PArT 3: CAPITAL BUDGETING
KEY TErMS
cannibalisation, 370
capital rationing, 377
depreciation tax shield, 363
diminishing value
method, 362equivalent annual cost (EAC)
method, 379
incremental cash flows,
357
net working capital, 364non-cash expenses, 360
opportunity costs, 369
prime cost method, 362
sunk cost, 369
terminal value, 365SELF-TEST PrOBLEMS
Answers to Self-test problems and the Concept review questions throughout the chapter appear on
CourseMate with SmartFinance Tools at http://www.login.cengagebrain.com.
ST10-1 Claross Ltd wants to determine the relevant operating cash flows associated with the proposed
purchase of a new piece of equipment that has an installed cost of $100 million, an expected
life of five years and is to be depreciated using the diminishing value method. The company’s
financial analyst estimated that the relevant time horizon for analysis is six years. She expects
the revenues attributable to the equipment to be $158 million in the first year and to increase
at 5% per year through year 6. Similarly, she estimates all expenses, other than depreciation
attributable to the equipment, to total $122 million in the first year and to increase by 4% per
year until year 6. She plans to ignore any cash flows after year 6. The company has a marginal tax
rate of 30% and its required return on the equipment investment is 13%. (Note: round all cash
flow calculations to the nearest $0.01 million.)
a Find the relevant incremental cash
flows for years 0 to 6.
b Using the cash flows found in part (a),
determine the NPV and IRR for the
proposed equipment purchase.c Based on your findings in part (b),
would you recommend that Claross
Ltd purchase the equipment? Why?ST10-2 Tektek Industries wants to determine whether it would be advisable for it to replace an existing,
fully depreciated machine with a new one. The new machine will have an after-tax installed cost
of $300,000 and will be depreciated under a three-year diminishing value schedule. The old■ To find working capital cash flow, calculate
the change in net working capital from one
period to the next. Increases in net working
capital represent cash outflows, whereas
decreases in net working capital represent
cash inflows.■ To find operating cash flow, calculate after-
tax net income (as if the company had no
debt) and add back any non-cash expenses.
■ To find terminal value, or terminal cash flow,
employ one of several methods, including
the perpetual growth model and the use of
book value, or market multiples.
■ When capital rationing exists, managers
should analyse all combinations of projectsthat satisfy the budget constraint and
choose the combination that has the
highest overall NPV.■ When evaluating alternative equipment
purchases with unequal lives, determine the
equivalent annual cost (EAC) of each type of
equipment and choose the one that is least
expensive.
■ When confronted with proposals to use
excess capacity, think carefully about the true
cost of that capacity. It is rarely zero.
■ When analysing capital budgeting projects,
it is important to consider human factors and
make sure that the project, in addition to
having a positive NPV, makes sense.LO 10.4LO 10.5LO 10.6