Fm10e ch10

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  • Fm10e ch10

    1. 1. Chapter 10 - Cash Flows and Other Topics in Capital Budgeting  2005, Pearson Prentice Hall
    2. 2. Capital Budgeting : The process of planning for purchases of long-term assets . <ul><li>For example : Our firm must decide whether to purchase a new plastic molding machine for $127,000 . How do we decide? </li></ul><ul><li>Will the machine be profitable ? </li></ul><ul><li>Will our firm earn a high rate of return on the investment? </li></ul><ul><li>The relevant project information follows: </li></ul>
    3. 3. <ul><li>The cost of the new machine is $127,000 . </li></ul><ul><li>Installation will cost $20,000 . </li></ul><ul><li>$4,000 in net working capital will be needed at the time of installation. </li></ul><ul><li>The project will increase revenues by $85,000 per year, but operating costs will increase by 35% of the revenue increase. </li></ul><ul><li>Simplified straight line depreciation is used. </li></ul><ul><li>Class life is 5 years, and the firm is planning to keep the project for 5 years. </li></ul><ul><li>Salvage value at the end of year 5 will be $50,000 . </li></ul><ul><li>14% cost of capital; 34% marginal tax rate. </li></ul>
    4. 4. Capital Budgeting Steps <ul><li>1) Evaluate Cash Flows </li></ul><ul><li>Look at all incremental cash flows occurring as a result of the project. </li></ul><ul><li>Initial outlay </li></ul><ul><li>Differential Cash Flows over the life of the project (also referred to as annual cash flows). </li></ul><ul><li>Terminal Cash Flows </li></ul>
    5. 5. Capital Budgeting Steps <ul><li>1) Evaluate Cash Flows </li></ul>0 1 2 3 4 5 n 6 . . .
    6. 6. Capital Budgeting Steps <ul><li>1) Evaluate Cash Flows </li></ul>Initial outlay 0 1 2 3 4 5 n 6 . . .
    7. 7. Capital Budgeting Steps <ul><li>1) Evaluate Cash Flows </li></ul>Annual Cash Flows Initial outlay 0 1 2 3 4 5 n 6 . . .
    8. 8. Capital Budgeting Steps <ul><li>1) Evaluate Cash Flows </li></ul>Terminal Cash flow Annual Cash Flows Initial outlay 0 1 2 3 4 5 n 6 . . .
    9. 9. <ul><li>2) Evaluate the Risk of the Project </li></ul><ul><li>We’ll get to this in the next chapter. </li></ul><ul><li>For now, we’ll assume that the risk of the project is the same as the risk of the overall firm. </li></ul><ul><li>If we do this, we can use the firm’s cost of capital as the discount rate for capital investment projects. </li></ul>Capital Budgeting Steps
    10. 10. <ul><li>3) Accept or Reject the Project </li></ul>Capital Budgeting Steps
    11. 11. Step 1: Evaluate Cash Flows <ul><li>a) Initial Outlay : What is the cash flow at “time 0?” </li></ul><ul><li>(Purchase price of the asset) </li></ul><ul><li>+ ( shipping and installation costs) </li></ul><ul><li>(Depreciable asset) </li></ul><ul><li>+ (Investment in working capital) </li></ul><ul><li>+ After-tax proceeds from sale of old asset </li></ul><ul><li>Net Initial Outlay </li></ul>
    12. 12. Step 1: Evaluate Cash Flows <ul><li>a) Initial Outlay : What is the cash flow at “time 0?” </li></ul><ul><li>(127,000) </li></ul><ul><li>+ ( shipping and installation costs) </li></ul><ul><li>(Depreciable asset) </li></ul><ul><li>+ (Investment in working capital) </li></ul><ul><li>+ After-tax proceeds from sale of old asset </li></ul><ul><li>Net Initial Outlay </li></ul>
    13. 13. Step 1: Evaluate Cash Flows <ul><li>a) Initial Outlay : What is the cash flow at “time 0?” </li></ul><ul><li>(127,000) </li></ul><ul><li>+ ( 20,000 ) </li></ul><ul><li>(Depreciable asset) </li></ul><ul><li>+ (Investment in working capital) </li></ul><ul><li>+ After-tax proceeds from sale of old asset </li></ul><ul><li>Net Initial Outlay </li></ul>
