CHAPTER 10

MAKING CAPITAL INVESTMENT DECISIONS

– DCF (Discounted CF Analysis)

Jeep is reviving a classic. See the

new Grand Wagoneer

What went into Jeep’s decision to launch its new

Grand Wagoneer ?

https://www.cnn.com/2021/03/11/success/jeep-grand-

wagoneer-reveal/index.html

Here's what it's like to drive a new

$100,000 Jeep(CNN) Cruising up a highway heading north out of New York City, the bright

white Jeep Grand Wagoneer I was driving got the sort of attention usually

given to Lamborghinis and Ferraris. Other vehicles maneuvered to get a better

look and smartphones were held out through car windows for a shot. I was

driving the luxuriously equipped Grand Wagoneer, with a total price of more

than $100,000, toward an off-road course on private land.

The new Jeep Grand Wagoneer offers a level of luxury not seen in a Jeep

before.

Here's what it's like to drive a new

$100,000 Jeep

Features and Competitors:

•As the heir to an iconic American luxury SUV, the new model – 2022 Grand Wagoneer

– has a reputation to live up to. It’s available with a 6.4-liter V8 and an eight-speed

automatic transmission. The V8 is rated at 471 hp and lets the body-on-frame SUV go

0-60 mph in 6 seconds. But, while the Grand Wagoneer doesn’t offer hybrid options

like the Range Rover, it does offer standard 4WD with a two-speed transfer case. And

with the integrated tow hitch, it can tow up to 9850 pounds. In Rock Mode, the SUV

has 10.1” of ground clearance and can wade into water 24” deep. Plus, like the Range

Rover, it has independent front and rear suspension.

•If it were a contest, the Grand Wagoneer makes a strong play for leader in total

touchscreen area inside an SUV. There was even a screen just for the front passenger,

one each for rear passengers and one in the center between the second row passengers.

•The Jeep Grand Wagoneer has a surprising level of technology throughout. It’s

available with driving assistance technologies that help it hold its lane on the highway

and maintain a set speed in traffic without driving into vehicles ahead of it.

Here's what it's like to drive a new

$100,000 Jeep

Features and Competitors:

•Still, the best things about both the Wagoneer and Grand Wagoneer are built into their

bones. These are, fundamentally, excellent big SUVs that are comfortable, practical and

capable. The more expensive Grand Wagoneer is in a price range with the most opulent

European SUVs, like the BMW X7 and Mercedes-Benz GLS. While they do provide a

more luxurious experience for those who want to ride like royalty, the European SUVs

might not be so good at crawling over rock beds. The Grand Wagoneer and Wagoneer

are clear contenders for king of the mountain among big SUVs.

Pricing

The Grand Wagoneer has a starting price near $90,000, a sizable jump up from

the $60,000 for the two-wheel drive base version of the Wagoneer. The lowest-

price version won't be available until later, though. The Wagoneer that's

currently on the market costs nearly $70,000.

Do you think $70,000 starting

price is reasonable?

Any theoretical foundation?

How exactly to set a

competitive price on a new

product?

Here's what it's like to drive a new

$100,000 Jeep

What went into Jeep’s decision to launch its new

Grand Wagoneer ?

How would you go about making such a project

decision?

https://www.cnn.com/2021/08/31/success/jeep-grand-

wagoneer-review/

❑ Decision Rules (Ch 9)

❑ Cash flows (Ch10)

❑ Discount rates/Cost of

Capital (Ch14)

Chapter10 Outline

– 2nd Chapter under Capital budgeting

 Incremental Cash Flows

 Financial Statements and Project Cash Flows

 Alternative Definitions of Operating Cash Flow

 Some Special Cases of Discounted Cash Flow

(DCF) Analysis

10-7

Relevant Cash Flows

❑ The first and most important step for capital

budgeting decision – is to decide which cash flows

are relevant.

