FNAN 303

Solutions to test bank problems – relevant cash flows and NPV analysis

Some answers may be slightly different than provided solutions due to rounding

1. Kwon Jewelers is evaluating a 1-year project that would involve an initial investment in
equipment of $27,000 and an expected cash flow of $34,500 in 1 year. The project has a cost of
capital of 8.74 percent and an internal rate of return of 27.78 percent. If Kwon Jewelers were to
use $27,000 in cash from its bank account to purchase the equipment, the net present value of the
project would be $4,727. However, Kwon Jewelers has no cash in its bank account, so using
money from its account is not possible. Therefore, the firm would need to borrow money to
raise the $27,000. If Kwon Jewelers were to borrow money to raise the $27,000, the interest rate
on the loan would be 12.36 percent. Kwon Jewelers would receive $27,000 at the start of the
project and would pay $30,337 one year later. What is the NPV of the project if Kwon Jewelers
borrows $27,000 to pay for the project?
(Spring 2014, test 4, question 1)
(Spring 2015, final, question 15)
(Fall 2015, final, question 11)
(Fall 2017, test 3, question 4)

If Kwon Jewelers borrows money to raise $27,000, then the NPV of the project would be $4,727.

Projects should be evaluated solely on cash flows expected to be produced by assets. It does not
matter if funds are borrowed to pay for the project or whether new stock is issued or whether
the firm uses cash it already has. Ignore any and all cash flows associated with debt and equity
including debt-issuance proceeds, debt payments, equity-issuance proceeds, dividends, and
stock buybacks.

Therefore, the NPV computed based on the assumption that Kwon Jewelers used $27,000
in cash that was in its bank account would be the same as the NPV computed based on the
assumption that Kwon Jewelers borrowed the $27,000.

Regardless of where the money for the project comes from, the NPV is $4,727.

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FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

2. Striped Potato is evaluating a project that would require the purchase of a piece of equipment
for $365,000 today. During year 1, the project is expected to have relevant revenue of $216,000,
relevant costs of $57,000, and relevant depreciation of $84,000. Striped Potato would need to
borrow $365,000 today to pay for the equipment and would need to make an interest payment of
$14,000 to the bank in 1 year. Relevant net income for the project in year 1 is expected to be
$44,000. What is the tax rate expected to be in year 1?
(Fall 2011, test 4, question 1) (Fall 2012, final, question 14)
(Spring 2013, final, question 14) (Spring 2015, test 3, question 1)
(Fall 2016, test 3, question 6) (Spring 2017, final, question 11)

The $14,000 interest payment is not included in the analysis. Projects should be evaluated
solely on cash flows expected to be produced by assets. It does not matter if funds are borrowed
to pay for the project or whether new stock is issued or whether the firm uses cash it already
has. Ignore any and all cash flows associated with debt and equity including debt-issuance
proceeds, debt payments, equity-issuance proceeds, dividends, and stock buybacks.

To solve:
1) Find expected taxable income
2) Find expected taxes paid
3) Find the expected tax rate

1) Find expected taxable income

Taxable income = EBIT = revenues – costs – depreciation
216,000 – 57,000 – 84,000
= 75,000

2) Find expected taxes paid

Net income = taxable income – taxes paid
44,000 = 75,000 – taxes paid
So taxes paid = 75,000 – 44,000 = 31,000

Tables are useful for steps 1 and 2

Given Step 1 Step 2
Year 1 Year 1 Year 1
Revenue 216,000 216,000 216,000
– Costs 57,000 57,000 57,000
– Annual depreciation 84,000 84,000 84,000
= EBIT = taxable income 75,000 75,000
– Taxes 31,000
= Net income 44,000 44,000 44,000

3) Find the expected tax rate

The tax rate = taxes paid / taxable income
= 31,000 / 75,000
= 0.4133 = 41.33%

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FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

3. Celebrity Food is evaluating the kale crisper project. During year 1, the kale crisper project is
expected to have relevant revenue of $256,000, relevant variable costs of $87,000, and relevant
depreciation of $11,000. In addition, Celebrity Food would have one source of fixed costs
associated with the kale crisper project. Celebrity Food just signed a deal with Lights Camera
Action to develop a advertising campaign for use in the project. The terms of the deal require
Celebrity Food to pay Lights Camera Action either $18,000 in 1 year if the project is pursued or
$34,000 in 1 year if the project is not pursued. Relevant net income for the kale crisper project in
year 1 is expected to be $112,000. What is the tax rate expected to be in year 1?
(Fall 2011, final, question 14)
(Fall 2017, test 3, question 5)

The cost is partially sunk in 1 year.

Celebrity Food must pay $18,000 in 1 year if it does the project
And Celebrity Food must pay $34,000 in 1 year if it does not do the project
So the incremental cost would be $18,000 – $34,000 = -$16,000
Therefore, -$16,000 of the fixed cost should be included in the cost of the project in 1 year
Note that the incremental effect of pursuing the project is to lower fixed costs.

Since total costs = fixed costs + variable costs, total costs = (-$16,000) + $87,000 = $71,000

To solve:
1) Find expected taxable income
2) Find expected taxes paid
3) Find the expected tax rate

1) Find expected taxable income

Taxable income = EBIT = revenues – costs – depreciation
256,000 – 71,000 – 11,000 = 174,000

2) Find expected taxes paid

Net income = taxable income – taxes paid
112,000 = 174,000 – taxes paid
So taxes paid = 174,000 – 112,000 = 62,000

Tables are useful for steps 1 and 2

Given &
Step 1 Step 2
relevant costs
Revenue 256,000 256,000 256,000
– Costs 71,000 71,000 71,000
– Annual depreciation 11,000 11,000 11,000
= EBIT = taxable income 174,000 174,000
– Taxes 62,000
= Net income 112,000 112,000 112,000

3) Find the expected tax rate

The tax rate = taxes paid / taxable income
= 62,000 / 174,000
= 0.3563 = 35.63%

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FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

4. Water’s Edge Resorts is evaluating a project that would require an initial investment in
equipment of $500,000 and that is expected to last for 4 years. MACRS depreciation would be
used where the depreciation rates in years 1, 2, 3, 4, and 5 are 25%, 45%, 15%, 10%. and 5%,
respectively. For each year of the project, Water’s Edge Resorts expects relevant annual revenue
associated with the project to be $648,000 and relevant annual costs associated with the project
to be $472,000. The tax rate is 50 percent. What is (X plus Y) if X is the relevant operating cash
flow (OCF) associated with the project expected in year 2 of the project and Y is the relevant
OCF associated with the project expected in year 4 of the project?
(Fall 2010, test 4, question 1)
(Spring 2011, test 4, question 4)
(Spring 2011, final, question 14)
(Spring 2012, final, question 16)
(Fall 2012, test 4, question 3)
(Spring 2013, final, question 15)
(Fall 2013, final, question 13)
(Spring 2014, test 4, question 3)
(Fall 2015, final, question 12)
(Fall 2016, final, question 11)
(Fall 2017, test 3, question 6)
(Fall 2017, final, question 11)
(Spring 2018, final, question 11)

  Year 2 Year 4
  MACRS rate .45 .10
× Initial investment 500,000 500,000
= Annual depreciation 225,000 50,000

Revenue 648,000 648,000

– Costs 472,000 472,000
– Annual depreciation 225,000 50,000
= EBIT -49,000 126,000
× Tax rate 0.50 0.50
= Taxes paid -24,500 63,000
Net income = EBIT – taxes paid -24,500 63,000
OCF = net income + depreciation 200,500 113,000

OCF in year 2 + OCF in year 4 = 200,500 + 113,000 = 313,500

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FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

