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Cash Flow Estimation and Risk Analysis


This worksheet contains the model used to analyze RIC's new project decision as described in the text. The TAB key labeled "Depreciation" provides details about depreciation. In addition, a model for analyzing replacement decisions is provided on a separate sheet that can be accessed by pressing the TAB key labeled "Replacement Analysis" at the bottom of the screen.

10 Incremental Cash Flows 11 12 13 The relevant cash flows in project analysis are the project's incremental cash flows, defined as the free cash flows of the firm with 14 the project minus the free cash flows of the firm without the project. Consider the following project to replace an older machine 15 with a newer and more efficient machine. The annual relevant costs, savings, cash flows are shown below for the new maching and the 16 17 Table 11-1 Incremental Cash Flows and Project Analysis 18 19 New Old Incremental 20 Initial investment 21 22 Annual revenues and costs: 23 Sales revenues 24 Operating costs 25 Depreciation 26 Taxable income 27 Taxes (40% ) 28 Net income 29 Add back depr'n 30 Net cash flow 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 WACC = Life = NPV: IRR: 10% 5 -$1,440 9.4% $3,685 12.4% $40,000 -10,000 -20,000 $10,000 $4,000 $6,000 $20,000 $26,000 $100,000

$40,000

$60,000

$25,000 -15,000 -8,000 $2,000 $800 $1,200 $8,000 $9,200

= = = = = = = =

$15,000 5,000 -12,000 $8,000 $3,200 $4,800 $12,000 $16,800

Notes: 1. The issue is whether to make a replacement investment. The operation must continue in order to meet obligations to customers. The old equipment is earning positive cash flows, but the return on the value of this equipment--which cannot be sold unless new equipment is purchased--is less than the WACC, so the NPV is negative. 2. The new equipment, when treated as a stand-alone investment, has a negative NPV, so it does not appear to be a good investment. 3. However, a proper analysis requires determining the firm's incremental cash flows if it makes the new investment--how much new money must it spend (its incremental investment), and how much additional (incremental) cash flow will that investment produce? If the incremental cash flow is more than enough to pay for the incremental investment, then the investment should be made. 4. In this case, the NPV of the incremental investment is positive, so the old equipment should be replaced.

Model for Evaluating A New Capital Budgeting Project:


The first section of this worksheet contains a model for evaluating new projects. In Part 1, we first list the key inputs used in the calculations. Part 2 goes on to calculate depreciation schedules for the building and for the equipment. Part 3 then determines the after-tax salvage values (i.e., net cash flows) that will come from disposing of the building and the equipment at the end of the project's life. Part 4 calculates the estimated cash flows over each year of the project's life. Part 5 then uses the estimated cash flows to estimate the key outputs, the project's NPV, IRR, MIRR, and Payback. Finally, in Parts 6 and 7, we consider the riskiness of the project by showing how changes in the inputs result in changes in the key outputs. Note that all dollars are shown in thousands; this is done for convenience. Identifying the relevant cash flows For a new project, the incremental cash flows can be divided into the following categories: initial investment outlay, operating cash flows over the project's life, and terminal year cash flows. The data used in the model were taken from the example in Chapter 11. In addition to the input data, we have included an excerpt from the MACRS Depreciation Schedule for 39-year (building) and 5-year (equipment) depreciation, and a table outlining the

Table 11-4. Analysis of a New (Expansion) Project of dollars)


Key Output: NPV $12,000 $8,000 10% 20,000 0.0% $3.00 $2.10 $8,000 Market value of building in 2009 Market value of equip. in 2009 Tax rate WACC Inflation: growth in sales price Inflation: growth in VC per unit Inflation: growth in fixed costs Years 2 3 2.6% 2.6% $312 $312 11,532 11,220 32.0% $2,560 3,840 19.0% $1,520 2,320 = $5,809 $7,500 $2,000 40% 12% 2.0% 2.0% 1.0% Cumulative Depr'n $1,092

75 Part 1. Input Data (in thousands 76 77 Building cost (= Depreciable basis) 78 Equipment cost (= Depreciable basis) 79 Net Operating WC / Sales 80 First year sales (in units) 81 Growth rate in units sold 82 Sales price per unit 83 Variable cost per unit 84 Fixed costs 85 86 Part 2. Depreciation Schedule 87 88 Building Depr'n Rate 89 Building Depr'n 90 Ending Book Val: Cost - Cum. Depr'n 91 92 Equipment Depr'n Rate 93 Equipment Depr'n 94 Ending Book Val: Cost - Cum. Depr'n 95 96
a

