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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 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% |
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|
|
|
|
Discount Rate |
8% |
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|
|
|
|
|
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% |
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|
|
|
|
Cumulative Cash Flows |
(500,000) |
(320,000) |
(140,000) |
40,000 |
|
|
Payback Period |
2.25 Years |
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|
|
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) |
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|
|
|
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After Tax Salvage Value |
156,000 |
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NPV |
557,638 |
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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 |
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|
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 |
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|
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 |
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Eliminating Product Line |
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||||||||
Working Capital |
3,592 |
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After Tax Salvage Value |
4,600 |
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Total Present Value |
8,192 |
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