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Unformatted text preview: Incremental Cash Flow Approach to NPV Analysis and Project Risk Management Mini Case: Lazy Chairs * by Kyung Hwan Shim University of New South Wales Australian School of Business School of Banking & Finance for FINS 5514 S1 2010 March 23, 2010 * These notes are preliminary and under development. They are available for FINS 5514 S1 2010 students only and may not be distributed or used without the aurthors written consent. 1 1 Lazy Chairs Expansion Project Lazy Chairs is looking to expand its operations by building a segment to its existing plant on an adjacent lot acquired for $2,000,000 three years ago. The lot can be leased out to Lazy Chairs neighbors for $4,000 per year. The project requires an immediate investment of $600,000 in depreciable assets and 25% of sales in net working capital. The expansion will reduce the cost of producing Lazy Chairs most popular line of chairs from $4 to $2.7 per chair. Currently Lazy Chairs is operating at full capacity at 100,000 chairs per year. The expansion will allow Lazy Chairs an increase in production capacity by 30%. Currently, Lazy Chairs foresees that the demand for their chairs will be 120,000 per year. The price of chairs is expected to remain at $5 each. The new segment has 10 years of economic life. Upon project completion, Lazy Chairs will receive salvage value of $50,000 on depreciable assets and the projects NWC will revert back down to zero. Lazy Chairs is subject to 40% tax rate, uses a hurdle rate of 10% and all depreciable assets are depreciated using the diminishing balance method. 2 Questions Hint: The solutions will require multiple NPV calculations. Students will find it useful to program the PV formulas in Excel, or in a similarly suitable program to solve this case. a) From the information given, what are the relevant sources of cash flows? What are not relevant sources of cash flows? Compute the PV for each relevant source of cash flows using the incremental cash flow approach and compute the projects NPV. Solution) The relevant sources of cash flows are: i) After Tax Operating Cash Flows Excluding Depreciation and Arrears (ATOCF), ii) Cash flows from investment and recovery of Net Working Capital (NWC), iii) Investment and Salvage of depreciable assets, iv) Tax Shield Gains from Depreciation of depreciable assets, v) Terminal Losses, and vi) Opportunity Costs due to foregone income from leasing the lot. The $2,000,000 purchase cost of the lot is a sunk cost and irrelevant for project analysis. The NPV is computed as follows: NPV = PV Investments + PV ATOCF + PV Inv. in NWC + PV Tax Shields + PV Terminal Loss PV Leases = C + S (1 + r ) n + [( c project ( c current )) q current + ( p c project ) ( q total q current )] (1 T C ) 1 (1 + r ) n r + nwc % p q total  1 + 1 (1 + r ) n + C T C d r + d S T C d (1 + r ) n ( r + d ) + T C ( C (1 d ) n S ) (1 + r ) n leases 1 (1 + r ) n r NPV...
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This note was uploaded on 03/30/2011 for the course FIN 5514 taught by Professor Jaffe during the Three '11 term at University of New South Wales.
 Three '11
 jaffe
 Finance

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