chapter 12 cash flows and other topics in capital budgeting 2005, pearson prentice hall

CHAPTER 12CHAPTER 12Cash Flows and Other Topics in Cash Flows and Other Topics in

Capital BudgetingCapital Budgeting

2005, Pearson Prentice Hall

Capital BudgetingCapital Budgeting:: The process of planning The process of planning for purchases of for purchases of long-termlong-term assetsassets..

For exampleFor example: : Our firm must decide whether Our firm must decide whether to purchase a new plastic molding machine to purchase a new plastic molding machine for for $127,000$127,000. How do we decide?. How do we decide?

Will the machine be Will the machine be profitableprofitable?? Will our firm earn a Will our firm earn a high rate of returnhigh rate of return on on

the investment?the investment? The relevant project information follows:The relevant project information follows:

The cost of the new machine is The cost of the new machine is $127,000$127,000. . Installation will cost Installation will cost $20,000$20,000.. $4,000$4,000 in net working capital will be needed at in net working capital will be needed at

the time of installation.the time of installation. The project will increase revenues by The project will increase revenues by $85,000$85,000 per per

year, but operating costs will increase by year, but operating costs will increase by 35%35% of of the revenue increase.the revenue increase.

Simplified straight line depreciation is used.Simplified straight line depreciation is used. Class life is Class life is 55 years, and the firm is planning to years, and the firm is planning to

keep the project for keep the project for 55 years. years. Salvage value at the end of year 5 will be Salvage value at the end of year 5 will be $50,000$50,000.. 14%14% cost of capital; cost of capital; 34%34% marginal tax rate. marginal tax rate.

Capital Budgeting StepsCapital Budgeting Steps

1) 1) Evaluate Cash FlowsEvaluate Cash Flows

Look at all relevant cash flows Look at all relevant cash flows occurring as a result of the project.occurring as a result of the project.

Initial outlayInitial outlay Differential Cash FlowsDifferential Cash Flows over the life over the life

of the project (also referred to as of the project (also referred to as annual cash flows).annual cash flows).

Terminal Cash FlowsTerminal Cash Flows

IDENTIFYING RELEVANT CASH FLOWSIDENTIFYING RELEVANT CASH FLOWS

A)A) PROJECT CASH FLOW vs ACCOUNTING PROJECT CASH FLOW vs ACCOUNTING INCOMEINCOME

1) 1) COST OF FIXED ASSETSCOST OF FIXED ASSETS

-- Asset purchases represent negative cash Asset purchases represent negative cash flows.flows.- Full cost of the asset includes shipping and - Full cost of the asset includes shipping and installation costs, used as the depreciable basis to installation costs, used as the depreciable basis to calculate depreciation charges.calculate depreciation charges.- The fixed assets are often sold at the end of - The fixed assets are often sold at the end of project’s life, giving after-tax cash proceeds which project’s life, giving after-tax cash proceeds which represents a +ve cash flow.represents a +ve cash flow.

2) NON CASH CHARGES2) NON CASH CHARGES

- Depreciation is subtracted from revenues. Depreciation Depreciation is subtracted from revenues. Depreciation shelters income from taxation, has an impact on cash flow, but shelters income from taxation, has an impact on cash flow, but it is NOT a cash flow, thus MUST be added back to net income it is NOT a cash flow, thus MUST be added back to net income when estimating project’s CF.when estimating project’s CF.

3) CHANGES IN NET OPERATING WORKING CAPITAL3) CHANGES IN NET OPERATING WORKING CAPITAL

- When sales expand, accounts receivable increase. Payables When sales expand, accounts receivable increase. Payables and accruals spontaneously increase, and this reduces the and accruals spontaneously increase, and this reduces the cash to finance inventories and receivables.cash to finance inventories and receivables.

- At end of project’s life, inventories will be used but not At end of project’s life, inventories will be used but not replaced, receivables will be collected without replacement, replaced, receivables will be collected without replacement, bringing cash inflows. NOWC will be returned and added bringing cash inflows. NOWC will be returned and added back to the cash flow.back to the cash flow.

