F305 Intermediate Corporate Finance

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F305Intermediate Corporate Finance

• Indiana University
• Class 4

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Alternative Uses of NPV/DCF Analysis

• Cost cutting proposals
• Setting a bid price
• Comparing projects of unequal lives
• Matching cycles v. equivalent annual cost
  analysis
• When to replace equipment

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Cost Cutting Proposals

• Consider the following
• A 10,000 machine will reduce operating costs
  3,000 per year over a 5 year period
• No change in Net Working Capital
• Scrap Value of 1,000 at the end of the period
• Straight-line depreciation
• Tax rate is 34
• Discount rate is 10
• Find the following
• Operating cash flow
• After tax salvage value
• Relevant cash flows
• NPV of the project is it acceptable or not?

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Setting the Bid Price

• Consider the following
• The Army is seeking bids on multiple-use
  digitizing devices (MUDD)
• 4 units per year delivered each of the next 3
  years
• Labor and materials are 10,000 per MUDD
• Production space can be leased for 12,000 per
  year
• Project requires 50,000 in new equipment that is
  expected to have a salvage value of 1,000 at the
  end of the project
• Project requires an initial investment of 10,000
  in NWC
• Tax rate is 34
• Required rate of return is 15
• Assume straight line depreciation

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Setting the Bid Price (cont)

• We are setting the price, so OCF is an unknown
• Set-up a CF with known variables
• Find the DCF assuming that OCF is 0
• This will result in negative Cash Flow
• Set a three year annuity necessary to achieve
  break-even status
• Calculate the components of OCF given the facts
  of the problem
• This will give you an annualized sales figure
  that allows you to set the bid price!

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Investments of Unequal Lives

• Matching operating cycles
• Equivalent Annual Costs

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An Example

• You must choose between two types of batteries to
  be used in electric golf carts at Bloomington
  Country Club
• Burnout Batteries
• Cost 36 each
• 3 year life
• 100 year to keep charged
• Salvage value of 5
• Ever-go Batteries
• Cost 60 each
• 5 year life
• 88 year to keep charged
• Salvage value of 5
• Constant replacement of batteries is a given
• 34 tax rate
• 15 required rate of return
• Assume straight-line depreciation

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Example (cont)

• Find the relevant cash flows for both Burnout and
  Ever-go
• Use Matching Operating Cycles
• What is the matching operating cycle?
• Use Equivalent Annual Costs

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General Decision on When to Replace

• Consider whether Zeppelin Corp. should replace an
  existing machine
• New machine costs 15,000
• Requires maintenance of 1,200 at the end of each
  year for 5 years
• At the end of 5 years, salvage value 4,500
• Assume a discount rate of 12

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More on Zeppelin

• Existing machine has the following maintenance
  requirements and salvage values for the next 5
  years

Year Maintenance Salvage
Present 0 5,500
Year 1 1,200 3,500
Year 2 3,000 2,000
Year 3 4,800 1,000
Year 4 6,600 0
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Zeppelin Machine Replacement (cont)

• Find the Equivalent Annual Cost of the new
  machine
• Compare to the cost of keeping the old machine