5. Based on the following information, what is the relevant operating cash flow (OCF) associated
with the project expected to be in year 3? The project would require an initial investment in
equipment of $120,000 that would be depreciated using MACRS where the depreciation rates in
years 1, 2, 3, and 4 are 33%, 44%, 15%, and 8%, respectively. At the end of the project in 3
years, the equipment would be sold for an expected after-tax cash flow of $31,500. In year 3 of
the project, relevant revenue associated with the project would be $39,000 and relevant costs
associated with the project would be $27,000. The tax rate is 35 percent.
(Fall 2009, test 4, question 3)
(Spring 2010, test 4, question 9)
(Spring 2010, final, question 8)
(Spring 2016, test 3, question 8)

The expected cash flow from capital spending is not relevant for OCF

Year 3
  MACRS rate 0.15
× Initial investment 120,000
= Annual depreciation 18,000

  Revenues 39,000
– Costs 27,000
– Annual depreciation 18,000
= EBIT -6,000
× Tax rate 0.35
= Taxes paid -2,100
Net income = EBIT – taxes paid -3,900

OCF = net income + depreciation 14,100

5
FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

6. Scarlet operates coffee shops in Ohio. The firm is evaluating the Cleveland project, which would
involve opening a new coffee shop in Cleveland. During year 1, Scarlet would have total revenue of
$335,000 and total costs of $171,000 if it pursues the Cleveland project, and the firm would have total
revenue of $288,000 and total costs of $163,000 if it does not pursue the Cleveland project. Depreciation
taken by the firm would be $203,000 if the firm pursues the project and $181,000 if the firm does not
pursue the project. The tax rate is 25%. What is the relevant operating cash flow (OCF) for year 1 of the
Cleveland project that Scarlet should use in its NPV analysis of the Cleveland project?
(Spring 2013, test 4, question 3)
(Spring 2015, final, question 16)
(Spring 2017, test 3, question 7)
(Spring 2018, test 3, question 6)

In evaluating the Cleveland project, Scarlet should use incremental revenue, incremental costs,
and incremental depreciation, which is what those values would be with the project minus what
they would be without the project. The incremental effects reflect the effect of the project,
which is what is of interest.
Incremental revenue = revenue with project – revenue without project
= $335,000 – $288,000 = $47,000
Incremental costs = costs with project – costs without project
= $171,000 – $163,000 = $8,000
Incremental depreciation = depreciation with project – depreciation without project
= $203,000 – $181,000 = $22,000
Year 1
Revenue 47,000
– Costs 8,000
– Annual depreciation 22,000
= EBIT 17,000
× Tax rate 0.25
= Taxes paid 4,250
Net income = EBIT – taxes 12,750
+ Annual depreciation 22,000
= OCF 34,750

Alternatively (can look at net income with project minus net income without project or can
compute net income from incremental revenue, costs, and depreciation)
With Without in Incremental in
in year 1 year 1 year 1
Revenue 335,000 288,000 47,000
– Costs 171,000 163,000 8,000
– Annual depreciation 203,000 181,000 22,000
= EBIT -39,000 -56,000 17,000
× Tax rate 0.25 0.25 0.25
= Taxes paid -9,750 -14,000 4,250
Net income = EBIT – taxes -29,250 -42,000 12,750
+ Annual depreciation 203,000 181,000 22,000
OCF = net income + dep 173,750 139,000 34,750

6
FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

7. Spotted Potato is evaluating project A, which would require the purchase of a piece of equipment for
$550,000. During year 1, project A is expected to have relevant revenue of $311,000, relevant costs of
$104,000, and some depreciation. Spotted Potato would need to borrow $550,000 for the equipment and
would need to make an interest payment of $40,000 to the bank in year 1. Relevant net income for project
A in year 1 is expected to be $94,000 and operating cash flows for project A in year 1 are expected to be
$166,000. Straight-line depreciation would be used. What is the tax rate expected to be in year 1?
(Fall 2013, test 4, question 2)

The $40,000 interest payment is not included in the analysis. Projects should be evaluated solely on cash
flows expected to be produced by assets. It does not matter if funds are borrowed to pay for the project or
whether new stock is issued or whether the firm uses cash it already has. Ignore any and all cash flows
associated with debt and equity including debt-issuance proceeds, debt payments, equity-issuance proceeds,
dividends, and stock buybacks.

The fact that straight-line depreciation is used is not relevant. The depreciation expense can be found from
OCF = net income + depreciation.

To solve:
1) Find expected depreciation in year 1
2) Find expected taxable income
3) Find expected taxes paid
4) Find the expected tax rate

1) Find expected depreciation in year 1

OCF = net income + depreciation
166,000 = 94,000 + depreciation
Depreciation = 166,000 – 94,000 = 72,000

2) Find expected taxable income

Taxable income = EBIT = revenues – costs – depreciation
311,000 – 104,000 – 72,000 = 135,000

3) Find expected taxes paid

Net income = taxable income – taxes paid
94,000 = 135,000 – taxes paid
So taxes paid = 135,000 – 94,000 = 41,000

Tables are useful for steps 1, 2, and 3

Given Step 1 Step 2 Step 3
Year 1 Year 1 Year 1 Year 1
Revenue 311,000 311,000 311,000 311,000
– Costs 104,000 104,000 104,000 104,000
– Annual depreciation 72,000 72,000
= EBIT = taxable income 135,000 135,000
– Taxes 41,000
= Net income 94,000 94,000 94,000 94,000
+ Annual depreciation 72,000 72,000 72,000
= OCF 166,000 166,000 166,000 166,000

4) Find the expected tax rate

The tax rate = taxes paid / taxable income
= 41,000 / 135,000
= 0.3037 = 30.37%
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FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

8. Spotted Potato is evaluating a project that would require the purchase of a piece of equipment for
$496,000 today. During year 1, the project is expected to have relevant revenue of $404,000,
relevant costs of $157,000, and relevant depreciation of $111,000. Spotted Potato would need to
borrow $496,000 today for the equipment and would need to make an interest payment of $28,000 to
the bank in 1 year. Relevant operating cash flow for the project in year 1 is expected to be $193,000.
What is the tax rate expected to be in year 1?
(Fall 2014, test 4, question 1)

The $28,000 interest payment is not included in the analysis. Projects should be evaluated solely on
cash flows expected to be produced by assets. It does not matter if funds are borrowed to pay for
the project or whether new stock is issued or whether the firm uses cash it already has. Ignore any
and all cash flows associated with debt and equity including debt-issuance proceeds, debt payments,
equity-issuance proceeds, dividends, and stock buybacks.

