1.

The Balboa Bottling Company is contemplating the replacement of one of its bottling machines with
a newer and more efficient one. The old machine has a book value of $600,000 and a remaining
useful life of 5 years. The firm does not expect to realize any return from scrapping the old machine
in 5 years, but it can sell it now to another firm in the industry for $265,000. The old machine is
being depreciated by $120,000 per year, using the straight-line method.
The new machine has a purchase price of $1,175,000, an estimated useful life and MACRS class life
of 5 years, and an estimated salvage value of $145,000. The applicable depreciation rates are 20%,
32%, 19%, 12%, 11%, and 6%. It is expected to economize on electric power usage, labor, and repair
costs, as well as to reduce the number of defective bottles. In total, an annual savings of $255,000
will be realized if the new machine is installed. The company’s marginal tax rate is 35%, and it has a
12% WACC.
a. What is the initial net cash flow if the new machine is purchased and the old one is replaced?
b. Calculate the annual depreciation allowances for both machines, and compute the change in
the annual depreciation expense if the replacement is made.
c. What are the incremental net cash flows in Years 1 through 5?
d. Should the firm purchase the new machine? Support your answer.
e. In general, how would each of the following factors affect the investment decision, and how
should each be treated?
i. The expected life of the existing machine decreases.
ii. The WACC is not constant but is increasing as Balboa adds more projects into its
capital budget for the year.

2. Madison Manufacturing is considering a new machine that costs $250,000 and would reduce pre-
tax manufacturing costs by $90,000 annually. Madison would use the 3-year MACRS method to
depreciate the machine, and management thinks the ma- chine would have a value of $23,000 at
the end of its 5-year operating life. The applicable depreciation rates are 33%, 45%, 15%, and 7%.
Working capital would increase by $25,000 initially, but it would be recovered at the end of the
project’s 5-year life. Madison’s marginal tax rate is 40%, and a 10% WACC is appropriate for the
project.
a. Calculate the project’s NPV, IRR, MIRR, and payback.
b. Assume management is unsure about the $90,000 cost savings—this figure could deviate by as
much as plus or minus 20%. What would the NPV be under each of these extremes?
c. Suppose the CFO wants you to do a scenario analysis with different values for the cost savings,
the machine’s salvage value, and the working capital (WC) requirement. She asks you to use
the following probabilities and values in the scenario analysis:

 Scenario Probability Cost savings alvage value WC
Worst case 0.35 72,000 18,000 30,000
Base case 0.35 90,000 23000 25,000
Best case 0.35 108,000 28000 20,000
Calculate the project’s expected NPV, its standard deviation, and its coefficient of variation. Would
you recommend that the project be accepted?

3. The Rodriguez Company is considering an average-risk investment in a mineral water spring project
that has a cost of $150,000. The project will produce 1,000 cases of mineral water per year
indefinitely. The current sales price is $138 per case, and the current cost per case is $105. The firm
is taxed at a rate of 34%. Both prices and costs are expected to rise at a rate of 6% per year. The
firm uses only equity, and it has a cost of capital of 15%. Assume that cash flows consist only of
after-tax profits, since the spring has an indefinite life and will not be depreciated.
a. Should the firm accept the project? (Hint: The project is perpetuity, so you must use the
formula for perpetuity to find its NPV.)
b. Suppose that total costs consisted of a fixed cost of $10,000 per year plus variable costs of $95
per unit, and suppose that only the variable costs were expected to increase with inflation.
Would this make the project better or worse? Continue to assume that the sales price will rise
with inflation.
4. You have been asked by the president of your company to evaluate the proposed acquisition of a
new spectrometer for the firm’s R&D department. The equipment’s basic price is $70,000, and it
would cost another $15,000 to modify it for special use by your firm. The spectrometer, which falls
into the MACRS 3-year class, would be sold after 3 years for $30,000. Use of the equipment would
require an increase in net working capital (spare parts inventory) of $4,000. The spectrometer
would have no effect on revenues, but it is expected to save the firm $25,000 per year in before-tax
operating costs, mainly labor. The firm’s marginal federal-plus-state tax rate is 40%.
a. What is the net cost of the spectrometer? (That is, what is the Year-0 net cash flow?)
b. What are the net operating cash flows in Years 1, 2, and 3?
c. What is the additional (non-operating) cash flow in Year 3?
d. If the project’s cost of capital is 10%, should the spectrometer be purchased?
5. The Everly Equipment Company purchased a machine 5 years ago at a cost of $90,000. The machine
had an expected life of 10 years at the time of purchase, and it is being depreciated by the straight-
line method by $9,000 per year. If the machine is not replaced, it can be sold for $10,000 at the end
of its useful life.
A new machine can be purchased for $150,000, including installation costs. During its 5-year life, it
will reduce cash operating expenses by $50,000 per year. Sales are not expected to change. At the
 end of its useful life, the machine is estimated to be worthless. MACRS depreciation will be used,
and the machine will be depreciated over its 3-year class life rather than its 5-year economic life, so
the applicable depreciation rates are 33%, 45%, 15%, and 7%.
The old machine can be sold today for $55,000. The firm’s tax rate is 35%, and the appropriate
WACC is 16%.
a. If the new machine is purchased, what is the amount of the initial cash flow at Year 0?
b. What are the incremental net cash flows that will occur at the end of Years 1 through 5?
c. What is the NPV of this project? Should Everly replace the old machine?

