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10.1
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10.5
Changes in net working capital (NWC) Increases in NWC are a cost of the project Decreases in NWC are a benefit of the project NWC often increases initially and then decreases at the end of the projects life
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Example 1
Your firm is contemplating the purchase of a new $700,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $160,000 at the end of that time. You will save $300,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $70,000 at the beginning of the project. Working capital will revert back to normal at the end of the project. If the tax rate is 35%, what is the IRR for this project?
10.8
Example 1 (cont.)
CF0 CF1 CF2 CF3 CF4 CF5 -630,000 244,000 244,000 244,000 244,000 278,000
IRR = 27.82%
IF I=11%
NPV = $291,976.23
10.9
Example 2
A company is evaluating a new acquisition of a milling machine. The machines price is $180,000 and it would cost another $25,000 to modify it for special use by the firm. The machine falls into the ACRS three-year class and it will be sold after three years for $80,000. The machine would require an increase in inventory of $7,500. This will be recovered when the machine is sold. The machine would have no effect on revenues, but it is expected to save the firm $75,000 per year in before tax operating costs. The firms marginal tax rate is 34%. Find the initial investment and all annual cash flows associated with this project.
10.10
Example 2 (cont.)
CF0 CF1 CF2 CF3 -212,500 72,731 80,475 125,295
NPV = $14,263.34
PP = 2.47 yrs
10.11
Example 3
Marsh Mining is considered an expansion project. The proposed project has the following features: - The project has an initial cost of $500,000 and this amount will be fully depreciated using the 3-yrs MACRS class. - If the project is undertaken, at year 0 the company will need to increase its inventories by $50,000, and its accounts payable will rise by $10,000. This net working capital will be recovered at the end of the projects life of 4 years. - If the project is undertaken, the company will realize an additional $580,000 in sales over each of the next 4 years. The companys operating costs (excluding depreciation) will increase by $400,000 each year. - The companys tax rate is 40%. - At the end of 4 yrs, the project will have a salvage value of $50,000. - The projects required rate of return (WACC) is 10%. What is the projects NPV?
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Example 3 (cont.)
CF0 CF1 CF2 CF3 CF4 -540,000 174,660 196,880 137,640 192,820
I = 10 NPV = $16,602.19
IRR = 11.42%
10.13
Example 4
Universal Farm Supplys Management has observed that it can sell as much fertilizer as it can stock and is considering the possibility of purchasing a forklift and expanding warehouse space in order to be able to handle and stock more fertilizer. The forklift costs $42,000 and would be depreciated on a straight-line basis to a salvage value of zero in seven years, even though it will last ten years. The forklift will not be sold. The warehouse expansion would cost $100,000 and would be straight-line depreciated to a salvage value of, and sold for $60,000 in ten years. The expansion would allow Universal to sell 1,000,000 more pounds per year at $0.20 per pound. The fertilizer costs Universal $0.17 per pound to produce. This increase in sales will also require an increase in accounts receivables of $200,000, in inventory of $50,000, and in accounts payable of $15,000. These will be recovered at the end of ten years. Universals marginal tax rate is 34%. Calculate the initial investment and the annual cash flows associated with this project. If the required rate of return (WACC) is 11%, calculate the projects net present value and internal rate of return.
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Example 4 (cont.)
CF0 CF17 CF89 CF10 -197,000 23,200 21,160 136,160
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10.16
GAAP requires that sales be recorded on the income statement when made, not when cash is received (recorded as an Account Receivable on the B/S) GAAP also requires that we record cost of goods sold when the corresponding sales are made, regardless of whether we have actually paid our suppliers yet (costs recorded as an Account Payable on the B/S) Finally, we have to buy inventory to support sales although we havent collected cash yet (Both inventory and accounts payable rise)