9 ($ 26,818 ) $0 ($ 11,783 ) $0 $ 10,423 $ 26,881 $ 16,458 Product Exp NPV = $15,161 ($ 268,182) ($ 365,180) ($ 19,639) $ 181,927 $ 138,973 $ 179,208 $ 219,443 NPV Required rate of return (k) = 10% Sum = 1.0 0.1 0 0.60 $0 0.075 0.15 0.075 Joint
Occurrence Chapter 11
Estimating Incremental Cash Flows 329 Take Note
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orientation. 330 Part III Capital Budgeting and Business Valuation Summary
1. Explain the difference between incremental cash flows and sunk costs.
Incremental cash flows are the cash flows that will occur if a capital budgeting project
is accepted. They will not occur if the investment is rejected. Sunk costs are costs that
will occur whether a project is accepted or rejected. Financial managers must screen
out sunk costs from the capital budgeting analysis to prevent distortion in cash flow
estimates. Any distortion in these estimates will, in turn, lead to inaccurate NPV or IRR
values and could result in poor capital budgeting decisions.
2. Identify types of incremental cash flows in a capital budgeting project.
Financial managers must examine three main types of cash flows to estimate the
incremental cash flows of a proposed capital budgeting project. First, they must assess
the cost of the initial investment: the purchase price, the installation and delivery
costs, and any change in net working capital. Then the financial manager must analyze
incremental operating cash flows. These may include tax changes due to changes in
sales and depreciation expense, opportunity costs, and externalities. Finally, a financial
manager must examine the project shutdown cash flows, such as those cash flows from
the project’s salvage value, the reduction of net working capital, and the tax-related cash
flows from the sale of the used asset.
3. Explain why cash flows associated with project financing are not included in
incremental cash flow estimates.
Incremental operating cash flows are treated separately from incremental financing cash
flows. The latter are captured in the discount rate used in the NPV calculation and in
the hurdle rate used when applying the IRR decision rule. Financial managers do not
include financing costs as incremental operating cash flows to avoid distorting the NPV
or IRR calculations in the capital budgeting process. Double counting would result if
financing costs were reflected in both the operating cash flows and the discount rate. Self-Test
ST-1. Fat Tire Corporation had $20,000 in
depreciation expense last year. Assume its
federal marginal tax rate is 36 percent, whereas
its state marginal tax rate is 4 percent. How
much are the firm’s taxes reduced (and cash
flow increased) by the depreciation deduction
on federal and state income tax returns? ST-2. Skinny Ski Corporation had net income of $2
million and depreciation expense of $400,000.
What was the firm’s operating cash flow for
the year? ST-3. Powder Hound Ski Company is considering the
purchase of a new helicopter for $1.5 million.
The company paid an aviation consultant
$20,000 to advise them on the need for a
new helicopter. The decision about buying
the helicopter hasn’t been made yet. If it is
purchased, what is the total initial cash outlay
that will be used in the NPV calculation? Chapter 11 ST-4. Estimating Incremental Cash Flows Rich Folks Ski Area is considering the
replacement of one of its older ski lifts.
