Chapter Four

Chapter One

Chapter Two

Chapter Three

Chapter Four

Chapter Five

1.

4.1 Net Present Value And Internal Rate Of Return

1.

4.2.1 Introduction

2.

4.2 Capital Investment Decisions

2.

4.2.2 Project Cash

3.

4.3 Project Analysis And Valuation

3.

4.2.3 Incremental

4.

4.4 Capital Market History

4.

4.2.4 Pro Forma F

5.

4.5 Return, Risk And The Security Market Line

5.

4.2.5 Operating C

6.

4.2.6 Cost Cutting

Capital investments are funds invested in a firm or enterprise for the

purposes of furthering its business objectives. Capital investment may
also refer to a firm's acquisition of capital assets or fixed assets such
as manufacturing plants and machinery that are expected to be
productive over many years. Sources of capital investment are
manifold and can include equity investors, banks, financial institutions,
venture capital and angel investors. While capital investment is usually
earmarked for capital or long-life assets, a portion may also be used
for working capital purposes.
Capital investment encompasses a wide variety of funding options.
While funding for capital investment is generally in the form of

common or preferred equity issuance, it may also be through straight

or convertible debt. Funding may range from an amount of less than
$100,000 in seed financing for a start-up to amounts in the hundreds
of millions for massive projects in capital-intensive sectors like mining,
utilities and infrastructure.
In this section, we'll examine various components of a company's
capital investment decisions, including project cash flows, incremental
cash flows and more.

Read more: Introduction To Capital Investment Decisions - Complete Guide To

Corporate Finance |
Investopedia http://www.investopedia.com/walkthrough/corporatefinance/4/capital-investment-decisions/introduction.aspx#ixzz4TApTyDjh
Follow us: Investopedia on Facebook

When beginning capital-budgeting analysis, it is important to determine a

project's cash flows. These cash flows can be segmented as follows:
1. Initial Investment Outlay
These are the costs that are needed to start the project, such as new equipment,
installation, etc.
2. Operating Cash Flow over a Project's Life
This is the additional cash flow a new project generates.
3. Terminal-Year Cash Flow
This is the final cash flow, both the inflows and outflows, at the end of the
project's life; for example, potential salvage value at the end of a machine's life.
Example: Expansion Project
Newco wants to add to its production capacity and is looking closely at investing
in Machine B. Machine B has a cost of $2,000, with shipping and installation
expenses of $500 and a $300 cost in net working capital. Newco expects the
machine to last for five years, at which point Machine B will have a book value

(BV) of $1,000 ($2,000 minus five years of $200 annual depreciation) and a
potential market value of $800.
With respect to cash flows, Newco expects the new machine to generate an
additional $1,500 in revenues and costs of $200. We will assume Newco has a
tax rate of 40%. The maximum payback period that the company has established
is five years.
Let's calculate the project's initial investment outlay, operating cash flow over the
project's life and the terminal-year cash flow for the expansion project.
Answer:
Initial Investment Outlay:
Machine cost + shipping and installation expenses + change in net working
capital = $2,000 + $500 + $300 = $2,800
Operating Cash Flow:
CFt = (revenues - costs)*(1 - tax rate)
CF1 = ($1,500 - $200)*(1 - 40%) = $780
CF2 = ($1,500 - $200)*(1 - 40%) = $780
CF3 = ($1,500 - $200)*(1 - 40%) = $780
CF4 = ($1,500 - $200)*(1 - 40%) = $780
CF5 = ($1,500 - $200)*(1 - 40%) = $780
Terminal Cash Flow:
Tips and Tricks
The key metrics for determining the terminal cash
flow are salvage value of the asset, net working
capital and tax benefit/loss from the asset.
The terminal cash flow can be calculated as illustrated:
Return of net working capital +$300
Salvage value of the machine +$800
Tax reduction from loss (salvage < BV) +$80
Net terminal cash flow $1,180
Operating CF5+$780
Total year-five cash flow $1,960

For determining the tax benefit or loss, a benefit is received if the book value of
the asset is more than the salvage value, and a tax loss is recorded if the book
value of the asset is less than the salvage value.

