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to the firm as a result of implementing the investment. By applying decision techniques that
capture time value of money and risk factors, the financial manager can estimate the impact
the investment will have on the firm™s share price. Clearly, only those investments that can
be expected to increase the stock price should be undertaken. Consistent application of cap-
ital budgeting procedures to proposed long-term investments should therefore allow the
firm to maximize its stock price.
327
CHAPTER 8 Capital Budgeting Cash Flows


REVIEW OF LEARNING GOALS
investment is the initial outflow required, taking
Understand the key motives for capital expen-
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into account the installed cost of the new asset, the
diture and the steps in the capital budgeting
after-tax proceeds from the sale of the old asset,
process. Capital budgeting is the process used to
and any change in net working capital. Finding the
evaluate and select capital expenditures consistent
after-tax proceeds from sale of the old asset, which
with the firm™s goal of maximizing owner wealth.
reduces the initial investment, involves cost, depre-
Capital expenditures are long-term investments
ciation, and tax data. The book value of an asset is
made to expand, replace, or renew fixed assets
its accounting value, which is used to determine
or to obtain some less tangible benefit. The capital
what taxes are owed as a result of its sale. Any of
budgeting process includes five distinct but inter-
three forms of taxable income”capital gain, recap-
related steps: proposal generation, review and
tured depreciation, or a loss”can result from sale
analysis, decision making, implementation, and
of an asset. The form of taxable income that applies
follow-up.
depends on whether the asset is sold for (1) more
than its initial purchase price, (2) more than book
Define basic capital budgeting terminology.
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value but less than what was initially paid, (3) book
Capital expenditure proposals may be inde-
value, or (4) less than book value. The change in
pendent or mutually exclusive. Typically, firms
net working capital is the difference between the
have only limited funds for capital investments
change in current assets and the change in current
and must ration them among carefully selected
liabilities expected to accompany a given capital
projects. Two basic approaches to capital budget-
expenditure.
ing decisions are the accept“reject approach and
the ranking approach. Conventional cash flow
Determine relevant operating cash inflows us-
patterns consist of an initial outflow followed
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ing the income statement format. The operating
by a series of inflows; any other pattern is non-
cash inflows are the incremental after-tax cash in-
conventional.
flows expected to result from a project. The income
statement format involves adding depreciation back
Discuss the major components of relevant
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to net profits after taxes and gives the operating
cash flows, expansion versus replacement cash
cash inflows associated with the proposed and pres-
flows, sunk costs and opportunity costs, and inter-
ent projects. The relevant (incremental) cash inflows
national capital budgeting and long-term invest-
are the difference between the operating cash in-
ments. The relevant cash flows for capital budget-
flows of the proposed project and those of the pre-
ing decisions are the initial investment, the
sent project.
operating cash inflows, and the terminal cash
flow. For replacement decisions, these flows are
Find the terminal cash flow. The terminal cash
found by determining the difference between the
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flow represents the after-tax cash flow, exclu-
cash flows of the new asset and the old asset.
sive of operating cash inflows, that is expected
Expansion decisions are viewed as replacement
from liquidation of a project. It is calculated by
decisions in which all cash flows from the old as-
finding the difference between the after-tax pro-
set are zero. When estimating relevant cash flows,
ceeds from sale of the new and the old asset at
one should ignore sunk costs, and opportunity
project termination and then adjusting this differ-
costs should be included as cash outflows. In
ence for any change in net working capital. Sale
international capital budgeting, currency risks and
price and depreciation data are used to find the
political risks can be minimized through careful
taxes and the after-tax sale proceeds on the new
planning.
and old assets. The change in net working capital
typically represents the reversion of any initial net
Calculate the initial investment associated with
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working capital investment.
a proposed capital expenditure. The initial
328 PART 3 Long-Term Investment Decisions


