The Conch Republic Electronics, Part 1: Mini-case The Conch Republic Electronics mini-case will allow you to apply the cash flow models for evaluating capital decisions. You are in the role of a recent MBA graduate and have the ability to apply what you learn this week to a “real life” simulation. Apply the calculations for payback analysis of a capital project. Apply the calculations for profitability analysis of a capital project. Apply the calculations for a NPV analysis of a capital project. Apply the calculations for a IRR analysis of a capital project. Make an appropriate recommendation based on the facts presented. Case Study: After you have completed the readings for chapter 10, you should be ready to complete this assignment. Return to the case study on p.341-342 of the text and reread it carefully. As you are thinking about your response, please remember that one thing about cases – usually the quick answer is not the correct one. You need to be able to decide what the issues at hand are and what information is really critical to giving the correct advice. Use the questions at the end of the case for guidance, but remember you may add to your explanations. One thing that student’s tend to do with a case is bring in more information than what is needed – stick to the facts as presented in the case and the chapter readings. Please prepare and submit a 1-3 page response including synthesis of chapter readings and applications to corporate organizational structure. You are to answer the questions that are found at the end of each case in your textbook as clearly and succinctly as possible. You will be graded on the accuracy of your answers and the application of the proper support from text/class material. Please show any and all computations required since partial credit will be given for your work (when work is shown).even if the final answer is incorrect. 5/30/2017 Fundamentals of Corporate Finance Standard Edition PRINTED BY: cdj22@ymail.com. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. https://bookshelf.textbooks.com/#/books/0077769562/cfi/383!/4/4@0.00:0.00 1/2 5/30/2017 Fundamentals of Corporate Finance Standard Edition PRINTED BY: cdj22@ymail.com. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without publisher's prior permission. Violators will be prosecuted. https://bookshelf.textbooks.com/#/books/0077769562/cfi/383!/4/4@0.00:0.00 2/2 McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. Key Concepts and Skills • Be able to compute payback and discounted payback and understand their shortcomings • Understand accounting rates of return and their shortcomings • Be able to compute internal rates of return (standard and modified) and understand their strengths and weaknesses • Be able to compute the net present value and understand why it is the best decision criterion • Be able to compute the profitability index and understand its relation to net present value 9-1 Chapter Outline • • • • • • • Net Present Value The Payback Rule The Discounted Payback The Average Accounting Return The Internal Rate of Return The Profitability Index The Practice of Capital Budgeting 9-2 Good Decision Criteria • We need to ask ourselves the following questions when evaluating capital budgeting decision rules: – Does the decision rule adjust for the time value of money? – Does the decision rule adjust for risk? – Does the decision rule provide information on whether we are creating value for the firm? 9-3 Net Present Value • The difference between the market value of a project and its cost • How much value is created from undertaking an investment? – The first step is to estimate the expected future cash flows. – The second step is to estimate the required return for projects of this risk level. – The third step is to find the present value of the cash flows and subtract the initial investment. 9-4 Project Example Information • You are reviewing a new project and have estimated the following cash flows: – – – – – Year 0: CF = -165,000 Year 1: CF = 63,120; NI = 13,620 Year 2: CF = 70,800; NI = 3,300 Year 3: CF = 91,080; NI = 29,100 Average Book Value = 72,000 • Your required return for assets of this risk level is 12%. 9-5 NPV – Decision Rule • If the NPV is positive, accept the project • A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. • Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal. 9-6 Computing NPV for the Project • Using the formulas: – NPV = -165,000 + 63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3 = 12,627.41 • Using the calculator: – CF0 = -165,000; C01 = 63,120; F01 = 1; C02 = 70,800; F02 = 1; C03 = 91,080; F03 = 1; NPV; I = 12; CPT NPV = 12,627.41 • Do we accept or reject the project? 