(K)
p. 196Incremental Cash Flows Which of the following should be treated as an incremental cash flow when computing the NPV of an investment? A reduction in the sales of a company’s other products caused by the investment. An expenditure on plant and equipment that has not yet been made, and will be made only if the project is accepted. Costs of research and development undertaken in connection with the product during the past three years. Annual depreciation expense from the investment. Dividend payments by the firm. The resale value of plant and equipment at the end of the project’s life. Salary and medical costs for production personnel who will be employed only if the project is accepted.
Incremental Cash Flows In the context of capital budgeting, what is an opportunity cost? Inflation and Capital Budgeting In a hyperinflationary environment, how would you incorporate inflation into a capital budgeting analysis? Explain your methodology in words to a manager who is worried about the power of capital budgeting when inflation is very high. Operating Cash Flows What is meant by operating cash flow? Review the different ways in which operating cash flow can be calculated. Equivalent Annual Cost Explain what is meant by the equivalent annual cost method. When is EAC analysis appropriate for comparing two or more projects? Why is this method used? Are there any implicit assumptions required by this method that you find troubling? Explain. Calculating Project NPV Your uncle has spent most of his retirement income on opening a new seafood restaurant. As part of the initial renovations he has ordered a wooden oven to cook squid in the style of the best Athenian restaurants he visited in his youth. The cost of the oven (£400,000) is staggering, but worth it, if it can make squid in the way he remembers. It is possible to buy this particular oven only from a local ovenmaker in Athens, and installation requires fluying over two engineers at cost. The company tells your uncle that the total installation expense is £50,000. Feeling slightly sick, your uncle asks you how to deal with the installation cost in the company accounts. Is it a capital investment or is it an expense? The tax rate is 28 per cent and the relevant discount rate is 5 per cent. If the installation is treated as a capital investment cost, what is the present value of tax savings using a depreciation method of 20 per cent reducing balance? Assume that the oven will be scrapped for nothing in five years’ time (you don’t have much confidence in your uncle’s business acumen). Which is better for your uncle: treating the installation cost as a capital investment or as an expense? Calculating Project NPV Best Manufacturing Ltd is considering a new investment. Financial projections for the investment are tabulated here. The corporate tax rate is 28 per cent. Assume all sales revenue is received in cash, all operating costs and income taxes are paid in cash, and all cash flows occur at the end of the year. All net working capital is recovered at the end of the project, and the investment is sold at its residual value after depreciation.
p. 197 (K) Compute the incremental net income of the investment for each year. Compute the incremental cash flows of the investment for each year. Suppose the appropriate discount rate is 12 per cent. What is the NPV of the project?
Calculating Project Cash Flow from Assets In the previous problem, suppose the project requires an initial investment in net working capital of £3,000 and the fixed asset will have a market value of £2,100 at the end of the project. What is the project’s year 0 net cash flow? Year 1? Year 2? Year 3? What is the new NPV? NPV and Accelerated Depreciation In the previous problem, suppose the fixed asset is depreciated using the reducingbalance method at 20 per cent per annum. All the other facts are the same. What is the project’s year 1 net cash flow now? Year 2? Year 3? What is the new NPV? Project Evaluation Your firm is contemplating the purchase of a new £925,000 computerbased order entry system. The system will be depreciated using reducing balance at 20 per cent per annum over its fiveyear life. It will be worth £90,000 at the end of that time. You will save £360,000 before taxes per year in order processing costs, and you will be able to reduce working capital by £125,000 (this is a onetime reduction). If the tax rate is 28 per cent, what is the IRR for this project? Project Evaluation Dog Up! Franks is looking at a new sausage system with an installed cost of €390,000. This cost will be depreciated straightline to zero over the project’s fiveyear life, at the end of which the sausage system can be scrapped for €60,000. The sausage system will save the firm €120,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of €28,000. If the tax rate is 34 per cent and the discount rate is 10 per cent, what is the NPV of this project? Calculating Salvage Value An asset used in a fouryear project is depreciated at 20 per cent reducing balance for tax purposes. The asset has an acquisition cost of £9,300,000 and will be sold for £3,100,000 at the end of the project. If the tax rate is 28 per cent, what is the aftertax salvage value of the asset? Calculating NPV Howell Petroleum is considering a new project that complements its existing business. The machine required for the project costs €2 million. The marketing department predicts that sales related to the project will be €1.2 million per year for the next four years, after which the market will cease to exist. The machine will be depreciated using a 20 per cent reducingbalance method. At the end of four years it will be sold at its residual value. Cost of goods sold and operating expenses related to the project are predicted to be 25 per cent of sales. Howell also needs to add net working capital of €100,000 immediately. The additional net working capital will be recovered in full at the end of the project’s life. The corporate tax rate is 35 per cent. The required rate of return for Howell is 14 per cent. Should Howell proceed with the project?
