Problems 327
Self-Test Problems (Solutions Appear in Appendix A)
You have been asked by the president of the Farr Construction Company to evaluate the pro-
posed acquisition of a new earth mover. The mover’s basic price is $50,000, and it would cost
another $10,000 to modify it for special use. Assume that the mover falls into the MACRS
3-year class, it would be sold after 3 years for $20,000, and it would require an increase in net
working capital (spare parts inventory) of $2,000. The earth mover would have no effect on rev-
enues, but it is expected to save the firm $20,000 per year in before-tax operating costs, mainly
labor. The firm’s marginal federal-plus-state tax rate is 40 percent.
a.What is the net cost of the earth mover? (That is, what are the Year 0 cash flows?)
b.What are the operating cash flows in Years 1, 2, and 3?
c.What are the additional (nonoperating) cash flows in Year 3?
d.If the project’s cost of capital is 10 percent, should the earth mover be purchased?
The staff of Porter Manufacturing has estimated the following net after-tax cash flows and
probabilities for a new manufacturing process:
Net After-Tax Cash Flows
Year P 0.2 P 0.6 P 0.2
0 ($100,000) ($100,000) ($100,000)
1 20,000 30,000 40,000
2 20,000 30,000 40,000
3 20,000 30,000 40,000
4 20,000 30,000 40,000
5 20,000 30,000 40,000
5* 0 20,000 30,000
Line 0 gives the cost of the process, Lines 1 through 5 give operating cash flows, and Line 5*
contains the estimated salvage values. Porter’s cost of capital for an average-risk project is 10
percent.
a.Assume that the project has average risk. Find the project’s expected NPV. (Hint: Use ex-
pected values for the net cash flow in each year.)
b.Find the best-case and worst-case NPVs. What is the probability of occurrence of the worst
case if the cash flows are perfectly dependent (perfectly positively correlated) over time? If
they are independent over time?
c.Assume that all the cash flows are perfectly positively correlated, that is, there are only three
possible cash flow streams over time: (1) the worst case, (2) the most likely, or base, case, and
(3) the best case, with probabilities of 0.2, 0.6, and 0.2, respectively. These cases are repre-
sented by each of the columns in the table. Find the expected NPV, its standard deviation,
and its coefficient of variation.
Problems
Johnson Industries is considering an expansion project. The necessary equipment could be pur-
chased for $9 million, and the project would also require an initial $3 million investment in net
operating working capital. The company’s tax rate is 40 percent. What is the project’s initial
investment outlay?
Nixon Communications is trying to estimate the first-year operating cash flow (at t 1) for a
proposed project. The financial staff has collected the following information:
Projected sales $10 million
Operating costs (not including depreciation) $7 million
Depreciation $2 million
Interest expense $2 million
8–2
OPERATING CASH FLOW
8–1
INVESTMENT OUTLAY
ST–2
CORPORATE RISK ANALYSIS
ST–1
NEW PROJECT ANALYSIS
326 Cash Flow Estimation and Risk Analysis