    14. 14. Step 1: Evaluate Cash Flows <ul><li>a) Initial Outlay : What is the cash flow at “time 0?” </li></ul><ul><li>(127,000) </li></ul><ul><li>+ ( 20,000 ) </li></ul><ul><li>(147,000) </li></ul><ul><li>+ (Investment in working capital) </li></ul><ul><li>+ After-tax proceeds from sale of old asset </li></ul><ul><li>Net Initial Outlay </li></ul>
    15. 15. Step 1: Evaluate Cash Flows <ul><li>a) Initial Outlay : What is the cash flow at “time 0?” </li></ul><ul><li>(127,000) </li></ul><ul><li>+ ( 20,000 ) </li></ul><ul><li>(147,000) </li></ul><ul><li>+ (4,000) </li></ul><ul><li>+ After-tax proceeds from sale of old asset </li></ul><ul><li>Net Initial Outlay </li></ul>
    16. 16. Step 1: Evaluate Cash Flows <ul><li>a) Initial Outlay : What is the cash flow at “time 0?” </li></ul><ul><li>(127,000) </li></ul><ul><li>+ ( 20,000 ) </li></ul><ul><li>(147,000) </li></ul><ul><li>+ (4,000) </li></ul><ul><li>+ 0 </li></ul><ul><li>Net Initial Outlay </li></ul>
    17. 17. Step 1: Evaluate Cash Flows <ul><li>a) Initial Outlay : What is the cash flow at “time 0?” </li></ul><ul><li>(127,000) Purchase price of asset </li></ul><ul><li>+ ( 20,000 ) Shipping and installation </li></ul><ul><li>(147,000) Depreciable asset </li></ul><ul><li>+ (4,000) Net working capital </li></ul><ul><li>+ 0 Proceeds from sale of old asset </li></ul><ul><li>($151,000) Net initial outlay </li></ul>
    18. 18. Step 1: Evaluate Cash Flows <ul><li>a) Initial Outlay : What is the cash flow at “time 0?” </li></ul><ul><li>(127,000) Purchase price of asset </li></ul><ul><li>+ ( 20,000 ) Shipping and installation </li></ul><ul><li>(147,000) Depreciable asset </li></ul><ul><li>+ (4,000) Net working capital </li></ul><ul><li>+ 0 Proceeds from sale of old asset </li></ul><ul><li>($151,000) Net initial outlay </li></ul>
    19. 19. Step 1: Evaluate Cash Flows <ul><li>b) Annual Cash Flows : What incremental cash flows occur over the life of the project? </li></ul>
    20. 20. <ul><li>Incremental revenue </li></ul><ul><li>- Incremental costs </li></ul><ul><li>- Depreciation on project </li></ul><ul><li>Incremental earnings before taxes </li></ul><ul><li>- Tax on incremental EBT </li></ul><ul><li>Incremental earnings after taxes </li></ul><ul><li>+ Depreciation reversal </li></ul><ul><li>Annual Cash Flow </li></ul>For Each Year, Calculate:
    21. 21. <ul><li>Incremental revenue </li></ul><ul><li>- Incremental costs </li></ul><ul><li>- Depreciation on project </li></ul><ul><li>Incremental earnings before taxes </li></ul><ul><li>- Tax on incremental EBT </li></ul><ul><li>Incremental earnings after taxes </li></ul><ul><li>+ Depreciation reversal </li></ul><ul><li>Annual Cash Flow </li></ul>For Years 1 - 5:
    22. 22. <ul><li>85,000 </li></ul><ul><li>- Incremental costs </li></ul><ul><li>- Depreciation on project </li></ul><ul><li>Incremental earnings before taxes </li></ul><ul><li>- Tax on incremental EBT </li></ul><ul><li>Incremental earnings after taxes </li></ul><ul><li>+ Depreciation reversal </li></ul><ul><li>Annual Cash Flow </li></ul>For Years 1 - 5:
    23. 23. <ul><li>85,000 </li></ul><ul><li>(29,750) </li></ul><ul><li>- Depreciation on project </li></ul><ul><li>Incremental earnings before taxes </li></ul><ul><li>- Tax on incremental EBT </li></ul><ul><li>Incremental earnings after taxes </li></ul><ul><li>+ Depreciation reversal </li></ul><ul><li>Annual Cash Flow </li></ul>For Years 1 - 5:
    24. 24. <ul><li>85,000 </li></ul><ul><li>(29,750) </li></ul><ul><li>(29,400) </li></ul><ul><li>Incremental earnings before taxes </li></ul><ul><li>- Tax on incremental EBT </li></ul><ul><li>Incremental earnings after taxes </li></ul><ul><li>+ Depreciation reversal </li></ul><ul><li>Annual Cash Flow </li></ul>For Years 1 - 5:
    25. 25. <ul><li>85,000 </li></ul><ul><li>(29,750) </li></ul><ul><li>(29,400) </li></ul><ul><li>25,850 </li></ul><ul><li>- Tax on incremental EBT </li></ul><ul><li>Incremental earnings after taxes </li></ul><ul><li>+ Depreciation reversal </li></ul><ul><li>Annual Cash Flow </li></ul>For Years 1 - 5:
    26. 26. <ul><li>85,000 </li></ul><ul><li>(29,750) </li></ul><ul><li>(29,400) </li></ul><ul><li>25,850 </li></ul><ul><li>(8,789) </li></ul><ul><li>Incremental earnings after taxes </li></ul><ul><li>+ Depreciation reversal </li></ul><ul><li>Annual Cash Flow </li></ul>For Years 1 - 5:
    27. 27. <ul><li>85,000 </li></ul><ul><li>(29,750) </li></ul><ul><li>(29,400) </li></ul><ul><li>25,850 </li></ul><ul><li>(8,789) </li></ul><ul><li>17,061 </li></ul><ul><li>+ Depreciation reversal </li></ul><ul><li>Annual Cash Flow </li></ul>For Years 1 - 5:
    28. 28. <ul><li>85,000 </li></ul><ul><li>(29,750) </li></ul><ul><li>(29,400) </li></ul><ul><li>25,850 </li></ul><ul><li>(8,789) </li></ul><ul><li>17,061 </li></ul><ul><li>29,400 </li></ul><ul><li>Annual Cash Flow </li></ul>For Years 1 - 5:
    29. 29. <ul><li>85,000 Revenue </li></ul><ul><li>(29,750) Costs </li></ul><ul><li>( 29,400 ) Depreciation </li></ul><ul><li>25,850 EBT </li></ul><ul><li>( 8,789 ) Taxes </li></ul><ul><li>17,061 EAT </li></ul><ul><li>29,400 Depreciation reversal </li></ul><ul><li>46,461 = Annual Cash Flow </li></ul>For Years 1 - 5:
    30. 30. Step 1: Evaluate Cash Flows <ul><li>c) Terminal Cash Flow : What is the cash flow at the end of the project’s life? </li></ul><ul><li>Salvage value </li></ul><ul><li>+/- Tax effects of capital gain/loss </li></ul><ul><li>+ Recapture of net working capital </li></ul><ul><li>Terminal Cash Flow </li></ul>
    31. 31. Step 1: Evaluate Cash Flows <ul><li>c) Terminal Cash Flow : What is the cash flow at the end of the project’s life? </li></ul><ul><li>50,000 Salvage value </li></ul><ul><li>+/- Tax effects of capital gain/loss </li></ul><ul><li>+ Recapture of net working capital </li></ul><ul><li>Terminal Cash Flow </li></ul>
    32. 32. Tax Effects of Sale of Asset: <ul><li>Salvage value = $50,000. </li></ul><ul><li>Book value = depreciable asset - total amount depreciated. </li></ul><ul><li>Book value = $147,000 - $147,000 </li></ul><ul><li>= $0. </li></ul><ul><li>Capital gain = SV - BV </li></ul><ul><li>= 50,000 - 0 = $50,000. </li></ul><ul><li>Tax payment = 50,000 x .34 = ($17,000). </li></ul>
    33. 33. Step 1: Evaluate Cash Flows <ul><li>c) Terminal Cash Flow : What is the cash flow at the end of the project’s life? </li></ul><ul><li>50,000 Salvage value </li></ul><ul><li>(17,000) Tax on capital gain </li></ul><ul><li> Recapture of NWC </li></ul><ul><li> Terminal Cash Flow </li></ul>
    34. 34. Step 1: Evaluate Cash Flows <ul><li>c) Terminal Cash Flow : What is the cash flow at the end of the project’s life? </li></ul><ul><li>50,000 Salvage value </li></ul><ul><li>(17,000) Tax on capital gain </li></ul><ul><li>4,000 Recapture of NWC </li></ul><ul><li> Terminal Cash Flow </li></ul>
    35. 35. Step 1: Evaluate Cash Flows <ul><li>c) Terminal Cash Flow : What is the cash flow at the end of the project’s life? </li></ul><ul><li>50,000 Salvage value </li></ul><ul><li>(17,000) Tax on capital gain </li></ul><ul><li>4,000 Recapture of NWC </li></ul><ul><li>37,000 Terminal Cash Flow </li></ul>
