1. Relevant cash flows Working capital treatment Unequal project lives Project Cash Flow Analysis

2. Whenever the companies contemplate the development of a new product, they must conduct a capital budgeting analysis(including project cash flow). For example, Coke is deciding whether to produce and market a new lemonade product. Here are some of the factors that it would have to consider: How many people would like the new product well enough to buy it, and how many units would each customer buy per year? What share of the lemonade market could Coke expect to capture? How important would price be; that is, would demand be greatly affected by a small change in price

3. If Coke did go into the lemonade market, and if it were highly profitable, how long would it take Pepsi and other competitors to follow, and how badly would Coke’s prices and sales be eroded? How much would lemonade sales cut into the sales of Coke’s other products? How large an investment would be required to set up a plant to produce lemonade and then launch a marketing campaign? What would the production and distribution costs per unit be? If the product were successful in the United States, might this lead to a worldwide expansion, hence to additional profits?

4. Cost: $200,000 + $10,000 shipping + $30,000 installation. Depreciable cost $240,000. Inventories will rise by $25,000 and payables will rise by $5,000. Economic life = 4 years. Salvage value = $25,000. Depreciation=MACRS 3-year class. Proposed Project

5. Incremental gross sales = $250,000. Incremental cash operating costs = $125,000. Tax rate = 40%. Overall cost of capital = 10%.

6. 01234 Initial Outlay OCF 1 OCF 2 OCF 3 OCF 4 + Terminal CF NCF 0 NCF 1 NCF 2 NCF 3 NCF 4 Set up without numbers a time line for the project CFs.

7. = Corporate cash flow with project minus Corporate cash flow without project Incremental Cash Flow

8. Net Investment Outlay at t = 0 (000s) Equipment Freight + Inst. Change in NWC Net CF 0 Equipment Freight + Inst. Change in NWC Net CF 0 ($200) (40) (20) ($260) ($200) (40) (20) ($260)  NWC= $25,000 - $5,000 = $20,000.  NWC= $25,000 - $5,000 = $20,000.

9. Basis = Cost + Shipping + Installation $240,000 Depreciation Basics

10. Straight-Line Method For stockholder report or “book” purpose = Cost of Asset - Salvage Value Economic Life of Asset

11. ClassType of Property 3 yrsCertain special manufacturing tools 5 yrsAutomobiles, light-duty trucks, computers, and certain special manufacturing equipment 7 yrsMost industrial equipment, office furniture, and fixtures 10 yrsCertain longer-lived types of equipment Modified Accelerated Cost Recovery System(MACRS)

12. Ownership Year3 Yrs5 Yrs7 Yrs10 Yrs 133%20%14%10% 245322518 315191714 4 7121312 511 9 9 6 6 9 7 7 9 7 8 4 7 9 7 10 6 11 3 100100100100

13. Year 1 2 3 4 % 0.33 0.45 0.15 0.07 Depr. $ 79 108 36 17 x Basis = Annual Depreciation Expense (000s) $240

14. Net revenue Depreciation Before-tax income Taxes (40%) Net income Depreciation Net operating CF $125 (79) $ 46 (18) $ 28 79 $107 Year 1 Year 1 Operating Cash Flows (000s)

15. Net revenue Depreciation Before-tax income Taxes (40%) Net income Depreciation Net operating CF Net revenue Depreciation Before-tax income Taxes (40%) Net income Depreciation Net operating CF $125 (79) $ 46 (18) $ 28 79 $107 $125 (79) $ 46 (18) $ 28 79 $107 $125 (17) $108 (43) $ 65 17 $ 82 $125 (17) $108 (43) $ 65 17 $ 82 Year 4 Year 1 Year 4 Operating Cash Flows (000s)

16. Net Terminal Cash Flow at t = 4 (000s) Salvage value Tax on SV Recovery on NWC Net terminal CF Salvage value Tax on SV Recovery on NWC Net terminal CF $25 (10) 20 $35 $25 (10) 20 $35

17. What if you terminate a project before the asset is fully depreciated? Cash flow from sale = Sale proceeds - taxes paid. Taxes are based on difference between sales price and tax basis, where: Basis = Original basis - Accum. deprec.

18. Original basis= $240. After 3 years= $17 remaining. Sales price= $25. Tax on sale= 0.4($25-$17) = $3.2. Cash flow = $25-$3.2=$21.7. Example: If Sold After 3 Years (000s)

19. Project Net CFs on a Time Line I = 10. NPV = $81,573. IRR = 23.8%. *In thousands. 01234 (260)*10711889117

20. What is the project’s payback? (000s) Cumulative: Payback = 2 + 35/89 = 2.4 years. 01234 (260)* (260) 107 (153) 118 (35) 89 54 117 171

21. S and L are mutually exclusive and will be repeated. k = 10%. Which is better? (000s) 01234 Project S: (100) Project L: (100) 60 33.5 60 33.5

22. SL CF 0 -100,000 -100,000 CF 1 60,000 33,500 N j 2 4 I 10 10 NPV 4,132 6,190 NPV L > NPV S. But is L better? Can’t say yet. Need to perform common life analysis.

23. Note that Project S could be repeated after 2 years to generate additional profits. Can use either replacement chain or equivalent annual annuity analysis to make decision.

24. Project S with Replication: k=10% NPV = $7,547. Replacement Chain Approach (000s) 01234 Project S: (100) (100) 60 60 (100) (40) 60

25. Compare to Project L NPV = $6,190. Or, use NPVs: 01234 4,132 3,415 7,547 4,132 10%

26. Equivalent Annual Annuity (EAA) Approach Finds the constant annuity payment whose PV is equal to the project’s raw NPV over its original life.

27. EAA Calculator Solution Project S PV = Raw NPV = $4,132. n = Original project life = 2. k = 10%. Solve for PMT = EAA S = $2,381. Project L PV = $6,190; n = 4; k = 10%. Solve for PMT = EAA L = $1,953.

28. The project, in effect, provides an annuity of EAA. EAA S > EAA L so pick S. Replacement chains and EAA always lead to the same decision if cash flows are expected to stay the same.

29. If the cost to repeat S in two years rises to $105,000, which is best? (000s) NPV S = $3,415 < NPV L = $6,190. Now choose L. NPV S = $3,415 < NPV L = $6,190. Now choose L. 01234 Project S: (100) 60 (105) (45) 60

30. Types of Abandonment Sale to another party who can obtain greater cash flows, e.g., IBM sold PC division. Abandon because losing money, e.g., smokeless cigarette.