Chapter 12 – Strategy and the Analysis of Capital Investments
12-39 (Continued)
Step 2: Complete the following “Goal Seek” dialog box:
Step 3: Results
4. Many firms raise the discount rate in evaluating a particular capital investment
in view of uncertainties underlying the investment. This approach allows
managers to factor in risks and uncertainties. The higher the risk or uncertainty
a project has, the higher the discount rate.
An alternative is to use a direct approach in dealing with risk or uncertainty.
For example, if a firm considers that revenues from an investment are likely to
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Education.
Chapter 12 – Strategy and the Analysis of Capital Investments
12-40 Basic Capital Budgeting Techniques (45-50 minutes)
a. Project A :
Or, 2 years and 9.36 months
b. Project B:
After-tax Cumulative
Year Cash Inflows After-tax Cash Inflows
1 $ 500 $ 500
c. Project C:
Depreciation expense per year: $5,000 ÷ 5 = $1,000
Taxable income each year: $2,500 – $1,000 = $1,500
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Chapter 12 – Strategy and the Analysis of Capital Investments
12-40 (Continued)
d. Project D:
(1) Depreciation expense per year: ($5,000 – $500) ÷ 5 = $900
Taxable income:
Sales $4,000
Expenses:
Cash expenditures $1,500
Depreciation 900 2,400
e. Net Present Values (@8%), rounded:
Project a: ($1,800 x 3.993) – $5,000 =
Project b:
After-tax 8% Discount Present
Year Cash Flows Factor Values
0 <$5,000>
1 $ 500 0.926 463
2 1,200 0.857 1,028
Project c: ($2,125 × 3.993) – $5,000 =
$8,485 – $5,000 = $3,485
Project d:
Present value of cash inflows:
Years 1 through 4 ($1,200 + $900) × 3.312 = $6,955
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Education.
Chapter 12 – Strategy and the Analysis of Capital Investments
12-41 Straightforward Capital Budgeting with Income Taxes (Non-MACRS-based
Depreciation) and Sensitivity Analysis (35 minutes)
1. Depreciation per year, SL basis: ($30,600 – $600) ÷ 6 years = $5,000
Taxable income $8,000 – $5,000 = 3,000
Tax rate × 40%
Income tax $1,200
2. Payback period: $30,600 ÷ $5,000* = 6.12 years (if cash flows are assumed to
occur at end of year, then the appropriate answer would be 7 years)
*Given/assumed.
3. PV of annual after-tax cash savings $5,000 × 4.623* = $23,115
PV of salvage value $ 600 × 0.63** = 378
4. The minimum net after-tax annual cost savings needed to justify this investment =
$6,537
Let X = minimum after-tax annual cost savings, and let NPV = 0. The Initial
Investment Outlay ($30,600) is reduced by the PV of the salvage value of the asset
@ an 8% discount rate (i.e., $378). Thus, when NPV = $0, we have (by definition):
(or, an increase of approximately 31% over the $5,000 amount given assumed
above in 2 and 3)
Chapter 12 – Strategy and the Analysis of Capital Investments
12-42 Capital Budgeting with Tax (Non-MACRS Depreciation) and Sensitivity
Analysis (45 minutes)
Annual after-tax net cash inflow:
Cash revenue, net of tax $1,200 × (1 – 0.35) = $780
1. Under the assumption that the cash inflows occur evenly throughout the year, the
payback period for the proposed investment is:
2. Estimated Operating Income per year:
Sales $1,200
Depreciation 600
Operating income before taxes $ 600
3. The maximum initial investment is such that the project at this level of
investment would yield a NPV = $0 (i.e., a situation where PV of cash inflows = PV
of cash outflows). Alternatively, we’re looking for the maximum level of investment
4. Required annual (pre-tax) cash revenue:
Given an initial investment outlay of $6,000, the after-tax
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Education.
Chapter 12 – Strategy and the Analysis of Capital Investments
12-42 (Continued)
5. NPV Calculations under different assumptions regarding the discount rate
(required rate of return) and annual after-tax net cash inflows. Assume a ten-year
life and an initial investment outlay of $6,000.