1 1.3% $156 11,844 20.0% $1,600 6,400

4 2.6% $312 $10,908 12.0% $960 $1,360

$6,640

The depreciation rates are multiplied by the depreciable basis ($12,000 for the building and $8,000 for the equipment) to determine the yearly depreciation expense. The correct depreciation percentages for the building depend upon the month that the building is put 97 in service. Because this analysis assumes that all cash flows occur at the end of the year, and to prevent unnecessary complexity, we 98 99 Part 3 of Table 11-4. Net 100 101 Estimated Market Value in 2009 102 Book Value in 2009
b c

Salvage Values in 2009


Building $7,500 10,908 -3,408 -1,363 Equipment $2,000 1,360 640 256 Total

103 Expected Gain or Loss 104 Taxes paid or tax credit d 105 Net cash flow from salvage

$8,863 $1,744 $10,607 106 107 b 108 Book value equals depreciable basis (initial cost in this case) minus accumulated MACRS depreciation. For the building, accumulated 109 depreciation equals $1,092, so book value equals $12,000 - $1,092 = $10,908. For the equipment, accumulated depreciation equals 110 111 c Building: $7,500 market value - $10,908 book value = -$3,408 a loss. This represents a shortfall in depreciation taken versus "true" 112 depreciation, and it is treated as an operating expense for 2009. Equipment: $2,000 market value- $1,360 book value = $640 profit. 113 Here the depreciation charge exceeds the "true" depreciation, and the difference is called "depreciation recapture". It is taxed as 114 ordinary income in 2009. The actual book value at the time of disposition depends on the month of disposition. We have simplified the 115 116 d 117 Net cash flow from salvage equals salvage (market) value minus taxes. For the building, the loss results in a tax credit, so net salvage 118 119 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151 152 153 154 155 156 157 158 159 160 161 162 163 164 165 166 167 168 169 170 171

Part 4 of Table 11-4. Projected Net Cash Flows (Time line of annual cash flows)
Investment Outlays: Long-Term Assets Building Equipment Operating Cash Flows over the Project's Life Units sold Sales price Sales revenue Variable costs Fixed operating costs Depreciation (building) Depreciation (equipment) Oper. income before taxes (EBIT) Taxes on operating income (40% ) Net Operating Profit After Taxes (NOPAT) Add back depreciation Operating cash flow Cash Flows Due to Net Operating Working Capital Net Operating Working Capital (based on sales) Cash flow due to investment in NOWC Salvage Cash Flows: Long-Term Assets Net salvage cash flow: Building Net salvage cash flow: Equipment Total salvage cash flows Net Cash Flow (Time line of cash flows)

Years 0 2005 ($12,000) (8,000) 1 2006 2 2007 3 2008 4 2009

20,000 $3.00 $60,000 42,000 8,000 156 1,600 8,244 3,298 4,946 1,756 $6,702

20,000 $3.06 $61,200 42,840 8,080 312 2,560 7,408 2,963 4,445 2,872 $7,317

20,000 $3.12 $62,424 43,697 8,161 312 1,520 8,734 3,494 5,241 1,832 $7,073

20,000 $3.18 $63,672 44,571 8,242 312 960 9,587 3,835 5,752 1,272 $7,024

$6,000 ($6,000)

$6,120 ($120)

$6,242 ($122)

$6,367 ($125)

$0 $6,367

$8,863 1,744 $10,607 ($26,000) $6,582 $7,194 $6,948 $23,999

Part 5 of Table 11-4. Key Output and Appraisal of the Proposed Project
Net Present Value (at 12% ) IRR MIRR Cumulative cash flow for payback Cum. CF > 0, hence Payback Year: Payback found with Excel function = Check: Payback = 3 + 5,275/23,999 = $5,809 20.12% 17.79%

3.22 3.22

Years 0 1 2 3 (26,000) (19,418) (12,223) (5,275) FALSE FALSE FALSE FALSE See note below for an explanation of the Excel calculation. Manual calculation for the base case.

4 18,723 3.22

The Excel payback calculation is based on the logical IF function. Returns FALSE if the cumulative CF is negative or the actual payback if the cumulative CF is positive. Then, we use the MIN (minimum) function to find first year when payback is positive. The Min function procedure is necessary for projects with longer lives, because then values, not the word FALSE, would appear in a number of cells. The Min function picks the smallest number, which is the payback. Based on the firm's 12% weighted average cost of capital, this project has a NPV of $5,809. Since the NPV is positive, 'we tentatively conclude that the project should be accepted. The IRR and MIRR confirm this decision because both exceed the cost of capital. Note, though, that no risk analysis has been conducted. It is possible that the firm's managers, after appraising the project's risk, might conclude that its projected return is insufficient to compensate for its risk, and reject it.