By replacing the lift, Rich Folks expects
sales revenues to increase by $500,000 per
year. Maintenance expenses are expected to
increase by $75,000 per year if the new lift
is purchased. Depreciation expense would
be $100,000 per year. (The company uses
the straight-line method.) The old lift has
been fully depreciated. The firm’s marginal
tax rate is 38 percent. What would the firm’s
incremental annual operating cash flows be if
the new lift is purchased? ST-5. 331 Snorkel Ski Company is considering the
replacement of its aerial tram. Sales are
expected to increase by $900,000 per year, and
depreciation expense is also expected to rise
by $300,000 per year. The marginal tax rate is
32 percent. The purchase will be financed with
a $900,000 bond issue carrying a 10 percent
annual interest rate. What are the annual
incremental operating cash flows if this project
is accepted? Review Questions
1. Why do we focus on cash flows instead of profits
when evaluating proposed capital budgeting
projects? 5. How and why does working capital affect the
incremental cash flow estimation for a proposed
large capital budgeting project? Explain. 2. What is a sunk cost? Is it relevant when evaluating
a proposed capital budgeting project? Explain. 6. How do opportunity costs affect the capital
budgeting decision-making process? 3. How do we estimate expected incremental cash
flows for a proposed capital budgeting project? 7. How are financing costs generally incorporated
into the capital budgeting analysis process? 4. What role does depreciation play in estimating
incremental cash flows? Build Your Communication Skills
CS-1. Pick a company and obtain a copy of its
recent income statement, balance sheet, and
statement of cash flows. Compare its profit and
cash flow for the period covered by the income
statement. Use the statement of cash flows to
describe where the firm’s cash came from and
where it went during that period. Examine the
balance sheet to assess the cash position of
the firm at that point in time. Submit a written
report that analyzes the firm’s cash position. CS-2. Stock market analysts often compare a firm’s
reported quarterly earnings and its expected
quarterly earnings. Quarterly earnings that
come in below expectations often mean a
drop in the stock price, whereas better than
expected earnings usually mean a stock price
increase. Is this consistent with the view
that cash flows and not accounting profits
are the source of firm value? Divide into
small groups and discuss these issues with
the group members for 15 minutes. Select a
spokesperson to present the group’s key points
to the class. 332 Part III Capital Budgeting and Business Valuation Expansion Project,
Cash Flows 11-1. Tru-Green Landscaping is shopping for a new lawn mower. The purchase
price of the model the company has selected is $6,000. However, Tru-Green
plans to add some special attachments that will cost $5,000, and painting
the company’s name on the side of the mower will cost $300. Building a
garage and maintenance facility for the mower and several other items of
new equipment will cost $12,000. What is the total cash outflow at t0 for the
mower? Salvage Value
Cash Flows 11-2. An asset falling under the MACRS five-year class was purchased three years
ago for $200,000 (its original depreciation basis). Calculate the cash flows if
the asset is sold now at
Assume the applicable tax rate is 40 percent. Operating
Cash Flows 11-3. Mr. Van Orten is evaluating the purchase of new trenching equipment
for Scorpio Enterprises. For now, he is only figuring the incremental
operating cash flow from the proposed project for the first year. Mr. Van
Orten estimates that the firm’s sales of earth-moving services will increase
by $10,000 in year 1. Using the new equipment will add an additional
$3,000 to their operating expenses. Interest expense will increase by $100
because the machine will be partly financed by a loan from the bank. The
additional depreciation expense for the new machine will be $2,000. Scorpio
Enterprises’ marginal tax rate is 35 percent.
a. Calculate the change in operating income (EBIT) for year 1.
b. Calculate the cash outflow for taxes associated with this new income.
c. What is the net new after-tax income (change in earnings after taxes)?
d. Calculate the net incremental operating cash flow from this project for
e. Are there any expenses listed that you did not use when estimating the net
incremental cash flow? Explain. Expansion Project,
Cash Flows 11-4. Ever-Fresh Landscaping bought a large-sized golf course mower for $20,000.
With this new machine, the company was able to increase its business,
raising its annual revenue from $250,000 to $350,000 each year. Operating
costs went up as well, however, from $70,000 to $100,000 annually. The
mower falls in the MACRS five-year class for depreciation expense, and the
company’s combined federal and state income tax rate is 35 percent.
What is the net incremental operating cash flow in year 1 for the new lawn
mower investment? Expansion Project,
Flows 11-5. Never Brown Landscaping has a lawn mower that it bought three years ago
for $10,000. The mower has an actual operating life of six years, at the end
of which the mower can be sold for $2,000. For depreciation purposes, the
mower is in the MACRS five-year class. Never Brown’s combined federal
and state income tax rate is 35 percent. What are the terminal cash flows
associated with the mower investment? Problems Chapter 11 11-6. Estimating Incremental Cash Flows Mr. Phelps, a financial analyst at Rhodes Manufacturing Corporation, is
trying to analyze the feasibility of purchasing a new piece of equipment that
falls under the MACRS five-year class. The initial investment, including
the cost of equipment and its start-up, would be $375,000. Over the next six
years, the following earnings before depreciation and taxes (EBDT) will be
generated from using this equipment:
End of Year 120,000 2 90,000 3 70,000 4 70,000 5 70,000 6 Estimating Cash
Flows EBDT ($) 1 333 70,000 Rhodes’s discount rate is 13 percent and the company is in the 40 percent tax
bracket. There is no salvage value at the end of year 6. Should Mr. Phelps
recommend acceptance of the project?
