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

Chapter 8: Planning investments – discounted cash flows
End of Chapter Questions
8.1 What is an ‘investment’? Why do companies make investments?
An investment is the outlay of capital made with a view to gaining future benefits.
The management of the firm needs to make investments with the shareholders’ capital
to generate returns for them. Therefore, the appraisal of new projects is an important
part of the role of managers.
8.2 Do you expect that every investment made by a firm would be rigorously
evaluated? Why?
Not every investment decision requires rigorous analysis prior to its implementation.
Investment opportunities with relatively small initial outlays, relatively short
timeframes, ones that are easily (and inexpensively reversed) or have very low risk do
not warrant an extensive and expensive analysis. For example, a firm with some
excess cash that does not need until next week has the opportunity to invest the cash
in the money market. This could be considered as a relatively large outlay but it has
low risk, a short timeframe and can be reversed within one day. There is no need to
analyse such an investment.
8.3 Identify two broad ways a business can grow. Is growth for its own sake a
desirable objective? Why?
Growth can be achieved by expanding current operations or making investments in

new activities. From the shareholder’s perspective, growth for its own sake is not
desirable. Shareholders only want growth that maintains or increases their returns.
8.4 How do new projects generate wealth for the owners of the firm?
Investors contribute funds to the firm in the expectation that the firm will earn their
required return. The cost of capital is the link between investment decisions and firm
value. This mean s that the management of the firm needs to make investments with
the shareholders’ capital to generate the returns. If returns on the firm’s projects are
greater than the shareholders’ required return the share price would increase. We use
the ordinary share price to measure the value of the firm. Capital investment decisions
determine the nature of the firm’s operations and are essential to maintain the long-
term viability of the firm.
© John Wiley and Sons Australia, Ltd 2008 8.1

Introducing Corporate Finance 2e Solution Manual
8.5 What are the criteria for investment evaluation techniques that are
consistent with the firm objective of wealth maximisation? What two
evaluation techniques meet these criteria?
The fundamental principal is that a project expected to generate more than the firm’s
cost of capital will increase the value of the firm. The best way to assess this is to use
an evaluation technique that utilises the cost of capital in its methodology. Another
main feature of maximising wealth is that the technique focuses on cash flows.
Further, the appraisal technique should consider the time value of money because a
dollar received next year does not have the same value now as a dollar received today.
The technique should also have the capacity to deal with different amounts of risk for
projects. The two evaluation techniques that meet these criteria are the net present
value (NPV) and internal rate of return (IRR) methods.
The NPV uses the cost of capital as the discount rate for the project’s forecast cash
flows. If the NPV is positive, the project generates more than the cost of capital and is
acceptable. If the NPV is zero, the project generates the cost of capital and is
acceptable because it will maintain the value of the firm. A project’s IRR is calculated
using cash flows and considers the time value of money. The IRR is then compared to
the cost of capital. If the IRR is equal to or greater than the cost of capital, the project
is acceptable.
8.6 What types of cash flows are relevant to the discounted cash flow
techniques? Give some examples of cash flows that are irrelevant and
explain why you would exclude these from an investment evaluation.
The relevant cash flows for the discounted cash flow techniques are the incremental
cash flows. The incremental cash flows include the additional (or marginal) benefits
and the additional relevant costs. Incremental cash flows occur only as a result of the
acceptance of a project. If a cash flow will occur with or without the proposed project,
it is not incremental and it is irrelevant to the investment decision. If the cash flow
only exists when the new project is adopted, it is an incremental cash flow.
Market research undertaken prior to the decision to accept a project is not a relevant
cash flow (i.e. it is irrelevant). If the market research shows that the project is worth
proceeding with, then accepting the project won’t change the cash outflow associated
with testing. This is an example of a sunk cost. Similarly, the cost of patenting some
new technology discovered a couple of years before the decision to manufacture
equipment that uses the technology is irrelevant to the evaluation of the project. The
cost of patenting is in the past so cannot be changed irrespective of the technology
being utilised or not. Finally, the cost of preparing a company’s annual report is not
relevant to a project evaluation. If the company is required to provide annual reports,
adopting a new project will not change that requirement.

Chapter eight: Planning investments – discounted cash flows
8.7 Why don’t we include the cost of financing the project in the relevant
cash flows?
The cash flows associated with the cost of financing a project are not included as
relevant cash flows in project appraisal. The cost of financing is reflected in the cost
of capital. When projects are evaluated using the cost of capital the costs of financing
are reflected in the discount (or hurdle) rate. We would be ‘double counting’ if we
were to include the cash flows associated with the cost of financing as well as using
the discount rate.
8.8 Explain the concept of opportunity cost. What are the opportunity costs
associated with your decision to study this course?
Opportunity costs are the cash flows forgone when one path of action is chosen. They
are what the firm will have to give up if it decides to invest in a new project. This
makes opportunity costs relevant cash flows because they are the cash flows forgone
as a result of accepting a project. Some opportunity costs associated with your study
of this course could include the wages you would have earned had you not chosen to
study. This applies to students who were working then decided to study (clearly, the
pay you would have received had you continued in your employment) and to students
who are working and studying (the overtime you turn down because you need to
complete your assignment) and to ‘full-time’ students working to support themselves
while studying (you can do less hours if you go to lecture or are preparing your
assignment). You will all be fully aware of the non-financial opportunity costs
associated with studying (less time at the pub, with family, or just doing something
you would rather be doing) but these are hard to put a dollar value on, so don’t form
part of your relevant cash flows.
8.9 What are sunk costs? When are they relevant to investment decisions?
Sunk costs are cash outflows that occur prior to the evaluation of a project. They have
occurred in the past and cannot be changed by an action (i.e. accepting a project)
today. They are never relevant to investment decisions because they are not
incremental. Sunk costs may have been necessary to get to the stage of making an
investment decision but they do not come about because a project is accepted.
8.10 Define the term ‘net working capital’. Why are increases or decreases in
net working capital included in the initial outlay for a project?
Net working capital is the excess of current assets over current liabilities. Consider a
firm that is evaluating a new product line and intends to offer customers credit when
they make purchases. The accounts receivable will increase when the project is
undertaken and the firm will need to fund this increase. Offering goods on credit
means the cash from the sale is not received until a future time and the firm offering
credit still needs money to make more product and run the factory. Credit sales mean
less cash for the firm to do other things with, so represents a cash outflow when the
project is established. Similarly, the firm may need to hold higher levels of raw

