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. Term

    How Market Segments Work

    A market segment is a group of people who share similar qualities.
  2. Active Trading

    Market Efficiency Basics

    Market efficiency theory states that a stock’s price will fully reflect all available and relevant information at any given time.
  3. Professionals

    Is A Stockbroker Career For You?

    Becoming a stockbroker requires a broad skill set and the willingness to put in long hours. But the rewards can be enormous.
  4. Economics

    Understanding Cost-Volume Profit Analysis

    Business managers use cost-volume profit analysis to gauge the profitability of their company’s products or services.
  5. Fundamental Analysis

    5 Must-Have Metrics For Value Investors

    Focusing on certain fundamental metrics is the best way for value investors to cash in gains. Here are the most important metrics to know.
  6. Fundamental Analysis

    5 Basic Financial Ratios And What They Reveal

    Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know.
  7. Investing

    What Investors Need to Know About Returns in 2016

    Last year wasn’t a great one for investors seeking solid returns, so here are three things we believe all investors need to know about returns in 2016.
  8. Investing Basics

    How to Analyze a Company's Inventory

    Discover how to analyze a company's inventory by understanding different types of inventory and doing a quantitative and qualitative assessment of inventory.
  9. Professionals

    A Day In The Life Of A Public Accountant

    Here's an inside look at the workdays of two experienced CPAs, to give you an idea of what it might be like to pursue a career as a public accountant.
  10. Professionals

    A Day in the Life of a Public Accountant

    There’s no typical day in the life of a public accountant, but one accountant’s experience may shed some light on what the career entails.
RELATED TERMS
  1. Tight Monetary Policy

    A course of action undertaken by the Federal Reserve to constrict ...
  2. Laissez Faire

    An economic theory from the 18th century that is strongly opposed ...
  3. Short-Term Debt

    An account shown in the current liabilities portion of a company's ...
  4. Audit

    An unbiased examination and evaluation of the financial statements ...
  5. Sortino Ratio

    A modification of the Sharpe ratio that differentiates harmful ...
  6. Climate Finance

    Climate finance is a finance channel by which developed economies ...
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. What is finance?

    "Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>
  6. What is the difference between positive and normative economics?

    Positive economics is objective and fact based, while normative economics is subjective and value based. Positive economic ... Read Full Answer >>
Hot Definitions
  1. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  2. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  3. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  4. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  5. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  6. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
Trading Center