Revenues (line 4). The company expects to be able to sell 750,000
pounds of magnoosium a year at a price of $20 a pound in Year 1.
That points to initial revenues of 750,000 20 = $15,000,000. But be
careful; inflation is running at about 5 percent a year.

10. Operating Cash Flows. Laurels Lawn Care, Ltd., has a new
mower line that can generate revenues of $120,000 per year. Direct
production costs are $40,000 and the fixed costs of maintaining the
lawn mower factory are $15,000 a year. The factory original

Now that we have examined many of the pieces of a cash-flow
analysis, lets try to put them together into a coherent whole. As the
newly appointed financial manager of Blooper Industries, you are
about to analyze a proposal for mining and selling a small d

assumption also explains why the depreciation is lower in the first year
than it is in the second.
MODIFIED
ACCELERATED
COST
RECOVERY
SYSTEM
(MACRS) Depreciation method that allows higher tax deductions in
early years and lower deductions later.
394
EXCEL

the project, such as its impact on the sales of the firms other products.
Forget sunk costs. Include opportunity costs, such as the value of
land which you could otherwise sell. Beware of allocated overhead
charges for heat, light, and so on. These may n

EXAMPLE 1 Measuring Beta for Turbot-Charged Seafoods
Suppose we look back at the trading history of Turbot-Charged
Seafoods and pick out 6 months when the return on the market
portfolio was plus or minus 1 percent.
Month Market Return, % Turbot-Charged Se

useful lives; neither will have any salvage value at the end of its life.
The firms tax rate is 35 percent, and the discount rate is 12 percent.
Which system should Blooper install? 25. Project Evaluation. The
following table presents sales forecasts for

and therefore increase present value. So if Blooper could get those tax
shields sooner, they would be worth more, right? Fortunately for
corporations, tax law allows them to do just that. It allows accelerated
depreciation. The rate at which firms are per

out when we look at the combined performance of thousands of
companies and securities. In principle the market portfolio should
contain all assets in the world economy not just stocks, but bonds,
foreign securities, real estate, and so on. In practice, ho

Increases in net working capital such as accounts receivable or
inventory are investments, and therefore use cashthat is, they
reduce the net cash flow provided by the project in that period. When
working capital is run down, cash is freed up, so cash flo

the year than your $100 could buy today. The real rate of interest is
therefore about 4 percent.3 If the discount rate is nominal, consistency
requires that cash flows be estimated in nominal terms as well, taking
account of trends in selling price, labor

investment in net working capital during 2001? All items are in
millions of dollars. Dec. 31, 2000 Dec. 31, 2001
Accounts receivable 32 35 Inventories 25 30 Accounts payable 12 25
16. Salvage Value.Quick Computing (from problem 5) installed its
previous g

required investment nor recognize the interest and principal payments
as cash outflows. Regardless of the actual financing, we should view
the project as if it were all equity-financed, treating all cash outflows
required for the project as coming from st

BEWARE OF ALLOCATED OVERHEAD COSTS We have already
mentioned that the accountants objective in gathering data is not
always the same as the investment analysts. A case in point is the
allocation of overhead costs such as rent, heat, or electricity. These

inventories more efficiently. If the firm can reduce inventories from 15
percent to 10 percent of next years cost of goods sold, what will be the
effect on project NPV?
1For convenience we assume that Blooper pays all its bills
immediately and therefore a

cash flow from investment is $800 million, and the cash flow in 7
years from the disinvestment in the production line will be $50 million
$10 million = $40 million.
INVESTMENT IN WORKING CAPITAL We pointed out earlier that
when a company builds up invent

1.02 Therefore, the real interest rate is .0392, or 3.92 percent.
386 SECTION FOUR
inflation rate of 3 percent. The firm believes that it will remain in the
building for 4 years. What is the present value of its rental costs if the
discount rate is 10 per

cash flows when assessing the net present value of proposed projects.
Depreciation is a noncash expense. Why then does it matter whether
we assume straight-line or MACRS depreciation when we assess
project NPV? 5. Proper Cash Flows. Quick Computing curren

392 SECTION FOUR
Investment in Working Capital. Weve seen that investment in working
capital, just like investment in plant and equipment, produces a
negative cash flow. Disinvestment in working capital produces a
positive cash flow. The numbers required

model. This model shows how risk should be measured and provides a
formula relating risk to the opportunity cost of capital. Leif
Jansson/Pica Pressfoto
arlier we began to come to grips with the topic of risk. We made the
distinction between unique risk a

The project will come to an end in 5 years, when the trap becomes
technologically obsolete. The firms tax bracket is 35 percent, and the
required rate of return on the project is 12 percent. What is project
NPV?
Year: 012345Thereafter
Sales (millions of t

HOW WELL DOES THE CAPM WORK? The basic idea behind the
capital asset pricing model is that investors expect a reward for both
waiting and worrying. The greater the worry, the greater the expected
return. If you invest in a risk-free Treasury bill, you jus

14
1.0
Expected return, percent
9.5
5
X
Y
Market portfolio
0
Beta (b)
14
12.2
.5 .8 1.0
3 On past evidence the risk premium on the market is 9 percent. With
a 5 percent Treasury bill rate, the expected market return would be 5 +
9 = 14 percent.
416 SECTIO

business, it makes sense to discount the forecast cash flows by the
company cost of capital. But suppose that Merck is wondering whether
to branch out into production of computer hardware. Its beta tells us
nothing about the project cost of capital. That

percent. You can now see why this has to be so. If that stock offered a
lower rate of return, nobody would buy even a little of itthey could
get 9.5 percent just by investing 50-50 in Treasury bills and the
market. And if nobody wants to hold the stock, i

PROJECT COST OF CAPITAL Minimum acceptable expected rate of
return on a project given its risk.
SEE BOX
FINANCE IN ACTION
DONT ADD FUDGE FACTORS TO DISCOUNT RATES Risk to an
investor arises because an investment adds to the spread of possible
portfolio re

interest rate +(beta expected market) risk premium r = 4.8% + (.61
9%) = 10.3% You can also use the capital asset pricing model to find
the discount rate for a new capital investment. For example, suppose
you are asked to analyze a proposal by Merck to e