PArT 3: CAPITAL BUDGETING
a Calculate the operating cash flows associated with each packaging machine. Be sure to
consider the depreciation in year 6.
b Calculate the incremental operating cash flows resulting from the proposed packaging
machine replacement.
c Depict on a time line the incremental operating cash flows found in part (b).
P10-6 Primary Wines, a producer of medium-quality wines, has maintained stable sales and profits over
the past eight years. Although the market for medium-quality wines has been growing by 4%
per year, Primary Wines has been unsuccessful in sharing this growth. To increase its sales, the
company is considering an aggressive marketing campaign that centres on regularly running
ads in major food and wine magazines and airing TV commercials in large metropolitan areas.
The campaign is expected to require an annual tax-deductible expenditure of $3 million over
the next five years. Sales revenue for 2015, as noted in the following income statement, totalled
$80 million. If the proposed marketing campaign is not initiated, sales are expected to remain
at this level in each of the next five years, 2016–2020. With the marketing campaign, sales are
expected to rise to the levels shown in the sales forecast table for each of the next five years. The
cost of goods sold is expected to remain at 75% of sales; general and administrative expense
(exclusive of any marketing campaign outlays) is expected to remain at 15% of sales; and annual
depreciation expense is expected to remain at $2 million. Assuming a 30% tax rate, find the cash
flows over the next five years associated with Primary Wines’ proposed marketing campaign.Primary Wines income statement for the year ended 31 December 2015
Sales revenue $80,000,000
Less: Cost of goods sold (75%) 60,000,000
Gross profits $20,000,000
Less: Operating expenses
General and administrative expense (15%) 12,000,000
Depreciation expense 2,000,000
Total operating expense 14,000,000
Net profits before taxes $6,000,000
Less: Taxes (rate = 30%) 1,800,000
Net profits after taxes $4,200,000
Primary Wines sales forecast
Year Sales revenue
2016 $82,000,000
2017 84,000,000
2018 86,000,000
2019 90,000,000
2020 94,000,000INCREMENTAL CASH FLOWS
P10-7 Identify each of the following situations as involving sunk costs, opportunity costs and/or
cannibalisation. Indicate what amount, if any, of these items would be relevant to the given
investment decision.