McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Making Capital Investment Decisions: Cost- cutting decisions, Bidding, EAC Module 3.2

6-1 Three “special cases”  Cost-cutting proposals  Setting the bid price  Investments with unequal lives  Really – only the last one is truly “new”

Cost-Cutting Proposals  Cost savings will increase pretax income But, we have to pay taxes on this amount  Depreciation will reduce our tax liability  Does the present value of the cash flow associated with the cost savings exceed the cost? If yes, then proceed.

6-3 Ohio Forge – Cost cutting example  Ohio Forge is considering an investment in new equipment. The equipment will cost $1.2 million, depreciated to zero using straight line method over the project’s 6-year life, at which point it will have zero market value. The equipment should have no effect on sales or NWC, but should reduce costs by $485,000 per year. Should the firm invest if their required return is 14% and tax rate is 35%? 9-3

6-4 Ohio Forge NPV calculation  Cash flows Dep = 1.2/6 = 0.2 million / year CF = ( )(1-.35) +.35(0.2) = 0.39 m/year NPV = 0.39(1/.14-1/(.14(1.14) 6 )) – 1.2 NPV =1.5 – 1.2 NPV= $0.3 million NPV>0, therefore, accept the investment 9-4

Setting the Bid Price  Find the sales price that makes NPV = 0 Step 1: Add PV of any future NWC and salvage value to the initial investment Step 2: Determine what yearly OCF is needed to make NPV = 0 Step 3: Determine what sales level (and/or price) are necessary to create the required OCF

6-6 Example: Setting the bid price  Jupiter Inc needs someone to supply it with 200,000 cartons of machine screws per year to support its manufacturing needs over the next five years, and you’ve decided to bid on the contract.  It will cost you $2 million to install the equipment to start production; you will depreciate it straight-line to zero over 5 years, but expect to sell it for $200,000 in 5 years.  Fixed production costs will be $285,000 per year  Variable production costs will be $8.00/carton  Initial NWC investment of $140,000 will be fully recovered in year 5  Tax rate = 35%, required rate of return = 12%  What is your bid price per carton?

6-7 Jupiter example (continued)  What is PV of initial investment net of PV of salvage value and NWC Initial Investment = -2,000,000 PV NWC Costs = -140, ,000/(1.12) 5 PV NWC Costs = -60,560 PV Salvage Value = 200,000/(1.12) 5 =113,485  Sum = -2,000,000-60, ,485  PV Investment = -1,947,075

6-8 Jupiter example (continued)  So, now we need to find the annual OCF that will have a PV of -1,947,075, because that would yield NPV=0.  Using our PV annuity formula: 1,947,075 = OCF/.12(1-1/(1.12) 5 ) 1,947,075 = OCF/.12(0.4326) OCF= $540,104

6-9 Jupiter example (last slide)  Now, we need to find price/carton that yields an OCF=$540,104 (using eq 6.7)  Depreciation=$400,000 per year  Total Var Cost = 200,000*$8=1,600,000  540,104=(P*200,000-1,600, ,000)(.65) + 400,000(.35)  540,104 = 130,000*P – 1,225, ,000  1,625,354 = 130,000*P  P = $12.50 per carton (this is the highest bid they should make)

Investments of Unequal Lives  There are times when application of the NPV rule can lead to the wrong decision. Consider a factory that must have an air cleaner that is mandated by law. There are two choices: The “Cadillac cleaner” costs $4,000 today, has annual operating costs of $100, and lasts 10 years. The “Cheapskate cleaner” costs $1,000 today, has annual operating costs of $500, and lasts 5 years.  Assuming a 10% discount rate, which one should we choose?

6-11 Investments of Unequal Lives  In this situation we need to handle the fact that the Cadillac cleaner lasts twice as long.  When we incorporate the difference in lives, the Cadillac cleaner is actually cheaper (i.e., has a higher NPV).

6-12 Equivalent Annual Cost (EAC)  The EAC is the value of the constant payment annuity that has the same PV as our original set of cash flows. For example, the EAC for the Cadillac air cleaner is $ The EAC for the Cheapskate air cleaner is $763.80, thus we should reject it.

6-13 Let’s verify the numbers…  Cadillac PV of Cadillac costs: $4,000 today, has annual operating costs of $100, and lasts 10 years; r=10%.  PV = /.1(1-1/(1.1) 10 )  PV = = $4, So the EAC will be the annuity payment that gives the same PV of  = EAC/.1(1-1/(1.1) 10 )  EAC = $750.98