FINM7006: Applied Foundations of Finance
Tutorial 4 Solutions
Question One
Two investment projects have been identified and the net cash flows for each appear
below. The required rate of return is 10% p.a. for each. Calculate the NPV for each
project and advise which project/s will increase the value of the host firm. If the
projects were mutually exclusive, which project would you advise the host firm to
choose?
Year
Project 0 1 2 3 4 5
A -10000 3000 3000 3000 3000 3000
B -21000 4000 4000 4000 8000 8000
The NPVs of the two projects are calculated as follows:
Given this, you would accept project A.
Question Two
Sault Ltd is considering the acquisition of an ice cream machine compactor at a cost
of $25,000. The machine is estimated to have zero value at the end of its five-year life.
Depreciation is 20% p.a. straight line and the company tax rate is 40%. The project
will also return the following annual net cash flows (pre-tax):
Year Net Cash Flow (pre-tax) ($)
1 6000
2 10000
3 12000
4 15000
5 7000
Given this information, and the fact that the project’s after-tax required rate of return
is 10% p.a., calculate the project’s NPV. Should Sault Ltd accept the project? Why?
Before we calculate the NPV of the project, we need to calculate the post-tax cash
flows for each of the 5 years of the project. These calculations and values are
tabulated below:
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FINM7006: Applied Foundations of Finance
Time (Years) Post-Tax Cash Flow Calculation Post-Tax Cash Flow Value
0 -$25,000 -$25,000
1 $6,000(0.60) + $5,000(0.40) $5,600
2 $10,000(0.60) + $5,000(0.40) $8,000
3 $12,000(0.60) + $5,000(0.40) $9,200
4 $15,000(0.60) + $5,000(0.40) $11,000
5 $7,000(0.60) + $5,000(0.40) $6,200
To calculate the NPV of the project, we simply discount each cash flow from the table
above back the relevant number of periods:
Given the fact that the project has a NPV>0, Sault Ltd should accept the project.
Question Three
Chaudhry Ltd is considering installing a new beer-making machine that costs
$110,000 plus installation costs of $10,000. The new machine will generate cash
revenues of $200,000 annually and has associated cash expenses of $125,000 per
annum. The machine itself will be depreciated to a salvage value of $10,000 over a
10-year period using the straight-line depreciation method. At the end of the 10 th year,
the machine will then be sold for $15,000. Given the corporate tax rate is 30% p.a.,
determine (and tabulate) the incremental cash flows associated with this project and
calculate its NPV using a discount rate of 50% p.a.
The incremental cash flows associated with the project can be summarized as follows:
Year 0:
Cost of new machine: $110,000; and,
Installation cost: $10,000.
Years 1-10, inclusive:
Yearly post-tax cash revenues less expenses: ($200,000-$125,000)(1-0.30)
=$52,500; and,
Because yearly depreciation equals ($120,000-$10,000)/10=$11,000, there is
an annual depreciation tax shield of $11,000x0.30=$3,300;
Year 10 only:
In addition to the post-tax cash revenue less expenses and depreciation tax shield for
year 10 (calculated above), there are additional cash flows of:
Sale price of $15,000 received at the end of year 10; and,
Gain on sale of $5,000, which is subject to tax of $5,000x0.3=$1,500.
Tabulating these incremental cash flows:
Year 0 1 2 3 4 5 6 7 8 9 10
Cost -$120,000
(1-)(R-E) $52,500 $52,500 $52,500 $52,500 $52,500 $52,500 $52,500 $52,500 $52,500 $52,500
D $3,300 $3,300 $3,300 $3,300 $3,300 $3,300 $3,300 $3,300 $3,300 $3,300
Sale Price $15,000
Tax on -$1,500
Sale
Total -$120,000 $55,800 $55,800 $55,800 $55,800 $55,800 $55,800 $55,800 $55,800 $55,800 $69,300
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FINM7006: Applied Foundations of Finance
NPV = -120,000 + 55,800[1-(1.50)-9 / 0.50] + 69,300 / (1.5010)
= -120,000 + 108,697.0279 + 1,201.768023
= -$10,101.20
Question Four
Chocolate Heaven Ltd, producers of fine quality chocolates, need to replace a
chocolate mixing machine. Two competing machines, A and B are available. Both
machines are considered adequate in terms of their ability to complete the required
tasks. Forecasted cash flows for each machine are provided below.
A B
Estimated life 3 years 6 years
Cost 13000 22000
Net Cash Flows (pre-tax) 10000 14000
Salvage Value 1000 4000
Depreciation (p.a.) 4000 3000
Given a tax rate of 40% and an after-tax required rate of return of 10% p.a., which
machine would you recommend Chocolate Heaven should purchase? Why?
Cash flows for Project A:
Year 0:
Cost of new machine: $13,000.
Years 1-3 inclusive:
Yearly post-tax cash revenues less expenses: $10,000 x (1-0.40) =$6,000; and,
Yearly depreciation tax shield of $4,000x0.40=$1,600;
Year 3 only:
In addition to the post-tax cash revenue less expenses and depreciation tax shield for
year 3 (calculated above), there are additional cash flows of:
Salvage value of $1,000 received at the end of year 3 (note: because sale price
= salvage value, there is no gain/loss on sale and therefore no tax on sale).
Cash flows for Project B:
Year 0:
Cost of new machine: $22,000.
Years 1-6 inclusive:
Yearly post-tax cash revenues less expenses: $14,000 x (1-0.40)=$8,400; and,
Yearly depreciation tax shield of $3,000x0.40=$1,200;
Year 6 only:
In addition to the post-tax cash revenue less expenses and depreciation tax shield for
year 6 (calculated above), there are additional cash flows of:
Salvage value of $4,000 received at the end of year 6 (note: because sale price
= salvage value, there is no gain/loss on sale and therefore no tax on sale).
Using this information, we can calculate the NPV for each project:
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FINM7006: Applied Foundations of Finance
However, as the projects have different lives, we cannot compare these NPV figures.
Instead, we need to calculate equivalent annual cash flows:
Using these equivalent annual figures, we can meaningfully compare the two projects.
We can see that, as Project B has the highest annual equivalent cash flows, this is the
project that should be accepted.