Financial Management

5a. Freddy Case

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Freddy Case
Objective of this case :

Be able to compute with marginal cash flows :

- The operational cash flow, OCF,
- The investment cash flow ,ICF
- The residual cash flow RCF
-
- Computing NPV with marginal cash flows

- Computing IRR with marginal cash flows

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 Freddy Case
Company Freddy is manufacturing candy bars. Its management is considering
replacing the current four automatic wrappers at the beginning of next year. The
supplier of this equipment suggested swapping the four old wrappers with two new
ones, giving the same production yield but operating much more efficiently.

At the end of the current year, the four wrappers, initially bought for 100,000 €
each, will have been in service for 5 years and 50% depreciated. They were
supposed to last for 10 years.

The plant manager assesses that they could still be used for 5 years, albeit with
heavy maintenance costs. They could be sold today for 22,000 € each. If they are
operated for 5 more years, their resale value then will only be 1,000 € each.
The price of each new machines is 250,000 €. They can be depreciated over 5
years (linear method) and generate a cost saving (outside depreciation) of 140,000
€ / year if used for 5 years only. After that time, maintenance costs rise so much
that the wrappers are best scrapped valueless.

The project lifetime is 5 years and the tax rate: 33 1/3%

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Freddy Case
1/ Based on the company's forecast, compute the projet's FCF

2/ Compute NPV using a cost of capital of 8%

3/ Computing IRR

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Freddy Case

Current new situation

versus
4 wrappers 2 new wrappers
same yield but more economical
(= less operating cost)
Question:
• Keep the 4 old wrappers
• Or replace them with 2 new ones

Approach:
Compare current to the new situation, over the next 5 years, with
marginal cash flows (cf Outram Case)

cash flows with cash flows without

[ marginal investment investment
= -
cash flow (new wrappers) (old wrappers)
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1) Based on the company's forecast, compute the projet's FCF

marginal cash flows

à EBITDA increase of
140,000 €/ per year

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1) Based on the company's forecast, compute the projet's FCF

Step 1a Net result 0 1 2 3 4 5 6

=> Difference in 140,000 140,000 140,000 140,000 140,000
EBITDA (new - old)

Or :
Step 1a Net result 0 1 2 3 4 5 6
Difference in sales 0 0 0 0 0
Difference in
-140,000 -140,000 -140,000 -140,000 -140,000
Operating expenses
=> Difference in
140,000 140,000 140,000 140,000 140,000
EBITDA (new - old)

[Same result
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1) Based on the company's forecast, compute the projet's FCF

just calculated

to compute with marginal cash flows

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 1) Based on the company's forecast, compute the projet's FCF

Reminder: working on marginal cash flows

Current : New :
4 old wrappers 2 new wrappers

Initial value of each: 100,000 € : 250,000 €

machine
Operating since 5 years
Lifetime : 10 years
Amortized 50% i.e. NBV = 50,000 €
per machine
_Linear depreciation over 10 [ Amortized over 5 years
years per machine (linear)
à 10,000 € per year and per [Depreciation of 50,000 €
machine per year and per machine
à 40,000 € per year for the 4 [ 100,000 € per year for the
old wrappers 2 new wrappers
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1) Based on the company's forecast, compute the projet's FCF

Step 1a Net result 0 1 2 3 4 5 6

=> Difference in EBITDA
140,000 140,000 140,000 140,000 140,000
(new - old)
Depreciations new
100,000 100,000 100,000 100,000 100,000
wrappers
Depreciations old
40,000 40,000 40,000 40,000 40,000
wrappers
=> Difference in
60,000 60,000 60,000 60,000 60,000
depreciation (new - old)

[Compute Result before Tax

Difference in Result before Tax
= Difference in EBITDA – Difference in Depreciation

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1) Based on the company's forecast, compute the projet's FCF

Reminder: working on marginal cash flows

Step 1a Net result 0 1 2 3 4 5 6
=> Difference in EBITDA
140,000 140,000 140,000 140,000 140,000
(new - old)
Depreciations new
100,000 100,000 100,000 100,000 100,000
wrappers
Depreciations old
40,000 40,000 40,000 40,000 40,000
wrappers
=> Difference in
60,000 60,000 60,000 60,000 60,000
depreciation (new - old)
Difference in Result 80,000 80,000 80,000 80,000 80,000
before Tax