    36. 36. Project NPV: <ul><li>CF(0) = -151,000. </li></ul><ul><li>CF(1 - 4) = 46,461. </li></ul><ul><li>CF(5) = 46,461 + 37,000 = 83,461. </li></ul><ul><li>Discount rate = 14%. </li></ul><ul><li>NPV = $27,721. </li></ul><ul><li>We would accept the project. </li></ul>
    37. 37. Capital Rationing <ul><li>Suppose that you have evaluated five capital investment projects for your company. </li></ul><ul><li>Suppose that the VP of Finance has given you a limited capital budget . </li></ul><ul><li>How do you decide which projects to select? </li></ul>
    38. 38. Capital Rationing <ul><li>You could rank the projects by IRR: </li></ul>
    39. 39. Capital Rationing <ul><li>You could rank the projects by IRR: </li></ul>1 IRR 5% 10% 15% 20% 25% $
    40. 40. Capital Rationing <ul><li>You could rank the projects by IRR: </li></ul>1 2 IRR 5% 10% 15% 20% 25% $
    41. 41. Capital Rationing <ul><li>You could rank the projects by IRR: </li></ul>1 2 3 IRR 5% 10% 15% 20% 25% $
    42. 42. Capital Rationing <ul><li>You could rank the projects by IRR: </li></ul>1 2 3 4 IRR 5% 10% 15% 20% 25% $
    43. 43. Capital Rationing <ul><li>You could rank the projects by IRR: </li></ul>1 2 3 4 5 IRR 5% 10% 15% 20% 25% $
    44. 44. Capital Rationing <ul><li>You could rank the projects by IRR: </li></ul>1 2 3 4 5 $X Our budget is limited so we accept only projects 1, 2, and 3. IRR 5% 10% 15% 20% 25% $
    45. 45. Capital Rationing <ul><li>You could rank the projects by IRR: </li></ul>1 2 3 $X Our budget is limited so we accept only projects 1, 2, and 3. IRR 5% 10% 15% 20% 25% $
    46. 46. Capital Rationing <ul><li>Ranking projects by IRR is not always the best way to deal with a limited capital budget. </li></ul><ul><li>It’s better to pick the largest NPVs. </li></ul><ul><li>Let’s try ranking projects by NPV. </li></ul>
    47. 47. Problems with Project Ranking <ul><li>1) Mutually exclusive projects of unequal size (the size disparity problem) </li></ul><ul><li>The NPV decision may not agree with IRR or PI. </li></ul><ul><li>Solution: select the project with the largest NPV . </li></ul>
    48. 48. Size Disparity Example <ul><li>Project A </li></ul><ul><li>year cash flow </li></ul><ul><li>0 (135,000) </li></ul><ul><li>1 60,000 </li></ul><ul><li>2 60,000 </li></ul><ul><li>3 60,000 </li></ul><ul><li>required return = 12% </li></ul><ul><li>IRR = 15.89% </li></ul><ul><li>NPV = $9,110 </li></ul><ul><li>PI = 1.07 </li></ul>
    49. 49. Size Disparity Example <ul><li>Project B </li></ul><ul><li>year cash flow </li></ul><ul><li>0 (30,000) </li></ul><ul><li>1 15,000 </li></ul><ul><li>2 15,000 </li></ul><ul><li>3 15,000 </li></ul><ul><li>required return = 12% </li></ul><ul><li>IRR = 23.38% </li></ul><ul><li>NPV = $6,027 </li></ul><ul><li>PI = 1.20 </li></ul><ul><li>Project A </li></ul><ul><li>year cash flow </li></ul><ul><li>0 (135,000) </li></ul><ul><li>1 60,000 </li></ul><ul><li>2 60,000 </li></ul><ul><li>3 60,000 </li></ul><ul><li>required return = 12% </li></ul><ul><li>IRR = 15. 89% </li></ul><ul><li>NPV = $9,110 </li></ul><ul><li>PI = 1.07 </li></ul>
    50. 50. Size Disparity Example <ul><li>Project B </li></ul><ul><li>year cash flow </li></ul><ul><li>0 (30,000) </li></ul><ul><li>1 15,000 </li></ul><ul><li>2 15,000 </li></ul><ul><li>3 15,000 </li></ul><ul><li>required return = 12% </li></ul><ul><li>IRR = 23.38% </li></ul><ul><li>NPV = $6,027 </li></ul><ul><li>PI = 1.20 </li></ul><ul><li>Project A </li></ul><ul><li>year cash flow </li></ul><ul><li>0 (135,000) </li></ul><ul><li>1 60,000 </li></ul><ul><li>2 60,000 </li></ul><ul><li>3 60,000 </li></ul><ul><li>required return = 12% </li></ul><ul><li>IRR = 15. 89% </li></ul><ul><li>NPV = $9,110 </li></ul><ul><li>PI = 1.07 </li></ul>