p. 198Calculating EAC You are evaluating two different silicon wafer milling machines. The Techron I costs €210,000, has a threeyear life, and has pretax operating costs of €34,000 per year. The Techron II costs €320,000, has a fiveyear life, and has pretax operating costs of €23,000 per year. For both milling machines, use 20 per cent reducing balance depreciation over the project’s life and assume a salvage value of €20,000. If your tax rate is 35 per cent and your discount rate is 14 per cent, compute the EAC for both machines. Which do you prefer? Why? Comparing Mutually Exclusive Projects Hagar Industrial Systems Company (HISC) is trying to decide between two different conveyor belt systems. System A costs 430,000 Norwegian kroner (NK), has a fouryear life, and requires NK120,000 in pretax annual operating costs. System B costs NK540,000, has a sixyear life, and requires NK80,000 in pretax annual operating costs. Both systems are to be depreciated using the reducingbalance method of 50 per cent per annum, and will have zero salvage value at the end of their life. Whichever system is chosen, it will not be replaced when it wears out. If the tax rate is 28 per cent and the discount rate is 20 per cent, which system should the firm choose? Comparing Mutually Exclusive Projects Suppose in the previous problem that HISC always needs a conveyor belt system: when one wears out, it must be replaced. Which system should the firm choose now? Inflation and Company Value Sparkling Water plc expects to sell 2 million bottles of drinking water each year in perpetuity. This year each bottle will sell for £1.25 in real terms and will cost £0.70 in real terms. Sales income and costs occur at yearend. Revenues will rise at a real rate of 7 per cent annually, while real costs will rise at a real rate of 5 per cent annually. The real discount rate is 10 per cent. The corporate tax rate is 28 per cent. What is Sparkling worth today? Calculating Nominal Cash Flow Etonic SA is considering an investment of €250,000 in an asset with an economic life of five years. The firm estimates that the nominal annual cash revenues and expenses at the end of the first year will be €200,000 and €50,000, respectively. Both revenues and expenses will grow thereafter at the annual inflation rate of 3 per cent. Etonic will use the 20 per cent reducingbalance method to depreciate its asset over five years. The salvage value of the asset is estimated to be €30,000 in nominal terms at that time. The onetime net working capital investment of €10,000 is required immediately, and will be recovered at the end of the project. All corporate cash flows are subject to a 34 per cent tax rate. What is the project’s total nominal cash flow from assets for each year? Equivalent Annual Cost Bridgton Golf Academy is evaluating different golf practice equipment. The ‘DimpleMax’ equipment costs £45,000, has a threeyear life, and costs £5,000 per year to operate. The relevant discount rate is 12 per cent. Assume that the reducing balance (20 per cent) depreciation method is used. Furthermore, assume the equipment has a salvage value of £20,000 at the end of the project’s life. The relevant tax rate is 28 per cent. All cash flows occur at the end of the year. What is the equivalent annual cost (EAC) of this equipment? Calculating NPV and IRR for a Replacement A firm is considering an investment in a new machine with a price of £32 million to replace its existing machine. The current machine has a book value of £1 million and a market value of £9 million. The new machine is expected to have a fouryear life, and the old machine has four years left in which it can be used. If the firm replaces the old machine with the new machine, it expects to save £8 million in operating costs each year over the next four years. Both machines will have no salvage value in four years. If the firm purchases the new machine, it will also need an investment of £500,000 in net working capital. The required return on the investment is 18 per cent, and the tax rate is 39 per cent.
p. 199What are the NPV and IRR of the decision to replace the old machine? The new machine saves £32 million over the next four years and has a cost of £32 million. When you consider the time value of money, how is it possible that the decision to replace the old machine has a positive NPV?