[ Compute Difference in Tax (rate 1/3)

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1) Based on the company's forecast, compute the projet's FCF

Reminder: working on marginal cash flows

Step 1a Net result 0 1 2 3 4 5 6

=> Difference in EBITDA

(new - old) 140,000 140,000 140,000 140,000 140,000
Depreciations new wrappers 100,000 100,000 100,000 100,000 100,000
Depreciations old wrappers 40,000 40,000 40,000 40,000 40,000

=> Difference in
depreciation (new - old) 60,000 60,000 60,000 60,000 60,000

Difference in Result before

Tax 80,000 80,000 80,000 80,000 80,000

Difference in Tax 26,664 26,664 26,664 26,664 26,664

80,000 × 1/3

_ End of step 1
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 1) Based on the company's forecast, compute the projet's FCF

Step 1b: Computing the Difference in change (ΔWC) :

Reminder: working on marginal cash flows

Since the level of produciotn remains unchanged, there should be no

change in AR, AP and Inventories so WC old = WC new

[ Difference in WC change is nil

Step 1b 0 1 2 3 4 5 6

Difference in
0 0 0 0 0
change in WC

_ End of Step 1b
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 1) Based on the company's forecast, compute the projet's FCF

Computing operational cash flows (OCF)

Reminder: working on marginal cash flows

OCF = EBITDA - ΔWC – Tax

Just computed

OCF 0 1 2 3 4 5 6
Difference in
OCF 113,336 113,336 113,336 113,336 113,336

_ End of OCF
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 1) Based on the company's forecast, compute the projet's FCF

Step 2 : Computing investment cash flows ICF

Reminder: working on marginal cash flows

Data given on new wrappers :

Initial value of each new machine : 250,000 €
[purchase of 2 new wrappers = 500,000 €
[ investment of : – 500,000 €

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 1) Based on the company's forecast, compute the projet's FCF

Step 2 : Computing investment cash flows ICF

Reminder: working on marginal cash flows

• But purchases of 2 new wrappers

• Implies sale of 4 old wrappers
Capital gain or loss [ Taxes or Tax credit
Data given:
Initial value of
: 100,000 € Operating since 5 years
each machine
Amortized 50% i.e. NBV = 50,000 € per old machine
Lifetime : 10 years can still be used : 5 years
Resale price: 22,000 €
Here NBV = 50,000 so _ capital loss of 28,000[ Tax credit if sale
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 1) Based on the company's forecast, compute the projet's FCF

Step 2 : Computing investment cash flows ICF

Reminder: working on marginal cash flows

Computing Tax credit over the sale of 4 old wrappers :

Disposal price = 4 × 22,000 € = 88,000 €
NBV for 4 old wrappers = 4 × 50,000 € = 200,000 €

[ capital loss incurred : -112,000 €

[ Tax credit = 112,000 × 1/3 = + 37,329.60 €

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 1) Based on the company's forecast, compute the projet's FCF

Step 2 : Computing investment cash flows ICF

Reminder: working on marginal cash flows

Step 2 ICF 0 1 2 3 4 5 6

Acquisition 2 new
wrappers -500,000

asset disposal old

wrappers 88,000

tax saving over

capital loss 37,330
Difference in ICF -374,670

_ End of Step 2
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 1) Based on the company's forecast, compute the projet's FCF

Step 3 : Computing residual cash flow RCF

Reminder: working on marginal cash flows
Net of tax over Capital
asset disposal price gains (or capital loss)
+ recuperating WC over the period= ΣΔWC on Disposal

= Residual Cash flows

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© T. Mezeret
 1) Based on the company's forecast, compute the projet's FCF

Step 3 : Computing residual cash flow RCF

Reminder: working on marginal cash flows
● old wrappers: OPPORTUNITY LOSS ● new wrappers
In use since 5 years
Amortized over 5 years (linear)
Amortized 50% i.e. NBV = 50,000 €
per old machine (at date 0) [ Depreciation of 50,000 € per year
and per machine
Inital lifetime: 10 years
[ NBV in 5 years = 0
Can still be used: 5 years
Resale price in 5 years : 1,000 € [ Resale price = nil
[ At date 6 (end of project),
[ NBV = 0 so _ capital gain
[ Tax to pay [ no Tax nor Tax credit
[ Resale price of 4 old wrappers : 4 ×
1000 = 4,000 €
[ Capital gain = 4,000 – 0 = 4,000 €
Tax20to pay 4,000 × 1/3 ≅ 1,333 € © T. Mezeret
 1) Based on the company's forecast, compute the projet's FCF