Read more: Project Cash Flows - Complete Guide To Corporate Finance |

Investopedia http://www.investopedia.com/walkthrough/corporatefinance/4/capital-investment-decisions/project-cash-flows.aspx#ixzz4TAoTDwCz
Follow us: Investopedia on Facebook

Incremental cash flow is the additional operating cash flow that an organization
receives from taking on a new project. A positive incremental cash flow means
that the company's cash flow will increase with the acceptance of the project.
There are several components that must be identified when looking at
incremental cash flows: the initial outlay, cash flows from taking on the project,
terminal cost (or value) and the scale and timing of the project. A positive
incremental cash flow is a good indication that an organization should spend
some time and money investing in the project.
Incremental Cash Flow and Capital Budgeting
When determining incremental cash flows from a new project, several problems
arise: sunk costs, opportunity costs, externalities and cannibalization.
1. Sunk Costs
These are the initial outlays required to analyze a project that cannot be
recovered even if a project is accepted. As such, these costs will not affect the
future cash flows of the project and should not be considered when making
capital-budgeting decisions.
Suppose Newco is considering whether to make an addition to its current plant to
increase production. To determine if the new addition is worthwhile, Newco hired
a consulting firm for $50,000 to analyze the addition and the effect it will have on
production. The $50,000 is considered a sunk cost. If the project is rejected, the

$50,000 will still be paid, and if the project is accepted, the $50,000 will not affect
the future cash flows of the addition.
2. Opportunity Cost
This is the cost of not going forward with a project or the cash outflows that will
not be earned as a result of utilizing an asset for another alternative. For example,
the opportunity cost of Newco's new addition considered above is the cost of the
land on which the company is considering putting the new plant addition. As
such, it should be included in the analysis of the project.
3. Externality
In the consideration of incremental cash flows of a new project, there may be
effects on the existing operations of the company to consider, known as
"externalities." For example, the addition to Newco's plant is for the purpose of
producing a new product. It must be considered whether the new product may
actually take away or add to sales of the existing product.
4. Cannibalization
Cannibalization is the type of externality where the new project takes sales away
from the existing product.
Changes in Net Working Capital
A change in net working capital is essentially the changes in current assets minus
changes in current liabilities. Within the capital-budgeting process, a project
typically adds to current assets given additional inventories or potential increases
in accounts receivables from new sales. The increases to current assets,
however, are offset by current liabilities needed to finance the new project.
Overall, there may be a change to net working capital from the new project.
If the change in net working capital is positive, the change to current assets
outweighs the change in the current liabilities.
If, however, the change in net working capital is negative, the change to
current liabilities outweighs the change in current assets.

Read more: Incremental Cash Flows - Complete Guide To Corporate Finance |

Investopedia http://www.investopedia.com/walkthrough/corporatefinance/4/capital-investment-decisions/incremental-cashflows.aspx#ixzz4TAoqNgVT
Follow us: Investopedia on Facebook

Chapter Four

Chapter One

Chapter Two

Chapter Three

Chapter Four

Chapter Five

1.

4.1 Net Present Value And Internal Rate Of Return

1.

4.2.1 Introduction

2.

4.2 Capital Investment Decisions

2.

4.2.2 Project Cash

3.

4.3 Project Analysis And Valuation

3.

4.2.3 Incremental

4.

4.4 Capital Market History

4.

4.2.4 Pro Forma F

5.

4.5 Return, Risk And The Security Market Line

5.

4.2.5 Operating C

6.

4.2.6 Cost Cutting

Many companies issue pro-forma financial statements in addition

to generally accepted accounting principles (GAAP) -adjusted
statements as a way to provide investors with a better understanding
of operating results. In legitimate cases, pro forma financial
statements take out one-time charges to smooth earnings. However,
companies can also manipulate their financial results under the guise

of pro-forma financial statements to provide a picture that is rosier

than reality. Let's take a closer look at what pro-forma financial
statements are, when they are useful and how companies can use
them to dupe investors.
What Are Pro-Forma Earnings?
Pro-forma earnings describe a financial statement that has
hypothetical amounts, or estimates, built into the data to give a
"picture" of a company's profits if certain nonrecurring items were
excluded. Pro-forma earnings are not computed using
standard GAAP and usually leave out one-time expenses that are not
part of normal company operations, such as restructuring costs
following a merger. Such an expense can be rightfully viewed as a
one-time item that does not contribute to the company's representative
valuation.
Essentially, a pro-forma financial statement can exclude anything a
company believes obscures the accuracy of its financial outlook, and it
can be a useful piece of information to help assess a company's future
prospects. Every investor should stress GAAP net income, which is
the "official" profitability determined by accountants, but a look at proforma earnings can also be an informative exercise.