materials or finished goods inventory for a new product line. The increase in the
inventory asset will cause an increase in net working capital that will have to be
funded if the project is accepted. Working capital decreases occur when the firm
receives credit from the suppliers of materials associated with the project. In this case,
the suppliers are funding part of the increased investment necessary, so this can offset
some or all of the increase in net working capital included in the initial outlay for a
project.
8.11 Why are the terminal cash flows of an existing asset included in the
calculation of the initial outlay for a replacement project, but not for an
expansion project?
The terminal cash flows for an existing asset represents a decrease in the amount of
cash needed to get a replacement machine. Therefore, it is included in the initial
outlay for a replacement decision. This terminal cash flow is a relevant cash flow
because it would not occur unless the project was accepted (i.e. the firm would
continue with the old machine and would not sell it). An expansion project does not
involve the replacement of an existing asset. There is no old asset to sell when the
firm is going into a new line of business or doing more of what it already does
(without replacing machines).
8.12 What are the decision rules for NPV? Explain what will happen to
shareholder wealth if:
(a) NPV is positive
If NPV is positive, shareholder wealth will be increased.
(b) NPV is zero
If NPV is zero, shareholders will receive their required returns and their wealth will
be maintained.
(c) NPV is negative
A negative NPV means that shareholder wealth will decrease. This project will not
generate the shareh olders’ required return.
The decision rules for NPV are to accept projects with positive or zero NPVs and
reject projects with negative NPVs.
8.13 What is the appropriate discount rate for evaluating a project with the
same risk as the firm’s existing projects? Why?
The cost of capital is the appropriate discount rate for a project with the same level of
risk as other projects in the firm. The firm’s cost of capital reflects the required
returns of the providers of capital given the current level of risk in the firm. Therefore,

the cost of capital represents the required return for new projects with the same level
of risk.
8.14 What are the decision rules for IRR? Explain what will happen to
shareholder wealth if:
(a) IRR is greater than the hurdle rate
An IRR greater than the hurdle rate will increase shareholder wealth as the project
generates more returns than are required by the suppliers of capital.
(b) IRR is equal to the hurdle rate
An IRR equal to the hurdle rate will maintain shareholder wealth as the project
generates the required return
(c) IRR is less than the hurdle rate
Accepting a project with an IRR less than the hurdle rate will decrease shareholder
wealth. The project will not earn sufficient returns to satisfy the suppliers of capital.
When an IRR exceeds or equals the hurdle rate the project should be accepted.
8.15 What is the appropriate hurdle rate for evaluating a project with the
same risk as the firm’s existing projects? Why?
The cost of capital is the appropriate hurdle rate for a project with the same level of
risk as the other projects in the firm. The firm’s cost of capital reflects the required
returns of the providers of capital given the current level of risk in the firm. Therefore,
the cost of capital represents the required return for new projects with the same level
of risk.
8.16 What is the relationship between NPV and IRR (Hint: what will the NPV
of a project equal if the IRR equals the hurdle rate)?
Both the NPV and IRR methods use discounted cash flow principles. They both give
the same decision with respect to accepting a project (as long as there are no negative
net cash flows after the initial outlay). A project with a zero NPV will have an IRR
that is equal to the hurdle rate (when the hurdle rate is the cost of capital used as the
discount rate). A project with a positive NPV will have an IRR greater than its hurdle
rate while a project with a negative NPV will have an IRR lower than its hurdle rate.
8.17 What is the typical cash flow pattern for a project?
The typical pattern for project cash flows is a negative initial outlay at the inception of
the project followed by net cash inflows over the life of the project. The final cash
flow from the project will come from the disposal of the projects assets.

