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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12-2
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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12-3
Principles Used in This Chapter
• Principle 3: Cash Flows Are the Source of
Value.
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12-4
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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12-6
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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12-7
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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12-8
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 firm’s 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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12-9
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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12-10
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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12-11
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 project’s
cash flows. Including it will lead to double
counting.
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12-12
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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12-14
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12-15
Dealing with Depreciation Expense,
Taxes and Cash Flow
• Depreciation expenses is subtracted while
calculating the firm’s 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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12-16
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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12-17
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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12-18
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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12-19
Four Step Procedure for Calculating
Project Cash Flows
1. Estimating a project’s operating cash
flows
2. Calculating a project’s working capital
requirements
3. Calculating a project’s capital expenditure
requirements
4. Calculating a project’s free cash flow.
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Four Step Procedure for Calculating
Project Cash Flows (cont.)
Step 1: Estimating a project’s operating cash
flows
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12-21
Checkpoint 12.1
Forecasting a Project’s 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 project’s 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 firm’s 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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12-22
Checkpoint 12.1
Forecasting a Project’s 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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12-23
Checkpoint 12.1
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12-24
Checkpoint 12.1
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12-25
Checkpoint 12.1
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12-26
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
firm’s management wants to know the impact of a
decrease in expected revenues from $360,000 to
$240,000 per year. What would be the project’s
operating cash flow under the revised revenue
estimate?
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12-27
Step 1: Picture the Problem
0
Years
Cash flow
1
OCF1
2
3
OCF2
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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12-28
Step 1: Picture the Problem (cont.)
• This is the information given to us:
Equipment
$2,00,000
Project life
5 years
Salvage Value
-
Depreciation expense
$40,000 per year
Cash Operating Expenses
-$5,000 per year
Revenues
Growth rate for revenues
$240,000 per year
0%
Cost of goods sold/Revenues
60%
Investment in Net operating
working capital
-$78,000
Required rate of return
20%
Tax rate
30%
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12-29
Step 2: Decide on a Solution
Strategy
• We can calculate the operating cash flows
using equation 12-3.
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12-30
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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12-31
Step 3: Solve (cont.)
Year 1-5
Project Revenues (growth rate =0%)
$240,000
- Cost of goods sold (60% of revenues)
-144,000
= Gross Profit
$96,000
- Cash operating expense
-$5,000
- Depreciation
-$40,000
= Net operating income
$51,000
- Taxes (30%)
-$15,300
=Net Operating Profit after Taxes
(NOPAT)
$35,700
+ Depreciation
$40,000
= Operating Cash Flows
$75,700
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12-32
Step 4: Analyze
• This project contributes $35,700 to the
firm’s 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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12-33
Four Step Procedure for Calculating
Project Cash Flows (cont.)
• Step 2: Calculating a Project’s 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 firm’s investment in inventories.
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12-34
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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12-35
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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12-36
Four Step Procedure for Calculating
Project Cash Flows (cont.)
• Step 3: Calculating a Project’s 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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12-37
Four Step Procedure for Calculating
Project Cash Flows (cont.)
• Step 4: Calculating a Project’s Free Cash
Flow
– Project’s free cash flow is calculated by using
equation 12-3
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12-38
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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12-40
Computing Project NPV (cont.)
Year 1-5
Project Revenues (growth rate =0%)
$240,000
- Cost of goods sold (60% of revenues)
-144,000
= Gross Profit
$96,000
- Cash operating expense
-$5,000
- Depreciation
-$40,000
= Net operating income
$51,000
- Taxes (30%)
-$15,300
=Net Operating Profit after Taxes
(NOPAT)
$35,700
+ Depreciation
$40,000
= Operating Cash Flows
$75,700
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12-41
Computing Project NPV (cont.)
Year 0
Year 1-4
Year 5
-
$75,700
$75,700
-$200,000
-
-
-$70,000
-
$70,000
-$270,000
$75,700
$145,700
Operating Cash flow
Less: Capital
expenditure
Less: additional net
working capital
Free Cash Flow
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12-42
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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12-43
Computing Project NPV (cont.)
• Using Spreadsheet
• NPV = -$270,000 +
npv(.15,75700,75700,75700,75700,145700)
• = $18,560.51
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12-44
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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12-46
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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12-47
12.4 Replacement
Project Cash
Flows
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Replacement Project Cash Flows
• An expansion project increases the
scope of firm’s operations, but does not
replace any existing assets or operations.
• A replacement project replaces an older,
less productive asset.
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12-49
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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12-50
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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12-51
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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12-52
Replacement Project Cash Flows
(cont.)
• There are three possible scenarios when an old asset is
sold:
Selling Price of old
asset
Tax Implications
At depreciated value
No taxes
Higher than depreciated
value (or book value)
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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12-53
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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12-54
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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12-55
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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12-56
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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12-57
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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12-58
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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12-59
Checkpoint 12.2
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Checkpoint 12.2
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Checkpoint 12.2
Step 3 cont.
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12-62
Checkpoint 12.2
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12-63
Checkpoint 12.2
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12-64
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 it’s
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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12-65
The Problem (cont.)
New Machine
Old Machine
Annual cost of defects
$20,000
$70,000
Net operating income
$600,000
$580,000
Book value of equipment
$350,000
$100,000
Salvage value (today)
N/A
$150,000
Salvage value (year 5)
$50,000
-
Shipping cost
$20,000
N/A
Installation cost
$30,000
N/A
Remaining project life (years)
5
5
Net operating working capital
$80,000
$60,000
$100,000
$200,000
Fringe Benefits
$10,000
$20,000
Maintenance
$60,000
$20,000
Salaries
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12-66
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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12-67
Step 1: Picture the Problem (cont.)
Years
0
Cash flows(New)
CF(N)0
1
2
3
4
CF(N)1
CF(N)2
CF(N)3
CF(N)4
5
CF(N)5
MINUS
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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12-68
Step 1: Picture the Problem (cont.)
• The decision to replace will be based on
the replacement cash flows.
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12-69
Step 2: Decide on a Solution
Strategy
• The cash flows will be calculated using
equation 12-3.
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12-70
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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12-71
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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12-72
Step 3: Solve (cont.)
Year 0
New Machine
Purchase price
-$350,000
Shipping cost
-$20,000
Installation cost
-$30,000
Working Capital
-$20,000
Total cost of New
-$420,000
Sale Price
Less: Tax on gain
Old Machine
$150,000
$50,000*.3
0
-$15,000
Net cash flow
Replacement Net
Cash Flow
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$135,000
-$285,000
12-73
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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12-74
Step 3: Solve (cont.)
Analysis of Annual
Cash Inflows
Years 1-4
Year 5
Increase in operating income
$20,000
$20,000
Reduced salaries
$100,000
$100,000
Reduced defects
$50,000
$50,000
Reduced fringe benefits
$10,000
$10,000
$180,000
$180,000
Total cash inflows
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12-75
Step 3: Solve (cont.)
Analysis of Annual
Cash Out Flows
Years 1-4
Years 5
Increased maintenance
-$40,000
-$40,000
Increased depreciation
-$50,000
-$50,000
Net operating income
$90,000
$90,000
Less: Taxes
-$27,000
-$27,000
Net operating profit after taxes
$63,000
$63,000
Plus: depreciation
$50,000
$50,000
$113,000
$113,000
Operating cash flow
Less: Change in operating
working capital
$20,000
Less: CAPEX
50,0000
Free Cash Flows
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$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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12-77
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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12-78
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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