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Common Types of Cash Flows
 1. Sunk costs: costs that have accrued in the past, orwill be paid regardless of the decision
 2. Opportunity costs: costs of lost options
 3. Side effects: Positive side effects, benefits to other projects, Negative side effects, costs to other projects
 4. Changes in net working capital
 5. Financing costs
 6. Taxes

Incremental Cash Flows that matter and don't matter
 1. Cash flows matter—not accounting earnings.
 2. Sunk costs don’t matter.
 3. Incremental cash flows matter.
 4. Opportunity costs matter.
 5. Side effects like cannibalism matter
 6. Taxes matter: we want incremental aftertaxcash flows.
 7. Inflation matters.
 8. Allocation of existing costs does not matter

Cash Flow from Operations
OCF = EBIT – Taxes + Depreciation
 OCF = NI + Depreciation
 (where there is no interest expense)
Cash Flow from Assets = OCF  net capital spending  changes in NWC

Tax shield approach
OCF = (Sales  Costs) (1T) + DT

Aftertax Salvage
Book Value = Initial cost  accumulated depreciation
Aftertax Salvage value = salvage  T(salvage  book value)

You purchase equipment for $100,000 and it costs $10,000 to have it delivered and installed. Based on past information, you believe that you can sell the equipment for$17,000 when you are done with it in 6 years.The company’s marginal tax rate is 40%. What is the depreciation expense each year and the aftertax salvage in year 6 for threeyear MACRS?
 BV = $110,000
 Accum D = BV*0.33+BV*0.44+BV*0.1483+BV*0.0741
 Accum D = 110,000
 BV in 6 years = BV  Accum D = 0
 Aftertax Salvage = 17,000  0.4(17,0000)
 Aftertax Salvage = 10,200

Replacement Problem
 Pro Forma Income Statement
 Cost Savings
 Depreciation New
 Depreciation Old
 Incremental (New Old)
 EBIT (Savings  Incremental)
 Taxes on EBIT
 Net Income
 OCF = NI + D
 Year 0 include After tax salvage of old machine and capital spending of new
 Year end after tax salvage of 2nd machine

Replacement Chain Analysis
 1. Repeat projects until they begin and end at the same time.
 2. Compute NPV for the “repeated projects.”
 3. In replacement year the cash flow cost includes old tool plus replacement cost

The cost of the new machine is $127,000.
Installation will cost $20,000.
$4,000 in net working capital will be needed at the time of installation.
The project will increase revenues by $85,000 per year, but operatingcosts will increase by 35% of the revenue increase.
Simplified straight line depreciation is used.
Class life is 5 years, and the firm is planning to keep the project for 5 years.
Salvage value at the end of year 5 will be $50,000.
14% cost of capital; 34% marginal tax rate.
Find Net Initial Outlay.
 Initial Outlay:
 (Cost)
 +(S&A)
 = (Depreciable Asset)
 +(Investment in working capital)
 + Aftertax proceeds from sale of old asset
= Net Initial Outlay = ($151,000)

The cost of the new machine is $127,000.Installation will cost $20,000.$4,000 in net working capital will be needed at the time of installation.The project will increase revenues by $85,000 per year, but operatingcosts will increase by 35% of the revenue increase.Simplified straight line depreciation is used.Class life is 5 years, and the firm is planning to keep the project for 5 years.Salvage value at the end of year 5 will be $50,000.14% cost of capital; 34% marginal tax rate.
Find Annual Cash Flows
 Incremental revenue
  Incremental costs
  Depreciation on project Incremental earnings before taxes
  Tax on incremental EBT Incremental earnings after taxes
 + Depreciation reversal
 = Annual Cash Flow
ACF = 46,461

The cost of the new machine is $127,000.Installation will cost $20,000.$4,000 in net working capital will be needed at the time of installation.The project will increase revenues by $85,000 per year, but operatingcosts will increase by 35% of the revenue increase.Simplified straight line depreciation is used.Class life is 5 years, and the firm is planning to keep the project for 5 years.Salvage value at the end of year 5 will be $50,000.14% cost of capital; 34% marginal tax rate.
Find Terminal Cash Flow
 Salvage value
  Tax on capital gain
 + Recapture of NWC
 = Terminal Cash Flow
TCF = 37,000