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Part 6. Evaluating Risk: Sensitivity Analysis


Risk in capital budgeting really means the probability that the actual outcome will be worse than the expected outcome. For example, if there were a high probability that the $5,166 expected NPV as calculated above will actually turn out to be negative, then the project would be classified as relatively risky. The reason for a worse-than-expected outcome is, typically, because sales were lower than expected, costs were higher than expected, or the project turned out to have a higher than expected initial cost. In other words, if the assumed inputs turn out to be worse than expected, then the output will likewise be worse than expected. In Part 6 we use Excel to examine the project's sensitivity to changes in the input variables.

I. Sensitivity of NPV and to Variations in Unit Sales. See the description at the right for an explanation of Here we use an Excel "Data Table" to find NPV different unit sales, holding other thing constant. % Deviation from Base Case -30% -15% 0% 15% 30% WACC WACC 8.4% 10.2% 12.0% 13.8% 15.6% NPV 5,809 $9,030 $7,362 $5,809 $4,363 $3,014 % Deviation from Base Case -30% -15% 0% 15% 30% 1st YEAR UNIT SALES Units NPV Sold $5,809 14,000 -$3,628 17,000 $1,091 20,000 $5,809 23,000 $10,528 26,000 $15,247

Base Case

Extra Q uestion: At what 1st Year Sales would the project break even in the sense that NPV = $0? Answer: You could plot NPV against Sales and see about where NPV = 0. Alternatively, you could use Tools > Goal Seek as described in the columns to the right. The answer is 16,307 units.

% Deviation from Base Case -30% -15% 0% 15% 30%

VARIABLE COSTS Variable NPV Cost $5,809 $1.47 $29,404 $1.79 $17,607 $2.10 $5,809 $2.42 -$5,988 $2.73 -$17,785

Base Case

% Deviation from Base Case -30% -15% 0% 15% 30%

GROWTH RATE, UNITS Growth NPV Rate % $5,809 -30% -$4,923 -15% -$115 0% $5,809 15% $12,987 30% $21,556

% Deviation from Base Case -30% -15% 0% 15% 30%

SALES PRICE Sales NPV Price $5,809 $2.10 -$27,223 $2.55 -$10,707 $3.00 $5,809 $3.45 $22,326 $3.90 $38,842

Base Case

% Deviation from Base Case -30% -15% 0% 15% 30%

FIXED COSTS Fixed NPV Costs $5,809 $5,600 $10,243 $6,800 $8,026 $8,000 $5,809 $9,200 $3,593 $10,400 $1,376

We summarize the data tables, arranged by sensitivity, and graphed the most sensitive items in the following chart:

Figure 11-1. Evaluating Risk: Sensitivity Analysis (Dollars in Thousands) $40,000 $30,000 $20,000 $10,000 $0 ($10,000) ($20,000) ($30,000) -30% -15% 0% 15% 30%
NPV ($)

Sales price Variable cost Growth rate Units sold Fixed cost WACC

Deviation from Base-Case Value (%)

Deviation from Base Case -30% -15% 0% 15% 30% Range

Sales Price ($27,223) ($10,707) $5,809 $22,326 $38,842 66,064

NPV at Different Deviations from Base Variable Growth Year 1 Fixed Cost/Unit Rate Units Sold Cost $29,404 ($4,923) ($3,628) $10,243 $17,607 ($115) $1,091 $8,026 $5,809 $5,809 $5,809 $5,809 ($5,988) $12,987 $10,528 $3,593 ($17,785) $21,556 $15,247 $1,376 47,189 26,479 18,875 8,867

WACC $9,030 $7,362 $5,809 $4,363 $3,014 6,016

We see from the tables and graph that NPV is most sensitive to changes in the sales price and variable costs, somewhat sensitive to changes in first-year sales and the sales growth rate, and not very sensitive to changes in WACC and fixed costs. Thus, the real issue is our confidence in the forecasts of the sales price and variable costs, as NPV can change dramatically if the key input variables change, but we do not know how much the variables are likely to change. For example, if we were buying components under a fixed price contract, then variable costs might be locked in and not likely to rise more than say 5% , and we might have a firm contract to sell the projected number of units at the indicated price per unit. In that case, the "bad conditions" would not materialize, and a positive NPV would be pretty well guaranteed. We go on to look at the probabilities of different conditions in Part 7.