8.18 Is IRR or NPV more reliable when a project’s cash flow pattern includes
net outflows during the project’s life? Why?
Some projects have atypical cash flow patterns where the initial outlay is not followed
by net cash inflows for every period until the end of the project. This might occur, for
example, if equipment needs to be replaced half way through the life of the project.
Negative net cash flows during the life of the project result in multiple IRRs. It will
not be immediately obvious which (if any) of the IRRs is the ‘true’ IRR for the
project. The NPV method is not compromised by negative net cash flows during the
life of the project.
8.19 What assumptions do NPV and IRR make about the reinvestment of a
project’s cash flows over its life? Which assumption is more realistic?
Why?
The NPV method implicitly assumes that the net cash inflows from the project are
reinvested at the discount rate used to calculate the NPV. The IRR method assumes
that the net cash inflows are reinvested at the project’s IRR. Reinvestment at the
discount rate is a more realistic assumption. The discount rate for a project with the
same risk as others already undertaken by the firm is the cost of capital. If the firm
cannot find more investments that generate the cost of capital, investors will not
supply it with capital. It is not plausible to assume that the cash flows from a project
with a very high IRR can be reinvested in other projects that also have unusually high
IRRs.
8.20 Do financial managers use IRR or NPV more? Why might managers use
both techniques?
Research shows that Australian companies use both IRR and NPV with about the
same frequency. The research also shows that managers use more than one technique
when evaluating the same project. Managers understand that the NPV is the more
reliable evaluation tool – they also understand that it is often easier for non-finance
people to interpret a rate of return than it is for them to understand the expected dollar
increase in the value of the firm.
Financial Problems
8.1 Cupsley Ltd is a manufacturer of cutlery. The firm’s managers have

asked you to evaluate a project proposal to diversify into manufacturing
nailfiles. A new machine to mould the plastic on to the end of the nailfiles
would need to be purchased at a cost of $150 000. Freight and insurance
for the new machine will cost $3500 and installation will cost a further
$1200. The files would be pressed on existing equipment. The files would
be produced by introducing a night shift, so will not displace any current

production capacity. The existing machine would be modified at a cost of

$20 000.
If the new project goes ahead, Cupsley will need to increase the raw
materials inventory by $2500. The finished goods inventory would need to
be $4500 higher than its current level. Cupsley will supply 30-day terms
to the distributors of the nailfiles and this is expected to result in an
increase of $60 000 in accounts receivable. The increase in accounts
receivable will occur during the first week of production for the project.
Cupsley has arranged credit with suppliers of the plastic that will be used
in the production process. This is expected to result in an increase of
$15 000 to accounts payable.
(a) What is the installed cost of the project?
(b) What is the change in net working capital?
(c) What is the initial outlay for the nailfile project?
(a) Installed cost of new asset
Purchase price 150 000

Installation 3 500
Transport cost 1 200
Modification 20 000
174 700
(b) Change in net working capital
Add increase in raw materials 2 500

Add increase in finished goods 4 500
Add increase in accounts receivable 60 000
Subtract increase in accounts payable (15 000)
52 000
(c) Initial outlay
Installed cost of new asset 174 700

Add increase in net working capital 52 000
226 700
8.2 Cupsley Ltd have set a 5-year life for the proposed nailfile project. Cupsley’s
management have given you the following forecasts of operating cash flows:
 Sales of nailfiles for the first year are $120 000. The estimated growth rate
for sales is 2% p.a. for the second and subsequent years of the project.
 Raw materials are estimated at 15% of sales.
 Labour costs for the project will be $30 000 per annum.
 Cupsley’s annual electricity bill is $50 000. The electricity cost for the
nailfile project is expected to be 12% of sales.
 Determine the annual net operating cash flow for the nailfile project.

Year 1 Year 2 Year 3 Year 4 Year 5

Sales of nailfiles 1 200 000 122 400 124 848 127 345 129 892
Raw materials -18 000 -18 360 -18 727 -19 102 -19 484
Labour -30 000 -30 000 -30 000 -30 000 -30 000
Electricity -14 400 -14 688 -14 982 -15 281 -15 587
Net operating cash 57 600 59 352 61 139 62 962 64 821
flow
8.3 At the end of 5 years, Cupsley will terminate the nailfile project. It is
expected that the plastic moulding machine that was purchased for the
project will be sold for $30 000. Removal costs of $650 are expected for
the moulding machine. The modifications to the machine used for
pressing the metal part of the files will not affect the future use of that
machine and will remain in place. The increase in net working capital (see
problem 8.1) will be returned to the firm at the end of the project. What is
the terminal value of the nailfile project?
Cash flow at project termination
Sale of machine 30 000

Subtract dismantling cost -650
Cash inflow from machine 29 350
Add return of net working capital 52 000
Terminal value 81 350
8.4 Using your calculations in problems 8.1 to 8.3:

(a) Construct a table of the annual cash flows for Cupsley’s nailfile
project.
(b) Calculate the NPV of the project using a discount rate of 10%.
(c) On the basis of the NPV, is the project acceptable? Why?
(d) Calculate the IRR of the project and compare it to a hurdle rate of
10%.
(e) On the basis of the IRR, is the project acceptable? Why?
(a)
Time zero Year 1 Year 2 Year 3 Year 4 Year 5
Initial outlay –226 700
Net operating cash flow 57 600 59 352 61 139 62 962 64 821
Terminal value 81 350
(a) Net cash flows –226 700 57 600 59 352 61 139 62 962 146 171
(1+0.10)–1 (1+0.10)–2 (1+0.10)–3 (1+0.10)–4 (1+0.10)–5
Discount factor 1 0.9091 0.8264 0.7513 0.6830 0.6209
Present value –1 282 000 52 364 49 048 45 934 43 003 90 758
(b) NPV $54 407

