Ross7e ch07

CHAPTER 7 Net Present Value and Capital Budgeting

Chapter Outline ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

7.1 Incremental Cash Flows ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Cash Flows—Not Accounting Earnings ,[object Object],[object Object],[object Object]

Incremental Cash Flows ,[object Object],[object Object],[object Object]

Incremental Cash Flows ,[object Object],[object Object]

Estimating Cash Flows ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Interest Expense ,[object Object],[object Object]

7.2 The Baldwin Company: An Example ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

The Worksheet for Cash Flows of the Baldwin Company ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],* We assume that the ending market value of the capital investment at year 5 is $30,000. Capital gain is the difference between ending market value and adjusted basis of the machine. The adjusted basis is the original purchase price of the machine less depreciation. The capital gain is $24,240 (= $30,000 – $5,760). We will assume the incremental corporate tax for Baldwin on this project is 34 percent. Capital gains are now taxed at the ordinary income rate, so the capital gains tax due is $8,240 [0.34  ($30,000 – $5,760)]. The after-tax salvage value is $30,000 – [0.34  ($30,000 – $5,760)] = 21,760. ($ thousands) (All cash flows occur at the end of the year.)

The Worksheet for Cash Flows of the Baldwin Company ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],($ thousands) (All cash flows occur at the end of the year.) 150 At the end of the project, the warehouse is unencumbered, so we can sell it if we want to.

The Worksheet for Cash Flows of the Baldwin Company (continued) ,[object Object],[object Object],[object Object],($ thousands) (All cash flows occur at the end of the year.) Recall that production (in units) by year during 5-year life of the machine is given by: (5,000, 8,000, 12,000, 10,000, 6,000). Price during first year is $20 and increases 2% per year thereafter. Sales revenue in year 3 = 12,000 ×[$20×(1.02) 2 ] = 12,000 ×$20.81 = $249,720.

The Worksheet for Cash Flows of the Baldwin Company (continued) ,[object Object],[object Object],[object Object],[object Object],($ thousands) (All cash flows occur at the end of the year.) Again, production (in units) by year during 5-year life of the machine is given by: (5,000, 8,000, 12,000, 10,000, 6,000). Production costs during first year (per unit) are $10 and (increase 10% per year thereafter). Production costs in year 2 = 8,000 ×[$10×(1.10) 1 ] = $88,000

The Worksheet for Cash Flows of the Baldwin Company (continued) ,[object Object],[object Object],[object Object],[object Object],[object Object],($ thousands) (All cash flows occur at the end of the year.) Depreciation is calculated using the Accelerated Cost Recovery System (shown at right) Our cost basis is $100,000 Depreciation charge in year 4 = $100,000 ×(.1152) = $11,520. Year ACRS % 1 20.00% 2 32.00% 3 19.20% 4 11.52% 5 11.52% 6 5.76% Total 100.00%

The Worksheet for Cash Flows of the Baldwin Company (continued) ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],($ thousands) (All cash flows occur at the end of the year.)

Incremental After Tax Cash Flows of the Baldwin Company Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 (1) Sales Revenues $100.00 $163.00 $249.72 $212.20 $129.90 (2) Operating costs -50.00 -88.00 -145.20 133.10 -87.84 (3) Taxes -10.20 -14.69 -29.01 -22.98 -10.38 (4) OCF (1) – (2) – (3) 39.80 60.51 75.51 56.12 31.68 (5) Total CF of Investment – 260. – 6.32 – 8.65 3.75 192.98 (6) IATCF [(4) + (5)] – 260. 39.80 54.19 66.86 59.87 224.66 05 . 588 , 51 $ ) 10 . 1 ( 66 . 224 $ ) 10 . 1 ( 87 . 59 $ ) 10 . 1 ( 86 . 66 $ ) 10 . 1 ( 19 . 54 $ ) 10 . 1 ( 80 . 39 $ 260 $ 5 4 3 2         NPV NPV

NPV Baldwin Company 1 39.80 51,588.05 – 260 CF1 F1 CF0 I NPV 10 1 54.19 CF2 F2 1 66.86 CF3 F3 1 59.87 CF4 F4 1 224.66 CF5 F5

