# Net Present Value and Salvage Value

FINC5001 Capital Market and Corporate Finance

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Workshop 5 – Capital Budgeting II

1. Basic Concepts Review

a) In applying Net Present Value, what factors do we include, and what factors do we ignore?

Use cash flows not accounting income

Ignore

* sunk costs

* financing costs

Include

* opportunity costs

* side effects

* working capital

* taxation

* inflation

2. Practice Questions

a) After spending $3 million on research, Better Mousetraps has developed a new trap. The project requires an initial investment in plant and equipment of $6 million. This investment will be depreciated straight-line over five years to a value of zero, but, when the project comes to an end in five years, the equipment can in fact be sold for $500,000. The firm believes that working capital at each date must be maintained at 10% of next year's forecasted sales. Production costs are estimated at $1.50 per trap and the traps will be sold for $4 each. (There are no marketing expenses.) Sales forecasts are given in the following table. The firm pays tax at 35% and the required return on the project is 12%. What is the NPV? |

Figures in 000's| |

Year| 0| 1| 2| 3| 4| 5|

Unit Sales| | 500| 600| 1,000| 1,000| 600|

Revenues| | 2,000| 2,400| 4,000| 4,000| 2,400|

Costs| | 750| 900| 1,500| 1,500| 900|

Depreciation| | 1,200| 1,200| 1,200| 1,200| 1,200| Pretax Profit (includes salvage in year 5)| | 50| 300| 1,300| 1,300| 800| Taxes at 35%| | 18| 105| 455| 455| 280|

Profit after tax| | 33| 195| 845| 845| 520|

| | | | | | |

Revenues| | 2,000| 2,400| 4,000| 4,000| 2,400|

Costs| | 750| 900| 1,500| 1,500| 900|

Tax on operations| | 18| 105| 455| 455| 280|

Cash Flow from Operations| | 1,232| 1,395| 2,045| 2,045| 1,220| Change in working capital| -200| -40| -160| 0| 160| 240| Capital Investment| -6,000| | | | | |

Salvage value| | | | | | 500|

Net Cash Flows| -6,200| 1,192| 1,235| 2,045| 2,205| 1,960| Discount Factor @ 12%| 1.000| 0.893| 0.797| 0.712| 0.636| 0.567| Present Value| -6,200| 1,064| 985| 1,456| 1,401| 1,111.32| | | | | | | |

NPV| -182.68| | | | | |

b). XYZ Ltd is considering expanding its operation requires the purchase of a new industrial oven. The machine cost $1,000,000 and has an economic life of 5 years. It will be depreciated for tax purposes at 10% p.a. of initial cost. Extra inventories and other working capital will be needed at a cost of $80,000. Inflation is expected to be 5% p.a. for the next five years. The working capital will be unaffected by inflation. The expected salvage value of the machine is $100,000 in year 5. The annual net operating cash flows before tax (in current values) that XYZ expects to receive is $334,000 each year. The company tax rate is expected to be 30% over the period of the project. The opportunity of capital is 10%. What is NPV?

Year| 0| 1| 2| 3| 4| 5|

Cash inflows (after tax)| | 233800| 233800| 233800| 233800| 233800| Inflation| | 1.05| 1.05| 1.05| 1.05| 1.05|

Inflation factor| | 1.05| 1.1025| 1.157625| 1.215506| 1.276282| Cash flows adjusted for inflation| | 245490| 257764.5| 270652.7| 284185.4| 298394.6| Depreciation tax-shield| | 30000| 30000| 30000| 30000| 30000| Salvage value| | | | | | 100000|

Tax credit on loss| | | | | | 120000|

Initial cost| -1000000| | | | | |

Working capital| -80000| | | | | 80000|

Total cash flows( after-tax)| -1080000| 275490| 287764.5| 300652.7| 314185.4| 628394.6| Discount factor| 1| 0.869565| 0.444444| 0.296296| 0.197531| 0.131687| PV of FCF| -1080000| 239556.5| 127895.3| 89082.29...

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