Calculating Project NPV With the growing popularity of casual surf print clothing, two recent MBA graduates decided to broaden this casual surf concept to encompass a ‘surf lifestyle for the home’. With limited capital, they decided to focus on surf print table and fluoor lamps to accent people’s homes. They projected unit sales of these lamps to be 5,000 in the first year, with growth of 15 per cent each year for the next five years. Production of these lamps will require £28,000 in net working capital to start. Total fixed costs are £75,000 per year, variable production costs are £20 per unit, and the units are priced at £45 each. The equipment needed to begin production will cost £60,000. The equipment will be depreciated using the reducingbalance method (20 per cent), and is not expected to have a salvage value. The effective tax rate is 28 per cent, and the required rate of return is 25 per cent. What is the NPV of this project? Calculating Project NPV Pilot Plus Pens is deciding when to replace its old machine. The machine’s current salvage value is €2 million. Its current book value is €1 million. If not sold, the old machine will require maintenance costs of €400,000 at the end of the year for the next five years. Depreciation on the old machine is calculated using 20 per cent reducing balances. At the end of five years it will have a salvage value of €200,000. A replacement machine costs €3 million now and requires maintenance costs of €500,000 at the end of each year during its economic life of five years. At the end of the five years the new machine will have a salvage value of €500,000. It will be depreciated by the reducingbalance method (20 per cent). In five years a replacement machine will cost €3,500,000. Pilot will need to purchase this machine regardless of what choice it makes today. The corporate tax rate is 34 per cent and the appropriate discount rate is 12 per cent. The company is assumed to earn sufficient revenues to generate tax shields from depreciation. Should Pilot Plus Pens replace the old machine now or at the end of five years? Inflation Your company manufactures nonstick frying pans. However, it outsources the production of the glass covers for the pans. Until now, this has been a good option. However, your supplier has become unreliable and doubled his prices. As a result, you feel that now might be the time to start producing your own glass covers. At the moment, your company produces 200,000 nonstick pans per year. The producer charges you €2 per cover and you estimate the costs of producing your own cover to be €1.50. A new machine will be required to produce the covers, and this costs €150,000 in the market. The machine will last for 10 years, at which point it will have no value. The expansion will require an increase in working capital of €30,000. Your company pays 28 per cent tax, and the appropriate discount rate is 15 per cent. Inflation is expected to be 4 per cent per year for the next 10 years. Assume you use the 20 per cent reducingbalance method for depreciation. Should you undertake this investment? State clearly any additional assumptions you have made in your analysis. Project Analysis and Inflation Dickinson Brothers is considering investing in a machine to produce computer keyboards. The price of the machine will be £400,000, and its economic life is five years. The machine will be depreciated by the reducingbalance method (20 per cent), but will be worthless in five years. The machine will produce 10,000 keyboards each year. The price of each keyboard will be £40 in the first year and will increase by 5 per cent per year. The production cost per keyboard will be £20 in the first year and will increase by 10 per cent per year. The project will have an annual fixed cost of £50,000 and require an immediate investment of £25,000 in net working capital. The corporate tax rate for the company is 28 per cent. If the appropriate discount rate is 15 per cent, what is the NPV of the investment?