    51. 51. Problems with Project Ranking <ul><li>2) The time disparity problem with mutually exclusive projects. </li></ul><ul><li>NPV and PI assume cash flows are reinvested at the required rate of return for the project. </li></ul><ul><li>IRR assumes cash flows are reinvested at the IRR. </li></ul><ul><li>The NPV or PI decision may not agree with the IRR. </li></ul><ul><li>Solution: select the largest NPV . </li></ul>
    52. 52. Time Disparity Example <ul><li>Project A </li></ul><ul><li>year cash flow </li></ul><ul><li>0 (48,000) </li></ul><ul><li>1 1,200 </li></ul><ul><li>2 2,400 </li></ul><ul><li>3 39,000 </li></ul><ul><li>4 42,000 </li></ul><ul><li>required return = 12% </li></ul><ul><li>IRR = 18.10% </li></ul><ul><li>NPV = $9,436 </li></ul><ul><li>PI = 1.20 </li></ul>
    53. 53. Time Disparity Example <ul><li>Project B </li></ul><ul><li>year cash flow </li></ul><ul><li>0 (46,500) </li></ul><ul><li>1 36,500 </li></ul><ul><li>2 24,000 </li></ul><ul><li>3 2,400 </li></ul><ul><li>4 2,400 </li></ul><ul><li>required return = 12% </li></ul><ul><li>IRR = 25.51% </li></ul><ul><li>NPV = $8,455 </li></ul><ul><li>PI = 1.18 </li></ul><ul><li>Project A </li></ul><ul><li>year cash flow </li></ul><ul><li>0 (48,000) </li></ul><ul><li>1 1,200 </li></ul><ul><li>2 2,400 </li></ul><ul><li>3 39,000 </li></ul><ul><li>4 42,000 </li></ul><ul><li>required return = 12% </li></ul><ul><li>IRR = 18.10 % </li></ul><ul><li>NPV = $9,436 </li></ul><ul><li>PI = 1.20 </li></ul>
    54. 54. Time Disparity Example <ul><li>Project B </li></ul><ul><li>year cash flow </li></ul><ul><li>0 (46,500) </li></ul><ul><li>1 36,500 </li></ul><ul><li>2 24,000 </li></ul><ul><li>3 2,400 </li></ul><ul><li>4 2,400 </li></ul><ul><li>required return = 12% </li></ul><ul><li>IRR = 25.51% </li></ul><ul><li>NPV = $8,455 </li></ul><ul><li>PI = 1.18 </li></ul><ul><li>Project A </li></ul><ul><li>year cash flow </li></ul><ul><li>0 (48,000) </li></ul><ul><li>1 1,200 </li></ul><ul><li>2 2,400 </li></ul><ul><li>3 39,000 </li></ul><ul><li>4 42,000 </li></ul><ul><li>required return = 12% </li></ul><ul><li>IRR = 18.10 % </li></ul><ul><li>NPV = $9,436 </li></ul><ul><li>PI = 1.20 </li></ul>
    55. 55. Mutually Exclusive Investments with Unequal Lives <ul><li>Suppose our firm is planning to expand and we have to select one of two machines. </li></ul><ul><li>They differ in terms of economic life and capacity . </li></ul><ul><li>How do we decide which machine to select? </li></ul>
    56. 56. <ul><li>The after-tax cash flows are: </li></ul><ul><li>Year Machine 1 Machine 2 </li></ul><ul><li>0 (45,000) (45,000) </li></ul><ul><li>1 20,000 12,000 </li></ul><ul><li>2 20,000 12,000 </li></ul><ul><li>3 20,000 12,000 </li></ul><ul><li>4 12,000 </li></ul><ul><li>5 12,000 </li></ul><ul><li>6 12,000 </li></ul><ul><li>Assume a required return of 14%. </li></ul>
    57. 57. Step 1: Calculate NPV <ul><li>NPV 1 = $1,433 </li></ul><ul><li>NPV 2 = $1,664 </li></ul><ul><li>So, does this mean #2 is better? </li></ul><ul><li>No! The two NPVs can’t be compared! </li></ul>
    58. 58. Step 2: Equivalent Annual Annuity (EAA) method <ul><li>If we assume that each project will be replaced an infinite number of times in the future, we can convert each NPV to an annuity . </li></ul><ul><li>The projects’ EAAs can be compared to determine which is the best project! </li></ul><ul><li>EAA: Simply annuitize the NPV over the project’s life. </li></ul>
