Project Free Cash Flows = NOPAT + Depreciation Gross Investment in Fixed Operating Assets Investment in Operating Working Capital

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Kristian Farmer
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1 Project Free Cash Flows = NOPAT + Depreciation Gross Investment in Fixed Operating Assets Investment in Operating Working Capital = EBIT (1 t) + Depreciation Gross Investment in Fixed Operating Assets ( Operating Current Assets Operating Current Liabilities)

2 Shipping and Installation Noncash Items Interest Expense Sunk Costs Opportunity Costs Externalities (product cannibalization)

3 Straight line MACRS You purchase a machine for $20,000, which has a depreciable life of 5 years. What is the annual depreciation expense? If you sell the machine at the end of the year 4 for $5,000, what is the after tax salvage value if the firm s tax rate is 40 percent?

4 Half year convention Table 13A 2

5 Asset Class Year 3 Year 5 Year % 20.00% % 32.00% % 19.20% % 11.52% % % You purchase a machine for $80,000, which is in the 3 year asset class. The machine costs an additional $20,000 in delivery and installation. Create a depreciation schedule.

6 If you sell the machine at the end of year 3 for $5,000, what is the after tax salvage value if the firm s tax rate is 40 percent? Bridgewell Industries is evaluating the option of purchasing a fork-lift truck costing $60,000. If purchased, the truck will replace 4 workers, each with an average annual salary of $15,000. However, an experienced fork-lift operator will have to be hired at a salary of $20,000 per year. Fuel and maintenance expense is expected to be $10,000 per year. At the end of its 5-year life, the truck will have a market value of $10,000. Bridgewell uses straight-line depreciation and depreciates the asset to $0, assigns a 10% required rate of return for this type of investment, and has a marginal tax rate of 40%. Should the fork-lift truck be purchased?

7 Your firm, MulletMan, Inc., is considering a project that will last 4 years and produce annual sales of 1,250 units at a price of $200 per unit. The cost to produce each unit is $100. Assume that price and cost increase at 3 percent per year after the first year. The firm requires net operating working capital to be 12 percent of next year s sales and has a 40 percent marginal tax rate. The project requires machinery costing $200,000, plus an additional $10,000 for shipping and $30,000 for installation. It is in the MACRS 3 year asset class and is expected to have a $25,000 salvage value at the end of the project. Projects of this risk have a 10 percent cost of capital. In addition, the firm spent $100,000 last year to improve the production line site. Should we invest?

8 Sensitivity Analysis Scenario Analysis Simulation Analysis Phased Decisions

9 What happens to NPV if our assumptions are off? For a particular input, evaluate a base case and then deviations from the base case. Change From Resulting NPV (000s) Base level Rate Unit sales Salvage -30% $113 $17 $85-15% $100 $52 $86 0% $88 $88 $88 15% $76 $124 $90 30% $65 $159 $91

10 NPV (000s) 88 Unit Sales Salvage Rate Base (%) Incorporates the probability of changes in our inputs Allows more than one to be changed at a time

Scenario Probability NPV(000) Best 0.25 $279 Base 0.50 $88 Worst 0.25 -$49 E(NPV) = $101.5 σ(npv) = 116.6 CV(NPV) = σ(npv)/e(npv) = 1.

11 Scenario Probability NPV(000) Best 0.25 $279 Base 0.50 $88 Worst $49 E(NPV) = $101.5 σ(npv) = CV(NPV) = σ(npv)/e(npv) = 1.15 Specify a distribution for each component (mean, standard deviation) Start with random values Compute NPV (or IRR) Repeat and create distribution

12 Normal distribution for unit sales: Mean = 1,250 Standard deviation = 200 Normal distribution for unit price: Mean = $200 Standard deviation = $30 Units Price NPV Mean 1,252 $200 $88,808 Std. Deviation 199 $30 $82,519 Maximum 1,927 $294 $475,145 Minimum 454 $94 ($166,208) Median 685 $163 $84,551 Prob NPV > % CV 0.93

13 Probability of NPV 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% NPV ($475,145) ($339,389) ($203,634) ($67,878) $67,878 $203,634 $339,389 $475,145 Create a decision tree Re evaluate project at key points Proceed or end project?

14 Your firm is considering the introduction of a new product. The marketing department has estimated that 100,000 units will be sold next year for $50 per unit. Unit sales are expected to increase at 6 percent for each of the four subsequent years and the price is expected to increase at the rate of inflation, 3 percent. Costs are estimated to be 25 percent of sales. Production equipment of $9 million is needed. For simplicity, assume no changes in net operating working capital and no depreciation or salvage value. The firm s marginal tax rate is 40 percent. If the firm s nominal required rate of return for a project of this risk is 13.3 percent, should your firm move forward with the product? Use a nominal discount rate with nominal cash flows Use a real discount rate with real cash flows (1+r n ) = (1+r r ) x (1+i) r n = r r + i+ (r r x i)

15 The Moore Equipment Company purchased a machine 5 years ago at a cost of $90,000. It had an expected life of 10 years at the time of purchase and an expected salvage value of $10,000 at the end of 10 years. It is being depreciated by the straight line method to zero, or by $9,000 per year. A new machine can be purchased for $150,000, including installation costs. Over its 5 year life, it will reduce cash operating expenses by $50,000 per year. Sales are not expected to change. At the end of its useful life, the machine is estimated to be worthless. MACRS depreciation will be used, and it will be depreciated over a 3 year recovery period rather than its 5 year economic life. The old machine can be sold today for $65,000. The firm s tax rate is 34 percent. The appropriate discount rate is 15 percent. Should the Moore Equipment Company purchase the new machine now?

17 Questions: 13 3 through 13 7 Problems: 13 1 through 13 8 and 13 11

CHAPTER 11. Topics. Cash Flow Estimation and Risk Analysis. Estimating cash flows: Relevant cash flows Working capital treatment

CHAPTER 11. Topics. Cash Flow Estimation and Risk Analysis. Estimating cash flows: Relevant cash flows Working capital treatment CHAPTER 11 Cash Flow Estimation and Risk Analysis 1 Topics Estimating cash flows: Relevant cash flows Working capital treatment Risk analysis: Sensitivity analysis Scenario analysis Simulation analysis