SELF-TEST PROBLEMS (Solutions in Appendix B)
ST 8“1 Book value, taxes, and initial investment Irvin Enterprises is considering the
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purchase of a new piece of equipment to replace the current equipment. The new
equipment costs $75,000 and requires $5,000 in installation costs. It will be
depreciated under MACRS using a 5-year recovery period. The old piece of
equipment was purchased 4 years ago for an installed cost of $50,000; it was
being depreciated under MACRS using a 5-year recovery period. The old equip-
ment can be sold today for $55,000 net of any removal or cleanup costs. As a
result of the proposed replacement, the firm™s investment in net working capital
is expected to increase by $15,000. The firm pays taxes at a rate of 40% on both
ordinary income and capital gains. (Table 3.2 on page 89 contains the applicable
MACRS depreciation percentages.)
a. Calculate the book value of the old piece of equipment.
b. Determine the taxes, if any, attributable to the sale of the old equipment.
c. Find the initial investment associated with the proposed equipment
replacement.

ST 8“2 Determining relevant cash flows A machine currently in use was originally pur-
LG4 LG5 LG6
chased 2 years ago for $40,000. The machine is being depreciated under MACRS
using a 5-year recovery period; it has 3 years of usable life remaining. The current
machine can be sold today to net $42,000 after removal and cleanup costs. A new
machine, using a 3-year MACRS recovery period, can be purchased at a price of
$140,000. It requires $10,000 to install and has a 3-year usable life. If the new
machine is acquired, the investment in accounts receivable will be expected to rise
by $10,000, the inventory investment will increase by $25,000, and accounts
payable will increase by $15,000. Profits before depreciation and taxes are
expected to be $70,000 for each of the next 3 years with the old machine and to
be $120,000 in the first year and $130,000 in the second and third years with the
new machine. At the end of 3 years, the market value of the old machine will
equal zero, but the new machine could be sold to net $35,000 before taxes. Both
ordinary corporate income and capital gains are subject to a 40% tax. (Table 3.2
on page 89 contains the applicable MACRS depreciation percentages.)
a. Determine the initial investment associated with the proposed replacement
decision.
b. Calculate the incremental operating cash inflows for years 1 to 4 associated
with the proposed replacement. (Note: Only depreciation cash flows must be
considered in year 4.)
c. Calculate the terminal cash flow associated with the proposed replacement
decision. (Note: This is at the end of year 3.)
d. Depict on a time line the relevant cash flows found in parts a, b, and c that
are associated with the proposed replacement decision, assuming that it is ter-
minated at the end of year 3.


PROBLEMS
8“1 Classification of expenditures Given the following list of outlays, indicate
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whether each is normally considered a capital or an operating expenditure.
Explain your answers.
329
CHAPTER 8 Capital Budgeting Cash Flows


a. An initial lease payment of $5,000 for electronic point-of-sale cash register
systems.
b. An outlay of $20,000 to purchase patent rights from an inventor.
c. An outlay of $80,000 for a major research and development program.
d. An $80,000 investment in a portfolio of marketable securities.
e. A $300 outlay for an office machine.
f. An outlay of $2,000 for a new machine tool.
g. An outlay of $240,000 for a new building.
h. An outlay of $1,000 for a marketing research report.

8“2 Basic terminology A firm is considering the following three separate situations.
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Situation A Build either a small office building or a convenience store on a par-
cel of land located in a high-traffic area. Adequate funding is available, and both
projects are known to be acceptable. The office building requires an initial
investment of $620,000 and is expected to provide operating cash inflows of
$40,000 per year for 20 years. The convenience store is expected to cost
$500,000 and to provide a growing stream of operating cash inflows over its 20-
year life. The initial operating cash inflow is $20,000, and it will increase by 5%
each year.

Situation B Replace a machine with a new one that requires a $60,000 initial
investment and will provide operating cash inflows of $10,000 per year for the
first 5 years. At the end of year 5, a machine overhaul costing $20,000 will be
required. After it is completed, expected operating cash inflows will be $10,000
in year 6; $7,000 in year 7; $4,000 in year 8; and $1,000 in year 9, at the end of
which the machine will be scrapped.