To solve:
1) Find expected net income
2) Find expected taxable income
3) Find expected taxes paid
4) Find the expected tax rate

1) Find expected net income

OCF = net income + depreciation
So net income = OCF – depreciation = 193,000 – 111,000 = 82,000

2) Find expected taxable income

Taxable income = EBIT = revenues – costs – depreciation
404,000 – 157,000 – 111,000 = 136,000

3) Find expected taxes paid

Net income = taxable income – taxes paid
82,000 = 136,000 – taxes paid
So taxes paid = 136,000 – 82,000 = 54,000

Tables are useful for steps 1, 2 and 3

Given Step 1 Step 2 Step 3
Year 1 Year 1 Year 1 Year 1
Revenue 404,000 404,000 404,000 404,000
– Costs 157,000 157,000 157,000 157,000
– Annual depreciation 111,000 111,000 111,000 111,000
= EBIT = taxable income 136,000 136,000
– Taxes 54,000 54,000
= Net income 82,000 82,000 82,000
+ Depreciation 111,000 111,000 111,000 111,000
= OCF 193,000 193,000 193,000 193,000

4) Find the expected tax rate

The tax rate = taxes paid / taxable income
= 54,000 / 136,000
= 0.3971 = 39.71%
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FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

9. What is the operating cash flow (OCF) for year 2 of the Kentucky project that Xavier should
use in its NPV analysis of the project? Xavier operates restaurants in Ohio. The firm is
evaluating the Kentucky project, which would involve opening a new restaurant in Kentucky.
During year 2, the Kentucky project is expected to have relevant revenue of $523,000, relevant
variable costs of $277,000, and relevant depreciation of $99,000. In addition, Xavier would have
one source of fixed costs associated with the Kentucky project. Yesterday, Xavier signed a deal
with Wildcat Design to develop an advertising campaign for use in Kentucky. The terms of the
deal require Xavier to pay $42,000 to Wildcat Design in 2 years from today. The tax rate is 40
percent. Finally, the equipment purchased for the project would be sold in 2 years for an
expected after-tax cash flow of $6,000.
(Spring 2010, test 4, question 4 – similar question asking for net income)
(Spring 2018, test 3, question 7)

The sale of the equipment is considered under cash flow from capital spending, not
operating cash flows. Therefore, it is not relevant for answering the question.

Xavier must pay $42,000 to Wildcat Design in 2 years if they do the Kentucky project or
Xavier must pay $42,000 to Wildcat Design in 2 years if they do not do the Kentucky
project. The cost is sunk.

The incremental cost in 2 years would be

Payment to Wildcat Design in 2 years if they do the Kentucky project –
Payment to Wildcat Design in 2 years if they do not do the Kentucky project
= $42,000 – $42,000
= $0

Therefore, $0 should be included as a fixed cost for year 2 (which includes in 2 years) since
doing the Kentucky project would have no effect on fixed costs paid by the firm

Since total costs = fixed costs + variable costs, total costs = $0 + $277,000 = $277,000

Year 2
Revenue 523,000
– Costs 277,000
– Annual depreciation 99,000
= EBIT 147,000
× Tax rate 0.40
= Taxes paid 58,800
Net income = EBIT – taxes 88,200
+ Annual depreciation 99,000
= OCF 187,200

9
FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

10. What is the operating cash flow for year 4 of the Eugene project that OreDuck should use in
its NPV analysis of the project? The tax rate is 20%. During year 4, the Eugene project is
expected to have relevant revenue of $78,000, relevant variable costs of $26,000, and relevant
depreciation of $16,000. In addition, OreDuck would have one source of fixed costs associated
with the Eugene project. Yesterday, OreDuck signed a deal with State Beaver Advertising to
develop a marketing campaign. The terms of the deal require OreDuck to pay State Beaver
Advertising either $17,000 in 4 years if the Eugene project is pursued or $20,000 in 4 years if the
Eugene project is not pursued. Finally, the equipment purchased for the project would be sold in
4 years for an expected after-tax cash flow of $8,000.
(Fall 2010, test 4, question 2 – similar question asking for net income)
(Fall 2010, final, question 14 – similar question asking for net income)
(Fall 2011, test 4, question 2)
(Fall 2012, test 4, question 2 – similar question asking for net income)
(Fall 2014, test 3, question 10 – similar question asking for net income)
(Fall 2015, test 3, question 7)
(Fall 2017, final, question 12)

The sale of the equipment is considered under cash flow from capital spending, not
operating cash flows. Therefore, it is not relevant for answering the question.

The cost is partially sunk in 4 years

OreDuck must pay $17,000 in 4 years if it does the project and $20,000 in 4 years if it does
not do the project, so the incremental cost would be $17,000 – $20,000 = -$3,000.

Therefore, -$3,000 of the fixed cost should be included in the cost of the project in 4 years.
The fixed cost would be $3,000 lower as a result of pursuing the project

Since total costs = fixed costs + variable costs, total costs = -$3,000 + $26,000 = $23,000

Year 4
Revenue 78,000
– Costs 23,000
– Annual depreciation 16,000
= EBIT 39,000
× Tax rate 0.20
= Taxes paid 7,800
Net income = EBIT – taxes 31,200
+ Annual depreciation 16,000
= OCF 47,200

10
FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

11. Abuela Pastries operates a chain of bakeries and is considering the sprinkle cookie project, which
would involve selling sprinkle cookies for 1 year. The firm expects sales of sprinkle cookies to be
$157,000 and associated costs from flour, butter, sugar, etc. used to make sprinkle cookies to be $68,000.
The firm believes that sales of frosted cookies, a type of cookie that is currently offered by the firm,
would be $32,000 less with the addition of sprinkle cookies, and that costs associated with frosted cookies
would be $16,000 less with the addition of sprinkle cookies. Finally, Abuela Pastries believes that selling
sprinkle cookies would increase traffic to its bakeries, which would increase expected sales of bread,
cakes, and other items by $24,000 more than it would be without the addition of sprinkle cookies, and
increase costs of bread, cakes, and other items by $14,000 more than it would be without the addition of
sprinkle cookies. What is the operating cash flow (OCF) for year 1 that Abuela Pastries should use to
analyze the sprinkle cookie project? The tax rate is 40 percent and the cost of capital is 3.64 percent.
Relevant depreciation is expected to be $5,000.
(Fall 2015, test 3, question 6 – similar question asking for net income)
(Spring 2018, final, question 12)

The relevant net income depends on incremental revenues and incremental costs. In order
to determine these in this case, side effects must be taken into account.

Relevant revenue for the sprinkle cookie project =

Sales of sprinkle cookies + effect on sales of frosted cookies + effect on sales from change in
traffic to bakeries
= 157,000 – 32,000 + 24,000 = $149,000

Relevant costs for the sprinkle cookie project =

Costs associated with sprinkle cookies + effect on costs of frosted cookies + effect on costs
from change in traffic to bakeries
= 68,000 – 16,000 + 14,000 = $66,000

Year 1
Revenue 149,000
– Costs 66,000
– Annual depreciation 5,000
= EBIT 78,000
× Tax rate 0.40
= Taxes paid 31,200
Net income = EBIT – taxes 46,800
+ Annual depreciation 5,000
= OCF 51,800

Note that the cost of capital is not relevant

11
FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

12. For project A, the cash flow effect from the change in net working capital is expected to be
$500 at time 2 and the level of net working capital is expected to be $800 at time 2. What is the
level of current liabilities for project A expected to be at time 1 if the level of current assets for
project A is expected to be $1,900 at time 1?
(Spring 2013, test 4, question 4)
(Fall 2014, final, question 14)

Recall that:
1) Cash flow effects from changes in NWC = -ΔNWC
2) The change in NWC equals NWC at a point in time minus NWC at the previous point in time, so
ΔNWCt = NWCt – NWCt-1 and in this case: ΔNWC2 = NWC2 – NWC1
3) Net working capital (NWC) is measured as current assets (CA) minus current liabilities (CL), so
NWC = CA – CL

To solve:
1) Find ΔNWC from the cash flow effects from changes in NWC
2) Find NWC1 from ΔNWC2 and NWC2
3) Find CL1 from NWC1 and CA1

1) Find ΔNWC from the cash flow effects from changes in NWC
Cash flow effects from changes in NWC = -ΔNWC
500 = -ΔNWC2
So ΔNWC2 = -500

Since the cash flow effect from the change in net working capital is expected to be $500 at time 2,
then the change in NWC at time 2 is expected to be -$500, which means that NWC is expected to
decline by $500 from time 1 to time 2

