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Capital Budgeting Discounted Cash Flow Analysis Case Solution
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 aftertax value has been used. Depreciation is added as it is a noncash 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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