    59. 59. EAA with your calculator: <ul><li>Simply “spread the NPV over the life of the project” </li></ul><ul><li>Machine 1 : PV = 1433, N = 3, I = 14, </li></ul><ul><li>solve: PMT = -617.24 . </li></ul><ul><li>Machine 2 : PV = 1664, N = 6, I = 14, </li></ul><ul><li>solve: PMT = -427.91 . </li></ul>
    60. 60. <ul><li>EAA 1 = $617 </li></ul><ul><li>EAA 2 = $428 </li></ul><ul><li>This tells us that: </li></ul><ul><li>NPV 1 = annuity of $617 per year. </li></ul><ul><li>NPV 2 = annuity of $428 per year. </li></ul><ul><li>So, we’ve reduced a problem with different time horizons to a couple of annuities. </li></ul><ul><li>Decision Rule: Select the highest EAA. We would choose machine #1. </li></ul>
    61. 61. Step 3: Convert back to NPV 
    62. 62. Step 3: Convert back to NPV <ul><li>Assuming infinite replacement, the EAAs are actually perpetuities. Get the PV by dividing the EAA by the required rate of return. </li></ul>
    63. 63. Step 3: Convert back to NPV <ul><li>Assuming infinite replacement, the EAAs are actually perpetuities. Get the PV by dividing the EAA by the required rate of return. </li></ul><ul><li>NPV 1 = 617/.14 = $4,407 </li></ul> 
    64. 64. Step 3: Convert back to NPV <ul><li>Assuming infinite replacement, the EAAs are actually perpetuities. Get the PV by dividing the EAA by the required rate of return. </li></ul><ul><li>NPV 1 = 617/.14 = $4,407 </li></ul><ul><li>NPV 2 = 428/.14 = $3,057 </li></ul>  
    65. 65. Step 3: Convert back to NPV <ul><li>Assuming infinite replacement, the EAAs are actually perpetuities. Get the PV by dividing the EAA by the required rate of return. </li></ul><ul><li>NPV 1 = 617/.14 = $4,407 </li></ul><ul><li>NPV 2 = 428/.14 = $3,057 </li></ul><ul><li>This doesn’t change the answer, of course; it just converts EAA to an NPV that can be compared. </li></ul>  
    66. 66. Practice Problems: Cash Flows & Other Topics in Capital Budgeting
    67. 67. <ul><li>Project Information : </li></ul><ul><li>Cost of equipment = $400,000 . </li></ul><ul><li>Shipping & installation will be $20,000 . </li></ul><ul><li>$25,000 in net working capital required at setup. </li></ul><ul><li>3-year project life, 5-year class life. </li></ul><ul><li>Simplified straight line depreciation. </li></ul><ul><li>Revenues will increase by $220,000 per year. </li></ul><ul><li>Defects costs will fall by $10,000 per year. </li></ul><ul><li>Operating costs will rise by $30,000 per year. </li></ul><ul><li>Salvage value after year 3 is $200,000 . </li></ul><ul><li>Cost of capital = 12%, marginal tax rate = 34% . </li></ul>Problem 1a
    68. 68. Problem 1a <ul><li>Initial Outlay : </li></ul><ul><li>(400,000) Cost of asset </li></ul><ul><li>+ ( 20,000 ) Shipping & installation </li></ul><ul><li>(420,000) Depreciable asset </li></ul><ul><li>+ ( 25,000 ) Investment in NWC </li></ul><ul><li>($445,000) Net Initial Outlay </li></ul>
    69. 69. <ul><li>220,000 Increased revenue </li></ul><ul><li>10,000 Decreased defects </li></ul><ul><li>(30,000) Increased operating costs </li></ul><ul><li>( 84,000 ) Increased depreciation </li></ul><ul><li>116,000 EBT </li></ul><ul><li>( 39,440 ) Taxes (34%) </li></ul><ul><li>76,560 EAT </li></ul><ul><li>84,000 Depreciation reversal </li></ul><ul><li>160,560 = Annual Cash Flow </li></ul>For Years 1 - 3: Problem 1a
    70. 70. <ul><li>Terminal Cash Flow : </li></ul><ul><li>Salvage value </li></ul><ul><li>+/- Tax effects of capital gain/loss </li></ul><ul><li>+ Recapture of net working capital </li></ul><ul><li>Terminal Cash Flow </li></ul>Problem 1a