2) Find NWC1 from ΔNWC2 and NWC2

ΔNWC2 = NWC2 – NWC1
-500 = 800 – NWC1
So NWC1 = 800 + 500 = 1,300

NWC is expected to be $1,300 at time 1 and $800 at time 2, which means that it is expected to
decline by $500 from time 1 to time 2

3) Find CL1 from NWC1 and CA1

NWC1 = CA1 – CL1
1,300 = 1,900 – CL1
So CL1 = 1,900 – 1,300 = 600

Given Step 1 Step 2 Step 3

1 2 1 2 1 2 1 2
CA 1,900 1,900 1,900 1,900
CL 600
NWC 800 800 1,300 800 1,300 800
∆NWC -500 -500 -500
CF ∆NWC 500 500 500 500

12
FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

13. For project A, the cash flow effect from the change in net working capital is expected to be -$500 at
time 2 and the level of net working capital is expected to be $800 at time 2. What is the level of current
assets for project A expected to be at time 1 if the level of current liabilities for project A is expected to
be $1,900 at time 1?
(Spring 2011, test 4, question 1) (Spring 2012, final, question 15)
(Spring 2017, test 3, question 8)

Recall that:
1) Cash flow effects from changes in NWC = -ΔNWC
2) The change in NWC equals NWC at a point in time minus NWC at the previous point in time, so
ΔNWCt = NWCt – NWCt-1 and in this case: ΔNWC2 = NWC2 – NWC1
3) Net working capital (NWC) is measured as current assets (CA) minus current liabilities (CL), so
NWC = CA – CL

To solve:
1) Find ΔNWC from the cash flow effects from changes in NWC
2) Find NWC1 from ΔNWC2 and NWC2
3) Find CL1 from NWC1 and CA1

1) Find ΔNWC from the cash flow effects from changes in NWC
Cash flow effects from changes in NWC = -ΔNWC
-500 = -ΔNWC2
So ΔNWC2 = 500

Since the cash flow effect from the change in net working capital is expected to be -$500 at time 2,
then the change in NWC at time 2 is expected to be $500, which means that NWC is expected to
increase by $500 from time 1 to time 2

2) Find NWC1 from ΔNWC2 and NWC2

ΔNWC2 = NWC2 – NWC1
500 = 800 – NWC1
So NWC1 = 800 – 500 = 300

NWC is expected to be $300 at time 1 and $800 at time 2, which means that it is expected to
increase by $500 from time 1 to time 2

3) Find CA1 from NWC1 and CL1

NWC1 = CA1 – CL1
300 = CA1 – 1,900
So CA1 = 300 + 1,900 = 2,200

Given Step 1 Step 2 Step 3

1 2 1 2 1 2 1 2
CA 2,200
CL 1,900 1,900 1,900 1,900
NWC 800 800 300 800 300 800
∆NWC 500 500 500
CF ∆NWC -500 -500 -500 -500

13
FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

14. For project A, the cash flow effect from the change in net working capital is expected to be -$400 at
time 2 and the level of net working capital is expected to be $700 at time 1. What is the level of current
liabilities for project A expected to be at time 2 if the level of current assets for project A is expected to
be $2,500 at time 2?
(Fall 2014, test 4, question 2)
(Spring 2018, test 3, question 8)

Recall that:
1) Cash flow effects from changes in NWC = -ΔNWC
2) The change in NWC equals NWC at a point in time minus NWC at the previous point in time, so
ΔNWCt = NWCt – NWCt-1 and in this case: ΔNWC2 = NWC2 – NWC1
3) Net working capital (NWC) is measured as current assets (CA) minus current liabilities (CL), so
NWC = CA – CL

To solve:
1) Find ΔNWC from the cash flow effects from changes in NWC
2) Find NWC2 from ΔNWC2 and NWC1
3) Find CL2 from NWC2 and CA2

1) Find ΔNWC from the cash flow effects from changes in NWC
Cash flow effects from changes in NWC = -ΔNWC
-400 = -ΔNWC2
So ΔNWC2 = 400

Since the cash flow effect from the change in net working capital is expected to be -$400 at time 2,
then the change in NWC at time 2 is expected to be $400, which means that NWC is expected to
increase by $400 from time 1 to time 2

2) Find NWC2 from ΔNWC2 and NWC1

ΔNWC2 = NWC2 – NWC1
400 = NWC2 – 700
So NWC2 = 400 + 700 = 1,100

NWC is expected to be $700 at time 1 and $1,100 at time 2, which means that it is expected to
increase by $400 from time 1 to time 2

3) Find CL2 from NWC2 and CA2

NWC2 = CA2 – CL2
1,100 = 2,500 – CL2
So CL2 = 2,500 – 1,100 = 1,400

Given Step 1 Step 2 Step 3

1 2 1 2 1 2 1 2
CA 2,500 2,500 2,500 2,500
CL 1,400
NWC 700 700 700 1,100 700 1,100
∆NWC 400 400 400
CF ∆NWC -400 -400 -400 -400

14
FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

15. For project A, the cash flow effect from the change in net working capital is expected to be $400 at
time 2 and the level of net working capital is expected to be $700 at time 1. What is the level of current
assets for project A expected to be at time 2 if the level of current liabilities for project A is expected to
be $2,500 at time 2?
(Spring 2014, test 4, question 4)
(Fall 2017, test 3, question 7)

Recall that:
1) Cash flow effects from changes in NWC = -ΔNWC
2) The change in NWC equals NWC at a point in time minus NWC at the previous point in time, so
ΔNWCt = NWCt – NWCt-1 and in this case: ΔNWC2 = NWC2 – NWC1
3) Net working capital (NWC) is measured as current assets (CA) minus current liabilities (CL), so
NWC = CA – CL

To solve:
1) Find ΔNWC from the cash flow effects from changes in NWC
2) Find NWC2 from ΔNWC2 and NWC1
3) Find CA2 from NWC2 and CL2

1) Find ΔNWC from the cash flow effects from changes in NWC
Cash flow effects from changes in NWC = -ΔNWC
400 = -ΔNWC2
So ΔNWC2 = -400

Since the cash flow effect from the change in net working capital is expected to be $400 at time 2,
then the change in NWC at time 2 is expected to be -$400, which means that NWC is expected to
decline by $400 from time 1 to time 2

2) Find NWC2 from ΔNWC2 and NWC1

ΔNWC2 = NWC2 – NWC1
-400 = NWC2 – 700
So NWC2 = -400 + 700 = 300

NWC is expected to be $700 at time 1 and $300 at time 2, which means that it is expected to decline
by $400 from time 1 to time 2

3) Find CA2 from NWC2 and CL2

NWC2 = CA2 – CL2
300 = CA2 – 2,500
So CA2 = 2,500 + 300 = 2,800

Given Step 1 Step 2 Step 3

1 2 1 2 1 2 1 2
CA 2,800
CL 2,500 2,500 2,500 2,500
NWC 700 700 700 300 700 300
∆NWC -400 -400 -400
CF ∆NWC 400 400 400 400

15
FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

16. For project A, the cash flow effect from the change in net working capital is expected to be $400 at
time 2, the level of net working capital is expected to be $700 at time 0, and the level of net working
capital is expected to be $900 at time 2. What is the cash flow effect from the change in net working
capital expected to be at time 1?
(Fall 2011, test 4, question 3)
(Fall 2016, test 3, question 7)

To solve
1) Find ΔNWC at time 2
2) Find NWC at time 1
3) Find ΔNWC at time 1
4) Find CF effect from ΔNWC at time 1

Timeline helps identify what we know and what we want to know and how we can get there
0 1 2
NWC 700 900
ΔNWC
CF effect from ΔNWC 400

