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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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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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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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60%
-$78,000 20% 30%
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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 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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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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The next slide includes the original information from Checkpoint 12.1: Check Yourself
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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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-$200,000
-$70,000 -$270,000
$75,700 $75,700
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$18,560
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Real cash flows are cash flows that occur in the absence of inflation.
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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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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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Maintenance
Copyright 2011 Pearson Prentice Hall. All rights reserved.
$60,000
$20,000
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The new machine will help improve efficiency and reduce repairs, but it will also increase the annual maintenance expense.
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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
CF(O)0
CF(O)1
CF(O)2
CF(O)3
CF(O)4
CF(O)5
EQUALS
CF1
CF2
CF3
CF4
CF5
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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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$50,000*.3 0
-$15,000
$135,000
-$285,000
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$20,000
$100,000 $50,000 $10,000 $180,000
$20,000
$100,000 $50,000 $10,000 $180,000
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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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