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Chapter 12

Analyzing Project Cash Flows

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Slide Contents
Learning Objectives Principles Used in This Chapter
1.Identifying Incremental Cash Flows 2.Forecasting Project Cash Flows 3.Inflation and Capital Budgeting 4.Replacement Project Cash Flows

Key Terms

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Learning Objectives
1. Identify incremental cash flows that are relevant to project valuation. 2. Calculate and forecast project cash flows for expansion type investments. 3. Evaluate the effect of inflation on project cash flows. 4. Calculate the incremental cash flows for replacement type investments.

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Principles Used in This Chapter


Principle 3: Cash Flows Are the Source of Value.

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12.1 Identifying Incremental Cash Flows

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Identifying Incremental Cash Flows


Incremental cash flow refers to the additional cash flow generated by a new project.

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Guidelines for Forecasting Incremental Cash Flows


Sunk Costs are Not Incremental Cash Flows
Sunk costs are costs that have already been incurred or are going to be incurred regardless of whether or not the investment is undertaken.

For example, the cost of market research or a pilot program.


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Guidelines for Forecasting Incremental Cash Flows (cont.)


Overhead Costs are Generally Not Incremental Cash Flows
Overhead costs often occur regardless of whether we accept or reject a particular project. For example, cost of utilities.

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Guidelines for Forecasting Incremental Cash Flows (cont.)


Look for Synergistic Effects
Oftentimes, the acceptance of a new project will have a positive or negative effect on the cash flows of the firms other projects or investments. For example, an introduction of new variety of cereal can lead to loss of sales of existing cereal (called revenue cannibalization, a negative effect).
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Guidelines for Forecasting Incremental Cash Flows (cont.)


Account for Opportunity Costs
Opportunity cost refers to the cost of passing up the next best choice when making a decision. For example, use of an existing vacant building for a new project entails opportunity costs in the form of potential lost rent.

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Guidelines for Forecasting Incremental Cash Flows (cont.)


Work in Working Capital Requirements
Additional working capital arises out of the fact that cash inflows and outflows from the operations of an investment are often mismatched. Actual amount of new investment required by the project is given by:
Increase in accounts receivable + Increase in inventories - Increase in accounts payable

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Guidelines for Forecasting Incremental Cash Flows (cont.)


Ignore Interest Payments and Other Financing Costs
Interest payments and other financing costs are accounted for in the cost of capital (discount rate) used to discount the projects cash flows. Including it will lead to double counting.

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12.2 Forecasting Project Cash Flows

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Forecasting Project Cash Flows


Pro forma financial statements are forecasts of future financial statements. Free cash flow can be calculated using the following equation:

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Dealing with Depreciation Expense, Taxes and Cash Flow


Depreciation expenses is subtracted while calculating the firms taxable income. However, depreciation is a non-cash expense. Thus depreciation must be added back to the net operating income to determine the cash flows.

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Dealing with Depreciation Expense, Taxes and Cash Flow (cont.)


We calculate the depreciation expense using straight line method as follows: Annual Depreciation expense
= (Cost of equipment + Shipping & Installation Expense Expected salvage value) (Life of the equipment)

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Dealing with Depreciation Expense, Taxes and Cash Flow (cont.)


Example 12.1
Consider a firm that purchased an equipment for $500,000 and incurred an additional $50,000 for shipping and installation. What will be the annual depreciation expense if the equipment is expected to last 10 years and have a salvage value of $25,000?

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Dealing with Depreciation Expense, Taxes and Cash Flow (cont.)


Annual Depreciation expense
= (Cost of equipment + Shipping & Installation Expense Expected salvage value) (Life of the equipment)
= ($500,000 + $50,000 - $25,000) (10) = $52,500

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Four Step Procedure for Calculating Project Cash Flows


1. Estimating a projects operating cash flows 2. Calculating a projects working capital requirements 3. Calculating a projects capital expenditure requirements 4. Calculating a projects free cash flow.

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Four Step Procedure for Calculating Project Cash Flows (cont.)


