FINA 3000: TEST 3. LECTURE 3 PROBLEM DAY FOR CASH FLOWS: what changes if we say yes? Example 1: Project Valuation • Suppose a steel company is thinking of adding a new blast furnace to its operations. You have just completed a $1 million feasibility study and have found the following: $1 million is sunk cost • Adding the blast furnace will result in $50 million in new sales each year and will save $100 million per year in expenses. However, the furnace will cost $10 million per year to operate. Sales = +50 ; expenses = 100 + 10 = 90 • Suppose the furnace costs $1,000 million and uses some parts from a (fully depreciated) retired furnace that could be sold for $30 million if the parts were not used for the new furnace. The new furnace will last 10 years and has a salvage value of $200 million. The project will require $20 million of working capital over its 10year life. 1,000 million = ∆gross PPE ; Could be sold = opportunity cost 10 years = useful life 200 million = TCF 20 million = initial NWC = ∆NWC0 = 20 • The firm uses straightline depreciation for tax purposes and pays 40% in corporate income taxes. • Assume the cost of capital is 10%. Yr 0: ∆gross PPE = blast furnace = 1,000 ∆NWC = initial investment = 20 Opportunity costs = NSV of furnace parts NSV MV = 30 BV = 0 (fully depreciated) NSV = MV – taxes Taxes = T x (MV – BV) =0.40 x (30 – 0) = 12 million NSV = 30 – 12 = 18 million (needs to do better than 18 million) FCF0 = (0 – 0 – 0) x (1 – 0.40) + 0 – 20 – 1,000 – 18=1,038 million Yr 1: Sales = +50 Expenses = 90 D = basis / useful life = 1,000 / 10 years = $100/yr ∆NWC = 0 ∆gross PPE = 0 Side effects = 0 (not mentioned) FCF1 = (50 90 – 100) x (1.40) + 100 – 0 – 0 +0 FCF1 = $124 million Sales, expenses, depreciation : same for years 19 Years 19 are the same Yr. 10: FCF10 = 124 + TCF10 (cash flow you get when the project is over) TCF = NSV of blast furnace + recovered NWC NSV of blast furnace MV = salvage = 200 BV = basis – all depreciation = 1,000 – 10 x 100 = $0 Taxes = 0.40 x (200 – 0) = 80 million NSV = MV – taxes 200 – 80 = $120 million TCF = 120 + 20 = $140 million FCF10 = 124 + 140 = $264 million Solve for NPV: CF0 = 1038 C01 = 124 F01 = 9 C02 = 264 I = 10 NPV = $222.10 million IRR = 5.10% reject since NPV < 0 and IRR < r (10%)Replacement problem: Example 2: Nguyen, Inc. is considering the purchase of a new computer system for $130,000. The system will require an additional $30,000 for installation. If the new computer is purchased it will replace an old system that has been fully depreciated. The new system will be depreciated over a period of 10 years using straightline depreciation. If the new computer is purchased, the old system will be sold for $20,000. The new computer has a useful life of 10 years and will increase revenues by $32,000 per year over its useful life. Operating costs are expected to decrease by $2,000 per year over the life of the system. The firm is taxed at a 40 percent marginal rate. *what changes if we replace the old computer?* a. What net investment is required to acquire the new computer system and replace the old system? b. Compute the annual net cash flows associated with the purchase of the new system. Yr. 0: New computer cost = $130,000 Installation and Delivery (assumed) = $30,000 Total = $160,000 = depreciable basis ∆gross PPE = depreciable basis = $160,000 ∆NWC = $0 (not mentioned, no change) Opportunity cost = $0 if we say yes: if we need to use old equipment: opportunity cost sell old equipment: replacement FCF = (s – e – d) x (1 – T) + D ∆NWC ∆gross PPE – PV of opportunity cost + NSV of replaced asset need NSV of old computer: MV = 20,000BV = 0 (fully depreciated) NSV = MV – taxes Taxes = T x (MV – BV) =0.40 x (20,000) =8,000 NSV = 20,000 – 8,000 =12,000 FCF0 = (0 – 0 – 0) x (1 .40) + 0 – 0 – 160,000 – 0 +12,000 = $148,000 Yr. 1: (looking at changes new computer will make) S = 32,000 E = 2,000 D = Dnew computer – Dold computer Dnew comp = basis / useful life = 160,000/10 = 16,000/year Dold = 0 D = 16,000 – 0 = 16,000 ∆NWC = 0 ∆gross PPE = 0 Side effect = 0 FCF1 = (32,000 2,000 – 16,000) x (1 .40) + 16,000 – 0 – 0 +/ 0 = $26,800 Process: 1. Find FCF’s for life of new computer 2. Calculate NPV 3. If NPV > or = $0 ; replace old computer Side effect problem: Example 3: You are the owner of a small hardware store, and you are considering opening a gardening shop in a vacant area in the back of the store. You estimate that it will cost you $50,000 to set up the store and that you will generate $10,000 in aftertax cash flows for the life of the store (which is expected to be 10 years.) The one concern you have is that you have limited parking; by opening the garden shop you run the risk of not having enough parking for customers who shop at your hardware store. You estimate that the lost sales would amount to $3,000 per year and that your aftertax operating margin on sales at the hardware store is 40%. If your discount rate is 14%, would you open the gardening shop? Project synergy: This is the increase in cash flows that accrue to other projects, as a consequence of the project under consideration. FCF0 = $50,000 FCF110 = $10,000 (after tax) +/ cashflow from side effects Cash flow side effects = ∆sales x aftertax operating margin = $3,000 x 40% = $1,200/ year FCF110 = 10,000 – 1,200 =$8,800 Solve with CF: CF0= 5,000 C01 = 8,800 F01 = 10 I = 14 NPV = $4,098.18 : do not add garden shopEXAMPLE PROBLEM: Hillerich and Bradsby (maker of Louisville Slugger bats) considers the following project. The firm will have to immediately purchase new equipment for a cost of $200,000 (∆gross PPE). The equipment will be depreciated using a 3year MACRS schedule (accelerated depreciation, % each time). The equipment will be used to manufacture a new wood bat for amateur baseball. The firm will run the project for four years. At the end of four years, the equipment can be sold for $12,000. The project also requires use of an old lathe that has a current NSV of $25,000 (TCF). Hillerich and Bradsby could otherwise sell this equipment if the project is rejected. The lathe has been completely depreciated. During the life of the project, an economic consultant estimated the following:
1
2
3
4
price
12
15
15
15
sold
40,000
50,000
50,000
50,000
expenses
288000
450000
450000
450000
What net investment is required to acquire the new computer system and replace the old system?

