Solutions to Chapter 8

1.

Net income = ($74 42 10) .35 ($74 42 10) = $22 $7.7 = $14.3 million

Revenues cash expenses taxes paid = $74 $42 $7.7 = $24.3 million

Net Profit + Deprec = $14.3 + $10 = $24.3 million

(Revenues cash expenses) (1 T) + T Deprec

= $32 .65 + .35 $10 = $24.3 million

2.

a.

NWC

= Acct Receivable + Inventory Acct Payable

=

b.
3.

$1,500

+ $1,000

$2,000

Cash flow = $36,000 $24,000 + $2,500 = $14,500

Net income = ($7 4 1) .40 ($7 4 1) = $2 $0.8 = $1.2 million

Revenues cash expenses taxes paid = $3 $0.8 = $2.2 million

Net Profit + Deprec = $1.2 + $1.0 = $2.2 million

(Revenues cash expenses) (1 T) + T Deprec

= $3 .60 + .40 $1 = $2.2 million

6.

7.

= $2,500

Revenue

$160,000

Rental costs

35,000

Variable costs

45,000

Depreciation

10,000

Pretax profit

70,000

Taxes (35%)

24,500

Net income

$45,500

a.

Net Profit + Depreciation = $45,500 + $10,000 = $55,500

b.

Revenue rental costs variable costs taxes

= $160,000 $35,000 $45,000 $24,500
= $55,500

c.

(Revenue rental costs variable costs) (1.35) + .35 (Depreciation)

= ($160,000 $35,000 $45,000) .65 + .35 $10,000
= $52,000 + $3,500 = $55,500

10.

Capital investment: $1,000,000

CCA calculation:
End of Year
UCC

Year

UCC

CCA (5%)

$1,000,000

$25,000

$975,000

975,000

48,750

926,250

926,250

46,313

879,937

879,937

43,997

835,940

835,940

41,797

794,143

794,143

39,707

754,436

Operating cash flows of the project for the next six years (figures in thousands of
dollars).
Year:
Capital Investment
Revenues

-1,000
120

120

120

120

120

120

Direct production
costs

40

40

40

40

40

40

Fixed maintenance
costs

15

15

15

15

15

15

Pre-tax Profits

65

65

65

65

65

65

Tax @35%

22.75

22.75

22.75

22.75

22.75

22.75

Operating Cash
Flow (excluding
CCA Tax Shield)

42.25

Operating
Expenses:

42.25

42.25

42.25

42.25

42.25

CCA Tax Shield

8.75

17.063

16.209

15.399

14.629

13.898

51.000

59.313

58.459

57.649

56.879

56.148

(CCA x 35%)
Total Cash Flow

-1,000

13.

Cash flow = Net income + depreciation increase in NWC

1.2 = 1.2 + .5 NWC
NWC = $0.5 million

20.

a.

The year-wise CCA for the new grill, over its expected life, is as follows:
End of year
UCC

Year

UCC

CCA (30%)

$20,000

$3,000

17,000

5,100

11,900

11,900

3,570

8,330

$17,000

Operating cash flow contribution, excluding tax shields, for year 1 through 3
= Saving in energy expenses x (1 - .35) = $10,000 x (1 - .35) = $6,500. Now,
we must consider the effect of the CCA tax shield on the projects yearly cash
flows.
Year:

b.

Contribution from saving in energy

expenses

6,500

6,500

6,500

CCA Tax Shield (CCA x .35)

1,050

1,785

1,250

Total Operating Cash Flow

7,550

8,285

7,750

Total Cash Flow (0-3) = Operating CF + CF associated with investments.

At time 0, the CF from the investment is -$20,000. At the end of year 3, the
grill is sold for $5,000.
Therefore, total cash flows are:
Time
0
1
2
3

Cash Flows ($)

-20,000
7,550
8,285
12,750

[=7,750 + 5,000]

c.

First, we compute present value of cash flows excluding the CCA tax shield:
PV = -20,000 + 6,500 x annuity factor(12%, 3 years) + 5,000 x discount factor
(12%, 3 years) = -$829.3.
We next calculate the present value of the CCA tax shield:
PV of CCA tax shield:
=

CdTc 1 + 0.5r SdTc

1

r + d 1 + r d + r (1 + r ) t

20000 0.3 0.35 1 + ( 0.5 0.12 ) 5000 0.3 0.35

1

0.12 + 0.3
0.3 + 0.12
(1 + 0.12 ) 3
1 + 0.12

= $3,842.41
NPV = Total PV excluding CCA tax shields + PV of CCA tax shield
= -$829.3 + $3, 842.41 = -$3,013.11

21.

a.

