++ Corporate Finance Lecture 3++ Outline for today a The application of DCF in capital budgeting = The Baldwin Company NOVA oo7.2 The Baldwin Company: AN, Example + Costs of test marketing (already spent): $250,000. Current market value of proposed factory site (which we own): $150,000. Cost of bowling ball machine: $100,000 (depreciated according to ACRS 5-year life). Increase in net working capital: $10,000. Production (in units) by year during 5-year life of the machine: 5,000, 8,000, 12,000, 10,000, 6,000. Price during first year is $20; price increases 2% per year thereafter. Production costs during first year are $10 per unit and increase 10% per year thereafter. Working Capital: initially $10,000 changes with sales.| The Worksheet for Cash Flows an of the Baldwin Company ($ thousands) (All cash flows occur at the end of the year.) YearO Yeart Year2 Investments: ee ball machine (1) (2) Accumulated 20.00 52.00 depreciation (3) Adjusted basis of 80.00 48.00 machine after depreciation (end of year) (4) — Opportunity cost —-150.00 150.00 (warehouse) (s) Net working capital 10.00 10,00 16.32 (end of year) (6) Change in net -10.00 21.22 working capital (7) Total cash flow of 260.00 6.32 investment [@) + (4) + ©)] Year 3 71.20 28.80 24.97 6.32 -8.65 Year4 Year 5 82.72 17.28 5.76 21.22 0 -8.65 3.75 3.75 192.98The after-tax salvage | value | NOVA The salvage value of the capital investment at year 5 is $30,000. Capital gain: Salvage value - adjusted basis of the machine. The adjusted basis: the original purchase price - depreciation. $100,000 — $94,240 = $5,760 The capital gain $30,000 — $5,760 = $24,240 Assume corporate tax: 34%. capital gains tax due [0.34*($30,000 — $5,760) = $8,240 The after-tax salvage value $30,000 — [0.34*($30,000 — $5,760)] = $21,760.The Worksheet for Cash Flows of the Baldwin Company ($ thousands) (All cash flows occur at the end of the year.) YearO Yeart Year2 Inve: (1) (2) (3) (4) 6) (6) (7) jents: Bowling ball machine -100.00 Accumulated 52.00 depreciation Adjusted basis of 80.00 48.00 machine after depreciation (end of year) Opportunity cost -150.00 (Warehouse) Net working capital 10.00 10.00 16.32 (end of year) Change in net -10.00 6.32 working capital Total cash flow of -260.00 6.32 investment [@) + (4) + ©)] Year 3 71.20 28.80 24.97 -8.65 -8.65 Year 4 82.72 17.28 21.22 3.75 3.75 | NOVA Year 5 21.76* 94.24 5.76 150.00 21.22 192.98The Worksheet for Cash Flows of the <2 oo i - CoE Baldwin Company (continued) (S thousands) (All cash flows occur at the end of the year:) + Year 0 Year1 Year2 Year3 Year4 Year5 (Acmumulated 20.00 52.00 71.20 82.72 94.24 lepreciation (10) Depreciation 20.00 32.00 19.20 11.52 Year ACRS % a . 1 20.00% Depreciation is calculated using the Accelerated 2 32.00% Cost Recovery System (shown at right) FE is 20% Our cost basis is $100,000 4 11.52% Depreciation charge in year 4 5 11.52% = $100,000x(.1152) = $11,520. 6 5.76% Total 100.00%The Worksheet for Cash Flows of the Baldwin Company ($ thousands) (All cash flows occur at the end of the year.) YearO Yeart Year2 Tnvesimentsr (1) | Bowling ball machine 100.00 (2) Accumulated 20.00 52.00 depreciation 3) Adjusted basis of 8 48.00 See depreciation (end of year) (4) — Opportunity cost -150.00 (Warehouse) (5) Net working capital 10.00 10.00 16.32 (end of year) (6) Change in net -10.00 6.32 working capital (7) Total cash flow of -260.00 6.32 investment [@) + (4) + ©)] Year 3 71.20 28.80 24.97 -8.65 -8.65 Year 4 82.72 17.28 21.22 3.75 3.75 | NOVA Year 5 21.76* 94.24 5.76 150.00 21.22 192.98The Worksheet for Cash Flows of the Baldwin Company NOVA be (S thousands) (All cash flows occur at the end of the year.) — YearO Year! Year2 Year3 Year4 Year5 Investments: (1) Bowling ball machine -100.00 21.76* (2) Accumulated 20.00 94.24 depreciation (3) Adjusted basis of 80.00 machine after depreciation (end of year) 4) Opportuni st 150.00 (4) Qpport nity cos (warehouse) (5) Net working capital 10.00 10.00 (end of year) (6) Change in net —-10.00 working capital (7) Total cash flow of -260.00 investment (4) + 4) + ©] At the end of the project, the warehouse is unencumbered, so we can sell it if we want to.The Worksheet for Cash Flows of the Baldwin Company ($ thousands) (All cash flows occur at the end of the year.) YearO Yeart Year2 Tnvesimentsr (1) | Bowling ball machine 100.00 (2) Accumulated 20.00 52.00 depreciation (3) Adjusted basis of 80.00 48.00 machine after depreciation (end of year) (4) Gao ee -150.00 warehouse (5) Net working capital 10.00 16.32 (end of year) (6) Change in net -10.00 6.32 working capital (7) Total cash flow of -260.00 