7.3 Inflation and Capital Budgeting ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Example of Capital Budgeting under Inflation ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Example of Capital Budgeting under Inflation ,[object Object],[object Object], Year 1 Year 2 Year 3 Year 4 Physical Production (units) 100,000 200,000 200,000 150,000 Labor Input (hours) 2,000,000 2,000,000 2,000,000 2,000,000 Energy input, physical units 200,000 200,000 200,000 200,000

Example of Capital Budgeting under Inflation ,[object Object],[object Object],[object Object],[object Object],CF0 Depreciation tax shield = $8,000,000 × .34 = $2,720,000 4 2,720,000 0 CF1 F1 9,873,315 I NPV 4 $8,000,000 = $32,000,000 4 years

Year 1 After-tax Real Risky Cash Flows ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Example of Capital Budgeting under Inflation $ 5,524,200 $ 31,499,886 $31,066,882 $17,425,007 -$32,000,000 0 1 2 3 4 1 5,524,000 – 32 m CF1 F1 CF0 1 31,499,886 CF2 F2 1 31,066,882 CF3 F3 1 17,425,007 CF4 F4 69,590,868 I NPV 8

Example of Capital Budgeting under Inflation ,[object Object],[object Object]

7.3 The Boeing 777: A Real-World Example ,[object Object],[object Object],[object Object]

Table 7.5 Incremental Cash Flows: Boeing 777 Year Units Sales Revenue Operating Costs Dep. Taxes  NWC Capital Spending Invest-ment Net Cash Flow 1991 $865.00 $40.00 $(307.70) $400.00 $400.00 $(957.30) 1992 1,340.00 96.00 (488.24) 600.00 600.00 (1,451.76) 1993 1,240.00 116.40 (461.18) 300.00 300.00 (1,078.82) 1994 840.00 124.76 (328.02) 200.00 200.00 (711.98) 1995 14 $1,847.55 1,976.69 112.28 (82.08)  1.85 182.91 (229.97) 1996 145 19,418.96 17,865.45 101.06 493.83  19.42 1,741.42 681.74 1997 140 19,244.23 16,550.04 90.95 885.10 (17.12) 19.42 2.30 1,806.79 Net Cash Flow can be determined in three steps: Taxes ($19,244.23 – $16,550.04 – $90.95) ×0.34 = $885.10 Investment –$17.12 + $19.42 = $2.30 NCF $19,244.23 – $16,550.04 – $885.10 – $2.30 = $1,806.79

Year Year Year NCF NCF NCF $ 2,964.45 2024 $ 2,882.44 2023 $ 2,576.47 2012 $ 1,716.80 2001 $ 2,798.77 2022 $ 2,331.33 2011 $ 1,640.25 2000 $ 2,717.53 2021 $ 1,886.96 2010 $ 1,676.05 1999 $ 2,641.01 2020 $ 677.92 2009 $ 1,914.06 1998 $ 2,568.60 2019 $ 1,641.97 2008 $ 1,806.79 1997 $ 2,496.05 2018 $ 2,173.59 2007 $ 681.74 1996 $ 2,423.89 2017 $ 1,484.73 2006 $ (229.97) 1995 $ 2,353.81 2016 $ 616.79 2005 $ (711.98) 1994 $ 2,285.77 2015 $ 1,798.97 2004 $ (1,078.82) 1993 $ 2,104.73 2014 $ 1,590.01 2003 $ (1,451.76) 1992 $ 2,213.18 2013 $ 1,717.26 2002 $ (957.30) 1991

NPV Profile of the Boeing 777 Project ,[object Object],[object Object],IRR = 21.12%

Boeing 777 ,[object Object],[object Object]

7.4 Investments of Unequal Lives: The Equivalent Annual Cost Method ,[object Object],[object Object],[object Object],[object Object],[object Object]

EAC with a Calculator ,[object Object],10 – 100 – 4,614.46 – 4,000 10 5 – 500 – 2,895.39 – 1,000 10 CF1 F1 CF0 I NPV CF1 F1 CF0 I NPV Cadillac Air Cleaner Cheapskate Air Cleaner

