Managerial Finance

Lynda Livingston

PRIMER ON CAPITAL BUDGETING

basic idea Capital budgeting is the companion piece to weighted average cost of capital. WACC tells us how much it will cost to raise new debt and equity funds to purchase new projects; capital budgeting tells us which projects will generate more than this cost. Only projects that can return more than they cost are acceptable to a company. There are many methods of capital budgeting. This primer considers only one: net present value (NPV). We focus on NPV because it can be used in all situations,1 uses all relevant information,2 and gives an easily interpretable answer.3 Net present value is calculated as: NPV = PV(all future cash flows) investment,

where the i for discounting is WACC. The units of NPV are dollars. The decision criteria for NPV are: accept an independent project if NPV > 0 reject an independent project is NPV < 0 accept/reject (indifferent) if NPV = 0 Our main job will be to identify the cash flows that we will substitute into this equation. Once we know these cash flows, the actual calculation of NPV is easy. finding the cash flows We assume that we are considering a replacement project: we already have a machine operating, and were considering replacing that machine with a new one. We adopt the perspective that we will accept the new machine, then we identify all of the incremental cash flows that wed face given that well go ahead. That is, we only care about cash flows that will be different with the new machine. Cash flows that would be the same under either alternative (old or new machine) will not affect our decision, since we cant affect them. We look for incremental cash flows that apply to three phases of a projects life. Well discuss each of these three phases below.

1 2

IRR, for example, does not always exist. Methods like ARR and payback ignore many relevant inputs. 3 Is a 50% IRR good?

CAPITAL BUDGETING PRIMER

INITIAL CASH FLOWS (t=0)

At time 0, we look for the cash flows required to initiate the project: establish the new machine and remove the old. There are five primary types of cash flows to look for. The sum of these five cash flows becomes the investment in the NPV expression.4 1) cost of the new machine this will normally be an outflow note that we assume that the full cost of the machine is paid at t=0: we assume that it is all equity financed. WACC accounts for our true financing mix. 2) set-up costs for the new machine examples: installation, delivery, remodeling these will normally be outflows remember that set-up costs are included in the depreciable basis of the new machine 3) sale of the old machine this will normally be an inflow 4) tax effect on sale of old machine this can be an inflow or an outflow: outflow (pay tax) for gains; inflow (refund) for losses we find tax effect as follows (assuming a gain): tax effect on sale = = = (taxable gain)*(marginal tax rate) (MV BV)*(T) (MV [basis accumulated depreciation])*(T)

we find the depreciable basis as = cost + set-up charges

basis

we find accumulated depreciation various ways, depending on the depreciation method: for straight-line: accumulated depreciation = (basis/# of years of depreciable life)*(# of years so far)

Note that NPV is defines as PV(future CFs) investment. Dont get confused by the signsthe - before investment just suggests that this will be an outflow. If you find that the sum of your initial cash flows is an outflow, dont subtract this outflow from PV(CFs) (in other words, dont subtract a negative number and end up making it positive!).

CAPITAL BUDGETING PRIMER

depreciable basis, continued for other methods: accumulated depreciation = sum of annual depreciation for all years so far

throughout the problem, be careful to distinguish between a machines useful (economic) life (which will normally help define the length of the problem [time T]) and its depreciable life. These two periods can be quite different if a machine is fully depreciated, its book value is zero: we always depreciate toward a ze4ro salvage value (this is the tax-books assumption) for a taxable loss, the method is the same; we just note that the MV is now less than the BV, and that we will receive a refund 5) working capital Working capital is defined as: WC = current assets current liabilities CA CL

As always, we are concerned with incremental cash flows, so we really work with changes to working capital: does accepting the new machine have any cash-flow implications on our CA and/or CL accounts? We will consider three accounts here: current assets: inventory: if the new machine causes inventory to increase, we have used cash outflow if the new machine causes inventory to decrease, we have a source of cash inflow accounts receivable: if the new machine causes A/R to increase, we have used cash if the new machine causes A/R to decrease, we have a source of cash outflow inflow

current liabilities: accounts payable: if the new machine causes A/P to increase, we have a source of cash inflow if the new machine causes A/P to decrease, we have used cash outflow

To find the WC increment to include in the initial cash flow, just net the effects of the three accounts. For example, if inventory increases by $100, A/R decreases by $500, and A/P increases by $75, youd have <$100> + $500 + $75 = $475 an inflow. Youd put a positive $475 in the initial cash flow.

