Solutions Manual: Introducing Corporate Finance 2e

Solutions Manual
to accompany
Introducing
Corporate Finance 2e
Diana Beal, Michelle Goyen
Abul Shamsuddin
Prepared by
Michelle Goyen
© John Wiley & Sons Australia, Ltd 2008

Chapter 9: Planning investments — Some real world
complications
End of Chapter Questions
9.1 What is capital rationing and how does it impact on the investment
evaluation process?
Capital rationing is a self-imposed limit that is placed on the size of the capital
budget. This means that the size of the capital budget is constrained by setting a limit
on the amount of funds that can be invested in projects. The impact on the investment
evaluation process is that we need to depart from the capital budgeting rule of
accepting all positive NPV projects. Under capital budgeting, the financial manager
needs to select the set of projects that generates the highest possible NPV for the size
of the capital budget. This could mean that positive NPV projects are rejected, so
capital rationing is inconsistent with maximising shareholder wealth.
9.2 Which projects should be accepted if there are no capital constraints on

the firm?
A firm should adopt all positive NPV projects if there are no capital constraints.
9.3 What is an ‘unconstrained hurdle rate’?
The unconstrained hurdle rate is the return that would be required on all projects in
the absence of capital rationing.
9.4 What are mutually exclusive projects? How are they different to
independent projects?
Mutually exclusive projects either perform the same task or utilise the same scarce
physical resources. Acceptance of one project means that the others must be rejected.
Independent projects can be accepted or rejected without having to accept or reject
some other project (i.e. they are independent of other projects).
9.5 Why is capital rationing a special case of mutual exclusivity?
Capital rationing is a special case of mutual exclusivity because the use of capital to
invest in one project means that other projects cannot be accepted. Under capital
rationing, the projects are competing for the scarce resource of capital.
© John Wiley and Sons Australia, Ltd 2008 9.1

Introducing Corporate Finance 2e Solutions Manual
9.6 How do you choose between mutually exclusive projects that have equal
lives, the same initial outlay and similar cash flow patterns?
You select the project with the highest NPV if the mutually exclusive projects have
equal lives, the same initial outlay and similar cash flow patterns. In other words,
mutually exclusive projects with these features are analysed the same way as
independent projects.
9.7 Which three factors can create ranking problems among mutually
exclusive projects? Explain each factor and show how the associated
ranking problem can be overcome.
The three factors that can create ranking problems among mutually exclusive projects
are the size disparity, cash flow disparity and unequal lives. Different sized initial
outlays create difficulties in evaluating mutually exclusive projects under capital
rationing. Here, we need to consider the return that could be earned on the difference
in outlays for the projects before making a decision. In the absence of capital
rationing, the size disparity is overcome by using NPV. Under capital rationing,
ranking problems caused by the size disparity are resolved by considering the project
as part of the set of projects that are being analysed. The cash flow timing disparity
also creates ranking problems when the NPV and IRR methods are compared. The
differing reinvestment assumptions made by NPV and IRR contribute to the
differences in ranking. The NPV has the most realistic and logical reinvestment
assumption and this technique overcomes the timing disparity problem. The third
source of ranking disparity, unequal lives, comes from the competition for scarce
resources. The scarce resource becomes available for use elsewhere sooner if the
shorter lived project is accepted. The replacement chain method or an equivalent
annual annuity can be used to accommodate this feature of mutually exclusive
projects.
9.8 Should riskier projects have a higher or lower required return than the
current projects being undertaken in the firm? Why?
Riskier projects should have a higher required return than the current projects being
undertaken in the firm. Shareholders will demand more return for taking on more risk
and the project evaluation should reflect this. Evaluating a higher risk project with the
cost of capital will result in the acceptance of projects that will decrease shareholder
wealth.
9.9 What is the most used method of incorporating risk into project
appraisal? Why is it so often chosen over competing methods?
The most often used method of incorporating risk into project appraisal is the risk-
adjusted discount rate (RADR) approach. This method is popular because it is
relatively simple and easy to apply.

Chapter 9: Planning investments — Some real world complications
9.10 How do you determine if before- or after-tax cash flows are relevant to
the investment evaluation process?
The choice of before- or after-tax cash flows for use in project appraisal is determined
by the taxation position of the firm’s owners. A firm that is fully integrated with the
dividend imputation system will maximise shareholders’ wealth by using before-tax
cash flows and a before-tax discount rate to analyse projects. Companies owned by
Australian resident shareholders should use before-tax cash flows. A firm that is not
integrated with the dividend imputation system will maximise owners’ wealth by
using after-tax cash flows and an after-tax discount rate to analyse projects. Sole
traders, partnerships and companies with a large proportion of non-resident
shareholders should use after-tax cash flows.
9.11 How are after-tax cash flows different to before-tax cash flows? To
answer this question, discuss the impact of taxes on the initial outlay, the
operating cash flows and the terminal value of a project.
In all cases, before-tax cash flows are not affected by taxation. The installed cost for a
new machine is only affected by taxation when the machine is a replacement for an
existing one and there is a gain or loss on the sale of the old equipment. The initial
outlay for a project may include some tax deductible expenses (e.g. staff training or
advertising). After-tax operating cash flows reflect the tax deductibility of expenses
(including depreciation) and the assessability of income from the project. Normally,
we would expect after-tax cash flows to be lower than before-tax cash flows. The
after-tax terminal value of a project will often be affected by any difference between
the book value (for taxation purposes) of the assets used in the project and the
expected amount to be received from disposing of these assets.
9.12 What two methods of depreciation does the ATO allow for new assets?
Describe how depreciation is calculated under each of these methods.
The ATO allow the prime cost and diminishing value methods of depreciation for new
assets. Under the prime cost method, it is usual for the effective life specified in
Schedule 1 of the Income Tax Assessment Act to be applied. The installed cost of the
asset is divided by the effective life to give an annual depreciation charge that does
not change over the asset’s life. Diminishing value depreciation allows relatively
higher depreciation charges at the start of the asset’s effective life, so the depreciation
charge does change each year. Again, the effective life comes from the Income Tax
Assessment Act but the annual charge is determined by multiplying the installed cost
of the asset by 1.5/effective life.
9.13 When is tax payable on the sale of the old depreciable asset? When is a
tax benefit received from the sale of the old depreciable asset?
Tax payable on the sale of the old depreciable asset when the sale price is larger than
the book value of the asset. Selling the asset for more than its book value means that
too much depreciation has been claimed for tax purposes. A tax benefit is received

