CHAPTER 12 Cash Flows and Other Topics in Capital Budgeting

Time line for Solution Practice Problem 2 Cash Flows 01 $197,500 2 $197,500 3 $197,500 4 $197,500 5 $197,500 8 $158,400+ $41,400 = $199,800 6 $158,400 7 $158,400 Terminal Cash flow Annual Cash Flows Initial outlay $590,000

Automation Project:  Cost of equipment = $550,000.  Shipping & installation will be $25,000.  $15,000 in net working capital required at setup.  8-year project life, 5-year class life.  Simplified straight line depreciation.  Current operating expenses are $640,000 per yr.  New operating expenses will be $400,000 per yr.  Already paid consultant $25,000 for analysis.  Salvage value after year 8 is $40,000.  Cost of capital = 14%, marginal tax rate = 34%. Problem 2

Initial Outlay: (550,000)Cost of new machine (550,000)Cost of new machine + (25,000)Shipping & installation (575,000)Depreciable asset (575,000)Depreciable asset + (15,000)NWC investment (590,000)Net Initial Outlay (590,000)Net Initial Outlay

240,000 Cost decrease 240,000 Cost decrease (115,000) Depreciation increase (115,000) Depreciation increase 125,000EBIT 125,000EBIT (42,500)Taxes (34%) (42,500)Taxes (34%) 82,500EAT 82,500EAT 115,000Depreciation reversal 115,000Depreciation reversal 197,500 = Annual Cash Flow 197,500 = Annual Cash Flow For Years 1 - 5: Problem 2

 CALCULATION OF ANNUAL DEPRECIATION FOR NEW MACHINE: Depreciable asset/class life =$575,000/5 yrs Depreciable asset/class life =$575,000/5 yrs = $115,000 = $115,000 The machine is used only for 5 years. From years 6-10, no depreciation; therefore depreciation will be $0 for these last 5 years. The machine is used only for 5 years. From years 6-10, no depreciation; therefore depreciation will be $0 for these last 5 years.

240,000 Cost decrease 240,000 Cost decrease ( 0) Depreciation increase ( 0) Depreciation increase 240,000EBIT 240,000EBIT (81,600)Taxes (34%) (81,600)Taxes (34%) 158,400EAT 158,400EAT 0Depreciation reversal 0Depreciation reversal 158,400 = Annual Cash Flow 158,400 = Annual Cash Flow For Years 6 - 8: Problem 2

Terminal Cash Flow: 40,000 Salvage value 40,000 Salvage value (13,600) Tax on capital gain (13,600) Tax on capital gain 15,000 Recapture of NWC 15,000 Recapture of NWC 41,400 Terminal Cash Flow 41,400 Terminal Cash Flow Problem 2

CALCULATION OF TERMINAL CASH FLOW Annual depreciation of new machine=$115,000 (from slide 7) Book value = Depreciable asset – Total amount depreciated = $575,000 - $115,000(5yrs) = $0  Capital gain = Salvage value-Book Value = $40,000-$0 = $40,000 Tax on capital gain = 34% x $40,000 = $13,600 (refer slide 8)

Problem 2 Solution NPV and IRR:  CF(year 0) = -$590,000 (slide 4)  CF(years 1 - 5) =$197,500 (slide 5)  CF(years 6 - 7) = $158,400 (slide 7)  CF(year 8) = $158,400 + $41,400 = $199,800 (slides 7 + 8)  Discount rate = 14%.  IRR = 28.13%  NPV = $293,543.  We would accept the project.

FINDING NPV- 1 st method (annuity + individual CF) NPV= -$590,000 (year 0) + $197,500 (PVIFA 14%, years 1-5) (years 1-5) + $197,500 (PVIFA 14%, years 1-5) (years 1-5) + $158,400 (PVIF 14%, 6 th yr) (year 6) + $158,400 (PVIF 14%, 6 th yr) (year 6) + $158,400 (PVIF 14%, 7 th yr) (year 7) + $158,400 (PVIF 14%, 7 th yr) (year 7) + $199,800 (PVIF 14%, 8 th yr) (year 8) + $199,800 (PVIF 14%, 8 th yr) (year 8) = -$590,000 + $197,500(3.4331) + $197,500(3.4331) + $158,400 ( (0.4556) + $158,400 ( (0.4556) + $158,400 ( (0.3996) + $158,400 ( (0.3996) + $199,800 (0.3506) + $199,800 (0.3506) = -$590,000 +$678,037 +$72,167 +$63,297 +$70,050 = -$590,000 +$883,551 = $293,551 Accept the project since NPV is positive.

FINDING NPV- 2 nd method (annuities) NPV= -$590,000 (year 0) + $197,500 (PVIFA 14%, 5years ) (years 1-5) + $197,500 (PVIFA 14%, 5years ) (years 1-5) + $158,400 (PVIFA 14%, 2 years,6&7) (PVIF 14%, 5) (annuities years 6-7)(bring back to time 0). Refer to TVM ppt, slides for understanding. + $158,400 (PVIFA 14%, 2 years,6&7) (PVIF 14%, 5) (annuities years 6-7)(bring back to time 0). Refer to TVM ppt, slides for understanding. + $199,800 (PVIF 14%,10 th year ) (year 8) + $199,800 (PVIF 14%,10 th year ) (year 8) = -$590,000 + $197,500(3.4331) + $197,500(3.4331) + $158,400 (1.6467)(0.5194) + $158,400 (1.6467)(0.5194) + $199,800 (0.3506) + $199,800 (0.3506) = -$590,000 +$678,037 +$135,479 +$70,050 = -$590,000 +$883,556 = $293,566 Accept the project since NPV is positive.