Unit 11 Fin 320F
What is the nominal rate of return on an investment
the actual percentage change in the dollar value of an investment unadjusted for inflation
the relationship between nominal rates, real rates, and inflation is called
the fisher effect
model that precisely specifies the relationship between the nominal rate and the real rate is: R= the nominal rate of interest r = the real rate of interest h = the inflation rate
(1 + R) = (1 + r) * (1 + h)
what are relevant cash flows?
- CF from erosion effects - CF from beneficial spillover effects - CF from external costs
The Oceanside Marina is considering the purchase of an excursion boat. Model SL would require an initial investment of $2.2 million and produce annual after-tax cash inflows of $1.2 million for each of three years. Model LL would require an initial investment of $5.5 million and produce annual after-tax cash inflows of $1.3 million for each of 7 years. Oceanside's discount rate is 8%. Which model should be chosen?
- Model SL First step: find the NPV of each project NPVSL = -$2,200,000 + $1,200,000(PVFA.08, 3) = $892,516 NPVLL = -$5,500,000 + $1,300,000(PVFA.08, 7) = $1,268,281 Second step: find the EAS of each project NPVSL = EASSL(PVFA.08, 3) $892,516 = EASSL(2.5771) gives EASSL = $892,516/2.5771 = $346,326 NPVLL = EASLL(PVFA.08, 7) $1,268,281 = EASLL(5.2064) gives EASSL = $1,268,281/5.2064 = $243,600 Model SL has the highest EAS and should be selected.
what is the real rate of return?
- a percentage change in buying power - a rate of return that has been adjusted for inflation
cash flows should always be considered on a _______ basis
- after tax
cash flows used in project estimation should always reflect
- cash flows when they occur - after- tax cash flows
investment in net working capital arises when ______
- cash is kept from unexpected expenditures - inventory is purchased - credit sales are made
incremental cash flows come about as a _________ consequence of taking a project under consideration
- direct
Sprigg Lane Manufacturing, Inc., needs to purchase a new central air-conditioning system for a plant. There are two choices. The first system costs $50,000 and is expected to last 10 years, and the second system costs $72,000 and is expected to last 15 years. Assume that the opportunity cost of capital is 10 percent. Which air-conditioning system should Sprigg Lane purchase?
- first system The equivalent annual cost for each system is: EAC1 = (0.1)($50,000)[(1.1)10/{(1.1)10/[(1.1)10 - 1}] = 8,137.27 EAC2 = (0.1)($72,000)[(1.1)15/{(1.1)15/[(1.1)15 - 1}] = 9,466.11 Sprigg Lane should purchase the first one.
the stand-alone principle assumes that evaluation of a project may be based on the project's ____________ CF
- incremental
first in estimating cash flow is to determine the ______ CF
- relevant
1. Cash Flow and Depreciation. "When evaluating projects, we're only concerned with the relevant incremental aftertax cash flows. Therefore, because depreciation is a noncash expense, we should ignore its effects when evaluating projects." Critically evaluate this statement.
1. Cash Flow and Depreciation. Depreciation is a non-cash expense, but it is tax-deductible on the income statement. Thus depreciation causes taxes paid, an actual cash outflow, to be reduced by an amount equal to the depreciation tax shield TCD. A reduction in taxes that would otherwise be paid is the same thing as a cash inflow, so the effects of the depreciation tax shield must be added in to get the total incremental aftertax cash flows. (Chapter 9, 9.5)
1. Opportunity Cost. In the context of capital budgeting, what is an opportunity cost?
1. Opportunity Cost. In this context, an opportunity cost refers to the value of an asset or other input that will be used in a project. The relevant cost is what the asset or input is actually worth today, not, for example, what it cost to acquire. (Chapter 9, 9.1)
6. Relevant Cash Flows. Kenny, Inc., is looking at setting up a new manufacturing plant in South Park. The company bought some land six years ago for $5.3 million in anticipation of using it as a warehouse and distribution site, but the company has since decided to rent facilities elsewhere. The land would net $7.4 million if it were sold today. The company now wants to build its new manufacturing plant on this land; the plant will cost $26.5 million to build, and the site requires $1.32 million worth of grading before it is suitable for construction. What is the proper cash flow amount to use as the initial investment in fixed assets when evaluating this project? Why?
