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Unformatted text preview: included in the analysis. So, the initial cash flow of keeping the old machine will be: Keep machine Taxes Total –$1,800,000 204,000 –$1,596 ,000 Next, we can calculate the operating cash flow created if the company keeps the old machine. We need to account for the cost of maintenance, as well as the cash flow effects of depreciation. The pro forma income statement, adding depreciation to net income to calculate the operating cash flow will be: Maintenance cost Depreciation EBT Taxes Net income OCF $520,000 240,000 –$760,000 –258,400 –$501,600 –$261,600 The old machine also has a salvage value at the end of five years, so we need to include this in the cash flows analysis. The aftertax salvage value will be: Sell machine Taxes Total $200,000 –68,000 $132,000 So, the NPV of the decision to keep the old machine will be: NPV = –$1,596,000 – $261,600(PVIFA12%,5) + $132,000 / 1.125 NPV = –$2,464,109.11 The company should keep the old machine since it has a greater NPV. There is another way to analyze a replacement decision that is often used. It is an incremental cash flow analysis of the change in cash flows from the existing machine to the new machine, assuming the new machine is purchased. In this type of analysis, the initial cash outlay would be the cost of the new machine, and the cash inflow (including any applicable taxes) of selling the old machine. In this case, the initial cash flow under this method would be: 165 Purchase new machine –$3,000,000 Sell old machine 1,800,000 Taxes on old machine –204,000 Total –$1,404,000 The cash flows from purchasing the new machine would be the difference in the operating expenses. We would also need to include the change in depreciation. The old machine has a depreciation of $240,000 per year, and the new machine has a depreciation of $600,000 per year, so the increased depreciation will be $360,000 per year. The pro forma income statement and operating cash flow under this approach will be: Maintenance cost Depreciation EBT Taxes Net income OCF –$170,000 360,000 –$190,000 –64,600 –$125,400 $234,600 The salvage value of the differential cash flow approach is more complicated. The company will sell the new machine, and incur taxes on the sale in five years. However, we must also include the lost sale of the old machine. Since we assumed we sold the old machine in the initial cash outlay, we lose the ability to sell the machine in five years. This is an opportunity loss that must be accounted for. So, the salvage value is: Sell machine Taxes Lost sale of old Taxes on lost sale of old Total The NPV under this method is: NPV = –$1,404,000 + $234,600(PVIFA12%,5) + $198,000 / 1.125 NPV = –$445,968.99 So, this analysis still tells us the company should not purchase the new machine. This is really the same type of analysis we originally did. Consider this: Subtract the NPV of the decision to keep the old machine from the NPV of the decision to purchase the new machine. You will get: Differential NPV = –$2,910,078.10 – (–2,464,109.11) = –$445,968.99 This is the exact same NPV we calculated when using the second analysis method. $500,000 –170,000 –200,000 68,000 $198,000 166 26. Here we are comparing two mutually exclusive assets, with inflation. Since each will be replaced when it wears out, we need to calculate the EAC for each. We have real cash flows. Similar to other capital budgeting projects, when calculating the EAC, we can use real cash flows with the real interest rate, or nominal cash flows and the nominal interest rate. Using the Fisher equation to find the real required return, we get: (1 + R) = (1 + r)(1 + h) (1 + .14) = (1 + r)(1 + .05) r = .0857 or 8.57% This is the interest rate we need to use with real cash flows. We are given the real aftertax cash flows for each asset, so the NPV for the XX40 is: NPV = –$1,500 – $120(PVIFA8.57%,3) NPV = –$1,806.09 So, the EAC for the XX40 is: –$1,806.09 = EAC(PVIFA8.57%,3) EAC = –$708.06 And the EAC for the RH45 is: NPV = –$2,300 – $150(PVIFA8.57%,5) NPV = –$2,889.99 –$2,889.99 = EAC(PVIFA8.57%,5) EAC = –$734.75 The company should choose the XX40 because it has the greater EAC. 27. The project has a sales price that increases at 5 percent per year, and a variable cost per unit that increases at 6 percent per year. First, we need to find the sales price and variable cost for each year. The table below shows the price per unit and the variable cost per unit each year. Year 1 $40.00 $20.00 Year 2 $42.00 $21.20 Year 3 $44.10 $22.47 Year 4 $46.31 $23.82 Year 5 $48.62 $25.25 Sales price Cost per unit Using the sales price and variable cost, we can now construct the pro forma income statement for each year. We can use this income statement to calculate the cash flow each year. We must also make sure to include the net working capital outlay at the beginning of the project, and the recovery of the net working capital at the end of the project. The pro forma income statement and cash flows for each year will be: 167 Year 0 Revenues Fixed costs Variable costs...
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 Spring '10
 eshmalwi
 Finance, Corporate Finance

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