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CORPORATE FINANCE
SECOND EDITION
Cash Flows
Equation 14-1 shows that the initial investment at t = 0
consists of:
C0 = the initial capital cost of the asset
NWC0 = the change in the net working capital
OC = the opportunity costs associated with the project
CF0 C 0 NWC 0 OC
Cash Flows
Equation 14-2 needs to be modified if a project requires
any build-up of net working capital as the project
progresses.
Cash Flows
Equation 14-4 shows that the ending cash flow in the absence
of tax issues (i.e. SVn = UCCn ) consists of:
SVn = the estimated salvage value of the asset.
NWCn = the net working capital investment released at
the end of the project.
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Purchase price
Shipping & installation
Initial capital cost
Increase in NWC
Initial outlay
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12
13
14
$102, 000
2
3
1.15
1.15
1.15
NPV $24,174 $23, 440 $59, 019 $102, 000
NPV $4, 633
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Cash Flows
ASSUMPTIONS:
(1) Asset class is closed. Highly unlikely!
(2) Asset is sold before the end of year n. Would only be done
if UCCn > Sn.
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Cash Flows
ASSUMPTIONS ALWAYS USED IN THIS COURSE:
(1) Asset class remains open.
(2) Asset is sold on the first day of year n + 1.
(3) No new asset purchased for this class in year n + 1.
(4) C0 > SVn.
Td UCCn SVn
ECFn SVn NWCn
kd
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19
20
21
Td UCCn SVn
ECFn SVn NWCn
kd
0.15 0.20
22
23
=2 t=3
$24,000 $24,000
(R-O)(1-
$53,040
NCF
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$102, 000
2
3
1.15
1.15
1.15
NPV $24,174 $23, 440 $34, 875 $102, 000
NPV $19, 511
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27
28
CFBTt 1 T
t 1
1 k
C0 dT
dk
1 0.5k SVn dT
1 k
dk
1
(1 k)n
29
SVn
1 k n
t
n
1
k
1
t 1
STEP 5:
CF0
30
k
(1 k)n
0.15
1.15
1.15 3
0.20 0.15
1.15
0.2 0.15
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$10, 000
PV
$6, 575
3
1.15
Net working capital effects in years 1 through n
PV
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Sensitivity to Inputs
Stress testing NPV models to determine the sensitivity
of the decision to input variables is an important part
of risk assessment
There are two common approaches:
Sensitivity analysis is an examination of how an
investments NPV changes as the value of one input
at a time is changed
Scenario analysis is an examination of how an
investments NPV changes in response to varying
scenarios in terms of one or more estimates, such
as sales or costs
Booth/Cleary Introduction to Corporate Finance,
Second Edition
34
Sensitivity to Inputs
In scenario analysis, input variables are often given
discrete forecast ranges: best case, most likely case,
worst case, etc.
Analysts are interested in what the NPV might be in the
worst combination of cases, for example: worst-case
operating cash flows (low), worst-case initial cost
(high), and worst-case net working capital investment
(high)
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The unit variable cost is $6 and the firm can produce 100 units.
As long as ore prices are above $6, the firm can operate the
mine for a profit.
Below $6, the mine shuts down and variable costs at t = 1 are
Booth/Cleary
Introduction to Corporate Finance,
avoided.
37
Second Edition
38
39
40
1
1
1
0.12
1.1212
1
1
1
0.12
1.1212
41
Replacement Decisions
Expansion projects add something extra to the firm in
terms of sales or cost savings; their new cash flows are
incremental cash flows
Replacement projects involve the replacement of an
existing asset (or assets) with a new one and, in such cases,
we must clearly identify the incremental cash flows paying
particular attention to:
The effect on the incremental capital cost (C0), which is the
difference between the purchase price of the new
equipment and the salvage price of the equipment
The effect on the CCA tax shield. The equipment to be
replaced is normally sold early. Normally, there are no tax
consequences on disposal, except when assets are sold at a
price greater than their original cost, which triggers capital
on the difference.
Booth/Cleary gains
Introduction taxes
to Corporate Finance,
42
Second Edition
Replacement Decisions:
The Effect on the CCA Tax Shield
When an asset is removed from a CCA class:
There is no CCA in the year of disposal
The UCC of the pool or class is reduced by the disposal
value
d salvage
k 1 values:
k
d k (1 k ) n
in the initial outlay and
Booth/Cleary Introduction to Corporate Finance,
Second Edition
43
Replacement Decisions
Replacement Decisions
Solution: Steps 1 and 2
C0 = 350,000 50,000 = $300,000
CF0 = C0 + NWC0 + OC = $300,000 + $0 + $0 =
$300,000
SVn = 100,000 15,000 = $85,000
CFBT (1 T )
1
PV (Operating CFs)
1
n
k
(
1
k
)
$50,000(1 0.4)
1
PV (Operating CFs)
1
$134,620
8
0.15
1.15
1.158
0.3 0.15
1.15
0.3 0.15
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Replacement Decisions
Solution (contd): Step 3
Salvage Value = ($100,000 - $15,000) = $85,000
$85,000
PV ( SVn )
$27, 787
8
1.15
Since there are no net working capital effects in this problem,
Step 4 is zero. Now sum up first 4 Steps and subtract the
incremental initial outlay (Step 5).
NPV $134,620 $67,373 $27,787 $0 $300,000 $70,220
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Copyright
Copyright 2010 John Wiley & Sons Canada, Ltd. All rights
reserved. Reproduction or translation of this work beyond that
permitted by Access Copyright (the Canadian copyright licensing
agency) is unlawful. Requests for further information should be
addressed to the Permissions Department, John Wiley & Sons
Canada, Ltd. The purchaser may make back-up copies for his or her
own use only and not for distribution or resale. The author and the
publisher assume no responsibility for errors, omissions, or
damages caused by the use of these files or programs or from the
use of the information contained herein.
Copyright 2011 Dr. William F. Rentz & Associates. Unless
permission is given, additions, deletions, and corrections prepared
by Dr. William F. Rentz are solely for use at the University of Ottawa.
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