Part 7. Evaluating Risk: Scenario Analysis


Scenario analysis extends risk analysis in two ways: (1) It allows us to change more than one variable at a time, hence to see the combined effects of changes in several variables on NPV, and (2) It allows us to bring in the probabilities of 133,126 3,454 (36,765) 25,817 64,094 2.48

We saw from the sensitivity analysis that the key variables are sales price, variable costs, unit sales, and the unit growth rate. Therefore, in our sensitivity analysis we hold the other variables at their base case levels and then examine the situation when the key variables change. We assume that the company regards the worst case as one where each of the three variables is 30% worse than the base level, and the best case has each variable 30% better than base. We also assume that there is a 25% chance of the best and worst cases, and a 50% chance of base case

Table 11-5. Scenario Analysis (Dollars in Thousands)


Sales Price $3.90 $3.00 $2.10 Unit Sales 26,000 20,000 14,000 Variable Costs $1.47 $2.10 $2.73 Growth Rate 30% 0% -30%

Squared Deviation Times Probability


###########

Scenario Best Case Base Case Worst Case

Probability 25% 50% 25%

NPV $146,180 $5,809 ($37,257) $30,135 $69,267 2.30

295,883,220 ###########
4797908060

Expected NPV = sum, prob times NPV Standard Deviation = Sq Root of column I sum Coefficient of Variation = Std Dev / Expected NPV a. Probability Graph Probability 50%

25%

(37,257)

0 5,809 Most Likely

30,135 NPV ($) Mean of distribution

146,180

b. Continuous Approximation Probability Density

(37,257)

0 5,809

30,135 NPV ($)

146,180

An even easier way to do scenario analysis is with the Scenario Manager. To use this, click on Tools, then Scenarios. You will get the dialog box shown below.

We have already define the three scenarios. See below for instructions on

To show one of the existing scenarios, simply highlight that scenario, click Show, and Excel will replace all the variables in that scenario with the desired numbers. To create a new scenario, select the Add button shown above and you will get the dialog box shown below Enter a name for the new scenario (you can probably be more original than we were). The changing cells are the ones for which you select different input values. Since there are already some scenarios that are defined, the dialog box starts with those cells (corresponding to unit sales, growth rate, sales price, and unit costs). If you were creating a scenario for the first time, you would have to enter the cells you want to change. In this case, we don't want to add any new changing cells to the ones already specified, but in other situations you may want to add or remove some of the changing cells that are already identified. After entering a name, click OK. (As noted above, you may choose to add or remove changing cells in other situations, but not here.)

My new one

After naming the new scenario and clicking OK, you will get the dialog box shown below.

These values are the ones for the base case. Try typing in some of your own choices. We feel optimistic today, so we will type in 25000 for sales, 10% for growth, 3.50 for price, and 2.0 for cost, as shown below.

Click Add, and it will return the original Scenario Manager dialog box, except you will have a new scenario, as shown below.

To "see" the the new scenario, simply select it and then click on Show. When you close the box, the new values will be in the worksheet cells.

The Scenario Manager also has another powerful feature. Suppose you have already defined several scenarios, as we have, and you would like to see the inputs and selected outputs for the various scenarios. To do this, click on Tool, Scenarios, and you will get the box

If you click on Summary, you will get the dialog box shown below.

In our case, we would like to see the NPV for each scenario. To do this, enter the appropriate references in the results cells (D153), then click OK. You will get a new worksheet, called Scenario Summary, with the results. To see our result, click on the Tab For those who want to use even more Excel features, you can give names to the input and output cells before doing the Summary. To do this, select a particular cell, such as D153 (which has NPV), then put your cursor at the top left of the sheet on the Name box which is to the left of the formula bar (which shows the cell reference, such as D153, if you have not yet named the cell), and type in a new name, such as NPV. Then when you run the summary, the summary table will have the name for the variable, and not its cell Adjusting for Risk The scenario analysis suggests that the project could be highly profitable, but also that it is quite risky. There is a 25% probability that the project would result in a loss of $32 million. There is also a 25% probability that it could produce an NPV of $146 million. The standard deviation is high, at $68 million, and the coefficient of variation is a high 2.17. Note that the expected NPV in the scenario analysis is much higher than the base case value. This occurs because under good conditions we have high numbers multiplied by other high numbers, giving a very high result. This analysis suggest that the project is relatively risky, hence that the base case NPV should be recalculated using a higher WACC. At a WACC of 15% (versus 12% for an average risk project), the base case NPV is: That number is not very high in relation to the project's cost. Changing the WACC would also change the scenario analysis. Here are new figures: Probability 25% 50% 25% NPV $133,126 $3,454 ($36,765) $25,817 $64,094 2.48 Dev. Sqd^2 ########### 250,056,826 979,137,230