6. The Taylor Toy Corporation currently uses an injection-molding machine that was purchased 2
years ago. This machine is being depreciated on a straight-line basis, and it has 6 years of remaining
life. Its current book value is $2,100, and it can be sold for $2,500 at this time. Thus, the annual
depreciation expense is $2,100/6 = $350 per year. If the old machine is not replaced, it can be sold
for $500 at the end of its useful life.
Taylor is offered a replacement machine that has a cost of $8,000, an estimated useful life of 6
years, and an estimated salvage value of $800. This machine falls into the MACRS 5-year class, so
the applicable depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. The replacement machine
would permit an output expansion, so sales would rise by $1,000 per year; even so, the new
machine’s much greater efficiency would reduce operating expenses by $1,500 per year. The new
machine would require that inventories be increased by $2,000, but accounts payable would
simultaneously increase by $500. Taylor’s marginal federal-plus-state tax rate is 40%, and its WACC
is 15%. Should it replace the old machine?

7. The Yoran Yacht Company (YYC), a prominent sailboat builder in Newport, may design a new 30-
foot sailboat based on the “winged” keels first introduced on the 12-meter yachts that raced for the
America’s Cup.
First, YYC would have to invest $10,000 at t = 0 for the design and model tank testing of the new
boat. YYC’s managers believe there is a 60% probability that this phase will be successful and the
project will continue. If Stage 1 is not successful, the project will be abandoned with zero salvage
value.
The next stage, if undertaken, would consist of making the molds and producing two prototype
boats. This would cost $500,000 at t = 1. If the boats test well, YYC would go into production. If they
do not, the molds and prototypes could be sold for $100,000. The managers estimate the
probability is 80% that the boats will pass testing and that Stage 3 will be undertaken.
Stage 3 consists of converting an unused production line to produce the new design. This would
cost $1 million at t = 2. If the economy is strong at this point, the net value of sales would be $3
 million; if the economy is weak, the net value would be $1.5 million. Both net values occur at t = 3,
and each state of the economy has a probability of 0.5. YYC’s corporate cost of capital is 12%.
a. Assume this project has average risk. Construct a decision tree and determine the project’s
expected NPV.
b. Find the project’s standard deviation of NPV and coefficient of variation of NPV. If YYC’s
average project had a CV of between 1.0 and 2.0, would this project be of high, low, or average
stand-alone risk?

8. Temple Corp. is considering a new project whose data are shown below. The equipment that
would be used has a 3-year tax life, would be depreciated by the straight-line method over its
3-year life, and would have a zero salvage value. No new working capital would be required.
Revenues and other operating costs are expected to be constant over the project’s 3-year life.
What is the project’s NPV?
Risk-adjusted WACC 10.0%
Net investment cost (depreciable basis) $65,000
Straight-line depreciation rate 33.3333%
Sales revenues, each year $65,500
Operating costs (excl. depreciation), each year $25,000
Tax rate 35.0%