9-7 Decision Criteria Test - NPV • Does the NPV rule account for the time value of money? • Does the NPV rule account for the risk of the cash flows? • Does the NPV rule provide an indication about the increase in value? • Should we consider the NPV rule for our primary decision rule? 9-8 Calculating NPVs with a Spreadsheet • Spreadsheets are an excellent way to compute NPVs, especially when you have to compute the cash flows as well. • Using the NPV function – The first component is the required return entered as a decimal – The second component is the range of cash flows beginning with year 1 – Subtract the initial investment after computing the NPV 9-9 Payback Period • How long does it take to get the initial cost back in a nominal sense? • Computation – Estimate the cash flows – Subtract the future cash flows from the initial cost until the initial investment has been recovered • Decision Rule – Accept if the payback period is less than some preset limit 9-10 Computing Payback for the Project • Assume we will accept the project if it pays back within two years. – Year 1: 165,000 – 63,120 = 101,880 still to recover – Year 2: 101,880 – 70,800 = 31,080 still to recover – Year 3: 31,080 – 91,080 = -60,000 project pays back in year 3 • Do we accept or reject the project? 9-11 Decision Criteria Test Payback • Does the payback rule account for the time value of money? • Does the payback rule account for the risk of the cash flows? • Does the payback rule provide an indication about the increase in value? • Should we consider the payback rule for our primary decision rule? 9-12 Advantages and Disadvantages of Payback • Advantages – Easy to understand – Adjusts for uncertainty of later cash flows – Biased toward liquidity • Disadvantages – Ignores the time value of money – Requires an arbitrary cutoff point – Ignores cash flows beyond the cutoff date – Biased against long-term projects, such as research and development, and new projects 9-13 Discounted Payback Period • Compute the present value of each cash flow and then determine how long it takes to pay back on a discounted basis • Compare to a specified required period • Decision Rule - Accept the project if it pays back on a discounted basis within the specified time 9-14 Computing Discounted Payback for the Project • Assume we will accept the project if it pays back on a discounted basis in 2 years. • Compute the PV for each cash flow and determine the payback period using discounted cash flows – Year 1: 165,000 – 63,120/1.121 = 108,643 – Year 2: 108,643 – 70,800/1.122 = 52,202 – Year 3: 52,202 – 91,080/1.123 = -12,627 project pays back in year 3 • Do we accept or reject the project? 9-15 Decision Criteria Test – Discounted Payback • Does the discounted payback rule account for the time value of money? • Does the discounted payback rule account for the risk of the cash flows? • Does the discounted payback rule provide an indication about the increase in value? • Should we consider the discounted payback rule for our primary decision rule? 9-16 Advantages and Disadvantages of Discounted Payback • Advantages – Includes time value of money – Easy to understand – Does not accept negative estimated NPV investments when all future cash flows are positive – Biased towards liquidity • Disadvantages – May reject positive NPV investments – Requires an arbitrary cutoff point – Ignores cash flows beyond the cutoff point – Biased against long-term projects, such as R&D and new products 9-17 Average Accounting Return • There are many different definitions for average accounting return • The one used in the book is: – Average net income / average book value – Note that the average book value depends on how the asset is depreciated. • Need to have a target cutoff rate • Decision Rule: Accept the project if the AAR is greater than a preset rate 9-18 Computing AAR for the Project • Assume we require an average accounting return of 25% • Average Net Income: – (13,620 + 3,300 + 29,100) / 3 = 15,340 • AAR = 15,340 / 72,000 = .213 = 21.3% • Do we accept or reject the project? 