CAPITAL BUDGETING PRIMER

TERMINAL CASH FLOWS (t=T)

These are the cash flows associated with unwinding our investment in the new machine. There are three basic types of cash flows to look for, all of which have counterparts in the initial cash flows. The sum of these three cash flows will be a lump-sum amount at t=T, which you will later discount to t=0 when finding NPV. (There will also be an operating cash flow at t=T, but well handle that with the other operating cash flows.) 1) sale of the new machine again, this is usually an inflow, since the machine will probably have some salvage value 2) tax effect on sale of the machine if the new machine has been fully depreciated, its BV = 0, so its MV = gain pay taxes 3) recovery of working capital investment whatever amount was used at t=0 is used here, but with the opposite sign (e.g., if the t=0 amount were an outflow of $500, the t=T amount is an inflow of $500)

OPERATING CASH FLOWS (t=1 through t=T)

For each year that the new machine is operating, we must identify all the incremental cash flows that well experience. We can do this systematically by filling in the following equation for each year of the new machines useful life:

CFATt
where:

(R OC)*(1-T) + D*T

means change inwe always define this as (new machines value old machines value) CFAT means cash flow after taxes R means revenue OC mean operating cost D means depreciation T means marginal tax rate

The signs in this expression are the expected signs. The rule is that anything that increases cash (cash inflow) should come in as a positive number; outflows should be negative. Thus, we have Ra positive numberbecause we expect the new machines revenue to be higher than the old machines. If the new machines revenue is lower, however, wed have a negative number for the revenue term. OC is associated with a negative sign, because we assume that the new operating costs will be higher than the old (a net outflow). If the new costs are lower, OC will enter as a positive number.

CAPITAL BUDGETING PRIMER

operating cash flows, continued D is the net new depreciation for the year. If the new machines depreciation deduction is higher than the old machines, you will have a positive D. Note that the operating term, (R OC), is multiplied by (1-T). This is because any new net operating cash flow must be shared with the IRSyou keep only (1-T) percent of it. (Of course, you also pay only (1-T) percent of any new decrease in operating cash flow.) (Remember that multiplying something by (1-T0 gives you an after-tax amount.) The depreciation term, on the other hand, is multiplied by T. This is because this term is a tax shield term. Depreciation itself is a non-cash charge. The only reason we care about it is because it affects taxes (a cash charge). Thus, increasing our depreciation deduction decreases our taxes, and therefore gives us a net cash inflow. We care here about the different tax amount; multiplying D by T gives us this tax amount. where does this equation come from? This expression is based on an income statement written sideways. An income statement gets to net income as: revenue operating costs depreciation taxes = net income: R OC D taxes = NI. Now taxes come from (taxable income)*(T), where taxable income is (R OC D). Thus, taxes = (R OC D)*(T). Net income is therefore: NI = = = R OC D taxes R OC D (R OC D)*(T) (R OC D)*(1-T)

Now, net income isnt a cash flow, since its been reduced by depreciation (a non-cash charge). To get back to cash, wed have to add depreciation back to net income. This gives us cash flow after taxes: CFAT = = = = = NI + D (R OC D)*(1-T) + D [(R OC)*(1-T) + D*(1-T)] + D (R OC)*(1-T) + D*(1 T + 1) (R OC)*(1-T) + D*T,

which, when you incorporate the s, is our CFAT expression. CFAT gives us the after-tax increment to cash flow attributable to the new machine. Although we need a value for CFAT for every operating year, we ma not need to recalculate the value over and over. Thats because CFAT only changes if R, OC, or D changes. Until something changes, we have a series of consecutive CFAT amounts that we can treat as an annuity. You should expect at least one change in a problem, usually a change in D when the old depreciation runs out. Look for this in the examples that follow.