1) Find ΔNWC at time 2

Cash flow effects from ΔNWC = -ΔNWC
Therefore, CF effect from ΔNWC2 = -ΔNWC2 = 400
So ΔNWC2 = -400
0 1 2
NWC 700 900
ΔNWC -400
CF effect from ΔNWC 400

2) Find NWC at time 1

ΔNWC2 = NWC2 – NWC1
-400 = 900 – NWC1
So NWC1 = 900 + 400 = 1,300
0 1 2
NWC 700 1,300 900
ΔNWC -400
CF effect from ΔNWC 400

3) Find ΔNWC at time 1

ΔNWC1 = NWC1 – NWC0
= 1,300 – 700
= 600
0 1 2
NWC 700 1,300 900
ΔNWC 600 -400
CF effect from ΔNWC 400

4) Find CF effect from ΔNWC at time 1

CF effect from ΔNWC1 = -ΔNWC1 = -600
0 1 2
NWC 700 1,300 900
ΔNWC 600 -400
CF effect from ΔNWC -600 400

16
FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

17. For project A, the change in net working capital is expected to be $800 at time 0, the cash flow effect from the
change in net working capital is expected to be -$100 at time 1, and the level of net working capital is expected to be
$600 at time 2. What is the cash flow effect from the change in net working capital expected to be at time 2?
(Spring 2015, test 3, question 3)

To solve
1) Find NWC at time 0
2) Find ΔNWC at time 1
3) Find NWC at time 1
4) Find ΔNWC at time 2
5) Find CF effect from ΔNWC at time 2

Timeline helps identify what we know and what we want to know and how we can get there
0 1 2
NWC 600
ΔNWC 800
CF effect from ΔNWC -100

1) Find NWC at time 0

ΔNWC0 = NWC0, so NWC0 = 800
0 1 2
NWC 800 600
ΔNWC 800
CF effect from ΔNWC -100

2) Find ΔNWC at time 1

CF effect from ΔNWC1 = -ΔNWC1 = -100
ΔNWC1 = 100
0 1 2
NWC 800 600
ΔNWC 800 100
CF effect from ΔNWC -100

3) Find NWC at time 1

ΔNWC1 = NWC1 – NWC0
100 = NWC1 – 800
NWC1 = 100 + 800 = 900
0 1 2
NWC 800 900 600
ΔNWC 800 100
CF effect from ΔNWC -100

4) Find ΔNWC at time 2

ΔNWC2 = NWC2 – NWC1= 600 – 900 = -300
0 1 2
NWC 800 900 600
ΔNWC 800 100 -300
CF effect from ΔNWC -100

5) Find CF effect from ΔNWC at time 2

CF effect from ΔNWC2 = -ΔNWC2 = 300
0 1 2
NWC 800 900 600
ΔNWC 800 100 -300
CF effect from ΔNWC -100 300

17
FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

18. What is the expected after-tax cash flow from selling a piece of equipment if TwoPlus
purchases the equipment today for $160,000, the tax rate is 30 percent, the equipment is sold in 3
years for $37,500, and MACRS depreciation is used where the depreciation rates in years 1, 2, 3,
4, and 5 are 42%, 31%, 15%, 8%, and 4%, respectively?
(Fall 2009, final, question 12)
(Spring 2012, test 4, question 4)
(Fall 2013, test 4, question 3)
(Fall 2014, test 4, question 3)
(Spring 2015, test 3, question 4)
(Fall 2015, test 3, question 8)
(Spring 2017, test 3, question 9)
(Spring 2018, test 3, question 9)

CF from asset sale = sales price of asset – taxes paid on sale of asset
Taxes paid = (sales price of asset – book value of asset) × tax rate = taxable gain × tax rate
Book value = initial price of asset – accumulated depreciation
Accumulated depreciation equals depreciation in year 1 + depreciation in year 2 +
depreciation in year 3

Depreciation in year 1 = 42% × 160,000 = 67,200

Depreciation in year 2 = 31% × 160,000 = 49,600
Depreciation in year 3 = 15% × 160,000 = 24,000
Accumulated depreciation = 67,200 + 49,600 + 24,000 = 140,800

Book value = 160,000 – 140,800 = 19,200

Taxes paid on sale of asset = (37,500 – 19,200) × 0.30 = 18,300 × 0.30 = 5,490

After-tax CF from asset sale = 37,500 – 5,490 = 32,010

18
FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

19. What is the expected after-tax cash flow from selling a piece of equipment if Probst
purchases the equipment today for $537,000, the tax rate is 25 percent, the equipment will be
sold in 5 years for $97,000, and the equipment will be depreciated to $69,000 over 12 years
using straight-line depreciation?
(Fall 2009, test 4, question 2)
(Spring 2010, test 4, question 7)
(Fall 2010, test 4, question 4)
(Fall 2012, test 4, question 4)
(Fall 2016, test 3, question 8)
(Spring 2017, final, question 12)
(Fall 2017, test 3, question 8)

CF from asset sale = sale price of asset – taxes paid on sale of asset
Taxes paid = (sale price of asset – book value of asset) × corporate tax rate
Book value = initial price of asset – accumulated depreciation
Depreciation = (investment – amount asset is depreciated to) / useful life

Depreciation = [($537,000 – $69,000) / 12] = [$468,000 / 12]

= $39,000 per year for years 1-12

Accumulated depreciation over the next 5 years = 5 × $39,000 = $195,000

Book value = $537,000 – $195,000 = $342,000
Sale price of asset = $97,000
Taxes paid = ($97,000 – $342,000) × 0.25 = (-$245,000) × 0.25 = -$61,250

After-tax CF from sale = $97,000 – (-$61,250) = $158,250

19
FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

20. Monroe Printing is evaluating the pamphlet project. The project would require an initial
investment of $73,000 that would be depreciated to $13,000 over 4 years using straight-line
depreciation. The first annual operating cash flow of $17,000 is expected in 1 year, and annual
operating cash flows of $17,000 are expected each year forever. Monroe Printing expects the
project to have an after-tax terminal value of $108,000 in 3 years. The tax rate is 30%. What is
(X+Y)/Z if X is the project’s relevant expected cash flow for NPV analysis in year 3, Y is the
project’s relevant expected cash flow for NPV analysis in year 4, and Z is the project’s relevant
expected cash flow for NPV analysis in year 2?
(Fall 2016, final, question 12)
(Spring 2017, test 3, question 10)

Recall that in a given year:

Relevant CF for a project
= OCF + CF effects from ΔNWC + CF from capital spending + terminal value

For year 3:
X = relevant CF for the pamphlet project = $17,000 + $0 + $0 + $108,000 = $125,000

Since we have a terminal value for year 3, in years 4 and later:

Relevant CF for the pamphlet project (for Monroe Printing analysis) = $0

For year 4:
Y = relevant CF for the pamphlet project = $0 + $0 + $0 + $0 = $0

For year 2:
Z = relevant CF for the pamphlet project = $17,000 + $0 + $0 + $0 = $17,000

So (X + Y) / Z
= ($125,000 + $0) / $17,000
= $125,000 / $17,000
= 7.35

Note that the depreciation information is not relevant. It is used to compute OCF, but
OCF is provided. The tax rate information is not relevant either, as all necessary figures
are given as after-tax cash flows.