❑ Should be straightforward to determine – But in a

few situations it is easy to make mistakes

10-8

Any and all changes in the firm's future cash

flows that are a direct consequence of taking the

project ‒ The incremental cash flows

Example

Suppose Hill’s Pet Nutrition Company hires a financial

marketing company to help evaluate whether a line of

new dog treat should be launched. When the consultant

turns in the report, Hill’s pet objects to the analysis

because the consultant did not include the hefty

consulting fee as a cost of the dog treat project.

Should the consulting fee be included in the cost of the

dog treat project?

Sunk Cost

❑ Consulting fee must be paid whether or not the new dog treat

line will be launched. So the consulting fee is a Sunk Cost.

❑ Sunk cost is NOT a relevant cash flow – Not a direct

consequence to accepting the project.

❑ The point is: we should always be careful to exclude sunk

costs (e.g. consulting fee) from our analysis.

10-10

Sunk cost is a cost we have already paid, or

already incurred the liability to pay.

No, exclude consulting fee

Example

A company is thinking of converting an old rustic factory

building (and the associated land) into an upscale office

building. The company bought the old building years

ago for $500,000. If they undertake this project, there

will be no direct cash outflow associated with buying the

old building because they already own it.

For purposes of evaluating the office building project,

should they treat the old building as “free”?

Opportunity Cost

 The old factory building is a valuable resource.

 Using it for the project has an opportunity cost:

 They give up the valuable opportunity of selling it (to build an

office building).

 Should they treat the old building as “free”?

The answer is NO!

What is the direct

consequence?

Take the project Use the old factory

building/land

Not take the project Sell it !

No, they should NOT treat the old building as free!

Opportunity Cost

 How much should we charge (the office project) for the

use of the old building?

 Should we use $500,000, given we paid that much years ago?

 No. The fact that we paid $500,000 some years ago is

irrelevant.

 Should charge the amount we give up – the opportunity cost

 That is what the factory would sell for today – Market value.

 The point: Need to pay attention to opportunity costs!

Side effects

❑ It is common for a project to have side, or spillover effects, both

good and bad → the cash flows should be adjusted to reflect these

side effects

❑ Negative impact (Erosion)

➢ Introducing of a new product may have a negative impact on the

cash flows of an existing product.

E.g. Opening an in Pullman ??

❑ Positive impact

➢ HP sells far more printers now than in the 1990s, but the price is

only 1/5 – they sell more cartridges and special papers

will drain customers

from Moscow Applebees.

Common Types of Cash Flows

Other incremental cash flows:❑ Changes in net working capital

▪ Most projects will require an increase in NWC initially as we build

inventory and receivables. Then, we recover NWC at the end of the

project.

❑ Financing costs – In analyzing a project, we will not include

financing costs such as interest paid, dividends repaid.

▪ Financing cost is included in the required return (cost of capital) –

avoid double counting

▪ finance the entire portfolio of projects at one time, not a single one

at a time.

❑ Taxes – we need to consider cash flows on an after-tax basis.

10-15

Question 3

Suppose that Ford is considering a project to make a

new brand of gas-saving car. In that project, the sales

of the new brand will decrease the sales of existing

brands of cars. This decrease in the sales of existing

brands of cars is an example of:a. fixed cost

b. sunk cost

c. opportunity cost

d. erosion

Note:

Erosion = negative side effect

Question 4

Which one of the following should NOT be included in the analysis

of a new product?

A. Increase in accounts payable for new product inventory

purchases.

B. Reduction in sales for a current product once the new product

is introduced.

C. Market value of a machine owned by the firm which will be

used to produce the new product.

D. Money already spent for research and development of the

new product.

B – Neg. Side effect: Erosion

C – Opportunity cost

D – Sunk cost

A – changes in NWC

Pro Forma (projected) Statements and Cash

Flow

 Capital budgeting relies heavily on pro forma, or

projected, accounting statements, particularly income

statements

 Computing cash flows – refresher

▪ Operating Cash Flow (OCF) = EBIT + depreciation – taxes

▪ Cash Flow From Assets (CFFA) =

OCF – net capital spending (NCS) – changes in NWC

10-18

Example – the Project

Suppose we can sell 50,000 cans of shark attractant per year at a price

of $4 per can. It costs us about $2.50 per can to produce, and a new

product like this typically has only a three-year life. We require a 20

percent return on new products.