Step 3 : Computing residual cash flow RCF

Reminder: working on marginal cash flows

Recuperating of the Difference in WC

Sum of the Difference in change in WC = 0
Recuperating Difference in WC year 5= 0

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 1) Based on the company's forecast, compute the projet's FCF

Step 3 : Computing residual cash flow RCF

Reminder: working on marginal cash flows
Step 3 RCF 0 1 2 3 4 5 6

asset disposal new wrappers at end of project 0

Tax over Capital gain on Disposal of new project 0

Disposal old wrappers at end of project 4,000

Tax over Capital gain on Disposal of old project -1,333

Recuperating Difference in WC 0
Difference in RCF -2,667

OPPORTUNITY LOSS

_ End of Step 3
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 1) Based on the company's forecast, compute the projet's FCF

Computing Net Free Cash flows with marginal cash flow

approach
Reminder: working on marginal cash flows

FCF 0 1 2 3 4 5 6

Diff. FCF -374,670 113,336 113,336 113,336 113,336 113,336 -2,667

_ End of Q1
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© T. Mezeret
Freddy Case
1/ Based on the company's forecast, compute the projet's FCF

2/ Compute NPV using a cost of capital of 8%

3/ Compute IRR

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 2/ Compute NPV using a cost of capital of 8%

0 1 2 3 4 5 6
FCF -374,670 113,336 113,336 113,336 113,336 113,336 -2,667

n
NPV = - I0 + Σ CF t × (1+i)-t
t=1
NPV (0,08) = -373,670 + 113,336× (1,08)-1 + 113,336 × (1,08)-2
+ 113,336 × (1,08)-3 + 113,336 × (1,08)-4
+ 113,336 × (1,08)-5 + -2,667× (1,08)-6
Step 6 FCF 0 1 2 3 4 5 6
FCF -374,670 113,336 113,336 113,336 113,336 113,336 - 2,667
discounted cash flows
at 8% -374,670 104 941 97,167 89 970 83 305 77 135 -1 681
NPV 76,167
NPV (Excel) 76,167

_ NPV > 0 à If Cost of capital is 8%

_ ’remplace 4 old wrappers with 2 new ones’ is a financially viable
25project.
© T. Mezeret
 2/ Compute NPV using a cost of capital of 8%

Graph of NPV (Excel)

NPV Freddy
140,000.00

120,000.00

100,000.00

NPV(8%) 80,000.00
= 76,167 60,000.00

40,000.00 NPV = 0 for cost VAN

of Frédérique
capital
20,000.00 between 15% and 16%
0.00

-20,000.00 Indication of IRR

-40,000.00

-60,000.00

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 3/ Computing IRR

Excel : IRR = 15.46%

IRR per linear interpolation with i1=15% and i2=16%

NPV (i1)= NPV (0,15) =-373,670 + 113,336× (1,15)-1 + 113,336 × (1,15)-2
+ 113,336 × (1,15)-3 + 113,336 × (1,15)-4
+ 113,336 × (1,15)-5 + (-2,667)× (1,15)-6
≅ 4 097

NPV (i2)= NPV (0,16) =-373,670 + 113,336× (1,16)-1 + 113,336 × (1,16)-2

+ 113,336 × (1,16)-3 + 113,336 × (1,16)-4
+ 113,336 × (1,16)-5 + (-2,667)× (1,16)-6
≅ - 4,670

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 3/ Computing IRR

IRR per linear interpolation with i1=15% and i2=16%

NPV (i1)= NPV (0,15) = 4 097

NPV (IRR) = 0
NPV (i2)= NPV (0,16) = - 4,670

Implies :
NPV (IRR) – NPV (i1)
IRR ≅ i1 + (i2 – i1) ×
NPV (i2) – NPV (i1)
0 – 4 097
IRR ≅ 0,15 + (0,16 – 0,15) ×
- 4,670 – 4 097
IRR ≅ 0,154673 ≅ 15,47%
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Freddy Case

Takeaway:
For mutually exclusive projects and if the projects are meant to create
cost savings, approach NPV with marginal cash flows

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