F305 Intermediate Corporate Finance Indiana University Class 4

Alternative Uses of NPV/DCF Analysis Cost cutting proposals Setting a bid price Comparing projects of unequal lives Matching cycles v. equivalent annual cost analysis When to replace equipment

Cost Cutting Proposals Consider the following: A $10,000 machine will reduce operating costs $3,000 per year over a 5 year period No change in Net Working Capital Scrap Value of $1,000 at the end of the period Straight-line depreciation Tax rate is 34% Discount rate is 10% Find the following: Operating cash flow After tax salvage value Relevant cash flows NPV of the project – is it acceptable or not?

Setting the Bid Price Consider the following: The Army is seeking bids on multiple-use digitizing devices (MUDD) 4 units per year delivered each of the next 3 years Labor and materials are $10,000 per MUDD Production space can be leased for $12,000 per year Project requires $50,000 in new equipment that is expected to have a salvage value of $1,000 at the end of the project Project requires an initial investment of $10,000 in NWC Tax rate is 34% Required rate of return is 15% Assume straight line depreciation

Setting the Bid Price (cont) We are setting the price, so OCF is an unknown Set-up a CF with known variables Find the DCF assuming that OCF is $0 This will result in negative Cash Flow Set a three year annuity necessary to achieve break-even status Calculate the components of OCF given the facts of the problem This will give you an annualized sales figure that allows you to set the bid price!

Investments of Unequal Lives Matching operating cycles Equivalent Annual Costs

An Example You must choose between two types of batteries to be used in electric golf carts at Bloomington Country Club Burnout Batteries Cost $36 each 3 year life $100 year to keep charged Salvage value of $5 Ever-go Batteries Cost $60 each 5 year life $88 year to keep charged Constant replacement of batteries is a given 34% tax rate 15% required rate of return Assume straight-line depreciation

Find the relevant cash flows for both Burnout and Ever-go Example (cont) Find the relevant cash flows for both Burnout and Ever-go Use Matching Operating Cycles What is the matching operating cycle? Use Equivalent Annual Costs

General Decision on When to Replace Consider whether Zeppelin Corp. should replace an existing machine New machine costs $15,000 Requires maintenance of $1,200 at the end of each year for 5 years At the end of 5 years, salvage value = $4,500 Assume a discount rate of 12%

More on Zeppelin Existing machine has the following maintenance requirements and salvage values for the next 5 years Year Maintenance Salvage Present $0 $5,500 Year 1 $1,200 $3,500 Year 2 $3,000 $2,000 Year 3 $4,800 $1,000 Year 4 $6,600

Zeppelin Machine Replacement (cont) Find the Equivalent Annual Cost of the new machine Compare to the cost of keeping the old machine