Corporate Finance Lecture 3

Outline for today The application of DCF in capital budgeting The application of DCF in capital budgeting The Baldwin Company The Baldwin Company

7.2 The Baldwin Company: An Example Costs of test marketing (already spent): $250,000. Costs of test marketing (already spent): $250,000. Current market value of proposed factory site (which we own): $150,000. Current market value of proposed factory site (which we own): $150,000. Cost of bowling ball machine: $100,000 (depreciated according to ACRS 5-year life). Cost of bowling ball machine: $100,000 (depreciated according to ACRS 5-year life). Increase in net working capital: $10,000. 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. Production (in units) by year during 5-year life of the machine: 5,000, 8,000, 12,000, 10,000, 6,000. Price during first year is $20; price increases 2% per year thereafter. 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. Production costs during first year are $10 per unit and increase 10% per year thereafter. Working Capital: initially $10,000 changes with sales. Working Capital: initially $10,000 changes with sales.

The Worksheet for Cash Flows of the Baldwin Company Year 0Year 1Year 2Year 3Year 4 Year 5 Investments: (1) Bowling ball machine– * (2) Accumulated depreciation (3)Adjusted basis of machine after depreciation (end of year) (4)Opportunity cost– (warehouse) (5) Net working capital (end of year) (6)Change in net –10.00–6.32 – working capital (7)Total cash flow of– –6.32 – investment [(1) + (4) + (6)] ($ thousands) (All cash flows occur at the end of the year.)

The after-tax salvage value The salvage value of the capital investment at year 5 is $30,000. The salvage value of the capital investment at year 5 is $30,000. Capital gain: Capital gain: Salvage value - adjusted basis of the machine.Salvage value - adjusted basis of the machine. The adjusted basis: The adjusted basis: the original purchase price - depreciation.the original purchase price - depreciation. $100,000 – $94,240 = $5,760$100,000 – $94,240 = $5,760 The capital gain The capital gain $30,000 – $5,760 = $24,240$30,000 – $5,760 = $24,240 Assume corporate tax: 34%. Assume corporate tax: 34%. capital gains tax due capital gains tax due [0.34*($30,000 – $5,760)] = $8,240[0.34*($30,000 – $5,760)] = $8,240 The after-tax salvage value The after-tax salvage value $30,000 – [0.34*($30,000 – $5,760)] = $21,760.$30,000 – [0.34*($30,000 – $5,760)] = $21,760.

The Worksheet for Cash Flows of the Baldwin Company Year 0Year 1Year 2Year 3Year 4 Year 5 Investments: (1) Bowling ball machine– * (2) Accumulated depreciation (3)Adjusted basis of machine after depreciation (end of year) (4)Opportunity cost– (warehouse) (5) Net working capital (end of year) (6)Change in net –10.00–6.32 – working capital (7)Total cash flow of– –6.32 – investment [(1) + (4) + (6)] ($ thousands) (All cash flows occur at the end of the year.)

The Worksheet for Cash Flows of the Baldwin Company (continued) Year 0Year 1Year 2Year 3Year 4 Year 5 (2)Accumulated depreciation (10) Depreciation ($ thousands) (All cash flows occur at the end of the year.) Depreciation is calculated using the Accelerated Cost Recovery System (shown at right) Our cost basis is $100,000 Depreciation charge in year 4 = $100,000×(.1152) = $11,520. YearACRS % % % % % % 65.76% Total100.00%

The Worksheet for Cash Flows of the Baldwin Company Year 0Year 1Year 2Year 3Year 4 Year 5 Investments: (1) Bowling ball machine– * (2) Accumulated depreciation (3)Adjusted basis of machine after depreciation (end of year) (4)Opportunity cost– (warehouse) (5) Net working capital (end of year) (6)Change in net –10.00–6.32 – working capital (7)Total cash flow of– –6.32 – investment [(1) + (4) + (6)] ($ thousands) (All cash flows occur at the end of the year.)

The Worksheet for Cash Flows of the Baldwin Company ($ thousands) (All cash flows occur at the end of the year.) Year 0Year 1Year 2Year 3Year 4 Year 5 Investments: (1) Bowling ball machine– * (2) Accumulated depreciation (3)Adjusted basis of machine after depreciation (end of year) (4)Opportunity cost– (warehouse) (5)Net working capital (end of year) (6)Change in net –10.00–6.32 – working capital (7)Total cash flow of– –6.32 – investment [(1) + (4) + (6)] At the end of the project, the warehouse is unencumbered, so we can sell it if we want to.