20
FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

21. What is the net present value of the flier project, which is a 3-year project where Dispersion
would spread fliers all over Fairfax? The project would involve an initial investment in
equipment of $230,000 today. To finance the project, Dispersion would borrow $230,000.
The firm would receive $230,000 from the bank today and would pay the bank $290,000 in 3
years (consisting of an interest payment of $60,000 and a principal payment of $230,000).
Cash flows from capital spending would be $0 in year 1, $0 in year 2, and $31,000 in year 3.
Operating cash flows are expected to be $140,000 in year 1, $95,000 in year 2, and -$30,000 in
year 3. The cash flow effects from the change in net working capital are expected to be
-$8,000 at time 0; -$21,000 in year 1; $12,000 in year 2, and $17,000 in year 3. The tax rate is
35 percent. The cost of capital is 7.12 percent and the interest rate on the loan would be 8.03
percent.
(Spring 2016, test 3, question 9)
(Spring 2018, test 3, question 10)
(Spring 2018, final, question 13)

Note that the tax rate is not relevant, as all information already reflects any effects of taxes.

Year
  0 1 2 3
OCF 0 140,000 95,000 -30,000
+ Cash flows from ΔNWC -8,000 -21,000 12,000 17,000
+ CF from capital spending -230,000 0 0 31,000
+ Terminal value 0 0 0 0
= Relevant CF -238,000 119,000 107,000 18,000
NPV = -238,000 + [119,000 / (1.0712)] + [107,000 / (1.0712)2] + [18,000 / (1.0712)3] = -19,017
npv(7.12,-238000,{119000,107000,18000})  -19,017

21
 FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

22. Washington Football owns a football team in Washington, DC. The objective of its
managers is to maximize shareholder value. The firm is evaluating the stadium project, which
involves building a new stadium in Fairfax County. Which assertion is true, based on the
information given in the question and the following table on the project?
Base-case NPV (based on final estimates and expectations) $215,000
Value created if the team loses 11 games a season (based on scenario analysis) -$3,400,000
Value created if worst-case taxes occur (based on sensitivity analysis) -$1,700,000
Value created if best-case taxes occur (based on sensitivity analysis) $450,000
Probability that project will create more than $0 of value (based on simulation analysis) 16.1%
A. Washington Football should be indifferent between accepting and rejecting the stadium
project
B. Washington Football should accept the stadium project
C. Washington Football should reject the stadium project
D. It is not clear whether Washington Football should accept or reject the stadium project,
because the information provided is contradictory with respect to answering the question
E. It is not clear whether Washington Football should accept or reject the stadium project,
because the cost of capital for the project is not given
(Fall 2009, test 4, question 6) (Spring 2010, final, question 10)
(Fall 2010, test 4, question 5) (Fall 2011, final, question 15)
(Fall 2012, test 4, question 6) (Spring 2013, test 4, question 6)
(Fall 2013, final, question 14) (Spring 2014, final, question 13)
(Fall 2014, test 4, question 7) (Spring 2015, test 3, question 6)
(Fall 2015, test 3, question 10) (Spring 2016, test 3, question 10)
(Fall 2016, test 3, question 9)

Answer: B. Washington Football should accept the stadium project

Recall that you should compute a base-case NPV based on final estimates, pursue the
project when that base-case NPV is positive, and reject the project when that base-case
NPV is negative. In this case, the base-case NPV based on final estimates and expectations
is positive, so Washington Football should accept the project.

If a what-if analysis indicates that the amount of value created would be negative, but the
base-case NPV based on expectations is positive, then pursue the project. If a what-if
analysis indicates that the amount of value created would be positive, but the base-case
NPV based on expectations is negative, then do not pursue the project.

22
 FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

23. Washington Football owns a football team in Washington, DC. The objective of its
managers is to maximize shareholder value. The firm is evaluating the stadium project, which
involves building a new stadium in Fairfax County. Which assertion is true, based on the
information given in the question and the following table on the project?
Base-case NPV (based on final estimates and expectations) -$130,000
Value created if the team wins 11 games a season (based on scenario analysis) $2,700,000
Value created if worst-case taxes occur (based on sensitivity analysis) -$650,000
Value created if best-case taxes occur (based on sensitivity analysis) $2,900,000
Probability that project will create more than $0 of value (based on simulation analysis) 82.7%
A. Washington Football should be indifferent between accepting and rejecting the stadium
project
B. Washington Football should accept the stadium project
C. Washington Football should reject the stadium project
D. It is not clear whether Washington Football should accept or reject the stadium project,
because the information provided is contradictory with respect to answering the question
E. It is not clear whether Washington Football should accept or reject the stadium project,
because the cost of capital for the project is not given
(Fall 2009, test 4, question 6) (Spring 2010, final, question 10)
(Fall 2010, test 4, question 5) (Fall 2011, final, question 15)
(Fall 2012, test 4, question 6) (Spring 2013, test 4, question 6)
(Fall 2013, final, question 14) (Spring 2014, final, question 13)
(Fall 2014, test 4, question 7) (Spring 2015, test 3, question 6)
(Fall 2015, test 3, question 10) (Spring 2016, test 3, question 10)
(Fall 2016, test 3, question 9)

Answer: C. Washington Football should reject the stadium project

Recall that you should compute a base-case NPV based on final estimates, pursue the
project when that base-case NPV is positive, and reject the project when that base-case
NPV is negative. In this case, the base-case NPV based on final estimates and expectations
is negative, so Washington Football should reject the project.

If a what-if analysis indicates that the amount of value created would be negative, but the
base-case NPV based on expectations is positive, then pursue the project. If a what-if
analysis indicates that the amount of value created would be positive, but the base-case
NPV based on expectations is negative, then do not pursue the project.

23
FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

24. Chaotic is considering a project that would last for 3 years and have a cost of capital of 11.7
percent. The relevant level of net working capital for the project is expected to be $9,000
immediately (at year 0); $33,000 in 1 year; $28,000 in 2 years; and $0 in 3 years. Relevant
expected operating cash flows and cash flows from capital spending in years 0, 1, 2, and 3 are
presented in the following table. What is the net present value of this project?
Year 0 Year 1 Year 2 Year 3
Operating cash flows $0 $52,000 $52,000 $52,000
Cash flows from capital spending -$98,000 $0 $0 $8,000
(Fall 2009, test 4, question 1)
(Spring 2010, test 4, question 5)
(Fall 2010, test 4, question 3)
(Spring 2011, final, question 13)
(Fall 2011, final, question 13)
(Spring 2012, test 4, question 3)
(Fall 2012, test 4, question 5)
(Fall 2013, test 4, question 5)
(Spring 2014, final, question 11)
(Fall 2014, test 4, question 4)
(Fall 2015, test 3, question 9)
(Spring 2017, test 4, question 1)

Relevant cash flows in a given year = OCF + CF effects from ΔNWC + CF from capital
spending + terminal value

In this problem, terminal value = 0

Therefore, relevant cash flows in a given year = OCF + CF effects from ΔNWC + CF from
capital spending

We are given OCF and CF from capital spending. We are given NWC for each point in
time (years 0, 1, 2, and 3) and must compute ΔNWC as NWC at the end of a period minus
NWC at the start of the period and the cash flow effects from ΔNWC as –ΔNWC.