(c) Using a 10% discount rate, the nailfile project would be accepted. The NPV of
$54 407 represents the expected amount of increase to shareholder wealth.
(d) Using a spreadsheet or financial calculator, the IRR of the project is 17.72%.
The IRR is higher than the 10% hurdle rate.
(e) The project should be accepted because the IRR is greater than the hurdle rate
(17.72 > 10).
8.5 Four-poster Co. restores antique brass beds. As part of the restoration
process, the beds are dipped into an acid bath to strip them of old paint.
At present, the company uses an old hand winch to raise and lower the
beds into the acid bath. A new computerised winch has been developed
and is currently available for purchase. The new winch costs $27 000.
Transport and insurance costs to get the new winch to the factory will be
$790. An electrician has quoted $200 to install the machine. The old winch
can be sold to the local museum for $500. Removal costs for the old winch
are expected to be $150. What is the installed cost for the replacement
winch?
Installed cost of replacement project
Cash outflows for replacement machine

Purchase price 27 000
Transport cost 790
Electrical 200
27 990
Cash inflow from existing machine
Sale of machine –500
Cash outflow from existing machine
Dismantling cost 150
Total cash inflows from existing machine –350
Total installed cost of replacement project 27 640
8.6 Sales revenues at Four-poster Co. (see problem 8.5) will not increase if the
new winch is purchased. However, the new winch will prevent employees
from being splashed with acid. The safety improvements mean the
company will save about $4000 each year on the cost of protective
clothing. Currently, staff burnt by acid splashes do not come to work for
an average of 3 days per incident. Elimination of acid splashes would save
the company around $5000 per annum in sick leave payments. Payments
for workers’ compensation insurance would decrease by $1000 p.a. if the
new machine was purchased. The annual electricity cost associated with
operating the new machine is expected to be $2000. The new winch would
be operated for 12 years and could be sold for $5000 at the end of that
time. Management tell you that the appropriate discount rate to use for
analysis is 15%. Using these data and the information from problem 8.5,

calculate the NPV of the new winch. Should the winch be purchased or
not? Why?
Annual cash savings
Gloves and goggles 4000
Sick leave 5000
Workers’ compensation insurance 1000
Electrical –2000
Net savings 8000
n
CFt
NPV    IO
t 1 (1  k a )
t
= -27 600 + 8 000 PVIFA0.15,12 + 5 000 (1 + 0.15)-12

= -27 600 + 8 000 (5.4206) + 5 000 (0.1869)
= $16 699
The existing machine should be replaced because the NPV is positive. Shareholder
wealth will increase if the project is adopted.
8.7 Using 12% as the discount and hurdle rates, calculate the NPV and IRR
for each of the following three projects:
Which projects should be accepted and which should be rejected? Why?

n
CFt
Using equation 8.1 NPV    IO
t 1 (1  k a ) t
NPVA = –50 000 + 15 000 PVIFA0.12,10

= –50 000 + 15 000 (5.6502)
= $34 753
NPVB = –75 000 + 10 000 (1.12)–1 + 10 000 (1.12)–2 + 15 000 (1.12)–3 + 15 000 (1.12)–
4
+ 18 000 (1.12)–5 + 18 000 (1.12)–6 + 17 000 (1.12)–7 + 15 000 (1.12)–8
= –75 000 + 8928.57 + 7971.94 + 10 676.70 + 9532.77 + 10 213.68 + 9119.36
+ 7689.94 + 6058.25
= $–4808.80

NPVC = –100 000 + 25 000 (1.12)–1 + 25 000 (1.12)–2 + 35 000 (1.12)–3 – 10 000
(1.12)–4 + 40 000 (1.12)–5 + 45 000 (1.12)–6
= –100 000 + 22 321.43 + 19 929.85 + 24 912.31 – 6355.18 + 22 697.07
+ 22 798.40
= $6303.88
Using the NPV as our acceptance criterion, Projects A and C would be accepted. The
positive NPVs of these projects indicate that acceptance will increase shareholder
wealth. Project B should be rejected as its negative NPV tells us that adoption will
decrease shareholder wealth.
IRRA = 27.32% IRRB = 10.31% IRRC = 14.05%
Using the IRR as our acceptance criterion, Projects A and C would be accepted. The
IRRs of these projects exceed the hurdle rate of 12% so indicate that acceptance will
increase shareholder wealth. Project B should be rejected as its IRR is lower than the
required return of 12%. If there had been conflict with the accept–reject decision
under NPV and IRR for Project C, the NPV result should be the deciding factor.
Project C has a net cash outflow in year 4, making the results of the IRR method
unreliable.
8.8 Babycare are considering a 4-year project to manufacture stain-resistant

baby bibs. The firm has spent $10 000 researching the project and have
estimated an annual demand of 20 000 units. The bibs will sell for $7.50
each and the cash costs per unit will be $3.25. An inventory of 25% of
sales will be maintained over the life of the project. Additional equipment
to manufacture the bibs will cost $70 000. Transport and insurance of the
equipment will cost $2000 and a further $8000 will be needed to install the
equipment and modify it to suit Babycare’s needs. The project equipment
will be sold for $10 000 at the end of the project and 80% of the working
capital will be returned. The firm’s cost of capital is 12% and the bib
project has the same level of risk as current projects.
(a) estimate the cash flows for the project.
Purchase price –70 000

Transport and insurance –2 000
Installation –8 000
Installed cost –80 000
Increase in inventory* –37 500
Annual sales = 20 000 × 7.50 = 150 000

