Making Capital Investment Decisions The Baldwin Company Example 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 See the text for the details of the case.

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

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)] * We assume that the ending market value of the capital investment at year 5 is $30,000. Capital gain is the difference between ending market value and adjusted basis of the machine. The adjusted basis is the original purchase price of the machine less depreciation. The Market value – book value is $24,200 (= $30,000 – $5,800). We will assume the incremental corporate tax for Baldwin on this project is 34 percent. Capital gains are now taxed at the ordinary income rate, so the capital gains tax due is $8,228 = [0.34 * ($30,000 – $5,800)]. The after-tax salvage value is $30,000 – 8,228 = $21,772.

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)] In practice, we would want to forecast the market value of the warehouse at the time the project ends. In this case, the implicit assumption is that there is no price inflation or deflation over the period. At the end of the project, the warehouse is unencumbered, so we can sell it if we want to.

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.

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

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

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

Incremental After Tax Cash Flows   Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 (1) Sales Revenues   $100.00 $163.20 $249.70 $212.24 $129.89 (2) Operating costs   -50.00 -88.00 -145.20 133.10 -87.85 (3) Taxes   -10.20 -14.69 -29.00 -23.00 -10.39 (4) OCF (1) – (2) – (3)   39.80 60.51 75.50 56.14 31.66 (5) Total CF of Investment –260.   –6.32 –8.65 3.75 193.00 (6) IATCF [(4) + (5)] –260. 39.80 54.19 66.85 59.89 224.66