4)4) INTEREST EXPENSESINTEREST EXPENSES

NOT included in project cash flow for 2 reasons. Firstly NOT included in project cash flow for 2 reasons. Firstly because they are already accounted for in the cost of because they are already accounted for in the cost of capital (Required rate of return). 2ndly, project cash capital (Required rate of return). 2ndly, project cash flow is the cash flow available to ALL investors, flow is the cash flow available to ALL investors, bondholders AND shareholders, so interest expenses are bondholders AND shareholders, so interest expenses are NOT subtracted.NOT subtracted.

B) B) INCREMENTAL CASH FLOWS (NET CASH INCREMENTAL CASH FLOWS (NET CASH FLOW IN AN INVESTMENT PROJECT)FLOW IN AN INVESTMENT PROJECT)

1)1) Sunk Costs: (EXCLUDE from CF)Sunk Costs: (EXCLUDE from CF)

A cash outlay that has ALREADY been incurred, cannot be A cash outlay that has ALREADY been incurred, cannot be recovered regardless of whether the project is accepted or recovered regardless of whether the project is accepted or rejected. Examples: Consultant fees, fees for marketing rejected. Examples: Consultant fees, fees for marketing surveys.surveys.

2)2) Opportunity costs: (INCLUDE in CF)Opportunity costs: (INCLUDE in CF)

The return on the best ALTERNATIVE use of an asset, that The return on the best ALTERNATIVE use of an asset, that will NOT be earned if funds are invested in a particular will NOT be earned if funds are invested in a particular project. Example he use of a land for the project site which project. Example he use of a land for the project site which could be sold, or the use of space/floor which could have could be sold, or the use of space/floor which could have been rented out. been rented out.

3)3) Effects on Other Parts of the Firm: (either INCLUDED or Effects on Other Parts of the Firm: (either INCLUDED or EXCLUDED)EXCLUDED)

ExternalitiesExternalities - -

Effects of a project on cash flows in other parts of the firm. Effects of a project on cash flows in other parts of the firm. Often difficult to Often difficult to quantify.quantify.

CannibalizationCannibalization - -

Occurs when the introduction of a new product causes sales Occurs when the introduction of a new product causes sales of existing products to decline. (Example: IBM for years of existing products to decline. (Example: IBM for years refused to provide full support for its PC division because it refused to provide full support for its PC division because it did not want to steal sales from its highly profitable did not want to steal sales from its highly profitable mainstream business. Huge strategic error, because it mainstream business. Huge strategic error, because it allowed Intel, Microsoft , Compaq and others to become allowed Intel, Microsoft , Compaq and others to become dominant forces in the computer industry.dominant forces in the computer industry.



0 1 2 3 4 5 n6 . . .



0 1 2 3 4 5 n6 . . .

TerminalCash flow

Annual Cash Flows

Initialoutlay

2)2) Evaluate the Risk of the ProjectEvaluate the Risk of the Project We’ll get to this in the next chapter.We’ll get to this in the next chapter. For now, we’ll assume that the For now, we’ll assume that the risk of the risk of the

projectproject is the same as the is the same as the risk of the risk of the overall firm.overall firm.

If we do this, we can use the firm’s If we do this, we can use the firm’s cost of cost of capitalcapital as the discount rate for capital as the discount rate for capital investment projects.investment projects.

Capital Budgeting Steps

3) 3) Accept or Reject the ProjectAccept or Reject the Project

Capital Budgeting Steps

Step 1: Evaluate Cash FlowsStep 1: Evaluate Cash Flows

a) a) Initial OutlayInitial Outlay:: What is the cash flow at What is the cash flow at “time 0?”“time 0?”

