Estimating Cash Flows for Replacement Projects
Fewer elements than new ventures
Identifying what is incremental can be tricky
Difficult to determine what will happen if you don’t do the project
If replacing an old production machine, do you:
compare the performance of the new machine to the current performance of the old, or
compare it to flows the current machine are expected to generate if it continues to deteriorate
Estimating Cash Flows for Replacement Projects Example 11.2 18 Q: Harrington Metals Inc. purchased a large stamping machine five years ago for $80,000. To keep the example simple we’ll assume that the tax laws at the time permitted straight-line depreciation over eight years and that machinery purchased today can be depreciated straight line over five years. The machine has not performed well, and management is considering replacing it with a new one that will cost $150,000. If the new machine is purchased, it is estimated that the old one can be sold for $45,000. The quoted costs include all freight, installation and setup. The old machine requires three operators, each of whom earns $25,000 a year including all benefits and payroll costs. The new machine is more efficiently designed and will require only two operators, each earning the same amount. Example
Estimating Cash Flows for Replacement Projects Example 11.2 19 Q: The old machine has the following history of high maintenance cost and significant downtime. Downtime on the machine is a major inconvenience, but it doesn’t usually stop production unless it lasts for an extended period. This is because the company maintains an emergency inventory of stamped pieces and has been able to temporarily reroute production without much notice. Manufacturing managers estimate that every hour of downtime costs the company $500, but have no hard data backing up that figure. Example $45 $42 $35 $10 In warranty Maintenance expense ($000) 128 130 100 60 40 Hours down 5 4 3 2` 1 Year
Estimating Cash Flows for Replacement Projects Example 11.2 20 Q: The makers of the replacement machines have said that Harrington will spend about $15,000 a year maintaining their product and that an average of only 30 hours of downtime a year should be expected. However, they are not willing to guarantee those estimates after the one-year warranty runs out. The new machine is expected to produce higher quality output than the old one. The result is expected to be better customer satisfaction and possibly more sales in the future. Management would like to include some benefit for this effect in the analysis, but is unsure of how to quantify it. Estimate the incremental cash flows over the next five years associated with buying the new machine. Assume Harrington’s marginal tax rate is 34%, and that the company is currently profitable so that changes in taxable income result in tax changes at 34% whether positive or negative. Assume any gain on the sale of the old machine is also taxed at 34% since corporations don’t receive favorable tax treatment on capital gains. Example
Estimating Cash Flows for Replacement Projects Example 11.2 21 A: There are two kinds of cash flows in this problem—those that can be estimated fairly objectively and those that require some degree of subjective guesswork. Objective Cash Flows: The initial outlay is relatively straightforward: Example $110.1 Initial outlay 39.9 Less proceeds from sale of old machine $150.0 Cost of new machine The old machine has a current market value of $45,000 and a book value of $30,000 (initial cost of $80,000 les depreciation of $50,000). Thus, a gain on the sale of the old machine of $15,000 results in additional taxes of $5.1. The net cash proceeds on the sale of the old machine are $39.9 (or $45.0 – $5.1).
Estimating Cash Flows for Replacement Projects Example 11.2 22 A: Depreciation and labor savings are straightforward as well: Example $25.0 $25.0 $25.0 $25.0 $25.0 Labor savings $10.2 $10.2 $6.8 $6.8 $6.8 Cash tax savings @ 34% $30.0 $30.0 $20.0 $20.0 $20.0 Net increase in depreciation 10.0 10.0 10.0 Old depreciation $30.0 $30.0 $30.0 $30.0 $30.0 New depreciation 5 4 3 2 1 Year Represent the cost savings from needing only two employees rather than three.
Estimating Cash Flows for Replacement Projects Example 11.2 23 A: The subjective benefits (which are based on opinions) are hard to quantify and lead to biases when estimated by people who want project approval. The financial analyst should ensure that only reasonable estimates of unprovable benefits are used. Example $30.0 $30.0 $30.0 $30.0 $45.0 Savings 15.0 15.0 15.0 15.0 In warranty New machine maintenance $45.0 $45.0 $45.0 $45.0 $45.0 Old machine maintenance 5 4 3 2 1 Year The question is: Should we assume maintenance on the old machine would have remained at $45.0 or increase as the machine gets older? Also, will maintenance on the new machine rise as the new machine ages?
Estimating Cash Flows for Replacement Projects Example 11.2 24 A: Another subjective estimate is that of downtime. The old machine has been having about 130 hours of downtime while the new one promises 30 hours—a savings of 100 hours. But, argument could be made for using different assumptions for downtime hours. Another question is: How much is each hour of downtime savings worth? Arguments range from no savings (as we are unable to say exactly how much it’s worth) to $500 an hour. Most people favor a middle-of-the-road approach—we’ll use $200 an hour, which yields an estimated cash flow savings of $20,000 per year. Example $49.5 $49.5 $49.5 $49.5 $59.4 Net after tax $75.0 $75.0 $75.0 $75.0 $90.0 Total $20.0 $20.0 $20.0 $20.0 $20.0 Downtime savings $30.0 $30.0 $30.0 $30.0 $45.0 Maintenance savings $25.0 $25.0 $25.0 $25.0 $25.0 Labor savings $59.7 $59.7 $56.3 $56.3 $66.2 Cash flow 10.2 10.2 6.8 6.8 6.8 Tax savings on depreciation 25.5 25.5 25.5 25.5 30.6 Tax 5 4 3 2 1 Year