Fixed costs for the project, including rent on the production facility,

which will run $12,000 per year.

Further, we will need to invest a total of $90,000 in manufacturing

equipment. Assume that this $90,000 will be 100 percent depreciated

over the three year (straight-line). Furthermore, the equipment will be

essentially worthless on a market value basis at the end.

Finally, the project will require an initial $20,000 investment in net

working capital, and the tax rate is 34 percent.

Should we accept the project?

Table 10.1 Pro Forma Income Statement

Sales (50,000 units at

$4.00/unit)

$200,000

Variable Costs ($2.50/unit) 125,000

Gross profit

Fixed costs

Depreciation ($90,000 / 3)

EBIT

Taxes (34%)

Net Income

10-20

Key Information:

•rent on facility,

$12,000 per year.

•Invest $90,000 in

equipment

$75,000

12,000

30,000

$ 33,000

11,220

$ 21,780

OCF = EBIT + depreciation – taxes

Projected Operating Cash Flow

Operating Cash Flow (OCF) = EBIT + depreciation – taxes

Table 10.5 Projected Total Cash Flows

Year

0 1 2 3

OCF $51,780 $51,780 $51,780

Change in

NWC

-$20,000 20,000

NCS -$90,000 0

CFFA -$110,000 $51,780 $51,780 $71,780

10-22

▪ OCF each year = $51,780 ;

▪ Further, we will need to invest a total of $90,000 in manufacturing equipment. the

equipment will be essentially worthless on a market value basis at the end.

▪ Finally, the project will require an initial $20,000 investment in net working capital

Making The Decision

❑ Now that we have the cash flows, required return=20%, we

can apply the techniques that we learned in Chapter 9

❑ Compute NPV &IRR

▪ CF0 = -110,000; ▪ C01 = 51,780; F01 = 2; ▪ C02 = 71,780; F02 = 1;▪ NPV: I = 20; ▪ CPT NPV = 10,648▪ CPT IRR = 25.8%

❑ Should we accept or reject the project?

▪ The project creates over $10,000 and should be accepted.

▪ Also, we find that the IRR = 25.8 % > 20%

10-23

0 1 2 3

CFFA -$110,000 $51,780 $51,780 $71,780

Things that affect CFs:

10-24

Things that affect CFs:

❑ Depreciation

❑ Salvage Value

– market value of initial investments (e.g.

equipment) at the end of project

Things that affect CFs: Depreciation

 Depreciation itself is a non-cash expense;

▪ it is only relevant because it affects taxes

 Depreciation tax shield = D × T

▪ D = depreciation expense

▪ T = marginal tax rate

10-25

OCF = EBIT + depreciation – taxes

Taxes are determined by:

▪ EBIT = S – C – D

▪ the higher D, the lower the taxable income

Computing Depreciation

 Straight-line depreciation

➢ Dep. amount is the same each year during the life time of the asset

D = (Initial cost – salvage) / number of years

Salvage – market value of initial investments at the end of project

➢ If the requirement is “straight-line depreciation to 0”, then:

D = (Initial cost – 0) / number of years

➢ Very few assets are depreciated straight-line for tax purposes

 Modified Accelerated Cost Recovery System (MACRS)

➢ every asset is assigned to a particular class

D = initial cost x % given in table

➢ The expected salvage value are NOT explicitly considered in the

calculation of depreciation

10-26

MACRS

Class Examples

Three-year Equipment used in research

Five-year Autos, computers

Seven-year Most industrial equipments

TABLE 10.6

Modified ACRS Property Classes

❑ under MACRS, every asset is assigned to a

particular class

You can find the full list in IRS Pub 946.