(Purchase price of the asset)(Purchase price of the asset)

+ (+ (shipping and installation costs)shipping and installation costs)

(Depreciable asset)(Depreciable asset)

+ (Investment in working capital)+ (Investment in working capital)

+ + After-tax proceeds from sale of old assetAfter-tax proceeds from sale of old asset

Net Initial OutlayNet Initial Outlay



(127,000)(127,000) Purchase price of asset Purchase price of asset

+ (+ (20,00020,000)) Shipping and installation Shipping and installation

(147,000)(147,000) Depreciable asset Depreciable asset

+ (4,000)+ (4,000) Net working capital Net working capital

+ + 0 0 Proceeds from sale of old asset Proceeds from sale of old asset

($151,000) Net initial outlay($151,000) Net initial outlay



(127,000) Purchase price of asset(127,000) Purchase price of asset

+ (+ (20,00020,000) Shipping and installation) Shipping and installation

(147,000) Depreciable asset(147,000) Depreciable asset

+ (4,000) Net working capital+ (4,000) Net working capital

+ + 0 0 Proceeds from sale of old asset Proceeds from sale of old asset

($151,000) Net initial outlay($151,000) Net initial outlay


b) b) Annual Cash FlowsAnnual Cash Flows:: What What incremental cash flows occur over the incremental cash flows occur over the life of the project?life of the project?

Incremental revenueIncremental revenue

- Incremental costs- Incremental costs

- - Depreciation on project Depreciation on project

Incremental earnings before taxesIncremental earnings before taxes

- - Tax on incremental EBTTax on incremental EBT

Incremental earnings after taxesIncremental earnings after taxes

+ + Depreciation reversalDepreciation reversal

Annual Cash Flow Annual Cash Flow

For Each Year, Calculate:For Each Year, Calculate:

Incremental revenueIncremental revenue

- Incremental costs- Incremental costs

- - Depreciation on project Depreciation on project

Incremental earnings before taxesIncremental earnings before taxes

- - Tax on incremental EBTTax on incremental EBT

Incremental earnings after taxesIncremental earnings after taxes

+ + Depreciation reversalDepreciation reversal

Annual Cash Flow Annual Cash Flow

For Years 1 - 5:For Years 1 - 5:

85,00085,000 RevenueRevenue

(29,750)(29,750) CostsCosts

((29,40029,400) ) Depreciation Depreciation

25,85025,850 EBTEBT

((8,7898,789)) Taxes Taxes

17,06117,061 EATEAT

29,40029,400 Depreciation Depreciation reversalreversal

46,46146,461 = = Annual Cash FlowAnnual Cash Flow

For Years 1 - 5:For Years 1 - 5:


c) c) Terminal Cash FlowTerminal Cash Flow:: What is the cash What is the cash flow at the end of the project’s life?flow at the end of the project’s life?

Salvage valueSalvage value

+/- Tax effects of capital gain/loss+/- Tax effects of capital gain/loss

+ + Recapture of net working capitalRecapture of net working capital

Terminal Cash FlowTerminal Cash Flow



50,00050,000 Salvage value Salvage value




Tax Effects of Sale of Asset:Tax Effects of Sale of Asset:

Salvage value = Salvage value = $50,000.$50,000. Book value = depreciable asset - total Book value = depreciable asset - total

amount depreciated.amount depreciated. Book value = $147,000 - $147,000Book value = $147,000 - $147,000

= $0.= $0. Capital gain = SV - BVCapital gain = SV - BV

= 50,000 - 0 = $50,000.= 50,000 - 0 = $50,000. Tax payment = 50,000 x .34 = Tax payment = 50,000 x .34 = ($17,000).($17,000).



50,00050,000 Salvage value Salvage value

(17,000)(17,000) Tax on capital gain Tax on capital gain

4,0004,000 Recapture of NWC Recapture of NWC

37,00037,000 Terminal Cash Flow Terminal Cash Flow

Project NPV:Project NPV: CF(0) = CF(0) = -151,000.-151,000. CF(1 - 4) = CF(1 - 4) = 46,461. 46,461.