Pro forma earnings figures are inherently different for different

companies. There are no universal guidelines that companies must
follow when reporting pro forma earnings, which is why the distinction
between pro forma and earnings reported using GAAP is very, very
important.
GAAP enforces strict guidelines that companies must follow when
reporting earnings, but pro forma figures are better thought of as

"hypothetical," computed according to the estimated relevance of

certain events and conditions experienced by the company. Basically,
companies use their own discretion in calculating pro forma earnings,
including or excluding items depending on what they feel accurately
represents the company's true performance.
For example, net income does not tell the whole story when a
company has one-time charges that are irrelevant to future profitability.
Some companies therefore strip out certain costs that get in the way.
This kind of earnings information can be very useful to investors who
want an accurate view of a company's normal earnings outlook, but by
omitting items that reduce reported earnings, this process can make a
company appear profitable even when it is losing money. We like to
call pro forma the "everything-but-the-bad-stuff earnings."
The problem, however, is that there isn't nearly as much regulation of
pro-forma earnings as there is of financial statements falling under
GAAP rules, so sometimes companies bend or even abuse the rules
to make earnings appear better than they really are. Because traders
and brokers focus so closely on whether the company beats or meets
analyst expectations, the headlines that follow a company's earnings
announcements can mean everything. And, if a company missed nonpro-forma expectations but stated that it beat the pro-forma
expectations, its stock price will not suffer as badly; it might even go
up - at least in the short term.
Problems with Pro Forma
Despite the positive reasoning behind pro-forma statements, there are
many ways in which pro-forma earnings can be manipulated. Items
often left out of pro forma figures include the
following: depreciation, goodwill, amortization, restructuring and merg
er costs, interest and taxes, stock-based employee pay, losses
at affiliates and one-time expenses. The theory behind excluding non-

cash items such as amortization is that these are not true expenses
and therefore do not represent the company's actual earnings
potential. Amortization, for example, is not an item that is paid for as a
part of cash flow. But under GAAP, amortization is considered an
expense because it represents the loss of value of an asset.
(See What is the difference between amortization and depreciation? to
learn more.)
One-time cash expenses are often excluded from pro forma because
they are not a regular part of operations and are therefore considered
an irrelevant factor in the performance of a company's core activities.
Under GAAP, however, a one-time expense is included in earnings
calculations because, even though it is not a part of operations, a onetime expense is still a sum of money that exited the company and
therefore decreased income.
Sometimes companies even take unsold inventory off their balance
sheets when reporting pro-forma earnings. Ask yourself this: does
producing that inventory cost money? Of course it does, so why
should the company simply be able to write it off? It is bad
management to produce goods that can't be sold, and a company's
poor decisions shouldn't be erased from the financial statements.
The Securities and Exchange Commission (SEC) will investigate
companies suspected of trying to deceive investors in the pro-forma
modification of earnings. (Read more about how companies are
regulated in Compliance: The Price Companies Pay.)
This isn't to say companies are always dishonest with pro-forma
earnings; pro forma doesn't mean the numbers are automatically
being manipulated. But by being skeptical when reading pro-forma
earnings, you may end up saving yourself big money. To evaluate the
legitimacy of pro-forma earnings, be sure to look at what the excluded
costs are and decide whether these costs should be considering