*what changes if we replace the old computer?

PROBLEM DAY FOR CASH FLOWS: what changes if we say yes?

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The new bat is expected to decrease the net cash flow of other Louisville bat products by $50,000 per year (side effect). NWC for each year will take on the following: AR (accounts receivable) will be 10% of total sales, INV (inventory) will be 5% of total sales, and AP (accounts payable) will be 4% of total sales. Find all the cash flows for this project. Yr. 0: ∆gross PPE = 200,000 (also depreciable basis) ∆NWC = 0 (not mentioned) Opportunity cost = old lathe = 25,000 No more because side effects don’t start until year 1 FCF0 = (0 – 0 – 0) x (1 .40 (assumed)) + 0 – 0 – 200,000 – 25,000 Subtract opportunity cost because you have to keep this item if saying yes to project FCF0 = $225,000Yr. 1: Sales = unit price x units sold = 12 x 40,000 = 480,000 Expenses: 288,000 Depreciation IRS schedule Dt = allowed percentage for that year x depreciable basis 3 years MACRS mid year schedule, percentages given, 3 + 1 years or 4 years of depreciation D1 = 33.33% x 200,000 = 66,660 D2 = 44.45% x 200,000 = 88,900 ∆NWC1 = NWC1 – NWC0 NWC1 = current assets – current liabilites = (accounts receivable + inventory) – (accounts payable) NWC1 = 10$ of sales + 5% of sales – 4% of sales = 11% of sales = 11% x 480,000 = 52,800 ∆NWC1 = NWC1 – NWC0 = 52,800 – 0 = 52,800 ∆gross PPE = 0 Side effects = 50,000 FCF1 = (480,000 – 288,000 – 66,660) x (1 .40) + 66,660 – 52,800 – 0 – 50,000 = $39,064 Current Event: 3/23 ∙ watch market index over next week o Congress: “repeal & replace” the ACA “Obamacare” o Today: vote on initial plan ∙ Market is watching the results as a signal of future Trump legislation ∙ Dominoes: 1. health care act 2. tax return 3. bank deregulation 4. infrastructure ∙ tax return and bank regulation have caused the market to go up by about 1213% since the election, appealing to wall street ∙ if health care fails, this will make investors see greater risk in the future legislation o greater risk/uncertainty = less price EXAMPLE 5: Bookscape Books is considering adding a café to its bookstore. The café, it is hoped, will make the bookstore a more attractive destination for wouldbeshoppers. The following information relates to the proposed café: The initial cost of remodeling a portion of the store to make it a café and of buying equipment is expected to be $150,000. This investment is expected to have a life of five years, during which period it will be depreciated using straightline depreciation. Non e of the cost is expected to be recoverable at the end of the five years. The revenues in the first year are expected to be $60,000, growing at 10% a year for the next four years. There will be one employee, and the total cost for this employee in year 1 is expected to be $30,000, growing at 5% per year for the next four years. The cost of the material (food, drinks) needed to run the café is expected to be 40% of revenues in each of the five years. An inventory amounting to 5% of the revenues has to be maintained. Investments in the inventory are made at the beginning of each year. The tax rate for Bookscape as a business is 42%. The NWC at the end of year 5 is completely recoverable. The cost of capital is 11.75%.What is the NPV of the project as a stand alone project? Now, consider this possibility: Assume that the café will increase revenues at the bookstore by $500,000 in year 1, growing at 10% a year for the following four years. In addition, assume that the pretax operating margin on these sales is 10%. Incorporate the cash flows into your analysis and reevalute.