Fin 3322: Cashman
Investment Decisions
My Big Example 2
1 Your R&D department has come up with a innovative product. Your firm had
spent $2m as R&D expenses for this project. You are now wondering whether this
product introduction will increase shareholder wealth?
 Investment of $6.0m is required immediately and another $4.0m is required at the
end of year 1. The factory can start manufacturing only after this second
investment is made.
 Assume all assets have a life of 5 years, and depreciation starts after
manufacturing begins.
 You expect to sell 1m units in the first year of production, 1.5m units in the next
four years. You plan to sell the factory after that and you expect it to fetch $1m.
 Selling price is expected to be $10/unit in the first year of goods sold and is
expected to increase at 5% p.a. Cost of goods sold is $6/unit in the first year of
production and is expected to increase at 4% p.a.
 Assume the level of net working capital to be $1.0m in the first year of
production. Afterwards, it will increase by $1.0m each year. In the last year, the
firm will be able to liquidate its entire NWC without loss in value.
 Assume corporate income tax rate to be 35% and capital gains tax rate of 20%.
 This project requires a discount rate of 10%.
Yr 0
Investment
-R&D
- Equipment
Net Working Capital
Profit-Loss Account
Quantity
Selling Price growth (%)
Selling Price - $/unit
Sales ($m)
COGS growth (%)
COGS - $/unit
COGS ($m)
EBDT ($m)
Book Depreciation ($m)
EBT ($m)
Tax ($m)
Net Income ($m)
Corporate Tax Calculation
Tax Depreciation (%)
Tax Depreciation ($m)
EBT (for tax purpose)
Corporate Tax ($m)
Capital Gains Tax Calculation
Proceeds from sale of assets
Book Value of Assets ($m)
Profit on sale of asset
Capital Gains Tax
Summary of Cash Flows
Investment
Change in Net Working Capital
Net Income
Book Depreciation
Proceeds from sale of assets
Capital Gains Tax
Net Cash Flow
NPV
0.00
6.00
Yr 1
Yr 2
Yr 3
Yr 4
Yr 5
Yr 6
0.00
10.00
1.00
2.00
3.00
4.00
0.00
1.00
1.50
5%
10.50
15.75
4%
6.24
9.36
6.39
1.80
4.59
1.12
3.47
1.50
5%
11.03
16.54
4%
6.49
9.73
6.80
1.80
5.00
1.71
3.29
1.50
5%
11.58
17.36
4%
6.75
10.12
7.24
1.80
5.44
2.13
3.31
1.50
5%
12.16
18.23
4%
7.02
10.53
7.70
1.80
5.90
2.29
3.61
10.00
10.00
6.00
6.00
4.00
1.80
2.20
0.70
1.50
20.0% 32.0% 19.2% 11.52% 11.52%
2.00
3.20
1.92
1.15
1.15
2.00
3.19
4.88
6.09
6.55
0.70
1.12
1.71
2.13
2.29
6.00
10.00
1.00
0.58
0.42
0.08
8.00
4.80
2.88
1.73
(1.00)
1.50
1.80
(1.00)
3.47
1.80
(1.00)
3.29
1.80
(1.00)
3.31
1.80
4.00
3.61
1.80
1.00
(0.08)
2.30
4.27
4.09
4.11
10.33
(6.00) (4.00)
(6.00) (4.00)
6.65
2.
A project is expected to create operating cash flows of $22,500 a year for three
years. The initial cost of the fixed assets is $50,000. These assets will be
worthless at the end of the project. An additional $3,000 of net working capital
will be required throughout the life of the project. What is the project’s net
present value if the required rate of return is 10%?
Time
CF
Change in Net
Working Cap
PV
SUM
3.
0
-50,000
1
22,500
2
22,500
3
22,500
-3,000.00
-53,000.00
20,454.55
18,595.04
3,000.00
19,158.53
5,208.11
Walks Softly, Inc. sells customized shoes. Currently, it sells 10,000 pairs of shoes
annually at an average price of $68 a pair. It is considering adding a lowerpriced line of shoes which sell for $49 a pair. Walks Softly estimates it can sell
5,000 pairs of the lower-priced shoes but will sell 1,000 less pairs of the higherpriced shoes by doing so. What is the amount of the sales that should be used
when evaluating the addition of the lower-priced shoes?
The new line will generate gross sales of 49 * 5,000 = $245,000
But the new line will lower sales of the higher end line by 68 * 1,000 = $68,000
The amount sales to consider when considering the lower-priced shoes is:
$245,000 - $68,000 = $177,000
4
Two machines, A and B, which perform the same functions, have the following
costs and lives.
Type
Machine A
Machine B
PV Costs
Life
$6000
5
$8000
7
Which machine would you choose? The two machines are mutually exclusive
and the cost of capital is 15%.
Machine A
N
5
I/Y
15%
PV
$6,000
PMT
?
FV
0
Machine B
7
15%
$8,000
?
0
EAC
$1,922.88
$1,789.89
Chose Machine A
5. Ernie’s Electrical is evaluating a project which will increase sales by $50,000 and
costs by $30,000. The project will cost $150,000 and be depreciated straight-line
to a zero book value over the 10 year life of the project. The applicable tax rate is
34%. What is the operating cash flow for this project?
Depreciation per year = 150,000/10 = 15,000
(Sales – Costs – Depreciation) * (1-tax) + Dep = OCP
(50,000 – 30,000 - 15,000) * (1-0.34) + 15,000 = $18,300
6.
Your factory must buy one of the following two machines to produce bowling
balls. The Abfab machine will cost $40,000 and produce net cash flows of
$10,000 per year for the next 3 years. The BetterBall machine will cost $50,000
and produce net cash flows of $8,000 per year for the next 4 years. Assume that
whichever machine is purchased, you will replace it with an identical machine
going forward.
Which machine should you choose, and why? The appropriate discount rate is
6%.
First find NPV
Abfab
N
I/Y
PV
PMT
FV
3
6%
?
10,000
0
BetterBall
4
6%
?
8,000
0
PV
26,730.12
27,720.84
NPV
-13,270
-22,279
Abfab
N
I/Y
PV
PMT
FV
3
6%
-13,270
?
0
BetterBall
4
6%
-22,279
?
0
PMT
4,964
Find EAC
6,429
Accept Abfab it has the lower EAC – smallest reduction to firm value
7. Sean Co has decided to enter the mask making business. Sean Co can either
purchase the Halloween 5000, or the Mardi Gras Madness. Both machines can
produce 1,000,000 masks a year, which can be sold at $25 per mask. The
Halloween 5000 costs $150,000, will last for 5 years, and requires $95,000 to
operate per year. The Mardi Gras Madness costs $75,000, will last 3 years,
and requires $65,000 to operate per year. Which machine should Sean Co
purchase? The discount rate is 9%.
PV of Op Halloween 5000
N= 5, I/Y= 9, PV= ?, PMT= 95,000, FV=0:
PV=369,516.87
Total PV = 150,000 + 369,516.87 = 519,516.87
EAC of Halloween 5000
N= 5, I/Y= 9, PV= 519,516.87, PMT= ???, FV=0: PMT=133,563.87
PV of Op Mardi Gras Madness
N=3, I/Y=9, PV= ???, PMT=65,000, FV=0::
PV = 164,534.15
Total PV = 75,000 + 164,534.15 = 239,534.15
EAC of Halloween 5000
N=3, I/Y=9, PV= 239,534.15, PMT=???, FV=0:: PMT= 94,629.11
Buy the Mardi Gras Madness, it has a lower EAC