Chapter 7: Net Present Value and Capital Budgeting 7.1 a. b. c.

Yes, the reduction in the sales of the companys other products, referred to as erosion, should be treated as an incremental cash flow. These lost sales are included because they are a cost (a revenue reduction) that the firm must bear if it chooses to produce the new product. Yes, expenditures on plant and equipment should be treated as incremental cash flows. These are costs of the new product line. owever, if these expenditures have already occurred, they are sunk costs and are not included as incremental cash flows. No, the research and development costs should not be treated as incremental cash flows. The costs of research and development underta!en on the product durin" the past # years are sunk costs and should not be included in the evaluation of the pro$ect. %ecisions made and costs incurred in the past cannot be chan"ed. They should not affect the decision to accept or re$ect the pro$ect. Yes, the annual depreciation expense should be treated as an incremental cash flow. %epreciation expense must be ta!en into account when calculatin" the cash flows related to a "iven pro$ect. &hile depreciation is not a cash expense that directly affects cash flow, it decreases a firms net income and hence, lowers its tax bill for the year. 'ecause of this depreciation tax shield, the firm has more cash on hand at the end of the year than it would have had without expensin" depreciation. No, dividend payments should not be treated as incremental cash flows. ( firms decision to pay or not pay dividends is independent of the decision to accept or re$ect any "iven investment pro$ect. )or this reason, it is not an incremental cash flow to a "iven pro$ect. %ividend policy is discussed in more detail in later chapters. Yes, the resale value of plant and equipment at the end of a pro$ects life should be treated as an incremental cash flow. The price at which the firm sells the equipment is a cash inflow, and any difference between the boo! value of the equipment and its sale price will create "ains or losses that result in either a tax credit or liability. Yes, salary and medical costs for production employees hired for a pro$ect should be treated as incremental cash flows. The salaries of all personnel connected to the pro$ect must be included as costs of that pro$ect.

d.

e.

f.

".

7.*

+tem + is a relevant cost because the opportunity to sell the land is lost if the new "olf club is produced. +tem ++ is also relevant because the firm must ta!e into account the erosion of sales of existin" products when a new product is introduced. +f the firm produces the new club, the earnin"s from the existin" clubs will decrease, effectively creatin" a cost that must be included in the decision. +tem +++ is not relevant because the costs of ,esearch and %evelopment are sun! costs. %ecisions made in the past cannot be chan"ed. They are not relevant to the production of the new clubs. Choice C is the correct answer.

7.#

-ash )low -hart. 1. *. #. 1. 6. <. 7. ;. >. 10. 11. a. 2ales revenue 5peratin" costs %epreciation +ncome before tax 713(*8#)9 Taxes at #1: =et income 71369 -ash flow from operation 713*369 +nitial +nvestment -han"es in net wor!in" capital Total cash flow from investment 7>8109 Total cash flow 778109 /ear 0 3 3 3 3 3 0 0 3410,000 3*00 310,*00 3410,*00 /ear 1 47,000 *,000 *,600 *,600 ;60 1,<60 1,160 3 360 360 41,100 /ear * 47,000 *,000 *,600 *,600 ;60 1,<60 1,160 3 360 360 41,100 /ear # 47,000 *,000 *,600 *,600 ;60 1,<60 1,160 3 100 100 41,*60 /ear 1 47,000 *,000 *,600 *,600 ;60 1,<60 1,160 3 *00 *00 41,#60

+ncremental =et +ncome 7from <9. /ear 0 /ear 1 /ear * /ear # 0 41,<60 41,<60 41,<60 +ncremental cash flow 7from 119. /ear 0 /ear 1 /ear * 3410,*00 41,100 41,100 /ear # 41,*60

/ear 1 41,<60 /ear 1 41,#60

b.

c.

The present value of each cash flow is simply the amount of that cash flow discounted bac! from the date of payment to the present. )or example, discount the cash flow in /ear 1 by 1 period (1.1*), and discount the cash flow that occurs in /ear * by * periods (1.1*)*. =ote that since the /ear 0 cash flow occurs today, its present value does not need to be ad$usted. ?@(-0) ?@(-1) ?@(-*) ?@(-#) ?@(-1) =?@ A 3410,*00 A 41,100 B (1.1*) A 4#,<<1 A 41,100 B (1.1*)* A 4#,*<; A 41,*60 B (1.1*)# A 4#,0*6 A 41,#60 B (1.1*)1 A 4*,7<6 A ?@(-0) 8 ?@(-1) 8 ?@(-*) 8 ?@(-#) 8 ?@(-1) A $2, !"

These calculations could also have been performed in a sin"le step. =?@ A 3410,*00 8 41,100 B (1.1*) 8 41,100 B (1.1*)* 8 41,*60 B (1.1*)# 8 41,#60 B (1.1*)1 A $2, !"

#he NPV o$ the pro%ect is $2, !".

7.1

The initial payment, which occurs today (year 0), does not need to be discounted. ?@ A 41,100,000 The expected value of his bonus payment is. Cxpected @alue A -0 (?robability of 5ccurrence) 8 -1 (?robability of =onoccurrence) A 4760,000 (0.<0) 8 40 (0.10) A 4160,000 The expected value of his salary, includin" the expected bonus payment, is 4*,>60,000 (A4*,600,000 8 4160,000). The present value of his three3year salary with bonuses is. ?@ (nnuity A -1 (Tr A 4*,>60,000 (#0.1*#< A 47,011,7>>

,emember that the annuity formula yields the present value of a stream of cash flows one period prior to the initial payment. Therefore, applyin" the annuity formula to a stream of cash flows that be"ins four years from today will "enerate the present value of that annuity as of the end of year three. %iscount that result by three years to find the present value. ?@ %elayed (nnuity A ((Tr) B (18r)T31 A (41,*60,000 (100.1*#<) B (1.1*#<)# A 41,>0<,167

Thus, the total ?@ of his three3year contract is. ?@ A 41,100,000 8 4*,>60,000 (#0.1*#< 8 (41,*60,000 (100.1*#<) B (1.1*#<)# A 41,100,000 8 47,011,7>> 8 41,>0<,167 A $!&,&'(,2 )

#he present *alue o$ the contract is $!&,&'(,2 ). 7.6 -ompute the =?@ of both alternatives. +f either of the pro$ects has a positive =?@, that pro$ect is more favorable to 'enson than simply continuin" to rent the buildin". +f both of the pro$ects have positive net present values, recommend the one with the hi"her =?@. +f neither of the pro$ects has a positive =?@, the correct recommendation is to re$ect both pro$ects and continue rentin" the buildin" to the current occupants. =ote that the remainin" fraction of the value of the buildin" and depreciation are not incremental and should not be included in the analysis of the two alternatives. The 4**6,000 purchase price of the buildin" is a sun! cost and should be i"nored.

?roduct (. ,evenues 3)ore"one rent 3Cxpenditures 3%epreciationD Carnin"s before taxes 3Taxes (#1:) =et income 8%epreciation -apital investment (BT3=-)

tA0

t A 1 3 11 4106,000 1*,000 <0,000 1*,000 4*1,000 7,110 41#,;<0 1*,000 4*6,;<0

t A 16 4106,000 1*,000 <#,760 1*,000 417,*60 6,;<6 411,#;6 1*,000 4*#,#;6

DD

341;0,000 341;0,000

D2ince the two assets, equipment and buildin" modifications, are depreciated on a strai"ht3line basis, the depreciation expense will be the same in each year. To compute the annual depreciation expense, determine the total initial cost of the two assets (4111,000 8 4#<,000 A 41;0,000) and divide this amount by 16, the economic life of each of the * assets. (nnual depreciation expense for buildin" modifications and equipment equals 41*,000 (A 41;0,000 B 16). DD-ash expenditures (4<0,000) 8 ,estoration costs (4#,760) The cash flows in years 1 3 11 (-1 3 -11) could have been computed usin" the followin" simplification. (fter3Tax =-) A ,evenue (1 E T-) 3 Cxpenses (1 3 T-) 8 %epreciation (T-) A 4106,000 (0.<<) 3 47*,000 (0.<<) 8 41*,000 (0.#1) A 4*6,;<0

The cash flows for year 16 could have been computed by ad$ustin" the annual after3tax net cash flows of the pro$ect (computed above) for the after3tax value of the restoration costs. (fter3Tax value of restoration costs A ,estoration -osts (1 3 T-) A 34#,760 (0.<<) A 34*,176

(fter3Tax =-)

A 4*6,;<0 3 4*,176 A 4*#,#;6

The present value of the initial outlay is simply the cost of the outlay since it occurs today (year 0). ?@(-0) A 341;0,000 2ince the cash flows in years 1311 are identical, their present value can be found by determinin" the value of a 113year annuity with payments of 4*6,;<0, discounted at 1* percent. ?@(-1311) A 4*6,;<0 (110.1* A 4171,101 'ecause the last cash flow occurs 16 years from today, discount the amount of the cash flow bac! 16 years at 1* percent to determine its present value. ?@(-16) A 4*#,#;6 B (1.1*)16 A 41,*7* =?@( A ?@(-0) 8 ?@(-1311) 8 ?@(-16) A +$',&2'

These calculations could also have been performed in a sin"le step. =?@( A 341;0,000 8 4*6,;<0 (110.1* 8 4*#,#;6 B (1.1*)16 A 341;0,000 8 4171,101 8 41,*7* A +$',&2'

,ince the net present *alue o$ Pro%ect - is negati*e, Benson would rather rent the .uilding to its current occupants than i/ple/ent Pro%ect -. ?roduct ' ,evenues 3)ore"one rent 3Cxpenditures 3%epreciationD Carnin"s before taxes 3Taxes (#1:) =et income 8%epreciation -apital investment (BT3=-) tA0 t A 1 3 11 41*7,600 1*,000 76,000 11,100 4*<,100 ;,;71 417,**< 11,100 4#1,<*< t A 16 41*7,600 1*,000 10#,1*6 11,100 34*,0*6 3<;> 341,##< 11,100 41#,0<1

DD

34*1<,000 34*1<,000

D 2ince the two assets, equipment and buildin" modifications, are depreciated on a strai"ht3line basis, the depreciation expense will be the same in each year. To compute the annual depreciation expense, determine the total initial cost of the two assets (41<*,000 8 461,000 A 4*1<,000) and divide this amount by 16, the economic life of each of the two assets. (nnual depreciation expense for buildin" modifications and equipment is 411,100 (A 4*1<,000B 16). DD-ash expenditures (476,000) 8 ,estoration costs (4*;,1*6) The cash flows in years 1 3 11 (-1 3 -11) could have been computed usin" the followin" simplification. (fter3Tax =-) A ,evenue (1 3 T) 3 Cxpenses (1 3 T) 8 %epreciation (T) A 41*7,600 (0.<<) 3 4;7,000 (0.<<) 8 411,100 (0.#1) A 4#1,<*<

The cash flows for year 16 could have been computed by ad$ustin" the annual after3tax net cash flows of the pro$ect (computed above) for the after3tax value of the restoration costs. (fter3tax value of restoration costs A ,estoration -osts (1 3 T-) A 3 4*;,1*6(0.<<) A 341;,6<* (fter3Tax =-) A 4#1,<*< 3 41;,6<* A 41#,0<1

The present value of the initial outlay is simply the cost of the outlay since it occurs today (year 0). ?@(-0) A 34*1<,000 'ecause the cash flows in years 1311 are identical, their present value can be found by determinin" the value of a 113year annuity with payments of 4#1,<*<, discounted at 1* percent. ?@(-1311) A 4#1,<*< (110.1*

A 4*0>,<** 2ince the last cash flow occurs 16 years from today, discount the amount of the cash flow bac! 16 years at 1* percent to determine its present value. ?@(-16) A 41#,0<1 B (1.1*)16 A 4*,#;7 =?@' A ?@(-0) 8 ?@(-1311) 8 ?@(-16) A 34*1<,000 8 4*0>,<** 8 4*,#;7 A +$&,""!