    71. 71. <ul><li>Terminal Cash Flow : </li></ul><ul><li>Salvage value = $200,000 . </li></ul><ul><li>Book value = depreciable asset - total amount depreciated. </li></ul><ul><li>Book value = $168,000. </li></ul><ul><li>Capital gain = SV - BV = $32,000 . </li></ul><ul><li>Tax payment = 32,000 x .34 = ($10,880) . </li></ul>Problem 1a
    72. 72. <ul><li>Terminal Cash Flow : </li></ul><ul><li>200,000 Salvage value </li></ul><ul><li>(10,880) Tax on capital gain </li></ul><ul><li>25,000 Recapture of NWC </li></ul><ul><li>214,120 Terminal Cash Flow </li></ul>Problem 1a
    73. 73. Problem 1a Solution <ul><li>NPV and IRR: </li></ul><ul><li>CF(0) = -445,000 </li></ul><ul><li>CF(1 ), (2), = 160,560 </li></ul><ul><li>CF(3 ) = 160,560 + 214,120 = 374,680 </li></ul><ul><li>Discount rate = 12% </li></ul><ul><li>IRR = 22.1% </li></ul><ul><li>NPV = $93,044. Accept the project! </li></ul>
    74. 74. <ul><li>Project Information : </li></ul><ul><li>For the same project, suppose we can only get $100,000 for the old equipment after year 3, due to rapidly changing technology. </li></ul><ul><li>Calculate the IRR and NPV for the project. </li></ul><ul><li>Is it still acceptable? </li></ul>Problem 1b
    75. 75. <ul><li>Terminal Cash Flow : </li></ul><ul><li>Salvage value </li></ul><ul><li>+/- Tax effects of capital gain/loss </li></ul><ul><li>+ Recapture of net working capital </li></ul><ul><li>Terminal Cash Flow </li></ul>Problem 1b
    76. 76. <ul><li>Terminal Cash Flow : </li></ul><ul><li>Salvage value = $100,000 . </li></ul><ul><li>Book value = depreciable asset - total amount depreciated. </li></ul><ul><li>Book value = $168,000. </li></ul><ul><li>Capital loss = SV - BV = ($68,000) . </li></ul><ul><li>Tax refund = 68,000 x .34 = $23,120 . </li></ul>Problem 1b
    77. 77. <ul><li>Terminal Cash Flow : </li></ul><ul><li>100,000 Salvage value </li></ul><ul><li>23,120 Tax on capital gain </li></ul><ul><li>25,000 Recapture of NWC </li></ul><ul><li>148,120 Terminal Cash Flow </li></ul>Problem 1b
    78. 78. Problem 1b Solution <ul><li>NPV and IRR: </li></ul><ul><li>CF(0) = -445,000. </li></ul><ul><li>CF(1), (2) = 160,560. </li></ul><ul><li>CF(3) = 160,560 + 148,120 = 308,680. </li></ul><ul><li>Discount rate = 12%. </li></ul><ul><li>IRR = 17.3% . </li></ul><ul><li>NPV = $46,067. Accept the project! </li></ul>
    79. 79. <ul><li>Automation Project : </li></ul><ul><li>Cost of equipment = $550,000 . </li></ul><ul><li>Shipping & installation will be $25,000 . </li></ul><ul><li>$15,000 in net working capital required at setup. </li></ul><ul><li>8-year project life, 5-year class life. </li></ul><ul><li>Simplified straight line depreciation. </li></ul><ul><li>Current operating expenses are $640,000 per yr. </li></ul><ul><li>New operating expenses will be $400,000 per yr. </li></ul><ul><li>Already paid consultant $25,000 for analysis. </li></ul><ul><li>Salvage value after year 8 is $40,000 . </li></ul><ul><li>Cost of capital = 14%, marginal tax rate = 34% . </li></ul>Problem 2
    80. 80. Problem 2 <ul><li>Initial Outlay : </li></ul><ul><li>(550,000) Cost of new machine </li></ul><ul><li>+ ( 25,000 ) Shipping & installation </li></ul><ul><li>(575,000) Depreciable asset </li></ul><ul><li>+ ( 15,000) NWC investment </li></ul><ul><li>(590,000) Net Initial Outlay </li></ul>
    81. 81. <ul><li>240,000 Cost decrease </li></ul><ul><li>( 115,000 ) Depreciation increase </li></ul><ul><li>125,000 EBIT </li></ul><ul><li>( 42,500 ) Taxes (34%) </li></ul><ul><li>82,500 EAT </li></ul><ul><li>115,000 Depreciation reversal </li></ul><ul><li>197,500 = Annual Cash Flow </li></ul>For Years 1 - 5: Problem 2