impactful. Intangibles like depreciation and goodwill are okay to write

down occasionally, but if the company is doing it every quarter, the
reasons for doing so might be less than honorable. (For further
reading, see Impairment Charges: The Good, The Bad and The Ugly.)
The dotcom era of the late 1990s saw some of the worst abusers of
pro-forma earnings manipulations. Many Nasdaq-listed companies
utilized pro-forma earnings management to report more robust proforma numbers. Taken cumulatively, the difference between GAAP
earnings and pro-forma earnings for the dotcom sector during its
heyday exceeded billions of dollars.
One of the more notable occurrences of this phenomenon is Network
Associates. The company went so far as to exclude its dotcom
department's operating earnings. The dotcom department wasn't
making or spending pretend money, so why did the company exclude
these numbers? No doubt the department was losing money and
decided to hide those numbers that reflected poor company strategy
from investors. (Learn about dotcom companies that made it in 5
Successful Companies That Survived The Dotcom Bubble.)
Benefits of Pro-Forma Analysis
Pro-forma figures are supposed to give investors a clearer view of
company operations. For some companies, pro-forma earnings
provide a much more accurate view of their financial performance and
outlook because of the nature of their businesses. Companies in
certain industries tend to use pro-forma reporting more than others, as
the impetus to report pro-forma numbers is usually a result of industry
characteristics. For example, some cable and telephone companies
almost never make a net operating profit because they are constantly
writing down big depreciation costs.

In cases where pro-forma earnings do not include non-cash charges,

investors can see what the actual cash profit is. For example, recall
AOL Time Warner's massive goodwill write-off of about $54 billion in
2002 to reflect the value of AOL's merger with Time Warner in the
previous year. With accounting charges nearing $100 billion, Time
Warner's GAAP earnings for the year probably would not have been a
very good predictor of future prospects - those extraordinary
expenses would probably never occur again. Analysis of pro-forma
earnings is an important exercise to undertake before considering an
investment in a company that reports pro-forma numbers, so be sure
to do so.
Also, when a company undergoes substantial restructuring or
completes a merger, significant one-time charges can occur. These
types of expenses do not compose part of the business's ongoing cost
structure and therefore can unfairly weigh on short-term profit
numbers. An investor concerned with valuing the long-term potential of
the company would do well to analyze pro-forma earnings, which
exclude these non-recurring expenses.
Pro-forma financial statements are also prepared and used by
corporate managers and investment banks to assess the operating
prospects for their own businesses in the future and to assist in the
valuation of potential takeover targets. They are useful tools to help
identify a company's core value drivers and analyze changing trends
within company operations.

GAAP Manipulation
Aside from misusing pro-forma income statements, companies can
also mislead investors by creatively classifying their income in several
ways, including the following:

 Operating income is not strictly defined under the GAAP

because classification lines are often subject to discretion. Items
that are classified into this element can be selectively chosen by
management. For example, non-recurring income such as
special charges, shareholder class action settlements and
unusual events may be included or omitted within the metric to
present a value that will please shareholders.
Sales and gross profits can also be manipulated in many ways
within the constraints of the GAAP. For example, companies can
classify sales as either the gross amount billed to a customer or
expected amounts to be received. Furthermore, sales can also
depend on whether or not shipping and handling is treated as a
part of revenues. Finally, gross margins can be manipulated by
moving certain expenses between SG&A and other costs of
sales.
In the end, these changes create artificially higher or lower
income-statement metrics that can mislead shareholders.
The Bottom Line
To sum up, pro-forma earnings are informative when official earnings
are blurred by large amounts of asset depreciation and goodwill. But,
when you see pro forma, it's up to you to dig deeper to see why the
company is treating its earnings as such. Remember that when you
read pro-forma figures, they have not undergone the same level of
scrutiny as GAAP earnings and are not subject to the same level of
regulation.
Although a company reporting pro forma earnings is not doing
anything fraudulent or dishonest (because it does report exactly what
is and what is not included), it is very important for investors to know
and evaluate what went into the company's pro forma calculation, as

well as to compare the pro forma figure to the GAAP figure. Often,
companies can have a positive pro forma earnings figure while having
a negative GAAP earnings figure.
A final cautionary note for when you are analyzing pro forma figures:
because companies' definitions of pro forma vary, you must be very
careful when comparing pro forma figures between different
companies. If you are not aware of how the companies define their pro
forma figures, you may be inadvertently comparing apples to oranges.
Do your homework and maintain a balanced perspective when
reading pro-forma statements. Try to identify the key differences
between GAAP earnings and pro-forma earnings and determine
whether the differences are reasonable or if they are only there to
make a losing company look better. You want to base your decisions
on as clear a financial picture as possible.