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putting it all together: NPV Now that we have all the relevant incremental cash flows, we can find the present value of all the future cash flows, combine them with the initial cash flow, and evaluate the resulting NPV. This amounts to nothing more than a relatively simple time value problem. miscellaneous final notes There are two additional cash flow types you must consider: sunk costs: These are the costs we want to include but must not. IGNORE THEM! Any cash flows thats in the past is unrecoverable! You cant affect it! Its already happened! You cant control it! No matter what you do, its already been paid! Its not a decision variable! opportunity costs: These are the costs that we want to ignore but cant. These are things over which we have control; our decision makes a difference. Dont overdo it, though; although there are always an infinite number of alternatives to any decision, theres only one second-best alternative. Its this first runner-up that we consider as our opportunity cost. For example, lets assume that our current machine could be sold today for $500 or at t=15 for $100. If we buy the new machine, we sell the old one today; if we keep the old machine, we sell it at t=15. We could sell the old machine at any time, of course, but weve already determined that we will actually choose only t=0 or t=15. Given our take-the-new-machine NPV perspective, the sale at t=15 thus becomes our opportunity cost action. Because we could have sold the old machine at t=15, but instead sold it at t=0, we include the following at t=15: lost opportunity to sell old machine saved tax on gain at t=15 <$ salvage value at t=15> + $ taxes not paid

(Were assuming that the salvage value is positive and the book value is zero.) Didnt we already have something like this, but with different signs, at t=0? YES! Doesnt that account for all of this? NO! Selling at t=0 had a t=15 cost; that t=15 cost is an opportunity cost, and is handled at t=15, the period affected by our initial decision. Another example of this would be: Say we have an old machine that will require a huge, tax-deductible maintenance charge at t=6. If we sell this machine today, we get to avoid this maintenance. This has to be a good thinga factor encouraging us to buy the new machine. We account for this at t=6 as: saved maintenance on old machine lost tax deduction on maintenance + $ of maintenance cost <$ taxes not saved from deduction>

We thus add a positive cash flow, in the amount of the after-tax maintenance charges saved, to the NPV of the new machine. This will make it more like that we accept the new machine.

CAPITAL BUDGETING PRIMER

EXAMPLE PROBLEMS WITH ANSWERS

EXAMPLE #1 Determine whether or not your company should accept the following replacement project opportunity. Use NPV for your analysis. SHOW YOUR WORK.

remaining useful life initial cost delivery installation remodeling salvage value at t=0 salvage value at t=5 years in service to date 2 depreciation method depreciable life initial working capital investment incremental revenue per year incremental operating costs per year marginal tax rate weighted average cost of capital

current machine 5 years $200,000 -$0$25,000 $75,000 $420,000 -$0straight-line 5 years N/A 25% 9%

potential replacement 5 years $650,000 $50,000 $45,000 $100,000 N/A $300,000 N/A straight-line 5 years $20,000 increase of $75,000 increase of $60,000

ANSWERS TO EXAMPLE #1

marginal tax rate: WACC: initial cash flow cost of new machine installation on new machine delivery on new machine remodeling for new machine sale of old machine tax due on gain working capital increment

0.25 0.09 calculation of tax effect on sale of old machine: basis $300,000 depreciation per year $60,000 accumulated depreciation $120,000 book value $180,000 gain on sale $240,000 tax due on gain $60,000 =cost+delivery+installation+remodeling =basis/(years of depreciable life) =(depr/year)*(#years so far) =basis-accumulated depreciation =MV - BV =(gain)*T

($650,000) ($45,000) ($50,000) ($100,000) $420,000 ($60,000) ($20,000) ($505,000)

terminal cash flow sale of new tax due on gain working capital recovery PV of terminal cash flow

$300,000 ($75,000) $20,000 $245,000 $159,233 = $245,000/(1.09)^5

note: BV of new machine is $0, since it is fully depreciated. The entire MV is therefore a gain, so the tax effect is $300,000*(T), an outflow.

operating cash flows year 1 revenues and operating costs R $75,000 OC $60,000 R - OC $15,000 (R - OC)*(1-T) $11,250 depreciation new depreciation old depreciation D 2 $75,000 $60,000 $15,000 $11,250 3 $75,000 $60,000 $15,000 $11,250 4 $75,000 $60,000 $15,000 $11,250 5 $75,000 $60,000 $15,000 $11,250

