Chapter 8: Net Present Value and Capital Budgeting
Chapter 8: Questions 1, 5, 6, 8, 10, and 15
8.1 a. Yes, the reduction in the sales of the company’s other products, referred to as erosion, and 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.
b. Yes, expenditures on plant and equipment should be treated as incremental cash flows. These are costs of
the new product line. However, if these expenditures have already occurred, they are sunk costs and are not
included as incremental cash flows.
c. No, the research and development costs should not be treated as incremental cash flows. The costs of
research and development undertaken on the product during the past 3 years are sunk costs and should not
be included in the evaluation of the project. Decisions made and costs incurred in the past cannot be
changed. They should not affect the decision to accept or reject the project.
d. Yes, the annual CCA expense should be treated as an incremental cash flow. CCA expense must be taken
into account when calculating the cash flows related to a given project. While CCA is not a cash expense
that directly affects cash flow, it decreases a firm’s net income and hence, lowers its tax bill for the year.
Because of this CCA tax shield, the firm has more cash on hand at the end of the year than it would have
had without expensing depreciation.
e. No, dividend payments should not be treated as incremental cash flows. A firm’s decision to pay or not
pay dividends is independent of the decision to accept or reject any given investment project. For this
reason, it is not an incremental cash flow to a given project. Dividend policy is discussed in more detail in
later chapters.
f. Yes, the resale value of plant and equipment at the end of a project’s 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 book value of the equipment and its sale price will create gains or losses that result in either a
tax credit or liability.
g. Yes, salary and medical costs for production employees on leave should be treated as incremental cash
flows. The salaries of all personnel connected to the project must be included as costs of that project. Thus,
the costs of employees who are on leave for a portion of the project life must be included as costs of that
project.
8.5 Real interest rate = (1.13 / 1.05) – 1 = 0.07619 or 7.619%
NPVA = –$55,000+ $30,000 / 1.07619 + $18,000 / 1.076192 + $18,000 / 1.076193
= –$55,000 + $27,876.10 +$15,541.54 +$14,441.25 = $2,858.91
NPVB = –$60,000+ $10,000 / 1.13 + $25,000/ 1.132 + $40,000/ 1.133
= –$60,000 + $8,849.55 + $19,578.66 + $27,722 = – $3,849.77
Choose project A as it has the higher positive NPV.
Answers to End–of–Chapter Problems 8-1
8.6 PV = $275,000/[0.13 – (–0.085)]
= $1,279,069.77
8.8 The simplest approach to this problem is to discount the real cash flows. Since the revenues and costs are
growing perpetuities, the formula for computing the PV of such a stream can be used. The first year amounts
of the revenues and costs are stated in nominal terms. Since the growth rate and discount rate are real rates,
adjust the initial amounts. For revenues, labour costs and the other costs, those amounts are
$265,000 / 1.06, $185,000 / 1.06 and $55,000 / 1.06, respectively.
PV ( revenue ) = ( $265,000 / 1.06 ) / ( 0.10 – 0.04 ) = $4,166,666.67
PV ( labour costs ) = ( $185,000 / 1.06 ) / ( 0.10 – 0.03 ) = $2,493,261.46
PV (other costs) = ( $55,000 / 1.06) / { 0.10 – 0.01 } = $576,519.92
The lease payment is given in nominal terms and it should be discounted by the nominal rate which is
0.166 = (1.06 ´ 1.10) – 1.
NOTE: By the “end of year 1” the textbook means the end of the year, i.e., the end of the initial period. The
timing of the rent payment is the same as the timing of all other cash flows.
Thus, the present value of the lease payments is $90,000 / 0.166 = $542,168.67.
To find the NPV of BICC’s toad ranch, deduct the present values of the costs from the present value of
revenues. Recall, the start–up costs are negligible.
NPV = $4,166,666.67 – $2,493,261.46 – $576,519.92 – $542,168.67
= $554,716.62
8.10 Initial revenues = $2.00 ´ 4,600,000 = $9,200,000
Initial expenses = $0.45 ´ 4,600,000 = $2,070,000
PV after tax = $9,200,000 (1 – 0.34) / (0.12 – 0.06) – $$2,070,000 (1 – 0.34) / (0.12 – 0.04)
= $101,200,000 – $17,077,500
= $84,122,500
8.15 Real discount rate = ( 1.14 / 1.05) – 1 = 0.0857 or 8.57%
PV – XX40 = $900 + $120 / 1.0857 + $120 / 1.08572 + $120 / 1.08573
= $1,206.09
$1,206.09 = EAC A83.57% = EAC 2.5508
EAC = $472.84
PV – RH45 = $1,400 + $95 / 1.0857 + $95 / 1.08572 + $95 / 1.08573 + $95 / 1.08574 + $95/1.08575
= $1,773.67
$1,773.67 = EAC * A85.57% = EAC* 3.9333
Answers to End–of–Chapter Problems 8-2
EAC = $450.94
Choose RH45.
Answers to End–of–Chapter Problems 8-3