Lecture 02.03.2016

Investment
& Financing Decisions by the Financial Manger
Andreas Bange Diplom Betriebswirt (FH)
Fundamentals of Capital Budgeting
+++ MCO 201 +++ Finance +++ Spring 2016 +++
Investment & Financing Decisions by the Financial Manger
Cash Flows in a Typical Project
Operating Expenses Versus Capital Expenditures

Depreciation
Depreciation expenses do not correspond to actual cash
outflows
Straight-Line Depreciation
Forecasting Incremental Earnings

Factors to consider when estimating a projects revenues and
costs:
1. A new product typically has lower sales initially
2. The average selling price of a product and its cost of
production will generally change over time
3. For most industries, competition tends to reduce profit
margins over time
Incremental Revenue and Cost Estimates

The evaluation is on how the project will change the cash flows
of the firm
Thus, focus is on incremental Revenues and Costs

The Evaluation is on how the project will change the cash flows of the firm. Thus,
focus is on Incremental Revenues & Costs.
Incremental Revenue
minus
Incremental Costs
minus
Depreciation

Marginal Corporate Tax Rate
'()*+, ./0 = 12'. 46 789:< =>9?8@>A BC9DC9>46 ./0 E/F,
Incremental Earnings Forecast

'()G,+,(F/H 1/G(I(JK = 12'. (M ./0 E/F,)
The Tax Rate a firm will pay on an Incremental Dollar of Pre-Tax Income.
Problem:
Suppose that Linksys is considering the development of a wireless home
networking appliance, called HomeNet, that will provide both the hardware and the
software necessary to run an entire home from any Internet connection. HomeNet
will also control new Internet-capable stereos, digital video recorders, heating and
air-conditioning units, major appliances, telephone and security systems, office
equipment, and so on. The major competitor for HomeNet is a product being
developed by Brandt-Quigley Corporation.
Problem:
Based on extensive marketing surveys, the sales forecast for HomeNet is
50,000 units per year. Given the pace of technological change, Linksys expects the
product will have a four-year life and an expected wholesale price of $260 (the price
Linksys will receive from stores). Actual production will be outsourced at a cost
(including packaging) of $110 per unit.
To verify the compatibility of new consumer Internet-ready appliances with the
HomeNet system as they become available, Linksys must also establish a new lab for
testing purposes. They will rent the lab space, but will need to purchase $7.5 million
of new equipment. The equipment will be depreciated using the straight-line
method over a 5-year life. Linksys' marginal tax rate is 40%.
The lab will be operational at the end of one year. At that time, HomeNet will be
ready to ship. Linksys expects to spend $2.8 million per year on rental costs for the
lab space, as well as rent marketing and support for this product. Forecast the
incremental earnings from the HomeNet project.
Solution Plan: We need 4 items to calculate incremental earnings:
(1) incremental revenues, (2) incremental costs, (3) depreciation, and
(4) the marginal tax rate:

Calculating Incremental Earnings:
(1) Incremental Revenues are:
(2) Incremental Costs are:
additional units sold production costs = 50,000 * $110 = $5,500,000
Selling, General and Administrative = $2,800,000 for marketing and support
(3) Depreciation is:
Depreciable basis Depreciable Life = $7,500,000 5 = $1,500,000
(4) Marginal Tax Rate:
40%
Note: Even though the project lasts for 4 years, the equipment has a 5-year
life, so we must account for the final depreciation charge in the 5th year.
Execute:
Write an Excel Sheet to calculate EBIT and Incremental Earnings
additional units sold price = 50,000 * $260 = $13,000,000