Year 0 1 2 3
OCF 0 52,000 52,000 52,000
NWC 9,000 33,000 28,000 0
ΔNWC = NWC at end of period minus NWC 33k – 9k = 28k – 33k = 0 – 28k =
at start of period (except ΔNWC0 = NWC0) 9,000 24,000 -5,000 -28,000
Cash flow effects from ΔNWC = -ΔNWC -9,000 -24,000 5,000 28,000
Cash flows from capital spending -98,000 0 0 8,000
Rel CF (OCF + CF ΔNWC + CF cap spend) -107,000 28,000 57,000 88,000

npv(11.7,-107000,{28000,57000,88000})  26,894

24
FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

25. WizCap is evaluating Project A, a 2-year project that would involve buying equipment for $84,000
that would be depreciated to zero over 2 years using straight-line depreciation. Cash flows from capital
spending would be $0 in year 1 and $20,000 in year 2. Relevant annual revenues are expected to be
$92,000 in year 1 and $84,000 in year 2. Relevant expected annual variable costs from the project are
expected to be $26,000 in year 1 and $26,000 in year 2. Finally, the firm has no fixed costs in year 1 and
one fixed cost in year 2 of the project. Yesterday, WizCap signed a deal with Great White Marketing to
develop an advertising campaign. The terms of the deal require WizCap to pay Great White Marketing
either $34,000 in 2 years from today if Project A is pursued or $22,000 in 2 years from today if Project A
is not pursued. The tax rate is 40 percent and the cost of capital for Project A is 14.2 percent. What is the
net present value of Project A?
(Fall 2016, final, question 13)
(Spring 2017, final, question 13)

Relevant costs = relevant fixed costs + relevant variable costs

In year 1, there are no fixed costs and relevant variable costs = $26,000
So relevant costs in year 1 = $0 + $26,000 = $26,000
In year 2, there are fixed costs, but we need to evaluate whether they are relevant by looking at the
incremental fixed cost, which is the advertising cost with the project minus the advertising cost
without the project
WizCap must pay $34,000 in 2 years to Great White Marketing if it does the project and $22,000 in
2 years if it does not do the project
So the incremental cost would be $34,000 – $22,000 = $12,000
Therefore, $12,000 of the fixed cost should be included in the cost of the project in 2 years
So relevant costs in year 2 = $12,000 + $26,000 = $38,000
The initial investment is $84,000
The investment is depreciated to $0 over 2 years
Annual depreciation in years 1 and 2 is ($84,000 – $0) / 2 = $42,000
NPV based on overview
  Year
  0 1 2
Revenues 0 92,000 84,000
Costs 0 26,000 38,000
Annual depreciation 0 42,000 42,000
EBIT (revs – costs – depreciation) 0 24,000 4,000
Tax rate 0.40 0.40 0.40
Taxes paid 0 9,600 1,600
Net income = EBIT – taxes paid 0 14,400 2,400
OCF = net income + depreciation 0 56,400 44,400
  Year
  0 1 2
OCF 0 56,400 44,400
Cash flow effects from ΔNWC 0 0 0
CF from capital spending -84,000 0 20,000
Terminal value 0 0 0
Relevant CF -84,000 56,400 64,400
npv(14.2,-84000,{56400,64400})  14,767

25
FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

26. Vermont Technology is considering a project that would last for 3 years and have a cost of
capital of 21.72 percent. The relevant level of net working capital for the project is expected to
be $2,000 immediately (at year 0); $5,000 in 1 year; $15,000 in 2 years; and $0 in 3 years.
Relevant expected revenue, costs, depreciation, and cash flows from capital spending in years 0,
1, 2, and 3 are presented in the following table. The tax rate is 50 percent. What is the net
present value of this project?
Year 0 Year 1 Year 2 Year 3
Revenue $0 $12,000 $12,000 $12,000
Costs $0 $4,000 $4,000 $4,000
Depreciation $0 $2,000 $2,000 $2,000
Cash flows from capital spending -$7,000 $0 $0 $4,000
(Fall 2012, final, question 15)
(Spring 2015, final, question 17)
(Spring 2016, test 4, question 1)
(Fall 2017, final, question 13)

Relevant cash flows in a given year = OCF + CF effects from ΔNWC + CF from capital
spending + terminal value

In this problem, terminal value = 0

Therefore, relevant cash flows in a given year = OCF + CF effects from ΔNWC + CF from
capital spending. We are given CF from capital spending. We can compute OCF from
revenue, costs, depreciation, and the tax rate. We are given NWC for each point in time
(years 0, 1, 2, and 3) and must compute ΔNWC as NWC at the end of a period minus NWC
at the start of the period and the cash flow effects from ΔNWC as –ΔNWC.

Year 0 1 2 3
Revenue 12,000 12,000 12,000
Costs 4,000 4,000 4,000
Depreciation 2,000 2,000 2,000
EBIT = revenues – costs – depreciation 6,000 6,000 6,000
tax rate 0.50 0.50 0.50
Taxes = tax rate × EBIT 3,000 3,000 3,000
net inc 3,000 3,000 3,000
OCF = net income + depreciation 0 5,000 5,000 5,000

NWC 2,000 5,000 15,000 0

ΔNWC = NWC at end of period minus NWC 5k – 2k = 15k – 5k = 0 – 15k =
at start of period (except ΔNWC0 = NWC0) 2,000 3,000 10,000 -15,000
Cash flow effects from ΔNWC = -ΔNWC -2,000 -3,000 -10,000 15,000

Cash flows from capital spending -7,000 0 0 4,000

Rel CF (OCF + CF ΔNWC + CF cap spend) -9,000 2,000 -5,000 24,000

npv(21.72,-9000,{2000,-5000,24000})  2,577
26
FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

27. Mario’s Plumbing is considering a project that would last for 2 years. The project would involve an initial
investment of $282,000 for new equipment that would be sold for an expected price of $126,000 at the end of
the project in 2 years. The equipment would be depreciated to zero over 3 years using straight-line
depreciation. In years 1 and 2, relevant annual revenue for the project is expected to be $320,000 per year and
relevant annual costs for the project are expected to be $150,000 per year. The tax rate is 25 percent and the
cost of capital for the project is 8.73 percent. What is the net present value of the project?
(Fall 2010, final, question 11) (Spring 2011, test 4, question 2) (Spring 2011, final, question 15)
(Fall 2011, final, question 12) (Spring 2012, final, question 14) (Spring 2013, final, question 17)
(Fall 2013, final, question 15) (Fall 2014, final, question 15) (Fall 2015, final, question 13)
(Spring 2016, final, question 9) (Fall 2016, final, question 14) (Fall 2017, final, question 14)
In a given year, the relevant cash flow for a project = operating cash flow + cash flow effects from changes in
net working capital + cash flow from capital spending + terminal value
In this case, cash flow effects from changes in net working capital and terminal value are zero in each year.
Therefore, to get relevant CF in each year, we need to find operating cash flow and CF from capital spending.
Annual SL depreciation = (investment – amount asset is depreciated to) / depreciable life
= (282,000 – 0) / 3 = 94,000 per year for 3 years
OCF
  Year
  0 1 2 CF from asset sale:
Revenues 0 320,000 320,000 CF from asset sale
Costs 0 150,000 150,000 = sales price of
asset – taxes paid
Annual depreciation 0 94,000 94,000
on sale of asset
EBIT (revs – costs – depreciation) 0 76,000 76,000
Taxes paid on sale
Tax rate 0.25 0.25 0.25
of asset = taxable
Taxes paid 0 19,000 19,000 gain on sale of
Net income = EBIT – taxes paid 0 57,000 57,000 asset × tax rate
OCF = Net income + depreciation 0 151,000 151,000 Taxable gain on
sale of asset = (sales price of asset – book value of asset)
Book value = initial price of asset – accumulated depreciation
Accumulated depreciation = 0 + 94,000 + 94,000 = 188,000
Book value = 282,000 – 188,000 = 94,000
Taxable gain on asset sale = 126,000 – 94,000 = 32,000
Taxes paid on sale of asset = 32,000 × .25 = 8,000
CF from asset sale = 126,000 – 8,000 = 118,000
Relevant CF
  Year
  0 1 2
OCF 0 151,000 151,000
Cash flow effects from ΔNWC 0 0 0
CF from capital spending -282,000 0 118,000
Terminal value 0 0 0
Relevant CF -282,000 151,000 269,000
npv(8.73,-282000,{151000,269000})  84,414