MACRS

Property Class

Year Three-Year Five-Year Seven-Year

1 33.33% 20.00% 14.29%

2 44.45 32.00 24.49

3 14.81 19.20 17.49

4 7.41 11.52 12.49

5 11.52 8.93

6 5.76 8.92

7 8.93

8 4.46

TABLE 10.7 Modified ACRS Depreciation Allowances

▪ depreciation % are much higher in early years than in later years

o asset is most heavily used when it is new, functional

o Why might firms prefer an accelerated depreciation method (MACRS)?

lower taxes in early years, defer taxes to later periods

❑ After-tax Salvage Value

❑ Sell the equipment at the end, and pay tax

▪ After-tax salvage value affect firms’ cash flows at the end

of project life

❑ After-tax salvage = salvage – T*(salvage – book value)

▪ BV = initial cost – accumulated depreciation

▪ If the salvage value is different from the BV of the asset,

then there is a tax effect

10-29

Things that affect CFs: After-Tax Salvage

Example: Depreciation affets After-tax Salvage

❑ You purchase equipment for $100,000, and it costs $10,000

to have it delivered and installed.

❑ Based on past information, you believe that you can sell the

equipment for $17,000 when you are done with it in 6 years.

❑ The company’s marginal tax rate is 40%.

❑ What is the depreciation expense each year and what is the

after-tax salvage in year 6 for each of the following

situations?

▪ Straight-line depreciation to salvage value

▪ MACRs depreciation

10-30

Case 1: Straight-line to Salvage

D = (Initial cost – salvage) / number of years

❑ D = (110,000 – 17,000) / 6 = 15,500 every year for 6 years

❑ BV in year 6 = 110,000 – 6*(15,500) = 17,000

❑ After-tax salvage = salvage – T*(salvage – book value)

=17,000 – .4 * (17,000 – 17,000)

= 17,000

10-31

Key information:

You purchase equipment for $100,000, and it costs $10,000 to have it delivered and

installed.

you can sell the equipment for $17,000 when you are done with it in 6 years.

Tax rate is 40%.

Before-tax salvage value

Case2: Three-year MACRSYr MACRS

percentD =

initial cost x % dep.

1 .3333 .3333(110,000)

= 36,663

2 .4445 .4445(110,000)

= 48,895

3 .1481 .1481(110,000)

= 16,291

4 .0741 .0741(110,000)

= 8,151

5 0

6 0

BV in year 6 =

110,000 – 36,663 –

48,895 – 16,291 – 8,151

= 0

After-tax salvage

= 17,000 – .40 * (17,000 – 0) = $10,200

Will the effect always be negative?

10-32

No, salvage < BV, positive

Chapter Outline

 Incremental Cash Flows

 Financial Statements and Project Cash Flows

 Alternative Definitions of Operating Cash Flow

 Some Special Cases of Discounted Cash Flow (DCF)

Analysis

10-33

Other Methods for Computing OCF

 Top-Down Approach

▪ OCF = Sales – Costs – Taxes

▪ Don’t subtract non-cash deductions

 Bottom-Up Approach

▪ OCF = NI + depreciation

 Tax Shield Approach

▪ OCF = (Sales – Costs)(1 – T) + Depreciation*T

10-34

Traditional Approach:

OCF = EBIT +Depreciation – Taxes

Tax shield

Other Methods for Computing OCF

 Top-Down Approach

▪ Start from traditional:

▪ OCF = EBIT + Dep. – Taxes

Since EBIT=Sales – Costs – Dep., if add back Depreciation:

▪ Top-down: OCF = Sales – Costs – Taxes

 Examples

▪ Traditional approach

▪ OCF = EBIT + D – T

▪ EBIT = S – C – D

= $1,500 -700 -600 = $200

▪ Taxes = EBIT x T =$200 x 0.34 = $68

▪ OCF = $200 + 600 – 68 = $732 10-35

Top-down ApproachOCF = Sales – Costs – Taxes

= 1,500 – 700 – 68

= $732

Sales = $1,500

Costs=$700

Depreciation =$600

T=34%

Other Methods for Computing OCF

❑ Bottom-Up Approach

▪ OCF = NI + depreciation

▪ The bottom-up approach – start with the accountant's bottom

line (net income) and add back any noncash deductions such

as depreciation

❑ Example

10-36

.