These calculations could also have been performed in a sin"le step. =?@' A 34*1<,000 8 4#1,<*< (110.1* 8 41#,0<1 B (1.1*)16 A 34*1<,000 8 4*0>,<** 8 4*,#;7 A +$&,""!

,ince the net present *alue o$ Pro%ect B is negati*e, Benson would rather rent the .uilding to its current occupants than i/ple/ent Pro%ect B. ,ince the net present *alues o$ .oth Pro%ect - and Pro%ect B are negati*e, Benson should continue to rent the .uilding to its current occupants. 7.< /ear 0 1. Feyboards ?roduced *. ?rice per Feyboard #. 2ales revenue 71D*9 1. -ost per Feyboard 6. 5peratin" costs71D19 <. Gross Har"in 7#369 7. %epreciation ;. ?retax +ncome 7<379 >. Taxes at #1: 10. =et income 7;3>9 11. -ash flow from operations 710879 1*. +nvestment 1#. Total -ash )low /ear 1 10,000 10 100,000 *0 *00,000 *00,000 ;0,000 1*0,000 10,;00 7>,*00 16>,*00 416>,*00 /ear * 10,000 10(1.06) 1*0,000 *0(1.10) **0,000 *00,000 ;0,000 1*0,000 10,;00 7>,*00 16>,*00 416>,*00 /ear # 10,000 10(1.06)* 111,000 *0(1.10)* *1*,000 1>>,000 ;0,000 11>,000 10,1<0 7;,610 16;,610 416;,610 /ear 1 10,000 10(1.06)# 1<#,060 *0(1.10)# *<<,*00 1><,;60 ;0,000 11<,;60 #>,7*> 77,1*1 167,1*1 4167,1*1 /ear 6 10,000 10(1.06)1 1;<,*0# *0(1.10)1 *>*,;*0 1>#,#;# ;0,000 11#,#;# #;,61> 71,;#1 161,;#1 4161,;#1

3100,000 34100,000

2ince the initial investment occurs today (year 0), its present value does not need to be ad$usted. ?@(-0) ?@(-1) ?@(-*) ?@(-#) ?@(-1) ?@(-6) =?@ A 34100,000 A 416>,*00 B (1.16) A 41#;,1#6 A 416>,*00 B (1.16)* A 41*0,#7; A 416;,610 B (1.16)# A 4101,*1# A 4167,1*1 B (1.16)1 A 4;>,;#1 A 4161,;#1 B (1.16)6 A 47<,>;0 A ?@(-0) 8 ?@(-1) 8 ?@(-*) 8 ?@(-#) 8 ?@(-1) 8 ?@(-6) A $!2",(70

These calculations could also have been performed in a sin"le step. =?@ A 34100,0008 416>,*00 B (1.16) 8 416>,*00 B (1.16)* 8 416;,610 B (1.16)# 8 4167,1*1 B (1.16)1 8 4161,;#1 B (1.16)6 A $!2",(70

#he NPV o$ the in*est/ent is $!2",(70. 7.7 1. *. #. 1. 6. <. 7. ;. /ear 0 (nnual 2alary 2avin"s %epreciation Taxable +ncome 713 *9 Taxes 5peratin" -ash )low 713 19 4100,000 =et wor!in" capital +nvestment 34600,000 Total -ash )low 34100,000 /ear 1 41*0,000 100,000 *0,000 <,;00 11#,*00 /ear * 41*0,000 100,000 *0,000 <,;00 11#,*00 /ear # 41*0,000 100,000 *0,000 <,;00 11#,*00 /ear 1 41*0,000 100,000 *0,000 <,;00 11#,*00 /ear 6 41*0,000 100,000 *0,000 <,;00 11#,*00 3100,000 <<,000D 47>,*00

411#,*00

411#,*00

411#,*00

411#,*00

D &hen calculatin" the salva"e value, remember that tax liabilities or credits are "enerated on the difference between the resale value and the boo! value of the asset. +n this case, the computer has a boo! value of 40 and a resale value of 4100,000 at the end of year 6. The total amount received in salva"e value is the resale value minus the taxes paid on the difference between the resale value and the boo! value. 4<<,000 A 4100,000 3 0.#1 (4100,000 3 40). ?@(-0) ?@(-1) ?@(-*) ?@(-#) ?@(-1) ?@(-6) =?@ A 34100,000 A 411#,*00 B (1.1*) A 4101,071 A 411#,*00 B (1.1*)* A 4>0,*1* A 411#,*00 B (1.1*)# A 4;0,671 A 411#,*00 B (1.1*)1 A 471,>11 A 47>,*00 B (1.1*)6 A 411,>10 A ?@(-0) 8 ?@(-1) 8 ?@(-*) 8 ?@(-#) 8 ?@(-1) 8 ?@(-6) A +$!!,2&2

These calculations could also have been performed in a sin"le step. =?@ A 34100,000 8 411#,*00 B (1.1*) 8 411#,*00 B (1.1*)* 8 411#,*00 B (1.1*)# 8 411#,*00 B (1.1*)1 8 47>,*00 B (1.1*)6 A +$!!,2&2

,ince the NPV o$ the co/puter is negati*e, it is not a worthwhile in*est/ent.

7.; tA0 1. ,evenues *. Cxpenses #. %epreciation 1. ?retax +ncome 713*3#9 6. Taxes (#6:) <. =et +ncome 71369 7. =et &or!in" -apital ;. -) from 5perations 7<8#879 >. -apital +nvestment 10. Tax benefit from -apital IossD 11. (BT3=-) t A 13 * 4<00,000 160,000 160,000 4#00,000 106,000 41>6,000 3 *6,000 3 *6,000 3 4760,000 3 4776,000 4#16,000 4#16,000 tA# 4<00,000 160,000 160,000 4#00,000 106,000 41>6,000 4*6,000 4#70,000 410,000 4>1,000 4601,000

D The capital loss arises because the resale value (410,000) is less than the net boo! value (4#00,000). The tax benefit from the capital loss is computed by multiplyin" the amount of the capital loss by the tax rate (4>1,000 A 0.#6 D 4*<0,000). This represents the tax shield, i.e. the reduction in taxes from the capital loss. The cash flows in years 1 and * could also have been computed usin" the followin" simplification. (fter3Tax =-) A ,evenue (1 E Tc) 3 Cxpenses (1 E Tc) 8 %epreciation (Tc) A 4<00,000 (0.<6) 3 4160,000 (0.<6) 8 4160,000(0.#6) A 4#16,000

?@(-0) ?@(-1) ?@(-*) ?@(-#) =?@

A 34776,000 A 4#16,000B (1.17) A 4*>1,;7* A 4#16,000B (1.17)* A 4*6*,0*7 A 4601,000B(1.17)# A 4#1*,;10 A ?@(-0) 8 ?@(-1) 8 ?@(-*) 8 ?@(-#) A $(',70"

These calculations could also have been performed in a sin"le step. =?@ A 34776,000 8 4#16,000B (1.17) 8 4#16,000B (1.17)* 8 4601,000B(1.17)# A 34776,000 8 4*>1,;7* 8 4*6*,0*7 8 4#1*,;10 A $(',70"

#he NPV o$ the new so$tware is $(',70". 7.> The least amount of money that the firm should as! for the first3year lease payment is the amount that will ma!e the net present value of the purchase of the buildin" equal to Jero. +n other words, the least that the firm will char"e for its initial lease payment is the amount that ma!es the present value of future cash flows $ust enou"h to compensate it for its 41,000,000 purchase. +n order to determine this amount, set the net present value of the pro$ect equal to Jero. 2olve for the amount of the initial lease payment. 2ince the purchase of the buildin" will occur today (year 0), its present value does not need to be ad$usted.

?@(?urchase of 'uildin") A 341,000,000 2ince the initial lease payment also occurs today (year 0), its present value also does not need to be ad$usted. owever, since it will be recorded as revenue for the firm and will be taxed, the inflow must be ad$usted to the corporate tax rate. ?@(+nitial Iease ?ayment) A -0(13 0.#1) =ote that in this problem we are solvin" for -0, which is not yet !nown. The second lease payment represents the first cash flow of a "rowin" annuity. 2ince lease payments increase by three percent each year, the amount of the second payment is the amount of the first payment multiplied by 1.0#, ad$usted for taxes, or -0(13 0.<<)(1.0#). ,ecall that the appropriate discount rate is 1* percent, the "rowth rate is three percent, and that the annuity consists of only 1> payments, since the first of the *0 payments was made at tA0. ?@(,emainder of Iease ?ayments) A -0(13 0.#1)(1.0#)(G(1>0.1*, 0.0#)D D The notation G(Tr, " represents a "rowin" annuity consistin" of T payments "rowin" at a rate of g per payment, discounted at r. (nnual depreciation, calculated by the strai"ht3line method (+nitial +nvestment B Cconomic Iife of +nvestment), is 4*00,000 (A 41,000,000 B *0). 2ince net income will be lower by 4*00,000 per year due to this expense, the firms tax bill will also be lower. The annual depreciation tax shield is found by multiplyin" the annual depreciation expense by the tax rate. The annual tax shield is 4<;,000 (A 4*00,000 D 0.#1). (pply the standard annuity formula to calculate the present value of the annual depreciation tax shield. ?@(%epreciation Tax 2hield) A 4<;,000(*00.1* ,ecall that the least that the firm will char"e for its initial lease payment is the amount that ma!es the present value of future cash flows $ust enou"h to compensate it for its 41,000,000 purchase. This is represented in the equation below. ?@(?urchase) 41,000,000 -0 A ?@(Iease ?ayments) 8 ?@(%epreciation Tax 2hield) A -0(13 0.#1) 8 -0(13 0.#1)(1.0#)( G(1>0.1*, 0.0#) 8 4<;,000(*00.1* A 46*#,117

#here$ore, the least that the $ir/ should charge $or its initial lease pa1/ent is $ 2&,!!7.

7.10

The decision to accept or re$ect the pro$ect depends on whether the =?@ of the pro$ect is positive or ne"ative. (in thousands) 1. *. #. 1. 6. <. 7. ;. >. 10. 11. 2ales revenue 5peratin" costs %epreciation +ncome before tax 713*3#9 Taxes at #6: =et income 71369 -ash flow from operation 713*369 +nitial +nvestment -han"es in net wor!in" capital Total cash flow from investment 7;8>9 Total cash flow 778109 /ear 0 3 3 3 3 3 0 0 3*000 3100 3*,100 3*,100 /ear 1 41,*00 #00 100 600 176 #*6 7*6 3 3 3 7*6 /ear * 41,*00 #00 100 600 176 #*6 7*6 3 3 3 7*6 /ear # 41,*00 #00 100 600 176 #*6 7*6 3 3 3 7*6 /ear 1 41,*00 #00 100 600 176 #*6 7*6 *#7.6D 100 ##7.6 1,0<*.6

2 ,emember that, when calculatin" the salva"e value, tax liabilities or credits are "enerated on the difference between the resale value and the boo! value of the asset. 2ince the capital asset is depreciated over five years, yet sold in the year 1, the boo! value at the time of sale is 4100,000 (A 4*,000,000 E 41,<00,000). 2ince the salva"e value of 4160,000 is below boo! value, the resultin" capital loss creates a tax credit. (fter3Tax ,esale @alue A 4160,000 3 0.#6 (4160,000 E 100,000) A 4*#7,600

=ote that an increase in required net wor!in" capital is a ne"ative cash flow whereas a decrease in required net wor!in" capital is a positive cash flow. Thus, in year 0, the firm realiJes a 4100,000 cash outflow while in year 1 the firm realiJes a 4100,000 cash inflow. 2ince year 0 is today, year 0 cash flows do not need to be discounted. ?@(-0) ?@(-1) ?@(-*) ?@(-#) ?@(-1) =?@ A 34*,100,000 A 47*6,000 B (1.1<66) A 47*6,000 B (1.1<66)* A 47*6,000 B (1.1<66)# A 41,0<*,600 B (1.1<66)1 A 4<**,061 A 46##,7*0 A 4167,>#* A 4676,;11

A ?@(-0) 8 ?@(-1) 8 ?@(-*) 8 ?@(-#) 8 ?@(-1) A $(", !'