Execute:
Evaluate:
These incremental earnings are an intermediate step on the way to calculating the
incremental cash flows that would form the basis of any analysis of the HomeNet
project. The cost of the equipment does not affect earnings in the year it is
purchased, but does so through the depreciation expense in the following
five years.
Problem:
Suppose that Linksys is considering the development of a wireless home
networking appliance, called HomeNet, that will provide both the hardware and the
software necessary to run an entire home from any Internet connection. HomeNet
will also control new Internet-capable stereos, digital video recorders, heating and
air-conditioning units, major appliances, telephone and security systems, office
equipment, and so on. The major competitor for HomeNet is a product being
developed by Brandt-Quigley Corporation.
Problem:
Based on extensive marketing surveys, the sales forecast for HomeNet is
40,000 units per year. Given the pace of technological change, Linksys expects the
product will have a four-year life and an expected wholesale price of $200 (the price
Linksys will receive from stores). Actual production will be outsourced at a cost
(including packaging) of $90 per unit.
To verify the compatibility of new consumer Internet-ready appliances with the
HomeNet system as they become available, Linksys must also establish a new lab for
testing purposes. They will rent the lab space, but will need to purchase $6.5 million
of new equipment. The equipment will be depreciated using the straight-line
method over a 5-year life.
The lab will be operational at the end of one year. At that time, HomeNet will be
ready to ship. Linksys expects to spend $2.0 million per year on rental costs for the
lab space, as well as marketing and support for this product. Forecast the
incremental earnings from the HomeNet project.
Solution Plan: We need 4 items to calculate incremental earnings:
(1) Incremental Revenues, (2) Incremental Costs, (3) Depreciation, and
(4) the Marginal Tax Rate:
additional units sold price = 40,000 $200 = $8,000,000

(2) Incremental Costs are:
additional units sold production costs = 40,000 $90 = $3,600,000
Selling, General and Administrative = $2,000,000 for marketing and support
(3) Depreciation is:
Depreciable basis Depreciable Life = $6,500,000 5 = $1,300,000
(4) Marginal Tax Rate:
40%
Note: Even though the project lasts for 4 years, the equipment has a 5-year
life, so we must account for the final depreciation charge in the 5th year.
Execute:
Calculating Incremental Earnings:

(1) Incremental Revenues are:

2 Revenues
3 Cost of Goods Sold
4 Gross Profit
5
Selling, General and

Admin
6 Depreciation
7 EBIT
8 Income Tax at 40%
9
Incremental Earnings
(Unlevered Net Income)
8,000 8,000
8,000
8,000
-3,600 -3,600 -3,600
-3,600
4,400 4,400
Example Assumptions
Units Sold
(thousands)
Sale price ($/unit)
Cost of goods
($/unit)
40
200
4,400
4,400
-2,000 -2,000 -2,000
-2,000
NWC ($ thousands)
-1,300 -1,300 -1,300
-1,300 -1,300
Selling, General and

Admin ($ thousands)
2,000
Depreciation
($ thousands)
1,300
1,100 1,100
1,100
1,100 -1,300
90
660
-440
-440
-440
-440
520
Income Tax Rate
40%
660
660
660
660
-780
Cost of purchase
in year 0
6,500
Evaluate:
Note that the depreciable life, which is based on accounting rules, does not have
to be the same as the economic life of the assetthe period over which it will
have value. Here the firm will use the equipment for four years, but depreciates
it over five years.
1 Year
Incremental Earnings Forecast

Pro Forma Statement
Taxes and Negative EBIT
Interest Expense
Unlevered Net Income
Problem:
Kellogg Company plans to launch a new line of high-fiber, zero-trans-fat breakfast
pastries. The heavy advertising expenses associated with the new product launch
will generate operating losses of $15 million next year for the product. Kellogg
expects to earn pre-tax income of $460 million from operations other than the new
pastries next year. If Kellogg pays a 40% tax rate on its pre-tax income, what will it
owe in taxes next year without the new pastry product?
What will it owe with the new pastries?
Taxing Losses for Projects in Profitable Companies
Execute:
Without the new pastries, Kellogg will owe $460 million 40% = $184 million in
corporate taxes next year.
With the new pastries, Kelloggs pre-tax income next year will be only
$460 million - $15 million = $445 million,
and it will owe $445 million 40% = $178 million in tax.
Evaluate:
Thus, launching the new product reduces Kelloggs taxes next year by
$184 million - $178 million = $6 million.
Because the losses on the new product reduce Kelloggs taxable income
dollar for dollar, it is the same as if the new product had a tax bill of
negative $6 million.
Solution Plan:
We need Kelloggs pre-tax income with and without the new product
losses and its tax rate of 40%. We can then compute the tax without the losses and
compare it to the tax with the losses.
Problem:
Kellogg Company plans to launch a new line of high-fiber, zero-trans-fat
breakfast pastries. The heavy advertising expenses associated with the new product
launch will generate operating losses of $10 million next year for the product.
Kellogg expects to earn pre-tax income of $320 million from operations other than
the new pastries next year. If Kellogg pays a 40% tax rate on its pre-tax income, what
will it owe in taxes next year without the new pastry product? What will it owe with
the new pastries?
Solution Plan:
We need Kelloggs pre-tax income with and without the new product losses and its
tax rate of 40%. We can then compute the tax without the losses and compare it to
the tax with the losses.
Execute:
Without the new pastries, Kellogg will owe $320 million 40% = $128 million in
corporate taxes next year. With the new pastries, Kelloggs pre-tax income next year
will be only $320 million - $10 million = $310 million, and it will owe
$310 million 40% = $124 million in tax.
Converting from Earnings to Free Cash Flow

Free Cash Flow
The incremental effect of a project on a firms available cash
Capital Expenditures and Depreciation
Determining Incremental Free Cash Flow
Deducting & then Adding Back Depreciation
Incremental Free Cash Flows
Solution Plan:
The difference between the Incremental Earnings and Incremental Free Cash Flows
in the HomeNet example will be driven by the equipment purchased for the lab. We
need to recognize the $7.5 million cash outflow associated with the purchase in year
0 and add back the $1.5 million depreciation expenses from year 1 to 5 as they are
not actually cash outflows.
Problem:
Lets return to the first HomeNet example. We computed the incremental
earnings for HomeNet, but we need the incremental free cash flows to decide
whether Linksys should proceed with the project.
Execute:
Execute:
By recognizing the outflow from purchasing the equipment in year 0, we account for
the fact that $7.5 million left the firm at that time. By adding back the $1.5 million
depreciation expenses in years 1 5, we adjust the incremental earnings to reflect
the fact that the depreciation expense is not a cash outflow.
Solution Plan:
The difference between the Incremental Earnings and Incremental Free Cash Flows
in the HomeNet example will be driven by the equipment purchased for the lab. We
need to recognize the $6.5 million cash outflow associated with the purchase in year
0 and add back the $1.3 million depreciation expenses from year 1 to 5 as they are
not actually cash outflows.
Problem:
Lets return to the second HomeNet example. we computed the incremental
earnings for HomeNet, but we need the incremental free cash flows to decide
whether Linksys should proceed with the project.

1
Year
Revenues
Cost of Goods Sold
Gross Profit
Spreadsheet shown in Example -- HomeNet Example Continued

1
8,000
8,000
8,000
8,000
-3,600
-3,600
-3,600
-3,600
4,400
4,400
4,400
4,400
Selling, General & Admin
-2,000
-2,000
-2,000
-2,000
Depreciation
-1,300
-1,300
-1,300
-1,300
-1,300
EBIT
1,100
1,100
1,100
1,100
-1,300
Income Tax at 40%
-440
-440
-440
-440
520
660
660
660
660
-780
10
Add Back Depreciation
1,300
1,300
1,300
1,300
1,300
11
Purchase Equipment
-6,500
12
-6,500
1,960
1,960
1,960
1,960
520
Execute:
By recognizing the outflow from purchasing the equipment in year 0, we account for the
fact that $6.5 million left the firm at that time. By adding back the $1.3 million
depreciation expenses in years 1 5, we adjust the incremental earnings to
reflect the fact that the depreciation expense is not a cash outflow.
EXAMPLE SPREADSHEET
Determining Incremental Free Cash Flows
Net Working Capital

Current Assets minus
Current Liabilities
PQ/(J, I( RSP I( T,/G F = RSPF RSPFUM
Converting from Earnings to Free Cash Flow

