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BF3326 Corporate Finance: Deciding Capital Investment
BF3326 Corporate Finance: Deciding Capital Investment
You should always ask yourself “Will this cash flow occur
ONLY if we accept the project?”
– If the answer is “part of it,” then we should include the part that occurs
because of the project
Common Items of Cash Flows
Three years ago, the Jamestown Co. purchased some land for $1.24 million.
Today, the land is valued at $1.32 million. Six years ago, the company
purchased some equipment for $189,000. This equipment has a current
book value of zero and a current market value of $39,900.
What value should be assigned to the land and the equipment if the
Jamestown Co. opts to use both for a new project?
Relevant costs
The Blue Shoe currently sells 13,000 pairs of athletic shoes and 4,500
pairs of dress shoes every year. The athletic shoes sell for an average
price of $79 a pair while the average price for the dress shoes is $49. The
company is considering expanding their offerings to include sandals at
an average price of $29 a pair. The Blue Shoe estimates that the addition
of sandals to their lineup will reduce their dress shoe sales by 1,000
pairs and increase their athletic shoes sales by 800 pairs. The Blue Shoe
expects to sell 4,500 pairs of sandals if they decide to carry them.
What amount should the Blue Shoe use as the annual estimated sales
revenue when they analyze the addition of sandals to their lineup?
Relevant Revenue
The Fritz Co. is considering a new project and asked the chief accountant to
review potential changes to the net working capital accounts should the project
be adopted. The accountant’s report is as follows:
Current Projected
Accounts receivable $ 89,430 $110,000
Inventory $ 99,218 $ 75,000
Accounts payable $ 58,640 $ 50,000
What amount should be included in the initial cash flow of the project for net
working capital?
Net working capital
0 1 2 3
Enter the cash flows into the calculator and compute NPV
and IRR
– CF0 = -110,000; C01 = 51,780; C02 = 51,780 C03 = 71,780;
– I = 20;
– Find NPV
Should we accept or reject the project?
Net Working Capital
• Straight-line depreciation
– D = (Initial cost – salvage) / number of years
– Very few assets are depreciated straight-line for tax purposes
• MACRS
– Need to know which asset class is appropriate for tax purposes
– Multiply percentage given in table by the initial cost
– Depreciate to zero
– Mid-year convention
After-Tax Salvage
• If the salvage value is different from the book value of the asset,
then there is a tax effect
- Straight Line
- 3 Years MACRS
- 7 Years MACRS
Straight-line
Suppose the appropriate depreciation schedule is straight-line
Depr.
New 49,995 66,675 22,215 11,115 0
Old 9,000 9,000 9,000 9,000 9,000
Increm. 40,995 57,675 13,215 2,115 (9,000)
EBIT 9,005 (7,675) 36,785 47,885 59,000
Taxes 3,602 (3,070) 14,714 19,154 23,600
Net Income 5,403 (4,605) 22,071 28,731 35,400
Incremental Net Capital Spending
Year 0
– Cost of new machine = 150,000 (outflow)
– After-tax salvage on old machine = 65,000 - 0.4(65,000 – 55,000)
= 61,000 (inflow)
Year 5
– After-tax salvage on old machine = 10,000 - 0.4(10,000 – 10,000) = 10,0
00 (outflow because we no longer receive this)
Cash Flow From Assets
Year 0 1 2 3 4 5
In 0 0
NWC
CFFA -89,000 46,398 53,070 35,286 30,846 16,400
Replacement Problem – Making the Decision
Bottom-Up Approach
– Works only when there is no interest expense
– OCF = NI + depreciation
Top-Down Approach
– OCF = Sales – Costs – Taxes
– Don’t subtract non-cash deductions
Tax Shield Approach
– OCF = (Sales – Costs)(1 – T) + Depreciation*T