1. Relevant Cash Flows. This first question involves the direct and indirect cash flows connected with obtaining the manufacturing plant. The $5.3 million acquisition cost of the land six years ago is a sunk cost. This amount would occur in Kenny, Inc.'s Balance Sheet, but it does not reflect what the land is worth today. The $7.4 million current after-tax value of the land is an opportunity cost if the land is used rather than sold off. As you could get $7.4 million for the land, you should include the use of the land as part of the incremental cash flows for the project. The $26.5 million cash outlay and $1,320,000 grading expenses are the initial fixed asset investments needed to get the plant ready for use. No plant, no operating cash flows! Therefore, the proper year zero cash flow to use in evaluating this project is: Cash flow = $7,400,000 + 26,500,000 + 1,320,000 Cash flow = $35,220,000 (Chapter 9, 1)
10. Calculating Depreciation. A piece of newly purchased industrial equipment costs $715,000 and is classified as seven-year property under MACRS. Calculate the annual depreciation allowances and end-of-the-year book values for this equipment.
10. Calculating Depreciation. The MACRS depreciation schedule is shown in Table 9.7. The ending book value for any year is the beginning book value minus the depreciation for the year. Remember, to find the amount of depreciation for any year, you multiply the purchase price of the asset times the MACRS percentage for the year. The depreciation schedule for this asset is: Beginning Year Beginning Book Value Depreciation Depreciation Allowance Book Value ending 1 $715,000.00 14.29% $102,173.50 $612,826.50 2 612,826.50 24.49% 175,103.50 437,723.00 3 437,723.00 17.49% 125,053.50 312,669.50 4 312,669.50 12.49% 89,303.50 223,366.00 5 223,366.00 8.93% 63,849.50 159,516.50 6 159,516.50 8.92% 63,778.00 95,738.50 7 95,738.50 8.93% 63,849.50 31,889.00 8 31,889.00 4.46% 31,889.00 0 This is useful information. The depreciation expense for each year can be used to calculate Operating Cash Flow (OCF). You can also calculate the book value of an asset, which will help you in replacement decisions (what is the after-tax value of an old asset if you sell it), or the salvage value if the project life is less than the depreciation life of an asset. (Chapter 9, 5)
11. Calculating Salvage Value. Consider an asset that costs $545,000 and is depreciated straight-line to zero over its eight-year tax life. The asset is to be used in a five-year project; at the end of the project, the asset can be sold for $95,000. If the relevant tax rate is 35 percent, what is the aftertax cash flow from the sale of this asset?
11. Calculating Salvage Value. This question builds on my comments in question 10: If you sell an asset before it is fully depreciated, you need to know its current book value. This book value is the basis for computing any capital gains taxes you might have to pay on the sale. The basis is the current value for tax purposes. The government allows you to take an annual depreciation expense that reduces income taxes. When you sell the asset, if its market value is different from its basis (book value), then there will be a settling up. If the asset's market value is greater than its book value, you will owe taxes. If the asset's market value is less than its book value, then you have a loss that allows you a tax credit. The two major taxes we face in Unit 11 are income taxes, paid on income earned by producing goods and services, and capital gains tax, which is levied on the difference between the price you pay for an asset and the price at which you sell the asset. For a share of stock, the price you pay for the stock is the basis for computing the capital gain on the stock. For capital budgeting projects, the book value of the project's productive assets is the basis for computing the capital gain tax or tax credit. The asset has a useful life of 8 years and we want to find the book value of the asset after 5 years. With straight-line depreciation, the depreciation each year will be: Annual depreciation = $545,000/8 Annual depreciation = $68,125 So, after five years, the accumulated depreciation will be: Accumulated depreciation = 5 x $68,125 Accumulated depreciation = $340,625 The book value at the end of year five is thus: BV5 = $545,000 - 340,625 BV5 = $204,375 The asset is sold at a loss to book value, so the depreciation tax shield of the loss is recaptured. After-tax salvage value = $95,000 + ($204,375 - 95,000)(.35) After-tax salvage value = $133,281.25 To find the taxes on salvage value, remember to use the equation: Taxes on salvage value = (BV - MV)TC This equation will always give the correct sign for a tax inflow (refund) or outflow (payment). (Chapter 9, 6)
12. Calculating Salvage Value. An asset used in a four-year project falls in the five-year MACRS class for tax purposes. The asset has an acquisition cost of $7,100,000 and will be sold for $1,460,000 at the end of the project. If the tax rate is 34 percent, what is the aftertax salvage value of the asset?
