Lec 2 After Mid Term

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Analysis and Evaluation of Inv.

Project

Lecture 2, After Mid Term


Chapter 11 (Gitman) Capital Budgeting Cashflow

Presented by:
Dr. Mohamed Sameh
Finding the Operating Cash
Inflows
The benefits expected from a capital expenditure or “project”
It should be: incremental after-tax cash inflows

• Must be measured on an after-tax basis, because the firm will not


have the use of any benefits until it has satisfied the government’s
tax claims.
• deducting taxes before making comparisons between proposed
investments is necessary for consistency when evaluating capital
expenditure alternatives.
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Finding the Operating Cash
Inflows
The benefits expected from a capital expenditure or “project”
It should be: incremental after-tax cash inflows

• All benefits expected from a proposed project must be measured on a cash


flow basis.
• Cash inflows represent dollars that can be spent, not merely “accounting profits.”
• The basic calculation for converting after-tax net profits into operating cash inflows
requires adding depreciation (for tangible assets) and any other noncash charges such
as amortization (Intangible assets) and depletion (Natural Resources ex: Oil Well)
deducted as expenses on the firm’s income statement back to net profits after taxes.

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Calculation of Operating Cash Inflows
Using the Income Statement Format

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Example 1
• A firm is considering renewing its equipment to meet increased demand for its
product. The cost of equipment modifications is $1.9 million plus $100,000 in
installation costs.
• The firm will depreciate the equipment modifications under MACRS
(20,32,19,12,12,5%), using a 5-year recovery period. Additional sales revenue from
the renewal should amount to $1.2 million per year, and additional operating
expenses and other costs (excluding depreciation and interest) will amount to 40%
of the additional sales. The firm is subject to a tax rate of 40%.
• (Note: Answer the following questions for each of the next 6 years. And The IRR=8%)
What incremental operating cash inflows will result from the renewal? And Is this Renewing
decision will be True (Using NPV Method)?

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Answer
• Incremental profits before depreciation and tax = Revenue - Expenses
= $1,200,000 – (1,200,000 X 0.40)
= $1,200,000 – $480,000 = $720,000 each year
Year (1) (2) (3) (4) (5) (6)
Profits before depr. & taxes (PBDT) $720,000 $720,000 $720,000 $720,000 $720,000 $720,000
*0.2 *0.32 *0.19 *0.12 *0.12 *0.05
- Depr. (for 2 m$)
400,000 640,000 380,000 240,000 240,000 100,000
= Net profits before taxes (NPBT) 320,000 80,000 340,000 480,000 480,000 620,000
- Tax (40%) 128,000 32,000 136,000 192,000 192,000 248,000
= Net profits after taxes (NPAT) 192,000 48,000 204,000 288,000 288,000 372,000
+ Depr. 400,000 640,000 380,000 240,000 240,000 100,000
Incremental Operating cash inflows $592,000 $688,000 $584,000 $528,000 $528,000 $472,000
PV Factor 0.926 0.857 0.794 0.735 0.681 0.630
PV of Operating cash inflows $548,192 $589,616 $463,696 $388,080 $359,568 $297,360
Sum of PV of Operating Cash Inflow $2,646,512
NPV = ∑ PV Operating Cash Inflow – Initial Investment = $2,646,512 – $2,000,000 = $646,512 (Accepted)
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Example 2
• Richard and Linda Thomson operate a local lawn maintenance service for
commercial and residential property. They have been using a John Deere riding
mower for the past several years and feel it is time to buy a new one. They
would like to know the feasibility of this decision with 8% IRR. The following data
are available:
• There are 5 years of remaining useful life on the old mower. And It has a zero book
value.
• The new mower is expected to last 5 years.
• The Thomsons will follow a 5-year MACRS (20,32,19,12,12,5%) recovery period for
the new mower.
• Depreciable value of the new mower is $1,800 and They are subject to a 40% tax rate.
• The new mower is expected to be more fuel efficient, maneuverable, and durable than
previous models and can result in reduced operating expenses of $500 per year.
• The Thomsons will buy a maintenance contract that calls for annual payments of $120.
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Answer

MACRS Depreciation Schedule


*

Year Base MACRS Depreciation


Year 1 $1,800 20.0% $360
Year 2 1,800 32.0% 576
Year 3 1,800 19.0% 342
Year 4 1,800 12.0% 216
Year 5 1,800 12.0% 216
Year 6 1,800 5.0% 90
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Thomson Incremental Operating Cash Flows Replacement of John Deere Riding Mower
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Savings from new mower $500 $ 500 $500 $500 $500 —
- Annual maintenance cost 120 120 120 120 120 0
- Depreciation* 360 576 342 216 216 90
= Savings (loss) before taxes 20 (196) 38 164 164 (90)
- Taxes (40%) 8 (78) 15 66 66 (36)
= Savings (loss) after taxes 12 (118) 23 98 98 (54)
+ Depreciation 360 576 342 216 216 90
= Incremental operating cash flow $372 $ 458 $365 $314 $314 $ 36
* PV Factor 8% 0.926 0.857 0.794 0.735 0.681 0.630
= PV Operating Cash Flow $344.47 $392.51 $289.81 $230.79 $213.83 $22.68
Sum of PV of Operating Cash Inflow $1,494.09
NPV = ∑ PV Operating Cash Inflow – Initial Investment = $1,494.09 – 1,800 = - 305.91 (Rejected)

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