Step 1: Estimating a projects operating cash flows

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Checkpoint 12.1
Forecasting a Projects Operating Cash Flow
The Crockett Clothing Company, located in El Paso, TX, owns and operates a clothing factory across the Mexican border in Juarez. The Juarez factory imports materials into Mexico for assembly and then exports the assembled products back to the United States without having to pay duties or tariffs. This type of factory is commonly referred to as a maquiladora. Crockett is considering the purchase of an automated sewing machine that will cost $200,000 and is expected to operate for five years, after which time it is not expected to have any value. The investment is expected to generate $360,000 in additional revenues for the firm during each of the five years of the projects life. Due to the expanded sales, Crockett expects to have to expand its investment in accounts receivable by $60,000 and inventories by $36,000. These investments in working capital will be partially offset by an increase in the firms accounts payable of $18,000, which makes the increase in net operating working capital equal to $78,000 in year zero. Note that this investment will be returned at the end of year five as inventories are sold, receivables are collected, and payables are repaid. (cont.)
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Checkpoint 12.1
Forecasting a Projects Operating Cash Flow
(cont.) The project will also result in cost of goods sold equal to 60% of revenues while incurring other annual cash operating expenses of $5,000 per year. In addition, the depreciation expense for the machine is $40,000 per year. This depreciation expense is one-fifth of the initial investment of $200,000 where the estimated salvage value is zero at the end of its five-year life. Profits from the investment will be taxed at a 30% tax rate and the firm uses a 20% required rate of return. Calculate the operating cash flow.

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Checkpoint 12.1

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Checkpoint 12.1

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Checkpoint 12.1

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Checkpoint 12.1: Check Yourself


Crockett Clothing Company is reconsidering its sewing machine investment in light of a change in its expectations regarding project revenues. The firms management wants to know the impact of a decrease in expected revenues from $360,000 to $240,000 per year. What would be the projects operating cash flow under the revised revenue estimate?

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Step 1: Picture the Problem

0
Years Cash flow

1
OCF1

2
OCF2

3
OCF3

4
OCF4

5
OCF5

OCF1-5 = Sum of additional revenues less operating expenses (cash and depreciation) less taxes plus depreciation expense

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Step 1: Picture the Problem (cont.)


This is the information given to us:
Equipment Project life Salvage Value Depreciation expense Cash Operating Expenses Revenues Growth rate for revenues $2,00,000 5 years $40,000 per year -$5,000 per year $240,000 per year 0%

Cost of goods sold/Revenues


Investment in Net operating working capital Required rate of return Tax rate
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60%
-$78,000 20% 30%
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Step 2: Decide on a Solution Strategy


We can calculate the operating cash flows using equation 12-3.

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Step 3: Solve
Since there is no change in revenues or other sources of cash flows from year to year, the total operating cash flows will be the same every year.

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Step 3: Solve (cont.)


Year 1-5 Project Revenues (growth rate =0%) - Cost of goods sold (60% of revenues) = Gross Profit - Cash operating expense - Depreciation = Net operating income - Taxes (30%) =Net Operating Profit after Taxes (NOPAT) + Depreciation = Operating Cash Flows $240,000 -144,000 $96,000 -$5,000 -$40,000 $51,000 -$15,300 $35,700 $40,000 $75,700
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Step 4: Analyze
This project contributes $35,700 to the firms net operating income (after taxes) based on annual revenues of $240,000.This represents a significant drop from $69,300 when the revenues were $360,000. Since depreciation is a non-cash expense, it is added back to determine the annual operating cash flows.

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Four Step Procedure for Calculating Project Cash Flows (cont.)


Step 2: Calculating a Projects Working Capital Requirements A new project would imply:
An increase in sales leading to an increase in credit sales (or accounts receivable); and An increase in firms investment in inventories.

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Four Step Procedure for Calculating Project Cash Flows (cont.)


Both increase in accounts receivable and increase in inventory represent a cash outflow.

The total cash outflow will be reduced if the firm is able to finance some or all of its inventories using trade credit (accounts payable).

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Four Step Procedure for Calculating Project Cash Flows (cont.)


Thus increase in investment in net working capital
= Increase in accounts receivable + Increase in inventories Increase in accounts payable

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Four Step Procedure for Calculating Project Cash Flows (cont.)


Step 3: Calculating a Projects Capital Expenditure Requirements
Capital expenditures refer to the cash the firm spends to purchase fixed assets. For accounting purposes, the cost of fixed asset is allocated over the life of the asset by depreciating the asset.

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Four Step Procedure for Calculating Project Cash Flows (cont.)


Step 4: Calculating a Projects Free Cash Flow
Projects free cash flow is calculated by using equation 12-3

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Computing Project NPV


Once we have estimated the free cash flow, we can compute the NPV using equation 11-1 based on the assumed discount rate.

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Computing Project NPV (cont.)


Example 12.2
Compute the NPV for Checkpoint 12.1: Check Yourself based on the following additional assumptions:
Increase in net working capital = -$70,000 in Year 0 Increase in net working capital = $70,000 in Year 5 Discount Rate = 15%

The next slide includes the original information from Checkpoint 12.1: Check Yourself

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Computing Project NPV (cont.)