12. Calculating Salvage Value. To find the book value at the end of four years, we need to find the accumulated depreciation for the first four years. We could calculate a table as in Problem 10, but an easier way is to add the MACRS depreciation amounts for each of the first four years and multiply this percentage times the cost of the asset. We can then subtract this from the asset cost. Doing so, we get: BV4 = $7,100,000 - 7,100,000(.2000 + .3200 + .1920 + .1152) BV4 = $1,226,880 The asset is sold at a gain to book value, so this gain is taxable. After-tax salvage value = $1,460,000 + ($1,226,880 - 1,460,000)(.34) After-tax salvage value = $1,380,739.20 (Chapter 9, 7)
13. Calculating Project OCF. Rolston Music Company is considering the sale of a new sound board used in recording studios. The new board would sell for $27,300, and the company expects to sell 1,500 per year. The company currently sells 1,850 units of its existing model per year. If the new model is introduced, sales of the existing model will fall to 1,520 units per year. The old board retails for $24,900. Variable costs are 55 percent of sales, depreciation on the equipment to produce the new board will be $2,150,000 per year, and fixed costs are $3,200,000 per year. If the tax rate is 38 percent, what is the annual OCF for the project?
13. Calculating Project OCF. Rolston faces possible erosion of its existing sales if it introduces the new sound board. This example allows us to see how incremental cash flow analysis examines the wealth impact of the changes caused by this proposal. First, we calculate the net sales, taking into account the increase in sales from the new board and the decrease in sales of the existing model. Sales of new boards = $27,300 x 1,500 units = $40,950,000 Decline in sales of existing board = = $24,900 x (1,520 units -1,850 units) = $24,900 x (- 330) = - $8,217,000 Net sales = Sales of new sound board - lost sales of existing board $32,733,000 = $40,950,000 -8,217,000 Second, place the net sales into the Rolston's income statement. We follow a common procedure of stating variable production costs as a percent of sales. Depreciation and Fixed costs are given. Variable costs = Net sales x 55% $18,003,150 = $32,733,000 x .55 Net sales $32,733,000 Variable costs 18,003,150 Fixed costs 3,200,000 Depreciation 2,150,000 EBT $9,379,850 Tax 3,564,343 Net income $5,815,507 Third, with NI calculated, which includes the non-cash expense of depreciation and its impact on taxes, we can now calculate operating cash flow. Using EBIT Rolston's OCF is: OCF = EBIT + Depreciation - Taxes OCF = $9,379,850 + $2,150,000 - $3,564,343 OCF = $7,965,507 Again, we could use the alternate calculation of NI, which I prefer. OCF = NI + Depreciation OCF = $5,815,507 + $2,150,000 OCF = $7,965,507 (Chapter 9, 8)
14. Calculating Project OCF. H. Cochran, Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of $1,950,000. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $2,145,000 in annual sales, with costs of $1,205,000. If the tax rate is 35 percent, what is the OCF for this project?