11-7. Assume the same cash flows, initial investment, MACRS class, discount rate,
and income tax rate as given in problem 11-6. Now assume that the resale
value of the equipment at the end of six years will be $50,000. Calculate the
NPV and recommend whether the project should be accepted. Estimating Cash
Flows 11-8. George Kaplan is considering adding a new crop-dusting plane to his fleet
at North Corn Corner, Inc. The new plane will cost $85,000. He anticipates
spending an additional $20,000 immediately after the purchase to modify it
for crop-dusting. Kaplan plans to use the plane for five years and then sell
it. He estimates that the salvage value will be $20,000. With the addition of
the new plane, Kaplan estimates revenue in the first year will increase by
10 percent over last year. Revenue last year was $125,000. Other first-year
expenses are also expected to increase. Operating expenses will increase
by $20,000, and depreciation expense will increase by $10,500. Kaplan’s
marginal tax rate is 40 percent.
a. For capital budgeting purposes, what is the net cost of the plane? Or,
stated another way, what is the initial net cash flow?
b. Calculate the net incremental operating cash flow for year 1.
c. In which year would the salvage value affect the net cash flow
calculations? Initial Investment,
Salvage Value 11-9. Ghost Squadron Historical Aircraft, Inc. (GSHAI) is considering adding a
rare World War II B-24 bomber to its collection of vintage aircraft. The plane
was forced down in Burma in 1942, and it has remained there ever since.
Flying a crew to Burma and collecting the wreckage will cost $100,000.
Transporting all the parts to the company’s restoration facility in Texas will
cost another $35,000. Restoring the plane to flyable condition will cost an
additional $600,000 at t0. Evaluating an
Expansion Project 334 Part III Capital Budgeting and Business Valuation GSHAI’s operating costs will increase by $40,000 a year at the end of years
1 through 7 (on top of the restoration costs). At the end of years 3 through 7,
revenues from exhibiting the plane at airshows will be $70,000. At the end of
year 7, the plane will be retired. At that time the plane will be sold to a museum
The plane falls into the MACRS depreciation class for seven-year assets.
GSHAI’s combined federal and state income tax rate is 35 percent, and the
company’s weighted average cost of capital is 12 percent. Calculate the NPV
and IRR of the proposed investment in the plane.
Changes in Net
Working Capital 11-10. The management of the local cotton mill is evaluating the replacement
of low-wage workers by automated machines. If this project is adopted,
production and sales are expected to increase significantly: Norma Rae, the
mill’s financial analyst, expects cash will have to increase by $8,000 and
the accounts receivable will increase by $10,000 in response to the increase
in sales volume. Because of the higher level of production, inventory will
have to increase by $12,000, with an associated $6,000 increase in accounts
payable. Accrued taxes and wages, even with the decrease in the number of
laborers, are estimated to increase by $2,500.
a. Calculate the change in net working capital if the automation project is
b. Is this change in NWC a cash inflow or outflow?
c. Given the limited information about the duration of the project, in what
year should this change affect the net incremental cash flow calculations? Cash Flows and
Capital Budgeting 11-11. Sunstone, Inc., has entrusted financial analyst Flower Belle Lee with the
evaluation of a project that involves buying a new asset at a cost of $90,000.
The asset falls under the MACRS three-year class and will generate the
following revenue stream:
End of Year 1 2 3 4 Revenues ($) 50,000 30,000 20,000 20,000 The asset has a resale value of $10,000 at the end of the fourth year. Sunstone’s
discount rate is 11 percent. The company has an income tax rate of 30 percent.
Should Flower recommend purchase of the asset?