7.4 Investments of Unequal Lives: The Equivalent Annual Cost Method ,[object Object],[object Object]

[object Object],7.4 Investments of Unequal Lives: The Equivalent Annual Cost Method The Cheapskate cleaner time line of cash flows over ten years: -$4,000 –100 -100 -100 -100 -100 -100 -100 -100 -100 -100 0 1 2 3 4 5 6 7 8 9 10 -$1,000 –500 -500 -500 -500 -1,500 -500 -500 -500 -500 -500 0 1 2 3 4 5 6 7 8 9 10

The Equivalent Annual Cost Method ,[object Object],10 – 100 – 4,614.46 – 4,000 10 4 – 500 – 4,693 – 1,000 CF1 F1 CF0 I NPV 10 1 – 1,500 CF2 F1 5 – 500 CF3 F1 CF1 F1 CF0 I NPV Cadillac Air Cleaner Cheapskate Air Cleaner

Investments of Unequal Lives ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Investments of Unequal Lives: EAC ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Cadillac EAC with a Calculator ,[object Object],[object Object],10 – 100 – 4,614.46 – 4,000 10 750.98 10 – 4,614.46 10 CF1 F1 CF0 I NPV PMT I/Y FV PV N PV

Cheapskate EAC with a Calculator ,[object Object],[object Object],5 – 500 – 4,693.21 – 1,000 10 763.80 10 – 4,693.21 10 CF1 F1 CF0 I NPV PMT I/Y FV PV N PV

Example of Replacement Projects ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Example of Replacement Projects ,[object Object],[object Object],[object Object],[object Object],[object Object],Note that the total cost of keeping an autoclave for the first year includes the $200 maintenance cost as well as the opportunity cost of the foregone future value of the $900 we didn’t get from selling it in year 0 less the $850 we have if we still own it at year 1. Total Cost for year 1 = (900 × 1.10 – 850) + 200 = $340 340 435 Total Cost for year 2 = (850 × 1.10 – 775) + 275 = $435 478 Total Cost for year 3 = (775 × 1.10 – 700) + 325 = $478 620 Total Cost for year 4 = (700 × 1.10 – 600) + 450 = $620 Total Cost for year 5 = (600 × 1.10 – 500) + 500 = $660 660

Example of Replacement Projects ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],340 435 478 620 660 ,[object Object],[object Object]

7.5 Summary and Conclusions ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Dorm Beds Example ,[object Object],[object Object],[object Object]

Dorm Beds Example ,[object Object],[object Object],[object Object],[object Object]

Dorm Beds Example OCF 0 ,[object Object],[object Object],[object Object],[object Object]

Dorm Beds Example OCF 1,2 ,[object Object],Revenue 10,000 × $200 = $2,000,000 Variable cost 10,000 × $90 = $900,000 Fixed cost $25,000 Depreciation $60,000 ÷ 3 = $20,000 EBIT $1,055,000 Tax (34%) $358,700 Net Income $696,300 OCF = $696,300 + $20,000 $716,300 OCF = $2,000,000 – 925,000 – 358,700 = $716,300 ($2,000,000 – 925,000) ×(1 – .34)+20,000×.34 = $716,300

Dorm Beds Example OCF 3 We get our $10,000 NWC back and sell the equipment. The after-tax salvage value is $6,600 = $10,000 × (1-.34) Thus, OCF 3 = $716,300 + $10,000 + $6,600 = $732,900 Revenue 10,000 × $200 = $2,000,000 Variable cost 10,000 × $90 = $900,000 Fixed cost $25,000 Depreciation $60,000 ÷ 3 = $20,000 EBIT 10,000 × $200 = $1,055,000 Tax $358,700 NI $696,300 OCF = NI + D $716,300

Dorm Beds Example NPV ,[object Object],[object Object],CF2 CF1 F2 F1 CF0 2 $716,300 1 $1,749,552.19 – $109,600 $732,900 I NPV 8

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