Or CF (1-5) = 45,461Or CF (1-5) = 45,461 CF(5) = 46,461 + 37,000 = CF(5) = 46,461 + 37,000 = 83,461.83,461.

Or CF (5) = 37,000Or CF (5) = 37,000 Discount rate = Discount rate = 14%.14%. NPV = NPV = $27,721.$27,721. We would We would acceptaccept the project.the project.

Capital RationingCapital Rationing

Suppose that you have evaluated Suppose that you have evaluated five capital investment projectsfive capital investment projects for your company.for your company.

Suppose that the VP of Finance Suppose that the VP of Finance has given you a has given you a limited capital limited capital budgetbudget..

How do you decide which How do you decide which projects to select?projects to select?


You could rank the projects by IRR:You could rank the projects by IRR:


You could rank the projects by IRR:You could rank the projects by IRR:IRR

5%

10%

15%

20%

25%

$

11 22 33 44 55

$X

Our budget is limitedso we accept only projects 1, 2, and 3.


You could rank the projects by IRR:You could rank the projects by IRR:IRR

5%

10%

15%

20%

25%

$

11 22 33

$X

Our budget is limitedso we accept only projects 1, 2, and 3.


Ranking projects by IRR is not Ranking projects by IRR is not always the best way to deal with a always the best way to deal with a limited capital budget.limited capital budget.

It’s better to pick the largest NPVs.It’s better to pick the largest NPVs. Let’s try ranking projects by NPV.Let’s try ranking projects by NPV.

Problems with Project RankingProblems with Project Ranking

1) Mutually exclusive projects of 1) Mutually exclusive projects of unequal unequal sizesize (the (the size disparitysize disparity problem) problem)

The NPV decision may not agree with The NPV decision may not agree with IRR or PI.IRR or PI.

Solution:Solution: select the project with the select the project with the largest largest NPVNPV..

Size Disparity ExampleSize Disparity Example

Project BProject B

yearyear cash flowcash flow

00 (30,000) (30,000)

11 15,000 15,000

22 15,000 15,000

33 15,000 15,000

required return = 12%required return = 12%

IRR = IRR = 23.38%23.38%

NPV = $6,027NPV = $6,027

PI = 1.20PI = 1.20

Project AProject A


00 (135,000)(135,000)

11 60,000 60,000

22 60,000 60,000

33 60,000 60,000


IRR = 15.IRR = 15.89%89%

NPV = $9,110NPV = $9,110

PI = 1.07PI = 1.07

Size Disparity ExampleSize Disparity Example

Project BProject B


00 (30,000) (30,000)

11 15,000 15,000

22 15,000 15,000

33 15,000 15,000


IRR = 23.38%IRR = 23.38%

NPV = $6,027NPV = $6,027

PI = 1.20PI = 1.20

Project AProject A


00 (135,000)(135,000)

11 60,000 60,000

22 60,000 60,000

33 60,000 60,000


IRR = 15.IRR = 15.89%89%

NPV = $9,110NPV = $9,110

PI = 1.07PI = 1.07

Problems with Project RankingProblems with Project Ranking2) The 2) The time disparitytime disparity problem with mutually problem with mutually

exclusive projects.exclusive projects. NPV and PI assume cash flows are NPV and PI assume cash flows are

reinvested at the required rate of returnreinvested at the required rate of return for for the project.the project.

IRR assumes cash flows are IRR assumes cash flows are reinvested at reinvested at the IRR.the IRR.

The NPV or PI decision may not agree with The NPV or PI decision may not agree with the IRR. the IRR.

Solution:Solution: select the largest select the largest NPVNPV..