14. Calculating Project OCF. Cochran's expansion project does not have economic interdependencies. Their stated costs include both variable and fixed costs. We do need to calculate depreciation using the straight-line method. Annual depreciation expense = (Fixed asset investment)/Project life = $1,950,000/3 = $650,000 With these inputs we can now calculate NI. Net sales $2,145,000 Costs 1,205,000 Depreciation 650,000 EBT $290,000 Tax 101,500 Net income $188,500 Using the methods we've developed, Cochran's OCF is OCF = NI + Depreciation OCF = $188,500 + $650,000 OCF = $838,500 We can also use the tax shield approach to calculating OCF (Remember the approach is irrelevant; the final answer will be the same no matter which of the four methods you use.), we get: OCF = (Sales - Costs)(1 - TC) + Depreciation(TC) OCF = ($2,145,000 - 1,205,000)(1 - .35) + .35($1,950,000 / 3) OCF = $838,500 (Chapter 9, 9)
15. Calculating Project NPV. In the previous problem, suppose the required return on the project is 14 percent. What is the project's NPV?
15. Calculating Project NPV. Calculating the incremental cash flows, as we've done in the last few problems, is only part of determining the NPV, which we now turn to. Going back to Cochran, Inc. Since we have the OCF, we can find the NPV as the initial cash outlay, plus the PV of the OCFs, which are an annuity, so the NPV is: NPV = -$1,950,000 + $838,500(PVIFA14%,3) NPV = -$3,311.55 As this is a negative NPV, this project would not be worth taking on. While we could use time value tables or equations, the financial calculator is the most efficient way to work out NPV problems. See Section 3: Cash Flow Analysis, Calculation 1: Calculate NPV with level cash flows. (Chapter 9, 10)
16. Project Evaluation. Kolby's Korndogs is looking at a new sausage system with an installed cost of $655,000. This cost will be depreciated straight-line to zero over the project's five-year life, at the end of which the sausage system can be scrapped for $85,000. The sausage system will save the firm $183,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $35,000. If the tax rate is 34 percent and the discount rate is 8 percent, what is the NPV of this project?
16. Project Evaluation. With our practice in the previous problems, we're now prepared to do an entire cash flow NPV evaluation for Kolby's Korndogs. This problem is a bit different from our other problems in that it is a cost-reduction problem. Revenues are not changing and are thus not included in our calculations First, we will calculate the annual depreciation of the new sausage equipment. Annual depreciation = $655,000/5 = $131,000 Second, drawing on problem 11's insights, we calculate the after-tax salvage value. The after-tax salvage value is the market price minus (or plus) the taxes on the sale of the equipment, so: After-tax salvage value = MV + (BV - MV)TC As we are looking at the salvage value and the equipment is depreciated to a zero ending value, the equation for the after-tax salvage value becomes: After-tax salvage value = MV + (0 - MV)TC After-tax salvage value = MV(1 - TC) After-tax salvage value = $85,000(1 - .34) = $56,100 Third, using the tax shield approach, we find the OCF for the project is: OCF = $183,000(1 - .34) + .34($131,000) = $165,320 We could also use NI to get OCF. Net sales No change Costs +$183,000 Depreciation 131,000 EBT $52,000 Tax 17,680 Net income $34,320 The cost savings (inflow) of $183,000 does increase our revenues, but also exposes this amount to taxes. OCF = NI + Depreciation OCF = $34,320 + $131,000 OCF = $165,320 Fourth: However we get it, OCF now goes into our project NPV calculation. Notice we include the NWC in the initial cash outlay. The recovery of the NWC occurs in Year 5, along with the after-tax salvage value. NPV = Equip. cost - NWC + OCF(PVIFA8%,5) + [Salvage value + return of NWC) / 1.085] NPV = -$655,000 - 35,000 + $165,320(PVIFA8%,5) + [($56,100 + 35,000) / 1.085] NPV = $32,075.95 (Chapter 9, 13)
17. Project Evaluation. Your firm is contemplating the purchase of a new $410,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. It will be worth $30,000 at the end of that time. You will save $125,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $35,000 at the beginning of the project. Working capital will revert back to normal at the end of the project. If the tax rate is 35 percent, what is the IRR for this project?
