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14-1

Part 5

Handling Risk and


Uncertainty
14-2

Chapter 14 Inflation and Its Impact on Project Cash Flows


Measure of Inflation

14.1
(a) Ottawa-Gatineau:

74.2(1 + )12 = 95.2


= 2.0985%
F = 100(1+ 0.020985)12
F = 128.30

Toronto:

78.9 (1 + )12 = 98.9


= 1.9006%
F = 100(1+ 0.019006)12
F = 125.35

Thunder Bay:

84.2 (1 + )12 = 102.7


= 1.6689%
F = 100(1+ 0.016689)12
F = 121.97

(b)
Ottawa-Gatineau Toronto Thunder Bay
January 2009 94.04 100.00 106.72
February 2009 97.34 103.42 113.05
March 2009 102.41 107.35 110.39
April 2009 102.53 107.98 111.79
May 2009 113.18 119.65 124.46
June 2009 119.65 125.22 136.12
14-3

July 2009 113.43 119.01 135.36


August 2009 118.76 124.59 134.60
September 2009 114.70 120.79 132.70
October 2009 116.10 121.17 125.35
November 2009 120.03 124.33 128.01
December 2009 115.72 119.65 122.56
January 2010 120.66 125.35 130.16

14.2
(a) Average price index:

92.0(1 f ) 4 117.3
f 6.262%

(b) Price index (2010 = 117.3(1+0.06262)5 = 158.92

(c)
2001 100.0
2002 102.2
2003 104.9
2004 123.8
2005 127.5

14.3
100(1 0.05)(1 0.08) 113.40
100( F / P, f , 2) 113.40
f 6.4894%

14.4
(a) Given: = 3.14%, N = 75

F = 1(1 + 0.0314)-75

F = (1.0314)-75

F = $0.0963

F = 9.63

(b) Given: = 3.14%, F = 0.5

0.5 = 1(1 + 0.0314)-N


14-4

0.5 = (1.0314)-N

-N log 1.0314 = log 0.5

N = -log 0.5 / log 1.0314

N = 22.42 years

72
Comments: If you use the Rule of 72, you may find 22.93 years , which
3.14
is very close to the actual value.

Actual versus Constant Dollars

14.5 Given: i 12%, f 5% , 10 annuity payments in actual dollars

P $4,500( P / A,12%,10)
$25, 426

Comments: Since the annuity payments are made in actual dollars, we use the
market interest rate to find its equivalent lump sum amount in todays dollars.

14.6 Given: i 15%, f 8%, maintenance costs are given in constant dollars,
i ' 6.48%

P $25, 000( P / F , 6.48%,1) $30, 000( P / F , 6.48%, 2)


$32, 000( P / F , 6.48%,3) $35, 000( P / F , 6.48%, 4)
$40, 000( P / F , 6.48%,5)
$132,894
A $132,894( A / P,15%,5)
$39, 644

14.7 Given: i 16%, f 4%

n Actual Dollars Constant Dollars


0 $1,500 $1,500(P/F,4%,0) = $1,500
4 2,500 2,500(P/F,4%,4) = 2,137
5 3,500 3,500(P/F,4%,5) = 2,877
7 4,500 4,500(P/F,4%,7) = 3,420
14-5

14.8 Given:P $25, 000, i 1% per month, f 0.5% per month

th
The 20 payment in actual dollars:

A20 $25, 000( A / P,1%, 48) $658.35

The 20th payment in constant dollars:


A '20 $658.35( P / F , 0.5%, 20) $595.85

14.9
(a) Constant-dollar analysis: we need to find the inflation-free interest rate.
i f
i' 5.607%
1 f
Then find the equivalent present worth of this geometric series at i ' .

P $7, 000( P / A1 ,8%,5.607%, 4)


$27, 428

(b) Actual-dollar analysis

Net Cash Flow Conversion Net Cash Flow


Period
in Constant $ Factor in Actual $
1 $7,000 (1 0.07)1 $7,490
2 7,560 (1 0.07) 2 8,655
3 8,165 (1 0.07)3 10,002
4 8,818 (1 0.07) 4 11,559

P $7, 490( P / F ,13%,1) $8, 655( P / F ,13%, 2)


$10, 002( P / F ,13%,3) $11,559( P / F ,13%, 4)
$27, 428

Comments: As an alternative way of finding the equivalent cash flows in


actual dollars, we may use the compound growth rate (geometric growth and
inflation):

g (1 0.08)(1 0.07) 1
15.56%
P $7, 000(1.07)( P / A1 ,15.56%,13%, 4)
$27, 428
14-6

14.10 Given: i 9%, f 3.8% , we find the inflation-free interest rate as follows:

i ' (0.09 0.038) /(1 0.038) 5.01%

First compute the equivalent present worth of the constant dollar series at i ' :

P $1, 000( P / A,5.01%, 4)


$3,545.13

Then we compute the equivalent annual payment in actual dollars using i:

A $3,545.13( A / P,9%, 4)
$1, 094.27

14.11 Given: i 12%, f 6% , bond interest rate = 9% compounded semiannually,


face value = $1,000

The 16th interest payment in actual dollars:

I16 $1, 000(0.045) $45

The 16th interest payment (8th year) in constant dollars:

I '16 $45( P / F , 6%,8) $28.23

Equivalence Calculation Under Inflation

14.12 Given: i 1% per month, f 0.5% per month, P = $20,000, N = 60 months

0.01 0.005
i'
1 0.005
0.4975%
A ' $20, 000( A / P, 0.4975%, 60)
$386.38

14.13 Given: i ' 6%, f 5%, N 5 years, A $1.5 million in constant dollars

Market interest rate:


i 0.06 0.05 (0.06)(0.05) 11.3%
14-7

Actual dollar analysis:


Period Net Cash Net Cash Flow Equivalent
Flow in Actual $ Present Worth
in Constant $
1 $1,500,000 $1,575,000 $1,415,094
2 1,500,000 1,653,750 1,334,995
3 1,500,000 1,736,438 1,259,429
4 1,500,000 1,823,259 1,188,140
5 1,500,000 1,914,422 1,120,887

P $1,575, 000( P / F ,11.3%,1)


L $1,914, 422( P / F ,11.3%,5)
$6,318,545

14.14 Given: i 0.75% per month, f 0.5% per month,


P $5, 000, N 24 months, down payment = $1,000

(a) Inflation-free interest rate:

0.0075 0.005
i' 0.2488% per month
1 0.005

(b) Equal monthly payment in constant dollars:

A ' $5, 000( A / P, 0.2488%, 24)


$214.87

14.15 Given: i 6% compounded monthly, f 5% compounded annually, number


of months to deposit = 240 months, number of annual withdrawals = 10, first
withdrawal = six months after retirement

Effective inflation rate per semiannual: Since the first withdrawal is made after
six months from retirement, it is necessary to calculate the effective inflation
rate per semiannual.

1.05 1/ 2
f ( ) 1 2.4695% per semiannual
1

Annual withdrawals in actual dollars: On semiannual basis, the first withdrawal


will be made after 41 semiannual periods. Then we can calculate the equivalent
amount of this first withdrawal in actual dollars as follows:
14-8

A41 $40, 000( F / P, 2.4695%, 41) $108, 753

The second withdrawal will be made after 43 semiannual periods. The


equivalent amount of this second withdrawal in actual dollars is

A43 $40, 000( F / P, 2.4695%, 43) $114,190

The remaining withdrawals in actual dollars are

A45 $40, 000( F / P, 2.4695%, 45) $119,990


A47 $40, 000( F / P, 2.4695%, 47) $125,895
A49 $40, 000( F / P, 2.4695%, 49) $132,189
A51 $40, 000( F / P, 2.4695%,51) $138, 799
A53 $40, 000( F / P, 2.4695%,53) $145, 739
A55 $40, 000( F / P, 2.4695%,55) $153, 026
A57 $40, 000( F / P, 2.4695%,57) $160, 677
A59 $40, 000( F / P, 2.4695%,59) $168, 711

$168,711
$160,677

$108,753

(240 months)
0 20 Years
21 22 29 30

Monthly Deposits (A)

Equivalence calculation: To find the required equal monthly deposit amount (A),
we establish the following equivalence relationship:

A( F / A, 0.5%, 240)( F / P, 0.5%, 6) $180, 753


$114,190( P / F , 6.168%,1)
$119,900( P / F , 6.168%, 2)
14-9

M
$168, 711( P / F , 6.168%,9)
$1, 035, 236
A $1, 035, 236 / 476.08
= $2,174.52 per month
*
14.16
Given : i 2% per quarter, f 6% per year
(a)
Actual dollar analysis:

A( F / A, 2%,160) $600, 000( F / P, 6%, 40)


$6,171, 431
A $5, 420.69

Constant dollar analysis: Given: i 2% per quarter and f =6% per year, we
need to find the inflation free interest rate (i ') per quarter. In doing so, we first
compute the equivalent inflation rate per quarter.

(1 f ) 4 1 6%
f 1.4674% per quarter
i f 0.02 0.014674
i' 0.525%
1 f 1 0.014674

Now, we can establish the following equivalence relationship:

A '( F / A, 0.525%,160) $600, 000


A ' $2, 402.41

(b)
Effective annual interest rate:

ia (1 0.08 / 4) 4 1 8.243%

Equivalent value of $600,000 in actual dollars at the end of 63rd birthday:

*An asterisk next to a problem number indicates that the solution is available to students on the Companion
Website.
14-10

$600, 000( F / P, 6%, 40) $6,171, 431

Conversion of a gradient series to an equivalent uniform series:

A G ( A / G,8.243%, 40)
$1, 000(10.3746)
$10,374

Amount of the first deposit ( A1 ) :


( A1 $10,374)( F / A,8.243%, 40) $6,171, 431
276.21A1 3,306, 026
A1 $11,969

14.17 Given: i 3% per year, f 2% per year

(a) Frosh-year expense in actual dollars:

$20, 000( F / P, 2%,10) $24,380

(b) Equivalent single-sum amount at n 0

i f 0.03 0.02
i'
1 f 1 0.02
0.009804
P [$20, 000( P / A,9.804%,3) $20.000]*( P / F , 0.9804%,10)
$71,513.78

(c) Required annual deposit in actual dollars:

A $71514( A / P,3%,10) $8,381

Effects of Inflation on Project Cash Flows


14.18 Consider the following projects after-tax cash flow and the expected annual
general inflation rate during the project period:

End of Cash Flow Expected General


Year in Actual Dollars Inflation Rate
0 -$45,000
14-11

1 $26,000 6.5%
2 $26,000 7.7%
3 $26,000 8.1%

(a) The average annual general inflation rate:

(1 0.065)(1 0.077)(1 0.081) 1.2399


(1 f )3 1.2399
f 7.4312%

(b) Constant dollars:

Actual Constant
n
Dollars Dollars
0 -$45,000 -$45,000
1 $26,000 26,000(0.9390) = 24,414
2 $26,000 26,000(0.8718) = 22,667
3 $26,000 26,000(0.8065) = 20,969

Conversion factors:

( P / F , 6.5%,1) 0.9390
( P / F , 7.7%,1)( P / F , 6.5%,1) 0.8718
( P / F ,8.1%,1)( P / F , 7.7%,1)( P / F , 6.5%,1) 0.8065

(c) The project is still profitable under inflationary economy.

P $45, 000 $24, 414( P / F ,5%,1)


$22, 667( P / F ,5%, 2) $20,969( P / F ,5%,3)
$16,925 0
14-12

14.19 (a) and (b)

0 1 2
Income Statement
$114,000 $114,000
Revenues
Expenses
O & M $56,490 $59,315
CCA $8,250 $14,025
Interest $5,000 $7,381

Taxable Income $44,260 $33,280


Income Taxes $17,704 $13,312

Net Income $26,556 $19,968

Cash Flow Statement


Operating Activities
Net Income $26,556 $19,968
CCA $8,250 $14,025
Investment Activities
Investment/Salvage ($55,000) $29,768
Disposal Tax Effect $1,183
Working Capital ($12,000) ($600) $12,600
Loan Repayment $50,000 ($23,810) ($26,190)

Net Cash Flow (Actual) ($17,000) $10,396 $51,353


Net Cash Flow (Constant) ($17,000) $9,901 $46,578

PW(18%), Actual Dollars: $28,691


PW(18%), Constant Dollars: $24,843
14-13

14.20 * (a)

0 1 2 3 4 5 6
Income Statement
$152,250 $159,863 $167,856 $185,061 $194,314
Revenues $176,248
Expenses
$104,655 $109,888
O & M $86,100 $90,405 $94,925 $99,672
CCA $27,000 $41,850 $23,018 $12,660 $6,963 $3,830
Interest $10,800 $10,800

Taxable Income $28,350 $16,808 $49,913 $63,917 $73,443 $80,596


Income Taxes $11,340 $6,723 $19,965 $25,567 $29,377 $32,239

Net Income $17,010 $10,085 $29,948 $38,350 $44,066 $48,358

Cash Flow Statement


Operating Activities
Net Income $17,010 $10,085 $29,948 $38,350 $44,066 $48,358
CCA $27,000 $41,850 $23,018 $12,660 $6,963 $3,830
Investment Activities
($120,000
Investment/Salvage ) $20,101
Disposal Tax Effect ($6,168)
Working Capital
$120,000 ($120,000
Loan Repayment )

Net Cash Flow (Actual) $0 $44,010 ($68,066) $52,965 $51,010 $51,029 $66,121

PW(18%), Actual Dollars: $93,758


PW(12.38%), Actual Dollars: $115,856
14-14

* (b)

0 1 2 3 4 5 6
Income Statement
$145,000 $145,000 $145,000 $145,000
Revenues $145,000 $145,000
Expenses
O & M $82,000 $82,000 $82,000 $82,000 $82,000 $82,000
CCA $27,000 $41,850 $23,018 $12,660 $6,963 $3,830
Interest $10,800 $10,800

Taxable Income $25,200 $10,350 $39,983 $50,340 $56,037 $59,170


Income Taxes $10,080 $4,140 $15,993 $20,136 $22,415 $23,668

Net Income $15,120 $6,210 $23,990 $30,204 $33,622 $35,502

Cash Flow Statement


Operating Activities
Net Income $15,120 $6,210 $23,990 $30,204 $33,622 $35,502
CCA $27,000 $41,850 $23,018 $12,660 $6,963 $3,830
Investment Activities
Investment/Salvage ($120,000) $15,000
Disposal tax effect ($4,128)
Working Capital
Loan Repayment $120,000 ($120,000)

Net Cash Flow (Constant) $0 $42,120 ($71,940) $47,007 $42,864 $40,585 $50,204

PW(18%), Constant Dollars: $71,085


PW(12.38%), Constant Dollars: $88,074

(c) Present value gain (or loss) due to inflation:

0.18 0.05
i 12.38%
1 0.05
PW (12.38%) no inflation $88, 074
PW (18%) with inflation $93, 758
present value gain = $93,758 - $88,074
=$5,684

(d) Present value gain due to borrowing:


14-15

Net Financing Cost Net


n Principal Interest (A/T) Loan Flow
0 +$120,000 +$120,000
1 -(1-0.4)(10,800) -$6,480
2 -$120,000 -(1-0.4)(10,800) -$126,480

PW (18%) Loan $120, 000 $6, 480( P / F ,18%,1)


$126, 480( P / F ,18%, 2)
$23, 673

Comments: The present value gain is possible here due to the fact that the
firm was able to finance the project at a lower interest rate than its MARR. In
practice, the lenders would raise their lending rates under inflationary
economy, so that it is not likely to realize a significant gain.
14-16

14.21 (a)

0 1 2 3 4 5
Income Statement
Revenues $15,750 $18,743 $16,207 $17,017 $17,868
Expenses
O & M $0 $0 $0 $0 $0
CCA $2,000 $3,600 $2,880 $2,304 $1,843
Interest $2,000 $3,396 $731

Taxable Income $11,750 $11,747 $12,596 $14,713 $16,025


Income Taxes $4,700 $4,699 $5,038 $5,885 $6,410

Net Income $7,050 $7,048 $7,557 $8,828 $9,615

Cash Flow Statement


Operating Activities
Net Income $7,050 $7,048 $7,557 $8,828 $9,615
CCA $2,000 $3,600 $2,880 $2,304 $1,843
Investment Activities
Investment/Salvage ($20,000) $2,553
Disposal Tax Effect $1,928
Working Capital
Loan Repayment $20,000 ($6,042) ($6,647) ($7,311)

Net Cash Flow (Actual) $0 $3,008 $4,001 $3,126 $11,132 $15,939

PW(20%), Actual Dollars: $18,868


PW(14.29%), Actual Dollars: $22,490
14-17

(b)
0 1 2 3 4 5
Income Statement
Revenues $15,000 $17,000 $14,000 $14,000 $14,000
Expenses:
O&M $0 $0 $0 $0 $0
CCA $2,000 $3,600 $2,880 $2,304 $1,843
Interest $2,000 $3,396 $731

Taxable Income $11,000 $10,004 $10,389 $11,696 $12,157


Income Taxes $4,400 $4,002 $4,156 $4,678 $4,863

Net Income $6,600 $6,002 $6,233 $7,018 $7,294

Cash Flow Statement


Operating Activities
Net Income $6,600 $6,002 $6,233 $7,018 $7,294
CCA $2,000 $3,600 $2,880 $2,304 $1,843
Investment Activities
Investment/Salvage ($20,000) $2,000
Disposal Tax Effect $2,149
Working Capital
Loan Repayment $20,000 ($6,042) ($6,647) ($7,311)

Net Cash Flow (Constant) $0 $2,558 $2,955 $1,802 $9,322 $13,286

PW(20%), Constant Dollars: $15,062


PW(14.29%), Constant Dollars: $17,987

(c) Present Value Gain: $881


14-18

14.22 (a) and (b)

0 1 2 3
Income Statement
$84,000 $88,200
Revenues $92,610
Expenses
O & M
$22,500 $38,250
CCA $26,775
Interest

$61,500 $49,950
Taxable Income $65,835
$24,600 $19,980
Income Taxes $26,334

$36,900 $29,970
Net Income $39,501

Cash Flow Statement


Operating Activities
$36,900 $29,970
Net Income $39,501
$22,500 $38,250
CCA $26,775
Investment Activities
($150,000
Investment/Salvage ) $80,000
Disposal Tax Effect ($7,010)
Working Capital ($10,000) ($800) ($864) $11,664
Loan Repayment

($160,000 $58,600 $67,356 $150,930


Net Cash Flow (Actual) )
Net Cash Flow (Constant ($160,000 $55,283 $59,947 $126,724
) )

PW(20%), Actual Dollars: $22,952


PW(20%), Constant Dollars: $1,034
14-19

Rate of Return Analysis Under Inflation


14.23 (a)

0 1 2 3 4 5 6 7 8
Income Statement
Revenues $20,000 $20,000 $20,000 $20,000 $20,000 $20,000 $20,000 $20,000
Expenses
O&M $8,000 $8,000 $8,000 $8,000 $8,000 $8,000 $8,000 $8,000
CCA $7,500 $12,750 $8,925 $6,248 $4,373 $3,061 $2,143 $1,500
Interest

Taxable Income $4,500 ($750) $3,075 $5,753 $7,627 $8,939 $9,857 $10,500
Income Taxes $1,575 ($263) $1,076 $2,013 $2,669 $3,129 $3,450 $3,675

Net Income $2,925 ($488) $1,999 $3,739 $4,957 $5,810 $6,407 $6,825

Cash Flow Statement


Operating Activities
Net Income $2,925 ($488) $1,999 $3,739 $4,957 $5,810 $6,407 $6,825
CCA $7,500 $12,750 $8,925 $6,248 $4,373 $3,061 $2,143 $1,500
Investment Activities
Investment/Salvage ($50,000) $5,000
Disposal Tax Effect ($525)
Working Capital ($10,000) $10,000