COGS = 20 000 × 3.25 = 65 000
* required inventory = 150 000 × 0.25 = 37 500

t=0 Year 1 Year 2 Year 3 Year 4

Sales 150 000 150 000 150 000 150 000
COGS –65 000 –65 000 –65 000 –65 000
Operating CF 85 000 85 000 85 000 85 000
Terminal value** 40 000
Cash flows –117 500 85 000 85 000 85 000 125 000
**terminal value = 10 000 + 0.8(37 500) = 40 000
(b) calculate the NPV for the project. Should the project be accepted?
Using a discount rate of 12%, the NPV of the project is $166 095.42. As the NPV is
greater than zero, the project should be accepted to increase shareholder wealth.
(c) calculate the IRR for the project. Should the project be accepted?
Using Excel to calculate the IRR gives 65.71%. As the IRR is larger than the hurdle
rate (i.e. 65.71 > 12), the project should be accepted to increase shareholder wealth.
8.9 Given your interest in sports and computers, you are considering
establishing a computer games development business. You would like to
run the business for the next 5 years and your required return is 18%.
You would need hardware worth around $200 000 to start development
and production of your first game ‘Super Hoop Croquet’. The equipment
would be scrapped at the end of the project.
You have decided to locate your business in a regional centre rather than
the city in order to lower rental costs. Your annual rent will be $30 000.
The going rate for programmers in the area is $70 000 p.a. and you would
employ 4 of these.
Sales for the first year are expected to be 3 700 units. Sales are expected to
grow at 7% p.a. for the following 4 years of the project. The selling price
will be around $130 per unit and the production costs will be $16 per unit.
Marketing costs are expected to be 20% of annual sales and are paid at
the start of each year based on the sales estimate for the year. An
inventory worth $52 000 will also be needed at the commencement of
operations. The inventory cost will be recovered at the end of the project.
Showing all relevant cash flows, calculate the project’s NPV and IRR. No
incomplete units can be sold, so round the unit sales to the nearest whole
number. Should you start this business?
Installed cost –200 000

Increase in inventory –52 000
Year 1 sales = 3 700 × 130 = 481 000

Year 2 sales = 3 700(1.07) × 130 = 514 670

Year 3 sales = 3 959 (1.07) × 130 = 550 680

Year 4 sales = 4 236 (1.07) × 130 = 589 290
Year 5 sales = 4 533 (1.07) × 130 = 630 500
initial outlay = 200 000 + 52 000 = 252 000

terminal value = return of working capital = 52 000
Salaries = 70 000 * 4 = 280 000
t=0 Year 1 Year 2 Year 3 Year 4 Year 5

Sales 481 000 514 670 550 680 589 290 630 500
COGS –59 200 –63 344 –67 776 –72 528 –77 600
Rent –30 000 –30 000 –30 000 –30 000 –30 000
Salaries –280 000 –280 000 –280 000 –280 000 –280 000
Marketing –96 200 –102 934 –110 136 –117 858 –126 100
Operating CF –96 200 8 866 31 190 55 046 80 662 242 900
Terminal value** 52 000
Cash flows –348 200 8 866 31 190 55 046 80 662 294 900
PVF (18%) 1 0.8475 0.7182 0.6086 0.5158 0.4371
PV of CF –348 200 7 514 22 401 33 501 41 605 128 901
NPV = -$114 278 - reject

IRR = 7.29%
8.10 Hard Rider design, manufacture and sell motor cycle leathers. They
currently have 15% of the market for these goods (the total market is
worth $4 million pa). Hard Rider’s fixed costs are $25 000 and variable
costs are 45% of sales. The management of the firm believe that their
market share would increase to 30% if they replace the existing
manufacturing equipment and spend an additional $150 000 p.a. on
advertising. The current equipment has a market value of $25 000. New
equipment would cost $800 000 and has an estimated resale value of
$50 000 at the end of the 10 year project life. Hard Rider will continue to
maintain working capital at 14% of sales. Determine the relevant cash
flows for the project and calculate the NPV using a required return of
15%.

Sale of old equipment 25 000
Increase in inventory* –84 000
Annual incremental sales = $4 000 000 × (0.3 – 0.15) = 600 000

Annual incremental variable costs = 600 000 × 0.45 = 270 000
* required inventory = 600 000 × 0.14 = 84 000

*terminal value = 50 000 + 84 000 = 134 000

t=0 year 1 year 2 year 3 year 4 year 5 year 6 year 7 year 8 year 9 year 10
working capital –84 000
inc sales 600 000 600 000 600 000 600 000 600 000 600 000 600 000 600 000 600 000 600 000
–270 –270 –270 –270 –270 –270 –270 –270 –270
inc VC –270 000 000 000 000 000 000 000 000 000 000
–150 –150 –150 –150 –150 –150 –150 –150
inc advertising –150 000 000 000 000 000 000 –150000 000 000 000
terminal value* 134 000
net cash flows –859 000 180 000 180 000 180 000 180 000 180 000 180 000 180000 180 000 180 000 314 000
PVF 1 0.8696 0.7561 0.6575 0.5718 0.4972 0.4323 0.3759 0.3269 0.2843 0.2472
NPV $77 501.10

8.11 Postal Chic is an upmarket mail-order fashion distributor. They are
considering replacing their manual ordering system with a computerised
system that allows customers to order online. The system will also be used to
order stock from Postal Chic’s suppliers and halve the current delivery time
to the Postal Chic warehouses.
The computerised system will cost $3 million to purchase and install and will
have annual running costs of $400 000. It will replace a manual system that
costs $600 000 to operate. The new system is expected to last 6 years and will
have no salvage value at the end of that time.
The attractiveness and accessibility of the new system is expected to increase
sales from the current level of $2 million p.a. to $2.5 million for the next
6 years. Postal Chic will be able to cut their inventory from 60% of sale to
20%. The reduced inventory levels would apply at the commencement of the
project. Postal Chic hope this lower level of inventory would continue even
when the proposed system is replaced in 6 years time. The project has the
same level of risk as those current undertaken in the firm. Postal Chic have a
cost of capital of 16%.
(a) determine the relevant cash flows for the project.
Purchase price –3 000 000