Situation C Invest in any or all of the four machines whose relevant cash flows
are given in the following table. The firm has $500,000 budgeted to fund these
machines, all of which are known to be acceptable. Initial investment for each
machine is $250,000.


Operating cash inflows
Year Machine 1 Machine 2 Machine 3 Machine 4

1 $ 50,000 $70,000 $65,000 $90,000
2 70,000 70,000 65,000 80,000
3 90,000 70,000 80,000 70,000
4 30,000 70,000 80,000 60,000
5 100,000 70,000 20,000 50,000




For each situation, indicate:
a. Whether the projects involved are independent or mutually exclusive.
b. Whether the availability of funds is unlimited or capital rationing exists.
c. Whether accept“reject or ranking decisions are required.
d. Whether each project™s cash flows are conventional or nonconventional.
330 PART 3 Long-Term Investment Decisions


8“3 Relevant cash flow pattern fundamentals For each of the following projects,
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determine the relevant cash flows, classify the cash flow pattern, and depict the
cash flows on a time line.
a. A project that requires an initial investment of $120,000 and will generate
annual operating cash inflows of $25,000 for the next 18 years. In each of
the 18 years, maintenance of the project will require a $5,000 cash outflow.
b. A new machine with an installed cost of $85,000. Sale of the old machine
will yield $30,000 after taxes. Operating cash inflows generated by the
replacement will exceed the operating cash inflows of the old machine by
$20,000 in each year of a 6-year period. At the end of year 6, liquidation of
the new machine will yield $20,000 after taxes, which is $10,000 greater
than the after-tax proceeds expected from the old machine had it been
retained and liquidated at the end of year 6.
c. An asset that requires an initial investment of $2 million and will yield
annual operating cash inflows of $300,000 for each of the next 10 years.
Operating cash outlays will be $20,000 for each year except year 6,
when an overhaul requiring an additional cash outlay of $500,000 will be
required. The asset™s liquidation value at the end of year 10 is expected to
be $0.

8“4 Expansion versus replacement cash flows Edison Systems has estimated the
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cash flows over the 5-year lives for two projects, A and B. These cash flows are
summarized in the following table.

Project A Project B

$12,000a
Initial investment $40,000

Year Operating cash inflows

1 $10,000 $ 6,000
2 12,000 6,000
3 14,000 6,000
4 16,000 6,000
5 10,000 6,000
aAfter-tax cash inflow expected from liquidation.



a. If project A were actually a replacement for project B and if the $12,000 ini-
tial investment shown for project B were the after-tax cash inflow expected
from liquidating it, what would be the relevant cash flows for this replace-
ment decision?
b. How can an expansion decision such as project A be viewed as a special form
of a replacement decision? Explain.

8“5 Sunk costs and opportunity costs Covol Industries is developing the relevant
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cash flows associated with the proposed replacement of an existing machine tool
with a new, technologically advanced one. Given the following costs related to
the proposed project, explain whether each would be treated as a sunk cost or
an opportunity cost in developing the relevant cash flows associated with the
proposed replacement decision.
331
CHAPTER 8 Capital Budgeting Cash Flows


a. Covol would be able to use the same tooling, which had a book value of
$40,000, on the new machine tool as it had used on the old one.
b. Covol would be able to use its existing computer system to develop programs
for operating the new machine tool. The old machine tool did not require
these programs. Although the firm™s computer has excess capacity available,
the capacity could be leased to another firm for an annual fee of $17,000.
c. Covol would have to obtain additional floor space to accommodate the
larger new machine tool. The space that would be used is currently being
leased to another company for $10,000 per year.
d. Covol would use a small storage facility to store the increased output of the
new machine tool. The storage facility was built by Covol 3 years earlier at a
cost of $120,000. Because of its unique configuration and location, it is cur-
rently of no use to either Covol or any other firm.
e. Covol would retain an existing overhead crane, which it had planned to sell
for its $180,000 market value. Although the crane was not needed with the
old machine tool, it would be used to position raw materials on the new
machine tool.