9-19 Decision Criteria Test - AAR • Does the AAR rule account for the time value of money? • Does the AAR rule account for the risk of the cash flows? • Does the AAR rule provide an indication about the increase in value? • Should we consider the AAR rule for our primary decision rule? 9-20 Advantages and Disadvantages of AAR • Advantages – Easy to calculate – Needed information will usually be available • Disadvantages – Not a true rate of return; time value of money is ignored – Uses an arbitrary benchmark cutoff rate – Based on accounting net income and book values, not cash flows and market values 9-21 Internal Rate of Return • This is the most important alternative to NPV • It is often used in practice and is intuitively appealing • It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere 9-22 IRR – Definition and Decision Rule • Definition: IRR is the return that makes the NPV = 0 • Decision Rule: Accept the project if the IRR is greater than the required return 9-23 Computing IRR for the Project • If you do not have a financial calculator, then this becomes a trial and error process • Calculator – Enter the cash flows as you did with NPV – Press IRR and then CPT – IRR = 16.13% > 12% required return • Do we accept or reject the project? 9-24 NPV Profile for the Project 70,000 60,000 IRR = 16.13% 50,000 NPV 40,000 30,000 20,000 10,000 0 -10,000 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22 -20,000 Discount Rate 9-25 Decision Criteria Test - IRR • Does the IRR rule account for the time value of money? • Does the IRR rule account for the risk of the cash flows? • Does the IRR rule provide an indication about the increase in value? • Should we consider the IRR rule for our primary decision criteria? 9-26 Advantages of IRR • Knowing a return is intuitively appealing • It is a simple way to communicate the value of a project to someone who doesn’t know all the estimation details • If the IRR is high enough, you may not need to estimate a required return, which is often a difficult task 9-27 Calculating IRRs With A Spreadsheet • You start with the cash flows the same as you did for the NPV • You use the IRR function – You first enter your range of cash flows, beginning with the initial cash flow – You can enter a guess, but it is not necessary – The default format is a whole percent – you will normally want to increase the decimal places to at least two 9-28 Summary of Decisions for the Project Summary Net Present Value Accept Payback Period Reject Discounted Payback Period Reject Average Accounting Return Reject Internal Rate of Return Accept 9-29 NPV vs. IRR • NPV and IRR will generally give us the same decision • Exceptions – Nonconventional cash flows – cash flow signs change more than once – Mutually exclusive projects • Initial investments are substantially different (issue of scale) • Timing of cash flows is substantially different 9-30 IRR and Nonconventional Cash Flows • When the cash flows change sign more than once, there is more than one IRR • When you solve for IRR you are solving for the root of an equation, and when you cross the x-axis more than once, there will be more than one return that solves the equation • If you have more than one IRR, which one do you use to make your decision? 9-31 Another Example – Nonconventional Cash Flows • Suppose an investment will cost $90,000 initially and will generate the following cash flows: – Year 1: 132,000 – Year 2: 100,000 – Year 3: -150,000 • The required return is 15%. • Should we accept or reject the project? 9-32 NPV Profile IRR = 10.11% and 42.66% $4,000.00 $2,000.00 NPV $0.00 ($2,000.00) 0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55 ($4,000.00) ($6,000.00) ($8,000.00) ($10,000.00) Discount Rate 9-33 Summary of Decision Rules • The NPV is positive at a required return of 15%, so you should Accept • If you use the financial calculator, you would get an IRR of 10.11% which would tell you to Reject • You need to recognize that there are non-conventional cash flows and look at the NPV profile 9-34 IRR and Mutually Exclusive Projects • Mutually exclusive projects – If you choose one, you can’t choose the other – Example: You can choose to attend graduate school at either Harvard or Stanford, but not both • Intuitively, you would use the following decision rules: – NPV – choose the project with the higher NPV – IRR – choose the project with the higher IRR 9-35 Example With Mutually Exclusive Projects Period Project Project The required return A B for both projects is 0 -500 -400 10%. 1 325 325 2 325 200 IRR 19.43 % 64.05 22.17 % 60.74 NPV Which project should you accept and why? 9-36 NPV Profiles $160.00 IRR for A = 19.43% $140.00 IRR for B = 22.17% $120.00 Crossover Point = 11.8% NPV $100.00 $80.00 A B $60.00 $40.00 $20.00 $0.00 ($20.00) 0 0.05 0.1 0.15 0.2 0.25 0.3 ($40.00) Discount Rate 9-37 Conflicts Between NPV and IRR • NPV directly measures the increase in value to the firm • Whenever there is a conflict between NPV and another decision rule, you should always use NPV • IRR is unreliable in the following situations – Nonconventional cash flows – Mutually exclusive projects 9-38 Modified IRR • Calculate the net present value of all cash outflows using the borrowing rate. • Calculate the net future value of all cash inflows using the investing rate. • Find the rate of return that equates these values. • Benefits: single answer and specific rates for borrowing and reinvestment 9-39 Profitability Index • Measures the benefit per unit cost, based on the time value of money • A profitability index of 1.1 implies that for every $1 of investment, we create an additional $0.10 in value • This measure can be very useful in situations in which we have limited capital 9-40 Advantages and Disadvantages of Profitability Index • Advantages • Disadvantages – Closely related to – May lead to NPV, generally incorrect decisions leading to identical in comparisons of decisions mutually exclusive investments – Easy to understand and communicate – May be useful when available investment funds are limited 9-41 Capital Budgeting In Practice • We should consider several investment criteria when making decisions • NPV and IRR are the most commonly used primary investment criteria • Payback is a commonly used secondary investment criteria 9-42 Summary – DCF Criteria • Net present value – – – – Difference between market value and cost Take the project if the NPV is positive Has no serious problems Preferred decision criterion • Internal rate of return – – – – Discount rate that makes NPV = 0 Take the project if the IRR is greater than the required return Same decision as NPV with conventional cash flows IRR is unreliable with nonconventional cash flows or mutually exclusive projects • Profitability Index – – – – Benefit-cost ratio Take investment if PI > 1 Cannot be used to rank mutually exclusive projects May be used to rank projects in the presence of capital rationing 9-43 Summary – Payback Criteria • Payback period – Length of time until initial investment is recovered – Take the project if it pays back within some specified period – Doesn’t account for time value of money, and there is an arbitrary cutoff period • Discounted payback period – Length of time until initial investment is recovered on a discounted basis – Take the project if it pays back in some specified period – There is an arbitrary cutoff period 9-44 Summary – Accounting Criterion • Average Accounting Return – Measure of accounting profit relative to book value – Similar to return on assets measure – Take the investment if the AAR exceeds some specified return level – Serious problems and should not be used 9-45 Quick Quiz • Consider an investment that costs $100,000 and has a cash inflow of $25,000 every year for 5 years. The required return is 9%, and required payback is 4 years. – What is the payback period? – What is the discounted payback period? – What is the NPV? – What is the IRR? – Should we accept the project? • What decision rule should be the primary decision method? • When is the IRR rule unreliable? 9-46 Ethics Issues • An ABC poll in the spring of 2004 found that onethird of students age 12 – 17 admitted to cheating and the percentage increased as the students got older and felt more grade pressure. If a book entitled “How to Cheat: A User’s Guide” would generate a positive NPV, would it be proper for a publishing company to offer the new book? • Should a firm exceed the minimum legal limits of government imposed environmental regulations and be responsible for the environment, even if this responsibility leads to a wealth reduction for the firm? Is environmental damage merely a cost of doing business? • Should municipalities offer monetary incentives to induce firms to relocate to their areas? 9-47 Comprehensive Problem • An investment project has the following cash flows: CF0 = -1,000,000; C01 – C08 = 200,000 each • If the required rate of return is 12%, what decision should be made using NPV? • How would the IRR decision rule be used for this project, and what decision would be reached? • How are the above two decisions related? 9-48 End of Chapter 9-49 McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. Key Concepts and Skills • Understand how to determine the relevant cash flows for various types of proposed investments • Understand the various methods for computing operating cash flow • Understand how to set a bid price for a project • Understand how to evaluate the equivalent annual cost of a project 10-1 Chapter Outline • Project Cash Flows: A First Look • Incremental Cash Flows • Pro Forma Financial Statements and Project Cash Flows • More about Project Cash Flow • Alternative Definitions of Operating Cash Flow • Some Special Cases of Discounted Cash Flow Analysis 10-2 Relevant Cash Flows • The cash flows that should be included in a capital budgeting analysis are those that will only occur (or not occur) if the project is accepted • These cash flows