$169,000 $169,000 $169,000 $60,000 $60,000 $60,000 $109,000 $109,000 $109,000 D*T $27,250 $27,250 $27,250 (R - OC)*(1-T) + D*T $38,500 PV(CFATt) $35,321 sum of PV(CFATt) $170,127 $38,500 $32,405 $38,500 $29,729

$169,000 $0 $169,000 $42,250 $53,500 $37,901

$169,000 $0 $169,000 $42,250 $53,500 $34,771 CFATt

= $38,500*(P/A, i=9%, n=3) + $53,500*(P/A, i=9%, n=2)/(1.09)^3 NPV initial cash flow PV(terminal cash flow) sum of PV(CFAT) NPV ($505,000) $159,233 $170,127 ($175,640)

REJECT PROJECT SINCE NPV < 0

EXAMPLE #2 The RELee company is considering the replacement of a 6 year-old EFEM wafer carrier. This carrier was purchased for $1.5 million, and then required an additional $350,000 to deliver and install. It is being depreciated over a 15-year life toward a zero salvage value, using straight-line depreciation.5 This carrier generates annual revenues of $250,000 and annual operating costs of $175,000. Its remaining useful (economic) life is 15 years. If this machine were sold today, it would have market value of $250,000; however, its market value in all future years would be zero. The carrier which is being considered as the replacement cost $2.35 million (which includes all delivery and set-up charges). Because of the state-of-the-art particle filtering system, this carrier would generate much higher annual revenues than the current machine; management estimates these revenues at $500,000 per year. However, the annual maintenance requirements are much more stringent and therefore more expensive, and management has estimated annual operating costs to be $225,000. This machine has a useful and depreciable life of 15 years, and would be depreciated using the straight-line method. Its estimated salvage value at t=15 is $195,750. If RELees marginal tax rate is 20%, and its weighted average cost of capital is 10%, should it replace the old machine? EXTRA CREDIT: For each of the following INDEPENDENT additions, explain its effect on the NPV analysis you have just done. Identify the years whose cash flows would be affected, the amount by which those years cash flows would be affected, and the overall effect on NPV (increase, decrease, or stay the same). (You do not need to recalculate the NPV; simply identify the direction of change, if any.) You may do any, all, or none of these parts. Each part is worth 1 extra credit point. (a) Last year, the old wafer carrier generated exceptional revenues, increasing its normal operating revenues by $75,000. (b) Because of the vacuum-generating system required to initiate the new machine, purchasing it will result in the following initial adjustments to RELees working capital accounts: accounts receivable: accounts payable: inventory: decreases by $75,000 increases by $40,000 increases by $100,000

(c) Management projects that the old machine would be worth $270,500 in 15 years.

Note that we will ignore the half-year convention here, assuming that a full years depreciation is taken during the year of purchase.

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ANSWERS TO EXAMPLE #2

marginal tax rate: weighted average cost of capital:

0.20 0.10

initial cash flow cost of new delivery, installation, remodeling sale of old tax effect on sale of old total initial cash flow

($2,350,000.00) $0.00 $250,000.00 $172,000.00 ($1,928,000.00)

calculation of tax effect on sale of old: depreciable basis: depreciation per year: accumulated depr.: book value: loss on sale: tax effect on loss: $ $ $ $ $ $ 1,850,000.00 123,333.33 740,000.00 1,110,000.00 860,000.00 172,000.00
= cost + delivery/installation/remodeling = (basis)/(15 years of depreciable life) = (depreciation/year)*(6 years so far) = basis - accum. depr. = market value - book value = (loss)*(marginal tax rate)

calculation of tax effect on sale of new teminal cash flow sale of new machine tax effect on sale of new total terminal cash flow PV(terminal cash flow) $195,750.00 ($39,150.00) $156,600.00 $37,488.79 depreciable basis: depreciation per year: accumulated depr.: book value: gain on sale: tax effect on gain $ $ $ $ $ $ 2,350,000.00 156,666.67 2,350,000.00 195,750.00 39,150.00
= cost + delivery/installation = (basis)/(# yrs of depr.life) = (depr/yr)*(# yrs so far) = basis - accum. depr. = book value - market value = (gain)*(marginal tax rate)