8“6 Book value Find the book value for each of the assets shown in the following
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table, assuming that MACRS depreciation is being used. (Note: See Table 3.2 on
page 89 for the applicable depreciation percentages.)

Recovery Elapsed time
period since purchase
Asset Installed cost (years) (years)

A $ 950,000 5 3
B 40,000 3 1
C 96,000 5 4
D 350,000 5 1
E 1,500,000 7 5


8“7 Book value and taxes on sale of assets Troy Industries purchased a new
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machine 3 years ago for $80,000. It is being depreciated under MACRS with a
5-year recovery period using the percentages given in Table 3.2 on page 89.
Assume 40% ordinary and capital gains tax rates.
a. What is the book value of the machine?
b. Calculate the firm™s tax liability if it sold the machine for each of the follow-
ing amounts: $100,000; $56,000; $23,200; and $15,000.

8“8 Tax calculations For each of the following cases, describe the various taxable
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components of the funds received through sale of the asset, and determine the
total taxes resulting from the transaction. Assume 40% ordinary and capital
gains tax rates. The asset was purchased 2 years ago for $200,000 and is being
depreciated under MACRS using a 5-year recovery period. (See Table 3.2 on
page 89 for the applicable depreciation percentages.)
a. The asset is sold for $220,000.
b. The asset is sold for $150,000.
c. The asset is sold for $96,000.
d. The asset is sold for $80,000.
332 PART 3 Long-Term Investment Decisions


8“9 Change in net working capital calculation Samuels Manufacturing is consider-
LG4
ing the purchase of a new machine to replace one they feel is obsolete. The firm
has total current assets of $920,000 and total current liabilities of $640,000. As
a result of the proposed replacement, the following changes are anticipated in
the levels of the current asset and current liability accounts noted.

Account Change

Accruals $ 40,000
Marketable securities 0
Inventories 10,000
Accounts payable 90,000
Notes payable 0
Accounts receivable 150,000
Cash 15,000



a. Using the information given, calculate the change, if any, in net working capi-
tal that is expected to result from the proposed replacement action.
b. Explain why a change in these current accounts would be relevant in deter-
mining the initial investment for the proposed capital expenditure.
c. Would the change in net working capital enter into any of the other cash
flow components that make up the relevant cash flows? Explain.

8“10 Calculating initial investment Vastine Medical, Inc., is considering replacing its
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existing computer system, which was purchased 2 years ago at a cost of
$325,000. The system can be sold today for $200,000. It is being depreciated
using MACRS and a 5-year recovery period (see Table 3.2, page 89). A new
computer system will cost $500,000 to purchase and install. Replacement of the
computer system would not involve any change in net working capital. Assume a
40% tax rate on ordinary income and capital gains.
a. Calculate the book value of the existing computer system.
b. Calculate the after-tax proceeds of its sale for $200,000.
c. Calculate the initial investment associated with the replacement project.

8“11 Initial investment”Basic calculation Cushing Corporation is considering the
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purchase of a new grading machine to replace the existing one. The existing
machine was purchased 3 years ago at an installed cost of $20,000; it was
being depreciated under MACRS using a 5-year recovery period. (See Table 3.2
on page 89 for the applicable depreciation percentages.) The existing machine
is expected to have a usable life of at least 5 more years. The new machine
costs $35,000 and requires $5,000 in installation costs; it will be depreciated
using a 5-year recovery period under MACRS. The existing machine can cur-
rently be sold for $25,000 without incurring any removal or cleanup costs. The
firm pays 40% taxes on both ordinary income and capital gains. Calculate the
initial investment associated with the proposed purchase of a new grading
machine.

