CHAPTER 6

Making Investment Decisions with

the Net Present Value Rule

The values shown in the solutions may be rounded for display purposes. However, the answers were
derived using a spreadsheet without any intermediate rounding.

2. Real cash flow = $100,000 / (1 + .04) = $96,154

r = (1 + .08) / (1 + .04) – 1 = .03846, or 3.846%

PV = $96,154 / (1 + .03846) = $92,593

4. The longer the recovery period, the lower the present value of depreciation tax shields. This
applies to any positive discount rate.

First, calculate the PV for the depreciation schedules as shown below:

5-Year Schedule
Year 1 2 3 4 5 6
Cash .2000 .3200 .1920 .1152 .1152 .0576

PV at 10% .1818 .2645 .1443 .0787 .0715 .0325

NPV .7733

7-Year Schedule
Year 1 2 3 4 5 6 7 8
Cash .1429 .2449 .1749 .1249 .0893 .0892 .0893 .0446

PV at 10% .1299 .2024 .1314 .0853 .0554 .0504 .0458 .0208

NPV .7214

Next, to determine the tax shield for each class, use the following formula:

Tax shield = NPV of depreciation schedule × tax rate.

Five-year class:

Tax shield = .7733 × .35 = .271

Seven-year class:

Tax shield = .7214 × .35 = .253

5. 2016 2017 2018 2019 2020
Net working capital $50,000 $230,000 $305,000 $250,000 $ 0
Cash flows –50,000 – 180,000 –75,000 55,000 250,000
Net working capital = accounts receivable + inventory – accounts payable
Cash flows = change in net working capital

7. PV of costs = $1,500,000 + $200,000 × ((1 / .05) – {1 / [.05 × (1 + .05)25]})

PV of costs = $4,318,788.91

EAC = $4,318,788.91 / ((1 / .05) – {1 / [.05 × (1 + .05)25]})

EAC = $306,428.69

Est. Time: 01 - 05

8. a. NPVA = –$100,000 + $110,000 / (1 + .10) + $121,000 / (1 + .10) 2

NPVA = $100,000

NPVB = –$120,000 + $110,000 / (1 + .10) + $121,000 / (1 + .10) 2 + $133,000 / (1 + .10)3

NPVB = $179,925

b. EACFA = $100,000 / ((1 / .10) – {1 / [.10(1 + .10)2]})

EACFA = $57,619

EACFB = $179,925 / ((1 / .10) – {1 / [.10(1 + .10)3]})

EACFB = $72,350

c. Select Machine B because it has the higher equivalent annual cash flow.

Est. Time: 01 - 05

9. NPVB = –$120,000 + $110,000 / (1 + .10) + $121,000 / (1 + .10) 2 + $133,000 / (1 + .10)3

NPVB = $179,925

EACFB = $179,925 / ((1 / .10) – {1 / [.10(1 + .10)3]})

EACFB = $72,350

In this problem, we must ignore the sunk costs and past real cash flows and focus on future cash
flows.

Machine C is expected to last another five years and produces a real annual cash flow of
$80,000.

Since Machine C’s real annual cash flow exceeds Machine B’s equivalent annual cash flow, the
company should wait and replace Machine C at the end of five years.
10. rreal = [(1 + rnominal) / (1 + inflation rate)] – 1
rreal = [(1 + .20) / (1 + .10)] – 1
rreal = .0909, or 9.09%

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

Net Cash Flows (nominal $) −12,600 −1,484 2,947 6,323 10,534 9,985 5,757 3,269
Net Cash Flows (real $) −12,600 −1,349 2,436 4,751 7,195 6,200 3,250 1,678

NPVreal cash flows at real rate = $3,802

11. Nominal rate = 15%

Inflation rate = 10%

Rreal = [(1 + .15) / (1 + .10)] – 1

Rreal = .045455, or 4.5455%

(figures in $)
Year: 0 1 2 3 4 5

Revenues 200,000 220,000 242,000 266,200 292,820

Costs 100,000 110,000 121,000 133,100 146,410
Depreciation 100,000 100,000 100,000 100,000 100,000
Pretax profit 0 10,000 21,000 33,100 46,410
Taxes at 35% 0 3,500 7,350 11,585 16,244
Aftertax profit 0 6,500 13,650 21,515 30,167

Working capital 40,000 44,000 48,400 53,240 58,564 0

Operating cash flow 100,000 106,500 113,650 121,515 130,167

Change in working capital -40,000 -4,000 -4,400 -4,840 -5,324 58,564
Capital investment -500,000 0 0 0 0 0

Net cash flows (nominal) –540,000 96,000 102,100 108,810 116,191 188,731
NPV (nominal) at 15% –147,510

Net cash flows (real)

(10% inflation)* –540,000 87,273 84,380 81,751 79,360 117,187
NPV (real) at 4.5455% –147,510

* Real cash flowT = Nominal cash flowT / (1 + inflation rate)T

14. If the $50,000 installation cost is expensed at the end of year 1, the value of the tax shield is:

PV = ($50,000 × .35) / (1 + .05)

PV = $16,667

If the $50,000 cost is capitalized and then depreciated using a five-year MACRS depreciation
schedule, the value of the tax shield is:

PV = (.35 × $50,000) × (.20 / (1 + .05) + .32 / (1 + .05)2 + .192 / (1+.05)3 +

.1152 / (1 + .05)4 + .1152 / (1 + .05)5 + .0576 / (1 + .05)6
PV = $15,306

If the installation cost can be expensed, then the tax shield is larger, which means the after-tax
cost is smaller.

