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CHAPTER 12 Cash Flows and Other Topics in Capital Budgeting

CHAPTER 12 Cash Flows and Other Topics in Capital Budgeting. 7 $158,400. 0. 1 $197,500. 2 $197,500. 3 $197,500. 5 $197,500. 6 $158,400. 8 $158,400+ $41,400 = $199,800. 4 $197,500. Time line for Solution Practice Problem 2. Cash Flows. Terminal Cash flow. Initial outlay

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CHAPTER 12 Cash Flows and Other Topics in Capital Budgeting

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  1. CHAPTER 12 Cash Flows and Other Topics in Capital Budgeting

  2. 7 $158,400 0 1 $197,500 2 $197,500 3 $197,500 5 $197,500 6 $158,400 8 $158,400+ $41,400 = $199,800 4 $197,500 Time line for Solution Practice Problem 2 Cash Flows Terminal Cash flow Initial outlay $590,000 Annual Cash Flows

  3. Problem 2 Automation Project: • 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%.

  4. Problem 2 Initial Outlay: (550,000) Cost of new machine + (25,000) Shipping & installation (575,000) Depreciable asset + (15,000) NWC investment (590,000) Net Initial Outlay

  5. Problem 2 For Years 1 - 5: 240,000 Cost decrease (115,000) Depreciation increase 125,000 EBIT (42,500) Taxes (34%) 82,500 EAT 115,000 Depreciation reversal 197,500 = Annual Cash Flow

  6. CALCULATION OF ANNUAL DEPRECIATION FOR NEW MACHINE: Depreciable asset/class life =$575,000/5 yrs = $115,000 The machine is used only for 5 years. From years 6-10, no depreciation; therefore depreciation will be $0 for these last 5 years.

  7. Problem 2 For Years 6 - 8: 240,000 Cost decrease ( 0) Depreciation increase 240,000 EBIT (81,600) Taxes (34%) 158,400 EAT 0 Depreciation reversal 158,400 = Annual Cash Flow

  8. Problem 2 Terminal Cash Flow: 40,000 Salvage value (13,600) Tax on capital gain 15,000 Recapture of NWC 41,400 Terminal Cash Flow

  9. CALCULATION OF TERMINAL CASH FLOW Annual depreciation of new machine=$115,000 (from slide 7) Book value = Depreciable asset – Total amount depreciated = $575,000 - $115,000(5yrs) = $0 Capital gain = Salvage value-Book Value = $40,000-$0 = $40,000 Tax on capital gain = 34% x $40,000 = $13,600 (refer slide 8)

  10. Problem 2 Solution NPV and IRR: • CF(year 0) = -$590,000 (slide 4) • CF(years 1 - 5) =$197,500 (slide 5) • CF(years 6 - 7) = $158,400 (slide 7) • CF(year 8) = $158,400 + $41,400 = $199,800 (slides 7 + 8) • Discount rate = 14%. • IRR = 28.13% • NPV = $293,543. • We would accept the project.

  11. FINDING NPV-1st method (annuity + individual CF) NPV = -$590,000 (year 0) + $197,500 (PVIFA 14%, years 1-5) (years 1-5) + $158,400 (PVIF 14%, 6th yr) (year 6) + $158,400 (PVIF 14%, 7th yr) (year 7) + $199,800 (PVIF 14%, 8th yr) (year 8) = -$590,000 + $197,500(3.4331) + $158,400 ( (0.4556) + $158,400 ( (0.3996) + $199,800 (0.3506) = -$590,000 +$678,037 +$72,167 +$63,297 +$70,050 = -$590,000 +$883,551 = $293,551 Accept the project since NPV is positive.

  12. FINDING NPV-2nd method (annuities) NPV = -$590,000 (year 0) + $197,500 (PVIFA 14%, 5years) (years 1-5) + $158,400 (PVIFA 14%, 2 years,6&7) (PVIF 14%, 5)(annuities years 6-7)(bring back to time 0). Refer to TVM ppt, slides 68-71 for understanding. + $199,800 (PVIF 14%,10th year) (year 8) = -$590,000 + $197,500(3.4331) + $158,400 (1.6467)(0.5194) + $199,800 (0.3506) = -$590,000 +$678,037 +$135,479 +$70,050 = -$590,000 +$883,556 = $293,566 Accept the project since NPV is positive.

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