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The cost of the new machine is $127,000. Installation will cost $20,000. $4,000 in net working capital will be needed at the time of installation. The project will increase revenues by $85,000 per year, but operating costs will increase by 35% of the revenue increase. Simplified straight line depreciation is used. Class life is 5 years, and the firm is planning to keep the project for 5 years. Salvage value at the end of year 5 will be $50,000. 14% cost of capital; 34% marginal tax rate.
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For Years 1 - 5:
Incremental revenue - Incremental costs - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow
For Years 1 - 5:
85,000 - Incremental costs - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow
For Years 1 - 5:
85,000 (29,750) - Depreciation on project Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow
For Years 1 - 5:
85,000 (29,750) (29,400) Incremental earnings before taxes - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow
For Years 1 - 5:
85,000 (29,750) (29,400) 25,850 - Tax on incremental EBT Incremental earnings after taxes + Depreciation reversal Annual Cash Flow
For Years 1 - 5:
85,000 (29,750) (29,400) 25,850 (8,789) Incremental earnings after taxes + Depreciation reversal Annual Cash Flow
For Years 1 - 5:
85,000 (29,750) (29,400) 25,850 (8,789) 17,061 + Depreciation reversal Annual Cash Flow
For Years 1 - 5:
85,000 (29,750) (29,400) 25,850 (8,789) 17,061 29,400 Annual Cash Flow
For Years 1 - 5:
85,000 (29,750) (29,400) 25,850 (8,789) 17,061 29,400 46,461 = Revenue Costs Depreciation EBT Taxes EAT Depreciation reversal Annual Cash Flow
Project NPV:
CF(0) = -151,000 CF(1 - 4) = 46,461 CF(5) = 46,461 + 37,000 = 83,461 Discount rate = 14% NPV = $27,721 We would accept the project.
Capital Rationing
Suppose that you have evaluated 5 capital investment projects for your company. Suppose that the VP of Finance has given you a limited capital budget. How do you decide which projects to select?
Capital Rationing
You could rank the projects by IRR:
Capital Rationing
You could rank the projects by IRR: IRR
25% 20% 15%
10% 5%
1 $
Capital Rationing
You could rank the projects by IRR: IRR
25% 20% 15%
10% 5%
1
2
$
Capital Rationing
You could rank the projects by IRR: IRR
25% 20% 15%
10% 5%
1
3
$
Capital Rationing
You could rank the projects by IRR: IRR
25% 20% 15%
10% 5%
1
4 $
Capital Rationing
You could rank the projects by IRR: IRR
25% 20% 15%
10% 5%
1
5 $
Capital Rationing
You could rank the projects by IRR: IRR
25% 20% 15%
10% 5%
1
4 $X
5 $
Capital Rationing
You could rank the projects by IRR: IRR
25% 20% 15%
10% 5%
1
3
$X $
Capital Rationing
Ranking projects by IRR is not always the best way to deal with a limited capital budget. Its better to pick the largest NPVs. Lets try ranking projects by NPV.
Mutually Exclusive Investments with Unequal Lives Suppose our firm is planning to expand and we have to select 1 of 2 machines. They differ in terms of economic life and capacity. How do we decide which machine to select?
The after-tax cash flows are: Year Machine 1 Machine 2 0 (45,000) (45,000) 1 20,000 12,000 2 20,000 12,000 3 20,000 12,000 4 12,000 5 12,000 6 12,000 Assume a required return of 14%.
So, does this mean #2 is better? No! The two NPVs cant be compared!
EAA1 = $617 EAA2 = $428 This tells us that: NPV1 = annuity of $617 per year. NPV2 = annuity of $428 per year. So, weve reduced a problem with different time horizons to a couple of annuities. Decision Rule: Select the highest EAA. We would choose machine #1.
Project Information:
Problem 1a
Cost of equipment = $400,000 Shipping & installation will be $20,000 $25,000 in net working capital required at setup 3-year project life, 5-year class life Simplified straight line depreciation Revenues will increase by $220,000 per year Defects costs will fall by $10,000 per year Operating costs will rise by $30,000 per year Salvage value after year 3 is $200,000 Cost of capital = 12%, marginal tax rate = 34%
Problem 1a
Initial Outlay: (400,000) + ( 20,000) (420,000) + ( 25,000) ($445,000) Cost of asset Shipping & installation Depreciable asset Investment in NWC Net Initial Outlay
For Years 1 - 3:
220,000 10,000 (30,000) (84,000) 116,000 (39,440) 76,560 84,000 160,560 =
Problem 1a
Increased revenue Decreased defects Increased operating costs Increased depreciation EBT Taxes (34%) EAT Depreciation reversal Annual Cash Flow
Problem 1a
Terminal Cash Flow: Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow
Problem 1a
Salvage value = $200,000 Book value = depreciable asset - total amount depreciated. Book value = $168,000. Capital gain = SV - BV = $32,000 Tax payment = 32,000 x .34 = ($10,880)
Problem 1a
Terminal Cash Flow: 200,000 (10,880) 25,000 214,120 Salvage value Tax on capital gain Recapture of NWC Terminal Cash Flow
Problem 1a Solution: NPV and IRR: CF(0) = -445,000 CF(1 ), (2), = 160,560 CF(3 ) = 160,560 + 214,120 = 374,680 Discount rate = 12% IRR = 22.1% NPV = $93,044. Accept the project!