Net Cash Flow (Actual) ($60,000) $10,425 $12,263 $10,924 $9,987 $9,331 $8,871 $8,550 $22,800

PW(12.38%), Actual Dollars: ($4,709)


IRR(%) = 10.20%
14-20

(b)
0 1 2 3 4 5 6 7 8
Income Statement
Revenues $21,600 $23,328 $25,194 $27,210 $29,387 $31,737 $34,276 $37,019
Expenses
O&M $8,480 $8,989 $9,528 $10,100 $10,706 $11,348 $12,029 $12,751
CCA $7,500 $12,750 $8,925 $6,248 $4,373 $3,061 $2,143 $1,500
Interest

Taxable Income $5,620 $1,589 $6,741 $10,862 $14,308 $17,328 $20,105 $22,768
Income Taxes $1,967 $556 $2,359 $3,802 $5,008 $6,065 $7,037 $7,969

Net Income $3,653 $1,033 $4,382 $7,061 $9,300 $11,263 $13,068 $14,799

Cash Flow Statement


Operating Activities
Net Income $3,653 $1,033 $4,382 $7,061 $9,300 $11,263 $13,068 $14,799
CCA $7,500 $12,750 $8,925 $6,248 $4,373 $3,061 $2,143 $1,500
Investment Activities
Investment/Salvage ($50,000) $7,387
Disposal Tax Effect ($1,361)
Working Capital ($10,000) ($800) ($864) ($933) ($1,008) ($1,088) ($1,175) ($1,269) $17,138
Loan Repayment

Net Cash Flow (Constant) ($60,000) $10,353 $12,919 $12,374 $12,300 $12,585 $13,149 $13,941 $39,464

PW(18%), Constant Dollars: ($2,826)


IRR' (%) = 16.70%
14-21

14.24 (a) and (b)

0 1 2 3 4 5 6
Income Statement
Revenues $30,000 $35,000 $55,000 $70,000 $70,000 $60,000
Expenses
Rental $9,600 $9,600 $9,600 $9,600 $9,600 $9,600
O & M $15,000 $21,000 $25,000 $30,000 $30,000 $30,000
CCA $4,583 $8,403 $7,002 $5,835 $4,863 $4,052
Interest

Taxable Income $817 ($4,003) $13,398 $24,565 $25,537 $16,348


Income Taxes $245 ($1,201) $4,019 $7,369 $7,661 $4,904

Net Income $572 ($2,802) $9,378 $17,195 $17,876 $11,443

Cash Flow Statement


Operating Activities
Net Income $572 ($2,802) $9,378 $17,195 $17,876 $11,443
CCA $4,583 $8,403 $7,002 $5,835 $4,863 $4,052
Investment Activities
Investment/Salvage ($55,000) $13,401
Disposal Tax Effect $2,058
Working Capitol
Loan Repayment

Net Cash Flow (Actual) ($55,000) $5,155 $5,601 $16,381 $23,031 $22,739 $30,955
Net Cash Flow (Constant) ($55,000) $4,910 $5,080 $14,150 $18,947 $17,816 $23,099

PW(10%), Actual Dollars: $13,945


PW10%), Constant Dollars: $1,336
IRR'(%) = 10.65%
14-22

14.25
(a) Real after-tax yield on bond investment:

Provincial bond:

0.09 1 0.5 0.03


iprovincial 1.456%
1 0.03

Corporate bond:

10000
PE 10000 1200 1 0.5 P / A, i,5
1 /
5

i 6.000%
1 0.06

ccorporate 1 2.913%
1 0.03

The corporate bond provides a greater return on investment.

(b) Given z 6% f 3%
0.06 1 0.5 0.03

isavings 0%
1 0.03

Since both iprovincial and icorporate


are 0%, both investments are better than the
savings account. Moreover, since icorporate i provincial , the corporate bond is clearly
the best choice out of the three.
14-23

14.26 (a), (b), and (c)

Engine A 0 1 2 3 4 5
Income Statement
Revenues
Expenses
O&M ($216,000) ($233,280) ($251,942) ($272,098) ($293,866)
CCA $12,500 $21,875 $16,406 $12,305 $9,229
Interest

Taxable Income ($228,500) ($255,155) ($268,349) ($284,402) ($303,094)


Income Taxes ($91,400) ($102,062) ($107,339) ($113,761) ($121,238)

Net Income ($137,100) ($153,093) ($161,009) ($170,641) ($181,856)

Cash Flow Statement


Operating Activities
Net Income ($137,100) ($153,093) ($161,009) ($170,641) ($181,856)
CCA $12,500 $21,875 $16,406 $12,305 $9,229
Investment Activities
Investment/Salvage ($100,000) $40,000
Disposal Tax Effect ($4,926)
Working Capital
Loan Repayment

Net Cash Flow (Constant) ($100,000) ($124,600) ($131,218) ($144,603) ($158,337) ($137,554)

PW(20%), Constant Dollars: ($510,277)