Cash Flows Changes in Net
Working Capital 11-12. Moonstone, Inc., a competitor of Sunstone, Inc., in problem 11-11, is
considering purchasing similar equipment with the same revenue, initial
investment, MACRS class, and resale value. Moonstone’s discount rate is
10 percent and its income tax rate is 40 percent. However, Moonstone is
considering the new asset to replace an existing asset with a book value
of $20,000 and a resale value of $10,000. What would be the NPV of the
11-13. You have just joined Moonstone, Inc. as its new financial analyst. You have
learned that accepting the project described in problem 11-12 will require an
increase of $10,000 in current assets and will increase current liabilities by
$5,000. The investment in net working capital will be recovered at the end of
year 4. What would be the new NPV of the project? Chapter 11 335 Estimating Incremental Cash Flows 11-14. You have been hired by Drs. Venkman, Stantz, and Spenler to help them
with NPV analysis for a replacement project. These three New York City
parapsychologists need to replace their existing supernatural beings detector
with the new, upgraded model. They have calculated all the necessary
figures but are unsure about how to account for the sale of their old machine.
The original depreciation basis of the old machine is $20,000, and the
accumulated depreciation is $12,000 at the date of the sale. They can sell the
old machine for $18,000 cash. Assume the tax rate for their company is 30
a. What is the book value of the old machine?
b. What is the taxable gain (loss) on the sale of the old equipment?
c. Calculate the tax on the gain (loss).
d. What is the net cash flow from the sale of the old equipment? Is this a
cash inflow or an outflow?
e. Assume the new equipment costs $40,000 and they do not expect a
change in net working capital. Calculate the incremental cash flow for t0.
f. Assume they could only sell the old equipment for $6,000 cash.
Recalculate parts b through e. Challenge
Problem 11-15. Mitch and Lydia Brenner own a small factory located in Bodega Bay,
California. They manufacture rubber snakes used to scare birds away from
houses, gardens, and playgrounds. The recent and unexplained increase in
the bird population in northern California has significantly increased the
demand for the Brenners’ products. To take advantage of this marketing
opportunity, they plan to add a new molding machine that will double the
output of their existing facility. The cost of the new machine is $20,000. The
machine setup fee is $2,000. With this purchase, current assets must increase
by $5,000 and current liabilities will increase by $3,000. The economic life
of the new machine is four years, and it falls under the MACRS three-year
depreciation schedule. The machine is expected to be obsolete at the end of
the fourth year and have no salvage value.
The Brenners anticipate recouping 100 percent of the additional investment
in net working capital at the end of year 4. Sales are expected to increase by
$20,000 each year in years 1 and 2. By year 3, the Brenners expect sales to be
mostly from repeat customers purchasing replacements instead of sales to new
customers. Therefore, the increase in sales for years 3 and 4 is estimated to
only be $10,000 in each year. The increase in operating expenses is estimated
to be 20 percent of the annual change in sales. Assume the marginal tax rate is
a. Calculate the initial net incremental cash flow.
b. Calculate the net incremental operating cash flows for years 1 through
4. Round all calculations to the nearest whole dollar. Use Table 5-2 to
calculate the depreciation expense.
c. Assume the Brenners’ discount rate is 14 percent. Calculate the net
present value of this project. Would you recommend the Brenners add this
new machine to their factory? Cash Flows and
Capital Budgeting 336 Part III Cash Flows and
Capital Budgeting 11-16. The RHPS Corporation specializes in the custom design, cutting, and
polishing of stone raw materials to make ornate building facings. These
stone facings are commonly used in the restoration of older mansions and
estates. Janet Weiss and Brad Majors, managers of the firm, are evaluating the
addition of a new stone-cutting machine to their plant. The machine’s cost to
RHPS is $150,000. Installation and calibration costs will be $7,500. They do
not anticipate an increase in sales, but the reduction in the operating expenses
is estimated to be $50,000 annually. The machine falls under the MACRS
three-year depreciation schedule. The machine is expected to be obsolete
after five years. At the end of five years, Weiss and Majors expect the cash
received (less applicable capital gains taxes) from the sale of the obsolete
machine to offset the shutdown and dismantling costs. The RHPS cost of
capital is 10 percent, and the marginal tax rate is 35 percent.
a. Calculate the net present value for the addition of this new machine.