Cost of equipment = $400,000
Shipping & installation will be $20,000
$25,000 in net working capital required at setup
3year project life
5year class life
Simplified straight line depreciation
Revenues will increase by $220,000 per year
Defects costs will fall by $10,000 per year
Operating costs will rise by $30,000 per year
Salvage value after year 3 is $200,000
Cost of capital = 12%marginal tax rate = 34%
 CF(0) = 445,000
 CF(1 ), (2), = 160,560
 CF(3 ) = 160,560 + 214,120 = 374,680
 Discount rate = 12%
 IRR = 22.1%
 NPV = $93,044.
 Accept the project!

Cost of equipment = $550,000
Shipping & installation will be $25,000
$15,000 in net working capital required at setup
8year project life, 5year class life
Simplified straight line depreciation
Current operating expenses are $640,000 per yr.
New operating expenses will be $400,000 per yr.
Already paid consultant $25,000 for analysis.
Salvage value after year 8 is $40,000
Cost of capital = 14%, marginal tax rate = 34%
 Initial Outlay (590,000)
 197,500 = Annual Cash Flow yrs 15
 158,400 = Annual Cash Flow yrs 68
 41,400 Terminal Cash Flow

Replacement Project:
Old Asset (5 years old):
Cost of equipment = $1,125,000
10year project life, 10year class life
Simplified straight line depreciation
Current salvage value is $400,000
Cost of capital = 14%, marginal tax rate =35%
 (1,417,125) Net Initial Outlay
 337,295 = Differential Cash Flow
 393,000 Terminal Cash Flow
 NPV = (55,052.07)
 IRR = 12.55%

Which of these capital investment analysis techniques facilitates comparison of projects with unequal useful lives?
A.Internal rate of return
B.Net present value
C.Modified internal rate of return
D.Replacement Chain
D.Replacement Chain (this multiple choice question has been scrambled)

At the conclusion of your project, your company sells a fixed asset for $200,000. The asset’s book value is $148,000, and the firm’s tax rate is 34 percent. Calculate the aftertax cash flow from this sale
Aftertax cash flow $182,320

A firm purchases a machine for $2,000,000 which has a class life of 3 years MACRS. The firm’s cost of capital is 12 percent. When calculating operating cash flows, what are
1.The yearly depreciation tax shields
2.The total present value of the tax benefits
3Yr MACR
33.33%
44.45%
14.81%
PV $515,003

You are evaluating the proposed acquisition of a machine that costs $220,000. The machine will result in increased sales of $120,000 per year for 3 years, but costs will increase by $25,000 per year. The machine will be depreciated 3 years MACRS and will be sold for an estimated $50,000 after 3 years. NWC will increase by $75,000 and remain constant for the life of the project. The firm’s tax rate is 40 percent and discount rate is 9 percent. Calculate the project’s cash flows and NPV.
 Initial outlay (295,000)
 Operating Cash Flow 70,033
 Terminal Cash Flow 111,521

Which should treat as incremental cash flowa. Reduction in sales of a company's other products caused by the investmentb. an expenditure on plant and equipment that has not yet been made and will be made only if the project is accepted.c. cost of R&D in connection with the product during the past three years.d. annual depreciation expenses from the investmente. dividend payments by the firmf. resale value of plant and equipment at end of the project's lifeg. salary and medical costs for production personnel who will be employed only if the project is accepted.
a. yes, b. yes, c. no, d. yes, e. no, f. yes, g, yes

Which costs not relevanta. land you already own that will be used for the project but otherwise will be sold for $700K.b. a $300K drop in sales of other product that result from introduction of new one.c. $200K research last year
 a. Relevant  opportunity cost
 b. relevant  erosion side effect
 c. not relevant  sunk cost

Given the choice would firm prefer MACRS or straight line.
For tax purposes prefer MACRS because provide larger depreciation earlier and hence larger tax shield.

