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Unformatted text preview: es today, it will rent the building after year 15, so these cash flows are not incremental to any project. 178 We will begin by calculating the NPV of the decision of continuing to rent the building first. Continue to rent: Rent Taxes Net income $36,000 12,240 $23,760 Since there is no incremental depreciation, the operating cash flow is simply the net income. So, the NPV of the decision to continue to rent is: NPV = $23,760(PVIFA12%,15) NPV = $161,826.14 Product A: Next, we will calculate the NPV of the decision to modify the building to produce Product A. The income statement for this modification is the same for the first 14 years, and in year 15, the company will have an additional expense to convert the building back to its original form. This will be an expense in year 15, so the income statement for that year will be slightly different. The cash flow at time zero will be the cost of the equipment, and the cost of the initial building modifications, both of which are depreciable on a straightline basis. So, the pro forma cash flows for Product A are: Initial cash outlay: Building modifications Equipment Total cash flow –$45,000 –165,000 –$210,000 Years 114 $135,000 60,000 14,000 0 $61,000 20,740 $40,260 $54,260 Year 15 $135,000 60,000 14,000 29,000 $32,000 10,880 $21,120 $35,120 Revenue Expenditures Depreciation Restoration cost EBT Tax NI OCF The OCF each year is net income plus depreciation. So, the NPV for modifying the building to manufacture Product A is: NPV = –$210,000 + $54,260(PVIFA12%,14) + $35,120 / 1.1215 NPV = $156,060.70 179 Product B: Now we will calculate the NPV of the decision to modify the building to produce Product B. The income statement for this modification is the same for the first 14 years, and in year 15, the company will have an additional expense to convert the building back to its original form. This will be an expense in year 15, so the income statement for that year will be slightly different. The cash flow at time zero will be the cost of the equipment, and the cost of the initial building modifications, both of which are depreciable on a straightline basis. So, the pro forma cash flows for Product B are: Initial cash outlay: Building modifications Equipment Total cash flow –$65,000 –205,000 –$270,000 Years 114 $165,000 75,000 18,000 0 $72,000 24,480 $47,520 $65,520 Year 15 $165,000 75,000 18,000 35,000 $37,000 12,580 $24,420 $42,420 Revenue Expenditures Depreciation Restoration cost EBT Tax NI OCF The OCF each year is net income plus depreciation. So, the NPV for modifying the building to manufacture Product B is: NPV = –$270,000 + $65,520(PVIFA12%,14) + $42,420 / 1.1215 NPV = $172,027.56 We could have also done the analysis as the incremental cash flows between Product A and continuing to rent the building, and the incremental cash flows between Product B and continuing to rent the building. The results of this type of analysis would be: NPV of differential cash flows between Product A and continuing to rent: NPV = NPVProduct A – NPVRent NPV = $156,060.70 – 161,826.14 NPV = –$5,765.44 NPV of differential cash flows between Product B and continuing to rent: NPV = NPVProduct B – NPVRent NPV = $172,027.56 – 161,826.14 NPV = $10,201.42 180 Since the differential NPV of Product B and renting is the highest and positive, the company should choose Product B, which is the same as our original result. 35. The discount rate is expressed in real terms, and the cash flows are expressed in nominal terms. We can answer this question by converting all of the cash flows to real dollars. We can then use the real interest rate. The real value of each cash flow is the present value of the year 1 nominal cash flows, discounted back to the present at the inflation rate. So, the real value of the revenue and costs will be: Revenue in real terms = $225,000 / 1.06 = $212,264.15 Labor costs in real terms = $175,000 / 1.06 = $165,094.34 Other costs in real terms = $45,000 / 1.06 = $42,452.83 Lease payment in real terms = $25,000 / 1.06 = $23,584.91 Revenues, labor costs, and other costs are all growing perpetuities. Each has a different growth rate, so we must calculate the present value of each separately. Using the real required return, the present value of each of these is: PVRevenue = $212,264.15 / (0.10 – 0.05) = $4,245,283.02 PVLabor costs = $165,094.34 / (0.10 – 0.03) = $2,358,490.57 PVOther costs = $42,452.83 / (0.10 – 0.01) = $471,698.11 The lease payments are constant in nominal terms, so they are declining in real terms by the inflation rate. Therefore, the lease payments form a growing perpetuity with a negative growth rate. The real present value of the lease payments is: PVLease payments = $23,584.91 / [0.10 – (–0.06)] = $147,405.66 Now we can use the tax shield approach to calculate the net present value. Since there is no investment in equipment, there is no depreciation; therefore, no depreciation tax shield, so we will ignore this in our calcu...
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This note was uploaded on 07/10/2010 for the course FIN 6301 taught by Professor Eshmalwi during the Spring '10 term at University of TexasTyler.
 Spring '10
 eshmalwi
 Finance, Corporate Finance

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