Read more: Pro Forma Financial Statements - Complete Guide To Corporate

Finance | Investopedia http://www.investopedia.com/walkthrough/corporatefinance/4/capital-investment-decisions/pro-forma.aspx#ixzz4TAp1EGmh
Follow us: Investopedia on Facebook

The cash flow statement summarizes a business's cash inflows and outflows over
a period of time. It is important because it is very difficult for a business to
manipulate its cash situation. There is plenty that aggressive accountants can do
to manipulate earnings, but it's tough to fake cash in the bank. For this reason,
some investors use the cash flow statement as a more conservative measure of a
company's performance.
Operating cash flow (OCF) is found on the cash flow statement and is calculated
through a series of adjustments to net income. OCF is arguably a better measure

of a business's profits than earnings because a company can show positive net
earnings on the income statement and still not be able to pay its debts. Cash flow
is what pays the bills, and OCF can serve as a check on the quality of a
company's earnings. If a firm reports record earnings but negative cash, it may be
using aggressive accounting techniques. Overview of the Statement of Cash
Flows
The statement of cash flows for non-financial companies consists of three main
parts:
1. Operating flows - The net cash generated from operations (net income and
changes in working capital).
2. Investing flows - The net result of capital expenditures, investments,
acquisitions, etc.
3. Financing flows - The net result of raising cash to fund the other flows or
repaying debt.
By taking net income and making adjustments to reflect changes in the working
capital accounts on the balance sheet (receivables, payables, inventories) and
other current accounts, the operating cash flow section shows how cash was
generated during the period. It is this translation process from accrual accounting
to cash accounting that makes the operating cash flow statement so important.
Accrual Accounting vs. Cash Flows
The key differences between accrual accounting and real cash flow are
demonstrated by the concept of the cash cycle. A company's cash cycle is the
process that converts sales (based upon accrual accounting) into cash as follows:
- Cash is used to make inventory.
-Inventory is sold and converted into accounts receivables (because customers
are given 30 days to pay).

-Cash is received when the customer pays (which also reduces receivables).
There are many ways that cash from legitimate sales can get trapped on the
balance sheet. The two most common are for customers to delay payment
(resulting in a buildup of receivables) and for inventory levels to rise because the
product is not selling or is being returned.
For example, a company may legitimately record a $1 million sale but because
that sale allowed the customer to pay within 30 days, the $1 million in sales does
not mean the company made $1 million cash. If the payment date occurs after the
close of the end of the quarter, accrued earnings will be greater than operating
cash flow because the $1 million is still in accounts receivable.
Harder to Fudge Operating Cash Flows
Not only can accrual accounting give a rather provisional report of a company's
profitability, but under GAAP it allows management a range of choices to record
transactions. While this flexibility is necessary, it also allows for earnings
manipulation. Because managers will generally book business in a way that will
help them earn their bonus, it is usually safe to assume that the income
statement will overstate profits rather than understate them.
An example of income manipulation is called "stuffing the channel." To increase
their sales, a company can provide retailers with incentives such as extended
terms or a promise to take back the inventory if it is not sold. Inventories will then
move into the distribution channel and sales will be booked. Accrued earnings will
increase, but cash may actually never be received because the inventory may be
returned by the customer. While this may increase sales in one quarter, it is a
short-term exaggeration and ultimately "steals" sales from the following periods
(as inventories are sent back). (Note: While liberal return policies, such as
consignment sales, are not allowed to be recorded as sales, companies have
been known to do so quite frequently during a market bubble.)
The operating cash flow statement will catch these gimmicks. When operating
cash flow is less than net income, there is something wrong with the cash cycle.

In extreme cases, a company could have consecutive quarters of negative

operating cash flow and, in accordance with GAAP, legitimately report positive
earnings per share (EPS). In this situation, investors should determine the source
of the cash hemorrhage (inventories, receivables, etc.) and whether this situation
is a short-term issue or long-term problem. (For more on cash flow manipulation,
see Cash Flow On Steroids: Why Companies Cheat.)
Cash Exaggerations
While the operating cash flow statement is more difficult to manipulate, there are
ways for companies to temporarily boost cash flows. Some of the more common
techniques include delaying payment to suppliers (extending payables); selling
securities; and reversing charges made in prior quarters (such as restructuring
reserves).
Some view the selling of receivables for cash - usually at a discount - as a way for
companies to manipulate cash flows. In some cases, this action may be a cash
flow manipulation; but it can also be a legitimate financing strategy. The challenge
is being able to determine management's intent.
Cash Is King
A company can only live by EPS alone for a limited time. Eventually, it will need
cash to pay suppliers and, most importantly, the bankers. There are many
examples of once-respected companies who went bankrupt because they could
not generate enough cash. Strangely, despite all this evidence, investors are
consistently hypnotized by EPS and market momentum and ignore the warning
signs.
Investors can avoid a lot of bad investments if they analyze a company's
operating cash flow. It's not hard to do, but it is important to do because the
talking heads and analysts are all too often focused on EPS.
Alternative Methods of Calculating OCF
The bottom-up approach to operating cash flow takes the company's bottom
line--that is, its net income--and adds back non-cash expenses such as

depreciation and amortization.