Year 1-5 Project Revenues (growth rate =0%) - Cost of goods sold (60% of revenues) = Gross Profit - Cash operating expense - Depreciation = Net operating income - Taxes (30%) =Net Operating Profit after Taxes (NOPAT) + Depreciation = Operating Cash Flows
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$240,000 -144,000 $96,000 -$5,000 -$40,000 $51,000 -$15,300 $35,700 $40,000 $75,700
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Computing Project NPV (cont.)


Year 0 Year 1-4 Year 5

Operating Cash flow Less: Capital expenditure


Less: additional net working capital Free Cash Flow

-$200,000
-$70,000 -$270,000

$75,700 $75,700

$75,700 $70,000 $145,700

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Computing Project NPV (cont.)


Using Mathematical Equation

NPV =-$270,000 + {$75,700/(1.15)} +

{$75,700/(1.15)2 }+ {$75,700/(1.15)3}+ {$75,700/(1.15)4}+ {$145,700/(1.15)5}

$18,560
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Computing Project NPV (cont.)


Using Spreadsheet NPV = -$270,000 + npv(.15,75700,75700,75700,75700,145700) = $18,560.51

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12.3 Inflation and Capital Budgeting

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Inflation and Capital Budgeting


Cash flows that account for future inflation are referred to as nominal cash flows.

Real cash flows are cash flows that occur in the absence of inflation.

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Inflation and Capital Budgeting


For capital budgeting analysis, nominal cash flows must be discounted by nominal rate of return and real cash flows must be discounted at the real rate of interest.

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12.4 Replacement Project Cash Flows

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Replacement Project Cash Flows


An expansion project increases the scope of firms operations, but does not replace any existing assets or operations.

A replacement project replaces an older, less productive asset.

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Replacement Project Cash Flows


A distinctive feature of many replacement investment is that principal source of cash flows comes from cost savings, not new revenues, since the firm already operates an existing asset to generate revenues.

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Replacement Project Cash Flows (cont.)


To facilitate the capital budgeting analysis for replacement projects, we categorize the investment cash flows into two:
the initial cash flows (CF0), and
subsequent cash flows (CF1-end).

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Replacement Project Cash Flows (cont.)


Category 1: Initial Outlay, CF0 Initial outlay typically includes:
Cost of fixed assets Shipping and installation expense Investment in net working capital Sale of old equipment Tax implications from sale of old equipment

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Replacement Project Cash Flows (cont.)


There are three possible scenarios when an old asset is sold:
Selling Price of old asset At depreciated value Higher than depreciated value (or book value) Tax Implications No taxes Difference between the selling price and depreciated book value is a taxable gain and is taxed at the marginal corporate tax rate.

Lower than depreciated value (or book value)

Difference between the depreciated book value and selling price is a taxable loss and may be used to offset capital gains.
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Replacement Project Cash Flows (cont.)


Category 2: Annual Cash Flows
Annual cash flows for a replacement decision differ from a simple asset acquisition because we must now consider the differential operating cash flow of the new versus the old (replaced) asset.

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Replacement Project Cash Flows (cont.)


Change in Depreciation and Taxes:
We need to compute the incremental change in depreciation and taxes i.e. what the depreciation and taxes would be if the assets were replaced versus what they would be if the assets were not replaced. For depreciation, the expenses will increase by the amount of depreciation on the new asset but decrease by the amount of the depreciation of the replaced asset.

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Replacement Project Cash Flows (cont.)


Changes in Working Capital:
Increase in working capital is necessitated by the increase in accounts receivable and increased investment in inventories. The increase is partially offset if inventory is financed by accounts payable.

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Replacement Project Cash Flows (cont.)


Changes in capital spending:
The replacement asset may require an outlay at the time of acquisition and additional capital over its life. However, we must net out any additional capital spending requirements of the older, replaced asset.

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Checkpoint 12.2
Calculating Free Cash Flows for a Replacement Investment Leggett Scrap Metal, Inc. operates an auto salvage business in Salem, Oregon. The firm is considering the replacement of one of the presses it uses to crush scrapped automobiles. The following information summarizes the new versus old machine costs:

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Checkpoint 12.2
Leggett faces a 30% marginal tax rate and uses a 15% discount rate to evaluate equipment purchases for its automobile scrap operation.

The appeal of the new press is that it is more automated (requires two fewer employees to operate the machine). The older machine requires four employees with salaries totaling $200,000 and fringe benefits costing $20,000. The new machine cuts this total in half. In addition, the new machine is able to separate out the glass and rubber components of the crushed automobiles, which reduces the annual cost of defects which are $20,000 with the new machine compared to $70,000 for the older model. However, the added automation feature comes at the cost of higher annual maintenance fees of $60,000 compared to only $20,000 for the older press. Should Leggett replace the older machine with the newer one?