Increase in inventory* 700 000
Initial outlay –2 300 000
Annual incremental sales = $500 000

Annual operating cost saving = 600 000 × 0.45 = 270 000
* old inventory level = 2 000 000 × 0.6 = 1 200 000

new inventory level = 2 500 000 × 0.2 = 500 000
reduction of inventory level = 1 200 000 – 500 000 = 700 000
*operating cost savings = 600 000 – 400 000 = 200 000
t=0 year 1 year 2 year 3 year 4 year 5 year 6

initial outlay –3 000 000
working capital
reduction* 700 000
inc sales 500 000 500 000 500 000 500 000 500 000 500 000
op cost saving* 200 000 200 000 200 000 200 000 200 000 200 000
net cash flow –2 300 000 700 000 700 000 700 000 700 000 700 000 700 000
PVF 1 0.8621 0.7432 0.6407 0.5523 0.4761 0.4104
–2 300 000 603 470 520 240 448 490 386 610 333 270 287 280
NPV $279 360
(b) calculate the NPV. Should the project be accepted?

With an NPV of $279 360, the project should be accepted to increase shareholder wealth.
(c) calculate the IRR. Should the project be accepted?
Excel was used to calculate an IRR of 20.49%. This is higher than the hurdle rate of 16%,
so the project should be accepted to increase shareholder wealth.
8.12 The Entertainment Company operate a pay 3 TV channels, a free-to air

radio station and manufacture CDs and DVDs. They are considering
introducing an ‘on-demand’ movie channel that will allow customers to
purchase latest release movies for viewing as many times as they wish within
24 hours of the purchase. They are currently estimating the cash flows for
the on-demand movie project and are unsure how to deal with the following:
(i) Copyright costs: licence fees of $3.5 million are paid annually to movie
studios so the Entertainment Company can reproduce movies on DVD
and to show the movies in any setting other than a cinema.
The copyright costs are not incremental to the on-demand project. They will exist if the
project is accepted or not. They should not be included in the project’s cash flows.
(ii) Server costs: the firm currently has excess server capacity that could be
used for the on-demand project. Before the project was proposed,
management had planned to sell the excess server for $15 000.
The lost revenue associated with the server costs for the on-demand project should be
considered an opportunity cost of the new project. The $15 000 should be shown as an
outflow when estimating the operating cash flows.
(iii) Hardware costs: the firm’s current computer network would be used to
meet the needs of the on-demand movie customers. The network was
installed last year at a cost of $500 000.
The hardware cost of $500 000 has already been outlaid and will not change with
acceptance of the project, so it cannot be incremental and should not be included in the
relevant cash flows.
(iv) Software costs: the ordering of on-demand movies requires special

software that was purchased last month. The software cost $5000 and
the purchase was made to assess the technical feasibility of the project.
The software cost of $5000 is a sunk cost. It was made prior to the acceptance of the
project and, even though it relates only to this project, it is irrelevant — it will not change
with the acceptance of the new project.

(v) DVD sales and pay TV revenues: the firm estimates that the demand for
DVDs and pay TV subscriptions will decrease if an on-demand movie
service is offered. Management expect that their competitors will lose
$3 million p.a. if the on-demand project goes ahead. They also expect
that the Entertainment Company’s sales of DVDs would fall by $50 000
p.a. and that $100 000 less would be received from pay TV
subscriptions. Which of these cash flows would be the relevant cash
flows? Explain why you have included or excluded each of the 4 items.
Lost DVD and pay TV revenues are incremental to the project — if the project is not
accepted, these cash inflows will not be lost. They are opportunity costs and should be
shown as outflows of $150 000 p.a. when estimating the project’s operating cash flows.
8.13 The Entertainment Company is also considering replacing the broadcasting

equipment for the pay TV channels. Management expect the following
changes to be associated with replacing the equipment:
$
Spare parts inventory decrease –20 000
Accounts receivable increase 50 000
Accounts payable increase –1 000
Cash increase 5 000
What is the change in net working capital associated with the replacement project?
Change in net working capital

Add increase in cash 5 000
Less decrease in inventory –20 000
Less increase in accounts payable –1 000
34 000
8.14 Corrugated Metals want to modernise the welding section of their production
line. A new high tech production system will cost $250 000 to purchase, $5000
to insure and transport to the plant and $3000 to install. The existing
equipment cost $50 000 10 years ago and could be sold for $10 000 as is. The
new system would result in a significant annual sales increase and higher
production levels. To support these, management have estimated that
accounts receivable would increase by $30 000, accounts payable would
increase by $20 000 and inventory would increase by $10 000. What is the
initial outlay for the new welding system?
Installed cost

Insurance and transport –5 000

Installation –3 000
Sale of existing equipment 10 000
–248 000
Change in net working capital
Less increase in accounts payable –20 000
Add increase in inventory 10 000
20 000
8.15 Sportique Ltd operates a chain of 114 sports wear and equipment stores
nation wide. Sales last year were $700 million and cost of goods sold is 73%
of sales. The selling and advertising expenses of the firm are $190 000 per
annum. Sixty per cent of the advertising expense is charged to head office.
The remainder of the cost is shared equally among the stores.
The company is considering opening a new store that will cost $500 000 to
establish. 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 cash flows for the first 3 years of operation for the new store.
Round your calculations for revenue and expenses to the nearest whole
dollar.
Year 0 1 2 3
Sales 6 140 351 6 140 351 6 140 351
Cost of goods sold 4 482 456 4 482 456 4 482 456
Net cash flow –500 000 1 657 895 1 657 895 1 657 895
Average existing sales per store = 700 000 000 / 114

Advertising is not included as this cost is fixed. Fixed costs are not incremental so are not
relevant in the new project decision.
8.16 You have decided to cash in on the dancing craze in your town, so you are
thinking about setting up a dance studio. You can rent a warehouse close to
the business district for $40 000 p.a. In order to attract the ‘right’ sort of
clientele, you will need to spend $120 000 on redecorating and installing
mirrors on all surfaces. You will also purchase some equipment at a cost of
$70 000. You expect that the equipment can be sold at the end of four years
for $7 000.
Your market research suggests you can attract and maintain 600 students.
Each would pay an annual tuition fee of $900. Instructors are usually paid a

salary of $43 000 p.a. and you would employ 5 of these to keep the studio
operating 7 days a week. You will operate the business for 4 years before
retiring. If your cost of capital is 14%, should you set up the business?
Calculate IRR and NPV to support your decision.
Year 0 1 2 3 4
Redecorating –120 000
Equipment –70 000
Student fees 540 000 540 000 540 000 540 000
Rent –40 000 –40 000 –40 000 –40 000
Salaries –215 000 –215 000 –215 000 –215 000
Sale of equipment 7 000
Net cash flow –230 000 285 000 285 000 285 000 332 000
PVF 1 0.8772 0.7695 0.675 0.5921
–230 000 250 002 219 307.5 192 375 196 577.2
NPV 628 261.7
IRR 119.64%
Student fees are calculated as 600 × 900

Salaries are calculated as 43 000 × 5
IRR is calculated in Excel
The business should be established as the NPV is positive and the IRR is larger than the
hurdle rate.
8.17 You have been asked to evaluate a proposal for the owner of Gloss
Cosmetics. She has given you the following information about the project:
 it has a 7 year lifetime
 the installed cost of the project will be $430 000
 the asset will be sold at the end of the project for an estimated $15 000
 sales of $200 000 are expected in the first year of the project
 sales will grow at a rate of 8% p.a. for each year of the project
 cost of goods sold (excluding depreciation) is expected to be 25% of sales
 the owner’s required return is 18%.
Using IRR and NPV, advise the owner of Gloss Cosmetics on the
acceptability of the project. Round each calculation to the nearest whole
dollar.

Year 0 1 2 3 4 5 6 7
Sales 200 000 216 000 233 280 251 942 272 097 293 865 317 374
Cost of goods sold –50 000 –54 000 –58 320 –62 986 –68 024 –73 466 –79 344
Sale of asset 15 000
Net cash flow –430 000 150 000 162 000 174 960 188 956 204 073 220 399 253 030
PVF 1 0.8475 0.7182 0.6086 0.5158 0.4371 0.3704 0.3139
PV –430 000 127 125 116 348.4 106 480.7 97 463.5 89 200.31 81 635.79 79 426.12
NPV 267 679.78
IRR 36.08%
As the NPV is larger than zero, the project should be accepted to increase shareholder wealth.
The IRR was calculated in Excel. As 36.08 > 18, the IRR indicates that the project should be accepted to increase shareholder wealth.

8.18 Mick and Steve have a partnership that manufactures racing accessories that
can be fitted to street cars. They would like you to evaluate a project for
them and have provided the following details:
 The initial investment in the project is $300 000 for production

equipment.
 The assets purchased at the commencement of the project will be sold at
the end of year 6 for $90 000.
 The assets require an overhaul that will cost $27 000 at the end of year 4.
 Working capital will be 5% 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 50% of sales.
 Wages are $250 000 per annum
 The required return of the partners is 17%.
(a) calculate the relevant cash flows for the project

Year 0 1 2 3 4 5 6
Sales 300 000 600 000 700 000 500 000 500 000 400 000
Cost of goods sold –150 000 –300 000 –350 000 –250 000 –250 000 –200 000
Wages –250 000 –250 000 –250 000 –250 000 –250 000 –250 000
Change in working capital* –15 000 –15 000 –5 000 10 000 0 5 000 20 000
Asset overhaul –27 000
Sale of assets 90 000
Net cash flows –315 000 –115 000 45 000 110 000 –27 000 5 000 60 000
PVF 1 0.8547 0.7305 0.6244 0.5337 0.4561 0.3898
PV –315 000 –98 290.5 32 872.5 68 684 –14 409.9 2 280.5 23 388
NPV –300 475.4
IRR –19.80%
* working capital equal to 5% of the next year’s revenues is required at the start of each year. The first working capital cash outflow
must be made at the start of the project.
Working capital is not ‘used up’ and is remains in the firm until the project is completed. We need to calculate the change in working
capital for each year to see how much more is required for the following year (years 0 – 2) or how much is freed up each year
(years 3 – 6). The year 6 cash flow is the return of the year 5 working capital amount when the project is completed. The following
table shows the annual amounts used for this calculation.
Working capital required –15 000 –30 000 –35 000 –25 000 –25 000 –20 000
Change in working capital –15 000 –15 000 –5 000 10 000 0 5 000 20 000