Note to instructor: While this is not required in the present exercise, the above
two-variable “data table” could be generated by using the “Data Table” option under
“What-If Analysis” in Excel 2010. See Problem 12-62 and footnote #21 in Chapter
12.
12-36
Discount PV Annuity Annual Net After-Tax Cash Flow
Chapter 12 – Strategy and the Analysis of Capital Investments
12-43 Identifying Relevant Cash Flows: Asset-Replacement Decision (60 minutes)
1. Relevant Net Cash Flow, Purchase of New Machine (01 January 2016):
Incremental net working capital (non-cash) at time period 0 (given) $10,000
Net purchase price of new machine (including transportation, set-up cost, etc.) $190,000
After-tax cash inflow from sale of existing machine:
Current disposal (salvage) value of existing machine $68,000
Tax effect at time of disposal:
Original cost (at acquisition) $150,000
Estimated salvage value (at acquisition) $20,000
Life (in years) 8
Annual straight-line depreciation $16,250
Accumulated depreciation to date (3 years) $48,750
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Education.
Chapter 12 – Strategy and the Analysis of Capital Investments
12-43 (Continued-1)
2. Relevant (after-tax) cash inflow, years 1 through 5 (i.e., 01 January 2016 through 31
December 2020)
Difference in annual depreciation-related tax savings, in favor of new
machine:
Annual SL depreciation, old machine (see above) $16,250
Annual SL depreciation, new machine:
Purchase price of new machine $190,000
Estimated salvage value $25,000
Life (in years) 5
Annual depreciation deduction (SL basis) $33,000
3. Relevant after-tax cash flow, end of project life (i.e., end of year 5):
Old Machine New Machine
Original cost $150,000 $190,000
Total depreciation over 5 years 130 ,000 165,000
Book value of machines on Dec. 31, 2020 20,000 25,000
Terminal value of machines on Dec. 31, 2020 12 ,000 22,000
Gain (Loss) on disposal of machines ($ 8,0 00) ($3,000)
Tax savings on loss (@40%) $ 3,200 $ 1,200
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Education.
Chapter 12 – Strategy and the Analysis of Capital Investments
12-43 (Continued-2)
Working capital cash flow, end of project only:
Old New
Recovery of net working capital, end of year 5 $30,000 $40,000
4. Irrelevant information
The original cost ($150,000) of the old machine and the accumulated depreciation to
date (3 years’ worth) are both sunk costs and therefore irrelevant to the decision. It
should be noted, however, that both pieces of information are needed to determine
this occurs regardless of the machine-purchase decision.
5. Decision
Based on an undiscounted analysis, and not considering any non-financial
considerations, the new machine should be purchased. The net, after-tax, benefit
over the five-year period is $25,800, as follows:
Net (after-tax cash flow, purchase of new machine: 01 January 2016) ($118,700)
Cumulative, after-tax cash flow advantage–if new machine is purchased:
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Education.
Chapter 12 – Strategy and the Analysis of Capital Investments
12-44 Asset-Replacement Decision; NPV Analysis (60 Minutes)
1. Relevant (i.e., differential) cash flows (after tax) at:
Project Initiation (i.e., time period 0)
If asset B is purchased, the net investment outlay would be $480,000 (i.e., $600,000
− $120,000).
NBV of existing asset, A $300,000
Less: Current disposal value of asset A $0
Gain (Loss) on disposal ($300,000)
Tax effect of sale of existing asset (@ 40%) ($120,000)
Net outlay, asset B:
Project Operation (i.e., years 1-3, inclusive)
A B
Annual depreciation deduction $100,000 $200,000
Annual tax benefit/savings (@40%) $40,000 $80,000
Differential annual tax savings, assuming asset replacement $40,000
Annual pre-tax cost savings under asset B $280,000
Project Termination/Disposal (end of year 3)
N/R—the estimated disposal value of each asset at the end of year 3 is the same, $0,
and therefore not relevant to this asset-replacement decision.
2. Estimated NPV of decision to replace asset A: