CFA Level 1

Corporate Finance - Applying NPV Analysis to Project Decisions


As a primer, readers should remember that:

Expansion projects are projects companies invest in to expand the earnings of its business.


Replacement projects, are projects that companies invest in to replace old assets in order to maintain efficiencies.

Example: NPV Analysis
Assume Newco is planning to add new machinery to its current plant. There are two machines Newco is considering, with cash flows as follows:

Figure 11.7: 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 11.14

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.

Determining a Project's Cash Flows
When beginning capital-budgeting analysis, it is important to determine the cash flows of a project. 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, such as potential salvage value at the end of a machine's life.

Look Out!
It is important to note that while interest expense is included in a company\'s earnings per share, it is not included in operating cash flows as it is already in the discounting process.

 
Example: Expansion Project
Let us begin with our previous example. Newco is looking 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 $300 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 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 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
For determining the terminal cash flow, the key metrics 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.

Example: Replacement Project
Now, let us assume that rather than investing in an additional machine, 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

Look Out!
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



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