These calculations could also have been performed in a sin"le step. =?@ A 34*,100,000 8 47*6,000 B (1.1<66) 8 47*6,000 B (1.1<66)* 8 47*6,000 B (1.1<66)# 8 41,0<*,600 B (1.1<66)1 A $(", !'

,ince the NPV o$ the pro%ect is positi*e, 3o1al 4utch should proceed with the pro%ect. 7.11 To determine the maximum price that HH- should be willin" to pay for the equipment, calculate how hi"h the price for the new equipment must be for the pro$ect to have an =?@ of Jero. %etermine the cash flows pertainin" to the sale of the existin" equipment, the purchase of the new equipment, the future incremental benefits that the new equipment will provide to the firm, and the sale of the new equipment in ei"ht years. 2ale of existin" equipment To find the after3tax resale value of the equipment, ta!e into consideration the current mar!et value and the accumulated depreciation. The difference is the amount sub$ect to capital "ains taxes. ?urchase ?rice %epreciation per year (ccumulated %epreciation =et 'oo! @alue of existin" equipment A 410,000 A 410,000 B 10 years A 41,000 per year A 6 years D 41,000 per year A 4*0,000 A ?urchase ?rice E (ccumulated %epreciation A 410,000 3 4*0,000 A 4*0,000 A 2ale ?rice E Tc (2ale ?rice E =et 'oo! @alue) A 4*0,000 3 0.#1 (4*0,000 E 4*0,000) A 4*0,000

?@((fter3Tax =et ,esale @alue)

?urchase of new equipment Iet I equal the maximum price that HH- should be willin" to pay for the equipment. ?@(=ew Cquipment) A 34+ Iower operatin" costs 'efore3tax operatin" costs are lower by 410,000 per year for ei"ht years if the firm purchases the new equipment. Iower operatin" costs raise net income, implyin" a lar"er tax bill. +ncreased annual taxes due to hi"her net income A 410,000 D 0.#1 A 4#,100

+f the firm purchases the new equipment, its net income will be 410,000 hi"her but it will also pay 4#,100 more in taxes. Therefore, lower operatin" costs increase the firms annual cash flow by 4<,<00. ?@(5peratin" -ost 2avin"s) A 4<,<00 (;0.0; A 4#7,>*; owever, the firm also fore"oes the

+ncremental depreciation tax shield The firm will realiJe depreciation tax benefits on the new equipment. depreciation tax shield on the old equipment.

+ncremental depreciation per year due to new equipment A (nnual %epreciation on new equipment E (nnual %epreciation on old equipment if it had been retained (nnual %epreciation on =ew Cquipment A (?urchase ?riceB Cconomic Iife) A (4+B6)

(nnual %epreciation on 5ld Cquipment

A 41,000

+ncremental %epreciation per year due to new equipment A (4+B6) 3 41,000 +ncremental %epreciation tax shield per year A +ncremental %epreciation per year D TA 7(4+B6) 3 41,0009 D 0.#1 ?@(+ncremental %epreciation Tax 2hield) A 0.#17(4+B6) 3 41,0009 (60.0; =ote that since both old and new equipment will be fully depreciated after 6 years, no depreciation tax shield is applicable in years <3;. 2ale of =ew Cquipment The new equipment will be sold at the end of year ;. 2ince it will have been fully depreciated by year 6, capital "ains taxes must be paid on the entire resale price. 2ale ?rice of new equipment A 46,000

=et 'oo! @alue of new equipment A 40 (+t had been fully depreciated as of year 6.) (fter3Tax =et -ash )low A 2ale ?rice E Tc (2ale ?rice E =et 'oo! @alue) A 46,000 3 0.#1 (46,000 E 0) A 4#,#00 A 4#,#00 B (1.0;); A 41,7;#

?@(,esale @alue)

The maximum price that HH- should be willin" to pay for the new equipment is the price that ma!es the =?@ of the investment equal to Jero. +n order to solve for the price, set the net present value of all incremental after3tax cash flows related to the new equipment equal to Jero and solve for I. 0 A (4*0,000 E 4+) 8 4<,<00 (;0.0; 8 70.#197(4+B6) 3 41,0009 (60.0; 8 4#,#00B (1.0;); + A $7', !0 #here$ore, the /axi/u/ price that 55C should .e willing to pa1 $or the e6uip/ent is $7', !0. 7.1* ?urchase of =ew Cquipment A 3$2(,000,000 2ince the old equipment is sold at a price that is "reater than its boo! value, the firm will record a capital "ain on the sale, and this sale will be sub$ect to the corporate tax rate. (fter3Tax 2alva"e @alue A 2ale ?rice E T-(2ale ?rice E =et 'oo! @alue) (fter3Tax @alue of 2ale of 5ld Cquipment A 4*0,000,000 3 0.10(4*0,000,000341*,000,000) A $!),(00,000 (fter3Tax 5peratin" -ost 2avin"s due to =ew Cquipment /ear 1 A (130.10)(417,600,000) A $!0, 00,000 /ear * A (130.10)(417,600,000)(1.1*) A $!!,7)0,000 /ear # A (130.10)(417,600,000)(1.1*)* A $!&,!7!,200 /ear 1 A (130.10)(417,600,000)(1.1*)# A $!',7 !,7'' %epreciation of 5ld Cquipment /ear 1 A (41*,000,000B1) /ear * A (41*,000,000B1) A 4#,000,000 A 4#,000,000

/ear # A (41*,000,000B1) /ear 1 A (41*,000,000B1) %epreciation of =ew Cquipment /ear 1 A (4*;,000,000 D 0.###) /ear * A (4*;,000,000D0.#>>) /ear # A (4*;,000,000D0.11;) /ear 1 A (4*;,000,000D0.1*0)

A 4#,000,000 A 4#,000,000 A 4>,#*1,000 A 411,17*,000 A 41,111,000 A 4#,#<0,000

+ncremental %epreciation due to =ew Cquipment /ear 1 A 4>,#*1,000 3 4#,000,000 A $),&2',000 /ear * A 411,17*,0003 4#,000,000 A $(,!72,000 /ear # A 41,111,0003 4#,000,000 A $!,!'',000 /ear 1 A 4#,#<0,0003 4#,000,000 A $&)0,000 +ncremental %epreciation Tax 2hield due to =ew Cquipment /ear 1 A 4<,#*1,000 D 0.10 A $2, 2",)00 /ear * A 4;,17*,000 D 0.10 A $&,2)(,(00 /ear # A 41,111,000 D 0.10 A $' 7,)00 /ear 1 A 4#<0,000 D 0.10 A $!'',000 a. =et +nvestment A 3 ?urchase of =ew Cquipment 8 (fter3Tax ?roceeds from 2ale of 5ld Cquipment 8 +ncrease in =et &or!in" -apital A 34*;,000,000 8 41<,;00,000 3 46,000,000 A +$!),200,000

#here$ore, the cash out$low at the end o$ 1ear 0 is $!),200,000. b. ?urchase of =ew Cquipment (fter3Tax 2ale of 5ld Cquipment =et &or!in" -apital (fter3Tax 5peratin" -ost 2avin"s +ncremental %epreciation Tax 2hield (fter3Tax +ncremental -ash )low c. +,, -alculation. +n order to determine the internal rate return (+,,) of the investment in new equipment, determine the discount rate that ma!es the =?@ of the pro$ect equal to Jero. 0 A341<,*00,000 8 41#,0*>,<00B(18+,,) 8 416,0*;,;00B(18+,,)* 8 41#,<*;,;00B(18+,,)# 8 41>,;>6,711B(18+,,)1 +,, A 0.7>1; A 7".'(7 +!),200,000 /ear 0 3*;,000,000 1<,;00,000 36,000,000 /ear 1 /ear * /ear # /ear 1

10,600,00 0 *,6*>,<00 !&,02",)0 0

11,7<0,00 0 #,*<;,;00 ! ,02(,(0 0

1#,171,*0 0 167,<00 !&,)2(,(0 0

6,000,000 11,761,71 1 111,000 !",(" ,7' '

#he internal rate o$ return o$ the in*est/ent in new e6uip/ent is 7".'(7. d. =?@ -alculation.

=?@

A341<,*00,000 8 41#,0*>,<00B(1.11) 8 416,0*;,;00B(1.11)* 8 41#,<*;,;00B(1.11)# 8 41>,;>6,711B(1.11)1 A $27,772, 77

#he net present *alue o$ the in*est/ent in new e6uip/ent is $27,772, 77. 7.1# =ominal cash flows should be discounted at the nominal discount rate. ,eal cash flows should be discounted at the real discount rate. ?ro$ect (s cash flows are presented in real terms. Therefore, one must compute the real discount rate before calculatin" the =?@ of ?ro$ect (. 2ince the cash flows of ?ro$ect ' are "iven in nominal terms, discount its cash flows by the nominal rate in order to calculate its =?@. =ominal %iscount ,ate +nflation ,ate 1 8 ,eal %iscount ,ate ,eal %iscount ,ate A 0.16 A 0.01 A (18 =ominal %iscount ,ate) B (18 +nflation ,ate) A 0.106; A10.6;:

?ro$ect (s cash flows are expressed in real terms and therefore should be discounted at the real discount rate of 10.6;:. ?ro$ect (. ?@(-0) A 3410,000 ?@(-1) A 4*0,000 B (1.106;) A 41;,0;< ?@(-*) A 416,000B (1.106;)* A 41*,*<7 ?@(-#) A 416,000 B (1.106;)# A 411,0># =?@( A ?@(-0) 8 ?@(-1) 8 ?@(-*) 8 ?@(-#) A $!,'')

These calculations could also have been performed in a sin"le step. =?@( A 3410,0008 4*0,000 B (1.106;) 8 416,000 B (1.106;)* 8 416,000 B (1.106;)# A $!,'')

?ro$ect 's cash flows are expressed in nominal terms and therefore should be discounted at the nominal discount rate of 16:. ?ro$ect '. ?@(-0) A 3460,000 ?@(-1) A 410,000 B (1.16) A 4;,<>< ?@(-*) A 4*0,000B (1.16)* A 416,1*# ?@(-#) A 410,000 B (1.16)# A 4*<,#01 =?@' A ?@(-0) 8 ?@(-1) 8 ?@(-*) 8 ?@(-#) A $!20

These calculations could also have been performed in a sin"le step. =?@' A 3460,0008 410,000 B (1.16) 8 4*0,000 B (1.16)* 8 410,000 B (1.16)# A 4!20

,ince the NPV o$ Pro%ect - is greater than the NPV o$ Pro%ect B, choose Pro%ect -. 7.11 =otice that the problem provides the nominal values at the end of the first year, so to find the values for revenue and expenses at the end of year 6, compound the values by four years of inflation, e.". 4*00,000D(1.0#)1 A 4**6,10*. 2ince the resale value is "iven in nominal terms as of the end of year 6, it does not need to be ad$usted for inflation. (lso, no inflation ad$ustment is needed for either the

depreciation char"e or the recovery of net wor!in" capital since these items are already expressed in nominal terms. =ote that an increase in required net wor!in" capital is a ne"ative cash flow whereas a decrease in required net wor!in" capital is a positive cash flow.