9. TexMex Food Company is considering a new salsa whose data are shown below. The
equipment to be used would be depreciated by the straight-line method over its 3-year life and
would have a zero salvage value, and no new working capital would be required. Revenues
and other operating costs are expected to be constant over the project’s 3-year life. However,
this project would compete with other TexMex products and would reduce their pre-tax
annual cash flows. What is the project’s NPV? (Hint: Cash flows are constant in Years 1-3.)
WACC 10.0%
Pre-tax cash flow reduction for other products (cannibalization) $5,000
Investment cost (depreciable basis) $80,000
Straight-line depreciation rate 33.333%
Sales revenues, each year for 3 years $67,500
Annual operating costs (excl. depreciation) $25,000
Tax rate 35.0%
10. Sub-Prime Loan Company is thinking of opening a new office, and the key data are shown
below. The company owns the building that would be used, and it could sell it for $100,000
after taxes if it decides not to open the new office. The equipment for the project would be
depreciated by the straight-line method over the project’s 3-year life, after which it would be
 worth nothing and thus it would have a zero salvage value. No new working capital would be
required, and revenues and other operating costs would be constant over the project’s 3-year
life. What is the project’s NPV? (Hint: Cash flows are constant in Years 1-3.)
WACC 10.0%
Opportunity cost $100,000
Net equipment cost (depreciable basis) $65,000
Straight-line depreciation rate for equipment 33.333%
Sales revenues, each year $123,000
Operating costs (excl. depreciation), each year $25,000
Tax rate 35%
11. Foley Systems is considering a new investment whose data are shown below. The equipment
would be depreciated on a straight-line basis over the project’s 3-year life, would have a zero
salvage value, and would require some additional working capital that would be recovered at
the end of the project’s life. Revenues and other operating costs are expected to be constant over
the project’s life. What is the project’s NPV? (Hint: Cash flows are constant in Years 1 to 3.)
WACC 10.0%
Net investment in fixed assets (basis) $75,000
Required new working capital $15,000
Straight-line depreciation rate 33.333%
Sales revenues, each year $75,000
Operating costs (excl. depreciation), each year $25,000
Tax rate 35.0%
12. Thomson Media is considering some new equipment whose data are shown below. The
equipment has a 3-year tax life and would be fully depreciated by the straight-line method over
3 years, but it would have a positive pre-tax salvage value at the end of Year 3, when the
project would be closed down. Also, some new working capital would be required, but it would
be recovered at the end of the project’s life. Revenues and other operating costs are expected
to be constant over the project’s 3-year life. What is the project’s NPV?
WACC 10.0%
Net investment in fixed assets (depreciable basis) $70,000
Required new working capital $10,000
Straight-line depreciation rate 33.333%
Sales revenues, each year $75,000
Operating costs (excl. depreciation), each year $30,000
Expected pretax salvage value $5,000
Tax rate 35.0%
13. Desai Industries is analyzing an average-risk project, and the following data have been
developed. Unit sales will be constant, but the sales price should increase with inflation. Fixed
costs will also be constant, but variable costs should rise with inflation. The project should last
for 3 years, it will be depreciated on a straight-line basis, and there will be no salvage value.
This is just one of many projects for the firm, so any losses can be used to offset gains on other
firm projects. What is the project’s expected NPV?
WACC 10.0%
Net investment cost (depreciable basis) $200,000
Units sold 50,000
Average price per unit, Year 1 $25.00
Fixed op. cost excl. depreciation (constant) $150,000
Variable op. cost/unit, Year 1 $20.20
Annual depreciation rate 33.333%
Expected inflation rate per year 5.00%
Tax rate 40.0%

14. Poulsen Industries is analyzing an average-risk project, and the following data have been
developed. Unit sales will be constant, but the sales price should increase with inflation. Fixed
costs will also be constant, but variable costs should rise with inflation. The project should last
for 3 years, it will be depreciated on a straight-line basis, and there will be no salvage value.
This is just one of many projects for the firm, so any losses can be used to offset gains on other
firm projects. The marketing manager does not think it is necessary to adjust for inflation since
both the sales price and the variable costs will rise at the same rate, but the CFO thinks an
adjustment is required. What is the difference in the expected NPV if the inflation adjustment is
made vs. if it is not made?
WACC 10.0%
Net investment cost (depreciable basis) $200,000
Units sold 50,000
Average price per unit, Year 1 $25.00
Fixed op. cost excl. depreciation (constant) $150,000
Variable op. cost/unit, Year 1 $20.20
Annual depreciation rate 33.333%
Expected inflation 4.00%
Tax rate 35.0%

 15. Aggarwal Enterprises is considering a new project that has a cost of $1,000,000, and the CFO
set up the following simple decision tree to show its three most likely scenarios. The firm could
arrange with its work force and suppliers to cease operations at the end of Year 1 should it
choose to do so, but to obtain this abandonment option, it would have to make a payment to
those parties. How much is the option to abandon worth to the firm?

WACC = 11.5% Dollars in Thousands NPV This Prob. ×
t = 0 t = 1 t = 2 t = 3 State NPV
Prob. = 20% $800.0 $800.0 $800.0 $938.10 $187.62
Prob. = 60% -$1,000 $520.0 $520.0 $520.0 $259.76 $155.86
Prob. = 20% -$200.0 -$200.0 -$200.0 -$1,484.52 -$296.90
Exp. NPV = $ 46.57

16. Florida Car Wash is considering a new project whose data are shown below. The equipment to
be used has a 3-year tax life, would be depreciated on a straight-line basis over the project’s 3-
year life, and would have a zero salvage value after Year 3. No new working capital would be
required. Revenues and other operating costs will be constant over the project’s life, and this
is just one of the firm’s many projects, so any losses on it can be used to offset profits in other
units. If the number of cars washed declined by 40% from the expected level, by how much
would the project’s NPV decline? (Hint: Note that cash flows are constant at the Year 1 level,
whatever that level is.)
WACC 10.0%
Net investment cost (depreciable basis) $60,000
Number of cars washed 2,800
Average price per car $25.00
Fixed op. cost (excl. depreciation) $10,000
Variable op. cost/unit (i.e., VC per car washed) $5.375
Annual depreciation $20,000
Tax rate 35.0%







Answers
1. Answer
a. −$792,750.
b. $115,000; $256,000; $103,250; $21,000; $9,250.
c. $206,000; $255,350; $201,888; $173,100; $287,913.
d. NPV = $11,820.
2. Answer
a. NPV = $37,035.13; IRR = 15.30%;
b. MIRR = 12.81%;
c. Payback = 3.33 years.
d. $77,976; −$3,905.
e. E(NPV) = $34,800;
f. σNPV = $35,968; CV = 1.03.

3. NPV = $106,537.
4. Answer
a. −$89,000 $26,220; $30,300; $20,100. $24,380. NPV = −$6,704;
b. Don’t purchase.
5. Answer
a. −$98,500.
b. $46,675; $52,975; $37,225; $33,025; $22,850.
c. $34,073.
6. NPV of replace = $921.
7. Answer
a. $117,779.
b. σNPV = $445,060;

c. CVNPV = 3.78.

8. WACC 10.0% Years 0 1 2 3

Investment cost -$65,000
Sales revenues $65,500 $65,500 $65,500
− Operating costs (excl. deprec.) 25,000 25,000 25,000
− Depreciation rate = 33.333% 21,667 21,667 21,667
Operating income (EBIT) $18,833 $18,833 $18,833
− Taxes Rate = 35% 6,592 6,592 6,592
After-tax EBIT $12,242 $12,242 $12,242
+ Depreciation 21,667 21,667 21,667
Cash flow -$65,000 $33,908 $33,908 $33,908
NPV $19,325

9. t = 0 t = 1 t = 2 t = 3
Investment (Basis) WACC = 10% -$80,000
Sales revenues $67,500 $67,500 $67,500
− Cannibalization cost 5,000 5,000 5,000
− Operating costs (excl. deprec.) 25,000 25,000 25,000
− Basis x rate = deprec. Rate = 33.33% 26,667 26,667
Operating income (EBIT) $10,833 $10,833 $
− Taxes Rate = 35% 3,792 3,792 3,792
After-tax EBIT $ 7,042 $ 7,042 $ 7,042
+ Depreciation 26,667 26,667 26,667
Cash flow -$80,000 $33,708 $33,708 $33,708
NPV $3,828

10. t = 0 t = 1 t = 2 t = 3
Investment WACC = 10% -$ 65,000
Opportunity cost -100,000
Revenues $123,000 $123,000 $123,000
− Operating costs (excl. deprec.) 25,000 25,000 25,000
− Basis x rate = deprec. Rate = 33.33% 21,667 21,667
Operating income (EBIT) $ 76,333 $ 76,333 $ 76,333
− Taxes Rate = 35% 26,717 26,717 26,717
After-tax EBIT $ 49,617 $ 49,617 $ 49,617
+ Depreciation 21,667 21,667 21,667
Cash flow -$165,000 $ 71,283 $ 71,283 $ 71,283
NPV $12,271

11. t = 0 t = 1 t = 2 t = 3
Investment in fixed assets WACC = 10% -$75,000
Investment in net working capital -$15,000
Sales revenues $75,000 $75,000 $75,000
- Operating costs (excl. deprec.) 25,000 25,000 25,000
Depreciation Rate = 33.333% 25,000 25,000 25,000
Operating income (EBIT) $25,000 $25,000 $25,000
- Taxes Rate = 35% 8,750 8,750 8,750
After-tax EBIT $16,250 $16,250 $16,250
+ Depreciation 25,000 25,000 25,000
Cash flow from operations -$90,000 $41,250 $41,250 $41,250
Recovery of working capital 15,000
Total cash flows -$90,000 $41,250 $41,250 $56,250
NPV $23,852