Initial investment = $50,000 + $8,000 for working capital (20% of 40,000)

= $58,000

b.

CCA for the first 5 years of the plant and equipments life is as follows:
Year

UCC

CCA (25%)

End of year
UCC

$50,000

$6,250

$43,750

43,750

10,938

32,812

32,812

8,203

24,609

24,609

6,152

18,457

18,457

4,614

13,843

(In thousands of dollars)

Year:

Sales

40

30

20

10

Expenses

16

12

= Profit before tax

24

18

12

-tax @ 40%

9.6

7.2

4.8

2.4

= Operating Cash Flow

(excl. CCA tax shield)

14.4

10.8

7.2

3.6

For calculating project cash flows for each year, we will need to calculate the
tax savings generated from the CCA tax shield. We do this by multiplying
each years CCA by the firms tax rate (40% in this case).
(in thousands of dollars)

Year:

Capital investment

-50.00

Initial investment in working

capital

- 8.00

2.0

2.0

2.0

2.0

14.4

10.8

7.2

3.6

16.4

12.8

9.2

5.6

2.5

4.4

3.3

2.5

18.9

17.2

12.5

8.1

Decrease in working capital from

previous year

Operating Cash Flow

(excluding CCA tax shield)
Total Cash Flow
- 58.00
(excluding CCA tax shield)
CCA tax shield (CCA x 0.40)
Total

c.

- 58.00

The project NPV is calculated in two phases. First, we calculate the present
value from cash flows excluding the CCA tax shield:
Year:

Total Cash Flow (excluding

CCA tax shield)

(58)

16.40

12.80

9.20

5.60

x Discount Factor (10%)

1.000

0.909

0.826

0.751

0.683

PV of total cash flow (excl.

CCA tax shield)*

(58)

14.91

10.57

6.91

3.83

Total PV (excl. CCA tax shield) (21.78)

* Notice, you could also calculate this as follows, keeping in mind that there
could be some difference of result due to rounding errors.
58 +

16 .4
12 .8
9 .2
5 .6
+
+
+
1 .1
(1.1) 2
(1.1) 3
(1.1) 4

We next calculate the present value of the CCA tax shield:

PV of CCA tax shield =

CdTc 1 + 0.5r SdTc

1

, where S = 0

r + d 1 + r d + r (1 + r ) t

50000 0.25 0.4 1 + ( 0.5 0.10 )

0

0.10 + 0.25
=
1 + 0.10

= $13,636
NPV (in thousands of dollars) = Total PV excluding CCA tax shields + PV of
CCA tax shield
= -$21.78 + $13.64 = -$8.14
Solutions to Chapter 9
3.

a.

(Revenue expenses) changes by $1 million $0.5 million = $0.5 million.

After-tax profits increase by $0.5 million (1 .35) = $0.325 million. Because
depreciation is unaffected, cash flow changes by an equal amount.

b.

4.

Expenses increase from $5 million to $6 million. After-tax income and CF fall

by $1 million (1 .35) = $0.65 million.
The 12%, 10-year annuity factor is 5.650. So the effect on NPV equals the change
in CF 5.650

a.

$.325 million 5.650 = $1.836 million increase

$.65 million 5.650 = $3.673 million decrease

b.

Fixed costs can increase until the point at which the higher costs (after taxes) reduce NPV
by $2 million.
Increase in fixed costs (1 T) annuity factor(12%, 10 years) = $2 million

Increase (1 .35) 5.650 = $2 million

Increase = $544,588
Accounting profits currently are $(10 5 2) million (1 .35) = $1.95
million. Pretax profits are currently $(10 5 2) = $3 million. Fixed costs can increase by this amount
($ 3 million) before pretax profits are reduced to zero.

c.

5.

Revenue = Price quantity = $2 6 million = $12 million

Expense = Variable cost + fixed cost
= $1 6 million + $2 million = $8 million
Depreciation = $5 million/5 years = $1 million per year
CF = (1 T) (Revenue expenses) + T depreciation
= .60 ($12 million $8 million) + .4 $1 million = $2.8 million
a.

