Complete Guide To Corporate Finance

AAA

Capital Investment Decisions - Cost Cutting And Asset Replacement

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


Introduction To Project Analysis And Valuation
Related Articles
  1. Fundamental Analysis

    Calculating Return on Net Assets

    Return on net assets measures a company’s financial performance.
  2. Economics

    Understanding Cost of Revenue

    The cost of revenue is the total costs a business incurs to manufacture and deliver a product or service.
  3. Economics

    Explaining Carrying Cost of Inventory

    The carrying cost of inventory is the cost a business pays for holding goods in stock.
  4. Fundamental Analysis

    Is India the Next Emerging Markets Superstar?

    With a shift towards manufacturing and services, India could be the next emerging market superstar. Here, we provide a detailed breakdown of its GDP.
  5. Investing

    How To Calculate Minority Interest

    Minority interest calculations require the use of minority shareholders’ percentage ownership of a subsidiary, after controlling interest is acquired.
  6. Term

    Estimating with Subjective Probability

    Subjective probability is someone’s estimation that an event will occur.
  7. Economics

    Explaining Replacement Cost

    The replacement cost is the cost you’d have to pay to replace an asset with a similar asset at the present time and value.
  8. Economics

    How Does National Income Accounting Work?

    National income accounting is an economic term describing the system used by a country to gather data and determine aggregate economic activity.
  9. Investing Basics

    Understanding the Modigliani-Miller Theorem

    The Modigliani-Miller (M&M) theorem is used in financial and economic studies to analyze the value of a firm, such as a business or a corporation.
  10. Economics

    Explaining Kurtosis

    Kurtosis describes the distribution of data around an average.
RELATED TERMS
  1. Receivables Turnover Ratio

    An accounting measure used to quantify a firm's effectiveness ...
  2. International Financial Reporting ...

    A set of international accounting standards stating how particular ...
  3. Days Sales Outstanding - DSO

    A measure of the average number of days that a company takes ...
  4. Principal-Agent Problem

    The principal-agent problem develops when a principal creates ...
  5. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis ...
  6. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
RELATED FAQS
  1. What should I study in school to prepare for a career in corporate finance?

    Depending on which area you want to specialize in, corporate finance can be one of the most competitive fields in business. ... Read Full Answer >>
  2. Why would a company issue preference shares instead of common shares?

    Preference shares, or preferred stock, act as a hybrid between common shares and bond issues. As with any produced good or ... Read Full Answer >>
  3. What is the difference between cost of debt capital and cost of equity?

    In corporate finance, capital – the money a business uses to fund operations – comes from two sources: debt and equity. While ... Read Full Answer >>
  4. What is the difference between gross profit, operating profit and net income?

    The terms profit and income are often used interchangeably in day-to-day life. In corporate finance, however, these terms ... Read Full Answer >>
  5. Can I use my IRA to pay for my college loans?

    If you are older than 59.5 and have been contributing to your IRA for more than five years, you may withdraw funds to pay ... Read Full Answer >>
  6. Can I use my 401(k) to pay for my college loans?

    If you are over 59.5, or separate from your plan-sponsoring employer after age 55, you are free to use your 401(k) to pay ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!