6.32 investment [@) + (4) + ©)] Year 3 71.20 28.80 24.97 -8.65 -8.65 Year 4 82.72 17.28 21.22 3.75 3.75 | NOVA Year 5 21.76* 94.24 5.76 150.00 21.22 192.98A note on net working = [ capital = Net working capital — Current asset minus current liabilities — Current asset: = Investment in inventory: raw materials must be bought before production and sale = Cash buffer = Credit sales: Accounts receivable = Credit purchases: Accounts payable, short- term liabilityA note on net working = { capital = For the ist year, among the sales revenue of $100,000, $9,000 will be credit sales. The amount will be received at the end of the second year. — Cash income of year 1: $91,000 — Account receivable of year 1: $9,000 = For the ist year, among the costs of $50,000, $3,000 can be deferred. — Cash disbursement of year 1: $47,000 — Account payable of year 1: $3,000A note on net working | capital NOVA = An inventory of $2,500 should be left on hand at the end of year 1 to avoid stockouts. = Acash buffer of $1,500 is kept for unexpected expenditures. = NWkKat the end of year 1 = — +accounts receivable $9,000 — -accounts payable $3,000 — +inventory 2,500 — +cash 1,500 — = 10,000The Worksheet for Cash Flows of the Baldwin Company ($ thousands) (All cash flows occur at the end of the year.) YearO Yeart Year2 Tnvesimentsr (1) | Bowling ball machine 100.00 (2) Accumulated 20.00 52.00 depreciation (3) Adjusted basis of 80.00 48.00 machine after depreciation (end of year) (4) — Opportunity cost -150.00 (Warehouse) (5) Net working capital 10.00 10.00 16.32 (end of year) (6) Change in net 6.32 working capital 29) (7) Total cash flow of -260.00 6.32 investment [@) + (4) + ©)] Year 3 71.20 28.80 24.97 -8.65 -8.65 Year 4 82.72 17.28 21.22 3.75 3.75 | NOVA Year 5 21.76* 94.24 5.76 150.00 21.22 192.98The Worksheet for Cash Flows of the Baldwin Company ($ thousands) (All cash flows occur at the end of the year.) YearO Yeart Year2 Tnvesimentsr (1) | Bowling ball machine 100.00 (2) Accumulated 20.00 52.00 depreciation (3) Adjusted basis of 80.00 48.00 machine after depreciation (end of year) (4) — Opportunity cost -150.00 (Warehouse) (5) Net working capital 10.00 10.00 16.32 (end of year) (6) Change in net -10.00 6.32 working capital (7) Total cash flow of 6.32 investment [@) + (4) + ©)] Year 3 71.20 28.80 24.97 -8.65 -8.65 Year 4 82.72 17.28 21.22 3.75 3.75 | NOVA Year 5 21.76* 94.24 5.76 150.00 21.22 192.98The Worksheet for Cash Flows of xov. the Baldwin Company (continued)== ae ($ thousands) (All cash flows occur at the end of the year.) YearO Year1 Year2 Year3 Year4 Year5 Income: (8) Sales Revenues 100.00 163.00249-72 912.20 129.90 Recall that production (in units) by year during 5-year life of the machine i given by: (5,000, 8,000, 12,000, 10,000, 6,000). Price during first year is $20 and increases 2% per year thereafter. Sales revenue in year 3 = 12,000%[$20x(1.02)] = 12,000%$20.81 = $249,720The Worksheet for Cash Flows of s0v* the Baldwin Company (continued) (S thousands) (All cash flows occur at the end of the year) T YearO Year1 Year2 Year3 Year4 Year5 Income: (8) Sales Revenues 100.00 163.00 249.72 212.20 129.90 (9) Operating costs 50.00 145.20 133.10 87.84 Again, production (in units) by year during 5-year life of the machine is given by: (5,000, 8,000, 12,000, 10,000, 6,000). Production costs during first year (per unit) are $10 and (increase 10% per year thereafter). Production costs in year 2 = 8,000*[$10x(1.10)!] = $88,000The Worksheet for Cash Flows of NOVA the Baldwin Company (continued)™" + ($ thousands) (All cash flows occur at the end of the year.) Year 0 Year! Year2 Year? Year4 Year5 Income: (8) Sales Revenues 100.00 163.00 249.72 212.20 129.90 (9) Operating costs 50.00 88.00 145.20 133.10 87.84 (10) Depreciation 20.00 32.00 19.20 11.52 (11) Income before taxes 30.00 43.20 85.32 67.58 [(8) - (9) - (10)] (12) Tax at 34 percent 10.20 14.69 29.01 22.98 (13) Net Income 19.80 28.51 56.31 44.60 11.52 30.54 10.38 20.16Incremental After Tax Cash Flows; of the Baldwin Company Year0 Year 1 Year 2 Year 3 Year 4 Year 5 (1) Sales $100.00 $163.00 $249.72, $212.20 $129.90 Revenues (2) Operating -50.00 -88.00 -145.20 133.10, 87.84, costs (3) Taxes -10.20 -14.69 -29.01 -22.98 10.38, (4) OCF 39.80 60.51 5. 56.12 31.68 ()-@)-(3) (5) Total CF of —260. 6.32 .65 3.75 192.98, Investment (6) Total CF —260. . 34.19 . 59.87 224.66 (4) +6)] 4,839.80 | $54.19 |, $66.86 , $59.87 , $224.66 (1.10) 1.10" (1.10 (1.10) (1.109 NPV =$51,588.05 NPV =-$260 +——Pz LO} | =| [> NPV of Baldwin Company: Sensitivity test + 1=4% 123.641 r=10% 51.59 t=15% 5.472 1=15.67% 0 r=20% -31.351