17. Project Evaluation. This project is also a cost-reduction project. Your firm already processes orders. You want to improve your order processing system by purchasing a new computer-based system. This new system will save your company cash in two ways. $125,000 will be saved each year in processing costs. $35,000 will also be saved in that your need for working capital will be reduced. As this is a cost-reduction project, not one that increases revenues, the tax shield approach is the most efficient one to use, and we'll not involve NI. To add some variety, we will use the IRR decision rule for our analysis. First, we will calculate the annual depreciation of the new equipment using the straight-line method Annual depreciation charge = $410,000/5 = $82,000 Second, we need the after-tax salvage value of the equipment. After-tax salvage value = $30,000(1 - .35) = $19,500 Third, using the tax shield approach, the OCF is: OCF = $125,000(1 - .35) + .35($82,000) = $109,950 Fourth, there is an unusual feature that is a part of this project. Accepting this project means that we will reduce NWC. This reduction in NWC is a cash inflow at Year 0. This reduction in NWC implies that when the project ends, we will have to increase NWC. So, at the end of the project, we will have a cash outflow to restore the NWC to its level before the project. We must also include the after-tax salvage value at the end of the project. The IRR of the project is: Fifth, now we can find the project IRR. NPV = 0 = -$410,000 + 35,000 + $109,950(PVIFAIRR%,5) + [($19,500 - 35,000) / (1 + IRR)5] IRR = 13.37% The IRR could also be calculated using your calculator. Go to the Calculator Guide: Section 2: Basic Time Value Calculations Calculation 4: Solve for Interest Rate. You could do this using Section 3: Cash Flow Analysis, but our five favorite buttons work quite nicely here! The entries would be: N = 5 PV = -$410,000 + $35,000 = -$375,000 PMT = $109,950 FV = +$19,500 - $35,000 = -$15,500 Push i/YR to get 13.37%, which is the IRR. (Chapter 9, 14)
18. Project Evaluation. In the previous problem, suppose your required return on the project is 10 percent and your pretax cost savings are $145,000 per year. Will you accept the project? What if the pretax cost savings are only $105,000 per year?
18. Project Evaluation. This question takes question 17, changes the pre-tax cost savings and evaluates the project at a discount rate of 8% To evaluate the project with a $145,000 cost savings, we need the OCF to compute the NPV. Using the tax shield approach, the OCF is: OCF = $145,000(1 - .35) + .35($82,000) = $122,950 Given the OCF, we can now determine the NPV. NPV = -$410,000 + 35,000 + $122,950(PVIFA10%,5) + [($19,500 - 35,000) / (1.10)5] = $81,452.95 To evaluate the project with a $105,000 cost savings is: OCF = $105,000(1 - .35) + .35($82,000) = $96,950 NPV = -$410,000 + 35,000 + $96,950(PVIFA10%,5) + [($19,500 - 35,000) / (1.10)5] = -$17,107.50 We would accept the project if the cost savings were $145,000, and reject the project if the cost savings were $105,000. Using the discount rate of 10% and the IRRs calculated using each of the cost savings amounts would give us the same accept/reject decisions. We will see in Lesson 2 that this is not always true! (Chapter 9, 15)
2. Capital Budgeting Considerations. A major college textbook publisher has an existing finance textbook. The publisher is debating whether or not to produce an "essentialized" version, meaning a shorter (and lower-priced) book. What are some of the considerations that should come into play?
2. Capital Budgeting Considerations. There are two particularly important considerations. The first is erosion. Will the essentialized book simply displace copies of the existing book that would have otherwise been sold? This is of special concern given the lower price. The second consideration is competition. Will other publishers step in and produce such a product? If so, then any erosion is much less relevant. A particular concern to book publishers (and producers of a variety of other product types) is that the publisher only makes money from the sale of new books. Thus, it is important to examine whether the new book would displace sales of used books (good from the publisher's perspective) or new books (not good). The concern arises any time that there is an active market for used product. Our own course is a major example of this. McGraw-Hill is increasingly offering online content. I have a corporate course that I teach and for the first time the text is coming out in soft cover rather than the traditional hard-bound textbook. In a couple of years they may cease to offer standard texts and instead go to eBooks, which have a set life, similar to the one we use. One of the motives in this is to sell information and not experience the loss of sales in the secondary market. (Chapter 9, 9.6)