p. 200Project Evaluation Aguilera Acoustics (AA) projects unit sales for a new sevenoctave voice emulation implant as follows:
Production of the implants will require €1,500,000 in net working capital to start, and additional net working capital investments each year equal to 15 per cent of the projected sales increase for the following year. Total fixed costs are €900,000 per year, variable production costs are €240 per unit, and the units are priced at €325 each. The equipment needed to begin production has an installed cost of €21,000,000. Because the implants are intended for professional singers, this equipment is considered industrial machinery and is thus depreciated by the reducingbalance method at 20 per cent per annum. In five years, this equipment can be sold for about 20 per cent of its acquisition cost. AA is in the 35 per cent marginal tax bracket and has a required return on all its projects of 18 per cent. Based on these preliminary project estimates, what is the NPV of the project? What is the IRR? Calculating Required Savings A proposed costsaving device has an installed cost of £480,000. The device will be used in a fiveyear project and be depreciated using the reducingbalance method at 20 per cent per annum. The required initial net working capital investment is £40,000, the marginal tax rate is 28 per cent, and the project discount rate is 12 per cent. The device has an estimated year 5 salvage value of £45,000. What level of pretax cost savings do we require for this project to be profitable? Calculating a Bid Price Another utilization of cash flow analysis is setting the bid price on a project. To calculate the bid price, we set the project NPV equal to zero and find the required price. Thus the bid price represents a financial breakeven level for the project. Guthrie Enterprises needs someone to supply it with 150,000 cartons of machine screws per year to support its manufacturing needs over the next five years, and you’ve decided to bid on the contract. It will cost you €780,000 to install the equipment necessary to start production: you’ll depreciate this cost using 20 per cent reducing balances over the project’s life. You estimate that in five years this equipment can be salvaged for €50,000. Your fixed production costs will be €240,000 per year, and your variable production costs should be €8.50 per carton. You also need an initial investment in net working capital of €75,000. If your tax rate is 35 per cent and you require a 16 per cent return on your investment, what bid price should you submit? Financial BreakEven Analysis The technique for calculating a bid price can be extended to many other types of problem. Answer the following questions using the same technique as setting a bid price: that is, set the project NPV to zero and solve for the variable in question. In the previous problem, assume that the price per carton is €13 and find the project NPV. What does your answer tell you about your bid price? What do you know about the number of cartons you can sell and still break even? How about your level of costs? Solve the previous problem again with the price still at €13 – but find the quantity of cartons per year that you can supply and still break even. (Hint: It’s less than 150,000.) Repeat (b) with a price of €13 and a quantity of 150,000 cartons per year, and find the highest level of fixed costs you could afford and still break even. (Hint: It’s more than €240,000.)
p. 201Calculating a Bid Price Your company has been approached to bid on a contract to sell 10,000 voice recognition (VR) computer keyboards a year for four years. Because of technological improvements, beyond that time they will be outdated and no sales will be possible. The equipment necessary for the production will cost £2.4 million and will be depreciated on a reducing balance basis (20 per cent). Production will require an investment in net working capital of £75,000, to be returned at the end of the project, and the equipment can be sold for £200,000 at the end of production. Fixed costs are £500,000 per year, and variable costs are £165 per unit. In addition to the contract, you feel your company can sell 3,000, 6,000, 8,000 and 5,000 additional units to companies in other countries over the next four years, respectively, at a price of £275. This price is fixed. The tax rate is 28 per cent, and the required return is 13 per cent. Additionally, the managing director of the company will undertake the project only if it has an NPV of £100,000. What bid price should you set for the contract? Project Analysis Benson Enterprises is evaluating alternative uses for a threestorey manufacturing and warehousing building that it has purchased for £225,000. The company can continue to rent the building to the present occupants for £12,000 per year. The present occupants have indicated an interest in staying in the building for at least another 15 years. Alternatively, the company could modify the existing structure to use for its own manufacturing and warehousing needs. Benson’s production engineer feels the building could be adapted to handle one of two new product lines. The cost and revenue data for the two product alternatives are as follows:
The building will be used for only 15 years for either product A or product B. After 15 years the building will be too small for efficient production of either product line. At that time, Benson plans to rent the building to firms similar to the current occupants. To rent the building again, Benson will need to restore the building to its present layout. The estimated cash cost of restoring the building if product A has been undertaken is £3,750. If product B has been manufactured, the cash cost will be £28,125. These cash costs can be deducted for tax purposes in the year the expenditures occur. Benson will depreciate the original building shell (purchased for £225,000) over a 30year life to zero, regardless of which alternative it chooses. The building modifications and equipment purchases for either product are estimated to have a 15year life. They will be depreciated by the 20 per cent reducingbalance method. At the end of the project’s life the salvage value of the equipment will be equal to the residual value. The firm’s tax rate is 28 per cent, and its required rate of return on such investments is 12 per cent. For simplicity, assume all cash flows occur at the end of the year. The initial outlays for modifications and equipment will occur today (year 0), and the restoration outlays will occur at the end of year 15. Benson has other profitable ongoing operations that are sufficient to cover any losses. Which use of the building would you recommend to management? Project Analysis and Inflation Genetic Engineering Research Studies Ltd (GERS) has hired you as a consultant to evaluate the NPV of its proposed toad house. GERS plans to breed toads and sell them as ecologically desirable insect control mechanisms. They anticipate that the business will continue into perpetuity. Following the negligible startup costs, GERS expects the following nominal cash flows at the end of the year:
p. 202The company will lease machinery for £20,000 per year. The lease payments start at the end of year 1 and are expressed in nominal terms. Revenues will increase by 5 per cent per year in real terms. Labour costs will increase by 3 per cent per year in real terms. Other costs will decrease by 1 per cent per year in real terms. The rate of inflation is expected to be 6 per cent per year. GERS’s required rate of return is 10 per cent in real terms. The company has a 28 per cent tax rate. All cash flows occur at yearend. What is the NPV of GERS’s proposed toad house today? Project Analysis and Inflation Sony International has an investment opportunity to produce a new 100inch widescreen TV. The required investment on 1 January of this year is $32 million. The firm will depreciate the investment to zero using the straightline method over four years. The investment has no resale value after completion of the project. The firm is in the 34 per cent tax bracket. The price of the product will be $400 per unit, in real terms, and will not change over the life of the project. Labour costs for year 1 will be $15.30 per hour, in real terms, and will increase at 2 per cent per year in real terms. Energy costs for year 1 will be $5.15 per physical unit, in real terms, and will increase at 3 per cent per year in real terms. The inflation rate is 5 per cent per year. Revenues are received and costs are paid at yearend. Refer to the following table for the production schedule:
The real discount rate for Sony is 8 per cent. Calculate the NPV of this project. Project Analysis and Inflation After extensive medical and marketing research, Pill plc believes it can penetrate the pain reliever market. It is considering two alternative products. The first is a medication for headache pain. The second is a pill for headache and arthritis pain. Both products would be introduced at a price of £4 per package in real terms. The headacheonly medication is projected to sell 5 million packages a year, whereas the headache and arthritis remedy would sell 10 million packages a year. Cash costs of production in the first year are expected to be £1.50 per package in real terms for the headacheonly brand. Production costs are expected to be £1.70 in real terms for the headache and arthritis pill. All prices and costs are expected to rise at the general inflation rate of 5 per cent. Either product requires further investment. The headacheonly pill could be produced using equipment costing £10.2 million. That equipment would last three years and have no resale value. The machinery required to produce the broader remedy would cost £12 million and last three years. The firm expects that equipment to have a £1 million resale value (in real terms) at the end of year 3. Pill plc uses reducing balance (20 per cent) depreciation. The firm faces a corporate tax rate of 28 per cent and believes that the appropriate real discount rate is 13 per cent. Which pain reliever should the firm produce? Calculating Project NPV Petracci SpA manufactures fine furniture. The company is deciding whether to introduce a new mahogany dining room table set. The set will sell for €5,600, including a set of eight chairs. The company feels that sales will be 1,300, 1,325, 1,375, 1,450 and 1,320 sets per year for the next five years, respectively. Variable costs will amount to 45 per cent of sales, and fixed costs are €1.7 million per year. The new tables will require inventory amounting to 10 per cent of sales, produced and stockpiled in the year prior to sales. It is believed that the addition of the new table will cause a loss of 200 tables per year of the oak tables the company produces. These tables sell for €4,500 and have variable costs of 40 per cent of sales. The inventory for this oak table is also 10 per cent. Petracci currently has excess production capacity. If the company buys the necessary equipment today, it will cost €10.5 million. However, the excess production capacity means the company can produce the new table without buying the new equipment. The company controller has said that the current excess capacity will end in two years with current production. This means that if the company uses the current excess capacity for the new table, it will be forced to spend the €10.5 million in two years to accommodate the increased sales of its current products. In five years the new equipment will have a market value of €2.8 million if purchased today, and €6.1 million if purchased in two years. The equipment is depreciated using reducing balances at 20 per cent per annum. The company has a tax rate of 38 per cent, and the required return for the project is 14 per cent.
p. 203Should Petracci undertake the new project? Can you perform an IRR analysis on this project? How many IRRs would you expect to find? How would you interpret the profitability index?