▪ EBIT= S – C – D

=1500 – 700 – 600 = $200

▪ Taxes=200 x 0.34 = $68

▪ NI = EBIT – Taxes = $200 – 68 =$132

▪ OCF = NI + Dep. = $132 + 600 = $732

Sales = $1,500

Costs=$700

Depreciation =$600

T=34%

▪ NI = Total sales x Profit margin

o profit margin = NI/ Total sales

▪ Profit margin=8.8%,

NI = $1500 x 8.8% = $132

Other Methods for Computing OCF

❑ Tax Shield Approach

❑ OCF = after-tax profit + Dep. Tax shield

= (Sales – Costs)(1 – T) + Depreciation*T

❑ Do we get the same answer?

▪ OCF = ($1,500 – $ 700) x.66 + 600 x 0.34

= $528 + $204 = $732

❑ All 4 methods give us the same OCF. ▪ If we know NI, bottom up is more efficient,

▪ Otherwise we should use top down, or tax shield

approach.

10-37

Sales = $1,500

Costs=$700

Depreciation =$600

T=34%

OCF=$732

Question 6:

 The Beach House has sales of $784,000 and a profit margin of

11 percent. The annual depreciation expense is $14,000. What is

the amount of the operating cash flow?

A. $68,760

B. $72,240

C. $86,240

D. $100,240

E. $101,760

Answer – D

▪NI = Total sales x Profit margin

= $784,000  0.11=$86,240

▪Bottom up:

OCF = NI + D

=$86,240 + $14,000

= $100,240

Question 5:Lily's Fashions is considering a project that will require $28,000

in net working capital and $87,000 in initial investment in fixed

assets. The project is expected to produce annual sales of

$75,000 with associated costs of $57,000. The project has a 5-

year life. The company uses straight-line depreciation to a zero

book value over the life of the project. Salvage value is zero. The

tax rate is 30 percent. Using tax shield approach, what is the

operating cash flow for this project?

A. -$1,520

B. -$580

C. $420

D. $15,680

E. $17,820

Answer: E

OCF = (Sales – Costs)(1 – T) +Depreciation*T

Depreciation Tax shield = ($87,000/5)*0.30 =$5,220

OCF = ($75,000 – $57,000)(1 – 0.30) + $5,220

= $17,820

Practicing Question 10You have the following information:

 A $1,000,000 investment will be straight-line depreciated to 0 at the 6th year. Salvage value will be $200,000 at that time.

 The project requires $150,000 in additional inventory and will increase accounts payable by $50,000.

 It will generate $207,160 operating cash flows (OCF) each year. The tax rate is 40%.

 What is the incremental cash flow in years 0 and year 6 respectively?

10-40

Year 0 Years1 – 5 Year 6

OCF $207,160 $207,160

Change in NWC -$100,000 +$100,000

NCS

CFFA

❑Changes in NWC = 150,000 – 50,000 = 100,000

Practicing Question 10You have the following information:

 A $1,000,000 investment will be straight-line depreciated to 0 at the 6th year. Salvage value will be $200,000 at that time.

 The project requires $150,000 in additional inventory and will increase accounts payable by $50,000.

 It will generate $207,160 operating cash flows (OCF) each year. The tax rate is 40%.

 What is the incremental cash flow in years 0 and year 6 respectively?

