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Chapter 06 - Making Capital Investment Decisions
In year 2, the company will have a cash outflow to pay for the cost of the new equipment. Since the equipment will be purchased in two years rather than now, the equipment will have a higher salvage value. The book value of the equipment in five years will be the initial cost, minus the accumulated depreciation, or:
Book value = $18,000,000 – 2,572,200 – 4,408,200 – 3,148,200 Book value = $7,871,400
The taxes on the salvage value will be:
Taxes on salvage = ($7,871,400 – 7,400,000)(.40) Taxes on salvage = $188,560
So, the aftertax salvage value of the equipment in five years will be:
Sell equipment Taxes
Salvage value
$7,400,000 188,560 $7,588,560
Next, we need to calculate the variable costs each year. The variable costs of the lost sales are included as a variable cost savings, so the variable costs will be: New
Lost sales Variable costs
Year 1 $4,941,000 –450,000 $4,491,000
Year 2 $5,352,750 –450,000 $4,902,750
Year 3 $6,862,500 –450,000 $6,412,500
Year 4 $6,450,750 –450,000 $6,000,750
Year 5 $5,764,500 –450,000 $5,314,500
Now we can prepare the rest of the pro forma income statements for each year. The project will have no incremental depreciation for the first two years as the equipment is not purchased for two years. Adding back depreciation to net income to calculate the operating cash flow, we get:
Sales VC
Fixed costs Dep. EBT Tax NI +Dep. OCF
Year 1 $9,855,000 4,491,000 1,900,000
0
$3,464,000 1,385,600 $2,078,400
0
$2,078,400
Year 2 $10,770,000 4,902,750 1,900,000
0
$3,967,250 1,586,900 $2,380,350
0
$2,380,350
Year 3 $14,125,000 6,412,500 1,900,000 2,572,200 $3,240,300 1,296,120 $1,944,180 2,572,200 $4,516,380
Year 4 $13,210,000 6,000,750 1,900,000 4,408,200 $901,050 360,420 $540,630 4,408,200 $4,948,830
Year 5 $11,685,000 5,314,500 1,900,000 3,148,200 $1,322,300 528,920 $793,380 3,148,200 $3,941,580
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? 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Chapter 06 - Making Capital Investment Decisions
Next, we need to account for the changes in inventory each year. The inventory is a percentage of sales. The way we will calculate the change in inventory is the beginning of period inventory minus the end of period inventory. The sign of this calculation will tell us whether the inventory change is a cash inflow, or a cash outflow. The inventory each year, and the inventory change, will be:
Beginning Ending Change
Year 1 $1,098,000 1,189,500 –$91,500
Year 2 $1,189,500 1,525,000 –$335,500
Year 3 $1,525,000 1,433,500 $91,500
Year 4 $1,433,500 1,281,000 $152,500
Year 5 $1,281,000
0
$1,281,000
Notice that we recover the remaining inventory at the end of the project. The total cash flows for the project will be the sum of the operating cash flow, the capital spending, and the inventory cash flows, so: OCF
Equipment Inventory Total
Year 1 Year 2 $2,078,400 $2,380,350
0 –18,000,000 –91,500 –335,500 $1,986,900 –$15,955,150
Year 3 $4,516,380
0 91,500 $4,607,880
Year 4 $4,948,830
0 152,500 $5,101,330
Year 5 $3,941,580 7,588,560 1,281,000 $12,811,140
The NPV of the project, including the inventory cash flow at the beginning of the project, will be: NPV = –$985,500 + $1,986,900 / 1.11 – $15,955,150 / 1.112 + $4,607,880 / 1.113 + $5,101,330 / 1.114 + $12,811,140 / 1.115 NPV = $2,187,376.60
The company should go ahead with the new table. b. c.
You can perform an IRR analysis, and would expect to find three IRRs since the cash flows change signs three times.
The profitability index is intended as a “bang for the buck” measure; that is, it shows how much shareholder wealth is created for every dollar of initial investment. This is usually a good measure of the investment since most projects have conventional cash flows. In this case, the largest investment is not at the beginning of the project, but later in its life, so while the interpretation is the same, it really does not measure the bang for the dollar invested.
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? 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.