NPV =
($1,928,000.00) $1,313,240.62 $37,488.79 ($577,270.58) initial cash flow + PV(operating) + PV(terminal) REJECT PROJECT

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ANSWERS TO EXAMPLE #2 (continued)

operating cash flows year new revenues old revenues R new operating costs old operating costs OC R - OC (R - OC)*(1-T) new depreciation old depreciation D (D)*(T) (R-OC)*(1-T)+D*(T) PV(annual after-tax CF) sum of PV(ann. AT CF) 1 2 3 4 5 6 7 8 9 $500,000.00 $500,000.00 $500,000.00 $500,000.00 $500,000.00 $500,000.00 $500,000.00 $500,000.00 $500,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $225,000.00 $225,000.00 $225,000.00 $225,000.00 $225,000.00 $225,000.00 $225,000.00 $225,000.00 $225,000.00 $175,000.00 $175,000.00 $175,000.00 $175,000.00 $175,000.00 $175,000.00 $175,000.00 $175,000.00 $175,000.00 $50,000.00 $50,000.00 $50,000.00 $50,000.00 $50,000.00 $50,000.00 $50,000.00 $50,000.00 $50,000.00 $200,000.00 $200,000.00 $200,000.00 $200,000.00 $200,000.00 $200,000.00 $200,000.00 $200,000.00 $200,000.00 $160,000.00 $160,000.00 $160,000.00 $160,000.00 $160,000.00 $160,000.00 $160,000.00 $160,000.00 $160,000.00 $156,666.67 $156,666.67 $156,666.67 $156,666.67 $156,666.67 $156,666.67 $156,666.67 $156,666.67 $156,666.67 $123,333.33 $123,333.33 $123,333.33 $123,333.33 $123,333.33 $123,333.33 $123,333.33 $123,333.33 $123,333.33 $33,333.33 $33,333.33 $33,333.33 $33,333.33 $33,333.33 $33,333.33 $33,333.33 $33,333.33 $33,333.33 $6,666.67 $6,666.67 $6,666.67 $6,666.67 $6,666.67 $6,666.67 $6,666.67 $6,666.67 $6,666.67 $166,666.67 $166,666.67 $166,666.67 $166,666.67 $166,666.67 $166,666.67 $166,666.67 $166,666.67 $166,666.67 $151,515.15 $137,741.05 $125,219.13 $113,835.58 $103,486.89 $94,078.99 $85,526.35 $77,751.23 $70,682.94 $1,313,240.62

operating cash flows year new revenues old revenues R new operating costs old operating costs OC R - OC (R - OC)*(1-T) new depreciation old depreciation D (D)*(T) (R-OC)*(1-T)+D*(T) PV(annual after-tax CF) sum of PV(ann. AT CF) 10 11 12 13 14 15 $500,000.00 $500,000.00 $500,000.00 $500,000.00 $500,000.00 $500,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $250,000.00 $225,000.00 $225,000.00 $225,000.00 $225,000.00 $225,000.00 $225,000.00 $175,000.00 $175,000.00 $175,000.00 $175,000.00 $175,000.00 $175,000.00 $50,000.00 $50,000.00 $50,000.00 $50,000.00 $50,000.00 $50,000.00 $200,000.00 $200,000.00 $200,000.00 $200,000.00 $200,000.00 $200,000.00 $160,000.00 $160,000.00 $160,000.00 $160,000.00 $160,000.00 $160,000.00 $156,666.67 $156,666.67 $156,666.67 $156,666.67 $156,666.67 $156,666.67 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $156,666.67 $156,666.67 $156,666.67 $156,666.67 $156,666.67 $156,666.67 $31,333.33 $31,333.33 $31,333.33 $31,333.33 $31,333.33 $31,333.33 $191,333.33 $191,333.33 $191,333.33 $191,333.33 $191,333.33 $191,333.33 $73,767.28 $67,061.17 $60,964.70 $55,422.45 $50,384.05 $45,803.68

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ANSWERS TO EXAMPLE #2 (continued)

EXTRA CREDIT:
(a) This has no effect on our analysis. Since it happened in the past, it has no effect on FUTURE cash flows, which is what we use for analysis.