8“12 Initial investment at various sale prices Edwards Manufacturing Company is
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considering replacing one machine with another. The old machine was pur-
333
CHAPTER 8 Capital Budgeting Cash Flows


chased 3 years ago for an installed cost of $10,000. The firm is depreciating the
machine under MACRS, using a 5-year recovery period. (See Table 3.2 on page
89 for the applicable depreciation percentages.) The new machine costs $24,000
and requires $2,000 in installation costs. The firm is subject to a 40% tax rate
on both ordinary income and capital gains. In each of the following cases, calcu-
late the initial investment for the replacement.
a. Edwards Manufacturing Company (EMC) sells the old machine for
$11,000.
b. EMC sells the old machine for $7,000.
c. EMC sells the old machine for $2,900.
d. EMC sells the old machine for $1,500.

8“13 Depreciation A firm is evaluating the acquisition of an asset that costs
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$64,000 and requires $4,000 in installation costs. If the firm depreciates the
asset under MACRS, using a 5-year recovery period (see Table 3.2 on page 89
for the applicable depreciation percentages), determine the depreciation charge
for each year.

8“14 Incremental operating cash inflows A firm is considering renewing its equip-
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ment to meet increased demand for its product. The cost of equipment modifica-
tions is $1.9 million plus $100,000 in installation costs. The firm will depreciate
the equipment modifications under MACRS, using a 5-year recovery period. (See
Table 3.2 on page 89 for the applicable depreciation percentages.) Additional
sales revenue from the renewal should amount to $1.2 million per year, and
additional operating expenses and other costs (excluding depreciation) will
amount to 40% of the additional sales. The firm has an ordinary tax rate of
40%. (Note: Answer the following questions for each of the next 6 years.)
a. What incremental earnings before depreciation and taxes will result from the
renewal?
b. What incremental earnings after taxes will result from the renewal?
c. What incremental operating cash inflows will result from the renewal?

8“15 Incremental operating cash inflows”Expense reduction Miller Corporation is
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considering replacing a machine. The replacement will reduce operating
expenses (that is, increase revenues) by $16,000 per year for each of the 5 years
the new machine is expected to last. Although the old machine has zero book
value, it can be used for 5 more years. The depreciable value of the new machine
is $48,000. The firm will depreciate the machine under MACRS using a 5-year
recovery period (see Table 3.2 on page 89 for the applicable depreciation per-
centages) and is subject to a 40% tax rate on ordinary income. Estimate the
incremental operating cash inflows generated by the replacement. (Note: Be sure
to consider the depreciation in year 6.)

8“16 Incremental operating cash inflows Strong Tool Company has been consider-
LG5
ing purchasing a new lathe to replace a fully depreciated lathe that will last 5
more years. The new lathe is expected to have a 5-year life and depreciation
charges of $2,000 in year 1; $3,200 in year 2; $1,900 in year 3; $1,200 in both
year 4 and year 5; and $500 in year 6. The firm estimates the revenues and
expenses (excluding depreciation) for the new and the old lathes to be as shown
in the following table. The firm is subject to a 40% tax rate on ordinary income.
334 PART 3 Long-Term Investment Decisions


New lathe Old lathe
Expenses Expenses
Year Revenue (excl. depr.) Revenue (excl. depr.)

1 $40,000 $30,000 $35,000 $25,000
2 41,000 30,000 35,000 25,000
3 42,000 30,000 35,000 25,000
4 43,000 30,000 35,000 25,000
5 44,000 30,000 35,000 25,000



a. Calculate the operating cash inflows associated with each lathe. (Note: Be
sure to consider the depreciation in year 6.)
b. Calculate the incremental (relevant) operating cash inflows resulting from the
proposed lathe replacement.
c. Depict on a time line the incremental operating cash inflows calculated in
part b.

