1. F305 Intermediate Corporate Finance
Indiana University
Class 4

2. 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

3. 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?

4. 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

5. 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!

6. Investments of Unequal Lives
Matching operating cycles
Equivalent Annual Costs

7. 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

8. 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

9. 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%

10. 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

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