# Capital Budgeting Discounted Cash Flow Analysis Case Solution

Solution Id Length Case Author Case Publisher
1259 1211 Words (6 Pages) Thomas R. Piper Harvard Business School : 298068
This solution includes: A Word File and An Excel File

To calculate the net present value of the machine, all the cash inflows and outflows are identified. As shown in Exhibit 1, the cost of the machine is an immediate outflow. The cost benefits are inflow and they are after-tax value has been used. Depreciation is added as it is a non-cash charge. Buying the machine economically is feasible as the NPV is positive and IRR is more than the discount rate. The payback period of 2.25 years is also very appropriate.

## Case Analysis for Capital Budgeting Discounted Cash Flow Analysis

All the calculations are shown in the Exhibit 1.

Exhibit 1

 Tax Rate 40% Discount Rate 8% Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 \$ \$ \$ \$ \$ \$ Machine Cost (500,000) Depreciation 100,000 100,000 100,000 100,000 100,000 Cost Savings After Tax 80,000 80,000 80,000 80,000 80,000 Tax Cash Proceeds on Selling 75,000 After Tax Salvage Value 45,000 Total Cash Flows (500,000) 180,000 180,000 180,000 180,000 225,000 Present value @ 8% (500,000) 166,667 154,321 142,890 132,305 153,131 NPV 249,314 IRR 25% Cumulative Cash Flows (500,000) (320,000) (140,000) 40,000 Payback Period 2.25 Years

The actual cash flows for using the old machine are only depreciation and the tax savings due to the depreciation expense. The cash flow for each year using the old machine is 28,000 DM. After discounting the cash flows, the net present value of the first alternative which is using the old machine is 222,395 DM.

Now if the machine is replaced, several incremental cash flows would occur. Firstly, the immediate cash outflow will occur which is equal to the cost of the new machine. This outflow will be adjusted by the after tax salvage value of the old machine. This is shown in Exhibit 2. Moreover, the tax savings from incremental depreciation will also be taken into account. Lastly, the labor saving, cash savings and floor space savings are also cash inflows. The actual cash flows for each year as shown in Exhibit 2 are 110,000 DM. After discounting it, the net present value of the new machine comes out to be 557,638 DM. It shows that buying the new machine will bring more economic benefit.

 After Tax Labor Savings After Tax Cash Savings Saving on Space Incremental Depreciation Incremental Tax Savings Total Incremental Cash Flows Present Value Year 0 (324,000) (324,000) Year 1 81,000 15,000 3,000 20,000 12,000 111,000 103,738 Year 2 81,000 15,000 3,000 20,000 12,000 111,000 96,952 Year 3 81,000 15,000 3,000 20,000 12,000 111,000 90,609 Year 4 81,000 15,000 3,000 20,000 12,000 111,000 84,681 Year 5 81,000 15,000 3,000 20,000 12,000 111,000 79,141 Year 6 81,000 15,000 3,000 20,000 12,000 111,000 73,964 Year 7 81,000 15,000 3,000 20,000 12,000 111,000 69,125 Year 8 81,000 15,000 3,000 20,000 12,000 111,000 64,603 Year 9 81,000 15,000 3,000 20,000 12,000 111,000 60,377 Year 10 81,000 15,000 3,000 20,000 12,000 111,000 56,427 Year 11 81,000 15,000 3,000 20,000 12,000 111,000 52,735 Year 12 81,000 15,000 3,000 20,000 12,000 111,000 49,285 Machine Cost (480,000) After Tax Salvage Value 156,000 NPV 557,638

Exhibit 3 shows the calculation of the cash flows if the product line is not discontinued. The net present value is \$7,615,000; it is less than the value if the product line is discontinued. So it is recommended that the product line must be discontinued.

Exhibit 3

 1998 1999 2000 2001 2002 2003 2004 2005 \$ 000_ \$ 000_ \$ 000_ \$ 000_ \$ 000_ \$ 000_ \$ 000_ Units 1000 1000 1000 1000 1000 1000 1000 Unit Price 20 20.6 21 21.15 21.25 21.25 21 Sales 20,000 20,600 21,000 21,150 21,250 21,250 21,000 COGS 10,000 10,001 10,002 10,003 10,004 10,005 10,006 Depreciation 1,057 1,124 1,204 1,304 1,404 1,504 1,504 GP 8,943 9,475 9,794 9,843 9,842 9,741 9,490 Sell & G Expense 7,000 7,001 7,002 7,003 7,004 7,005 7,006 EBIT 1,943 2,474 2,792 2,840 2,838 2,736 2,484 Tax 777 990 1,117 1,136 1,135 1,094 993 EBIAT 1,166 1,484 1,675 1,704 1,703 1,641 1,490 Capex (400) (400) (400) (400) (300) (200) - Working Capital 3,700 3,811 3,890 3,930 3,963 3,980 3,957 NET WC (108) (111) (79) (40) (33) (17) 23 3,957 Net Cash Flows 658 973 1,196 1,264 1,370 1,424 1,513 3,957 Present Value 658 869 954 900 870 808 767 1,790 NPV 7,615 Eliminating Product Line Working Capital 3,592 After Tax Salvage Value 4,600 Total Present Value 8,192

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