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for purchases of long-term assets.

For example: Our firm must decide whether

to purchase a new plastic molding machine

for $127,000. How do we decide?

Will the machine be profitable?

Will our firm earn a high rate of return on

the investment?

The relevant project information follows:

Installation will cost $20,000.

$4,000 in net working capital will be needed at

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.

1) Evaluate Cash Flows

Look at all incremental cash flows

occurring as a result of the project.

Initial outlay

Differential Cash Flows over the life

of the project (also referred to as

annual cash flows).

Terminal Cash Flows

1) Evaluate Cash Flows

...

1) Evaluate Cash Flows

Initial

outlay

...

1) Evaluate Cash Flows

Initial

outlay

...

1) Evaluate Cash Flows

Terminal

Cash flow

Initial

outlay

...

2) Evaluate the Risk of the Project

Well get to this in the next chapter.

For now, well assume that the risk of the

project is the same as the risk of the

overall firm.

If we do this, we can use the firms cost of

capital as the discount rate for capital

investment projects.

3) Accept or Reject the Project

a) Initial Outlay: What is the cash flow at

time 0?

(Purchase price of the asset)

+ (shipping and installation costs)

(Depreciable asset)

+ (Investment in working capital)

+ After-tax proceeds from sale of old asset

Net Initial Outlay

a) Initial Outlay: What is the cash flow at

time 0?

(127,000)

+ (shipping and installation costs)

(Depreciable asset)

+ (Investment in working capital)

+ After-tax proceeds from sale of old asset

Net Initial Outlay

a) Initial Outlay: What is the cash flow at

time 0?

(127,000)

+ ( 20,000)

(Depreciable asset)

+ (Investment in working capital)

+ After-tax proceeds from sale of old asset

Net Initial Outlay

a) Initial Outlay: What is the cash flow at

time 0?

(127,000)

+ ( 20,000)

(147,000)

+ (Investment in working capital)

+ After-tax proceeds from sale of old asset

Net Initial Outlay

a) Initial Outlay: What is the cash flow at

time 0?

(127,000)

+ (20,000)

(147,000)

+ (4,000)

+ After-tax proceeds from sale of old asset

Net Initial Outlay

a) Initial Outlay: What is the cash flow at

time 0?

(127,000)

+ (20,000)

(147,000)

+ (4,000)

+

0

Net Initial Outlay

a) Initial Outlay: What is the cash flow at

time 0?

(127,000)

+ (20,000)

(147,000)

+ (4,000)

+

0

($151,000)

Shipping and installation

Depreciable asset

Net working capital

Proceeds from sale of old asset

Net initial outlay

a) Initial Outlay: What is the cash flow at

time 0?

(127,000)

+ (20,000)

(147,000)

+ (4,000)

+

0

($151,000)

Shipping and installation

Depreciable asset

Net working capital

Proceeds from sale of old asset

Net initial outlay

b) Annual Cash Flows: What

incremental cash flows occur over the

life of the project?

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:

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

c) Terminal Cash Flow: What is the cash

flow at the end of the projects life?

Salvage value

+/- Tax effects of capital gain/loss

+ Recapture of net working capital

Terminal Cash Flow

c) Terminal Cash Flow: What is the cash

flow at the end of the projects life?

50,000

Salvage value

+/- Tax effects of capital gain/loss

+ Recapture of net working capital

Terminal Cash Flow

Salvage value = $50,000.

Book value = depreciable asset - total

amount depreciated.

Book value = $147,000 - $147,000

= $0.

Capital gain = SV - BV

= 50,000 - 0 = $50,000.

Tax payment = 50,000 x .34 = ($17,000).

c) Terminal Cash Flow: What is the cash

flow at the end of the projects life?

50,000

(17,000)

Salvage value

Tax on capital gain

Recapture of NWC

Terminal Cash Flow

c) Terminal Cash Flow: What is the cash

flow at the end of the projects life?

50,000

(17,000)

4,000

Salvage value

Tax on capital gain

Recapture of NWC

Terminal Cash Flow

c) Terminal Cash Flow: What is the cash

flow at the end of the projects life?

50,000

(17,000)

4,000

37,000

Salvage value

Tax on capital gain

Recapture of NWC

Terminal 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

five 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

Capital Rationing

IRR

25%

20%

15%

10%

5%

1

$

Capital Rationing

IRR

25%

20%

15%

10%

5%

2

$

Capital Rationing

IRR

25%

20%

15%

10%

5%

3

$

Capital Rationing

IRR

25%

20%

15%

10%

5%

4

$

Capital Rationing

IRR

25%

20%

15%

10%

5%

5

$

Capital Rationing

IRR

so we accept only

projects 1, 2, and 3.

25%

20%

15%

10%

5%

4

$X

5

$

Capital Rationing

IRR

so we accept only

projects 1, 2, and 3.

25%

20%

15%

10%

5%

3

$X

Capital Rationing

always the best way to deal with a

limited capital budget.

Its better to pick the largest NPVs.

Lets try ranking projects by NPV.

1) Mutually exclusive projects of unequal

size (the size disparity problem)

The NPV decision may not agree with

IRR or PI.

Solution: select the project with the

largest NPV.

Project A

year cash flow

0

(135,000)

1

60,000

2

60,000

3

60,000

required return = 12%

IRR = 15.89%

NPV = $9,110

PI = 1.07

Project A

year cash flow

0

(135,000)

1

60,000

2

60,000

3

60,000

required return = 12%

IRR = 15.89%

NPV = $9,110

PI = 1.07

Project B

year cash flow

0

(30,000)

1

15,000

2

15,000

3

15,000

required return = 12%

IRR = 23.38%

NPV = $6,027

PI = 1.20

Project A

year cash flow

0

(135,000)

1

60,000

2

60,000

3

60,000

required return = 12%

IRR = 15.89%

NPV = $9,110

PI = 1.07

Project B

year cash flow

0

(30,000)

1

15,000

2

15,000

3

15,000

required return = 12%

IRR = 23.38%

NPV = $6,027

PI = 1.20

2) The time disparity problem with mutually

exclusive projects.

NPV and PI assume cash flows are

reinvested at the required rate of return for

the project.

IRR assumes cash flows are reinvested at

the IRR.

The NPV or PI decision may not agree with

the IRR.

Solution: select the largest NPV.

Project A

year cash flow

0

(48,000)

1

1,200

2

2,400

3

39,000

4

42,000

required return = 12%

IRR = 18.10%

NPV = $9,436

PI = 1.20

Project A

year cash flow

0

(48,000)

1

1,200

2

2,400

3

39,000

4

42,000

required return = 12%

Project B

year cash flow

0

(46,500)

1

36,500

2

24,000

3

2,400

4

2,400

required return = 12%

IRR = 18.10%

NPV = $9,436

PI = 1.20

IRR = 25.51%

NPV = $8,455

PI = 1.18

Project A

year cash flow

0

(48,000)

1

1,200

2

2,400

3

39,000

4

42,000

required return = 12%

Project B

year cash flow

0

(46,500)

1

36,500

2

24,000

3

2,400

4

2,400

required return = 12%

IRR = 18.10%

NPV = $9,436

PI = 1.20

IRR = 25.51%

NPV = $8,455

PI = 1.18

with Unequal Lives

and we have to select one of two machines.

They differ in terms of economic life and

capacity.

How do we decide which machine to select?

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%.

NPV1 = $1,433

NPV2 = $1,664

So, does this mean #2 is better?

No! The two NPVs cant be

compared!

Annuity (EAA) method

replaced an infinite number of times in the

future, we can convert each NPV to an

annuity.

The projects EAAs can be compared to

determine which is the best project!

EAA: Simply annuitize the NPV over the

projects life.

of the project

solve: PMT = -617.24.

solve: PMT = -427.91.

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.

EAAs are actually perpetuities. Get the

PV by dividing the EAA by the required

rate of return.

EAAs are actually perpetuities. Get the

PV by dividing the EAA by the required

rate of return.

EAAs are actually perpetuities. Get the

PV by dividing the EAA by the required

rate of return.

NPV 2 = 428/.14 = $3,057

are actually perpetuities. Get the PV by

dividing the EAA by the required rate of

return.

it just converts EAA to an NPV that can be

compared.

Practice Problems:

Cash Flows & Other Topics

in Capital Budgeting

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

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

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)

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:

40,000

(13,600)

15,000

41,400

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%.

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:

Problem 3

+ ( 56,000) Shipping & installation

(1,806,000) Depreciable asset

+ ( 68,000) NWC investment

+ 456,875 After-tax proceeds (sold

old machine)

(1,417,125) Net Initial Outlay

For Years 1 - 5:

385,000

(248,700)

136,300

(47,705)

88,595

248,700

337,295 =

Problem 3

Extra depreciation

EBT

Taxes (35%)

EAT

Depreciation reversal

Differential Cash Flow

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!

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