Problem 1b
Project Information: For the same project, suppose we can only get $100,000 for the old equipment after year 3, due to rapidly changing technology.
Calculate the IRR and NPV for the project. Is it still acceptable?
Problem 1b
Terminal Cash Flow: Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow
Problem 1b
Salvage value = $100,000 Book value = depreciable asset - total amount depreciated. Book value = $168,000. Capital loss = SV - BV = ($68,000) Tax refund = 68,000 x .34 = $23,120
Problem 1b
Terminal Cash Flow: 100,000 23,120 25,000 148,120 Salvage value Tax on capital gain Recapture of NWC Terminal Cash Flow
Problem 1b Solution NPV and IRR: CF(0) = -445,000 CF(1 ), (2), = 160,560 CF(3 ) = 160,560 + 148,120 = 308,680 Discount rate = 12% IRR = 17.3% NPV = $46,067. Accept the project!
Automation Project: Problem 2 Cost of equipment = $550,000 Shipping & installation will be $25,000 $15,000 in net working capital required at setup 8-year project life, 5-year class life Simplified straight line depreciation Current operating expenses are $640,000 per yr. New operating expenses will be $400,000 per yr. Already paid consultant $25,000 for analysis. Salvage value after year 8 is $40,000 Cost of capital = 14%, marginal tax rate = 34%
Problem 2
Initial Outlay: (550,000) + (25,000) (575,000) + ( 15,000) (590,000) Cost of new machine Shipping & installation Depreciable asset NWC investment Net Initial Outlay
For Years 1 - 5:
240,000 (115,000) 125,000 (42,500) 82,500 115,000 197,500 =
Problem 2
Cost decrease Depreciation increase EBIT Taxes (34%) EAT Depreciation reversal Annual Cash Flow
For Years 6 - 8:
240,000 ( 0) 240,000 (81,600) 158,400 0 158,400 =
Problem 2
Cost decrease Depreciation increase EBIT Taxes (34%) EAT Depreciation reversal Annual Cash Flow
Problem 2
Terminal Cash Flow:
Salvage value Tax on capital gain Recapture of NWC Terminal Cash Flow
Problem 2 Solution: NPV and IRR: CF(0) = -590,000 CF(1 - 5) = 197,500 CF(6 - 7) = 158,400 CF(10) = 158,400 + 41,400 = 199,800 Discount rate = 14% IRR = 28.13% NPV = $293,543 We would accept the project!
Problem 3
Replacement Project:
Old Asset (5 years old): Cost of equipment = $1,125,000 10-year project life, 10-year class life Simplified straight line depreciation Current salvage value is $400,000 Cost of capital = 14%, marginal tax rate = 35%
Replacement Project:
Problem 3
New Asset: Cost of equipment = $1,750,000 Shipping & installation will be $56,000 $68,000 investment in net working capital. 5-year project life, 5-year class life Simplified straight line depreciation Will increase sales by $285,000 per year Operating expenses will fall by $100,000 per year Already paid $15,000 for training program Salvage value after year 5 is $500,000 Cost of capital = 14%, marginal tax rate = 34%
Problem 3: Sell the Old Asset: Salvage value = $400,000 Book value = depreciable asset - total amount depreciated. Book value = $1,125,000 - $562,500 = $562,500. Capital gain = SV - BV = 400,000 - 562,500 = ($162,500) Tax refund = 162,500 x .35 = $56,875
Initial Outlay:
(1,750,000) + ( 56,000) (1,806,000) + ( 68,000) + 456,875
Problem 3
Cost of new machine Shipping & installation Depreciable asset NWC investment After-tax proceeds (sold old machine) (1,417,125) Net Initial Outlay
Problem 3
Terminal Cash Flow: 500,000 (175,000) 68,000 393,000 Salvage value Tax on capital gain Recapture of NWC Terminal Cash Flow
Problem 3 Solution: NPV and IRR: CF(0) = -1,417,125 CF(1 - 4) = 337,295 CF(5) = 337,295 + 393,000 = 730,295 Discount rate = 14% NPV = (55,052.07) IRR = 12.55% We would not accept the project!