Chapter 6

Making Capital Investment Decisions

The Baldwin Company Example

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
6.2 The Baldwin Company
 Costs of test marketing (already spent):
$250,000
 Current market value of proposed factory site
(which we own): $150,000
 Cost of bowling ball machine: $100,000
(depreciated according to MACRS 5-year)
 Increase in net working capital: $10,000
 Production (in units) by year during 5-year
life of the machine: 5,000, 8,000, 12,000,
10,000, 6,000
6-1
The Baldwin Company
 Price during first year is $20; price increases
2% per year thereafter.
 Production costs during first year are $10 per
unit and increase 10% per year thereafter.
 Annual inflation rate: 5%
 Working Capital: initial $10,000 changes with
sales

6-2
The Baldwin Company
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Investments:
(1) Bowling ball machine –100.00 21.77*
(2) Accumulated 20.00 52.00 71.20 82.70 94.20
depreciation
(3) Adjusted basis of 80.00 48.00 28.80 17.30 5.80
machine after
depreciation (end of year)
(4) Opportunity cost –150.00 150.00
(warehouse)
(5) Net working capital 10.00 10.00 16.32 24.97 21.22 0
(end of year)
(6) Change in net –10.00 –6.32 –8.65 3.75 21.22
working capital
(7) Total cash flow of –260.00 –6.32 –8.65 3.75 193.00
investment
[(1) + (4) + (6)]
6-3
The Baldwin Company
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Investments:
(1) Bowling ball machine –100.00 21.77
(2) Accumulated 20.00 52.00 71.20 82.70 94.20
depreciation
(3) Adjusted basis of 80.00 48.00 28.80 17.30 5.80
machine after
depreciation (end of year)
(4) Opportunity cost –150.00 150.00
(warehouse)
(5) Net working capital 10.00 10.00 16.32 24.97 21.22 0
(end of year)
(6) Change in net –10.00 –6.32 –8.65 3.75 21.22
working capital
(7) Total cash flow of –260.00 –6.32 –8.65 3.75 193.00
investment
[(1) + (4) + (6)]
At the end of the project, the warehouse is unencumbered, so we can sell it if we want to. 6-4
The Baldwin Company
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89

Recall that production (in units) by year during the 5-year life of the machine is
given by:
(5,000, 8,000, 12,000, 10,000, 6,000).
Price during the first year is $20 and increases 2% per year thereafter.
Sales revenue in year 2 = 8,000×[$20×(1.02)1] = 8,000×$20.40 = $163,200.

6-5
The Baldwin Company
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89
(9) Operating costs 50.00 88.00 145.20 133.10 87.85

Again, production (in units) by year during 5-year life of the machine is given
by:
(5,000, 8,000, 12,000, 10,000, 6,000).
Production costs during the first year (per unit) are $10, and they increase
10% per year thereafter.
Production costs in year 2 = 8,000×[$10×(1.10)1] = $88,000

6-6
The Baldwin Company
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89
(9) Operating costs 50.00 88.00 145.20 133.10 87.85
(10) Depreciation 20.00 32.00 19.20 11.50 11.50

Depreciation is calculated using the Modified Year MACRS

Accelerated Cost Recovery System (shown at 1 20.0%
right). 2 32.0%
Our cost basis is $100,000. 3 19.2%
Depreciation charge in year 4 4 11.5%
= $100,000×(.115) = $11,500. 5 11.5%
6 5.8%
Total 100.00%

6-7
The Baldwin Company
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89
(9) Operating costs 50.00 88.00 145.20 133.10 87.85
(10) Depreciation 20.00 32.00 19.20 11.50 11.50
(11) Income before taxes 30.00 43.20 85.30 67.64 30.55
[(8) – (9) - (10)]
(12) Tax at 34 percent 10.20 14.69 29.00 23.00 10.39
(13) Net Income 19.80 28.51 56.30 44.64 20.16

6-8
Incremental After Tax Cash Flows
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

(1) Sales $100.00 $163.20 $249.70 $212.24 $129.89

Revenues
(2) Operating -50.00 -88.00 -145.20 133.10 -87.85
costs
(3) Taxes -10.20 -14.69 -29.00 -23.00 -10.39

(4) OCF 39.80 60.51 75.50 56.14 31.66

(1) – (2) – (3)
(5) Total CF of –260. –6.32 –8.65 3.75 193.00
Investment
(6) IATCF –260. 39.80 54.19 66.85 59.89 224.66
[(4) + (5)]

$39.80 $54.19 $66.85 $59.89 $224.66

NPV  $260   2
 3
 4

(1.10) (1.10) (1.10) (1.10) (1.10)5
NPV  $51.59 6-9
NPV of Baldwin Company
–260 1
CF0 F3
59.89 10
CF1 39.80 CF4 I
1 1 NPV 51.59
F1 F4
54.19
CF2 224.66
CF5
1
F2
1
F5
66.85
CF3
6-10