Net Working Capital
Problem:
Suppose that HomeNet will have no incremental cash or inventory
requirements (products will be shipped directly from the contract manufacturer to
customers). However, receivables related to HomeNet are expected to account for
15% of annual sales, and payables are expected to be 15% of the annual cost of
goods sold (COGS).
Fifteen percent of $13 million in sales is $1.95 million and 15% of $5.5 million in
COGS is $825,000. HomeNets net working capital requirements are shown in the
following table.
How does the requirement affect the projects free cash flow?
Incorporating Changes in Net Working Capital
Solution Plan:
Any increases in net working capital represent an investment that reduces
the cash available to the firm and so reduces free cash flow.
We can use our forecast of HomeNets net working capital requirements to
complete our estimate of HomeNets free cash flow.
In year 1, net working capital increases by $1.125 million. This increase represents a
cost to the firm. This reduction of free cash flow corresponds to the fact that $1.950
million of the firms sales in year 1, and $0.825 million of its costs, have not yet been
paid.
In years 24, net working capital does not change, so no further contributions are
needed.
In year 5, when the project is shut down, net working capital falls by $1.125 million
as the payments of the last customers are received and the final bills are paid.
We add this $1.125 million to free cash flow in year 5.
Execute (contd):
The incremental free cash flows would then be:
Evaluate:
The free cash flows differ from unlevered net income by reflecting the cash flow effects of
capital expenditures on equipment, depreciation and changes in net working capital. Note
that in the first year, free cash flow is lower than unlevered net income (incremental
earnings), reflecting the upfront investment in equipment. In later years, free
cash flow exceeds unlevered net income because depreciation is not a cash
expense. In the last year, the firm ultimately recovers the investment in net
working capital, which adds to the free cash flow.
Problem:
Suppose that HomeNet will have no incremental cash or inventory
requirements (products will be shipped directly from the contract manufacturer to
customers). However, receivables related to HomeNet are expected to account for
15% of annual sales, and payables are expected to be 15% of the annual cost of
goods sold (COGS). Fifteen percent of $8 million in sales is $1.2 million and 15% of
$3.6 million in COGS is $540,000. HomeNets net working capital requirements are
shown in the following table.
1
Year
Net Working Capital

Forecast($000s)
Cash Requirements
Inventory
Receivables (15% of Sales)
1,200
1,200
1,200
1,200
Payables (15% of COGS)
-540
-540
-540
-540
Net Working Capital
660
660
660
660
How does the requirement affect the projects free cash flow?
Solution Plan:
Any increases in net working capital represent an investment that reduces
the cash available to the firm and so reduces free cash flow. We can use our forecast
of HomeNets net working capital requirements to complete our estimate of
HomeNets free cash flow.
In year 1, net working capital increases by $0.660 million. This increase represents a
cost to the firm. This reduction of free cash flow corresponds to the fact that $1.2
million of the firms sales in year 1, and $0.540 million of its costs, have not yet been
paid.
In years 24, net working capital does not change, so no further contributions are
needed. In year 5, when the project is shut down, net working capital falls by $0.660
million as the payments of the last customers are received and the final bills are
paid. We add this $0.660 million to free cash flow in year 5.
1
Year
Net Working Capital
660
660
660
660
Change in NWC
660
-660
Cash Flow Effect
-660
660

Execute (contd):
The incremental free cash flows would then be:
Year
Revenues
Cost of Goods Sold
Gross Profit
8,000
8,000
8,000
8,000
-3,600
-3,600
-3,600
-3,600
4,400
4,400
4,400
4,400
Selling, General and Admin
-2,000
-2,000
-2,000
-2,000
Depreciation
-1,300
-1,300
-1,300
-1,300
-1,300
EBIT
1,100
1,100
1,100
1,100
-1,300
Income Tax at 40%
-440
-440
-440
-440
520
660
660
660
660
-780
10
1,300
1,300
1,300
1,300
1,300
11
Purchase Equipment
12
Subtract Changes in NWC
13
-6,500
-660
-6,500
1,300
660
1,960
1,960
1960
1,180
Evaluate:
The free cash flows differ from unlevered net income by reflecting the
cash flow effects of capital expenditures on equipment, depreciation and changes in
net working capital. Note that in the first year, free cash flow is lower than unlevered
net income (incremental earnings), reflecting the upfront investment in equipment.
In later years, free cash flow exceeds unlevered net income because depreciation is
not a cash expense. In the last year, the firm ultimately recovers the investment in net
working capital, which adds to the free cash flow.
Adjusting Free Cash Flow