are called incremental cash flows • The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows 10-3 Asking the Right Question • You should always ask yourself “Will this cash flow occur ONLY if we accept the project?” – If the answer is “yes,” it should be included in the analysis because it is incremental – If the answer is “no,” it should not be included in the analysis because it will occur anyway – If the answer is “part of it,” then we should include the part that occurs because of the project 10-4 Common Types of Cash Flows • Sunk costs – costs that have accrued in the past • Opportunity costs – costs of lost options • Side effects – Positive side effects – benefits to other projects – Negative side effects – costs to other projects • Changes in net working capital • Financing costs • Taxes 10-5 Pro Forma Statements and Cash Flow • Capital budgeting relies heavily on pro forma accounting statements, particularly income statements • Computing cash flows – refresher – Operating Cash Flow (OCF) = EBIT + depreciation – taxes – OCF = Net income + depreciation (when there is no interest expense) – Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS) – changes in NWC 10-6 Table 10.1 Pro Forma Income Statement Sales (50,000 units at $4.00/unit) $200,000 Variable Costs ($2.50/unit) 125,000 Gross profit $ 75,000 Fixed costs 12,000 Depreciation ($90,000 / 3) 30,000 EBIT Taxes (34%) Net Income $ 33,000 11,220 $ 21,780 10-7 Table 10.2 Projected Capital Requirements Year 0 1 2 3 NWC $20,000 $20,000 $20,000 $20,000 NFA 90,000 60,000 30,000 0 Total $110,000 $80,000 $50,000 $20,000 10-8 Table 10.5 Projected Total Cash Flows Year 0 OCF Change in NWC -$20,000 NCS -$90,000 CFFA -$110,00 1 2 3 $51,780 $51,780 $51,780 20,000 $51,780 $51,780 $71,780 10-9 Making The Decision • Now that we have the cash flows, we can apply the techniques that we learned in Chapter 9 • Enter the cash flows into the calculator and compute NPV and IRR – CF0 = -110,000; C01 = 51,780; F01 = 2; C02 = 71,780; F02 = 1 – NPV; I = 20; CPT NPV = 10,648 – CPT IRR = 25.8% • Should we accept or reject the project? 10-10 More on NWC • Why do we have to consider changes in NWC separately? – GAAP requires that sales be recorded on the income statement when made, not when cash is received – GAAP also requires that we record cost of goods sold when the corresponding sales are made, whether we have actually paid our suppliers yet – Finally, we have to buy inventory to support sales, although we haven’t collected cash yet 10-11 Depreciation • The depreciation expense used for capital budgeting should be the depreciation schedule required by the IRS for tax purposes • Depreciation itself is a non-cash expense; consequently, it is only relevant because it affects taxes • Depreciation tax shield = DT – D = depreciation expense – T = marginal tax rate 10-12 Computing Depreciation • Straight-line depreciation – D = (Initial cost – salvage) / number of years – Very few assets are depreciated straight-line for tax purposes • MACRS – Need to know which asset class is appropriate for tax purposes – Multiply percentage given in table by the initial cost – Depreciate to zero – Mid-year convention 10-13 After-tax Salvage • If the salvage value is different from the book value of the asset, then there is a tax effect • Book value = initial cost – accumulated depreciation • After-tax salvage = salvage – T(salvage – book value) 10-14 Example: Depreciation and After-tax Salvage • 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 after-tax salvage in year 6 for each of the following situations? 10-15 Example: Straight-line • Suppose the appropriate depreciation schedule is straight-line – D = (110,000 – 17,000) / 6 = 15,500 every year for 6 years – BV in year 6 = 110,000 – 6(15,500) = 17,000 – After-tax salvage = 17,000 - .4(17,000 – 17,000) = 17,000 10-16 Example: Three-year MACRS Year MACRS D percent 1 .3333 .3333(110,000) = 36,663 2 .4445 3 .1481 4 .0741 .4445(110,000) = 48,895 .1481(110,000) = 16,291 .0741(110,000) = 8,151 BV in year 6 = 110,000 – 36,663 – 48,895 – 16,291 – 8,151 = 0 After-tax salvage = 17,000 .4(17,000 – 0) = $10,200 10-17 Example: Seven-Year MACRS Year MACRS Percent D 1 .1429 .1429(110,000) = 15,719 2 .2449 .2449(110,000) = 26,939 3 .1749 .1749(110,000) = 19,239 4 .1249 .1249(110,000) = 13,739 5 .0893 .0893(110,000) = 9,823 6 .0892 .0892(110,000) = 9,812 BV in year 6 = 110,000 – 15,719 – 26,939 – 19,239 – 13,739 – 9,823 – 9,812 = 14,729 After-tax salvage = 17,000 – .4(17,000 – 14,729) = 16,091.60 10-18 Example: Replacement Problem • Original Machine – Initial cost = 100,000 – Annual depreciation = 9,000 – Purchased 5 years ago – Book Value = 55,000 – Salvage today = 65,000 – Salvage in 5 years = 10,000 • New Machine – Initial cost = 150,000 – 5-year life – Salvage in 5 years = 0 – Cost savings = 50,000 per year – 3-year MACRS depreciation • Required return = 10% • Tax rate = 40% 10-19 Replacement Problem – Computing Cash Flows • Remember that we are interested in incremental cash flows • If we buy the new machine, then we will sell the old machine • What are the cash flow consequences of selling the old machine today instead of in 5 years? 