FW(20%), Constant Dollars: ($1,269,733)
AE(20%), Constant Dollars: ($170,626)
14-24

(a), (b), and (c) contd


Engine B 0 1 2 3 4 5
Income Statement
Revenues
Expenses:
O & M ($138,240) ($149,299) ($161,243) ($174,143) ($188,074)
CCA $25,000 $43,750 $32,813 $24,609 $18,457
Interest

Taxable Income ($163,240) ($193,049) ($194,056) ($198,752) ($206,531)


Income Taxes ($65,296) ($77,220) ($77,622) ($79,501) ($82,612)

Net Income ($97,944) ($115,830) ($116,433) ($119,251) ($123,919)

Cash Flow Statement


Operating activities
Net income ($97,944) ($115,830) ($116,433) ($119,251) ($123,919)
CCA $25,000 $43,750 $32,813 $24,609 $18,457
Investment Activities
Investment/Salvage ($200,000) $80,000
Disposal Tax Effect ($9,852)
Working Capital
Loan Repayment

Net Cash Flow (Constant) ($200,000) ($72,944) ($72,080) ($83,621) ($94,642) ($35,313)

PW(20%), Constant Dollars: ($419,066)


FW(20%), Constant Dollars: ($1,042,771)
AE(20%), Constant Dollars: ($140,127)
Solution: Choose Engine B.
14-25

14.27 (a) and (b)

0 1 2
Income Statement
$126,000 $132,300
Revenues
Expenses
O & M $62,400 $64,896
CCA $9,000 $15,300
Interest

Taxable Income $54,600 $52,104


Income Taxes $16,380 $15,631

Net Income $38,220 $36,473

Cash Flow Statement


Operating Activities
Net Income $38,220 $36,473
CCA $9,000 $15,300
Investment Activities
Investment/Salvage ($60,000) $40,000
Disposal Tax Effect ($1,290)
Working Capital ($5,000) ($200) $5,200
Loan Repayment

Net Cash Flow (Actual) ($65,000) $47,020 $95,683


Net Cash Flow (Constant
) ($65,000) $43,537 $82,033

PW(15%), Actual Dollars: $48,237


PW(15%), Constant Dollars: $34,887
IRR(%) = 62.77%
IRR'(%) = 50.72%

(c) Given f 8%, i 15%

0.15 0.08
i 6.48% (Inflation-free MARR)
1 0.08

Since IRR (50.72%) > 6.48%, the project is a profitable one.


14-26

14.28 (a) and (b)


0 1 2 3 4 5 6
Income Statement
Revenues $84,800 $89,888 $95,281 $100,998 $107,058 $113,482
Expenses
O & M
CCA $15,000 $25,500 $17,850 $12,495 $8,747 $6,123
Interest

Taxable Income $69,800 $64,388 $77,431 $88,503 $98,312 $107,359


Income Taxes $27,920 $25,755 $30,973 $35,401 $39,325 $42,944

Net Income $41,880 $38,633 $46,459 $53,102 $58,987 $64,415

Cash Flow Statement


Operating Activities
Net Income $41,880 $38,633 $46,459 $53,102 $58,987 $64,415
CCA $15,000 $25,500 $17,850 $12,495 $8,747 $6,123
Investment Activities
Investment/Salvage ($100,000) $42,556
Disposal Tax Effect ($11,308)
Working Capital
Loan Repayment

Net Cash Flow (Actual) ($100,000) $56,880 $64,133 $64,309 $65,597 $67,733 $101,786
Net Cash Flow (Constant) ($100,000) $53,660 $57,078 $53,995 $51,959 $50,614 $71,755

PW(18%), Actual Dollars: $134,549


PW(18%), Constant Dollars: $94,834

IRR(%) = 59.24%
IRR'(%) = 50.22%
14-27

(c)
0 1 2 3 4 5 6
Income Statement
Revenues $84,800 $89,888 $95,281 $100,998 $107,058 $113,482
Expenses
O & M
CCA $15,000 $25,500 $17,850 $12,495 $8,747 $6,123
Interest $12,000 $10,521 $8,865 $7,010 $4,933 $2,606

Taxable Income $57,800 $53,867 $68,566 $81,493 $93,379 $104,753


Income Taxes $23,120 $21,547 $27,426 $32,597 $37,352 $41,901

Net Income $34,680 $32,320 $41,140 $48,896 $56,027 $62,852

Cash Flow Statement


Operating Activities
Net Income $34,680 $32,320 $41,140 $48,896 $56,027 $62,852
CCA $15,000 $25,500 $17,850 $12,495 $8,747 $6,123
Investment Activities
Investment/Salvage ($100,000) $42,556
Disposal Tax Effect ($11,308)
Working Capital
Loan Repayment $100,000 ($12,323) ($13,801) ($15,457) ($17,312) ($19,390) ($21,717)