(b) This working capital change would cause both the initial cash flow to change and the terminal cash flow to change.

working capital: accounts receivable decreases by: inventory increases by: accounts payable increases by: net initial change in WC: Our new initial cash flow would therefore be $15,000 higher: The new terminal cash flow would be $15,000 lower: NPV would rise by:

$75,000.00 $100,000.00 $40,000.00 $15,000.00 ($1,913,000.00) $141,600.00 $11,409.12

cash inflow cash outflow cash inflow cash inflow

(still reject project)

(c) This is an opportunity cost. Because we sold the old machine at t=0, we lost the opportunity to sell it at t=15. Thus, in the terminal cash flow, we would add: lost opportunity to sell old saved tax on gain on sale of old total change in terminal cash flow: new terminal cash flow: NPV would fall by: ($270,500.00) $54,100.00 -$216,400.00 -$59,800.00 -$51,804.44

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EXAMPLE #3 You are the VP for corporate finance for BighugeCompany. You have just heard from the head of R&D that a 6-year development project (which cost your company a total of $2 M) has just resulted in the development of a viable alternative to your current bighugemachine. It is now up to you to decide whether or not to undertake this replacement project. Your current bighugemachine was purchased 4 years ago for $3 M. Installation, remodeling, and delivery charges were an additional $400,000. This machine generates annual revenues of $6 M and requires an annual $3 M outlay for operating costs. It is being depreciated using straight-line depreciation over a 6-year life. It has a remaining useful life of five years. It has a current (t=0) salvage value of $500,000; its t=5 salvage value is $0. The new alternative would cost $5 M, plus $600,000 in set-up costs. It would also require the following adjustments to your working capital accounts: account inventory (nuts) accounts receivable accounts payable increase/decrease increase increase decrease amount $5 $10 $35

Annual revenues from this machine will be $7.8 M; annual operating costs will be $3 M (non-marketing) plus $1 M (marketing). This machine will also be depreciated using the straight-line method. Its depreciable (and useful) life is 5 years. You anticipate a t=5 salvage value for this alternative of $2.5 M. If your marginal tax rate is 30% and your WACC is 18%, should you undertake the new alternative? What if: time 5 salvage value for the old machine were $100,000?

ANSWER TO EXAMPLE #3
marginal tax rate: weighted average cost of capital: 30% 18%

initial cash flow cost of new delivery/installation/remodeling sale of old tax effect on sale of old working capital increment total initial cash flow

($5,000,000) ($600,000) $500,000 $190,000 ($50) ($4,910,050)

calculation of tax effect on sale of old: depreciable basis: $3,400,000 # years of depreciable life: 6 depreciation per year: $566,667 years in service to date: 4 accumulated depreciation: book value: gain/(loss) on sale: tax effect on gain/(loss): $2,266,667 $1,133,333 ($633,333) $190,000

= cost + set-up (given) = (basis)/(depreciable life) = (depr/year)*(# of years so far) = basis - accum. depr.

= MV - BV
= (loss)*(marginal tax rate)

teminal cash flow sale of new machine tax effect on sale of new unwind WC increment total terminal cash flow PV(terminal cash flow)

$2,500,000 ($750,000) $50 $1,750,050 $764,963

calculation of working capital increment: A/P decrease $35 A/R increase $10 inventory increase $5 $50

outflow outflow outflow outflow

= $334,372/(1.18)^5

calculation of tax effect on sale of new depreciable basis: years of depreciable life: depreciation per year: accumulated depr.: book value: gain on sale: tax effect on gain ($5,600,000) 5 ($1,120,000) ($5,600,000) $0 $2,500,000 ($750,000)
= cost + delivery/installation/remodeling (given) = (basis)/(# yrs of depr.life) = (depr/yr)*(# yrs so far) = basis - accum. depr. = market value - book value = (gain)*(marginal tax rate)