8“17 Terminal cash flow”Various lives and sale prices Looner Industries is cur-
LG6
rently analyzing the purchase of a new machine that costs $160,000 and requires
$20,000 in installation costs. Purchase of this machine is expected to result in an
increase in net working capital of $30,000 to support the expanded level of
operations. The firm plans to depreciate the machine under MACRS using a
5-year recovery period (see Table 3.2 on page 89 for the applicable depreciation
percentages) and expects to sell the machine to net $10,000 before taxes at the
end of its usable life. The firm is subject to a 40% tax rate on both ordinary and
capital gains income.
a. Calculate the terminal cash flow for a usable life of (1) 3 years, (2) 5 years,
and (3) 7 years.
b. Discuss the effect of usable life on terminal cash flows using your findings in
part a.
c. Assuming a 5-year usable life, calculate the terminal cash flow if the machine
were sold to net (1) $9,000 or (2) $170,000 (before taxes) at the end of 5 years.
d. Discuss the effect of sale price on terminal cash flow using your findings in
part c.

8“18 Terminal cash flow”Replacement decision Russell Industries is considering
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replacing a fully depreciated machine that has a remaining useful life of 10 years
with a newer, more sophisticated machine. The new machine will cost $200,000
and will require $30,000 in installation costs. It will be depreciated under MACRS
using a 5-year recovery period (see Table 3.2 on page 89 for the applicable depre-
ciation percentages). A $25,000 increase in net working capital will be required to
support the new machine. The firm™s managers plans to evaluate the potential
replacement over a 4-year period. They estimate that the old machine could be
sold at the end of 4 years to net $15,000 before taxes; the new machine at the end
of 4 years will be worth $75,000 before taxes. Calculate the terminal cash flow at
the end of year 4 that is relevant to the proposed purchase of the new machine.
The firm is subject to a 40% tax rate on both ordinary and capital gains income.
335
CHAPTER 8 Capital Budgeting Cash Flows


8“19 Relevant cash flows for a marketing campaign Marcus Tube, a manufacturer
LG4 LG5 LG6
of high-quality aluminum tubing, has maintained stable sales and profits over
the past 10 years. Although the market for aluminum tubing has been expanding
by 3% per year, Marcus has been unsuccessful in sharing this growth. To
increase its sales, the firm is considering an aggressive marketing campaign that
centers on regularly running ads in all relevant trade journals and exhibiting
products at all major regional and national trade shows. The campaign is
expected to require an annual tax-deductible expenditure of $150,000 over the
next 5 years. Sales revenue, as shown in the income statement for 2003 (below),
totaled $20,000,000. If the proposed marketing campaign is not initiated, sales
are expected to remain at this level in each of the next 5 years, 2004“2008. With
the marketing campaign, sales are expected to rise to the levels shown in the
accompanying table for each of the next 5 years; cost of goods sold is expected
to remain at 80% of sales; general and administrative expense (exclusive of any
marketing campaign outlays) is expected to remain at 10% of sales; and annual
depreciation expense is expected to remain at $500,000. Assuming a 40% tax
rate, find the relevant cash flows over the next 5 years associated with the pro-
posed marketing campaign.


Marcus Tube
Income Statement
for the Year Ended December 31, 2003
Marcus Tube
Sales Forecast
Sales revenue $20,000,000
Less: Cost of goods sold (80%) 16,000,000 Year Sales revenue
Gross profits $ 4,000,000
2004 $20,500,000
Less: Operating expenses
2005 21,000,000
General and administrative expense (10%) $2,000,000
2006 21,500,000
Depreciation expense 500,000
2007 22,500,000
Total operating expense 2,500,000
2008 23,500,000
Net profits before taxes $ 1,500,000
Less: Taxes (rate 40%) 600,000
Net profits after taxes $ 900,000