Time Disparity ExampleTime Disparity ExampleProject BProject B


00 (46,500) (46,500)

11 36,500 36,500

22 24,000 24,000

33 2,400 2,400

44 2,400 2,400


IRR = IRR = 25.51%25.51%

NPV = $8,455NPV = $8,455

PI = 1.18PI = 1.18

Project AProject A yearyear cash flowcash flow

00 (48,000) (48,000)

11 1,200 1,200

22 2,400 2,400

33 39,000 39,000

44 42,000 42,000


IRR = 18.10IRR = 18.10%%

NPV = $9,436NPV = $9,436

PI = 1.20PI = 1.20

Time Disparity ExampleTime Disparity ExampleProject BProject B


00 (46,500) (46,500)

11 36,500 36,500

22 24,000 24,000

33 2,400 2,400

44 2,400 2,400


IRR = 25.51%IRR = 25.51%

NPV = $8,455NPV = $8,455

PI = 1.18PI = 1.18

Project AProject A yearyear cash flowcash flow

00 (48,000) (48,000)

11 1,200 1,200

22 2,400 2,400

33 39,000 39,000

44 42,000 42,000


IRR = 18.10IRR = 18.10%%

NPV = $9,436NPV = $9,436

PI = 1.20PI = 1.20

Mutually Exclusive Investments Mutually Exclusive Investments with with Unequal LivesUnequal Lives

Suppose our firm is planning to expand Suppose our firm is planning to expand and we have to select one of two machines. and we have to select one of two machines.

They differ in terms of They differ in terms of economic lifeeconomic life and and capacitycapacity. .

How do we decide which machine to How do we decide which machine to select?select?

The after-tax cash flows are:The after-tax cash flows are:

YearYear Machine 1Machine 1 Machine 2Machine 2

0 (45,000) (45,000)0 (45,000) (45,000)

1 20,000 12,0001 20,000 12,000

2 20,000 12,0002 20,000 12,000

3 20,000 12,0003 20,000 12,000

4 12,0004 12,000

5 12,0005 12,000

6 12,0006 12,000

Assume a required return of 14%.Assume a required return of 14%.

Step 1: Calculate NPVStep 1: Calculate NPV

NPVNPV11 = = $1,433$1,433 NPVNPV22 = = $1,664$1,664

So, does this mean #2 is better?So, does this mean #2 is better? No! The two NPVs can’t be No! The two NPVs can’t be

compared!compared!

Step 2: Equivalent Annual Step 2: Equivalent Annual Annuity (EAA) methodAnnuity (EAA) method

If we assume that each project will be If we assume that each project will be replaced an infinite number of timesreplaced an infinite number of times in the in the future, we can convert each NPV to an future, we can convert each NPV to an annuityannuity..

The projects’ EAAs The projects’ EAAs cancan be compared to be compared to determine which is the best project!determine which is the best project!

EAA:EAA: Simply annuitize the NPV over the Simply annuitize the NPV over the project’s life.project’s life.

EAA with your calculator:EAA with your calculator:

Simply “spread the NPV over the life Simply “spread the NPV over the life of the project” of the project”

Machine 1Machine 1:: PV = 1433, N = 3, I = 14, PV = 1433, N = 3, I = 14,

solve: solve: PMT = -617.24PMT = -617.24. .

Machine 2Machine 2:: PV = 1664, N = 6, I = 14, PV = 1664, N = 6, I = 14,

solve: solve: PMT = -427.91PMT = -427.91..

EAAEAA11 = $617 = $617 EAAEAA22 = $428 = $428 This tells us that:This tells us that: NPVNPV11 = annuity of = annuity of $617$617 per year. per year. NPVNPV22 = annuity of = annuity of $428$428 per year. per year. So, we’ve reduced a problem with So, we’ve reduced a problem with

different time horizons to a couple of different time horizons to a couple of annuities.annuities.

Decision Rule:Decision Rule: Select the highest EAA.Select the highest EAA. We would choose machine #1. We would choose machine #1.

Step 3: Convert back to NPV Step 3: Convert back to NPV

Assuming infinite replacement, the Assuming infinite replacement, the EAAs are actually perpetuities. Get the EAAs are actually perpetuities. Get the PV by dividing the EAA by the required PV by dividing the EAA by the required rate of return.rate of return.