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ANSWERS TO EXAMPLE #3 (continued) operating cash flows year 1 new revenues $7,800,000 old revenues $6,000,000 8R $1,800,000 new operating costs $4,000,000 old operating costs $3,000,000 8OC $1,000,000 8R - 8OC $800,000 8 - 8OC)*(1-T) R new depreciation old depreciation 8D (8D)*(T) $560,000 $1,120,000 $566,667 $553,333 $166,000 2 $7,800,000 $6,000,000 $1,800,000 $4,000,000 $3,000,000 $1,000,000 $800,000 $560,000 $1,120,000 $566,667 $553,333 $166,000 $726,000 $521,402 3 $7,800,000 $6,000,000 $1,800,000 $4,000,000 $3,000,000 $1,000,000 $800,000 $560,000 $1,120,000 $0 $1,120,000 $336,000 $896,000 $545,333 4 $7,800,000 $6,000,000 $1,800,000 $4,000,000 $3,000,000 $1,000,000 $800,000 $560,000 $1,120,000 $0 $1,120,000 $336,000 $896,000 $462,147 5 $7,800,000 $6,000,000 $1,800,000 $4,000,000 $3,000,000 $1,000,000 $800,000 $560,000 $1,120,000 $0 $1,120,000 $336,000 $896,000 $391,650

8 R-8OC)*(1-T)+8D*(T) $726,000 PV(8CFAT) $615,254 sum of PV(8CFAT) $2,535,786

= $726,000*(P/A, i=18%, n=2) + $896,000*(P/A, i=18%, n=3)/(1.18)^2

NPV = ($4,910,050) initial cash flow $2,535,786 + PV(operating) + PV(terminal) $764,963 ($1,609,301) REJECT PROJECT

EXAMPLE #4 Determine whether or not the replacement opportunity described on the next page is acceptable. Answer the following questions/find the following values: (a) book value of old machine (b) annual depreciation of old machine (c) original depreciable basis of old machine (d) annual depreciation of new machine (e) original depreciable basis of new machine (f) number of years of old depreciation still remaining (g) working capital investment required at t=0 (h) working capital recovery at t=n (i) gain or loss on sale of old machine at t=0 (j) gain or loss on sale of new machine at t=n (k) tax effect on sale of old machine at t=0 (l) tax effect on sale of new machine at t=n (m) set-up costs for new machine at t=0 (n) total initial cash flow (t=0) (o) total terminal cash flow (t-n)
(p) (q) (r) (s) (t) (u) (v)

R for t=1 OC for t=1 D for t=1 R for t=n OC for t=n D for t=n CFAT1 CFATn (find them all)

(w) Clearly set up the PV expression you would need to use to find the NPV of this opportunity. (x) Find the NPV of this replacement opportunity. (y) Should this project be accepted or rejected? Why?

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EXAMPLE #4 (continued) project opportunity (note: [current = old] and [potential replacement = new]):

initial cost delivery remodeling installation annual revenue annual operating costs depreciable life (yrs) depreciation method years in service to date remaining useful life (yrs) salvage value at t=0 salvage value at t=15 required increment to: accounts payable accounts receivable inventory

current machine $657,000 $45,000 $35,000 $0 $34,500 $20,000 10 straight-line 4 15 $65,000 0 N/A N/A N/A

potential replacement $550,000 $10,000 $0 $15,000 $32,000 $15,000 10 straight-line N/A 15 N/A $42,500 $1,500 $10,000 $7,500 increase decrease decrease

WACC = marginal tax rate =

25% 15%

ANSWER TO EXAMPLE #4
marginal tax rate: weighted average cost of capital: 15% 25%

initial cash flow cost of new delivery/installation/remodeling sale of old tax effect on sale of old working capital increment total initial cash flow

($550,000) ($25,000) $65,000 $56,580 $19,000 ($434,420)

calculation of tax effect on sale of old: depreciable basis: $737,000 # years of depreciable life: 10 depreciation per year: $73,700 years in service to date: 4 accumulated depreciation: book value: gain/(loss) on sale: tax effect on gain/(loss): $294,800 $442,200 ($377,200) $56,580

= cost + set-up (given) = (basis)/(depreciable life) = (depr/year)*(# of years so far) = basis - accum. depr.