(b) calculate the NPV for the project. Make a recommendation about the
acceptability of the project.
The NPV of the project is -$300 475.40 (see part a). As the NPV is negative, the project
should be rejected to avoid decreasing the owners’ wealth.
(c) calculate the IRR for the project. Make a recommendation about the
acceptability of the project
The IRR of the project is negative (calculated in Excel). As –19.08% is well below the
owners’ required return, the project should be rejected. If the IRR had been greater than
the required return, you would still reject this project. There is a negative net cash
outflow in year 4 making the IRR method unreliable, so given the negative NPV, you
would reject the project.
8.19 Patterns Ltd have asked you to evaluate a project for them. They provide the
following details:
Year 1 Year 2 Year 3 Year 4
Revenue 220 000 230 000 240 000 180 000
Cost of goods sold 24 200 25 430 26 400 19 900
 The initial investment in the project is $300 000 and an additional
investment of $30 000 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 $50 000.
 Working capital will be 8% 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 15%.
(a) estimate the relevant cash flows for the project
Year 0 1 2 3 4
Revenue 220 000 230 000 240 000 180 000
Cost of goods sold 24 200 25 430 26 400 19 900
Additional investment –30 000
Change in working capital* –17 600 –800 –800 4 800 14 400
Sale of asset 50 000
Net cash flows –317 600 243 400 224 630 271 200 264 300
PVF 1 0.8696 0.7561 0.6575 0.5718
PV –317600 211660.6 169842.7 178 314 151 126.7
NPV 393 344.12
IRR 67.24%
* working capital equal to 8% of the next year’s revenues is required at the start of each
year. The first working capital cash outflow must be made at the start of the project.

Working capital is not ‘used up’ and is remains in the firm until the project is completed.
We need to calculate the change in working capital for each year to see how much more
is required for the following year (years 0–2) or how much is freed up each year (years 3–
4). The year 4 cash flow is the return of the year 3 working capital amount when the
project is completed. The following table shows the annual amounts used for this
calculation.
–14
Working capital required –17 600 –18 400 –19 200 400
change in working capital –17 600 –800 –800 4 800 14 400
(b) Calculate the NPV for the project
The NPV is $393 344.12, so the project should be accepted to increase shareholder
wealth.
(c) Calculate the IRR for the project
The IRR (calculated in Excel) is 67.24%. As 67.24% > 15%, the IRR indicates that the
project should be accepted.

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John Wiley & Sons Australia, Ltd

End of Chapter Questions

8.1 What is an ‘investment’? Why do companies make investments?

Growth can be achieved by expanding current operations or making investments in

© John Wiley and Sons Australia, Ltd 2008 8.1

© John Wiley and Sons Australia, Ltd 2008 8.2

© John Wiley and Sons Australia, Ltd 2008 8.3

If NPV is positive, shareholder wealth will be increased.

(b) NPV is zero

(c) NPV is negative

© John Wiley and Sons Australia, Ltd 2008 8.4

(b) IRR is equal to the hurdle rate

(c) IRR is less than the hurdle rate

8.17 What is the typical cash flow pattern for a project?

© John Wiley and Sons Australia, Ltd 2008 8.5

8.1 Cupsley Ltd is a manufacturer of cutlery. The firm’s managers have

© John Wiley and Sons Australia, Ltd 2008 8.6

production capacity. The existing machine would be modified at a cost of

(a) Installed cost of new asset

Purchase price 150 000

(b) Change in net working capital

Add increase in raw materials 2 500

(c) Initial outlay

Installed cost of new asset 174 700

© John Wiley and Sons Australia, Ltd 2008 8.7

Year 1 Year 2 Year 3 Year 4 Year 5

Cash flow at project termination

Sale of machine 30 000

8.4 Using your calculations in problems 8.1 to 8.3:

(b) NPV $54 407

© John Wiley and Sons Australia, Ltd 2008 8.8

Installed cost of replacement project

Cash outflows for replacement machine

© John Wiley and Sons Australia, Ltd 2008 8.9

= -27 600 + 8 000 PVIFA0.15,12 + 5 000 (1 + 0.15)-12

Which projects should be accepted and which should be rejected? Why?

NPVA = –50 000 + 15 000 PVIFA0.12,10

© John Wiley and Sons Australia, Ltd 2008 8.10

IRRA = 27.32% IRRB = 10.31% IRRC = 14.05%

8.8 Babycare are considering a 4-year project to manufacture stain-resistant

Purchase price –70 000

Annual sales = 20 000 × 7.50 = 150 000

© John Wiley and Sons Australia, Ltd 2008 8.11

t=0 Year 1 Year 2 Year 3 Year 4

**terminal value = 10 000 + 0.8(37 500) = 40 000

Installed cost –200 000

Year 1 sales = 3 700 × 130 = 481 000

© John Wiley and Sons Australia, Ltd 2008 8.12

Year 3 sales = 3 959 (1.07) × 130 = 550 680

initial outlay = 200 000 + 52 000 = 252 000

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

NPV = -$114 278 - reject

Purchase price –800 000

Annual incremental sales = $4 000 000 × (0.3 – 0.15) = 600 000

* required inventory = 600 000 × 0.14 = 84 000

© John Wiley and Sons Australia, Ltd 2008 8.13