8“20 Relevant cash flows”No terminal value Central Laundry and Cleaners is con-
LG4 LG5
sidering replacing an existing piece of machinery with a more sophisticated
machine. The old machine was purchased 3 years ago at a cost of $50,000, and
this amount was being depreciated under MACRS using a 5-year recovery
period. The machine has 5 years of usable life remaining. The new machine that
is being considered costs $76,000 and requires $4,000 in installation costs. The
new machine would be depreciated under MACRS using a 5-year recovery
period. The firm can currently sell the old machine for $55,000 without incur-
ring any removal or cleanup costs. The firm pays a tax rate of 40% on both
ordinary income and capital gains. The revenues and expenses (excluding depre-
ciation) associated with the new and the old machine for the next 5 years are
given in the table below. (Table 3.2 on page 89 contains the applicable MACRS
depreciation percentages.)
336 PART 3 Long-Term Investment Decisions


New machine Old machine
Expenses Expenses
Year Revenue (excl. depr.) Revenue (excl. depr.)

1 $750,000 $720,000 $674,000 $660,000
2 750,000 720,000 676,000 660,000
3 750,000 720,000 680,000 660,000
4 750,000 720,000 678,000 660,000
5 750,000 720,000 674,000 660,000



a. Calculate the initial investment associated with replacement of the old
machine by the new one.
b. Determine the incremental operating cash inflows associated with
the proposed replacement. (Note: Be sure to consider the depreciation in
year 6.)
c. Depict on a time line the relevant cash flows found in parts a and b associ-
ated with the proposed replacement decision.

8“21 Integrative”Determining relevant cash flows Lombard Company is contem-
LG4 LG5 LG6
plating the purchase of a new high-speed widget grinder to replace the existing
grinder. The existing grinder was purchased 2 years ago at an installed cost of
$60,000; it was being depreciated under MACRS using a 5-year recovery
period. The existing grinder is expected to have a usable life of 5 more years.
The new grinder costs $105,000 and requires $5,000 in installation costs; it has
a 5-year usable life and would be depreciated under MACRS using a 5-year
recovery period. Lombard can currently sell the existing grinder for $70,000
without incurring any removal or cleanup costs. To support the increased busi-
ness resulting from purchase of the new grinder, accounts receivable would
increase by $40,000, inventories by $30,000, and accounts payable by $58,000.
At the end of 5 years, the existing grinder is expected to have a market value of
zero; the new grinder would be sold to net $29,000 after removal and cleanup
costs and before taxes. The firm pays taxes at a rate of 40% on both ordinary
income and capital gains. The estimated profits before depreciation and taxes
over the 5 years for both the new and the existing grinder are shown in the fol-
lowing table. (Table 3.2 on page 89 contains the applicable MACRS deprecia-
tion percentages.)


Profits before
depreciation and taxes
Year New grinder Existing grinder

1 $43,000 $26,000
2 43,000 24,000
3 43,000 22,000
4 43,000 20,000
5 43,000 18,000
337
CHAPTER 8 Capital Budgeting Cash Flows


a. Calculate the initial investment associated with the replacement of the exist-
ing grinder by the new one.
b. Determine the incremental operating cash inflows associated with the pro-
posed grinder replacement. (Note: Be sure to consider the depreciation in
year 6.)
c. Determine the terminal cash flow expected at the end of year 5 from the pro-
posed grinder replacement.
d. Depict on a time line the relevant cash flows associated with the proposed
grinder replacement decision.


CHAPTER 8 CASE Developing Relevant Cash Flows for Clark Upholstery
Company™s Machine Renewal or Replacement Decision

B o Humphries, chief financial officer of Clark Upholstery Company, expects
the firm™s net profits after taxes for the next 5 years to be as shown in the
following table.

