Topic 4 Capital Budgeting Part 2

# Topic 4 Capital Budgeting Part 2 - Topic 4 Capital...

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Topic 4 Capital Budgeting Part 2

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The NPV Investment Evaluation Process Step 1 - Calculate depreciation Step 2 - Calculate any gain/loss on disposal Step 3 - Calculate taxable income, i.e. profit or loss Step 4 – Calculate the tax item, i.e tax bill or rebate Step 5 - Calculate net cash flows Step 6 - Discount the net cash flows Step 7 – Conclusion – NPV: + accept, - reject
Example Purchase price \$42 000 Salvage value \$1 000 at end Year 3 Operating net cash-inflows Year 1 \$31 000 Year 2 \$29 000 Year 3 \$27 000 Feasibility study cost \$4 000 – yet to be paid Warehouse previously rented out for \$8,000 p.a. will be used for project New technician will replace existing technician. Existing technician’s salary = \$65 000 p.a. New technician’s salary = \$70 000 p.a. Old machine can be sold for \$2500, book value is \$3 000 Tax rate is 30% Depreciation is straight line Required rate of return is 12% p.a.

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Solution – depreciation and gain/loss on disposal Depreciation = cost price/no. of years = \$42,000/3 = \$14,000 p.a. Gain/loss on sale: Old Machine New Machine Book value yr 0 3000 Book value yr 3 0 Salvage value yr 0 25 00 Salvage value yr 3 10 00 Loss on sale 5 00 Gain on sale 10 00 Note: book value = cost price less accumulated depreciation
Solution - taxable income Profit & Loss Statement 0 1 2 3 Operating cash flows 31 000 29 000 27 000 - Depreciation (14 000) (14 000) (14 000) - Rent foregone (8 000) (8 000) (8 000) + Gain/loss on sale (500) 1 000 - Additional salary (5 000) (5 000) (5 000) = Taxable income (profit/loss) (500) 4 000 2 000 1000 Tax Paid (30%) (150) 1 200 600 300

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Cash Flow Statement 0 1 2 3 Tax (30%) 150 (1 200) (600) (300) Oper. cash flows 31 000 29 000 27 000 Rent foregone (8 000) (8 000) (8 000) Salvage value 2 500 1 000 Additional salary (5 000) (5 000) (5 000) Initial outlay (42 000) Net Cash Flows (39 350) 16 800 15 400 14 700 Solution – Cash flows
Solution – Discount The Net Cash Flows NPV = -\$39,350 + \$16,800(1.12) -1 + \$15,400(1.12) -2 + \$14,700(1.12) -3 = (\$1,610) Conclusion: NPV < 0 – therefore, reject the project.

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Finance costs Finance costs should not be included as an explicit cash flow in the analysis. Finance costs: cost of debt (interest expense), cost of equity (dividends) Finance costs are included in the required rate of return (discount rate) used to evaluate the project.
Incremental Cash-Flow Example In NPV analysis we are only interested in incremental cash- flows. Example: A firm is currently considering replacing a machine purchased 2 years ago with an original estimated useful life of 5 years. The replacement machine has an economic life of 3 years.

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Solution – depreciation and gain/loss on disposal Depreciation: old machine = \$48,000 p.a., new machine = \$120,000 p.a. Gain/loss on sale:
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Topic 4 Capital Budgeting Part 2 - Topic 4 Capital...

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