Round all calculations to the nearest whole dollar.
b. Would you recommend that Weiss and Majors go forward with this project? Comprehensive
Problem Capital Budgeting and Business Valuation 11-17. The Chemical Company of Baytown purchased new processing equipment
for $40,000 on December 31, 2007. The equipment had an expected life
of four years and was classified in the MACRS three-year class. Due to
changes in environmental regulations, the operating cost of this equipment
has increased. The company is considering replacing this equipment with a
more-efficient process line at the end of 2009. The salvage value of the old
equipment is estimated to be $4,000. The marginal tax rate is 40 percent.
a. Calculate the cash flow from the sale of this equipment. Assume the sale
occurred at the end of 2009. Use Table 4-1 to calculate the depreciation.
b. The new process line has a higher capacity than the old one and is expected
to boost sales. As a result, the cash requirement will increase by $1,000, accounts receivable by $5,000, and inventory by $10,000. It will also increase
accounts payable by $6,000 and accrued expenses by $3,000. Calculate the
incremental cash flow due to the change in the net working capital.
c. The new equipment will cost $180,000, including installation and start-up
costs. Calculate the net cash outflow at the end of 2009 if the new process
line is installed and is ready to operate by the end of the year.
d. Beginning in January 2010, this new equipment is expected to generate
additional sales of $60,000 each year for the next four years. It will have
an economic life of four years and will fall under the MACRS three-year
classification. Being more efficient, the new equipment will reduce yearly
operating expenses by $6,000. Calculate the net incremental operating
cash flows for 2010 through 2010. Assume the marginal tax rate will
remain at 40 percent. Round calculations to the nearest whole dollar.
e. At the end of its economic life, the new process line is expected to be sold
for $20,000. The cost of capital for the company is 6 percent. Calculate
the net present value and the internal rate of return (only if you have a
financial calculator) for this project. Round calculations to the nearest
whole dollar. Recommend whether the replacement project should be
adopted or rejected. (Hint: Preparation of a summary of incremental cash
flows similar to Table 11-5 may be helpful.)
f. Draw an NPV profile for the project. Chapter 11 337 Estimating Incremental Cash Flows 11-18. Joe and Tim are business partners who are considering opening a brewpub in
Breckinridge, Colorado. It is to be called J&T’s Double Diamond Brewhouse.
Joe and Tim’s first expenditure is the $300,000 investment required to build
the brewpub. Once it is built, customers will determine how successful it is.
According to Joe and Tim’s estimates, the probabilities are .25 that it will be
a smash hit, .50 that it will be moderately successful, and .25 that it will be
If the brewpub is a smash hit, operating cash flows of $200,000 at the end of
years 1 and 2 are expected. In that case, Joe and Tim will expand the business
at the end of year 2 at a cost of $100,000. After expansion, the probabilities are
.50 that subsequent operating cash flows at the end of year 3 will be $400,000,
.30 that they will be $200,000, and .20 that they will be $90,000. Each of these
cash flow streams would continue in years 4 and 5.
If the brewpub is moderately successful, operating cash flows of $100,000 per
year at the end of years 1 through 5 are expected.
If the brewpub is a bomb, operating cash flows of –$40,000 per year at the end
of years 1 through 5 are expected. This outcome would cause Joe and Tim to
abandon the business at the end of year 1. The probability is 1.0 that Joe and
Tim will abandon the project if cash flows at the end of year 1 are –$40,000.
a. Plot the decisions, outcomes, and probabilities associated with the new
project on a decision tree similar to Figure 11-3.
b. Calculate the NPV and joint probability of each path in the decision tree.
Assume that Joe and Tim’s required rate of return is 14 percent.
c. Calculate the expected NPV of the entire deal. Again, assume that Joe and
Tim’s required rate of return is 10 percent. Answers to Self-Test
ST-1. $20,000 × (.36 + .04) = $20,000 × .40 = $8,000 tax savings ST-2. $2,000,000 + $400,000 = $2,400,000 operating cash flow ST-3. $1,500,000 total initial cash outlay (The $20,000 for the consultant is a sunk
cost.) ST-4. ($500,000 – $75,000 – $100,000) × (1 – .38)
= $325,000 × .62 = $201,500 incremental net income
$201,500 + $100,000 depreciation expense
= $301,500 incremental cash flow ST-5. ($900,000 – $300,000) × (1 – .32)
= $600,000 × .68 = $408,000 incremental net income
$408,000 + $300,000 depreciation expense
= $708,000 incremental operating cash flow (The finance costs are not part of operating cash flows. They will be reflected in the
required rate of return.) Real Options
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- Fall '08