/ear 0 1. *. #. 1. 6. <. 7. ;. >. ,evenue Cxpenses %epreciation Taxable +ncome 71 E* E#9 Taxes 5peratin" -ash )low 71 E * E 69 =et wor!in" capital +nvestment Total -ash )low

/ear 1 4*00,000 60,000 60,000 100,000 #1,000 11<,000

/ear * 4*0<,000 61,600 60,000 101,600 #6,6#0 11;,>70

/ear # 4*1*,1;0 6#,016 60,000 10>,1#6 #7,10< 1**,0*>

/ear 1 4*1;,616 61,<#< 60,000 11#,>0> #;,7*> 1*6,1;0

/ear 6 4**6,10* 6<,*76 60,000 11;,;*7 10,101 1*;,1*< 10,000 1>,;00D $! (,22)

310,000 3*60,000 34*<0,000

411<,000

411;,>70

41**,0*>

41*6,1;0

D &hen calculatin" the salva"e value of the asset, remember that only the "ain on the sale of the asset is taxed. This "ain is calculated as the difference between the resale value and the net boo! value of the asset at the time of sale. +t follows that the tax associated with the sale is TC (Resale Value Net Book Value). Therefore, the after3tax salva"e value of the asset is 41>,;00 7A 4#0,000 E 0.#1(4#0,000 E 0)9. #he no/inal cash $low at 1ear 7.16 is $! (,22).

2ince the problem lists nominal cash flows and a real discount rate, one must determine the nominal discount rate before computin" the net present value of the pro$ect. 1 8 ,eal %iscount ,ate 1.11 =ominal %iscount ,ate A (1 8 =ominal %iscount ,ate) B (1 8 +nflation ,ate) A (18 =ominal %iscount ,ate) B (1.06) A 0.1>7 /ear * 46*,600 *1,100 17,11# 1#,>67 1,716 >,*1* *<,#66 3 3 /ear # 466,1*6 **,;>; 17,11# 16,0;1 6,1*> >,>66 *7,0>; 3 3 /ear 1 467,;;1 *1,601 17,11# 1<,*#7 6,6*1 10,71< *7,;6> 3 3 /ear 6 4<0,776 *<,*1< 17,11# 17,11< 6,>*1 11,1>6 *;,<#; 3 3 /ear < 4<#,;11 *;,061 17,11# 1;,<*0 <,##1 1*,*;> *>,1#* 3 3 /ear 7 4<7,006 #0,016 17,11# 1>,;17 <,71; 1#,0>> #0,*1* 3 3

1. *. #. 1. 6. <. 7. ;. 10.

11.

2ales revenue 5peratin" costs %epreciation +ncome before tax 713*3#9 Taxes at #1: =et income 71369 -ash flow from operation 713*369 +nitial +nvestment Total cash flow from investment 7>8109 Total cash flow 778109

/ear 0 3 3 3 3 3 3 3 31*0,000 31*0,000

/ear 1 460,000 *0,000 17,11# 1*,;67 1,#71 ;,1;< *6,<*> 3 3

31*0,000

*6,<*>

*<,#66

*7,0>;

*7,;6>

*;,<#;

*>,1#*

#0,*1*

?@(-0) ?@(-1) ?@(-*) ?@(-#) ?@(-1) ?@(-6) ?@(-<) ?@(-7) =?@

A 341*0,000 A 4*6,<*> B (1.1>7) A 4*1,111 A 4*<,#66 B (1.1>7)* A 41;,#>1 A 4*7,0>; B (1.1>7)# A 416,;00 A 4*7,;6> B (1.1>7)1 A 41#,670 A 4*;,<#; B (1.1>7)6 A 411,<61 A 4*>,1#* B (1.1>7)< A 410,00< A 4#0,*1* B (1.1>7)7 A 4;,6;> A ?@(-0) 8 ?@(-1) 8 ?@(-*) 8 ?@(-#) 8 ?@(-1) 8 ?@(-6) 8 ?@(-<) 8 ?@(-7) A 3$20, 7)

These calculations could also have been performed in a sin"le step. =?@ A 341*0,000 8 4*6,<*> B (1.1>7) 8 4*<,0*6 B (1.1>7)* 8 4*7,0>; B (1.1>7)# 8 4*7,;6> B (1.1>7)1 8 4*;,<#; B (1.1>7)6 8 4*>,1#* B (1.1>7)< 8 4#0,*1* B (1.1>7)7 A 3$20, 7)

To solve the problem usin" a strin" of annuities, find the present value of each cash flow. The investment occurs today and therefore is not discounted. ?@(+nvestment) A 341*0,000 The ?@ of the revenues is found by usin" the growing annuity formula. =ote that nominal cash flows must be discounted by nominal rates. The followin" solution treats revenues as a "rowin" annuity discounted at 1>.7 percent and "rowin" at five percent annually over seven years. ?@(,evenues) ?@(,evenues) A -1 (1 E Tc) G(Tr, " A 460,000 G(70.1>7, 0.06 (1 3 0.#1)D A 41#1,776

D The notation G(Tr, " represents a "rowin" annuity consistin" of T payments "rowin" at a rate of g per payment, discounted at r. The ?@ of the expenses is found usin" the same method that was used in findin" the ?@ of the revenues. ("ain, the expenses are treated as a nominal "rowin" annuity, discounted at 1>.7 percent and "rowin" at seven percent annually over seven years. ?@ Cxpenses ?@ Cxpenses A -1 G(Tr, " (1 E Tc) A 4*0,000 G(70.1>7, 0.07 (1 3 0.#1) A 46<,6#1

2ince the firm has positive net income, the firm will benefit from the depreciation tax shield. (pply the annuity formula to the strin" of annual tax shields to find the present value of the taxes saved. ?@(%epreciation Tax 2hield) ?@(%epreciation Tax 2hield) A Tc ((nnual %epreciation) (Tr A 0.#1 (41*0,000 B 7) (70.1>7 A 4*1,1;#

The present value of the pro$ect is the sum of the previous annuities. ?@ ?ro$ect ?@ ?ro$ect ?@ ?ro$ect A 3+nvestment 8 ,evenue 3 Cxpenses 8 %epreciation Tax 2hield A 341*0,000 8 41#1,776 3 46<,6#1 8 4*1,1;# A +$20, 7)

,ince the pro%ect has a negati*e NPV, +$20, 7), it should .e re%ected. #he no/inal cash $low during 1ear 7.1< is $! 7,"2).

(pply the "rowin" perpetuity formula to the payments that are declinin" at a constant rate. 'ecause the payments are declinin", they have a negati e "rowth rate. The initial cash flow of the perpetuity occurs one year from today and is expressed in real terms. -1 A 41*0,000 The real discount rate is 11:. r A 0.11 The real "rowth rate is 3<:. " A 30.0< ?@ A -1 B (r3") , where r K " A 41*0,000 B 7 0.11 E (30.0<)9 A 41*0,000 B (0.11 8 0.0<) A 41*0,000 B 0.17 A $70 ,((2

#he present *alue o$ Phillip8s net cash $lows is $70 ,((2. 7.17 =otice that the discount rate is expressed in real terms and the cash flows are expressed in nominal terms. +n order to solve the problem, convert all nominal cash flows to real cash flows and discount them usin" the real discount rate. /ear 1 ,evenue in ,eal Terms /ear 1 Iabor -osts in ,eal Terms /ear 1 5ther -osts in ,eal Terms /ear 1 Iease ?ayment in ,eal Terms A 4160,000 B 1.0< A 4;0,000 B 1.0< A 410,000 B 1.0< A 4*0,000 B 1.0< A 4111,60> A 476,17* A 4#7,7#< A 41;,;<;

,evenues and labor costs form "rowin" perpetuities and other costs form a declinin" perpetuity. ?@ (,evenue) ?@ (Iabor -osts) ?@ (5ther -osts) A (4111,60>.1#) B (0.10 3 0.06) A (476,171.70) B (0.10 3 0.0#) A (4#7,7#6.;6) B 70.10 3 (30.01)9 A 4*,;#0,1;> A 41,07;,1<7 A 4#1#,06#

2ince the lease payments are constant in nominal terms, they are declinin" in real terms by the inflation rate. Therefore, the lease payments form a declinin" perpetuity. ?@(Iease ?ayments) A (41;,;<; B 70.10 E (30.0<)9 A 4117,>*6

=?@ A ?@(,evenue) E ?@(Iabor -osts) E ?@(5ther -osts) E ?@(Iease ?ayments) A 4*,;#0,1;> 3 41,07;,1<7 3 4#1#,06# 3 4117,>*6

A 41,*>1,011 #he NPV o$ the proposed toad ranch is $!,2"!,0''. (lternatively, one could solve this problem by expressin" everythin" in nominal terms. This approach yields the same answer as "iven above. owever, in this case, the computation would have been !uch more difficult. &hen faced with two alternative approaches, where both are equally correct, always choose the simplest one. 7.1; /ear 1 410,000,00 0 #0,<00,000 1,0#0,000 ;,#70,000 6,6*1,*00 /ear * 4;0,000,00 0 #1,*1*,000 1,0<0,>00 17,7*7,100 #1,1>>,;;< /ear # 4;0,000,00 0 #1,;#<,*10 1,0>*,7*7 17,071,0## #1,0<<,;;* /ear 1 4<0,000,00 0 #*,17*,><6 1,1*6,60> *<,101,6*< 17,1*6,007

,evenues Iabor -osts Cner"y -osts ,evenues3-osts (fter3tax ,evenues3 -osts

2ince revenues and costs are expressed in real terms, after3tax income will be discounted at the real discount rate of ;:. ,emember that the depreciation tax shield also affects a firms after3tax cash flows. The present value of the depreciation tax shield must be added to the present value of a firms revenues and expenses to find the present value of the cash flows related to the pro$ect. The depreciation the firm will reco"niJe each year is. %epreciation A +nvestment B Cconomic Iife A 4#*,000,000 B 1 A 4;,000,000

=ext, find the annual depreciation tax shield. ,emember that this reduction in taxes is equal to the tax rate times the depreciation expense for the year. (nnual %epreciation Tax 2hield A Tc ((nnual %epreciation Cxpense) A 0.#1 (4;,000,000) A 4*,7*0,000

,emember that depreciation is a nominal quantity, and thus must be discounted at the nominal rate. To find the nominal rate, use the followin" equation. 18 ,eal %iscount ,ate 1.0; =ominal %iscount ,ate A (18=ominal %iscount ,ate) B (18+nflation ,ate) A (18=ominal %iscount ,ate) B (1.06) A 0.1#1

To find the present value of the depreciation tax shield, apply the four3year annuity formula to the annual tax savin"s. ?@(Tax 2hield) A -1 (10.1#1 A 4*,7*0,000 (10.1#1 A 4;,0*#,77> ?@(-0) ?@(-1) ?@(-*) ?@(-#) A 34#*,000,000 A 46,6*1,*00 B (1.0;) A 4#1,1>>,;;< B (1.0;)* A 4#1,0<<,;;* B (1.0;)# A 34#*,000,000 A 46,116,000 A 4*7,00<,076 A 4*1,<<1,;>#

?@(-1) A 417,1*6,007 B (1.0;)1 ?@(%epreciation Tax 2hield) =?@

A 41*,;07,>00 A 4;,0*#,77>

A ?@(-0) 8 ?@(-1) 8 ?@(-*) 8 ?@(-#) 8 ?@(-1) 8 ?@(%epreciation Tax 2hield) A $' ,)!',)'7

These calculations also could have been performed in a sin"le step. =?@ A 34#*,000,0008 46,6*1,*00 B (1.0;) 8 4#1,1>>,;;< B (1.0;)* 8 4#1,0<<,;;* B (1.0;)# 8 417,1*6,007 B (1.0;)1 8 (0.#1) (4;,000,000) (10.1#1 A $' ,)!',)'7

#he NPV o$ the pro%ect is $' ,)!',)'7. 7.1> +n order to determine how much 2par!lin" &ater, +nc. is worth today, find the present value of its cash flows. 2par!lin" will receive 4*.60 per bottle in revenues in real terms at the end of year 1. (fter3Tax ,evenue in /ear 1 in real terms A (*,000,000 D 4*.60)(130.#1) A 4#,#00,000

2par!lin"s revenues will "row at seven percent per year in real terms forever. (pply the "rowin" perpetuity formula. ?@(,evenues) A -1 B (r3") , where r K " A 4#,#00,000 B (0.10 E 0.07) A 4110,000,000

?er bottle costs will be 40.70 in real terms at the end of year 1. (fter3Tax -osts in /ear 1 in real terms A (*,000,000 D 40.70)(130.#1) A 4>*1,000 2par!lin"s costs will "row at 6: per year in real terms forever. This strin" of payments forms a "rowin" perpetuity. ?@(-osts) A -1 B (r3") , where r K " A 4>*1,000 B (0.10 E 0.06) A 41;,1;0,000

@alue of the firm A ?@(,evenues) E ?@(-osts) A 4110,000,000 3 41;,1;0,000 A $"!, 20,000 ,parkling 9ater, :nc., is worth $"!, 20,000 toda1. 7.*0 2ince all cash flows are stated in nominal terms and the "rowth rates of both the sales price and the variable cost are stated in real terms, these rates must be restated in nominal terms in order to solve the problem. 2ince the discount rate is expressed in nominal terms, it does not need to be ad$usted. (lternatively, one could solve this problem by expressin" everythin" in real terms. This approach yields the same answer. )ind the nominal "rowth rates.

1 8 ,eal ,ate 1.06 0.10*6 1.0* 0.071

A (1 8 =ominal ,ate) B (1 8 +nflation ,ate) A (1 8 =ominal 2ellin" ?rice Growth ,ate) B (1.06) A =ominal 2ellin" ?rice Growth ,ate A (1 8 =ominal @ariable -ost Growth ,ate) B (1.06) A =ominal @ariable -ost Growth ,ate

The revenue stream is a five3year "rowin" annuity. ?re3tax revenue in year 1 is found by multiplyin" the sellin" price (4#.16) by the number of units produced (1,000,000). The cash flows are "rowin" at the nominal rate of 0.10*6 and are discounted at 0.*0. +n order to find the after3tax present value, multiply revenues by (13T-). ?@ (,evenues) ?@ (,evenues) A (1 E Tc) (/ear 1 2ellin" ?rice) (/ear 1 ?roduction) G(Tr," D A (1 3 0.#1) (4#.16) (1,000,000) G(60.*0, 0.10*6 A 47,#<1,<16

D The notation G(Tr, " represents a "rowin" annuity consistin" of T payments "rowin" at a rate of g per payment, discounted at r. The ?@ of the variable costs is also calculated usin" the five3year "rowin" annuity formula. ?re3tax variable costs in year 1 are found by multiplyin" the variable cost (40.*<*6) by the number of units (1,000,000). The cash flows are "rowin" at the nominal rate of 0.071 and are discounted at 0.*0. +n order to find the after3tax present value, multiply variable costs by (13T-). ?@ (@ariable -osts) ?@ (@ariable -osts) A (1 E Tc) (/ear 1 @ariable -osts) (/ear 1 ?roduction) G(Tr," A (1 3 0.#1) (40.*<*6) (1,000,000) G(60.*0, 0.071 A 46;*,17>

2ince the firm is sub$ect to corporate taxes, it will benefit from the depreciation tax shield. )irst, find the annual depreciation tax shield, which is the tax rate multiplied by the annual depreciation expense. =ext, find the ?@ of all annual tax shields via the annuity formula, usin" the nominal discount rate of 0.*0. %epreciation is a nominal quantity, and therefore must be discounted at the nominal rate. (nnual %epreciation Cxpense A (+nvestment) B (Cconomic Iife) A 4<,000,000 B 6 A 41,*00,000

To find the annual depreciation tax shield, perform the followin" calculation. (nnual %epreciation Tax 2hield A Tc ((nnual %epreciation Cxpense) A 0.#1 (41,*00,000) A 410;,000

=ext, apply the annuity formula to calculate the ?@ of the annual depreciation tax shields. ?@(%epreciation Tax 2hield) A 410;,000 (60.*0 A 41,**0,170

The last relevant cash flow is the salva"e value of the factory. 2ince the resale value (4<#;,110.7;) is hi"her than the boo! value (40), the firm must pay capital "ains taxes on the difference. 5nce the after3tax value is calculated, the value must be discounted bac! five years to the present (year 0). ,emember that the salva"e value is expressed in nominal terms, and thus must be discounted by the nominal discount rate, 0.*0.

(fter3Tax 2alva"e @alue A 2alva"e @alue E Tc (2alva"e @alue E 'oo! @alue) A 4<#;,110.7; 3 0.#1 (4<#;,110.7; 3 40) A 41*1,17# ?@((fter3Tax 2alva"e @alue) A -6 B (18r)6 A 41*1,17# B (1.*0)6 A 41<>,*<0

To compute the =?@ of the pro$ect, consider the ?@s of all the relevant after3tax cash flows. =?@ A 3+nvestment 8 ?@(,evenues) 3 ?@(-osts) 8 ?@(%epreciation Tax 2hield) 8 ?@(2alva"e @alue) A 34<,000,000 8 47,#<1,<16 3 46;*,17> 8 41,**0,170 8 41<>,*<0 A $2,!7!, ")

These calculations could also have been performed in a sin"le step. =?@ A 34<,000,000 8 (1 3 0.#1) (4#.16) (1,000,000) (60.*0, 0.10*6 E (1 3 0.#1) (4.*<*6) (1,000,000) (60.*0, 0.071 8 0.#1 (4<,000,000 B 6) (60.*0 8 74<#;,110.7; 3 0.#1 (4<#;,110.7; 3 40)9 B (1.*0)6 A $2,!7!, ")

#he NPV o$ the pro%ect is $2,!7!, "). 7.*1 2ince the problem as!s which medicine the company should produce, solve for the =?@ of both medicines and select the one with the hi"her =?@. eadache3only medicine. )irst, find the ?@ of the initial investment. 2ince the cash outlay occurs today, no discountin" is necessary. ?@(+nitial +nvestment) A 3410,*00,000 )ind the ?@ of the revenues if the headache3only medicine were produced. The problem states that the sellin" price will be 41 in real terms. 2ince the discount rate, 0.1#, is also "iven in real terms, no ad$ustment is necessary and inflation can be i"nored. The problem also indicates that 6 million pac!a"es will be sold in each of the next three years. The ?@ will be expressed as a three3year annuity discounted at 0.1#. ,emember to find the after3tax revenues by multiplyin" pre3tax revenues by (1 3 Tc). (nnual ,evenues eadache3only ?@( eadache3only revenues) A 41 D 6,000,000 A 4*0,000,000 A (1 3 Tc) -1 (Tr, A (1 3 0.#1) 4*0,000,000 (#0.1# A 4#1,1<7,*11

(nnual costs per unit will be 41.60 in real terms. The ?@ will be expressed as a three3year annuity discounted at the real discount rate of 0.1#. ,emember to find the after3tax costs by multiplyin" pre3tax costs by (1 3 Tc). (nnual -osts eadache3only ?@( eadache3only costs) A 341.60 D 6,000,000 A 347,600,000 A (1 3 Tc) -1 (Tr, A (1 3 0.#1)( 347,600,000 (#0.1#) A 3411,<;7,706

2ince ?ill, +nc. has positive pre3tax income, the firm will benefit from a depreciation tax shield. ,emember, depreciation is a nominal quantity and therefore must be discounted at the nominal rate. 1 8 ,eal ,ate 1.1# =ominal ,ate A (1 8 =ominal ,ate) B (1 8 +nflation ,ate) A (1 8 =ominal ,ate) B (1.06) A 0.1;<6

(nnual depreciation, calculated by the strai"ht3line method (+nitial +nvestment B Cconomic Iife of +nvestment), is 4#,100,000 (A 410,*00,000 B # /ears). The strin" of annual tax shields forms an annuity. The present value of this annuity is. ?@(%epreciation Tax 2hield) ?@(%epreciation Tax 2hield) A Tc ((nnual %epreciation Cxpense) (Tr A 0.#1 (4#,100,000) (#0.1;<6 A 4*,1;7,6*1

2ince the resale value of the headache3only equipment is 40, it has no effect the =?@ of the pro$ect. To find the =?@ of the pro$ect, find the sum of the present values of the initial investment, after3tax revenues, after3tax costs, and the depreciation tax shield. =?@ A 3 +nitial +nvestment 8 ?@(,evenues) E ?@(-osts) 8 %epreciation Tax 2hield A 3410,*00,000 8 4#1,1<7,*11 E 411,<;7,706 8 4*,1;7,6*1 A $!!,7)7,0&0 These calculations could also have been performed in a sin"le step. =?@ A 3410,*00,000 8 (1 3 0.#1) 4*0,000,000 (#0.1# E (1 3 0.#1) 47,600,000 (#0.1# 8 0.#1 (4#,100,000) (#0.1;<6 A $!!,7)7,0&0 eadache and (rthritis medicine. )irst, find the ?@ of the initial investment. 2ince the cash outlay occurs today, no discountin" is necessary. ?@(+nitial +nvestment) A 341*,000,000 )ind the ?@ of the revenues if the headache and arthritis medicine were produced. The problem states that the sellin" price will be 41 in real terms. 2ince the discount rate, 0.1#, is also "iven in real terms, no ad$ustment is necessary, and inflation can be i"nored. The problem also indicates that 10 million pac!a"es will be sold in each of the next # years. The ?@ will be expressed as a three3year annuity discounted at 0.1#. ,emember to find the after3tax revenues by multiplyin" pre3tax revenues by (1 3 Tc). (nnual ,evenues eadache and (rthritis ?@( eadache and (rthritis revenues) A 41 D 10,000,000 A 410,000,000 A (1 3 Tc) -1 (Tr, A (1 3 0.#1) 410,000,000 (#0.1# A 4<*,##1,1*>

The annual costs will be calculated usin" the same method. The problem states that annual costs per unit will be 41.70. ("ain, since the costs and discount rate are "iven in real terms, inflation can be i"nored. The ?@ will be expressed as a three3year annuity discounted at 0.1#. ,emember to find the after3tax costs by multiplyin" pre3tax costs by (1 3 Tc). (nnual -osts eadache and (rthritis A 341.70 D 10,000,000 A 3417,000,000

?@( eadache and arthritis costs)

