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 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.
Years 1 - 4:
$23,250/yr. = $23,250 x 4 = $93,000
$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.)
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%.
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.
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
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
Total year 5 cash flow $1,960
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