2. Depreciation. Given the choice, would a firm prefer to use MACRS depreciation or straight-line depreciation? Why?
2. Depreciation. For tax purposes, a firm would choose MACRS because it provides for larger depreciation deductions earlier. These larger deductions reduce taxes, but have no other cash consequences. Notice that the choice between MACRS and straight-line is purely a time value issue; the total depreciation is the same, only the timing differs. Straight-line depreciation is a more conservative technique, as it is not accelerated, with the big cash flows front-loaded on the timeline. It thus does not produce as high a present value of the tax benefit of depreciation. There is one technical difference between MACRS and straight-line depreciation. MACRS requires that the asset is fully depreciated. Straight-line does permit a residual salvage value, which means that the entire cost of the asset would not be fully depreciated. (Chapter 9, 9.2)
To answer the next three questions, refer to the following example. In 2003, Porsche unveiled its new sports-utility vehicle (SUV), the Cayenne. With a price tag of more than $40,000, the Cayenne went from zero to 62 mph in 9.7 seconds. Porsche's decision to enter the SUV market was in response to the runaway success of other high-priced SUVs such as the Mercedes-Benz M-class. Vehicles in this class had generated years of very high profits. The Cayenne certainly spiced up the market, and Porsche subsequently introduced the Cayenne Turbo S, which goes from zero to 60 mph in 4.8 seconds and has a top speed of 168 mph. The price tag for the Cayenne Turbo S? About $114,000 in 2015. Some analysts questioned Porsche's entry into the luxury SUV market. The analysts were concerned not only that Porsche was a late entry into the market, but also that the introduction of the Cayenne would damage Porsche's reputation as a maker of high-performance automobiles. 3. Erosion. In evaluating the Cayenne, would you consider the possible damage to Porsche's reputation?
3. Erosion. Definitely. The damage to Porsche's reputation is definitely a factor the company needed to consider. If the reputation was damaged, the company would have lost sales of its existing car lines. (Chapter 9, 9.7)
3. Net Working Capital. IN our capital budgeting examples, we assumed that a firm would recover all of the working capital it invested in a project. Is this a reasonable assumption? When might it not be valid?
3. Net Working Capital. It's probably only a mild over-simplification. Current liabilities will all be paid presumably. The cash portion of current assets will be retrieved. Some receivables won't be collected, and some inventory will not be sold, of course. Counterbalancing these losses is the fact that inventory sold above cost (and not replaced at the end of the project's life) acts to increase working capital. These effects tend to offset. (Chapter 9, 9.3)
To answer the next three questions, refer to the following example. In 2003, Porsche unveiled its new sports-utility vehicle (SUV), the Cayenne. With a price tag of more than $40,000, the Cayenne went from zero to 62 mph in 9.7 seconds. Porsche's decision to enter the SUV market was in response to the runaway success of other high-priced SUVs such as the Mercedes-Benz M-class. Vehicles in this class had generated years of very high profits. The Cayenne certainly spiced up the market, and Porsche subsequently introduced the Cayenne Turbo S, which goes from zero to 60 mph in 4.8 seconds and has a top speed of 168 mph. The price tag for the Cayenne Turbo S? About $114,000 in 2015. Some analysts questioned Porsche's entry into the luxury SUV market. The analysts were concerned not only that Porsche was a late entry into the market, but also that the introduction of the Cayenne would damage Porsche's reputation as a maker of high-performance automobiles. 4. Capital Budgeting. Porsche was one of the last manufacturers to enter the sports-utility vehicle market. Why would one company decide to proceed with a product when other companies, at least initially, decide not to enter the market?