Est. Time: 06 - 10

15. The $3 million initial research costs are sunk costs so are excluded from the NPV calculation. The
following spreadsheet calculates a project NPV of −$465,000.

(Figures in 000's) Year: 0 1 2 3 4 5

Capital investment and disposal –6,000 500
Working capital 200 240 400 400 240 0
Unit sales 500 600 1,000 1,000 600

Revenues 2,000 2,400 4,000 4,000 2,400

Costs 750 900 1,500 1,500 900
Depreciation 1,200 1,200 1,200 1,200 1,200
Pretax profit 50 300 1,300 1,300 300
Taxes at 35% 18 105 455 455 105
Aftertax profit 33 195 845 845 195

Cash flow from operations 1,233 1,395 2,045 2,045 1,395

Change in working capital –200 –40 –160 0 160 240
Capital investment and aftertax
recovery –6,000 325
Net cash flows –6,200 1,193 1,235 2,045 2,205 1,960
Present value @ 12% –6,200 1,065 985 1,456 1,401 1,112

NPV –181
16. a. NPVA = –$100,000 + $26,000 × ((1 / .08) – {1 / [.08(1 + .08)5]})
NPVA = $3,810

NPVB = –investment + PV(aftertax cash flow) + PV(depreciation tax shield)

NPVB = –$100,000 + [$26,000 × (1 – .35)] × ((1 / .08) – {1 / [.08 × (1 + .08)5]})
+ (.35 × $100,000) × [.20 / (1 + .08) + .32 / (1 + .08)2 + .192 / (1 + .08)3 +
.1152 / (1 + .08)4 + .1152 / (1 + .08)5 + .0576 / (1 + .08)6]
NPVB = –$4,127

b. To calculate the effective tax rate, first compute the project cash flows for each year.
For years 1 and after, you can use this formula:

After-tax cash flowT = (pretax cash flowT × (1 – tax rate) + (initial investment
× depreciation rateT × tax rate)

After-tax cash flows:

Year: 0 1 2 3 4 5 6
Company A –100,000 26,000 26,000 26,000 26,000 26,000 0
Company B –100,000 23,900 28,100 23,620 20,932 20,932 2,016

IRRA = 9.43%
IRRB = 6.39%

c. Effective tax rate = 1 – (.0639 / .0943) = .323, or 32.3%

24. In order to solve this problem, we calculate the equivalent annual cost for each of the two
alternatives.
Alternative 1—Sell the new machine: If we sell the new machine, we receive the after-tax cash
flow from the sale of the new machine, pay the costs associated with keeping the old machine,
and receive the after-tax proceeds from the sale of the old machine at the end of year 5.

NPV1 = [$50,000 – $20,000 – $30,000 × ((1 / .12) – {1 / [.12(1 + .12)5]})

+ $5,000 / (1 + .12)5] × (1 – .35)
NPV1 = –$48,949.00

EAC1 = –1 × (–$48,949.00 / ((1 / .12) – {1 / [.12(1 + .12)5]})

EAC1 = $13,578.93

Alternative 2—Sell the old machine: If we sell the old machine, we receive the after-tax cash flow
from the sale of the old machine, pay the costs associated with keeping the new machine, and
receive the after-tax proceeds from selling the new machine at the end of year 10.
 NPV2 = $25,000 – $20,000 × ((1 / .12) – {1 / [.12(1 + .12)5]}) – $20,000 / (1 + .12)5 –
($30,000 × ((1 / .12) – {1 / (.12(1 + .12)5]}) / (1 + .12)5) + [$5,000 / (1 + .12)10] ×
(1 – .35)
NPV2 = –$76,828.44

EAC2 = –1 × (–$76,828.44 / ((1 / .12) – {1 / [.12(1 + .12)10]})

EAC2 = $13,597.42

Thus, the least-expensive alternative is to sell the new machine and keep the old machine
because this alternative has the lowest equivalent annual cost (but not by much).

One key assumption underlying this result is that, whenever the machines have to be replaced,
the replacement will be a machine that is as efficient to operate as the machine being replaced.

25. PVLE = –$3.60 – $2.00 × ((1 / .04) – {1 / [.04(1 + .04)9]})

PVLE = –$18.47

EACLE = –1 × [–$18.47 / ((1 / .04) – {1 / [.04(1 + .04)9]})]

EACLE = $2.48

PVConventional = –$.60 – $7.00 / (1 + .04)

PVConventional = –$7.33

EACConventional = –1 × [–$7.33 / ((1 / .04) – {1 / [.04(1 + .04)1]})]

EACConventional = $7.62

Select the low-energy lightbulb because it has the lower EAC.