OCF = N + D
The top-down approach starts with total sales and subtracts only cash
expenses (primarily fixed costs, variable costs and taxes), leaving out non-cash
expenses such as depreciation and amortization.
OCF = S - C - T
Because depreciation is tax deductible, it reduces a firm's tax liability. The tax
shield method of computing operating cash flow takes this fact into account by
multiplying the company's depreciation expense by its tax rate.
OCF = (S - C) x (1 - T) + D x T
Each of these three methods yields the same number for OCF.
Read more: Operating Cash Flow And Alternative Definitions Of Operating Cash
Flow - Complete Guide To Corporate Finance |
Investopedia http://www.investopedia.com/walkthrough/corporatefinance/4/capital-investment-decisions/operating-cash-flow.aspx#ixzz4TApCTkNA
Follow us: Investopedia on Facebook

In Section 4 of this walkthrough, we discussed the use of discounted cash flow as

a valuation method for estimating the attractiveness of an investment opportunity.
We showed how DCF analysis uses future free cash flow projections and
discounts them to arrive at a present value, and how if the present value is higher
than the current cost of the investment, the opportunity may be a good one. In
this section, we'll discuss how DCF analysis can be used to determine the value
of cost cutting and asset replacement projects under a company's consideration.
(Read more about the importance of evaluating the cost effectiveness of new

projects in 5 Of The Most Adaptive Companies and 5 Big Companies' Biggest

Blunders.)
Cost Cutting
Cost cutting refers to measures implemented by a company to reduce its
expenses and improve profitability. Cost cutting measures may include laying off
employees, reducing employee pay, switching to a less expensive employee
health insurance program, downsizing to a smaller office, lowering monthly bills,
changing hours of service, restructuring debt or upgrading to more efficient
systems. Let's say a company wants to upgrade its computer system to improve
efficiency. While the new computer system will cost money, its purpose is to cut
costs. But will it cut costs enough to make the purchase worthwhile? To find out,
we can use DCF analysis. (Learn more about the importance of computer
software in Most Costly Computer Hacks Of All Time.)
Assume the following:
Cost of new computer system: $100,000
Annual savings from improved efficiency: $25,000
Lifespan of new computer system: 5 years
Corporate tax rate: 35%
Depreciation: straight-line basis to zero
System value in 5 years: $25,000
Discount rate: 10%
Step 1: Identify capital spending. In this case, it is $100,000.
Step 2: Identify the salvage value of the new computer system using the following
calculation:
Salvage Value x (1 -0 35)
Salvage Value = $25,000 x (0.65) = $16,250

Step 3: Calculate the actual annual savings from improved efficiency, taking
taxes and depreciation into account. The computer system upgrade will save
$25,000 a year. In other words, it will increase operating cash flow by $25,000 a
year. On the plus side, the additional depreciation expense of $20,000 a year
($100,000 / 5). Subtracting the depreciation deduction from the increase in
operating income gives us $25,000 - $20,000 = $5,000, or earnings before
interest and taxes (EBIT). This $5,000 increase in cash flow will be taxed at the
company's 35% tax rate, yielding $5,000 x 0.35 = $1,750 in additional tax liability
for the company each year. EBIT + Depreciation - Taxes = OCF, so $5,000 +
$20,000 - $1,750 = $23,250. (Learn more about depreciation in Depreciation:
Straight-Line Vs. Double-Declining Methods.)
Step 4: Calculate the annual cash flows from undertaking the system upgrade.
Year 0:
-$100,000
Years 1 - 4:
$23,250/yr. = $23,250 x 4 = $93,000
Year 5:
$23,250 + $16,250 salvage value = $39,500
Total: -$100,000 + $93,000 + $39,500 = $32,500
Step 5: Calculate the net present value (NPV) using the discount rate, project life,
initial cost and each year's cash flows using an NPV calculator and determine if
the upgrade is truly cost-saving. In this case, the discount rate is 10%, the project
life is five years, the initial cost is $100,000 and each year's cash flows are
provided in step 4. The result is an NPV of -$1,774,24, so the system upgrade
would actually not cut costs and thus should not be undertaken. (For related
reading, see Should computer software be classified as an intangible asset or
part of property, plant and equipment? and Lady Godiva Accounting Principles.)
Asset Replacement