4. Capital Budgeting. This brief discussion of Porsche's decision cannot give you all of the facts, but rather introduces issues for you to consider. One company may have an advantage in that they might be able to produce at lower incremental cost or market better. Also, of course, one of the two may have made a mistake! One of the difficulties you have in studying Finance, or Business, or even politics, is that organizations that make mistakes often disappear from wide public view, along with the cautionary lessons that could be learned from their managers' mistakes. How many of you could discuss Kodak or Enron? The potential mistakes made by these companies are still out there, ready to be made by new managers and seasoned managers who forget! It's for this reason that we go back to historic decisions. As George Santana famously stated: "Those who cannot remember the past are condemned to repeat it." (Chapter 9, 9.8)
To answer the next three questions, refer to the following example. In 2003, Porsche unveiled its new sports-utility vehicle (SUV), the Cayenne. With a price tag of more than $40,000, the Cayenne went from zero to 62 mph in 9.7 seconds. Porsche's decision to enter the SUV market was in response to the runaway success of other high-priced SUVs such as the Mercedes-Benz M-class. Vehicles in this class had generated years of very high profits. The Cayenne certainly spiced up the market, and Porsche subsequently introduced the Cayenne Turbo S, which goes from zero to 60 mph in 4.8 seconds and has a top speed of 168 mph. The price tag for the Cayenne Turbo S? About $114,000 in 2015. Some analysts questioned Porsche's entry into the luxury SUV market. The analysts were concerned not only that Porsche was a late entry into the market, but also that the introduction of the Cayenne would damage Porsche's reputation as a maker of high-performance automobiles. 5. Capital Budgeting. In evaluating the Cayenne, what do you think Porsche needs to assume regarding the substantial profit margins that exist in this market? Is it likely they will be maintained as the market becomes more competitive, or will Porsche be able to maintain the profit margin because of its image and the performance of the Cayenne?
5. Capital Budgeting. Porsche would recognize that the outsized profits would dwindle as more products come to market and competition becomes more intense. This has occurred previously in the auto market. The luxury car in the 1960s through the 1980s was the Mercedes-Benz. I know, as I had one! This was a very popular brand, despite its being expensive. In fact, the price increased spectacularly in the 1970s as the drop in the U.S. dollar made German products quite expensive in the U.S. The more expensive it was, the more people lusted after the MB Star! Toyota developed as a fuel-efficient, well-made import. However there was substantial competition in the mid-range auto market, and Toyota management looked at the envious M-B profit margins. In 1989 they introduced the Lexus. Honda saw this and introduced the Acura. Nissan saw the party getting started and introduced the Infiniti. This basic short example on Porsche's SUV decision thus brings up some major issues. A positive NPV project is quite valuable. If a company is doing something neat—like the iPhone—other companies will muscle in on that lucrative market. Companies must thus constantly innovate, and seek to reduce costs, to stay up with the competition! (Chapter 9, 9.9)
7. Relevant Cash Flows. Winnebagel Corp. currently sells 28,000 motor homes per year at $77,000 each and 7,000 luxury motor coaches per year at $120,000 each. The company wants to introduce a new portable camper to fill out its product line; it hopes to sell 29,000 of these campers per year at $23,500 each. An independent consultant has determined that if the company introduces the new campers, it should boost the sales of its existing motor homes by 2,500 units per year and reduce the sales of its motor coaches by 750 units per year. What is the amount to use as the annual sales figure when evaluating this project? Why?
7. Relevant Cash Flows This second question involves estimating a project's annual sales incremental cash flows. Sales due solely to the new product line are: 29,000 x $23,500 = $681,500,000 The company should take economic interdependencies into account: how would the introduction of this new product affect their existing sales. Synergy: The new product is expected to attract new customers and increase the sales of Winnebagel's motor home line, producing an increase in sales of: 2,500 x $77,000 = $192,500,000 increase in sales Erosion: As with many new products, existing customers may switch from existing lines to the new product. The introduction of the portable camper is expected to decrease Wommebagels sales of luxury motor coach sales. 750 x $120,000 = $90,000,000 loss in sales The net sales figure to use in evaluating the new line is thus: Net sales = $681,500,000 + 192,500,000 - 90,000,000 Net sales = $784,000,000 NPV for a new product should include the project's impact on all cash flows of the company, not just the project's narrowly defined cash flows. (Chapter 9, 2)
8. Calculating Projected Net Income. A proposed new investment has projected sales of $645,000. Variable costs are 40 percent of sales, and fixed costs are $168,000; depreciation is $83,000. Prepare a pro forma income statement assuming a tax rate of 35 percent. What is the projected net income?