    82. 82. <ul><li>240,000 Cost decrease </li></ul><ul><li>( 0) Depreciation increase </li></ul><ul><li>240,000 EBIT </li></ul><ul><li>(81,600) Taxes (34%) </li></ul><ul><li>158,400 EAT </li></ul><ul><li>0 Depreciation reversal </li></ul><ul><li>158,400 = Annual Cash Flow </li></ul>For Years 6 - 8: Problem 2
    83. 83. <ul><li>Terminal Cash Flow : </li></ul><ul><li>40,000 Salvage value </li></ul><ul><li>(13,600) Tax on capital gain </li></ul><ul><li>15,000 Recapture of NWC </li></ul><ul><li>41,400 Terminal Cash Flow </li></ul>Problem 2
    84. 84. Problem 2 Solution <ul><li>NPV and IRR: </li></ul><ul><li>CF(0) = -590,000. </li></ul><ul><li>CF(1 - 5) = 197,500. </li></ul><ul><li>CF(6 - 7) = 158,400. </li></ul><ul><li>CF(10) = 158,400 + 41,400 = 199,800. </li></ul><ul><li>Discount rate = 14%. </li></ul><ul><li>IRR = 28.13% NPV = $293,543 . </li></ul><ul><li>We would accept the project! </li></ul>
    85. 85. <ul><li>Replacement Project : </li></ul><ul><li>Old Asset (5 years old): </li></ul><ul><li>Cost of equipment = $1,125,000 . </li></ul><ul><li>10-year project life, 10-year class life. </li></ul><ul><li>Simplified straight line depreciation. </li></ul><ul><li>Current salvage value is $400,000. </li></ul><ul><li>Cost of capital = 14%, marginal tax rate = 35%. </li></ul>Problem 3
    86. 86. <ul><li>Replacement Project : </li></ul><ul><li>New Asset: </li></ul><ul><li>Cost of equipment = $1,750,000. </li></ul><ul><li>Shipping & installation will be $56,000. </li></ul><ul><li>$68,000 investment in net working capital. </li></ul><ul><li>5-year project life, 5-year class life. </li></ul><ul><li>Simplified straight line depreciation. </li></ul><ul><li>Will increase sales by $285,000 per year. </li></ul><ul><li>Operating expenses will fall by $100,000 per year. </li></ul><ul><li>Already paid $15,000 for training program. </li></ul><ul><li>Salvage value after year 5 is $500,000. </li></ul><ul><li>Cost of capital = 14%, marginal tax rate = 34%. </li></ul>Problem 3
    87. 87. Problem 3: Sell the Old Asset <ul><li>Salvage value = $400,000 . </li></ul><ul><li>Book value = depreciable asset - total amount depreciated. </li></ul><ul><li>Book value = $1,125,000 - $562,500 </li></ul><ul><li>= $562,500. </li></ul><ul><li>Capital gain = SV - BV </li></ul><ul><li>= 400,000 - 562,500 = ($162,500) . </li></ul><ul><li>Tax refund = 162,500 x .35 = $56,875 . </li></ul>
    88. 88. Problem 3 <ul><li>Initial Outlay : </li></ul><ul><li>(1,750,000) Cost of new machine </li></ul><ul><li>+ ( 56,000 ) Shipping & installation </li></ul><ul><li>(1,806,000) Depreciable asset </li></ul><ul><li>+ ( 68,000) NWC investment </li></ul><ul><li>+ 456,875 After-tax proceeds (sold old machine) </li></ul><ul><li>(1,417,125) Net Initial Outlay </li></ul>
    89. 89. <ul><li>385,000 Increased sales & cost savings </li></ul><ul><li>(248,700) Extra depreciation </li></ul><ul><li>136,300 EBT </li></ul><ul><li>(47,705) Taxes (35%) </li></ul><ul><li>88,595 EAT </li></ul><ul><li>248,700 Depreciation reversal </li></ul><ul><li>337,295 = Differential Cash Flow </li></ul>For Years 1 - 5: Problem 3
    90. 90. <ul><li>Terminal Cash Flow : </li></ul><ul><li>500,000 Salvage value </li></ul><ul><li>(175,000) Tax on capital gain </li></ul><ul><li>68,000 Recapture of NWC </li></ul><ul><li>393,000 Terminal Cash Flow </li></ul>Problem 3
    91. 91. Problem 3 Solution <ul><li>NPV and IRR: </li></ul><ul><li>CF(0) = -1,417,125. </li></ul><ul><li>CF(1 - 4) = 337,295. </li></ul><ul><li>CF(5) = 337,295 + 393,000 = 730,295. </li></ul><ul><li>Discount rate = 14%. </li></ul><ul><li>NPV = (55,052.07) . </li></ul><ul><li>IRR = 12.55% . </li></ul><ul><li>We would not accept the project! </li></ul>

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