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18Changes in Net Working Capital (NWC)°NWC = current assets – current liabilities°A new project typically requires an investment in NWC±Extra cash (e.g. to provide change to customers)±Inventories (e.g. spare parts)°These investments are often recovered at the end of the project°Decision: ±include initial NWC investment, changes in NWC, recovery of NWC±investment in NWC and its recovery do not affect taxes°Example: You provide $200 in NWC at the beginning of a project and recover $200 at the end of the project.
1019Depreciation°Straight-line ±D = (asset price + installation – salvage value) / useful life°MACRS (Modified Accelerated Cost Recovery System)±D = (% value in the table) * (asset price + installation)±MACRS depreciates all assets to the book value of zero°Depreciation is a non-cash expense but it affects cash flows by reducing taxes±Tax Shield = (depreciation expense)*(tax rate)20Capital Investment (CapEx)°An asset purchase reflects capital expenditures (CapEx) and represents a cash outflow°An asset sale has the following effects:±1. Record the sale price as an inflow (i.e. as negative CapEx)±2. Record the tax effect from the sale: ±Tax effect = tax rate * (sale price – book value) ±If the asset is sold at a gain ´subtract taxes on gain±If the asset is sold at a loss ´add tax savings from loss
11Revenues– costs– depreciation= Taxable income from operations– taxes= Net operating income+ depreciation– capital expenditures– taxes from gain on asset sale (or + tax savings from loss)– increases in working capital (or + decreases in working capital ) + after-tax synergy effects (or – after-tax cannibalization effects ), if any– opportunity costs today, + opportunity costs after project ends= Free Cash Flow21Free Cash Flow for a Project -Recipe22Example 1: Comprehensive Cash Flow Problem°We are evaluating an investment project in the production of shampoo at a consumer products factory that we currently manage. The project requires purchasing new equipment for $3,400,000 and preparing it for operation, which costs another $60,000. The equipment will be depreciated based on the 5-year MACRS schedule and is expected to be sold for $200,000 at the end of project’s life (end of year 6). In addition to the fixed assets, the project requires an immediate investment in working capital in the amount of $200,000, which will be recovered at the end of year 6. °Our company regularly incurs annual overhead expenses of $1 million for legal counsel and administration. These expenses are allocated to products based on products’ share in total sales, and this share for the new shampoo is 10%.