Net Cash Flow (Actual) $0 $37,357 $44,019 $43,532 $44,078 $45,384 $78,505
Net Cash Flow (Constant) $0 $35,243 $39,177 $36,551 $34,914 $33,914 $55,343
PW(18%), Actual Dollars: $161,421
FW(18%), Actual Dollars: $435,766
AE(18%), Actual Dollars: $46,152
PW(18%), Constant Dollars: $133,582
FW(18%), Constant Dollars: $360,611
AE(18%), Constant Dollars: $38,192
14-28

(d)
0 1 2 3 4 5 6
Income Statement
Revenues $80,000 $80,000 $80,000 $80,000 $80,000 $80,000
Expenses:
O & M
CCA $15,000 $25,500 $17,850 $12,495 $8,747 $6,123
Interest

Taxable Income $65,000 $54,500 $62,150 $67,505 $71,254 $73,877


Income Taxes $26,000 $21,800 $24,860 $27,002 $28,501 $29,551

Net Income $39,000 $32,700 $37,290 $40,503 $42,752 $44,326

Cash Flow Statement


Operating Activities
Net Income $39,000 $32,700 $37,290 $40,503 $42,752 $44,326
CCA $15,000 $25,500 $17,850 $12,495 $8,747 $6,123
Investment Activities
Investment/Salvage ($100,000) $30,000
Disposal Tax Effect ($6,286)
Working Capital
Loan Repayment

Net Cash Flow (Actual) ($100,000) $54,000 $58,200 $55,140 $52,998 $51,499 $74,163
PW(11.32%) Actual Dollars: $139,049; IRR(%) = 51.19%; Present Value Loss = $139,049 - $134,549 = ($4,500)

(e) Required additional before-tax annual revenue in actual dollars (equal amount) to make-up the inflation loss.

$4500( A / P,18%, 6)
$2,144
1 0.40
14-29

Short Case Studies


ST14.1 (a) and (b)

0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues $80,000 $80,000 $80,000 $80,000 $80,000 $80,000 $80,000 $80,000 $80,000 $80,000
Expenses
O & M $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000
Labour $15,000 $15,000 $15,000 $15,000 $15,000 $15,000 $15,000 $15,000 $15,000 $15,000
Material $9,000 $9,000 $9,000 $9,000 $9,000 $9,000 $9,000 $9,000 $9,000 $9,000
Energy $4,500 $4,500 $4,500 $4,500 $4,500 $4,500 $4,500 $4,500 $4,500 $4,500
CCA
Equipment $16,500 $28,050 $19,635 $13,745 $9,621 $6,735 $4,714 $3,300 $2,310 $1,617
Tools $5,000 $5,000 $0 $0 $0 $5,000 $5,000 $0 $0 $0

Taxable Income $27,000 $15,450 $28,865 $34,756 $38,879 $36,765 $38,786 $45,200 $46,190 $46,883
Income Taxes $9,450 $5,408 $10,103 $12,164 $13,608 $12,868 $13,575 $15,820 $16,166 $16,409

Net Income $17,550 $10,043 $18,762 $22,591 $25,271 $23,897 $25,211 $29,380 $30,023 $30,474

Cash Flow Statement


Operating Activities
Net Income $17,550 $10,043 $18,762 $22,591 $25,271 $23,897 $25,211 $29,380 $30,023 $30,474
CCA $21,500 $33,050 $19,635 $13,745 $9,621 $11,735 $9,714 $3,300 $2,310 $1,617
Investment Activities
Investment/Salvage
Equipment ($110,000) $10,000
Tools ($10,000) $300
Replacement ($10,000) $300
14-30

Disposal Tax Effect


Equipment ($2,179)
Tools ($105) ($105)
Working Capitol

Net Cash Flow (Actual) ($120,000) $39,050 $43,093 $38,397 $36,336 $25,087 $35,632 $34,925 $32,680 $32,334 $40,107

PW(11.32%), Actual Dollars: $91,127


FW(11.32%), Actual Dollars: $266,323
AE(11.32%), Actual Dollars: $24,935
IRR(%) = 28.52%
14-31

(c) and (d)


0 1 2 3 4 5 6 7 8 9 10
Income Statement
Revenues $85,600 $91,592 $98,003 $104,864 $112,204 $120,058 $128,463 $137,455 $147,077 $157,372
Expenses
Operating costs $3,090 $3,183 $3,278 $3,377 $3,478 $3,582 $3,690 $3,800 $3,914 $4,032
Labour $15,750 $16,538 $17,364 $18,233 $19,144 $20,101 $21,107 $22,162 $23,270 $24,433
Material $9,360 $9,734 $10,124 $10,529 $10,950 $11,388 $11,843 $12,317 $12,810 $13,322
Energy $4,635 $4,774 $4,917 $5,065 $5,217 $5,373 $5,534 $5,700 $5,871 $6,048
CCA
Equipment $16,500 $28,050 $19,635 $13,745 $9,621 $6,735 $4,714 $3,300 $2,310 $1,617
Tools $5,000 $5,000 $0 $0 $0 $5,000 $5,000 $0 $0 $0

Taxable Income $31,265 $24,313 $42,685 $53,917 $63,794 $67,879 $76,574 $90,175 $98,901 $107,920
Income Taxes $10,943 $8,510 $14,940 $18,871 $22,328 $23,758 $26,801 $31,561 $34,615 $37,772