Time of Cash Flows
Accelerated Depreciation
MACRS (Modified Accelerated Cost Recovery System)
Other Effects on Incremental Free Cash Flow
Other Effects on Incremental Free Cash Flow
MACRS
Modified
Accelerated
Cost
Recovery
System
Computing Accelerated Depreciation
Solution Plan:
Under MACRS, we take the percentage in the table for each year and multiply it by
the original purchase price of the equipment to calculate the depreciation for that
year.
Problem:
What depreciation deduction would be allowed for HomeNets $7.5 million
lab equipment using the MACRS method, assuming the lab equipment is designated
to have a five-year recovery period?
Evaluate:
Compared with straight-line depreciation, the MACRS method allows for larger
depreciation deductions earlier in the assets life, which increases the present value
of the depreciation tax shield and so will raise the projects NPV. In the case of
HomeNet, computing the NPV using MACRS depreciation leads to an NPV of $3.179
million.
Execute:
Based on the table, the allowable depreciation expense for the lab
equipment is shown below (in thousands of dollars).
Note that Year 1 corresponds to our Year 0:
Problem:
What depreciation deduction would be allowed for HomeNets $6.5 million
lab equipment using the MACRS method, assuming the lab equipment is designated
to have a five-year recovery period?
Solution Plan:
year.
Year
MACRS Depreciation
Lab Equipment Cost
MACRS Depreciation Rate
Depreciation Expense
20.00%
32.00%
19.20%
11.52%
11.52%
5.76%
-1,300
-2,080
-1,248
-749
-749
-374
-6,500
Evaluate:
Compared with straight-line depreciation, the MACRS method allows for larger
depreciation deductions earlier in the assets life, which increases the present value
of the depreciation tax shield and so will raise the projects NPV. In the case
of HomeNet, computing the NPV using MACRS depreciation leads to an
NPV of $0.1917 million.
Execute:
Problem:
You are the production manager of a firm. What depreciation deduction
would be allowed for $15 million worth of equipment using the MACRS method,
assuming the equipment is designated to have a five-year recovery period?
How does this compare to straight-line depreciation over five years?
Solution Plan:
year.
Year
0
1
2
3
4
5
MACRS Depreciation
Equipment Cost
-$15,000,000
Depreciation Rate
20.00%
32.00%
19.20%
121.52%
11.52%
5.76%
Depreciation Amount -$3,000,000 -$4,800,000 -$2,880,000 -$18,228,000 -$1,728,000 -$864,000
Evaluate:
Compared with straight-line depreciation ($15,000,000/5 years = $3,000,000 per
year), the MACRS method allows for larger depreciation deductions earlier in the
assets life, which increases the present value of the depreciation tax shield
and thus will raise the projects NPV.
Execute:
Other Effects on Incremental Free Cash Flows
P/VIF/H W/I( = X/H,K YGI), 2**Z [/H\,
2**Z [/H\, = Y\G)Q/K, YGI), ]))\+\H/F,^ _,VG,)I/FI*(
]`F,G ./0 Pa `G*+ ]KK,F X/H,

= X/H, YGI), (./0 E/F, P/VIF/H W/I()
Adjusting Free Cash Flow

Liquidation or Salvage Value
When an Asset is liquidated, any Capital Gain is taxed as Income
Problem:
As production manager, you are overseeing the shutdown of
a production line for a discontinued product. Some of the
equipment can be sold for a total price of $50,000. The
equipment was originally purchased 4 years ago for
$500,000 and is being depreciated according to the 5-year
MACRS schedule. If your tax rate is 35%, what is the aftertax cash flow you can expect from selling the equipment?
Solution Plan:
In order to compute the after-tax cash flow, you will need to compute the Capital
Gain, which requires to know the Book Value of the equipment.
The book value is given as the original purchase price of the equipment less
accumulated depreciation. Thus, you need to follow these steps:
1.
2.
3.
4.
Use the MACRS schedule to determine the accumulated depreciation.

Determine the book value as purchase price minus accumulated depreciation
Determine the capital gain as the sale price less the book value.
Compute the tax owed on the capital gain and subtract it from the
sale price.
Computing After-Tax Cash Flows from an Asset Sale
Thus, the accumulated depreciation is

