Chapter 10: Making Capital Investment Decisions, Part II

Transcription

1 Chapter 10: Making Capital Investment Decisions, Part II Faculty of Business Administration Lakehead University Spring 2003 May 21, 2003 Outline 10.7 Special Cases of Cash Flow Analysis Evaluating Cost-Cutting Proposals Replacing an Asset 1

2 Evaluating Cost-Cutting Proposals Firms often have to decide whether to upgrade existing facilities to make them more cost-effective. Are the cost savings sufficiently large to justify the necessary capital expenditures? On top of cost savings, the purchase of new assets will affect the tax savings due to CCA. The tax shield approach is very convenient for analyzing this type of project. 2 Evaluating Cost-Cutting Proposals: An Example A firm is considering the purchase of a $300,000 computer-based inventory management system that would save the firm $130,000 in pretax income each year. With the help of this system, managing inventories more efficiently is expected to reduce net working capital by $40,000. The system has a CCA rate of 30% and is expected to last 4 years, at the end of which its salvage value is expected to be $30,000. The relevant tax rate is 36% and the required rate of return is 15%. What is the NPV of this project? 3

3 Evaluating Cost-Cutting Proposals: An Example We have seen that NPV = PV [ (1 T c )(R C) ] PV [ NWC ] PV [ NCS ] + PVCCATS, where PVCCATS = T cda( k) (k + d)(1 + k) T c ds (k + d)(1 + k) n. Note: R stands for sales (revenues) and S stands for salvage value. 4 Evaluating Cost-Cutting Proposals: An Example The system will save the firm $130,000 before tax annually over four years. These savings can be viewed as an annuity making four payments of (1 0.36) $130,000, and thus PV [ (1 T c )(R C) ] = (1 0.36) 130, = $237, 534. ( 1 ( ) )

4 Evaluating Cost-Cutting Proposals: An Example NWC decreases by $40,000 at time 0 and increases back to its original level after 4 years, so PV [ NWC ] = 40, ,000 (1.15) 4 = $17,130. In the case of net capital spending, we have PV [ NCS ] = 300,000 30,000 (1.15) 4 = $282, Evaluating Cost-Cutting Proposals: An Example The present value of the CCA tax shield is PVCCATS = and thus , = $63, 188, , (1.15) 4 NPV = PV [ (1 T c )(R C) ] PV [ NWC ] PV [ NCS ] + PVCCATS = 237,534 ( 17,130) 282, ,188 = $35,

5 Evaluating Cost-Cutting Proposals; An Example Note that PV [ (1 T c )(R C) ] PV [ NWC ] PV [ NCS ] = 237,534 ( 17,130) 282,847 = $28,183, and thus NPV is positive because of the CCA tax shield. 8 Replacing an Asset When evaluating a proposition to replace an asset, calculations involve net acquisitions and net dispositions. That is, opportunity costs related to asset purchases, asset sales and CCA tax shield have to be considered. 9

6 Net Capital Spending Replacing an Asset Assuming the old asset would have been sold at the same time as the replacing asset, let A r today s cost of the replacing asset, S r salvage value of the replacing asset after n years A o today s cost of the original asset, S o salvage value of the original asset after n years. 10 Replacing an Asset Then A r A o Net aquisitions at time 0, S r S o Net salvage value at time n. PVCCATS Regarding the CCA tax shield, its present value is PVCCATS = T cd(a r A o )( k) (k + d)(1 + k) T cd(s r S o ) (k + d)(1 + k) n. 11

7 Replacing an Asset: An Example Theatreplex Oleum is considering replacing a projector system in one of its cinemas. The new projector will significantly improve sound and image quality, thus increasing pre-tax operating income by $60,000 annually due to greater attendance. The new projector costs $300,000 and is expected to last 15 years, time at which its salvage value is expected to be $30,000. The actual projector can be sold now for $20,000 and would have had a salvage value of $2,000 after 15 years. The CCA rate is 25%, the required rate of return is 15% and the tax rate is 36%. What is the NPV of this project? 12 Replacing an Asset: An Example Let s first calculate the present value of the increase in the number of tickets sold, which can be seen as an annuity paying per year for 15 years. (1 0.36) 60,000 = $38,400 With a discount rate of 15%, the present value of this annuity is ( ( ) ) 38, = $224,

8 Replacing an Asset: An Example There is no change in net working capital, PV(NCS) = 300,000 20,000 + and PVCCATS = ,000 (1.075) = $58, ,000 2,000 (1.15) 15 = $276,559, , (1.15) Replacing an Asset: An Example The net present of this operation is then NPV = PV [ (1 T c )(R C) ] PV [ NWC ] PV [ NCS ] + PVCCATS = 224, , ,117 = $6, 097. Again, NPV is positive because of the CCA tax shield. 15