from the sale of the old depreciable asset when the asset is sold for less than its book
value. In this case, not enough depreciation has been claimed as a tax deduction to
adequately reflect the decrease in the asset’s market value.
9.14 How are capital gains taxed if the business is structured as a company?
Capital gains are taxed at the corporate tax rate if the business is structured as a
company. The discount on capital gains is only available to individuals, not to
companies. This means the gain on the sale of a non-depreciating asset is included as
taxable income in the company’s tax return.
9.15 How are capital gains taxed if the business is structured as a sole trader
or partnership?
Capital gains receive a 50% discount if the business is structured as a sole trader or
partnership because the income of these businesses is included in the owner’s
individual tax returns. After deducting 50% of the capital gain, the remainder is
included in the owner’s taxable income and tax is charged at the marginal tax rate.
9.16 What happens the capital losses in a year are larger than the capital
gains? What happens when capital gains are made in the years following
capital losses?
If capital losses are larger than the capital gains in the year, firms can carry forward
the loss. These carry forward losses can be offset against the net capital gains from
the following year or even later years. Therefore, the business gets the tax benefit
from capital losses in later years by reducing the amount of capital gains tax to be
paid in years when there are net capital gains.
9.17 Why are lost sales included in the calculation of after-tax cash flows?
Lost sales included in the calculation of after-tax cash flows because they represent an
opportunity cost of accepting the project. A reduction in sales made by another project
of the company will reduce shareholder wealth. Project evaluation needs to consider
the cash flows that are incremental to the firm.
9.18 Explain how the payback period is calculated and describe the decision
rule for acceptance of projects.
The payback period is calculated by subtracting the annual net cash inflow from the
initial outlay until the sum of the annual net cash inflows is greater than the initial
outlay. At this point, we can say that the number of payback years is one prior to the
last year of cash flow needed to exceed the initial outlay. To determine the proportion
of the final year that is needed to generate sufficient cash flow to equate the initial
outlay to the net cash inflows, we take the difference between the initial outlay and

the cumulative cash flow for the whole years prior to exceeding the initial outlay then
divide this amount by the size of the net cash inflow in the final year. This proportion
is then added to the number of entire years to determine the payback period.
The decision rule for the payback period is to accept any project that has a payback
shorter than the benchmark time. The benchmark is subjectively set by management.
9.19 Explain how the accounting rate of return is calculated and describe the
decision rule for acceptance of projects.
The accounting rate of return is calculated by dividing the average net profit for the
project’s life by the average level of investment. The average net profit is calculated
by summing the net profit for each year of the project and dividing this total by the
number of years the project runs. Average investment is the initial outlay divided by
two.
The decision rule for the accounting rate of return is to accept those projects that
generate a higher ARR than the benchmark (or hurdle) ARR. The benchmark ARR is
subjectively set by management.
9.20 What are the benefits of using non-discounted methods of project

appraisal? Why are non-discounted methods of project appraisal
considered inferior to the discounted cash flow methods?
Non-discounted methods of project appraisal are generally considered to be easier to

calculate than the discounted methods. They do get around the need to determine an
appropriate discount rate. However, they are considered inferior because they are
inconsistent with the objective of maximising shareholder wealth (the ARR because it
has a focus on profit, and the payback because it ignores cash flows that occur after
the payback period has been reached) and neither method can take risk into account.
9.21 Using an example, explain why using non-financial factors to override the
decision from a quantitative analysis may be inconsistent with wealth
maximisation in the short run, but consistent with it in the long run.
One example of the role of non-financial factors could be the decision to base
manufacturing in a developing nation rather than manufacture a product domestically.
Labour may be cheaper in the developing nation and there may also be gains if that
country has relatively less constrictive legislation with respect to pollution levels.
Shifting manufacturing offshore in these circumstances would be consistent with
maximising shareholder wealth in the short term (returns are higher because expenses
are lower). In the longer-term, the firm may find it becomes the target of ‘no-sweat’
campaigns (e.g. Nike) and looses sales to competitors that are not perceived to be
exploiting labour. Further, the firm may also find that polluting offshore is not good
for its reputation and may earn itself international condemnation (e.g. BHP). If this
type of thing happens, shareholder wealth is not expected to be maximised in the
longer term as sales are lost.

9.22 Daisy Co. has decided to take steps to reduce the impact of its operations
on the environment. Two alternative projects are being considered. The
first project involves the installation of equipment that reduces the
company’s greenhouse gas emissions. The equipment will cost $70 000.
The second project uses eucalyptus to absorb some of the company’s
emissions. The cost of purchasing the vacant land next to the factory and
planting the trees would be around $90 000. Neither of the projects will
generate any cash inflows. What factors would you take into
consideration if you had to decide which of the projects should be
adopted?
Some of the non-financial factors involved in this decision could include:

 The probability of the adoption of the Kyoto protocol
 Benefits to stakeholders (e.g. employees, local community, wildlife) from enjoying
the treed area.
Financial Problems
9.1 The board of Redroll Ltd has stated that the capital expenditure budget
for this year will not exceed $250 000. Management have given you
15 project proposals to analyse. The projects all have the same level of
risk as those currently undertaken by the firm, so you used the company’s
WACC of 15% in your analysis. You have identified 7 projects that
should be considered further:
Identify the seven feasible project sets. Each set must contain more than
one project. Calculate the NPV of each set then rank the sets in order of
their ability to increase the wealth of the shareholders of Redroll Ltd.

