Week 3 Problem Set (Solutions)

MBA 643
Week 3: Solutions
Question 1
You have been assigned to evaluate a discounted cash flow analysis that has been performed by the
engineering division of your firm, a large, profitable diversified manufacturing company. The analysis
evaluates a new project to product industrial robots; $50,000 has already been spent on research and
development on this project. Since the company currently has no debt in its capital structure, it is believed
that the total amount of funds required ($150,000) could be raised through a bond issue carrying an
interest rate of 10%. The engineering division's cash flow statement for the project is presented below.
NEW CASH FLOWS ($ thousands)
Year 0 Year 1 Year 2
Research & Development -50
Capital Expenditure -100
Working Capital Investment -50
Operating Profit 215 215
Depreciation Expense -50 -50
Interest Expense -15 -15
Income Before Taxes 150 150
Taxes (40% rate) -60 -60
Net Cash Flow -200 90 90
NPV at 10% = $43.8 thousand
With apologies to all engineers out there, there may be some problems with the above NPV analysis.
Identify the problems, and explain the correct way to deal with each problem. You do not need to perform
a whole new NPV analysis, just point out the problems with this one.
ANSWER:
1. The R&D expense is a sunk cost and thus irrelevant.
1
2. The interest expense should not be included in the cash flows.
3. Tax depreciation needs to be added back to after-tax income to get the net cash flow.
4. We also need to add a recovery of the working capital investment at the end of year 2.
Question 2: Estimating Cash Flows
ACE ELECTRONICS is negotiating with a Japanese auto manufacturer to supply instrumentation for a
new "smart" car with built-in navigational capabilities. The firm is considering two mutually exclusive
strategies. One strategy, the CONSERVATIVE plan, requires a moderate initial investment by ACE and a
commitment to supply for three years. The other strategy, the AGGRESSIVE plan, calls for a more
substantial initial investment and a commitment of six years. Data on the two strategies are reported
below. Neither project will be repeated at the end of its economic life.
Which strategy would be pursued if ACE's capital budgeting criterion was:

a) Payback
b) IRR
c) NPV
d) Equivalent Annual Annuity
CASH FLOWS ($ thousands)

CONSERVATIVE AGGRESSIVE
Initial Investment $1,800 $6,000
Salvage Value 0 500
Net Working Capital Required 1200 900

(Constant level throughout life)
Economic Life 3 years 6 years
Net Cash flow $1,800/yr $2,600/yr (year 1-3)

Before Depreciation and Taxes $3,400/yr (year 4-6)
The corporate income tax rate is 40%, the firm estimates that it can earn 15% after tax on investments
with similar risk, the firm uses straight line depreciation for all investments, and all investments are
depreciated to $0 by the end of their economic life. All cash flows, other than the initial investment and
the working capital requirement, occur at year end.
2
ANSWER:
Conservative Plan
Year 0 Year 1 Year 2 Year 3

Net operating cash flow before depr & taxes 1,800 1,800 1,800
- Depreciation -600 -600 -600
Earnings before interest and taxes (EBIT) 1,200 1,200 1,200
- Taxes (40%) -480 -480 -480
Net Income (NI) 720 720 720
+ Depreciation 600 600 600
Operating cash flow (OCF) 1,320 1,320 1,320
- Capital expenditure -1,800
- Opportunity cost (after-tax)
- Changes in net working capital -1,200 1,200
+ After-tax salvage value 0
+ Side effects (after-tax)
Total project cash flow -3,000 1,320 1,320 2,520
A. Payback = 2 + (3000 – 1320 – 1320)/2520 = 2 + 360/2520 = 2.14 years

B. IRR = 28.8%
C. NPV = $802.88
D. EAA = $351.64
(PV = 802.88, N=3, I=15, FV=0, compute PMT= -351.64)
Aggressive Plan
Year 0 Years 1-3 Years 4-5 Year 6

Net operating cash flow before depr & taxes 2,600 3,400 3,400
- Depreciation -1,000 -1,000 -1,000
Earnings before interest and taxes (EBIT) 1,600 2,400 2,400
- Taxes (40%) -640 -960 -960
Net Income (NI) 960 1,440 1,440
+ Depreciation 1,000 1,000 1,000
Operating cash flow (OCF) 1,960 2,440 2,440
- Capital expenditure -6,000
- Opportunity cost (after-tax)
- Changes in net working capital -900 900
+ After-tax salvage value 300
+ Side effects (after-tax)
Total project cash flow -6,900 1,960 2,440 3,640
3
A. Payback = 3 + (6900 – 1960 – 1960 – 1960)/2440 = 3 + 1020/2440 = 3.42 years
B. IRR = 23.15%
C. NPV = $1,757
D. EAA = $464.26
(PV = 1,757, N=6, I=15, FV=0, compute PMT= -464.26)
The optimal strategy by each of the following criterion is:

a) Payback: Conservative
b) IRR: Conservative
c) NPV: Aggressive
d) EAA: Aggressive
Question 3: Estimating Cash Flows

United Pigpen is considering a proposal to manufacture high-protein hog feed. The project would make
use of an existing warehouse, which is currently rented out to a neighboring firm. The next year’s rental
charge on the warehouse is $100,000 (before tax), and thereafter the rent is expected to grow in line with
inflation at 4% a year. In addition to using the warehouse, the proposal envisages an investment in plant
and equipment of $1.2 million. This could be depreciated for tax purposes straight-line over 10 years.
However, Pigpen expects to terminate the project at the end of eight years and to resell the plant and
equipment in year 8 for $400,000. Finally, the project requires an initial investment in working capital of
$350,000. Thereafter, working capital is forecasted to be 10% of sales in each years 1 through 7.
Year 1 sales of hog feed are expected to be $4.2 million, and thereafter sales are forecasted to grow by
5% a year, slightly faster than the inflation rate. Manufacturing costs are expected to be 90% of sales, and
profits are subject to tax at 35%. The cost of capital is 12%. What is the NPV of Pigpen’s project? (You
can use Excel to work out the cash flows for this problem)
ANSWER:
Please refer to Excel spreadsheet “Week 3 problem set, Question 3 solutions.xlsx”.

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MBA 643

Year 0 Year 1 Year 2

Research & Development -50

Capital Expenditure -100

Working Capital Investment -50

Operating Profit 215 215

Depreciation Expense -50 -50

Interest Expense -15 -15

Income Before Taxes 150 150

Taxes (40% rate) -60 -60

Net Cash Flow -200 90 90

NPV at 10% = $43.8 thousand

1. The R&D expense is a sunk cost and thus irrelevant.

Question 2: Estimating Cash Flows

Which strategy would be pursued if ACE's capital budgeting criterion was:

CASH FLOWS ($ thousands)

Initial Investment $1,800 $6,000

Salvage Value 0 500

Net Working Capital Required 1200 900

Economic Life 3 years 6 years

Net Cash flow $1,800/yr $2,600/yr (year 1-3)

Year 0 Year 1 Year 2 Year 3

A. Payback = 2 + (3000 – 1320 – 1320)/2520 = 2 + 360/2520 = 2.14 years

Year 0 Years 1-3 Years 4-5 Year 6

The optimal strategy by each of the following criterion is:

Question 3: Estimating Cash Flows

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