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**Case 11: If The Coat Fits Wear It**

Case Discussion

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**Objectives Analyzing replacement projects**

Estimating relevant cash flows

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**Background Information**

The Innovative Sporting Goods Company (ISGC) had developed a sound technique of making baseball bats. New coating machine available which would give the bats a better finish and make them more durable and powerful. Andy wants to know whether it would be financially prudent to replace the existing machine?

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Question 1: Your supervisor, Vic Gonzales, has asked you to prepare a capital budgeting report indicating whether ISGC should replace the existing machine or not. Indicate how you would proceed (without making any calculations)?

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Answer 1 Estimate the incremental cash flows over the economic life of the new machine. Initial Outlay in year 0 should include the after-tax salvage values of the old and new machine respectively and changes in net working capital. Net Cash flow = EBIT – Taxes + Depreciation During the terminal year, the net working capital would be assumed to be recovered, and treated as a cash inflow.

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Answer 1 (continued) Using the incremental cash flows, compute the Net Present Value of the project. If the NPV is greater than 0, replace the machine, otherwise…. Do not replace!

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Question 2: Explain the relevance of incremental cash flows, sunk costs, and incidental costs in the context of this case.

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Answer 2 Since this case involves the decision of whether or not to replace an existing machine, it is important to take into consideration only the difference between the various revenue and expense items that would occur if the old machine was replaced. These are called incremental cash flows. Sunk costs are not relevant in this case. An example of a sunk cost would be a consulting fee paid by the firm to come up with suggestions regarding output efficiency. Incidental costs are those that affect some other area or aspect of the firm’s business.

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Question 3 As is often the case, the marketing department has overestimated the annual sales growth. How can more conservative and realistic estimates be generated? How can these estimates be incorporated into the analysis so as to arrive at a good and well-justified decision?

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Answer 3 The marketing department’s sales forecast is a good place to start. However, it is better for managers to consider the overall market for baseball bats and accordingly estimate their niche. Also, various scenarios of growth (best case, worst case, and most likely case) could be used to estimate the pro forma financial statements and then analyzed using the various evaluation techniques.

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Question 4 1. What are the relevant factors and items to be considered when estimating the initial outlay? Calculate the initial outlay for this replacement project.

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**Answer 4 Price of new machine…………… $ 350,000**

Shipping, Handling, Installation… $ ,500 Change in Net Working Capital Increase in receivables $54,000 Increase in inventory $20,000 Increase in payables ($30,000) $ 44,000 Total Cash Outflow………………… $ 398,500 Cash Inflows at t=0 Selling Price of old machine 100,000 Tax shield on 34% 17,000 After-tax salvage value 117,000 Loss on sale = Book Value – Market Value Where BV = Cost – Accumulated Depreciation =225,000-(5*15,000)= 150,000 Loss = , ,000 = 50,000 Initial outlay = 398,500 – 117,000 = $281,500 =Tax Rate * Loss Where Loss = Book Value – Selling Price =Cash Outflow – After-tax Salvage Value

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Question 5: How are the interim cash flows to be computed for the productive life of the new machinery? How is depreciation to be accounted for?

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**Answer 5 The interim cash flows are computed as follows:**

(Operating Cash Flow )+/- (Change in Net working capital) +/- (Capital spending) where… OCF = (Incremental sales – Incremental costs (other than interest) – Depreciation)*(1-tax rate) + Depreciation = EBIT – Taxes + Depreciation

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Answer 5 (continued) Depreciation is accounted for as an annual charge against income and provides a tax shield. Accordingly, the difference in the tax shield due to the change in annual depreciation is effectively a cash inflow. Furthermore, since depreciation is not really a cash outflow, it is added back to earnings before interest and taxes to calculate the operating cash flow.

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Question 6 As a shrewd financial analyst you observe that the net working capital of the firm has typically been about 20% of the annual revenues. How would you incorporate this observation into the analysis?

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Answer 6 Calculate the annual net working capital (NWC) based on 20% of the annual forecasted incremental revenues. Next, calculate the change in NWC each year. If NWC gets larger than the starting level of $44,000, the increment would be accounted for as a cash outflow for that year and vice versa. At the end of the productive life of the machine, the NWC is assumed to be recovered and is treated as a cash inflow. No taxes have to be paid on this amount.

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Question 7: How should the annual interest expenses on the bank loan be handled? Explain.

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**Answer 7 The annual interest expenses should be ignored.**

This is done to avoid double counting the interest expense. The after-tax cost of borrowing is included in the weighted average cost of capital or discount rate. By discounting the cash flows to calculate the Net Present Value, interest costs are factored in.

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**Question 8 What is the relevance of the terminal year cash flow?**

Which factors must be considered when estimating the terminal year cash flow?

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**Answer 8 The terminal year cash flow accounts for**

the recovery of NWC, the after-tax salvage value of the new machine, and the lost salvage value of the old machine (if any). When estimating the terminal year cash flow, the pro forma NWC is treated as a cash inflow. the selling price of the machine is adjusted for taxes (either taxes paid or tax shield generated) based on its non-depreciated or book value.

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Question 9 After looking at the data provided by Vic, you realize that the revenue and cost figures have not been adjusted for inflation. If inflation were expected to be at least 3% per year, what effect would this have on your analysis? Adjust the data and recalculate the relevant cash flows.

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Answer 9 If revenues and costs are adjusted upwards by the 3% inflation rate, the Net Present Value will typically increase and the IRR will get larger. It is imperative that either nominal cash flows (adjusted upwards for inflation) be discounted at the nominal discount rate (15%) or that the discount rate be adjusted downwards (into the real rate) and then used to calculate the NPV of the unadjusted cash flows. See Spreadsheet calculations

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Question 10 What recommendation would you make to Vic regarding the replacement of the old coating machine? Explain.

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Answer 10 Based on the calculations, the new machine has a net present value of $-121,374, after the cash flows are adjusted for inflation. The IRR (4.9%) likewise is considerably less than the discount rate of 15%. This shows that the old machine should not be replaced. Either the selling price of the new bats would have to be higher or the costs reduced further.

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Question 11 If the new machine has an economic life of 15 years while the current machine has a life of only 10 years, how would the capital budgeting analysis have to be adjusted? Please explain by performing the necessary calculations.

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Answer 11 In effect, the interim cash flows would last for 5 additional years. The after-tax market value of the new machine would have to be accounted for at the end of the 15th year, and the loss of market value of the old machine would be a cash out flow in year 10. The recovery of net working capital would also be deferred until the 15th year. `

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Answer 11 (continued) With an economic life of 15 years, the NPV = -$79,536.22; IRR = 10.3%. The decision would remain unchanged. Spreadsheet Solution

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