lecture15 - Making Capital Investment Decisions Discounted...

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Making Capital Investment Decisions 1 Discounted Cash Flow Examples
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Agenda Examples of Discounted Cash Flow Analysis Cost Cutting Machine Replacement Setting a Bid Price Choices with Constrained Resources Equivalent Annual Costs 2
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Operational Cash Flows Recall OCF can be calculated as: OCF = EBIT + Depr. – Taxes OCF = Net Income + Depr. (if there is no interest expense) OCF = Sales – Costs – Taxes OCF = (Sales – Costs)×(1-T) + Depr. ×T (if there is no interest expense) 3
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Cost Cutting Some projects implement cost savings rather than new revenue For example, automation or new technology Example: A new machine will save $22,000 in costs. It will be depreciated by $16,000 every year. What is the annual incremental OCF? There are two sources of cash flows Operational savings Tax Shield Use Tax Shield Approach OCF = (Sales-Costs)(1-T)+Depr*T = 22,000(1-.34)+16,000*.34 = $19,960 4
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Example: Cost Cutting Your company is considering a new computer system that will initially cost $1 million. It will save $300,000 a year in fixed costs. The system is expected to last for five years and will be depreciated using 3-year MACRS. The system is expected to have a salvage value of $50,000 at the end of year 5. There is no impact on net working capital. The marginal tax rate is 40%. The required return is 8%. Click on the Excel icon to work through the example 5
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Example: Replacement Problem Original Machine Initial cost = 100,000 Annual depreciation = 9,000 Purchased 5 years ago Book Value = 55,000 Salvage today = 65,000 Salvage in 5 years = 10,000 New Machine Initial cost = 150,000 5-year life Salvage in 5 years = 0 Cost savings = 50,000 per year 3-year MACRS depreciation Required return = 10% Tax rate = 40% 6
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Cash Flows Remember that we are interested in incremental cash flows There are three sources of incremental cash flows Net Capital Spending Operational Cost Savings Incremental Depreciation Net Capital Spending If we buy the new machine, then we will sell the old machine What are the cash flow consequences of selling the old machine today instead of in 5 years? 7
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lecture15 - Making Capital Investment Decisions Discounted...

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