10-20 Replacement Problem – Pro Forma Income Statements Year Cost Savings 1 2 3 4 5 50,000 50,000 50,000 50,000 50,000 New 49,995 66,675 22,215 11,115 0 Old 9,000 9,000 9,000 9,000 9,000 40,995 57,675 13,215 2,115 (9,000) EBIT 9,005 (7,675) 36,785 47,885 59,000 Taxes 3,602 (3,070) 14,714 19,154 23,600 NI 5,403 (4,605) 22,071 28,731 35,400 Depr. Increm. 10-21 Replacement Problem – Incremental Net Capital Spending • Year 0 – Cost of new machine = 150,000 (outflow) – After-tax salvage on old machine = 65,000 .4(65,000 – 55,000) = 61,000 (inflow) – Incremental net capital spending = 150,000 – 61,000 = 89,000 (outflow) • Year 5 – After-tax salvage on old machine = 10,000 .4(10,000 – 10,000) = 10,000 (outflow because we no longer receive this) 10-22 Replacement Problem – Cash Flow From Assets Year 0 1 2 46,398 53,070 OCF 3 4 5 35,286 30,846 26,400 NCS -89,000 -10,000 In NWC CFFA 0 0 -89,000 46,398 53,070 35,286 30,846 16,400 10-23 Replacement Problem – Analyzing the Cash Flows • Now that we have the cash flows, we can compute the NPV and IRR – Enter the cash flows – Compute NPV = 54,801.74 – Compute IRR = 36.28% • Should the company replace the equipment? 10-24 Other Methods for Computing OCF • Bottom-Up Approach – Works only when there is no interest expense – OCF = NI + depreciation • Top-Down Approach – OCF = Sales – Costs – Taxes – Don’t subtract non-cash deductions • Tax Shield Approach – OCF = (Sales – Costs)(1 – T) + Depreciation*T 10-25 Example: Cost Cutting • Your company is considering a new computer system that will initially cost $1 million. It will save $300,000 per year in inventory and receivables management costs. The system is expected to last for five years and will be depreciated using 3-year MACRS. The system is expected to have a salvage value of $50,000 at the end of year 5. There is no impact on net working capital. The marginal tax rate is 40%. The required return is 8%. • Click on the Excel icon to work through the example 10-26 Example: Setting the Bid Price • Consider the following information: – Army has requested bid for multiple use digitizing devices (MUDDs) – Deliver 4 units each year for the next 3 years – Labor and materials estimated to be $10,000 per unit – Production space leased for $12,000 per year – Requires $50,000 in fixed assets with expected salvage of $10,000 at the end of the project (depreciate straight-line) – Require initial $10,000 increase in NWC – Tax rate = 34% – Required return = 15% 10-27 Example: Equivalent Annual Cost Analysis • Burnout Batteries – Initial Cost = $36 each – 3-year life – $100 per year to keep charged – Expected salvage = $5 – Straight-line depreciation • Long-lasting Batteries – Initial Cost = $60 each – 5-year life – $88 per year to keep charged – Expected salvage = $5 – Straight-line depreciation The machine chosen will be replaced indefinitely and neither machine will have a differential impact on revenue. No change in NWC is required. The required return is 15%, and the tax rate is 34%. 10-28 Quick Quiz • How do we determine if cash flows are relevant to the capital budgeting decision? • What are the different methods for computing operating cash flow and when are they important? • What is the basic process for finding the bid price? • What is equivalent annual cost and when should it be used? 10-29 Ethics Issues • In an L.A. Law episode, an automobile manufacturer knowingly built cars that had a significant safety flaw. Rather than redesigning the cars (at substantial additional cost), the manufacturer calculated the expected costs of future lawsuits and determined that it would be cheaper to sell an unsafe car and defend itself against lawsuits than to redesign the car. What issues does the financial analysis overlook? 10-30 Comprehensive Problem • A $1,000,000 investment is depreciated using a seven-year MACRS class life. It requires $150,000 in additional inventory and will increase accounts payable by $50,000. It will generate $400,000 in revenue and $150,000 in cash expenses annually, and the tax rate is 40%. What is the incremental cash flow in years 0, 1, 7, and 8? 10-31 End of Chapter 10-32
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