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Unformatted text preview: g of the project. So, the cash outlay today for the project will be: Equipment NWC Total –$450,000 90,000 –$360,000 Now we can calculate the operating cash flow each year for the project. Using the bottom up approach, the operating cash flow will be: Saved salaries Depreciation EBT Taxes Net income And the OCF will be: OCF = $33,000 + 90,000 OCF = $123,000 Now we can find the NPV of the project. In Year 5, we must replace the saved NWC, so: NPV = –$360,000 + $123,000(PVIFA12%,5) + ($52,800 – 90,000) / 1.125 NPV = $62,279.19 $140,000 90,000 $50,000 17,000 $33,000 156 21. Replacement decision analysis is the same as the analysis of two competing projects, in this case, keep the current equipment, or purchase the new equipment. We will consider the purchase of the new machine first. Purchase new machine: The initial cash outlay for the new machine is the cost of the new machine, plus the increased net working capital. So, the initial cash outlay will be: Purchase new machine Net working capital Total –$12,000,000 –250,000 –$12,250,000 Next, we can calculate the operating cash flow created if the company purchases the new machine. The saved operating expense is an incremental cash flow. Additionally, the reduced operating expense is a cash inflow, so it should be treated as such in the income statement. The pro forma income statement, and adding depreciation to net income, the operating cash flow created by purchasing the new machine each year will be: Operating expense Depreciation EBT Taxes Net income OCF $4,500,000 3,000,000 $1,500,000 585,000 $915,000 $3,915,000 So, the NPV of purchasing the new machine, including the recovery of the net working capital, is: NPV = –$12,250,000 + $3,915,000(PVIFA10%,4) + $500,000 / 1.104 NPV = $330,776.59 And the IRR is: 0 = –$12,250,000 + $3,915,000(PVIFAIRR,4) + $250,000 / (1 + IRR)4 Using a spreadsheet or financial calculator, we find the IRR is: IRR = 11.23% 157 Now we can calculate the decision to keep the old machine: Keep old machine: The initial cash outlay for the old machine is the market value of the old machine, including any potential tax consequence. The decision to keep the old machine has an opportunity cost, namely, the company could sell the old machine. Also, if the company sells the old machine at its current value, it will receive a tax benefit. Both of these cash flows need to be included in the analysis. So, the initial cash flow of keeping the old machine will be: Keep machine Taxes Total –$3,000,000 –390,000 –$3,390,000 Next, we can calculate the operating cash flow created if the company keeps the old machine. There are no incremental cash flows from keeping the old machine, but we need to account for the cash flow effects of depreciation. The income statement, adding depreciation to net income to calculate the operating cash flow will be: Depreciation EBT Taxes Net income OCF $1,000,000 –$1,000,000 –390,000 –$610,000 $390,000 So, the NPV of the decision to keep the old machine will be: NPV = –$3,390,000 + $390,000(PVIFA10%,4) NPV = –$2,153,752.48 And the IRR is: 0 = –$3,390,000 + $390,000(PVIFAIRR,4) Using a spreadsheet or financial calculator, we find the IRR is: IRR = –25.15% 158 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, the increased NWC, 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: Purchase new machine Net working capital Sell old machine Taxes on old machine Total –$12,000,000 –250,000 3,000,000 390,000 –$8,860,000 The cash flows from purchasing the new machine would be the saved operating expenses. We would also need to include the change in depreciation. The old machine has a depreciation of $1 million per year, and the new machine has a depreciation of $3 million per year, so the increased depreciation will be $2 million per year. The pro forma income statement and operating cash flow under this approach will be: Operating expense savings Depreciation EBT Taxes Net income OCF The NPV under this method is: NPV = –$8,860,000 + $3,525,000(PVIFA10%,4) + $250,000 / 1.104 NPV = $2,484,529.06 And the IRR is: 0 = –$8,860,000 + $3,525,000(PVIFAIRR,4) + $250,000 / (1 + IRR)4 Using a spreadsheet or financial calculator, we find the IRR is: IRR = 22.26% So, this analysis still tells us the company should 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 = $330,776.59 – (–$2,153,752.48) = $2,484,529.06 This is the exact same NPV we calculated when using the second analysis method. $4,500,000 2,000,000 $2,500,000 975,000 $1,525,000 $3,525,000 159 22. We can find the NPV of a p...
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 Spring '10
 eshmalwi
 Finance, Corporate Finance

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