$3,454

Best Case Base Case Worst Case Expected NPV: Standard Deviation: Coefficient of Variation:

At this point, the project looks risky but acceptable. There is a good chance that it will produce a positive NPV, but there is also a chance that the NPV could be dramatically higher or lower. If the bad conditions occur, this will hurt but not bankrupt the firm--this is just one project for a large company. We indicate at the start that this project's returns would be highly correlated with the firm's other projects' returns and also with the general stock market. Thus, its stand-alone risk (which is what we have been analyzing) also reflects its within-firm and market risk. If this were not true, then we would need to make further risk adjustments. Finally, recall that we stated at the start that if the firm undertakes the project, it will be committed to operate it for the full 4-year life. That is important, because if it were not so committed, then if the bad conditions occurred during the first year of operations, the firm could simply close down operations. This would cut its losses, and the worse case scenario would not be nearly as bad as we indicated. Then, the expected NPV would be higher, and the standard deviation and coefficient of variation would be lower. We explain abandonment options in Chapter 12.

497 Monte Carlo Simulation 498 499 500 Monte Carlo simulation is similar to scenario analysis in that different values of key inputs are input. Unlike scenario analysis, Monte 501 Carlo simulation draws the input values from a specified probability distribution and then computes the NPV. It repeats this process 502 hundred, or even thousands, of times. It then averages the NPVs from each repetition. See the file Ch 11 Tool Kit Simulation.xls for a 503 detailed example. To use this spreadsheet, you will need to install the Excel Add-In Simtools.xla . See the file Explanation of 504 505 506 507 508 509 510 511 512 513 514 515 516 517 518 519 520 521 522 523 524 525 526 527 528 529 530 531 532 533 534 535

Decision Tree Analysis


Stage 1: At t=0, the firm has the opportunity to spend $500,000 on a feasibility study. Stage 2: At t=1 the firm will learn whether the project appears feasibel (there is an 80% chance that the project will be feasible). If it is feasible, the firm can spend $1,000,000 on a prototype. Stage 3: At t=2 the firm will learn whether the prototype is successful (there is a 60% chance the prototype will be successful). If it is successful, the firm can spend $10,000,000 to launch the project.

Stage 4: At t=3 the firm will learn how well the market accepts the project. There is a 30% chance the project will have cash flows of $10,000,000 per year for 4 years, a 40% chance the project will have cash flows of $4,000,000 per year for four years, and a 30% chance the project will have cash flows of -$2,000,000 per year for four years. If the project is not successful, the firm can abandon

Cost of capital =

11.5% Join Probability 0.144 0.192 0.144 0.320 0.200

t=0

t=1

t=2
0.3 0.4

t=3 $18,000 $8,000 ($2,000)

t=4 $18,000 $8,000 Stop

t=5 $18,000 $8,000

NPV $25,635 $6,149 ($10,883) ($1,397) ($500)

Prob.xNPV $3,691 $1,181 ($1,567) ($447) ($100)

0.6

($10,000)
0.3

0.8

($1,000)
0.4

($500)

0.2

Stop Stop

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G 1.000

I $2,758 $10,584

Expected NPV=

s=

DEPRECIATION
Recovery Allowance Percentage for Personal Property Class of Investment Ownership Year 1 2 3 4 5 6 7 8 9 10 11 3-Year 33% 45% 15% 7% 5-Year 20% 32% 19% 12% 11% 6% 7-Year 14% 25% 17% 13% 9% 9% 9% 4% 10-Year 10% 18% 14% 12% 9% 7% 7% 7% 7% 6% 3% 100%

100%

100%

100%

MACRS for Residential Real Property Month Property Placed in Service Year 1 2 3 4 1 3.485% 3.182% 2.879% 2.576% 2-27 3.636% 3.636% 3.636% 3.636% 28 1.970% 2.273% 2.576% 2.879% 29 0.000% 0.000% 0.000% 0.000% 99.99% 99.99% 99.99% 99.99%