Net Income $20,322 $15,804 $27,745 $35,046 $41,466 $44,121 $49,773 $58,614 $64,286 $70,148

Cash Flow Statement


Operating Activities
Net Income $20,322 $15,804 $27,745 $35,046 $41,466 $44,121 $49,773 $58,614 $64,286 $70,148
CCA $21,500 $33,050 $19,635 $13,745 $9,621 $11,735 $9,714 $3,300 $2,310 $1,617
Investment Activities
Investment/Salvage
Equipment ($110,000) $10,000
Tools ($10,000) $300
Replacement ($10,000) $300
Disposal Tax Effect
Equipment ($2,179)
Tools ($105) ($105)
Working Capital
14-32

Net Cash Flow (Actual) ($120,000) $41,822 $48,854 $47,380 $48,790 $41,282 $55,856 $59,488 $61,914 $66,596 $79,781
Net Cash Flow (Constant) ($120,000) $39,455 $43,480 $39,781 $38,646 $30,849 $39,376 $39,563 $38,846 $39,418 $44,549
PW(18%), Actual Dollars: $108,671
FW(18%), Actual Dollars: $568,764
AE(18%), Actual Dollars: $24,181
IRR(%) = 38.52%

PW(18%), Constant Dollars: $57,032


FW(18%), Constant Dollars: $298,494
AE(18%), Constant Dollars: $12,690
IRR'(%) = 30.68%

(e) Economic loss (or gain) in present worth due to inflation = $108,671 $91,127 = $17,544
14-33

ST14.2 (a) and (b)


2011 2012 2013 2014
-2 -1 0 1
Income Statement
Revenues
Sales Unit $2,000
Unit Price $95,000
$190,000,000
Sales Volume
Expenses
Fixed Costs $5,000,000
$114,000,000
Variable Costs
CCA
Building $100,000
Equipment $1,200,000
Amortization $250,000

Taxable Income $69,450,000


Income Taxes $27,780,000

Net Income $41,670,000

Cash Flow Statement


Operating Activities
Net Income $41,670,000
CCA $1,300,000
Amortization $250,000
Investment Activities
Investment/Salvage
Opportunity Cost* ($600,000)
14-34

Land ($1,500,000)
Building ($1,000,000) ($4,000,000)
Equipment ($8,500,000)
Disposal Tax Effect
Land
Building
Equipment
Working Capital ($1,000,000) ($1,425,000)
Loan Repayment

Net Cash Flow (Actual) ($2,100,000) ($1,000,000) ($13,500,000) $41,795,000


Net Cash Flow (Constant) ($1,227,827) ($556,837) ($7,159,338) $21,109,315
14-35

(a) and (b) contd.

2015 2016 2017 2018 2019


2 3 4 5 6
Income Statement
Revenues
Sales Unit $2,000 $2,000 $2,000 $2,000 $2,000
Unit Price $99,750 $104,738 $109,974 $115,473 $121,247
Sales Volume $199,500,000 $209,475,000 $219,948,750 $230,946,188 $242,493,497
Expenses
Fixed Costs $5,250,000 $5,512,500 $5,788,125 $6,077,531 $6,381,408
Variable Costs $119,700,000 $125,685,000 $131,969,250 $138,567,713 $145,496,098
CCA
Building $196,000 $188,160 $180,634 $173,408 $166,472
Equipment $2,040,000 $1,428,000 $999,600 $699,720 $489,804
Amortization $250,000 $250,000 $250,000 $250,000 $250,000

Taxable Income $72,064,000 $76,411,340 $80,761,141 $85,177,815 $89,709,715


Income Taxes $28,825,600 $30,564,536 $32,304,457 $34,071,126 $35,883,886

Net Income $43,238,400 $45,846,804 $48,456,685 $51,106,689 $53,825,829

Cash Flow Statement


Operating Activities
Net Income $43,238,400 $45,846,804 $48,456,685 $51,106,689 $53,825,829
CCA $2,236,000 $1,616,160 $1,180,234 $873,128 $656,276
Amortization $250,000 $250,000 $250,000 $250,000 $250,000
Investment Activities
Investment/Salvage
Opportunity Cost*
Land $2,000,000
14-36

Building $3,000,000
Equipment $1,500,000
Disposal Tax Effect
Land ($560,000)
Building $398,130
Equipment $57,150
Working Capital ($1,496,250) ($1,571,063) ($1,649,616) ($1,732,096) ($8,874,025)
Loan Repayment

Net Cash Flow (Actual) $44,228,150 $46,141,902 $48,237,303 $50,497,721 $52,253,361


Net Cash Flow (Constant) $21,274,496 $21,138,137 $21,045,775 $20,982,846 $20,678,429

PW(20%), Constant Dollars: $60,509,246


IRR(%) = 148.68%
IRR' (%) = 136.83%

Note: If the firm decides not to invest in the project, the firm could write off the R&D expenditure.
This results in an opportunity cost in the amount of (0.40)($1,500,000) = $600,000.