10-41

Year 0 Years1 – 5 Year 6

OCF $207,160 $207,160

Change in NWC -$100,000 +$100,000

NCS -$1,000,000 +$120,000

CFFA

❑After-tax salvage = salvage – (salvage – BV)*T

= 200,000 – (200,000 – 0) * 40% = 120,000

Practicing Question 10

You have the following information:

 A $1,000,000 investment will be straight-line depreciated to 0 at the 6th year. Salvage value will be $200,000 at that time.

 The project requires $150,000 in additional inventory and will increase accounts payable by $50,000.

 It will generate $207,160 operating cash flows (OCF) each year. The tax rate is 40%.

 What is the incremental cash flow in years 0 and year 6 respectively?

10-42

Year 0 Years1 – 5 Year 6

OCF $207,160 $207,160

Change in NWC -$100,000 +$100,000

NCS -$1,000,000 +$120,000

CFFA -$1,100,000 $207,160 $427,160

Full-fledged DCF Analysis

10-43

❑ Relevant Cash Flows.

❑ Use financial statements and CF table

▪ Compute OCF and CFFAs

❑ Using decision rules (NPV, IRR) to make the

decision.

Some Special Cases

10-44

1. Investments that are primarily aimed at

improving efficiency and thereby cutting costs.

2. When a firm is involved in submitting

competitive bids.

Case1 – EVALUATING COST-CUTTING

PROPOSALS

Suppose we are considering automating some part of an

existing production process.

The necessary equipment costs $80,000 to buy and install.

The automation will save $22,000 per year (before taxes)

by reducing labor and material costs.

For simplicity, assume that the equipment has a five-year

life and is depreciated to 0 on a straight-line basis over that

period. It will actually be worth $20,000 in five years.

The tax rate is 34 percent, and the discount rate is 10

percent. Should we automate?

Case1 – EVALUATING COST-CUTTING

PROPOSALS

The first step – identify the relevant cash flows (OCF & CFFA)OCF = EBIT + D – Taxes

❑ EBIT = S – C – D

▪ Do we have sales and costs?

the project’s operating income (gross profit) is NOT in terms of (S

– C), BUT in terms of:

Cost saving = $22,000 each year

▪ D = $80,000/5 = $16,000 per year.

▪ So, EBIT = $22,000 − $16,000 = $6,000.

❑ Taxes = $6,000 × .34 = $2,040.

Basic information

automation will save $22,000 per year (before taxes) by reducing labor and

material costs.

The initial investment in equipment costs $80,000. The equipment has a 5-year

life and is depreciated to 0 on a straight-line basis.

EBIT = Cost saving – D

Case1 – EVALUATING COST-CUTTING

PROPOSALS

 Net Capital Spending (NCS):

▪ Initially outflow: – $80,000

▪ After-tax salvage value = $20,000 – $0.34 *($20,000 – 0)

= $13,200

The necessary equipment costs $80,000

the equipment has a 5-year life and is depreciated to 0 on a straight-line

basis over that period. It will actually be worth $20,000 in five years.

❑ At 10 percent, it's straightforward to verify: NPV = $3,860 > 0

❑ So we should go ahead and automate.

Question 2

The operating cash flow of a cost cutting project:

A. is equal to the depreciation tax shield.

B. is equal to zero because there is no incremental

sales.

C. can only be analyzed by projecting the sales and

costs for a firm's entire operations.

D. can be positive even though there are no sales.

Answer: D

Normal project: OCF = Aftertax Profit + D*T

Cost cutting: OCF = Aftertax cost saving +D*T

Case 2 – Setting Competitive Bid or

Price

Special Cases

10-49

Case2 – Setting the Bid Price

❑ Imagine we are in the business of buying stripped-down truck

platforms and then modifying them to customer specifications

for resale. A local distributor has requested bids for 5 specially

modified trucks each year for the next 4 years, for a total of 20

trucks in all.

❑ We need to decide what price per truck to bid.

❑ The goal of our analysis is to determine the lowest price we

can profitably charge.

➢ This price should be low enough to maximize our chances of getting

the contract

➢ while guarding against the winner's curse (that is, too cheap, we will

not earn the required return).