100,000 + 160,000 + 96,000 + 57,600 + 57,600 = 471,200,
such that the remaining book value is $500,000 - $471,200 = 28,800.
(Note we could have also calculated this by summing any years remaining on the
MACRS schedule (Year 5 is 5.76%, so .0576 500,000 = 28,800).
Execute:
Based on the table, we see that the first four years of the 5-year
MACRS schedule (including year 0) are:
Execute:
The Capital Gain is then
$50,000 - $28,800 = $21,200 and the tax owed is 0.35 $21,200 = $7,420.
Your After-Tax Cash Flow is then found as the Sale price minus the tax owed:
$50,000 - $7,420 = $42,580.
Evaluate:
Because you are only taxed on the capital gain portion of the sale price, figuring the
after-tax cash flow is not as simple as subtracting the tax rate multiplied by the sales
price. Instead, you have to determine the portion of the sales price that represents a
gain and compute the tax from there. The same procedure holds for selling
equipment at a loss relative to book valuethe loss creates a deduction for taxable
income elsewhere in the company.
Problem:
As production manager, you are overseeing the shutdown of
a production line for a discontinued product. Some of the
equipment can be sold for a total price of $25,000. The
$800,000 and is being depreciated according to the 5-year
MACRS schedule. If your tax rate is 40%, what is the aftertax cash flow you can expect from selling the equipment?
Solution Plan:
1.
2.
3.
4.

sale price.
Year
Depreciation Rate
20.00%
32.00%
19.20%
11.52%
11.52%
Depreciation Amount
160,000
256,000
153,600
92,160
92,160
Thus, the accumulated depreciation is

160,000 + 256,000 + 153,600 + 92,160 + 92,160 = 753,920,
such that the remaining book value is $800,000 - $753,920 = 46,080.
(Note we could have also calculated this by summing any years remaining on the
MACRS schedule (Year 5 is 5.76%, so .0576 800,000 = 46,080).
Execute:
Execute:
The Capital Loss is then
$25,000 - $46,080 = -$21,080 and the company will have a tax obligation of
0.4 -$21,080 = -$8,432, which is a tax savings.
Your after-tax cash flow is then found as the sale price minus the tax owed:
$25,000 (-$8,432) = $33,432.
Evaluate:
Because you are only taxed on the capital gain portion of the sale price, figuring the
after-tax cash flow is not as simple as subtracting the tax rate multiplied by the sales
price. Instead, you have to determine the portion of the sales price that represents a
gain and compute the tax from there. The same procedure holds for selling
equipment at a loss relative to book valuethe loss creates a deduction for taxable
income elsewhere in the company.
Problem:
Your are in charge of closing a factory. Some of the
equipment can be sold for a total price of $2,000,000. The
$15,000,000 and is being depreciated according to the 5-year
MACRS schedule. If your tax rate is 40%, what is the after-tax
cash flow you can expect from selling the equipment?
Solution Plan:
1.
2.
3.
4.

sale price.
Year
0
1
2
3
4
Depreciation Rate
20.00%
32.00%
19.20%
11.52%
11.52%
Depreciation Amount $3,000,000 $4,800,000 $2,880,000 $1,728,000 $1,728,000
Thus, the accumulated depreciation is $3 million + $4.8 million = $7.8 million,

such that the remaining book value is $15 million - $7.8 million = $7.2 million.
Execute:
Execute:
The Capital Gain is then
$2 million - $7.2 million = -$5.2 million and the tax credit earned is
0.40 $5.2 million = $2.08 million.
Your after-tax cash flow is then found as the Sale price minus the tax owed:
$2 million - -$2.08 million = $4.08 million.
Evaluate:
Selling the equipment at a loss relative to book value loss creates a deduction for
taxable income elsewhere in the company.
Replacement Decisions:
Often the financial manager must decide whether to replace an
existing piece of equipment
The new equipment may allow increased production,
resulting in incremental revenue, or it may simply be more
efficient, lowering costs
Other Effects on Incremental Free Cash Flows
Problem:
You are trying to decide whether to replace a machine on
your production line. The new machine will cost $1 million,
but will be more efficient than the old machine, reducing
costs by $500,000 per year. Your old machine is fully
depreciated, but you could sell it for $50,000. You would
depreciate the new machine over a 5-year life using MACRS.
The new machine will not change your working capital needs.
Your tax rate is 35%, and your cost of capital is 9%. Should you replace the machine?
Solution Plan:
Incremental Revenues: 0; Incremental Costs: -500,000; Depreciation Schedule
P/VIF/H W/I( *( X/Hb/J, = $de, eee $e = $de, eee

P/KQ aH*g `G*+ X/Hb/J, [/H\,
= +$de, eee ($de, eee e. jd) = $jk, dee
Replacing an Excising Machine
NPV = 897.50 +
Evaluate:
437.00 392.20 365.32 365.32 345.16