27
FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

28. Business Monkey is evaluating a 3-year project that would involve buying a new piece of
equipment for $360,000 today. The equipment would be depreciated straight-line to $20,000
over 2 years. In 3 years, the equipment would be sold for an after-tax cash flow of $30,000. In
each of the 3 years of the project, relevant revenues are expected to be $280,000 and relevant
costs are expected to be $90,000. The tax rate is 50% and the cost of capital for the project is
17.8%. What is the NPV of the project?
(Spring 2012, test 4, question 5)
(Spring 2015, test 3, question 5)
(Spring 2018, test 4, question 1)

The initial investment is $360,000

Annual depreciation in years 1 and 2 is ($360,000 – $20,000) / 2 = $170,000
Annual depreciation in years 3 is $0 since the equipment is depreciated over 2 years

There is no information about NWC or terminal values, so their effect on expected cash
flows can be assumed to be zero and only OCF and cash flow from capital spending need to
be computed for each year

  Year
  0 1 2 3
Revenues 0 280,000 280,000 280,000
Costs 0 90,000 90,000 90,000
Annual depreciation 0 170,000 170,000 0
EBIT 0 20,000 20,000 190,000
Tax rate 0.50 0.50 0.50 0.50
Taxes paid 0 10,000 10,000 95,000
Net income = EBIT – taxes paid 0 10,000 10,000 95,000
OCF = net income + depreciation 0 180,000 180,000 95,000

  Year
  0 1 2 3
OCF 0 180,000 180,000 95,000
+ Cash flow effect from ΔNWC 0 0 0 0
+ CF from capital spending -360,000 0 0 30,000
+ Terminal value 0 0 0 0
= Relevant CF -360,000 180,000 180,000 125,000

NPV = -360,000 + [180,000/(1.178)1] + [180,000/(1.178)2] + [125,000/(1.178)3] = -1,019.10

npv(17.8,-360000,{180000,180000,125000})  -1,019.10

Business Monkey should not pursue the project since NPV < 0

28
FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

29. What is the NPV of the mall project? The project would require an initial investment in
equipment of $94,000 and would last for either 3 years or 4 years (the date when the project ends
will not be known until it happens and that will be when the equipment stops working in either 3
years from today or 4 years from today). The first annual operating cash flow of $46,000 is
expected in 1 year, and annual operating cash flows of $46,000 per year are expected each year
until the project ends in either 3 years or 4 years. In 1 year, the project is expected to have an
after-tax terminal value of $81,000. The cost of capital for this project is 15.43 percent.
(Fall 2013, test 4, question 6)
(Spring 2014, final, question 12)
(Fall 2014, test 4, question 5)
(Spring 2016, test 4, question 2)
(Spring 2017, test 4, question 2)
(Fall 2017, test 3, question 9)
(Spring 2018, test 4, question 2)

There is a terminal value in 1 year, so we only need to examine cash flow components for
up to 1 year. The terminal value in 1 year reflects all subsequent expected cash flows (for
years 2, 3, and 4, taking into account the likelihood of the equipment stopping to work in 3
years or in 4 years).

All the information needed to find the NPV of the project is given.

Year
  0 1
OCF 0 46,000
+ Cash flows from ΔNWC 0 0
+ CF from capital spending -94,000 0
+ Terminal value 0 81,000
= Relevant CF -94,000 127,000

NPV = -94,000 + (127,000 / 1.1543) = 16,023

npv(15.43,-94000,{127000})  16,023

29
FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

30. Tripp Industries is considering buying a new recycling system. The new recycling system
would be purchased today for $7,800. It would be depreciated straight-line to $1,000 over 2
years. In 2 years, the recycling system would be sold and the after-tax cash flow from capital
spending in year 2 would be $1,200. The recycling system is expected to reduce costs by $2,800
in year 1 and by $8,700 in year 2. If the tax rate is 50% and the cost of capital is 7.26%, what is
the net present value of the new recycling system project?
(Fall 2009, test 4, question 4) (Spring 2010, final, question 9)
(Fall 2010, test 4, question 7) (Fall 2011, test 4, question 6)
(Spring 2012, test 4, question 6) (Spring 2013, test 4, question 7)
(Fall 2013, test 4, question 7) (Spring 2014, test 4, question 7)
(Fall 2014, final, question 16) (Spring 2015, final, question 18)
(Spring 2016, final, question 10) (Spring 2017, final, question 14)
(Fall 2017, test 3, question 10)

The initial investment is $7,800

The investment is depreciated to $1,000 over 2 years
Annual depreciation in years 1 and 2 is ($7,800 – $1,000) / 2 = $3,400

There is no information about NWC or terminal values, so their effect on expected cash
flows can be assumed to be zero and only OCF and CF from capital spending need to be
computed for each year

  Year
0 1 2
Revenues 0 0 0
- Costs 0 -2,800 -8,700
- Annual depreciation 0 3,400 3,400
= EBIT (revs - costs - depreciation) 0 -600 5,300
× Tax rate 0.50 0.50 0.50
= Taxes 0 -300 2,650
Net income = EBIT – taxes 0 -300 2,650
OCF = net income + depreciation 0 3,100 6,050

OCF 0 3,100 6,050

+ CF effects from ΔNWC 0 0 0
+ CF from capital spending -7,800 0 1,200
+ Terminal value 0 0 0
= Relevant CF -7,800 3,100 7,250

NPV = -7,800 + [3,100/(1.0726)1] + [7,250/(1.0726)2] = 1,391.94

npv(7.26,-7800,{3100,7250})  1,391.94

30
FNAN 303
Solutions to test bank problems – relevant cash flows and NPV analysis

31. Riverton Silver is considering buying a new extraction system. The new extraction system
would be purchased today for $56,000. It would be depreciated straight-line to $0 over 2 years.
In 2 years, the extraction system would be sold for an after-tax cash flow of $3,000. Without the
extraction system, costs are expected to be $97,000 in 1 year and $123,000 in 2 years. With the
extraction system, costs are expected to be $75,000 in 1 year and $37,000 in 2 years. If the tax
rate is 40% and the cost of capital is 18.29%, what is the net present value of the new extraction
system project?
(Fall 2014, test 4, question 6)
(Fall 2015, final, question 14)
(Fall 2016, test 3, question 10)
(Spring 2018, final, question 14)

The initial investment is $56,000

The investment is depreciated to $0 over 2 years
Annual depreciation in years 1 and 2 is ($56,000 – $0) / 2 = $28,000

Relevant costs = costs with the project – costs without project

In year 1, relevant costs = $75,000 – $97,000 = -$22,000
In year 1, costs are expected to be $22,000 lower with the extraction system

In year 2, relevant costs = $37,000 – $123,000 = -$86,000

In year 2, costs are expected to be $86,000 lower with the extraction system

  Year
  0 1 2
Revenues 0 0 0
- Costs 0 -22,000 -86,000
- Annual depreciation 0 28,000 28,000
= EBIT (revs - costs - depreciation) 0 -6,000 58,000
× Tax rate 0.40 0.40 0.40
= Taxes paid 0 -2,400 23,200
Net income = EBIT – taxes paid 0 -3,600 34,800
OCF = net income + depreciation 0 24,400 62,800

OCF 0 24,400 62,800

+ CF effects from ΔNWC 0 0 0
+ CF from capital spending -56,000 0 3,000
+ Terminal value 0 0 0
= Relevant CF -56,000 24,400 65,800

NPV = -56,000 + [24,400/(1.1829)1] + [65,800/(1.1829)2] = 11,652

npv(18.29,-56000,{24400,65800})  11,652

31