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Relevant cash flows Working capital treatment Unequal project lives

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##### Relevant cash flows Working capital treatment Unequal project lives

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**Project Cash Flow Analysis**• Relevant cash flows • Working capital treatment • Unequal project lives**Whenever the companies contemplate the development of a new**product, they must conduct a capital budgeting analysis(including project cash flow). For example, Coke is deciding whether to produce and market a new lemonade product. Here are some of the factors that it would have to consider: • How many people would like the new product well enough to buy it, and how many units would each customer buy per year? • What share of the lemonade market could Coke expect to capture? • How important would price be; that is, would demand be greatly affected by a small change in price**If Coke did go into the lemonade market, and if it were**highly profitable, how long would it take Pepsi and other competitors to follow, and how badly would Coke’s prices and sales be eroded? • How much would lemonade sales cut into the sales of Coke’s other products? • How large an investment would be required to set up a plant to produce lemonade and then launch a marketing campaign? • What would the production and distribution costs per unit be? • If the product were successful in the United States, might this lead to a worldwide expansion, hence to additional profits?**Proposed Project**• Cost: $200,000 + $10,000 shipping + $30,000 installation. • Depreciable cost $240,000. • Inventories will rise by $25,000 and payables will rise by $5,000. • Economic life = 4 years. • Salvage value = $25,000. • Depreciation=MACRS 3-year class.**Incremental gross sales = $250,000.**• Incremental cash operating costs = $125,000. • Tax rate = 40%. • Overall cost of capital = 10%.**Set up without numbers a time line for the project CFs.**0 1 2 3 4 Initial Outlay OCF1 OCF2 OCF3 OCF4 + Terminal CF NCF0 NCF1 NCF2 NCF3 NCF4**Incremental Cash Flow**= Corporate cash flow withproject minus Corporate cash flow without project**Net Investment Outlay at t = 0 (000s)**Equipment Freight + Inst. Change in NWC Net CF0 ($200) (40) (20) ($260) D NWC = $25,000 - $5,000 = $20,000.**Depreciation Basics**Basis = Cost + Shipping + Installation $240,000**Straight-Line Method**• For stockholder report or “book” purpose = Cost of Asset - Salvage Value Economic Life of Asset**Modified Accelerated Cost Recovery System(MACRS)**Class Type of Property 3 yrs Certain special manufacturing tools 5 yrs Automobiles, light-duty trucks, computers, and certain special manufacturing equipment 7 yrs Most industrial equipment, office furniture, and fixtures 10 yrs Certain longer-lived types of equipment**Modified Accelerated Cost Recovery System(MACRS)**Ownership Year 3 Yrs 5 Yrs 7 Yrs 10 Yrs 1 33% 20% 14% 10% 2 45 32 25 18 3 15 19 17 14 4 7 12 13 12 5 11 9 9 6 6 9 7 7 9 7 8 4 7 9 7 10 6 11 3 100 100 100 100**Annual Depreciation Expense (000s)**Year 1 2 3 4 % 0.33 0.45 0.15 0.07 x Basis = Depr. $ 79 108 36 17 $240**Year 1 Operating Cash Flows (000s)**Year 1 Net revenue Depreciation Before-tax income Taxes (40%) Net income Depreciation Net operating CF $125 (79) $ 46 (18) $ 28 79 $107**Year 4 Operating Cash Flows (000s)**Year 1 Year 4 Net revenue Depreciation Before-tax income Taxes (40%) Net income Depreciation Net operating CF $125 (79) $ 46 (18) $ 28 79 $107 $125 (17) $108 (43) $ 65 17 $ 82**Net Terminal Cash Flow at t = 4 (000s)**Salvage value Tax on SV Recovery on NWC Net terminal CF $25 (10) 20 $35**What if you terminate a project before the asset is fully**depreciated? Cash flow from sale = Sale proceeds - taxes paid. Taxes are based on difference between sales price and tax basis, where: Basis = Original basis - Accum. deprec.**Example: If Sold After 3 Years (000s)**• Original basis = $240. • After 3 years = $17 remaining. • Sales price = $25. • Tax on sale = 0.4($25-$17) = $3.2. • Cash flow = $25-$3.2=$21.7.**Project Net CFs on a Time Line**0 1 2 3 4 (260)* 107 118 89 117 I = 10. NPV = $81,573. IRR = 23.8%. *In thousands.**What is the project’s payback? (000s)**0 1 2 3 4 (260)* (260) 107 (153) 118 (35) 89 54 117 171 Cumulative: Payback = 2 + 35/89 = 2.4 years.**S and L are mutually exclusive and will be repeated. k =**10%. Which is better? (000s) 0 1 2 3 4 Project S: (100) Project L: (100) 60 33.5 60 33.5 33.5 33.5**S L**CF0 -100,000 -100,000 CF1 60,000 33,500 Nj 2 4 I 10 10 NPV 4,132 6,190 NPVL > NPVS. But is L better? Can’t say yet. Need to perform common life analysis.**Note that Project S could be repeated after 2 years to**generate additional profits. • Can use either replacement chain or equivalent annual annuity analysis to make decision.**Project S with Replication: k=10%**Replacement Chain Approach (000s) 0 1 2 3 4 Project S: (100) (100) 60 60 60 (100) (40) 60 60 60 60 NPV = $7,547.**Or, use NPVs:**0 1 2 3 4 4,132 3,415 7,547 4,132 10% Compare to Project L NPV = $6,190.**Equivalent Annual Annuity(EAA) Approach**Finds the constant annuity payment whose PV is equal to the project’s raw NPV over its original life.**EAA Calculator Solution**• Project S • PV = Raw NPV = $4,132. • n = Original project life = 2. • k = 10%. • Solve for PMT = EAAS = $2,381. • Project L • PV = $6,190; n = 4; k = 10%. • Solve for PMT = EAAL = $1,953.**The project, in effect, provides an annuity of EAA.**• EAAS > EAAL so pick S. • Replacement chains and EAA always lead to the same decision if cash flows are expected to stay the same.**If the cost to repeat S in two years rises to $105,000,**which is best? (000s) 0 1 2 3 4 Project S: (100) 60 60 (105) (45) 60 60 NPVS = $3,415 < NPVL = $6,190. Now choose L.**Types of Abandonment**• Sale to another party who can obtain greater cash flows, e.g., IBM sold PC division. • Abandon because losing money, e.g., smokeless cigarette.