+
+
+
+
= 598.75
2
3
4
5
1.09
1.09
1.09
1.09
1.09
Even though the decision has no impact on revenues, it still matters for cash flows
because it reduces costs. Further, both selling the old machine and buying the
new machine involve cash flows with tax implications. The NPV analysis shows
that replacing the machine will increase the value of the firm by almost $599
thousand.
Execute:
Problem:
You are trying to decide whether to replace a machine on
your production line. The new machine will cost $5 million,
but will be more efficient than the old machine, reducing
costs by $1,500,000 per year. Your old machine is fully
depreciated, but you could sell it for $100,000. You would
depreciate the new machine over a 5-year life using MACRS.
The new machine will not change your working capital needs. Your tax rate is 40%
and your cost of capital is 9%. Should you replace the machine?
Solution Plan:
Incremental Revenues: 0; Incremental Costs: -1,500,000; Depreciation Schedule
Depreciation Rate
Depreciation Amount
20%
32%
19.20%
11.52%
11.52%
5.76%
$300,000
$480,000
$288,000
$172,800
$172,800
$86,400
P/VIF/H W/I( *( X/Hb/J, = $Mee, eee $e = $Mee, eee

= +$Mee, eee $Mee, eee e. le = $me, eee

Year
Incremental Revenues
Incremental Cost of Goods Sold
Incremental Gross Profit
Depreciation Expense
EBIT
Income tax at 40%
Purchase of Equipment
Salvage Cash Flow
Incremental Free Cash Flow
NPV = 4,820 +
0
-300
-300
-120
-180
300
-5,000
60
-4,820
-1,500
1,500
-480
1,020
408
612
480
-1,500
1,500
-288
1,212
484.8
727.2
288
-1,500
1,500
-172.8
1,327.2
530.88
796.32
172.8
-1,500
1,500
-172.8
1,327.2
530.88
796.32
172.8
-1,500
1,500
-86.4
1,413.6
565.44
848.16
86.4
1,092
1,015.2
969.1
969.1
934.6
1092.0 1, 015.2 969.1 969.1 934.6

+
+
+
+
= 921.4
2
3
4
5
1.09
1.09
1.09 1.09
1.09
Evaluate:
because it reduces costs. Further, both selling the old machine and buying the new
machine involve cash flows with tax implications.
Execute:
Problem:
You are trying to decide whether to replace some equipment.
The new equipment will cost $3 million, but will be more
efficient than the old equipment, reducing costs by
$1,100,000 per year. Your old equipment is fully depreciated,
but you could sell it for $200,000. You would depreciate the
new equipment over a 5-year life using MACRS. The new
machine will not change your working capital needs. Your tax
rate is 35%, and your cost of capital is 9%. Should you replace the machine?
Solution Plan:
Incremental Revenues: 0; Incremental Costs: -1,100,000; Depreciation Schedule
Year
Depreciation Rate
Depreciation Amount
0
1
2
3
33.33%
44.45%
14.81%
7.41%
$999,900 $1,333,500 $444,300 $222,300
P/VIF/H W/I( *( X/Hb/J, = $kee, eee $e = $kee, eee

= +$kee, eee $kee, eee e. jd = $Mje, eee

Execute:
NPV = 620, 035 +
1
$0
$0
($999.900)
($999.900)
$349.965
($649.935)
$999.900
($1.100.000)
$130.000
($620.035)
$0
$0
$0
($1.100.000) ($1.100.000) ($1.100.000)
$1.100.000
$1.100.000
$1.100.000
($1.333.500)
($444.300)
($222.300)
($233.500)
$655.700
$877.700
$81.725
($229.495)
($307.195)
($151.775)
$426.205
$570.505
$1.333.500
$444.300
$222.300
$1.181.725
$870.505
$792.805
1,181, 725 870,505 792,805

+
+
= 1,808,994
2
3
1.09
1.09
1.09
Evaluate:
because it reduces costs. Further, both selling the old equipment and buying
the new equipment involve cash flows with tax implications.
Year
Incremental Revenue
Incremental COGS
Incremental Gross Profit
Depreciaiton Expense
EBIT
Inccome Tax
Add Depreciation
Purchase of Equipment
Salvage Cash Flow
incremental Free Cash Flow

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-3,600 -3,600 -3,600