26. The current copiers have net cost cash flows as follows:

After-tax
Year cash flow ($)
1 (-2,000  .65) + (.35  .0893  20,000) –674.90
2 (-2,000  .65) + (.35  .0892  20,000) –675.60
3 (-8,000  .65) + (.35  .0893  20,000) –4,574.90
4 (-8,000  .65) + (.35  .0445  20,000) –4,887.80
5 (-8,000  .65) –5,200.00
6 (-8,000  .65) –5,200.00

PV7% = –$15,856.71
EAC = -1 × [–$15,856.71 / ((1 / .07) – {1 / [.07 × (1 + .07)6]})]
EAC = $3,326.67

The copiers should be replaced only when the equivalent annual cost of the replacements is less
than $3,326.67.

When purchased, the new copiers will have net cost cash flows as follows:

After-tax
Year cash flow ($)
0 –25,000.00
1 (-1,000  .65) + (.35  .1429  25,000) 600.38
2 (-1,000  .65) + (.35  .2449  25,000) 1,492.88
3 (-1,000  .65) + (.35  .1749  25,000) 880.38
4 (-1,000  .65) + (.35  .1249  25,000) 442.88
5 (-1,000  .65) + (.35  .0893  25,000) 131.38
6 (-1,000  .65) + (.35  .0892  25,000) 130.50
7 (-1,000  .65) + (.35  .0893  25,000) 131.38
8 (-1,000  .65) + (.35  .0445  25,000) –259.75

PV7% = –$21,967.19
The decision to replace must also take into account the after-tax resale value of the old machine
as well as any cash flows for the old machine prior to its replacement.

Consider three cases:

(i). If the existing copiers are replaced now, then the present value of the cash flows is:

PV = –$21,967.19 + $8,000 – .35  {$8,000 – [$20,000 × (1 – .1429 – .2449 – .1749

–.1249)]}
PV = –$14,580.39

EAC = –1 × [–$14,580.39 / ((1 / .07) – {1 / [.07(1 + .07)8]})]

EAC = $2,441.75

(ii). If the existing copiers are replaced two years from now, then the present value of the
cash flows is:

PV = –$674.90 / (1 + .07) + (–$675.60) / (1 + .07)2 + (–$21,967.19) / (1 + .07)2 +

$3,500 – .35  {$3,500 – [$20,000 × (.0893 + .0446)]} / (1 + .07)2
PV = –$17,602.09
 EAC = –1 × [–$17,602.09 / ((1 / .07) – {1 / [.07(1 + .07)10]})]
EAC = $2,506.14

(iii). Six years from now, both the book value and the resale value of the existing copiers will
be zero. If the existing copiers are replaced six years from now, then the present value of
the cash flows is:

PV = –$15,856.71 + (–$21,967.19) / (1 + .07)6

PV = –$30,494.38

EAC = –1 × [–$30,494.38 / ((1 / .07) – {1 / [.07(1 + .07)10]})]

EAC = $3,486.88

The copiers should be replaced immediately since that option has the lowest EAC.

27. Payment = $400,000,000 / ((1 / .07) – {1 / [.07(1 + .07)25]})

Payment = $34,324,207

30. PVA = –$40,000 + [–$10,000 × (1 – .10)] / (1 + .06) + [–$10,000 × (1 – .10)2] / (1 + .06)2

+ [–$10,000 × (1 – .10)3] / (1 + .06)3
PVA = –$61,820.36

EACA = –1 × [–$61,820.36 / ((1 / .06) – {1 / [.06(1 + .06)3]})]

EACA = $23,127.60

PVB = –$50,000 + [–$8,000 × (1 – .10)] / (1 + .06) + [–$8,000 × (1 – .10)2] / (1 + .06)2

+ [–$8,000 × (1 – .10)3] / (1 + .06)3 + [–$8,000 × (1 – .10)4] / (1 + .06)4
PVB = –$71,613.83

EACB = 1 × [–$71,613.83 / ((1 / .06) – {1 / [.06(1 + .06)4]})]

EACB = $20,667.14

Annual rental is $23,127.60 for Machine A and $20,667.14 for Machine B.

31. PV of EAC of new jet:

EAC = $1,100,000 / ((1/.08) – {1 / [.08(1 + .08)6]})
EAC = $237,946.92
 If the jet is replaced at the end of year 3 rather than the end of year 4, then the firm will
incur an incremental cost of $237,946.92 in year 4. The present value of this cost is:

PV of EAC = $237,946.92 / (1 + .08)4

PV of EAC = $174,898.09

PV of cost savings:

PV of savings = ($100,000 – 20,000) / ((1 / .08) – {1 / [.08(1 + .08)3]})

PV of savings = $206,167.76

You should try to persuade the president to allow wider use of the present jet because the
present value of the savings is greater than the present value of the cost.