Case2 – Setting the Bid Price

Suppose we can buy the truck platforms for $10,000 each. The

facilities can be leased for $24,000 per year. The labor and

material costs work out to be about $4,000 per truck.

▪ Total cost per year (of 5 trucks) = $24,000 + 5 × (10,000 + 4,000) =

$94,000.

We will need to invest $60,000 in new equipment. This

equipment will be depreciated straight-line to a 0 over the 4

years. It will be worth about $5,000 at the end of that time.

We will also need to invest $40,000 in raw materials inventory

and other working capital items. The relevant tax rate is 39%.

What price per truck should we bid if we require a 20% return

on our investment?

Case2 – Setting the Bid Price

First, the basic intuition:

❑ By logic, what is the lowest possible price we can profitably

charge (at 20%)?

▪ When NPV=0 (at discount rate =20%): → earn exactly

20% !

▪ Set that price (NPV=0) as the optimal bidding price – no

more, no less!

❑ Conclusion: Optimal price (P*) is price at NPV=0

❑ we first determine the CF (or OCF) that the NPV = 0. Then

we can back out the P* from OCF.

That is: the price that maximize our chance of getting the

contract, and also make sure we earn our required return (20%)

Case2 – Setting the Bid Price

Steps to determine Optimal price (P*)

 First, Set up Cash Flow Table

 Second, solve for OCF* that will make NPV=0 (at

our required return)

 Third, backout the Optimal price from OCF*

◼Use OCF formula to back out P*

Case2 – Setting the Bid Price

 We can't determine the OCF just yet because we don't know

the sales price.

 Net Capital spending (NCS):▪ – $60,000 today for new equipment.

▪ The after-tax salvage =$5,000 – (5,000-0) × .39 = $3,050.

 Change in NWC:▪ invest – $40,000 today in working capital. We will get this back in

four years.

We will need to invest $60,000 in new equipment,

depreciated straight-line to a 0 over the 4 years. Salvage = $5,000 at the end

of that time.

Need to invest $40,000 in raw materials inventory and other WC items

Case2 – Setting the Bid Price

 We can't determine the OCF just yet because we don't know the

sales price. Thus, here is what our CF table looks like so far:

 Net Capital spending (NCS):▪ – $60,000 today for new equipment.

▪ The after-tax salvage =$5,000 – (5,000-0) × .39 = $3,050.

 Change in NWC:▪ invest +$40,000 today in working capital. We will get this back in

four years.

We will need to invest $60,000 in new equipment,

depreciated straight-line to a 0 over the 4 years. Salvage = $5,000. Need to invest

$40,000 in NWC

Case2 – Setting the Bid Price

❑ Therefore we first need to determine the annual OCF for the

NPV = 0.

– $100,000 + 43,050/1.24= – $79,239

Case2 – Setting the Bid Price

 Now, the OCF is now an annuity amount.

Determine OCF* that makes NPV=0:

▪ PV of OCF = OCF * PVIFA

▪ PV of OCF = OCF * 2.5887 = $79,239

▪ OCF = $79,239/2.5887 = $30,609

 Are we finished?

No! need optimal sales price results in an OCF* = $30,609.

The present value interest factor of

annuity (PVIFA) – refresher

PVIFA (r, n) = [1-1/(1+r)n]/r

PVIFA (20%, 4)

= [1-1/(1.20)4]/0.20= 2.5887

This is the OCF* that makes NPV=0

Case2 – Setting the Bid Price

Use OCF formula to back out price

❑ Tax Shield Approach

▪ OCF = (Sales – Costs)(1 – T) + Depreciation*T

▪ $30,609 = (Sales – $94,000) *0.61 +$15,000*0.39

▪ Sales = $134,589

❑ the contract calls for 5 trucks per year

Sale Price = $134,589/5 = $26,918.

Bid about $27,000 per truck.

OCF = $30,609

Costs = $94,000

D= $15,000

T=0.39