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F305 Intermediate Corporate Finance. Indiana University Class 4. 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. Cost Cutting Proposals.
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F305Intermediate Corporate Finance Indiana University Class 4
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
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?
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
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!
Investments of Unequal Lives • Matching operating cycles • Equivalent Annual Costs
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
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
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%
More on Zeppelin • Existing machine has the following maintenance requirements and salvage values for the next 5 years
Zeppelin Machine Replacement(cont) • Find the Equivalent Annual Cost of the new machine • Compare to the cost of keeping the old machine