NPV NPV 11 = 617/.14 = $4,407 = 617/.14 = $4,407

NPV NPV 22 = 428/.14 = $3,057 = 428/.14 = $3,057

Step 3: Convert back to NPV Step 3: Convert back to NPV

Assuming infinite replacement, the EAAs Assuming infinite replacement, the EAAs are actually perpetuities. Get the PV by are actually perpetuities. Get the PV by dividing the EAA by the required rate of dividing the EAA by the required rate of return.return.

NPV NPV 11 = 617/.14 = $4,407 = 617/.14 = $4,407

NPV NPV 22 = 428/.14 = $3,057 = 428/.14 = $3,057

This doesn’t change the answer, of course; This doesn’t change the answer, of course; it just converts EAA to an NPV that can it just converts EAA to an NPV that can be compared.be compared.

Practice Problems:Practice Problems:Cash Flows & Other Topics Cash Flows & Other Topics

in Capital Budgetingin Capital Budgeting

Project InformationProject Information:: Cost of equipment = Cost of equipment = $400,000$400,000.. Shipping & installation will be Shipping & installation will be $20,000$20,000.. $25,000$25,000 in net working capital required at setup. in net working capital required at setup. 3-year project life, 5-year class life.3-year project life, 5-year class life. Simplified straight line depreciation.Simplified straight line depreciation. Revenues will increase by Revenues will increase by $220,000$220,000 per year. per year. Defects costs will fall by Defects costs will fall by $10,000$10,000 per year. per year. Operating costs will rise by Operating costs will rise by $30,000$30,000 per year. per year. Salvage value after year 3 is Salvage value after year 3 is $200,000$200,000.. Cost of capital = Cost of capital = 12%,12%, marginal tax rate = marginal tax rate = 34%34%..

Problem 1aProblem 1a

Problem 1aProblem 1aInitial OutlayInitial Outlay::

(400,000)(400,000) Cost of assetCost of asset

+ (+ ( 20,000 20,000))Shipping & installationShipping & installation

(420,000)(420,000) Depreciable assetDepreciable asset

+ (+ ( 25,000 25,000))Investment in NWCInvestment in NWC

($445,000)($445,000) Net Initial OutlayNet Initial Outlay

220,000220,000 Increased revenueIncreased revenue

10,00010,000 Decreased defectsDecreased defects

(30,000)(30,000) Increased operating costsIncreased operating costs

((84,00084,000) ) Increased depreciation Increased depreciation

116,000116,000 EBTEBT

((39,44039,440)) Taxes (34%)Taxes (34%)

76,56076,560 EATEAT

84,00084,000 Depreciation reversalDepreciation reversal

160,560 = 160,560 = Annual Cash Flow Annual Cash Flow

For Years 1 - 3:For Years 1 - 3: Problem 1aProblem 1a

Terminal Cash FlowTerminal Cash Flow::






Terminal Cash FlowTerminal Cash Flow: :

Salvage value = Salvage value = $200,000$200,000..

Book value = depreciable asset - total Book value = depreciable asset - total amount depreciated.amount depreciated.

Book value = $168,000.Book value = $168,000. Capital gain = SV - BV = $32,000Capital gain = SV - BV = $32,000..

Tax payment = 32,000 x .34 = Tax payment = 32,000 x .34 = ($10,880)($10,880)..



200,000 Salvage value200,000 Salvage value

(10,880) Tax on capital gain(10,880) Tax on capital gain

25,000 25,000 Recapture of NWC Recapture of NWC

214,120 Terminal Cash Flow214,120 Terminal Cash Flow


Problem 1a SolutionProblem 1a Solution

NPV and IRR:NPV and IRR: CF(0) = -445,000CF(0) = -445,000 CF(1 ), (2), = 160,560CF(1 ), (2), = 160,560 CF(3 ) = 160,560 + 214,120 = 374,680CF(3 ) = 160,560 + 214,120 = 374,680 Discount rate = 12%Discount rate = 12% IRR = 22.1%IRR = 22.1% NPV = $93,044. Accept the project!NPV = $93,044. Accept the project!

