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1. 2. 3. 4. 5. 6. Expansion Replacement Mandatory Safety and regulatory Competitive Bid price Risk Analysis: Sensitivity Analysis, Scenario Analysis, and Simulation Analysis
Sales= 50,000 units Price=$4 Unit cost=$2.5 R=20% Fixed cost=$20,000 per year Initial cost=$90,000 NWC=$20,000 per year Tax rate=34% Straight Line Depreciation: 3 years Life
Depreciation ($90,000 / 3)
EBIT Taxes (34%) Net Income
30,000
$ 33,000 11,220 $ 21,780
NWC
Net Fixed Assets Total Investment
$20,000
90,000 $110,000
$20,000
60,000 $80,000
$20,000
30,000 $50,000
$20,000
0 $20,000
$51,780
$51,780
$51,780 20,000
Capital Spending
-$90,000
CF
-$110,00
$51,780
$51,780
$71,780
Depreciation
The depreciation expense used for capital budgeting should be the depreciation schedule required by the IRS for tax purposes Depreciation itself is a non-cash expense, consequently, it is only relevant because it affects taxes Depreciation tax shield = D (TC) D = depreciation expense TC = marginal tax rate
Computing Depreciation
Straight-line depreciation
D = (Initial cost salvage) / number of years Very few assets are depreciated straight-line for tax purposes
MACRS
Need to know which asset class is appropriate for tax purposes Multiply percentage given in table by the initial cost Depreciate to zero Mid-year convention
DEPRECIATION TABLES
3-Year
5-Year
7-Year
10-Year
1 2 3 4 5 6 7 8 9 10 11
100%
100%
100%
100%
After-tax Salvage
If the salvage value is different from the book value of the asset, then there is a tax effect Book value = initial cost accumulated depreciation After-tax salvage = salvage Tax rate (salvage book value)
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 companys marginal tax rate is 40%. What is the depreciation expense each year and the after-tax salvage in year 6 for each of the following situations?
1
2 3 4
.3333
.4444 .1482 .0741
.3333(110,000) = 36,663
.4444(110,000) = 48,884 .1482(110,000) = 16,302 .0741(110,000) = 8,151
2
3 4
.2449
.1749 .1249
.2449(110,000) = 26,939
.1749(110,000) = 19,239 .1249(110,000) = 13,739
BV in year 6 = 110,000 15,719 26,939 19,239 13,739 9,823 9,823 = 14,718 After-tax salvage = 17,000 .4(17,000 14,718) = 16,087.20
5
6
.0893
.0893
.0893(110,000) = 9,823
.0893(110,000) = 9,823
New Machine
Initial cost = 150,000 5-year life Salvage in 5 years = 0 Cost savings = 50,000 per year 3-year MACRS depreciation
Replacement Problem Computing Cash Flows Remember that we are interested in incremental cash flows If we buy the new machine, then we will sell the old machine What are the cash flow consequences of selling the old machine today instead of in 5 years?
NI
5,700
(5,100)
21,900
29,100
35,400
Year 0
Cost of new machine = 150,000 (outflow) After-tax salvage on old machine = 65,000 .4(65,000 55,000) = 61,000 (inflow) Incremental net capital spending = 150,000 61,000 = 89,000 (outflow)
Year 5
After-tax salvage on old machine = 10,000 .4(10,000 10,000) = 10,000 (outflow because we no longer receive this)
1
46,200
2
53,400
3
35,400
4
30,600
5
26,400
NCS
In NWC CF
-89,000
0 -89,000 46,200 53,400 35,400 30,600
-10,000
0 16,400
The machine chosen will be replaced indefinitely and neither machine will have a differential impact on revenue. No change in NWC is required. The required return is 9% and the tax rate is 40%.
Stand-Alone Risk
The projects risk if it were the firms only asset and there were no shareholders. Ignores both firm and shareholder diversification. Measured by the or CV of NPV, IRR, or MIRR.
Probability Density
E(NPV)
NPV
Corporate Risk
Reflects the projects effect on corporate earnings stability. Considers firms other assets (diversification within firm). Depends on projects , and its correlation, , with returns on firms other assets. Measured by the projects corporate beta.
Project X is negatively correlated to firms other assets, so has big diversification benefits.
Profitability
Years
Market Risk
Reflects the projects effect on a welldiversified stock portfolio. Takes account of stockholders other assets. Depends on projects and correlation with the stock market. Measured by the projects market beta.
Stand-Alone Risk
Stand-alone risk is easiest to measure, more intuitive. Core projects are highly correlated with other assets, so stand-alone risk generally reflects corporate risk. If the project is highly correlated with the economy, stand-alone risk also reflects market risk.
Sensitivity Analysis
Examines several possible situations, usually worst case, most likely case, and best case. Provides a range of possible outcomes. Shows how changes in a variable such as unit sales affect NPV or IRR. Each variable is fixed except one. Change this one variable to see the effect on NPV or IRR. Answers what if questions, e.g. What if sales decline by 30%?
scenario analysis
Only considers a few possible out-comes. Assumes that inputs are perfectly correlated--all bad values occur together and all good values occur together. Focuses on stand-alone risk, although subjective adjustments can be made.
Simulation Analysis
A computerized version of scenario analysis which uses continuous probability distributions. Computer selects values for each variable based on given probability distributions.
Summary
Sensitivity, scenario, and simulation analyses do not provide a decision rule. They do not indicate whether a projects expected return is sufficient to compensate for its risk. Sensitivity, scenario, and simulation analyses all ignore diversification. Thus they measure only stand-alone risk, which may not be the most relevant risk in capital budgeting.