Year Net profits after taxes

1 $100,000
2 150,000
3 200,000
4 250,000
5 320,000


Bo is beginning to develop the relevant cash flows needed to analyze
whether to renew or replace Clark™s only depreciable asset, a machine that origi-
nally cost $30,000, has a current book value of zero, and can now be sold for
$20,000. (Note: Because the firm™s only depreciable asset is fully depreciated”
its book value is zero”its expected net profits after taxes equal its operating
cash inflows.) He estimates that at the end of 5 years, the existing machine can
be sold to net $2,000 before taxes. Bo plans to use the following information to
develop the relevant cash flows for each of the alternatives.

Alternative 1 Renew the existing machine at a total depreciable cost of $90,000.
The renewed machine would have a 5-year usable life and would be depreciated
under MACRS using a 5-year recovery period. Renewing the machine would
result in the following projected revenues and expenses (excluding depreciation):

Expenses
Year Revenue (excl. depreciation)

1 $1,000,000 $801,500
2 1,175,000 884,200
3 1,300,000 918,100
4 1,425,000 943,100
5 1,550,000 968,100
338 PART 3 Long-Term Investment Decisions


The renewed machine would result in an increased investment in net working
capital of $15,000. At the end of 5 years, the machine could be sold to net
$8,000 before taxes.

Alternative 2 Replace the existing machine with a new machine that costs
$100,000 and requires installation costs of $10,000. The new machine would
have a 5-year usable life and would be depreciated under MACRS using a 5-
year recovery period. The firm™s projected revenues and expenses (excluding
depreciation), if it acquires the machine, would be as follows:


Expenses
Year Revenue (excl. depreciation)

1 $1,000,000 $764,500
2 1,175,000 839,800
3 1,300,000 914,900
4 1,425,000 989,900
5 1,550,000 998,900



The new machine would result in an increased investment in net working capital
of $22,000. At the end of 5 years, the new machine could be sold to net $25,000
before taxes.

The firm is subject to a 40% tax on both ordinary income and capital gains.
As noted, the company uses MACRS depreciation. (See Table 3.2 on page 89 for
the applicable depreciation percentages.)


Required
a. Calculate the initial investment associated with each of Clark Upholstery™s
alternatives.
b. Calculate the incremental operating cash inflows associated with each of
Clark™s alternatives. (Note: Be sure to consider the depreciation in year 6.)
c. Calculate the terminal cash flow at the end of year 5 associated with each of
Clark™s alternatives.
d. Use your findings in parts a, b, and c to depict on a time line the relevant cash
flows associated with each of Clark Upholstery™s alternatives.
e. Solely on the basis of your comparison of their relevant cash flows, which
alternative appears to be better? Why?


WEB EXERCISE Go to the Web site www.reportgallery.com. Click on Reports, at the top of the
WW page, navigate to the listing for Intel Corp., and click on Annual Report. This
W
takes you to an investor relations page; select the most recent annual report.
Answer the following questions using information in various report sections,
such as Intel Facts and Figures, Financial Summary, Consolidated Balance
Sheets, and Consolidated Statements of Cash Flow. (These may change from
year to year and may be listed in the left navigation bar.)
339
CHAPTER 8 Capital Budgeting Cash Flows


1. How much did Intel spend on capital expenditures for each of the past
5 years?
2. Did capital expenditures increase or decrease?
3. Is Intel™s capital spending consistent or erratic?
4. What were the major uses of capital spending for the most recent 2 years?
5. What were the account balances for property, plant, and equipment (PP&E)
for the most recent 2 years (found on the Consolidated Balance Sheets)?
6. What percent of PP&E does Intel replace every year? (Hint: For a rough esti-
mate, divide capital expenditures for a year by that year™s PP&E balance.)
7. Select one of the following companies, and use the Reportgallery site to
access its annual report. Research its capital spending patterns and compare
them to Intel™s.
a. Abbot Laboratories
b. Southwest Airlines
c. Ford Motor Company




Remember to check the book™s Web site at
www.aw.com/gitman
for additional resources, including additional Web exercises.
340 PART 3 Long-Term Investment Decisions
341
CHAPTER 8 Capital Budgeting Cash Flows

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