Earlier in this section, we discussed how to determine a project's cash flows.

Here, we'll consider how to analyze those cash flows to determine whether a
company should undertake a replacement project. Replacement projects are
projects that companies invest in to replace old assets in order to maintain
efficiencies.
Assume Newco is planning to add new machinery to its current plant. There are
two machines Newco is considering, with cash flows as follows:
Discounted Cash Flows for Machine A and Machine B

Calculate the NPV for each machine and decide which machine Newco should
invest in. As calculated previously, Newco's cost of capital is 8.4%.
Formula:

Answer:
NPVA = -5,000 + 500 + 1,000 + 1,000 + 1,500 + 2,500 + 1,000 = $469
(1.084)1 (1.084)2 (1.084)3 (1.084)4 (1.084)5 (1.084)6
NPVB = -2,000 + 500 + 1,500 + 1,500 + 1,500 + 1,500 + 1,500 = $3,929
(1.084)1 (1.084)2 (1.084)3 (1.084)4 (1.084)5 (1.084)6
When considering mutually exclusive projects and NPV alone, remember that the
decision rule is to invest in the project with the greatest NPV. As Machine B has
the greatest NPV, Newco should invest in Machine B.
Example: Replacement Project

Now, let us assume that rather than investing in an additional machine, as in our
earlier expansion project example, Newco is exploring replacing its current
machine with a newer, more efficient machine. Based on the current market,
Newco can sell the old machine for $200, but this machine has a book value of
$500.
The new machine Newco is looking to invest capital in has a cost of $2,000, with
shipping and installation expenses of $500 and $300 in net working capital.
Newco expects the machine to last for five years, at which point Machine B would
have a book value of $1,000 ($2,000 minus five years of $200 annual
depreciation) and a potential market value of $800.
With respect to cash flows, Newco expects the new machine to generate an
additional $1,500 in revenues and costs of $200. We will assume Newco has a
tax rate of 40%. The maximum payback period that the company established is
five years.
As required in the LOS, calculate the project's initial investment outlay, operating
cash flow over the project's life and the terminal-year cash flow for the
replacement project.
Answer:
Initial Investment Outlay
Computing the initial investment outlay of a replacement project is slightly
different than the computation for an existing project. This is primarily because of
the expected cash flow a company may receive on the sale of the equipment to
be replaced.
Value of the old machine = sale value + tax benefit/loss
= $200 + $120
= $320
Sale of old equipment + machine cost + shipping and installation expenses +
change in net working capital = $320 + $2,000 + $500 + $300 = $3,120
In the analysis of either an expansion or a
replacement project, the operating cash
flows and terminal cash flows are calculated

the same .

Operating cash flow:

CFt = (revenues - costs)*(1 - tax rate)
CF1 = ($1,500 - $200)*(1 - 40%) = $780
CF2 = ($1,500 - $200)*(1 - 40%) = $780
CF3 = ($1,500 - $200)*(1 - 40%) = $780
CF4 = ($1,500 - $200)*(1 - 40%) = $780
CF5 = ($1,500 - $200)*(1 - 40%) = $780
Terminal Cash Flow:
The terminal cash flow can be calculated as illustrated:
Return of net working capital +$300
Salvage value of the machine +$800
Tax reduction from loss (salvage < BV) +$80
Net terminal cash flow $1,180
Operating CF5+$780
Total year 5 cash flow $1,960

Read more: Cost Cutting And Asset Replacement - Complete Guide To

Corporate Finance |
Investopedia http://www.investopedia.com/walkthrough/corporatefinance/4/capital-investment-decisions/cost-cutting.aspx#ixzz4TApNbWot
Follow us: Investopedia on Facebook