Set Projects Initial outlay $ NPV $ Rank

4 1+3+4+5 245 000 17 619 1
13 1+3+5 220 000 14 792 2
14 1+3+4+6 220 000 14 792 2
31 1+3+4 170 000 14 355 4
23 3+4+6+5 195 000 13 704 5
38 3+4+5 145 000 13 267 6
8 1+3+7 235 000 12 836 7
21 1+3+6 195 000 11 965 8
17 3+4+6+7 210 000 11 748 9
18 3+5+7 210 000 11 748 9
37 1+3 145 000 11 528 11
34 3+4+7 160 000 11 311 12
2 1+4+5+6 250 000 10 880 13
32 3+6+5 170 000 10 877 14
20 1+4+5 200 000 10 443 15
43 3+5 120 000 10 440 16
44 3+4+6 120 000 10 440 16
49 3+4 70 000 10 003 18
15 2+3+4 220 000 10 003 19
26 3+6+7 185 000 8 921 20
16 1+4+7 215 000 8 487 21
40 3+7 135 000 8 484 22
6 1+7+6 240 000 8 053 23
10 1+5+6 225 000 8 053 24
7 4+5+6+7 240 000 7 836 25
27 1+5 175 000 7 616 26
29 1+4+6 175 000 7 616 26
47 3+6 95 000 7 613 28
25 4+5+7 190 000 7 399 29
41 1+4 125 000 7 179 30
22 2+3 195 000 7 176 31
36 4+5+6 150 000 6 528 32
46 4+5 100 000 6 091 33
3 2+4+5 250 000 6 091 34
24 1+7 190 000 5 660 35
35 1+6 150 000 4 789 36
33 5+7 165 000 4 572 37
1 1+2 250 000 4 352 38
45 4+7 115 000 4 135 39
42 5+6 125 000 3 701 40
9 2+5 225 000 3 264 41
11 2+5 225 000 3 264 41
12 2+4+6 225 000 3 264 41
48 4+6 75 000 3 264 44
28 2+4 175 000 2 827 45
30 2+4 175 000 2 827 45
39 6+7 140 000 1 745 47
5 2+7 240 000 1 308 48
19 2+6 200 000 437 49

Redroll should implement the set 4 (includes projects I, III, IV and V) as this gives the
highest set of NPVs.
9.2 Ratters Ltd is currently evaluating the following five projects. If Ratters
has a capital budget constraint of $1 million, which of the five indivisible
projects should the company accept?
Project set Initial investment $ NPV $

A&B 540 000 210 000
A&D 750 000 210 000
A&E 890 000 250 000
A, B & D 1 000 000 290 000
B&C 940 000 260 000
B&D 710 000 160 000
B&E 850 000 200 000
A&C 980 000 310 000
The project set of A & C will maximise shareholders wealth because it generates the
highest NPV of any possible set.
9.3 Daisy Chain Shoes is a small company that has limited access to funds.
They currently have a capital rationing constraint of $500 000 and have
asked you to recommend which investments they should make. Each
investment can only be undertaken one time and more than one project
will be undertaken. The proposed investments are:
The management of Daisy Chain will only raise the amount of funds
required to invest in the set of projects that will maximise the owners’
wealth.
(a) Identify the wealth maximising set of projects from those available to
Daisy Chain

Project set Initial investment NPV

$’000 $’000
Stilettos & Platforms 355 121
Stilettos & Sling backs 275 75
Stilettos, Platforms & creepers 450 141
Stilettos, Platforms, creepers & thongs 485 156
Stilettos, Sling backs & creepers 370 95
Stilettos & creepers 220 80
Stilettos, creepers & thongs 255 95
Stilettos, Sling backs, creepers & thongs 405 110
Platforms & Sling backs 380 76
Platforms, Sling backs & creepers 475 96
Platforms, Sling backs & thongs 415 91
Sling backs & creepers 245 35
Sling backs & thongs 185 30
Sling backs, creepers & thongs 280 50
Creepers & thongs 130 35
The project set of stilettos, platforms, creepers and thongs will maximise shareholders
wealth because it generates the highest NPV of any possible set.
(b) How much money should Daisy Chain raise to fund these projects?
Daisy Chain should raise $485 000 which is the total of the outlays for the stilettos,
platforms, creepers and thongs set of projects
9.4 You have been asked to recommend the best of three mutually projects.
The cost of capital is 10%. Each project has a two-year life and the cash
flows are as follows:
(a) recommend which project should be adopted
Project red 0 year 1 year 2

Cash flows –150 000 90 000 90 000
NPV (tables) 6195
NPV (excel) $6198.35
IRR 13.07%
Project blue
Cash flows 60 000 60 000 –90 000
NPV (tables) $40 170
NPV (excel) $40 165.29
IRR –17.71%

Project green
Cash flows –25 000 15 000 15 000
NPV (tables) $1032.06
NPV (excel) $1033.06
IRR 13.07%
Using the NPV technique we would select Project Blue. Using the IRR technique, we
would be indifferent between Projects Red and Blue (i.e. either would be
recommended). The IRR technique ranks Project Blue last. There is a conflict of
ranking between the two techniques.
(b) explain how you chose between NPV and IRR as your tool of analysis
As all projects have equal lives, we do not need to use the equivalent annual annuity
technique. The different recommendations from the IRR and NPV methods are
attributable to differences in the size of the projects and the timing of the cash flows
(the reinvestment assumption). The unusual pattern of cash flows for Blue Project also
causes difficulties for the IRR method. The assumed pattern for project cash flows for
the IRR method is an outflow followed by inflows, not inflows followed by an
outflow.
9.5 As the financial manager of Nesbitt Ltd, you are currently evaluating
three different mixing machines that could be used in the Hobgoblin
expansion project. Each machine has an expected life of 5 years. However,
the initial outlays for each machine and their potential cash flow patterns
are quite different. The project has a 12% required return and you have
made the following calculations:
NPV IRR
(a) Identify any disparities in the ranking of the projects and explain
why these disparities might occur.
(b) Which project would you choose? Why?
(a) Disparities in ranking these three mutually exclusive projects could result from
different
1. size of initial outlays — a project with a relatively small initial outlay can have
a very large IRR, but also have a relatively small NPV. The IRR of the Mix-O-
Matic is only 0.75% lower than that for the Mix-Right, but shareholder wealth
will only increase one quarter the amount expected for the Mix-Right.
2. timing of project cash flows — the IRR method assumes net cash inflows
received over the project’s life are reinvested at the project IRR. This
assumption is much less realistic than the NPV assumption that net cash
inflows are reinvested at the cost of capital.

3. cash flow patterns – multiple IRRs are possible when cash flow patterns are
atypical (i.e. cash flows subsequent to the initial outlay are negative). We
don’t know if any of the mutually exclusive machines have atypical cash flow
patterns – one may require a major overhaul after 3 years.
(b) Given the potential problems of the IRR method, NPV should be used as the
trigger for accepting a project. The Mix-Right machine should be purchased
because it is expected to increase shareholder wealth by the greatest amount.
9.6 Jason’s Publishing Co. wants to acquire a new printing machine so the
firm can expand into the production of glossy magazines. Jason has
identified two manufacturers that could supply the type of machine for
the job. The manufacturers have provided the following details:
Printley’s machine Page’s machine
Sales of $70 000 p.a. are expected from the magazine project. Jason’s
Printing has a WACC of 13% and the shareholders are fully integrated
with the dividend imputation system. The project has about the same level
of risk as those currently operating in the firm. Jason expects to be
printing magazines for many years to come.
(a) Use the replacement chain method and advise which of the machines
should be purchased.
(b) Use the EAA method to advise which of the machines should be
purchased.
Initial outlay Printley’s machine Page’s machine

Purchase price –175 000 v300 000
Transport –2 000 v1 000
Installation –1 500 –2 000
–178 500 –303 000
Annual net cash flow Printley’s machine Page’s machine

Sales 70 000 70 000
maintenance charge –2 000 –6 000
electricity –4 000 –2 500
insurance –2 000 –3 000
62 000 58 500

(a) The shortest possible chain for replacement is 9 years.
Printley Page
Year NCF PVIF PV NCF PVIF PV
0 –178 500 1 –178 500 –30 3000 1 –303 000
1 62 000 0.885 54 870 58 500 0.885 51 772.5
2 62 000 0.7831 48 552.2 58 500 0.7831 45 811.35
3 –66 000 0.6931 –45 744.6 58 500 0.6931 40 546.35
4 62 000 0.6133 38 024.6 58 500 0.6133 35 878.05
5 62 000 0.5428 33 653.6 58 500 0.5428 31 753.8
6 –66 000 0.4803 –31 699.8 58 500 0.4803 28 097.55
7 62 000 0.4251 26 356.2 58 500 0.4251 24 868.35
8 62 000 0.3762 23 324.4 58 500 0.3762 22 007.7
9 112 000 0.3329 37 284.8 128 500 0.3329 42 777.65
NPV = $6 121.4 NPV = $20 513.3
The machine supplied by Page should be purchased as it gives the higher NPV
(20 513.30 > 6 121.40)
NPVi
(b) Using equation 8.1 EAAi 
PVIFA k ,n
NPVPr int ley
EAAPr int ley 
PVIFA 0.13,3
NPVPrintley = -178 000 + 62 000 (0.885) + 62 000 (0.7831) + 112 000 (0.6931)
= $2549.40
2549.40
EAAPr int ley  = $1079.70
2.3612
NPV Page
EAAPage 
PVIFA 0.13,9
20 513.30
EAAPage  = $3997.37
5.1317
The Page supplied machine has the higher EAA (3997.37 >1079.70) so should be
selected.
9.7 Learning Circle Ltd, the leading publishers of educational books for
preschool children in Australia, is considering a project that would
capitalise on the familiarity of their brand name. The company is owned by
Australian-resident investors who can fully utilise dividend imputation
credits. The project proposal is for the establishment of 5 daycare centres.
The set-up costs for the project would be: $1.5 million for the purchase of
property and suitable buildings (no depreciation charge is allowed for these
costs); a further $500 000 for equipment that can be depreciated over a 10-
year useful life using the prime cost method. The corporate tax rate is 30%.

The project is being evaluated over a 10-year useful life. At the end of the
project, the land and buildings would be sold for $2.5 million and the
equipment would be scrapped. Net operating cash flows of $350 000 are
expected for each of the 10 years of operation. Learning Circle has the
following guidelines for evaluating projects:
(a) Which discount rate should Learning Circle use to evaluate the new
project? Why?
(b) Construct the relevant cash flow pattern for the 10 years of the
childcare project.
(c) Calculate the NPV and the IRR of the childcare project.
(d) Should the project be accepted? Why?
(a) Leaning Circle should use a discount rate of 15% because the project is
unrelated to current operations and the shareholders can fully utilise imputation
credits.
(b)
Initial outlay property and buildings –1 500 000
equipment –500 000
–2 000 000
Terminal property and buildings (sale) 2 500 000

equipment 0
2 500 000

Time 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Initial outlay –2 000 000
Net operating cash flows 350 000 350 000 350 000 350 000 350 000 350 000 350 000 350 000 350 000 350 000
Terminal value 2 500 000
Total cash flows –2 000 000 350 000 350 000 350 000 350 000 350 000 350 000 350 000 350 000 350 000 2 850 000
Calculate the NPV and the IRR of the childcare project.

n
(c) NPV   (CFt  PVIF( k ,t ) )  IO
t 1
NPV = –2 000 000 + 350 000 PVIFA .15,10 + 2 500 000 PVIF .15, 10
= –2 000 000 + 350 000 (5.0188) + 2 500 000 (0.2472)
= –2 000 000 + 1 756 580 + 618 000
= $374 580
IRR = 18.54%
Should the project be accepted? Why?

(d) The project should be accepted because it has a positive NPV.

9.8 Using the data in problem 9.7, assume now that Learning Circle is
structured as a partnership and the business has no other capital gains or
losses in year 10. The partners have a marginal tax rate of 45%.
(a) Which discount rate should Learning Circle use to evaluate the new
project? Why?
(b) Construct the relevant cash flow pattern for the 10 years of the
childcare project.
(c) Calculate the NPV and the IRR of the childcare project.
(d) Should the project be accepted? Why?
(a) If structured as a partnership, Leaning Circle should use a discount rate of 12%
because the project is unrelated to current operations and the owners cannot
utilise imputation credits.
(b) Initial outlay –2 000 000 (see problem 8.4)

Annual depreciation charge 500 000 / 10 = 50 000
Net cash flow Operating cash flows 350 000

depreciation –50 000
profit 300 000
Tax on profit (45%) 13 500
NCF after tax 336 500
Book value of equipment, year 10 = 0 (500 000 – (50 000 × 10))
Terminal property and buildings (sale) 2 500 000

Property purchase price 1 500 000
Gain on sale of property 1 000 000
Tax on 50% of capital gain 22 500
After-tax terminal value 2 477 500
Calculate the NPV and the IRR of the childcare project.