A (1 3 Tc) -1 (Tr, A (1 3 0.#1) 3417,000,000 (#0.1# A 34*<,1>*,1#*

2ince ?ill, +nc. has positive income, it will benefit from a depreciation tax shield. ,emember, depreciation is a nominal quantity and therefore must be discounted usin" the nominal rate. 1 8 ,eal %iscount ,ate 1.1# =ominal %iscount ,ate A (1 8 =ominal %iscount ,ate) B (1 8 +nflation ,ate) A (1 8 =ominal %iscount ,ate) B (1.06) A 0.1;<6

(nnual depreciation, calculated by the strai"ht3line method (+nitial +nvestment B Cconomic Iife of +nvestment), is 41,000,000 (A 41*,000,000 B # /ears). The strin" of annual tax shields forms an annuity. The present value of this annuity is. ?@(%epreciation Tax 2hield) ?@(%epreciation Tax 2hield) A Tc ((nnual %epreciation) (Tr A 0.#1 (41,000,000) (#0.1;<6 A 4*,>*<,1><

Lnli!e the eadache3only medicine equipment, the eadache and (rthritis medicine equipment has a resale value of 41 million at the end of three years. 2ince the net boo! value of the equipment is 40, ?ill, +nc. must pay capital "ains taxes on the total 41 million resale value. 'ecause the resale value is stated in real terms, it is discounted usin" the real discount rate. (fter3Tax 2alva"e @alue A 2alva"e @alue E Tc (2alva"e @alue E 'oo! @alue) A 41,000,000 E 0.#1 (41,000,000 E 40) A 4<<0,000 The salva"e value must then be discounted in order to find the ?@. ?@(2alva"e @alue) A -# B (1 8 r)# A 4<<0,000 B (1.1#)# A 4167,11#

To find the =?@ of the pro$ect, find the sum of the present values of the initial investment, after3tax revenues, after3tax costs, the depreciation tax shield, and the resale. =?@ A 3 +nitial +nvestment 8 ?@(,evenues) E ?@(-osts) 8 ?@(Tax 2hield) 8 ?@(,esale @alue) A 341*,000,000 8 4<*,##1,1*> E 4*<,1>*,1#* 8 4*,>*<,1>< 8 4167,11# A $27,22),20) These calculations could also have been performed in a sin"le step. =?@ A 341*,000,000 8 (1 3 0.#1) 410,000,000 (#0.1# E (1 3 0.#1) 417,000,000 (#0.1# ; 0.#1 (41,000,000) (#0.1;<6 8 741,000,000 E 0.#1 (41,000,000 E 40)9 B (1.1#)# A $27,22),20) Pill, :nc. should produce the <eadache and -rthritis /edicine since it has the higher NPV. 7.** ( time line of the costs of operatin" a series of such machines in perpetuity is shown below. tA0 tA1 tA* tA# tA1 tA6 tA< ...

41*,000

4<,000

4<,000

4<,000

41,000 41*,000

4<,000

4<,000

...

The present value of one cycle is. ?@ A 41*,000 8 4<,000 (#0.0< 8 41,000 B 1.0<1 A 41*,000 8 4<,000 (*.<7#0) 8 41,000 B 1.0<1 A 4#1,*0< +n order to calculate the equivalent annual cost (C(-) of the machine, set the =?@ equal to an annuity with the same economic life as the machine. 4#1,*0< A C(- D (10.0< C(A 4>,00< Ha!in" a payment of 4>,00< for four years is equivalent to ma!in" one cycle of payments, in present value terms. Therefore, the present value of the costs of operatin" a series of such machines in perpetuity is equal to the present value of a perpetuity with yearly payments of 4>,00<. ?@ A -1 B r A 4>,00< B 0.0< A $! 0,!00

#he present *alue o$ operating the /achines in perpetuit1 is $! 0,!00. 7.*# +n order to find the equivalent annual cost, first find the net present value of all costs related to the investment, net of any benefits the investment may yield. The initial investment is not discounted because it occurs today. ?@(+nitial +nvestment) A 34<0,000 Cach year, the machine requires 46,000 of maintenance. (pply the three3year annuity formula, discounted at 0.11. ,emember to ad$ust the maintenance cost for taxes. ?@(Haintenance) A (1 E Tc) -1 (Tr A (1 E 0.#1) (346,000 (#0.11) A 347,<<1

2ince the firm "enerates positive income and is sub$ect to corporate taxes, the firm benefits from a depreciation tax shield. (nnual %epreciation Cxpense (nnual %epreciation Tax 2hield A 4<0,000 B # A 4*0,000. A (Tc) ((nnual %epreciation Cxpense) A (0.#1) (4*0,000) A 4<,;00

To find the ?@ of the annual depreciation tax shields, apply the formula for a three3year annuity. ?@((nnual %epreciation Tax 2hields) A -1 (Tr A 4<,;00 (#0.11 A 416,7;7

The =?@ of the pro$ect is the combination of the above cash flows. =?@ A 3+nitial +nvestment E ?@(Haintenance) 8 ?@(Tax 2hield) A 34<0,000 3 47,<<1 8 416,7;7 A +$ !,(7' +n order to calculate the equivalent annual cost (C(-), set the =?@ of the equipment equal to an annuity with the same economic life. 2ince the pro$ect has an economic life of three years and is discounted at 11 percent, set the =?@ equal to a three3year annuity, discounted at 11 percent. 3461,;71 A C(- D (#0.11 C(A +$22,&'' #he e6ui*alent annual cost $or the pro%ect is $22,&''. 7.*1 +n order to find equivalent annual cost, first find the net present value of all costs related to the investment, net of any benefits the investment may yield. ?@(+nitial +nvestment) A 34<0,000 The new system will incur maintenance costs of 4*,000 per year for five years. The cost is treated as a five3year annuity, discounted at 0.1;. ,emember to ad$ust the maintenance cost for taxes. ?@(Haintenance -osts) A (1 E 0.#6) (34*,000) (60.1; A 341,0<6

2ince the firm "enerates positive income, it will benefit from a depreciation tax shield. (nnual %epreciation Cxpense (nnual %epreciation Tax 2hield A 4<0,000 B 6 A 41*,000 A (Tc) ((nnual %epreciation Cxpense) A (0.#6) (41*,000) A 41,*00

To find the ?@ of the annual depreciation tax shields, use the formula for a five3year annuity. ?@((nnual %epreciation Tax 2hields) A -1 (Tr A 41,*00 (60.1; A 41#,1#1

The =?@ of the equipment is the combination of the above cash flows. =?@ A 3+nitial +nvestment E ?@(Haintenance) 8 ?@(%epreciation Tax 2hield) A 34<0,000 3 41,0<6 8 41#,1#1 A 3460,>#1

+n order to calculate the equivalent annual cost (C(-), set the net present value of the pro$ect equal to a five3year annuity. 2olve for the payment amount, which is the equivalent annual cost. 3460, >#1 C(A C(- D (60.1; A 341<,*;<

#here$ore, the e6ui*alent annual cost o$ the new ad/itting s1ste/ is $!),2().

7.*6

+n order to find equivalent annual cost, first find the net present value of all costs related to the investment, net of any benefits the investment may yield. ?@(+nitial +nvestment) A 3416,000 The pro$ect requires annual maintenance of 46,000, be"innin" a year from now. The cost is treated as a three3year annuity, discounted at 0.1*. ,emember to ad$ust the maintenance cost for taxes. ?@(Haintenance) A (1 E Tc) -1 (Tr A (1 E 0.#1)(346,000) (#0.1* A 347,>*<

2ince the firm "enerates positive income, it benefits from the depreciation tax shield. The annual depreciation expense is 416,000 (A 416,000 B #). The annual depreciation tax shield is the annual depreciation expense multiplied by the tax rate. (nnual %epreciation Tax 2hield A (Tc) ((nnual %epreciation Cxpense) A (0.#1) (416,000) A 46,100

The strin" of annual depreciation tax shields forms a three3year annuity, discounted at 1*:. ?@(%epreciation Tax 2hield) A -1 (Tr A 46,100 (#0.1* A 41*,*1>

(t the end of its life, the equipment will have a 410,000 salva"e value. 2ince the equipment has been fully depreciated, a "ain on the sale equal to the salva"e value must be reco"niJed. (fter3Tax 2alva"e @alue A 2alva"e @alue E Tc (2alva"e @alue E 'oo! @alue) A 410,000 E 0.#1 (410,000 E 40) A 4<,<00 The after3tax salva"e value must be discounted bac! three periods to find its present value. ?@((fter3Tax 2alva"e @alue) A 4<,<00 B (1.1*)# A 41,<>;

The =?@ of the equipment is the combination of the above cash flows. =?@ A 3+nitial +nvestment E ?@(Haintenance) 8 ?@(%epreciation Tax 2hield) 8 ?@(2alva"e) A 3416,000 3 47,>*< 8 41*,*1> 8 41,<>; A +$& ,"7" +n order to calculate the equivalent annual cost, set the =?@ of the equipment equal to an annuity with the same economic life. 2ince the pro$ect has an economic life of three years and is discounted at 1* percent, set the =?@ equal to a three3year annuity, discounted at 1* percent. 34#6,>7>A C(- D (#0.1* C(A +$!',"(0 #he e6ui*alent annual cost $or the pro%ect is $!',"(0. 7.*< 2ince the cash flows are "iven in real terms, they must be discounted at the real discount rate.

18 ,eal %iscount ,ate ,eal %iscount ,ate

A (18 =ominal %iscount ,ate) B (18 +nflation ,ate) A 7(1.11) B (1.06)9 E 1 A 0.0;67

)ind the equivalent annual cost (C(-) of each of the copiers. The firm will choose the model with the lower equivalent annual cost. MM10 )ind the present value of both the initial cash outlay and the maintenance expenses. 2ince the initial cash outlay occurs today (year 0), it does not need to be discounted. To find the present value of the maintenance expenses, use the annuity formula. ?@ of cash outflows from MM10 4>66 A C(- D (#0.0;67 C(- A 4#71 #he e6ui*alent annual cost o$ /odel =='0 is $&7'. , 16 )ind the present value of both the initial cash outlay and the maintenance expenses. 2ince the initial cash outlay occurs today (year 0), it does not need to be discounted. To find the present value of the maintenance expenses, use the annuity formula. ?@ of cash outflows from , 16 41,### A C(- D (60.0;67 C(A 4##> #he e6ui*alent annual cost o$ /odel 3<' is $&&". ,ince the e6ui*alent annual cost o$ /odel 3<' is lower, the $ir/ should choose /odel 3<' . 7.*7 Lse the equivalent annual cost (C(-) method to determine which facility ?lexi Glasses should purchase. )acility 1. The first step is to find the =?@ of the pro$ect. The initial investment is not discounted because it occurs today (year 0). ?@(+nitial +nvestment) A 34*,100,000 Haintenance costs are 4<0,000 and are incurred at the end of the year. These costs form a seven3year annuity, discounted at 0.10. ,emember to ad$ust the maintenance cost for taxes. ?@(Haintenance -osts) A (1 E Tc) -1 (Tr A (1 E 0.#1)(34<0,000) (70.10 A 341>*,7;> A 4>00 8 4110 (60.0;67 A 41,### A 4700 8 4100 (#0.0;67 A 4>66

The annual depreciation expense is 4#00,000 (A 4*,100,000 B 7). The annual depreciation tax shield is the annual depreciation expense multiplied by the tax rate. (nnual %epreciation Tax 2hield A (Tc) ((nnual %epreciation Cxpense) A (0.#1) (4#00,000)