NPV = $5 million + $2.8 million annuity factor(5 years, 12%)

= $5 million + $2.8 million 3.605
= $5.1 million

b.

If variable cost = $1.20, then expenses increase to

$1.20 6 million + $2 million = $9.2 million.
CF = .60 ($12 million $9.2 million) + .4 $1 million = $2.08 million
NPV = $5 million + $2.08 million 3.605 = $2.5 million

c.

If fixed costs = $1.5 million, expenses fall to

($1 6 million) + $1.5 million = $7.5 million
CF = .60 ($12 million $7.5 million) + .4 $1 million = $3.1 million
NPV = $5 million + $3.1 million 3.605 = $6.2 million

d.

Call P the price per jar. Then

Revenue = P 6 million
Expense = $1 6 million + $2 million = $8 million

CF = (1 .40) (6P 8) + .40 1 = 3.6P 4.4

NPV = 5 + (3.6P 4.4) 3.605 = 20.862 + 12.978P
NPV = 0 when P = $1.61 per jar
6.

Base Case

Best Case

Worst Case

Price

$ 50

55

45

Variable Cost

$ 30

27

33

Fixed Cost

$300,000

270,000

330,000

Sales

$ 30,000

33,000

27,000

CF = (1 T) [Revenue Cash Expenses] + T Depreciation

Depreciation = $1 million/10 years = $100,000 per year
Best-case CF = .65 [33,000 (55 27) 270,000] + . 35 100,000 = $460,100
Worst-case CF = .65 [27,000 (45 33) 330,000] + .35 100,000 = $ 31,100
10-Year Annuity factor at 14% discount rate = 5.2161
Best-case NPV = 5.2161 $460,100 $1,000,000 = $1,399,928
Worst-case NPV = 5.2161 $ 31,100 $1,000,000 = $ 837,779
9.

a.

Each dollar of sales generates $0.70 of pretax profit. Depreciation is $100,000

and fixed costs are $200,000. Accounting break-even revenues are therefore:
(200,000 + 100,000)/.70 = $428,571
The firm must sell 4,286 diamonds annually.

b.

Call Q the number of diamonds sold. Cash flow equals

(1 .35)(Revenue expenses) + .35 depreciation
= .65 (100Q 30Q 200,000) + .35 (100,000)
= 45.5Q 95,000
The 12%, 10-year annuity factor is 5.650. Therefore, for NPV to equal zero,
(45.5Q 95,000) 5.650 = $1,000,000
257.075Q 536,750 = 1,000,000

Q = 5,978 diamonds per year

19.

DOL = 1 +
a.

Profit = Revenues variable cost fixed cost depreciation

= $ 8,000 $6,000 $1,000 $600 = $400
DOL = 1 + = 5.0

b.

Profit = Revenues variable cost fixed cost depreciation

= $10,000 $7,500 $1,000 $600 = $900
DOL = 1 + = 2.78

c.

28.

DOL is higher when profits are lower because a $1 change in sales leads to a
greater percentage change in profits.

a.
Price
Sales units
Variable cost

Optimistic

Pessimistic

$ 60

$ 55

50,000

30,000

$30

$ 30

CF = (1 T) (Revenue Cash Expenses) + T Depreciation

Optimistic CF = .65 [(60 30) 50,000] + .35 600,000 = $1,185,000

NPV = 6,000,000 + 1,185,000 annuity factor(12%, 10 years) = $ 695,514
(using annuity tables, we will get $695,487)
Pessimistic CF = .65 [ (55 30) 30,000] + .35 600,000 = $ 697,500
NPV = 6,000,000 + 697,500 annuity factor(12%, 10 years) = $2,058,969
(using annuity tables, we will get -$2,058,985.5)
Expected NPV = $695,514 + ($2,058,969) = $681,728
The firm will reject the project.

b.

If the project can be abandoned after 1 year, then it will be sold for $5.4 million. (There
will be no taxes, since this also is the depreciated value of the equipment.) Cash flow at t =
1 equals CF from project plus sales price:
$697,500 + $5,400,000 = $6,097,500
PV = = $5,444,196
NPV in the abandonment scenario is:
$5,444,196 $6,000,000 = $555,804
which is not as disastrous as the result in part (a).
Expected NPV is now positive:
$695,514 + ($555,804) = $69,855
Because of the abandonment option, the project is now worth pursuing.