8. Calculating Projected Net Income. We need to construct an income statement, which we studied in Unit 4. This statement lists the inflows (revenues) less the costs of producing those revenues. In this question, a in our general treatment of capital budgeting in Unit 11, we look at the operating characteristics of the project and not the impact of financing. We therefore have no interest expense to consider. Interest is certainly not irrelevant to the company, but we'd like to determine whether the project makes sense from an operating viewpoint, and examine the financing decision (from Unit 3) separately. The income statement is: Sales $ 645,000 Variable costs 258,000 Fixed costs 168,000 Depreciation 83,000 EBIT $ 136,000 Taxes@35% 47,600 Net income $ 88,400 Note that in this problem we've calculated the Net Income, and not the Net Cash flows! Chapter 9, 3)
9. Calculating OCF. Consider the following income statement: Sales $558,400 Costs 346,800 Depreciation 94,500 EBIT ? Taxes ? Net Income ? Fill in the missing numbers and then calculate the OCF. What is the depreciation tax shield?
9. To find the OCF, we need to complete the income statement as follows: Sales $ 558,400 Variable costs 346,800 Depreciation 94,500 EBIT $ 117,100 Taxes@35% 40,985 Net income $ 76,115 We can obtain OCF for the company by first calculating EBIT, which measures the operating profit before the interest expense and taxes. As I stated previously, we're ignoring interest expenses in this unit. As the depreciation expense is not a cash outflow, we add it back in. We then subtract taxes, which we nicely figured out after taking advantage of the tax-shield provided by depreciation. OCF = EBIT + Depreciation - Taxes OCF = $117,100 + 94,500 - 40,985 OCF = $170,615 We could also obtain OCF for the company by calculating NI, which is the net profit to the shareholders. As NI reflects the taxes paid to our nice government, we need only add back depreciation.. OCF = NI + Depreciation OCF = $76,115 + 94,500 OCF = $170,615 Yes, we get the same answer! As with time value calculations, there are several ways to examine a decision. This flexibility makes these financial issues a bit of a pain to study, but also provides a powerful tool for you to use when you're dealing with real money! The depreciation tax shield is the depreciation times the tax rate, so: Depreciation tax shield = Depreciation(TC) Depreciation tax shield = .35($94,500) Depreciation tax shield = $33,075 The depreciation tax shield shows us the increase in OCF by being able to expense depreciation. Let's say that depreciation was not allowed. Our NI would be Sales $ 558,400 Variable costs 346,800 EBIT $ 211,600 Taxes@35% 74,060 Net income $ 137,540 You might celebrate, as your NI went from $76,115 with depreciation to $137,540. However, without this expense your taxes went from $40,985 to $74,060. Your taxes went up by $74,060 - $40,985 = $33,075. Without the depreciation tax shield, your OCF becomes: OCF = NI + Depreciation OCF = $137,540 + squat OCF = $137,540 The reduction in OCF exactly matches the value of the depreciation tax shield. $137,540 - $170,615 = $33,075 While the material in this course looks quite complex, it is a logical system that gets far less complex as you understand basic relationships. Many of you state in Introduce Yourself that your careers will involve business decisions. Business decisions involve inflows and outflows. Understanding the basic accounting relationships, and then expanding them to consider incremental cash flow analysis will greatly enhance our career effectiveness. (Chapter 9, 4)
what is the equation for the approximating the nominal rate of return R= the nominal rate of interest r = the real rate of interest h = the inflation rate
R= r + h