12. t = 0 t = 1 t = 2 t = 3
Investment in fixed assets WACC = 10% -$70,000
Investment in net working capital -10,000
Sales revenues $75,000 $75,000 $75,000
− Operating costs (excl. deprec.) 30,000 30,000 30,000
Depreciation Rate = 33.333% 23,333 23,333 23,333
Operating income (EBIT) $21,667 $21,667 $21,667
− Taxes Rate = 35% 7,583 7,583 7,583
After-tax EBIT $14,083 $14,083 $14,083
+ Depreciation 23,333 23,333 23,333
 Cash flow from operations -$80,000 $37,417 $37,417 $37,417
Recovery of working capital 10,000
Salvage value, pre-tax 5,000
− Tax on salvage valueRate = 35% 1,750
Total cash flows -$80,000 $37,417 $37,417 $50,667
NPV $23,005

13. Base Case Calculations
t = 0 t = 1 t = 2 t = 3
Investment cost WACC = 10% -$200,000
Inflation 5.0% 5.0% 5.0%
Price per unit $25.00 $26.25 $27.56
VC per unit $20.20 $21.21 $22.27
Units sold 50,000 50,000 50,000

Sales revenues $1,250,000$1,312,500$1,378,125
− Fixed op. cost (excl. deprec.) 150,000 150,000 150,000
− Variable op costs 1,010,000 1,060,500 1,113,525
− Depreciation Rate = 33.333% 66,667 66,667 66,667
Operating income (EBIT) $ 23,333 $ 35,333 $ 47,933
− Taxes Rate = 40% 9,333 14,133 19,173
After-tax EBIT $ 14,000 $ 21,200 $ 28,760
+ Depreciation 66,667 66,667 66,667
Cash flow -$200,000 $ 80,667 $ 87,867 $ 95,427
NPV $17,646


14. NPV with no adjustment
t = 0 t = 1 t = 2 t = 3
Investment cost WACC = 10% -$200,000
Inflation (set to 0%) 0.0% 0.0% 0.0%
Price per unit $25.00 $25.00 $25.00
VC per unit $20.20 $20.20 $20.20
Units sold 50,000 50,000 50,000

Sales revenues $1,250,000$1,250,000$1,250,000
− Fixed op. cost (excl. deprec.) 150,000 150,000 150,000
− Variable op costs per unit = $20.20 1,010,000 1,010,000 1,010,000
− Depreciation Rate = 33.3% 66,667 66,667 66,667
Operating income (EBIT) $ 23,333 $ 23,333 $ 23,333
− Taxes Rate = 35% 8,167 8,167 8,167
After-tax EBIT $ 15,167 $ 15,167 $ 15,167
+ Depreciation 66,667 66,667 66,667
Cash flow -$200,000$ 81,833$ 81,833$ 81,833
NPV w/o infl. adjustment $3,507

NPV with adjustment

t = 0 t = 1 t = 2 t = 3
Investment cost WACC = 10% -$200,000
Inflation 4.0% 4.0% 4.0%
Price per unit $25.00 $26.00 $27.04
 VC per unit $20.20 $21.01 $21.85
Units sold 50,000 50,000 50,000

Sales revenues $1,250,000$1,300,000$1,352,000
− Fixed op. cost (excl. deprec.) 150,000 150,000 150,000
− Variable op costs per unit = $20.20 1,010,000 1,050,400 1,092,416
− Depreciation Rate = 33.3% 66,667 66,667 66,667
Operating income (EBIT) $ 23,333 $ 32,933 $ 42,917
− Taxes Rate = 35% 8,167 11,527 15,021
After-tax EBIT $ 15,167 $ 21,407 $ 27,896
+ Depreciation 66,667 66,667 66,667
Cash flow -$200,000$ 81,833$ 88,073$ 94,563
NPV w/infl. adjustment $18,228
Increase w/infl. adjustment $14,721

15.

NPV Without Abandonment Option
WACC = 11.5% Dollars in Thousands NPV this Prob x
t=0 t= 1 t=2 t=3 State NPV
Prob = 20% $800.0 $800.0 $800.0 $938.10 $187.62
Prob = 60% -$1,000 $520.0 $520.0 $520.0 $259.76 $155.86
Prob = 20% -$200.0 -$200.0 -$200.0 -$1,484.52 -$296.90
Exp. NPV= $46.57
NPV With Abandonment Option
WACC = 11.5% Dollars in Thousands NPV this Prob x
t=0 t= 1 t=2 t=3 State NPV
Prob = 20% $800.0 $800.0 $800.0 $938.10 $187.62
Prob = 60% -$1,000 $520.0 $520.0 $520.0 $259.76 $155.86
Prob = 20% -$200.0 $0.0 $0.0 -$1,179.37 -$235.87
Exp. NPV= $107.60
Value of the abandonment option $61.03