Project InformationProject Information:: For the same project, suppose we For the same project, suppose we

can only get $100,000 for the old can only get $100,000 for the old equipment after year 3, due to equipment after year 3, due to rapidly changing technology.rapidly changing technology.

Calculate the IRR and NPV for the Calculate the IRR and NPV for the project.project.

Is it still acceptable?Is it still acceptable?

Problem 1bProblem 1b

Terminal Cash FlowTerminal Cash Flow: :



Book value = $168,000.Book value = $168,000. Capital loss = SV - BV = ($68,000)Capital loss = SV - BV = ($68,000)..

Tax refund = 68,000 x .34 = Tax refund = 68,000 x .34 = $23,120$23,120..




23,120 Tax on capital gain23,120 Tax on capital gain




Problem 1b SolutionProblem 1b Solution

NPV and IRR: NPV and IRR: CF(0) = -445,000.CF(0) = -445,000. CF(1), (2) = 160,560.CF(1), (2) = 160,560. CF(3) = 160,560 + 148,120 = 308,680.CF(3) = 160,560 + 148,120 = 308,680. Discount rate = 12%.Discount rate = 12%. IRR = 17.3%IRR = 17.3%..

NPV = $46,067. Accept the project!NPV = $46,067. Accept the project!

Automation ProjectAutomation Project:: Cost of equipment = Cost of equipment = $550,000$550,000.. Shipping & installation will be Shipping & installation will be $25,000$25,000.. $15,000$15,000 in net working capital required at setup. in net working capital required at setup. 8-year project life, 5-year class life.8-year project life, 5-year class life. Simplified straight line depreciation.Simplified straight line depreciation. Current operating expenses are Current operating expenses are $640,000$640,000 per yr. per yr. New operating expenses will be New operating expenses will be $400,000$400,000 per yr. per yr. Already paid consultant Already paid consultant $25,000$25,000 for analysis. for analysis. Salvage value after year 8 is Salvage value after year 8 is $40,000$40,000.. Cost of capital = Cost of capital = 14%,14%, marginal tax rate = marginal tax rate = 34%34%..

Problem 2Problem 2

Problem 2 Problem 2

Initial OutlayInitial Outlay::

(550,000)(550,000) Cost of new machineCost of new machine

+ (+ (25,00025,000)) Shipping & Shipping & installationinstallation

(575,000)(575,000) Depreciable assetDepreciable asset

+ (+ (15,000)15,000) NWC investmentNWC investment

(590,000)(590,000) Net Initial OutlayNet Initial Outlay

240,000 240,000 Cost decreaseCost decrease

((115,000115,000) ) Depreciation increaseDepreciation increase

125,000125,000 EBITEBIT

((42,50042,500)) Taxes (34%)Taxes (34%)

82,50082,500 EATEAT


197,500 = Annual Cash Flow 197,500 = Annual Cash Flow

For Years 1 - 5:For Years 1 - 5: Problem 2

240,000 240,000 Cost decreaseCost decrease

( 0)( 0) Depreciation increaseDepreciation increase

240,000240,000 EBITEBIT

(81,600)(81,600) Taxes (34%)Taxes (34%)

158,400158,400 EATEAT

00 Depreciation reversalDepreciation reversal

158,400 = Annual Cash Flow 158,400 = Annual Cash Flow

For Years 6 - 8:For Years 6 - 8:Problem 2






Problem 2

Problem 2 SolutionProblem 2 Solution

NPV and IRR:NPV and IRR: CF(0) CF(0) = -590,000.= -590,000. CF(years 1 - 5) CF(years 1 - 5) = 197,500.= 197,500. CF(years 6 - 7) CF(years 6 - 7) = 158,400 (no = 158,400 (no

depreciation) depreciation) CF(terminal year 8) CF(terminal year 8) = 158,400 + 41,400 = 158,400 + 41,400

= 199,800.= 199,800. Discount rate Discount rate = 14%.= 14%.