5 2.273% 3.636% 3.182% 0.000% 99.99%

6 1.970% 3.636% 3.458% 0.000% 99.96%

7 1.667% 3.636% 3.636% 0.152% 99.99%

8 1.364% 3.636% 3.636% 0.455% 99.99%

9 1.061% 3.636% 3.636% 0.758% 99.99%

MACRS for Nonresidential Real Property Month Property Placed in Service Year 1 2 3 4 5 6 7 8 9 1 2.461% 2.247% 2.033% 1.819% 1.605% 1.391% 1.177% 0.963% 0.749% 2-39 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 40 0.107% 0.321% 0.535% 0.749% 0.963% 1.177% 1.391% 1.605% 1.819% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% Rounded Percentages Used in Analysis Property Life (in years): Depreciation in Year 1 (assuming half-year convention): Rounded Depreciation in Years 2-39: Depreciation in Year 40:

39 1.30% 2.60% 1.30%

10 0.758% 3.636% 3.636% 1.061% 99.99%

11 0.455% 3.636% 3.636% 1.364% 99.99%

12 0.152% 3.636% 3.636% 1.667% 99.99%

10 11 12 0.535% 0.321% 0.107% 2.564% 2.564% 2.564% 2.033% 2.247% 2.461% 100.00% 100.00% 100.00%

Scenario Summary
Current Values: Base Case Best case Worst case

Changing Cells: $D$80 20,000 20,000 26,000 14,000 $D$81 0.0% 0.0% 30.0% -30.0% $D$82 $3.00 $3.00 $3.90 $2.10 $D$83 $2.10 $2.10 $1.47 $2.73 Result Cells: $D$153 $5,809 $5,809 $146,180 ($37,257) Notes: Current Values column represents values of changing cells at time Scenario Summary Report was created. Changing cells for each scenario are highlighted in gray.

A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67

REPLACEMENT ANALYSIS
In this model, we analyze the issue of whether a piece of equipment should be replaced. While the mechanics of the analysis are somewhat different from the analysis for a new project, the process is similar in that we are concerned with incremental cash flows. In this instance, we will be looking at a case that consists of net salvage value being an intial benefit of the project. This replacement project is deemed by the firm to be of relatively low risk, and is evaluated with a cost of capital of 11.5%

Input Data
Cost of the new machine Reduction in operating costs New machine's salvage value at end of Year 5 Old machine's current market value Old machine's current book value Increase in Net Operating WC Tax rate WACC MACRS 3-year Depreciation Schedule Year Depr. Rate Depr. Exp. New depr. Old depr. Net depr. 1 33% $3,960 $3,960 $500 $3,460 2 45% $5,400 $5,400 $500 $4,900 3 15% $1,800 $1,800 $500 $1,300 4 7% $840 $840 $500 $340 0 $500 -$500 $12,000 $5,000 $2,000 $1,000 $2,500 $1,000 40% 11.5%

Replacement Project Net Cash Flow Schedule Year: 0 Section I. Investment Outlay Cost of new equipment ($12,000) Market value of old equipment 1,000 Tax savings on old equipment sale 600 Increase in net operating WC (1,000)

Section II. Operating Inflows over the Project's Life Decrease in operating costs Net change in depreciation Net earnings before taxes Taxes Net operating profit after taxes Add back depreciation Net operating cash flows Section III. Terminal Year Cash Flows Estimated salvage value of new machine Tax on salvage value (40%) Return of net operating WC Total termination cash flows Section IV. Net Cash Flow Cumulative cash flows (for payback) ($11,400) ($11,400)

$5,000 3,460 1,540 616 924 3,460 $4,384

$5,000 4,900 100 40 60 4,900 $4,960

$5,000 1,300 3,700 1,480 2,220 1,300 $3,520

$5,000 340 4,660 1,864 2,796 340 $3,136

$5,000 (500) 5,500 2,200 3,300 (500) $2,800

$2,000 (800) 1,000 $2,200 $4,384 ($7,016) FALSE $4,960 ($2,056) FALSE $3,520 $1,464 2.58 $3,136 $4,600 3.47 $5,000 $9,600 4.92

Section V. Capital Budgeting Analysis Net Present Value (11.5%) $3,991.08 IRR 25.03% MIRR 18.40% Payback (in years) 2.58

This project carries much less risk than the firm's average project, hence it was only evaluated at 11.5%. The project's NPV is positive; therefore, it should be accepted. A review of the IRR and MIRR also indicate that this project should be accepted because their values are greater than the 11.5% cost of capital. In addition, the payback period for this project is not very long, so if the required payback for this project were 3 years then according to the payback criterion this project would also be accepted.

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