A 410*,000 The strin" of annual depreciation tax shields form a seven3year annuity, discounted at 0.10. ?@(%epreciation Tax 2hield) A -1 (Tr A 410*,000 (70.10 A 41><,67>

The =?@ of the pro$ect is the combination of the above cash flows. =?@ A 3+nitial +nvestment E ?@(Haintenance -osts) 8 ?@(%epreciation Tax 2hield) A 34*,100,000 3 41>*,7;> 8 41><,67> A +$!,7"),2!0 +n order to calculate the equivalent annual cost, set the =?@ of the equipment equal to an annuity with the same economic life. 2ince the pro$ect has an economic life of seven years and is discounted at 10 percent, the =?@ is equal to a seven3year annuity, discounted at 10 percent. =?@ A C(- D (Tr 341,7><,*10 A C(- D (70.10 C(- A +$&)(," ! #he e6ui*alent annual cost $or the pro%ect is $&)(," !. )acility *. The first step is to find the =?@ of the pro$ect. The initial investment is not discounted because it occurs today (year 0). ?@(+nitial +nvestment) A 34*,;00,000 Haintenance costs are 4100,000 and are incurred at the end of the year. These costs form a 103year annuity, discounted at 0.10. ,emember to ad$ust the maintenance cost for taxes. ?@(Haintenance -osts) A (1 E Tc) -1 (Tr A (1 E 0.#1)(34100,000) (100.10 A 34106,611

The annual depreciation expense is 4*;0,000 (A 4*,;00,000 B 10). The annual depreciation tax shield is the annual depreciation expense multiplied by the tax rate. (nnual %epreciation Tax 2hield A (Tc) ((nnual %epreciation Cxpense) A (0.#1) (4*;0,000) A 4>6,*00

(pply the annuity formula to calculate the ?@ of the annual depreciation tax shields. ?@(%epreciation Tax 2hield) A -1 (Tr A 4>6,*00 (100.10 A 46;1,><#

The =?@ of the pro$ect is the combination of the above cash flows. =?@ A 3+nitial +nvestment E ?@(Haintenance -osts) 8 ?@(%epreciation Tax 2hield) A 34*,;00,000 3 4106,611.1#8 46;1,><# A +$2,)20, 7(

+n order to calculate the equivalent annual cost, set the =?@ of the equipment equal to an annuity with the same economic life. 2ince the pro$ect has an economic life of 10 years and is discounted at 10 percent, the =?@ is equal to a 103year annuity, discounted at 10 percent. 34*,<*0,67; C(A C(- D (100.10 A +$'2),'(7

#he e6ui*alent annual cost $or the pro%ect is $'2),'(7. #he $ir/ should choose $acilit1 ! since it has the lower >-C. 7.*; )ind the net present value (=?@) of each option. The firm will choose the option with the hi"her =?@. ,emember to ta!e into account both the maintenance costs and depreciation tax shields associated with both the old and new machines. =ote that the replacement machine will be bou"ht in five years re"ardless of the option chosen and therefore is not incremental to this decision. 5ption 1 2ell old machine and purchase new machine now. To find the cash flow from sellin" the old machine, consider both the sales price and the net boo! value of the machine. 2ince the firm will be sellin" the old machine (4*,000,000) for more than its net boo! value (41,000,000), the resultant capital "ain will be sub$ect to corporate taxes. (fter3Tax 2alva"e @alue A 2ale ?rice E T-(2ale ?rice E =et 'oo! @alue) ? 4*,000,000 E 0.#1(4*,000,000 3 41,000,000) ? 41,<<0,000 A 41,<<0,000

?@(2alva"e @alue)

The new machine is purchased today (year 0) and does not need to be discounted. ?@(=ew Hachine) A 34#,000,000 To find the present value of the new machines maintenance costs, use a five3year annuity, discounted at 1* percent. ,emember to account for taxes. ?@(Haintenance -osts) A (1 E 0.#1)(34600,000)(60.1* A 341,1;>,67<

The firm will also reco"niJe a depreciation tax shield from the new machine. The annual depreciation expense is 4<00,000 (A 4#,000,000 B 6 years). (nnual %epreciation Tax 2hield A T- D %epreciation per year A 0.#1 D 4<00,000 A 4*01,000

The present value of the depreciation tax shields can be found by usin" a five3year annuity, discounted at 1* percent. ?@(%epreciation Tax 2hield) A -1 (Tr A 4*01,000 (60.1* A 47#6,#71

The new machine will be sold at the end of its economic life. 2ince the resale price (4600,000) is hi"her than the net boo! value (40), the sale of the machine is sub$ect to capital "ains taxes. 2ince the sale occurs at the end of year 6, discount the after3tax salva"e value bac! 6 periods. (fter3Tax 2alva"e @alue A 2ale ?rice E T-(2ale ?rice E =et 'oo! @alue) A 4600,000 E 0.#1(4600,000 E 0) A 4##0,000 ?@(2alva"e @alue) A 4##0,000 B (1.1*)6 A 41;7,*61

=?@(5ption 1)

A 41,<<0,000 3 4#,000,000 3 41,1;>,67< 8 47#6,#71 8 41;7,*61 A +$!,)0)," 0

#he net present *alue @NPVA o$ selling the old /achine and purchasing the new /achine now is +$!,)0)," 0. 5ption * 2ell old machine in five years and purchase new machine in five years. The company will have to ma!e the scheduled maintenance costs for the old machine. Lse a five3year annuity, discounted at 1* percent to find the present value of the costs. ,emember to account for taxes. ?@(Haintenance -osts) A (1 E 0.#1)(34100,000)(60.1* ? +4>61,<<1

The firm will continue to reco"niJe depreciation on the old machine. The annual depreciation expense is 4*00,000 per year, and the firm will reco"niJe a depreciation tax shield. The present value of the tax shield is found by usin" a five3year annuity, discounted at 1* percent. (nnual %epreciation Tax 2hield ?@(%epreciation Tax 2hield) A 0.#1 D 4*00,000 A 4<;,000 A 4<;,000 (60.1* A 4*16,1*6

The salva"e value at the end of the old machines economic life of five years will be 4*00,000. 2ince the machine will have been depreciated to 40, the firm must pay capital "ains taxes on the sale. To find the present value, discount the after3tax salva"e value by five periods. (fter3Tax 2alva"e @alue A 2ale ?rice E T-(2ale ?rice E =et 'oo! @alue) A 4*00,000 E 0.#1(4*00,000 E 0) A 41#*,000 ?@(2alva"e @alue) =?@(5ption *) A 41#*,000 B (1.1*)6 A 471,>00 A 34>61,<<1 8 4*16,1*6 8 471,>00 A 3<#1,<#<

#he net present *alue @NPVA o$ selling the old /achine and purchasing the new /achine in $i*e 1ears is +)&!,)&). ,ince the NPV o$ Bption 2 is higher than the NPV o$ Bption !, the $ir/ will choose to sell the old e6uip/ent and purchase new e6uip/ent in $i*e 1ears.

7.*>

2(I 6000 The first step is to find the =?@ of the costs associated with the 2(I 6000. )ind the =?@ of one 2(I 6000, and later, when findin" the equivalent annual cost (C(-) of the decision, multiply the final answer by 10. The initial investment is not discounted because it occurs today (year 0). ?@(+nitial +nvestment) A 34#,760 Cach year, the computer requires 4600 of maintenance. (pply the ei"ht3year annuity formula, discounted at 11 percent, to find the ?@ of the cost. ?@(Haintenance -osts) A -1 (Tr A 34600 (;0.11 A 34*,67#

(t the end of the computers economic life, it will have a resale value of 4600. 2ince there are no capital "ains taxes, the ?@ is $ust that cash flow, discounted by ei"ht periods. ?@(2alva"e @alue) A -; B (1 8 r); A 4600 B (1.11); A 4*17

The =?@ of the computer is the combination of the above cash flows. =?@ A 3+nitial +nvestment E ?@(Haintenance -osts) 8 ?@(2alva"e @alue) A 34#,760 3 4*,67#8 4*17 A +$),!0) +n order to calculate the equivalent annual cost, set the =?@ of the computer equal to an annuity with the same economic life. 2ince the computer has an economic life of ei"ht years, set the =?@ equal to an ei"ht3 year annuity, discounted at 11 percent. 34<,10< A C(- D (;0.11 C(A +$!,!(7 2ince Gold 2tar +ndustries would have to buy 10 2(I 6000s, the C(- here would be. Total C(A (=umber of 2(I 6000s purchased) (C(- of one 2(I 6000) A (10) (341,1;7) A +$!!,(70

#he e6ui*alent annual cost @>-CA $or the decision to .u1 the ,-C 000 is $!!,(70. %CT 1000 The first step is to find the =?@ of the costs associated with the %CT 1000. )ind the =?@ of one %CT 1000, and later, when findin" the equivalent annual cost (C(-) of the decision, multiply the final answer by ;. The initial investment is not discounted because it occurs today (year 0). ?@(+nitial +nvestment) A 346,*60 Cach year, the computer requires 4700 of maintenance. (pply the six3year annuity formula, discounted at 11 percent, to find the ?@ of the cost. ?@(Haintenance -osts) A -1 (Tr A 34700 (<0.11

A 34*,><1 (t the end of the computers economic life, it will have a resale value of 4<00. 2ince there are no capital "ains taxes, the ?@ is $ust that cash flow, discounted by six periods. ?@ (2alva"e @alue) A -< B (1 8 r)< A 4<00 B (1.11)< A 4#*1

The =?@ of the computer is the combination of the above cash flows. =?@ A 3+nitial +nvestment E ?@(Haintenance) 8 ?@(2alva"e) A 346,*60 3 4*,><18 4#*1 A +$7,("0 +n order to calculate the equivalent annual cost, set the =?@ of the computer equal to an annuity with the same economic life. 2ince the computer has an economic life of six years, set the =?@ equal to a six3year annuity, discounted at 11 percent. 347,;>0 A C(- D (<0.11 C(A +$!,() 2ince Gold 2tar +ndustries would have to buy ei"ht %CT 1000s, the C(- here would be. Total C(A (=umber of %CT 1000s purchased) (C(- of one %CT 1000) A (;) (341,;<6) A +$!',"20

#he e6ui*alent annual cost $or the decision to .u1 the 4># !000 is $!',"20. Dold ,tar should purchase the ,-C 000 since it has a lower e6ui*alent annual cost @>-CA. 7.#0 To evaluate the word processors, compute their equivalent annual costs (C(-). C@) )ind the net present value of the costs associated with this model of word processor. The present value of purchasin" the 10 C@) word processors is. ?@(?urchase) A 10 D 34;,000 A 34;0,000

The present value of the maintenance costs is found by usin" a four3year annuity, discounted at 11 percent. ?@(Haintenance -osts) =?@ A (34*,000D10) (10.11 A 346;,*71

A 34;0,000 346;,*71 A 341#;,*71

+n order to calculate the equivalent annual cost, set the =?@ of the word processor equal to an annuity with the same economic life. 2ince the computer has an economic life of four years, set the =?@ equal to a four3year annuity, discounted at 11 percent. 41#;,*71 C(A C(- D (10.11 A $'7,' )

#he e6ui*alent annual cost o$ the >VE word processor is $'7,' ). (C )ind the net present value of the costs associated with the (C model. The present value of purchasin" the 11 (C word processors now is. ?@(?urchase) A 346,000 D 11 A 3466,000

The present value of the maintenance costs is found by applyin" the three3year annuity formula, discounted at 11 percent. ?@(Haintenance -osts) A (34*,600D11) (#0.11 A 34<#,;16

(t the end of the computers economic life, it will have a resale value of 4600. 2ince there are no capital "ains taxes, the ?@ is $ust that cash flow, discounted bac! three periods. ?@(,esale) =?@ A (11D600)B(1.11)# A 4#,71*

A 3466,000 3 4<#,;16 8 4#,71* A 34116,1##

+n order to calculate the equivalent annual cost, set the =?@ of the word processor equal to an annuity with the same economic life and discount rate. 2ince the computer has an economic life of three years, set the =?@ equal to a three3year annuity, discounted at 11 percent. 4116,1## C(A C(- D (#0.11 A $'", "!