= MV - BV
= (loss)*(marginal tax rate)

teminal cash flow sale of new machine tax effect on sale of new unwind WC increment total terminal cash flow PV(terminal cash flow)

$42,500 ($6,375) ($19,000) $17,125 $1,839

calculation of working capital increment: A/P increase $1,500 A/R decrease $10,000 inventory decrease $7,500 $19,000

inflow inflow inflow inflow

= $17,125/(1.18)^15

calculation of tax effect on sale of new depreciable basis: years of depreciable life: depreciation per year: accumulated depr.: book value: gain on sale: tax effect on gain $575,000 10 $57,500 $575,000 $0 $42,500 ($6,375)
= cost + delivery/installation/remodeling (given) = (basis)/(# yrs of depr.life) = (depr/yr)*(# yrs so far) = basis - accum. depr. = market value - book value = (gain)*(marginal tax rate)

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ANSWER TO EXAMPLE #4 (continued)

operating cash flows 1 new revenues $32,000 old revenues $34,500 R ($2,500) new operating costs $15,000 old operating costs $20,000 OC ($5,000) R OC $2,500 - OC)*(1-T) - | R $2,125 2 $32,000 $34,500 ($2,500) $15,000 $20,000 ($5,000) $2,500 $2,125 3 $32,000 $34,500 ($2,500) $15,000 $20,000 ($5,000) $2,500 $2,125 4 $32,000 $34,500 ($2,500) $15,000 $20,000 ($5,000) $2,500 $2,125 5 $32,000 $34,500 ($2,500) $15,000 $20,000 ($5,000) $2,500 $2,125 6 $32,000 $34,500 ($2,500) $15,000 $20,000 ($5,000) $2,500 $2,125 7 $32,000 $34,500 ($2,500) $15,000 $20,000 ($5,000) $2,500 $2,125 $57,500 $0 $57,500 $8,625 $10,750 $2,254 8 $32,000 $34,500 ($2,500) $15,000 $20,000 ($5,000) $2,500 $2,125 $57,500 $0 $57,500 $8,625 $10,750 $1,804 9 $32,000 $34,500 ($2,500) $15,000 $20,000 ($5,000) $2,500 $2,125 $57,500 $0 $57,500 $8,625 $10,750 $1,443 10 $32,000 $34,500 ($2,500) $15,000 $20,000 ($5,000) $2,500 $2,125 $57,500 $0 $57,500 $8,625 $10,750 $1,154 11 $32,000 $34,500 ($2,500) $15,000 $20,000 ($5,000) $2,500 $2,125 $0 $0 $0 $0 $2,125 $183 12 $32,000 $34,500 ($2,500) $15,000 $20,000 ($5,000) $2,500 $2,125 $0 $0 $0 $0 $2,125 $146 13 $32,000 $34,500 ($2,500) $15,000 $20,000 ($5,000) $2,500 $2,125 $0 $0 $0 $0 $2,125 $117 14 $32,000 $34,500 ($2,500) $15,000 $20,000 ($5,000) $2,500 $2,125 $0 $0 $0 $0 $2,125 $93 15 $32,000 $34,500 ($2,500) $15,000 $20,000 ($5,000) $2,500 $2,125 $0 $0 $0 $0 $2,125 $75

new depreciation $57,500 $57,500 $57,500 $57,500 $57,500 $57,500 old depreciation $73,700 $73,700 $73,700 $73,700 $73,700 $73,700 D ($16,200) ($16,200) ($16,200) ($16,200) ($16,200) ($16,200) ( D)*(T) ($2,430) D*(T) OC)*(1-T)+ | R- PV( CFAT) sum of PV( CFAT) ($305) ($244) $6,369 ($2,430) ($305) ($195) ($2,430) ($305) ($156) ($2,430) ($305) ($125) ($2,430) ($305) ($100) ($2,430) ($305) ($80)

= $305*(P/A, i=18%, n=5) + $10,750*(P/A, i=18%, n=4)/(1.18)^6 + $2,125*(P/A, i=18%, n=5)/(1.18)^10

NPV = ($434,420) initial cash flow + PV(operating) $6,369 + PV(terminal) $1,839 ($426,213) REJECT PROJECT