Time 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Initial outlay –2 000 000
Net operating cash flows 350 000 350 000 350 000 350 000 350 000 350 000 350 000 350 000 350 000 350 000
Depreciation –50 000 –50 000 –50 000 –50 000 –50 000 –50 000 –50 000 –50 000 –50 000 –50 000
Taxable income 300 000 300 000 300 000 300 000 300 000 300 000 300 000 300 000 300 000 300 000
Tax at 45% 135 000 135 000 135 000 135 000 135 000 135 000 135 000 135 000 135 000 135 000
After-tax cash flow 215 000 215 000 215 000 215 000 215 000 215 000 215 000 215 000 215 000 215 000
Terminal value (after-tax) 2 477
500
Total cash flows –2 000 000 215 000 215 000 215 000 215 000 215 000 215 000 215 000 215 000 215 000 2 692
500
n
(c) NPV   (CFt  PVIF( k ,t ) )  IO
t 1
NPV = –2 000 000 + 215 000 PVIFA .12,10 + 2 477 500 PVIF .12, 10
= –2 000 000 + 215 000 (5.6502) + 2 477 500 (0.3220)
= –2 000 000 + 1 214 793 + 797 755
= $12 548
IRR = 12.10%
(d) The project should be accepted because it has a positive NPV (i.e. will increase shareholder wealth)

9.9 The management of Kaleidoscope Ltd are considering two new projects
and have asked that you do the evaluation. The management of
Kaleidoscope have supplied you with the following cash forecasts:
Management estimate that Project Green has a level of risk similar to that
of most of the firm’s current projects. Project Purple is a new line of
business for Kaleidoscope, so is considered to have higher risk than
average. Kaleidoscope’s cost of capital is 15% and you have received the
following risk-adjusted discount rates and categories:
Use the NPV method to evaluate the projects and advise Kaleidoscope of
your recommendation.
Project Purple is high risk so should use the 20% discount rate. Project Green is in the
medium risk category so it should use the 15% discount rate.
Project purple Initial outlay Year 1 Year 2 Year 3

Net cash flows –350 000 100 000 200 000 300 000
Present value factor 1 0.8333 0.6944 0.5787
–350 000 83 330 138 880 173 610
NPV $45 820
Project green Initial outlay Year 1 Year 2 Year 3 Year 4

Net cash flows –300 000 150 000 110 000 100 000 90 000
Present value factor 1 0.8696 0.7561 0.6575 0.5718
–30 0000 130 440 83 171 65 750 51 462
NPV $30 823
Both projects should be accepted because they have positive NPVs, even after the risk
adjustment needed for project Purple.
9.10 Daft Girlie Ltd operates a chain of 179 fashion stores nation wide. Sales
last year were $400 million and cost of goods sold (not including
depreciation) is 65% of sales. The selling and advertising expenses of the
firm are $125 000 per annum. Three-quarters of this expense is fixed. The
remainder of the cost is shared equally among the stores. The corporate
tax rate is 30%.
The company is considering opening a new store that will cost $1.5 million
to establish. The establishment costs would be depreciated straight line
over an effective life of 8 years. Assume the new store will have the same
costs as existing stores and that sales will be the same as those for the

average existing store. Estimate the after-tax cash flows for the first 9
years of operation for the new store. Round your calculations for each
cash inflow or outflow to the nearest whole dollar.
Today year 1 year 2 year 3 year 4 year 5

Initial investment –1 500 000
Sales 2 234 637 2 234 637 2 234 637 2 234 637 2 234 637
Cost of goods sold –1 452 514 –1 452 514 –1 452 514 –1 452 514 –1 452 514
Other expenses –175 –175 –175 –175 –175
Operating CF 781 948 781 948 781 948 781 948 781 948
Depreciation –187 500 –187 500 –187 500 –187 500 –187 500
Taxable income 594 448 594 448 594 448 594 448 594 448
Tax –178 334 –178 334 –178 334 –178 334 –178 334
After tax CF –1 500 000 603 614 603 614 603 614 603 614 603 614
Average sales = 400 000 000 / 179 = 2 234 637

Fixed costs = 125 000 × 0.75 = 93 750
Variable costs = 125 000 – 93 750 = 31 250 per store
Variable costs for new store = 31 250 / 179 = 175
Depreciation = 1 500 000 / 8 = 187 500
9.11 Minx Ltd is evaluating a project to manufacture faux fur. The equipment
and set-up costs for the project will total $2.1 million. The equipment will
be depreciated straight line over a seven-year effective life. Sales of
$900 000 per annum are expected and cash operating costs will be 30% of
sales. The project will run for 7 years and will have a zero salvage value.
The corporate tax rate is 30%. The marginal shareholder of Minx is a
foreign investor and the after-tax required return is 13%
(a) Estimate the relevant cash flows. Round your calculations for each
cash inflow or outflow to the nearest whole dollar. Calculate the
NPV for the project.
years 1–7
Sales 900 000
Cost of goods sold –270 000
Operating CF 630 000
Depreciation –300 000
Taxable income 330 000
Tax –99 000
After tax CF –2 100 000 531 000
NPV = CF × PVA - IO
NPV = 531 000 (4.4226) – 2 100 000 = 248 401
As the NPV is positive, this project should be accepted.

(b) Assume that Minx is currently losing money on another major

project. It does not expect to have a taxable income for the first three
years of the faux fur project. Estimate the relevant cash flows and
NPV of the project under these circumstances. Is your
recommendation on the project different under this scenario?

t=0 year 1 year 2 year 3 year 4 year 5 year 6 year 7

Sales 900 000 900 000 900 000 900 000 900 000 900 000 900 000
Cost of goods sold –270 000 –270 000 –270 000 –270 000 –270 000 –270 000 –270 000
Operating CF 630 000 630 000 630 000 630 000 630 000 630 000 630 000
Depreciation –300 000 –300 000 –300 000 –300 000 –300 000 –300 000 –300 000
Taxable income 330 000 330 000 330 000 330 000 330 000 330 000 330 000
Tax 0 0 0 –99 000 –99 000 –99 000 –99 000
Op CF – tax =
After tax CF –2 100 000 630 000 630 000 630 000 531 000 531 000 531 000 531 000
PVF 1 0.885 0.7831 0.6931 0.6133 0.5428 0.4803 0.4251

PV of cash flows –2 100 000 557550 493353 436653 325662.3 288226.8 255039.3 225728.1
NPV 482 212.5
NPV $482 212.50
The NPV remains positive so the recommendation is unchanged – the project should be accepted.