The Worksheet for Cash Flows of the Baldwin Company Year 0Year 1Year 2Year 3Year 4 Year 5 Investments: (1) Bowling ball machine– * (2) Accumulated depreciation (3)Adjusted basis of machine after depreciation (end of year) (4)Opportunity cost– (warehouse) (5) Net working capital (end of year) (6)Change in net –10.00–6.32 – working capital (7)Total cash flow of– –6.32 – investment [(1) + (4) + (6)] ($ thousands) (All cash flows occur at the end of the year.)

A note on net working capital Net working capital Net working capital –Current asset minus current liabilities –Current asset: Investment in inventory: raw materials must be bought before production and sale Investment in inventory: raw materials must be bought before production and sale Cash buffer Cash buffer Credit sales: Accounts receivable Credit sales: Accounts receivable Credit purchases: Accounts payable, short- term liability Credit purchases: Accounts payable, short- term liability

A note on net working capital For the 1st year, among the sales revenue of $100,000, $9,000 will be credit sales. The amount will be received at the end of the second year. For the 1st year, among the sales revenue of $100,000, $9,000 will be credit sales. The amount will be received at the end of the second year. –Cash income of year 1: $91,000 –Account receivable of year 1: $9,000 For the 1st year, among the costs of $50,000, $3,000 can be deferred. For the 1st year, among the costs of $50,000, $3,000 can be deferred. –Cash disbursement of year 1: $47,000 –Account payable of year 1: $3,000

A note on net working capital An inventory of $2,500 should be left on hand at the end of year 1 to avoid stockouts. An inventory of $2,500 should be left on hand at the end of year 1 to avoid stockouts. A cash buffer of $1,500 is kept for unexpected expenditures. A cash buffer of $1,500 is kept for unexpected expenditures. NWK at the end of year 1 = NWK at the end of year 1 = –+accounts receivable $9,000 –-accounts payable $3,000 –+inventory 2,500 –+cash 1,500 –= 10,000

The Worksheet for Cash Flows of the Baldwin Company Year 0Year 1Year 2Year 3Year 4 Year 5 Investments: (1) Bowling ball machine– * (2) Accumulated depreciation (3)Adjusted basis of machine after depreciation (end of year) (4)Opportunity cost– (warehouse) (5) Net working capital (end of year) (6)Change in net –10.00–6.32 – working capital (7)Total cash flow of– –6.32 – investment [(1) + (4) + (6)] ($ thousands) (All cash flows occur at the end of the year.)

The Worksheet for Cash Flows of the Baldwin Company Year 0Year 1Year 2Year 3Year 4 Year 5 Investments: (1) Bowling ball machine– * (2) Accumulated depreciation (3)Adjusted basis of machine after depreciation (end of year) (4)Opportunity cost– (warehouse) (5) Net working capital (end of year) (6)Change in net –10.00–6.32 – working capital (7)Total cash flow of– –6.32 – investment [(1) + (4) + (6)] ($ thousands) (All cash flows occur at the end of the year.)

The Worksheet for Cash Flows of the Baldwin Company (continued) Year 0Year 1Year 2Year 3Year 4 Year 5 Income: (8) Sales Revenues (8) Sales Revenues ($ thousands) (All cash flows occur at the end of the year.) Recall that 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). Price during first year is $20 and increases 2% per year thereafter. Sales revenue in year 3 = 12,000×[$20×(1.02) 2 ] = 12,000×$20.81 = $249,720.

The Worksheet for Cash Flows of the Baldwin Company (continued) Year 0Year 1Year 2Year 3Year 4 Year 5 Income: (8) Sales Revenues (8) Sales Revenues (9) Operating costs (9) Operating costs ($ thousands) (All cash flows occur at the end of the year.) 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 first year (per unit) are $10 and (increase 10% per year thereafter). Production costs in year 2 = 8,000×[$10×(1.10) 1 ] = $88,000

The Worksheet for Cash Flows of the Baldwin Company (continued) Year 0 Year 1Year 2Year 3Year 4 Year 5 Year 0 Year 1Year 2Year 3Year 4 Year 5Income: (8) Sales Revenues (8) Sales Revenues (9) Operating costs (9) Operating costs (10) Depreciation (11) Income before taxes [(8) – (9) - (10)] (12) Tax at 34 percent (13) Net Income ($ thousands) (All cash flows occur at the end of the year.)

Incremental After Tax Cash Flows of the Baldwin Company Year 0Year 1Year 2Year 3Year 4Year 5 (1) Sales Revenues $100.00$163.00$249.72$212.20$ (2) Operating costs (3) Taxes (4) OCF (1) – (2) – (3) (5) Total CF of Investment –260. –6.32– (6) Total CF [(4) + (5)] – ,51$ )10.1( $ )10.1( 87.59$ )10.1( 86.66$ )10.1( 19.54$ )10.1( 80.39$ 260$ 5432   NPV

NPV of Baldwin Company: Sensitivity test r=10% r=15% r=4% r=15.67% r=20%