#he e6ui*alent annual cost o$ the ->< word processor is $'", "!. <arwell should purchase the >VE word processors since their e6ui*alent annual cost is lower. 7.#1 Hixer M The first step is to find the =?@ of the savin"s associated with Hixer M. The initial investment is not discounted because it occurs today (year 0). ?@(+nitial +nvestment) A 34100,000 Cach year, the mixer "enerates after3tax cash flow savin"s of 41*0,000. (pply the five3year annuity formula, discounted at 11 percent, to find the ?@ of the cash flow savin"s. ?@(2avin"s) A -1 (Tr A 41*0,000 (60.11 A 411#,607

The =?@ of the mixer is the sum of the above cash flows. =?@ A 3+nitial +nvestment 8 ?@(2avin"s) A 34100,000 8 411#,607 A $'&, 07

+n order to calculate the equivalent annual benefit (C(') of the mixer, set the =?@ of the mixer equal to an annuity with the same economic life. 2ince the mixer has an economic life of five years, set the =?@ equal to a five3year annuity, discounted at 11 percent. 41#,607 A C(' D (60.11 C(' A $!!,772 #he e6ui*alent annual .ene$it o$ 5ixer = is $!!,772. Hixer / The first step is to find the =?@ of the savin"s associated with Hixer /. The initial investment is not discounted because it occurs today (year 0). ?@(+nitial +nvestment) A 34<00,000 Cach year, the mixer "enerates after3tax cash flow savin"s of 41#0,000. (pply the ei"ht3year annuity formula, discounted at 11 percent, to find the ?@ of the cash flow savin"s. ?@(2avin"s) A -1 (Tr A 41#0,000 (;0.11 A 4<<;,>><

The =?@ of the mixer is the sum of the above cash flows. =?@ A 3+nitial +nvestment 8 ?@(2avin"s) A 34<00,000 8 4<<;,>>< A $)(,"")

+n order to calculate the equivalent annual benefit of the mixer, set the =?@ of the mixer equal to an annuity with the same economic life. 2ince the mixer has an economic life of ei"ht years, set the =?@ equal to an ei"ht3year annuity, discounted at 11 percent. 4<;,>>< A C(- D (;0.11 C(A $!&,'07 #he e6ui*alent annual .ene$it o$ 5ixer Y is $!&,'07. 4F Part1, :nc. should .u1 5ixer Y since it 1ields a higher e6ui*alent annual .ene$it. 7.#* Tamper ( Tamper ( is purchased today (year 0) and does not need to be discounted. ?@(?urchase) A 34<00,000

The present value of the maintenance costs is found by applyin" the five3year annuity formula, discounted at 1* percent. ?@(Haintenance -osts) A 34110,000 (60.1* A 34#><,6*6

=?@ A 34<00,000 3 4#><,6*6 A 34>><,6*6 +n order to calculate the equivalent annual cost (C(-) of the tamper, set the =?@ equal to an annuity with the same economic life. 2ince the tamper has an economic life of five years, set the =?@ equal to a five3 year annuity, discounted at 1* percent.

34>><,6*6 C(-

A C(- D (60.1* A 3$27),'')

#a/per - has an e6ui*alent annual cost o$ $27),'').

Tamper ' Tamper ' is purchased today (year 0) and does not need to be discounted. ?@(?urchase) A 34760,000

The present value of the maintenance costs is found by applyin" the seven3year annuity formula, discounted at 1* percent. ?@(Haintenance -osts) =?@ A 34>0,000 (70.1* A 34110,7#; A 34760,000 3 4110,7#; A341,1<0,7#;

+n order to calculate the equivalent annual cost of the tamper, set the =?@ equal to an annuity with the same economic life. 2ince the tamper has an economic life of seven years, set the =?@ equal to a seven3 year annuity, discounted at 1* percent. 341,1<0,7#; C(A C(- D (70.1* A 3$2 ',&&(

#a/per B has an e6ui*alent annual cost o$ $2 ',&&(. GH4 Construction should choose #a/per B since it has a lower e6ui*alent annual cost. 7.## Flious needs to compare the equivalent annual cost (C(-) of the new machine to the cost incurred by !eepin" the old autoclave one additional year. )irst, find the C(- of the new autoclave. =ext, find the total one3year cost, includin" the opportunity cost of not sellin" the old autoclave at the be"innin" of that particular year. +f the C(- of the new autoclave is hi"her than the one3year total cost of !eepin" the existin" autoclave, then Flious should not replace the old machine. +f the total one3year cost of the existin" autoclave is hi"her than the C(- of the new machine, Flious should replace. The first step of the problem is to calculate the =?@ of the new machine. The initial investment is not discounted because it occurs today (year 0). ?@(+nitial +nvestment) A 34#,000 Cach year, the autoclave "enerates 4*0 of maintenance costs. (pply the five3year annuity formula, discounted at 0.10 to calculate the ?@ of the maintenance costs. ?@(Haintenance -osts) A -1 (Tr A 34*0 (60.10 A 347<

The autoclave has a salva"e value of 41,*00 at the end of its economic life. ,emember that the cash flow occurs at the end of year 6, and therefore must be discounted bac! five years. ?@(2alva"e @alue) A -6 B (1 8 r)6

A 41,*00 B (1.10)6 A 4716 The =?@ of the autoclave is the combination of the above cash flows. =?@ A 3+nitial +nvestment 3 ?@(Haintenance -osts) 8 ?@(2alva"e @alue) A 34#,000 3 47< 8 4716 A 3$2,&&! +n order to calculate the equivalent annual cost of the new autoclave, set the =?@ equal to an annuity with the same economic life. 2ince the autoclave has an economic life of five years, set the =?@ equal to a five3 year annuity, discounted at 10 percent. 34*,##1 C(A C(- D (60.10 A 3$)!

#he e6ui*alent annual cost o$ the new autocla*e is $)! . To ma!e its decision, Flious must compare the total yearly cost from !eepin" the old autoclave with the 4<16 yearly cost of the new autoclave. The matrix below illustrates the relevant costs of !eepin" the existin" autoclave. ,eplacement %ateB/ear Feep throu"h /ear 1 Feep throu"h /ear * Feep throu"h /ear # Feep throu"h /ear 1 Feep throu"h /ear 6 /ear 0 3>00 3 3 3 3 /ear 1 3*00 ;60 3 3;60 3 3 3 /ear * 3 3*76 776 3 3776 3 3 /ear # 3 3 3#*6 700 3 3700 3 /ear 1 3 3 3 3160 <00 3 3<00 /ear 6 3 3 3 3 3600 600

-ompute the total end3of3year cost of the old autoclave for an additional year. ,emember to state the costs in terms of end3of3year dollars. This is necessary because the C(- of the new machine is stated in terms of end3of3year dollars. Feepin" the old autoclave throu"h /ear 1. The fore"one resale value is already stated as of the be"innin" of the year, and therefore does not need further discountin". ?@()ore"one ,esale @alue) A 34>00 'oth the maintenance cost and the realiJable resale value must be discounted bac! one year since these cash flows occur at the end of the year. ?@(Haintenance -osts) ?@(,esale @alue) A 34*00 B (1.10)1 A 341;* A 4;60 B (1.10)1 A 477#

The =?@ of !eepin" the old autoclave throu"h the first year is the combination of the above cash flows.

=?@ A 34>00 E 41;* 8 477# A 34#0> 'ecause the C(- of the new machine is expressed in terms of end3of3year dollars, multiply the =?@ of the old machines costs by the discount rate in order to find its future value as of the end of year 1. )@ A (34#0>) (1.10) A 3$&'0 #he cost o$ the old autocla*e in ter/s o$ end+o$+1ear ! dollars is $&'0. ,ince it is cheaper to operate the old autocla*e @$&'0A than to purchase the new one @$)! A, Glious should continue to operate the old /achine in 1ear !. Feepin" the old autoclave throu"h /ear *. The fore"one resale value is already stated as of the be"innin" of the year, and therefore does not need further discountin". ?@()ore"one ,esale @alue) A 34;60 'oth the maintenance cost and the realiJable resale value must be discounted bac! one year since they occur at the end of the year. ?@(Haintenance -osts) ?@(,esale @alue) A 34*76 B (1.10)1 A 34*60 A 4776 B (1.10)1 A 4706

The =?@ of !eepin" the old autoclave throu"h the second year is the combination of the above cash flows. =?@ A 34;60 E 4*60 8 4706 A 34#>6 'ecause the C(- of the new machine is expressed in terms of end3of3year dollars, multiply the =?@ of the old machines costs by the discount rate in order to find its future value as of the end of year *. )@ A (34#>6) (1.10) A 3$'& #he cost o$ the old autocla*e in ter/s o$ end+o$+1ear 2 dollars is $'& . ,ince it is cheaper to operate the old autocla*e @$'& A than to purchase the new one @$)! A, Glious should continue to operate the old /achine in 1ear 2. Feepin" the old autoclave throu"h /ear #. The fore"one resale value is already stated as of the be"innin" of the year, and therefore does not need further discountin". ?@()ore"one ,esale @alue) A 34776 'oth the maintenance cost and the realiJable resale value must be discounted bac! one year since they occur at the end of the year. ?@(Haintenance -osts) A 34#*6 B (1.10)1 A 34*>6

?@(,esale @alue)

A 4700 B (1.10)1 A 4<#<

The =?@ of !eepin" the old autoclave throu"h the third year is the combination of the above cash flows. =?@ A 34776 E 4*>6 8 4<#< A 341#1 'ecause the C(- of the new machine is expressed in terms of end3of3year dollars, multiply the =?@ of the old machines costs by the discount rate in order to find its future value in terms of end3of3year # dollars. )@ A (341#1) (1.10) A 3$'77 #he cost o$ the old autocla*e in ter/s o$ end+o$+1ear & dollars is $'77. ,ince it is cheaper to operate the old autocla*e @$'77A than to purchase the new one @$)! A, Glious should continue to operate the old /achine in 1ear &. Feepin" the old autoclave throu"h /ear 1. The fore"one resale value is already stated as of the be"innin" of the year, and therefore does not need further discountin". ?@()ore"one ,esale) A 34700 'oth the maintenance cost and the realiJable resale value must be discounted bac! one year since they occur at the end of the year. ?@(Haintenance) ?@(,esale @alue) A 34160 B (1.10)1 A 3410> A 4<00 B (1.10)1 A 4616

The =?@ of !eepin" the old autoclave throu"h the fourth year is the combination of the above cash flows. =?@ A 34700 E 410> 8 4616 A 346<1 'ecause the C(- of the new machine is expressed in terms of end3of3year dollars, multiply the =?@ of the old machines costs by the discount rate in order to find its future value as of the end of year 1. )@ A (346<1) (1.10) A 3$)20 #he cost o$ the old autocla*e in ter/s o$ end+o$+1ear ' dollars is $)20. ,ince it is /ore expensi*e to operate the old autocla*e @$)20A than to purchase the new one @$)! A, Glious should purchase the new autocla*e at the end o$ 1ear &.