9.12 You have decided to cash in on the fitness craze in your town, so you are
thinking about setting up a gym. You can rent a warehouse close to the
business district for $26 000 p.a. In order to attract the ‘right’ sort of
clientele, you will need to spend $70 000 on redecorating and installing
mirrors on all surfaces. You will also purchase some equipment at a cost
of $50 000. Both of these outlays can be depreciated straight line over a
4 year effective life. You expect that the equipment can be sold at the end
of four years for $5000.
Your market research suggests you can attract and maintain
450 members. Each would pay an annual membership fee of $650.
Instructors are usually paid a salary of $35 000 p.a. and you would
employ 4 of these to keep the gym operating 7 days a week. Your
marginal tax rate is 47% and you will operate the business for 4 years
before retiring. If your cost of capital is 16%, should you set up the
business? Calculate IRR and NPV to support your decision. Round your
calculations for each cash inflow or outflow to the nearest whole dollar.
t=0 year 1 year 2 year 3 year 4

Initial investment –120 000
Sales 292 500 292 500 292 500 292 500
Rent –26 000 –26 000 –26 000 –26 000
Salaries –140 000 –140 000 –140 000 –140 000
Operating CF 126 500 126 500 126 500 126 500
Depreciation –30 000 –30 000 –30 000 –30 000

Taxable terminal
value 2 500*
Taxable income 96 500 96 500 96 500 99 000
Tax –45 355 –45 355 –45 355 –46 530
Op CF – tax = 81 145 81 145 81 145 78 970

Terminal value 5 000
Net cash flows 81 145 81 145 81 145 84 970
PV 1 0.8621 0.7432 0.6407 0.5523

PV of CFs –120 000 69 955 60307 51 990 46 929
NPV 109 181 46 280
$109
NPV 180.60
IRR 35.1% Using excel function
Sales = 450 × 650 = 292 500

Salaries = 35 000 × 4 = 140 000
*5000 × 0.5
Yes, the project should be accepted because the NPV is positive (and the IRR is above
the hurdle rate of 16%) accepting the project will increase your wealth

9.13 You have been asked to evaluate a proposal for the owner of Bamboo
Traders. The owner’s marginal tax rate is 47%. She has given you the
following information about the project:
 it has a 5 year lifetime
 the installed cost of the project will be $250 000
 the tax office gives this type of asset an effective life of 4 years
 the asset will be sold at the end of the project for an estimated $20 000
 sales of $90 000 are expected in the first year of the project
 sales will grow at a rate of 5% p.a. for each year of the project
 cost of goods sold (excluding depreciation) is expected to be 30% of
sales
 the owner’s required return is 8%
Using IRR and NPV, advise the owner of Bamboo Traders on the
acceptability of the project. Round your calculations for each cash inflow
or outflow to the nearest whole dollar.
t=0 year 1 year 2 year 3 year 4 year 5

Sales 90 000 94 500 99 225 104 186 109 395
Cost of goods sold 27 000 28 350 29 768 31 256 32 819
63 000 66 150 69 457 72 930 76 576
Depreciation 62 500 62 500 62 500 62 500

Earnings before tax 500 3 650 6 957 10 430 76 576
Terminal value 20 000*
Taxable income 500 3 650 6 957 10 430 96 576
Tax 235 1 715.5 3 270 4 902 45 390.7
Terminal value 20 000*
Op CF – tax =
After tax CF –250 000 62 765 64 434.5 66 187 68 028 51 185.3
PVF .9259 .8573 .7938 .7350 .6806
PV of CFs –250 000 58 114.11 55 239.7 52 539.41 500 00.51 34 836.7
NPV $730.43
* Terminal value is the cash flow from the sale of the asset that needs to be added to
operating cash flow after tax. As this asset is depreciable, there is no ‘capital gain’ and
the recovered depreciation will be taxed in full.
The project should be accepted as it has a positive NPV and an IRR that is above the
owner’s required return. As the project has a low NPV, the owner should be advised
that her increase in wealth depends on the sales forecasts being realistic rather than
optimistic.
9.14 How would your answer to problem 9.13 change if the owner of Bamboo
Traders chose to use the declining balance method of depreciation? Assume
that any tax losses from this project can be used to offset tax payable on other
projects in the current year. Show calculations to support your answer,
rounding each calculation to the nearest dollar.

t=0 year 1 year 2 year 3 year 4 year 5


Sales 90 000 94 500 99 225 104 186 109 395
Cost of goods sold –27 000 –28 350 –29 768 –31 256 –32 819
63 000 66 150 69 457 72 930 76 576
Depreciation –93 750 –58 594 –36 621 –22 888 –14 305
Earnings before tax –30 750 7 556 32 836 50 042 62 271
Loss on sale of asset –3 842
Taxable income –30 750 7 556 32 836 50 042 58 429
Tax 14 453 –3 551 –15 433 –23 520 –27 462
Op CF – tax =
Sale of asset 20 000
After tax CF –250 000 77 453 62 599 54 024 49 410 69 114
NPV $1 619
Year 1 book value = 250 000

Year 2 book value = 250 000 – 93 750 = 156 250
Year 3 book value = 156 250 – 58 594 = 97 656
Year 4 book value = 97 656 – 36 621 = 61 035
Year 5 book value = 61 036 – 22 888 = 38 147
Book value at sale = 38 147 – 14 305 = 23 842
Loss on sale of asset = 20 000 – 23 842 = 3842
You would still accept the project as the NPV remains positive. The declining balance
method of depreciation would increase shareholder wealth more than the using
straight line method. This is due to the larger tax benefits being received earlier in the
project’s life.
9.15 Arkwright & Sons is a partnership where the partners all have a
marginal tax rate of 38%. They would like you to evaluate a project for
them and have provided the following details:
 The initial investment in the project is $200 000 and an additional

investment of $10 000 is required at the end of year 2.
 The asset purchased at the commencement of the project will be sold at the
end of the project for its book value.
 Working capital will be 9% of revenues for each year. The working capital
investment has to be made at the start of each period. All working capital
will be recovered.
 The required return of the partners is 10%.
(a) estimate the relevant cash flows for the project

(b) estimate the payback period


Cash flow –209 900 79 248 70 107 84 116 101 062
Cumulative CF 79 248 149 355 233 471
209 900  149 355 60 545

  0.7198
84 116 84 116
Payback = 2 years and 37 weeks
(c) calculate the accounting rate of return

(d) calculate the NPV for the project
(a), (c) and (d)

Initial investment –200 000 –10 000
Working capital change –9 900 –450 –450 2 700 8 100
Sales 110 000 115 000 120 000 90 000

Cost of goods sold 12 100 12 650 13 200 9 900
97 900 102 350 106 800 80 100
Depreciation 50 000 45 000 40 000 35 000

Taxable income 47 900 57 350 66 800 45 100
Tax 18 202 21 793 25 384 17 138
Op CF – tax =
After tax CF 79 698 80 557 81 416 62 962
Net cash flow –209 900 79 248 70 107 84 116 10 1062
PVF 1 0.9091 0.8264 0.7513 0.683
PV –209 900 72 044 57 936 63 196 69 025
NPV $52 302.48

IRR 21% Using excel function
9.16 Recently, a meeting of the partners of your firm decided to investigate the
viability of offering a baby-sitting service to the customers of the
partnership’s retail outlet. Consultants have been commissioned to
conduct a survey of your current and target customers. The consultant’s
report was positive and they will be paid $15 000 next month for the work
they have done.
You estimate that the licensing and set-up costs for the baby-sitting
service will be $100 000. The service will cost about $5000 per month to
operate and would open one month from today. The monthly sales of your
retail outlet are $150 000 and you expect that offering the baby-sitting will
increase these by 30%. The marginal cost of new sales will be 20%
(excluding the costs of the new service). The partners’ marginal tax rate is
40%. If the partnership’s cost of capital is 12% and you expect the baby-

sitting service to continue for 1 year, should the proposal be accepted?

Show equations and calculations to support your answer.
Monthly cash flows

Service cost –5 000
New sales 0.3*150 000 45 000
New COGS 0.2*150 000 –9 000
Operating cash flow 31 000
Tax 0.4*31 000 –12 400
After-tax cash flow 18 600
PVA  18600( PVFA 0.01,12 )  18600  11.2551  209344.4

NPV  100000  (209344.4  0.9901)  109344.40
The consultant’s fee is a sunk cost as it has to be paid if the project is accepted or not.
The present value of the operating cash flows is for one month from today, so needs to
be discounted for a further month to match the time value to the outlay for licensing
fees.
The project should be accepted as it has a positive NPV.
9.17 Moddie and Millie have a partnership and both partners all have a
marginal tax rate of 42%. They would like you to evaluate a project for
them and have provided the following details:
 The initial investment in the project is $700 000 for production

equipment. The tax office allows prime cost depreciation at the rate of
25% p.a. on these assets.
 The assets purchased at the commencement of the project will be sold
at the end of the project for $50 000.
 The assets require a tax-deductible overhaul that will cost $15 000
before production can begin in year 4.
 Working capital will be 7% of revenues for each year. The working
capital investment has to be made at the start of each period. All
working capital will be recovered.
 Cost of goods sold is 30% of sales.
 Wages are $100 000 per annum
 The required return of the partners is 15%.
a) calculate the relevant cash flows for the project
see part b
b) calculate the NPV for the project. Make a recommendation about the
acceptability of the project.
Year 1 Year 2 Year 3 Year 4 Year 5
Initial outlay –700 000
Working capital –35 000 –7 000 –7 000 14 000 14 000 21 000

Sales 500 000 600 000 700 000 500 000 300 000
Cost of goods sold –150 000 –180 000 –210 000 –150 000 –90 000
Wages –100 000 –100 000 –100 000 –100 000 –100 000
Overhaul –15 000
Operating flow 250 000 320 000 375 000 250 000 110 000
Depreciation –175 000 –175 000 –175 000 –175 000
Taxable income 75 000 145 000 200 000 75 000 110 000
Tax –31 500 –60 900 –84 000 –31 500 –46 200
After tax CF 218 500 259 100 291 000 218 500 63 800
Tax –21 000
Net cash flow –735 000 211500 252100 305000 232500 113 800
PVF 1 0.8696 0.7561 0.6575 0.5718 0.4972
PV –735 000 183 920.4 190 612.8 200 537.5 132 943.5 56 581.36
NPV 29 595.57
Depreciation = 700 000 × .25 = 175 000

The project should be accepted as the NPV is positive.
c) calculate the relevant cash flows for the project if the business is
structured as a company rather than a partnership. The corporate
rate of tax is 30%.
Year 1 Year 2 Year 3 Year 4 Year 5

Initial outlay –700 000
Working capital –35 000 –7 000 –7 000 14 000 14 000 21 000
Sales 500 000 600 000 700 000 500 000 300 000
Cost of goods
sold –150 000 –180 000 –210 000 –150 000 –90 000
Wages –100 000 –100 000 –100 000 –100 000 –100 000
Overhaul –15 000
Operating flow 250 000 320 000 375 000 250 000 110 000
Depreciation 0 0 0 0
Taxable income 250 000 320 000 375 000 250 000 110 000
Tax 0 0 0 0 0
After tax CF 250 000 320 000 375 000 250 000 110 000
tax 0
Net cash flow –735 000 243 000 313 000 389 000 264 000 181 000
PVF 1 0.8696 0.7561 0.6575 0.5718 0.4972
PV –735 000 211 312.8 236 659.3 255 767.5 150 955.2 89 993.2
NPV 209 688
d) calculate the NPV for the cash flows in part c. Has your
recommendation changed?
The NPV remains positive and the project should still be accepted.
9.18 McAuber & Sons are a family owned partnership that sells books by mail
order. Partnership income is shared among the three partners who all
have a marginal tax rate of 47%. The corporate tax rate is 30%.

The youngest partner has suggested that posting catalogues and asking
customers to return order forms by mail is a bit outdated. She has
suggested that the firm set up an online catalogue that allows customers to
order books and pay using a credit card from the customer’s computer.
The computerised system would replace the current mail system.
The current mail system used by McAuber costs $15 per 100 customers to
process. Each customer spends an average of $30 per order and this is
expected to continue under the new system.
Netlink Ltd have agreed to design and maintain the McAuber & Sons
website for an upfront fee of $500 000. There will also be an ongoing
service fee of $10 per 100 customers that order from the website. The
contract with Netlink is for 4 years. At the end of 4 years, the entire
ordering system will be reviewed. If McAuber decide to terminate the
contract with Netlink prior to the contract date, they will have to pay
Netlink a penalty of $100 000.
The new online advertising and ordering system is expected to increase
sales from the current level of $750 000 p.a. to $1.2 million p.a. for the
next 4 years.
Determine the relevant cash flows for the project and calculate the NPV
using a required return of 10%. Show all relevant equations and
calculations. Should the ordering system be changed?
Incremental sales = new sales – current sales

= 1 200 000 – 750 000 = 450 000
Number of new customers = 1 200 000 / 30 = 40 000 pa
Number of old customers = 750 000 / 30 =25 000 pa
Incremental costs = new costs – old costs
= (10 × 40 000 / 100) – (15 × 25 000 / 100)
= 4000 – 3750 = 250
year 1 year 2 year 3 year 4

initial outlay –500000
incremental sales 450000 450000 450000 450000
incremental costs –250 –250 –250 –250
449750 449750 449750 449750
Tax at 47% –211382.50 –211382.50 –211382.50 –211382.50
After tax CF 238367.5 238367.5 238367.5 238367.5
PVF 0.9091 0.8264 0.7513 0.683
PV of CF 216699.89 196986.9 179085.5 162805
NPV 255 577.30
The ordering system should be changed because the new system brings an increase of
$255 577.30 to the firm.
9.19 Your brother owns a rental property and needs to replace the hot water
system. He has provided you with the following three alternatives:

 A solar system which would cost $9000 to install and $200 annual
operating costs. The system will last for 30 years and you can assume
that the building will too.
 A gas system which would cost $3000 to install and $800 p.a. operating
costs. This system would have a useful life of 15 years
 An electric system with a cost of $2500 to install and $1200 p.a.
operating costs. This system would have a useful life of 12 years
(a) If your brother’s cost of capital is 12% and the hot water systems do
not generate any tax benefits, which system would you recommend
to maximise your brother’s wealth?
Initial Annual
investment cash flow n PVFA PV of CFs NPV EAA
solar –9000 –200 30 8.0552 –1611.04 –10 611.04 –1317.29
gas –3000 –800 15 6.8109 –5448.72 –8 448.72 –1246.34
electric –2500 –1200 12 6.1944 –7433.28 –9 933.28 –1603.59
Based on the wealth maximisation principle, you would recommend the gas water
system. It is the lowest cost option when you consider the initial investment and the
costs over the life of the project.
(b) Are there any non-financial factors your brother might consider in
his investment decision?
Non-financial factors might include:

 Environmental — solar energy is renewable and does not contribute to greenhouse
gas emissions
 Aesthetic — your brother might not like the look of solar panels on the roof of a
gas box
 Others?

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© John Wiley & Sons Australia, Ltd 2008

End of Chapter Questions

9.2 Which projects should be accepted if there are no capital constraints on

9.3 What is an ‘unconstrained hurdle rate’?

9.5 Why is capital rationing a special case of mutual exclusivity?

© John Wiley and Sons Australia, Ltd 2008 9.1

© John Wiley and Sons Australia, Ltd 2008 9.2

© John Wiley and Sons Australia, Ltd 2008 9.3

© John Wiley and Sons Australia, Ltd 2008 9.4

9.20 What are the benefits of using non-discounted methods of project

Non-discounted methods of project appraisal are generally considered to be easier to

© John Wiley and Sons Australia, Ltd 2008 9.5

Some of the non-financial factors involved in this decision could include:

© John Wiley and Sons Australia, Ltd 2008 9.6

Set Projects Initial outlay $ NPV $ Rank

© John Wiley and Sons Australia, Ltd 2008 9.7

Project set Initial investment $ NPV $

© John Wiley and Sons Australia, Ltd 2008 9.8

Project set Initial investment NPV

(a) recommend which project should be adopted

Project red 0 year 1 year 2

© John Wiley and Sons Australia, Ltd 2008 9.9

© John Wiley and Sons Australia, Ltd 2008 9.10

Initial outlay Printley’s machine Page’s machine

Annual net cash flow Printley’s machine Page’s machine

© John Wiley and Sons Australia, Ltd 2008 9.11

(a) The shortest possible chain for replacement is 9 years.

© John Wiley and Sons Australia, Ltd 2008 9.12

Terminal property and buildings (sale) 2 500 000

© John Wiley and Sons Australia, Ltd 2008 9.13

Calculate the NPV and the IRR of the childcare project.

Should the project be accepted? Why?

© John Wiley and Sons Australia, Ltd 2008 9.14

(b) Initial outlay –2 000 000 (see problem 8.4)

Net cash flow Operating cash flows 350 000

NCF after tax 336 500

Book value of equipment, year 10 = 0 (500 000 – (50 000 × 10))

Terminal property and buildings (sale) 2 500 000

After-tax terminal value 2 477 500

Calculate the NPV and the IRR of the childcare project.

© John Wiley and Sons Australia, Ltd 2008 9.15

© John Wiley and Sons Australia, Ltd 2008 9.16

Project purple Initial outlay Year 1 Year 2 Year 3

Project green Initial outlay Year 1 Year 2 Year 3 Year 4

© John Wiley and Sons Australia, Ltd 2008 9.17

Today year 1 year 2 year 3 year 4 year 5

Average sales = 400 000 000 / 179 = 2 234 637

As the NPV is positive, this project should be accepted.

© John Wiley and Sons Australia, Ltd 2008 9.18

(b) Assume that Minx is currently losing money on another major

© John Wiley and Sons Australia, Ltd 2008 9.19

t=0 year 1 year 2 year 3 year 4 year 5 year 6 year 7

PVF 1 0.885 0.7831 0.6931 0.6133 0.5428 0.4803 0.4251

NPV $482 212.50

© John Wiley and Sons Australia, Ltd 2008 9.20

t=0 year 1 year 2 year 3 year 4

Depreciation –30 000 –30 000 –30 000 –30 000

Op CF – tax = 81 145 81 145 81 145 78 970