ANSWERANSWER IRR = 28.13% NPV = $293,543IRR = 28.13% NPV = $293,543.. We would We would acceptaccept the project! the project!

Replacement ProjectReplacement Project::

Old Asset (5 years old):Old Asset (5 years old): Cost of equipment = Cost of equipment = $1,125,000$1,125,000.. 10-year project life, 10-year class life.10-year project life, 10-year class life. Simplified straight line depreciation.Simplified straight line depreciation. Current salvage value is Current salvage value is $400,000.$400,000. Cost of capital = Cost of capital = 14%,14%, marginal tax marginal tax

rate = rate = 35%.35%.

Problem 3Problem 3

Replacement ProjectReplacement Project::New Asset:New Asset: Cost of equipment = Cost of equipment = $1,750,000.$1,750,000. Shipping & installation will be Shipping & installation will be $56,000.$56,000. $68,000 $68,000 investment in net working capital.investment in net working capital. 5-year project life, 5-year class life.5-year project life, 5-year class life. Simplified straight line depreciation.Simplified straight line depreciation. Will increase sales by Will increase sales by $285,000$285,000 per year. per year. Operating expenses will fall by Operating expenses will fall by $100,000$100,000 per year. per year. Already paid Already paid $15,000$15,000 for training program. for training program. Salvage value after year 5 is Salvage value after year 5 is $500,000.$500,000. Cost of capital = Cost of capital = 14%,14%, marginal tax rate = marginal tax rate = 34%.34%.

Problem 3Problem 3

Problem 3: Sell the Old AssetProblem 3: Sell the Old Asset



Book value = $1,125,000 - $562,500Book value = $1,125,000 - $562,500

= $562,500.= $562,500. Capital gain = SV - BVCapital gain = SV - BV

= 400,000 - 562,500 = ($162,500)= 400,000 - 562,500 = ($162,500)..

Tax refund = 162,500 x .35 = Tax refund = 162,500 x .35 = $56,875$56,875..

Problem 3Problem 3Initial OutlayInitial Outlay::

(1,750,000)(1,750,000) Cost of new machineCost of new machine

+ (+ ( 56,000 56,000)) Shipping & installationShipping & installation

(1,806,000)(1,806,000) Depreciable assetDepreciable asset

+ ( 68,000)+ ( 68,000) NWC investmentNWC investment

+ + 456,875 456,875 After-tax proceeds (sold After-tax proceeds (sold old machine)old machine)

(1,417,125)(1,417,125) Net Initial OutlayNet Initial Outlay

385,000385,000 Increased sales & cost savingsIncreased sales & cost savings

(248,700)(248,700) Extra depreciation Extra depreciation

136,300136,300 EBTEBT

(47,705)(47,705) Taxes (35%)Taxes (35%)

88,59588,595 EATEAT


337,295 = Differential Cash Flow 337,295 = Differential Cash Flow

For Years 1 - 5:For Years 1 - 5:Problem 3






Problem 3

Problem 3 SolutionProblem 3 Solution

NPV and IRR: NPV and IRR: CF(0) = -1,417,125.CF(0) = -1,417,125. CF(1 - 4) = 337,295.CF(1 - 4) = 337,295. CF(5) = 337,295 + 393,000 = 730,295.CF(5) = 337,295 + 393,000 = 730,295. Discount rate = 14%.Discount rate = 14%. NPV = (55,052.07)NPV = (55,052.07)..

IRR = 12.55%IRR = 12.55%..

We wouldWe would notnot accept the project! accept the project!

chapter 12 cash flows and other topics in capital budgeting 2005, pearson prentice hall

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