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Checkpoint 12.2

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Checkpoint 12.2

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Checkpoint 12.2

Step 3 cont.
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Checkpoint 12.2

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Checkpoint 12.2

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Checkpoint 12.2: Check Yourself


Forecast the project cash flows for the replacement press for Leggett where the new press results in net operating income per year of $600,000 compared to $580,000 for the old machine. This increase in revenues also means that the firm will also have to increase its investment in net working capital by $20,000. Estimate the initial cash outlay required to replace the old machine with the new one and estimate the annual cash flow for years 1 through 5.

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The Problem (cont.)


New Machine Annual cost of defects Net operating income Book value of equipment Salvage value (today) Salvage value (year 5) Shipping cost Installation cost Remaining project life (years) Net operating working capital Salaries Fringe Benefits $20,000 $600,000 $350,000 N/A $50,000 $20,000 $30,000 5 $80,000 $100,000 $10,000 Old Machine $70,000 $580,000 $100,000 $150,000 N/A N/A 5 $60,000 $200,000 $20,000

Maintenance
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$60,000

$20,000
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Step 1: Picture the Problem


The new machine will require an initial outlay, which will be partially offset by the after-tax cash flows from the old machine.

The new machine will help improve efficiency and reduce repairs, but it will also increase the annual maintenance expense.

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Step 1: Picture the Problem (cont.)


Years

0
Cash flows(New) CF(N)0

1
CF(N)1

2
CF(N)2
MINUS

3
CF(N)3

4
CF(N)4

5
CF(N)5

Cash Flows (Old)

CF(O)0

CF(O)1

CF(O)2

CF(O)3

CF(O)4

CF(O)5

EQUALS

Difference (New Old) CF0


\

CF1

CF2

CF3

CF4

CF5

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Step 1: Picture the Problem (cont.)


The decision to replace will be based on the replacement cash flows.

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Step 2: Decide on a Solution Strategy


The cash flows will be calculated using equation 12-3.

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Step 2: Decide on a Solution Strategy (cont.)


However, for replacement projects, the emphasis is on the difference in costs and benefits of the new machine versus the old. Accordingly, we compute the initial cash outflow and the annual cash flows (from Year 1 through Year 5).

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Step 3: Solve
Initial cash outflow (CF0)
= Cost of new equipment + Shipping cost + Installation cost Sale of old equipment tax effects from sale of old equipment.

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Step 3: Solve (cont.)


Year 0 Purchase price Shipping cost Installation cost Working Capital Total cost of New Sale Price New Machine -$350,000 -$20,000 -$30,000 -$20,000 -$420,000 $150,000 Old Machine

Less: Tax on gain


Net cash flow

$50,000*.3 0

-$15,000
$135,000

Replacement Net Cash Flow


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-$285,000
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Step 3: Solve (cont.)


Thus, the total cost of new machine of $400,000 is partially offset by the old machine resulting in a net cost of $285,000. Next we compute the annual cash from years 1-5. Cash Flows for years 1-4 will be the same.

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Step 3: Solve (cont.)


Analysis of Annual Cash Inflows Years 1-4 Year 5

Increase in operating income


Reduced salaries Reduced defects Reduced fringe benefits Total cash inflows

$20,000
$100,000 $50,000 $10,000 $180,000

$20,000
$100,000 $50,000 $10,000 $180,000

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Step 3: Solve (cont.)


Analysis of Annual Cash Out Flows Increased maintenance Increased depreciation Net operating income Less: Taxes Net operating profit after taxes Plus: depreciation Years 1-4 -$40,000 -$50,000 $90,000 -$27,000 $63,000 $50,000 Years 5 -$40,000 -$50,000 $90,000 -$27,000 $63,000 $50,000

Operating cash flow


Less: Change in operating working capital Less: CAPEX Free Cash Flows
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$113,000

$113,000
$20,000 50,0000

$113,000

$183,000
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Step 4: Analyze
In this case, we observe that the new machine generated cost savings and also increased the revenues by $20,000.

Based on the estimates of initial cash outflow and subsequent annual free cash flows for years 1-5, we can compute the NPV.

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Computing NPV
Continue Checkpoint 12.2: Check Yourself example. Compute the NPV for this replacement project based on discount rate of 15%.

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Computing NPV
NPV can be easily computed using mathematical equation (11-1): NPV = -$285,000 + $113,000/(1.15)1 + $113,000/(1.15)2 + $113,000/(1.15)3 + $113,000/(1.15)4 + $183,000/(1.15)5
=

$128,595.90

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Key Terms
Expansion project Incremental cash flow Nominal cash flow Nominal rate of interest Pro forma statements Real cash flow Real rate of interest Replacement investment Sunk cost

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