1. Qinglei Dai for FEUNL Finanças October 17

2. Qinglei Dai for FEUNL Topics covered  Review: Incremental Cash Flows  The Baldwin Company: An Example

3. Qinglei Dai for FEUNL Review Incremental Cash Flows  Cash flows  Incremental cash flows  Sunk costs  Opportunity costs  Side effects like synergy and erosion  Taxes  Inflation

4. 7.2 The Baldwin Company: An Example Costs of test marketing (already spent): $250,000. Current market value of proposed factory site (which we own): $150,000. Cost of bowling ball machine: $100,000 (depreciated according to Accelerated Cost Recovery System 5-year life). Increase in net working capital: $10,000. Production (in units) by year during 5-year life of the machine: 5,000, 8,000, 12,000, 10,000, 6,000. Price during first year is $20; price increases 2% per year thereafter. Production costs during first year are $10 per unit and increase 10% per year thereafter. Working Capital: initially $10,000 changes with sales.

5. Qinglei Dai for FEUNL The Worksheet for Cash Flows of the Baldwin Company Year 0Year 1Year 2Year 3Year 4 Year 5 Investments: (1) Bowling ball machine–100.00 21.76* (2) Accumulated 20.0052.0071.2082.72 94.24 depreciation (3)Adjusted basis of 80.0048.0028.8017.28 5.76 machine after depreciation (end of year) (4)Opportunity cost–150.00 150.00 (warehouse) (5)Net working capital 10.00 10.0016.3224.9721.22 0 (end of year) (6)Change in net –10.00–6.32 –8.653.75 21.22 working capital (7)Total cash flow of–260.00 –6.32 –8.653.75 192.98 investment [(1) + (4) + (6)] ($ thousands) (All cash flows occur at the end of the year.)

6. Qinglei Dai for FEUNL The after-tax salvage value the ending market value of the capital investment at year 5 is $30,000. Capital gain is The adjusted basis is The capital gain = We will assume the incremental corporate tax for Baldwin on this project is 34 percent. Capital gains are now taxed at the ordinary income rate, so the capital gains tax due is The after-tax salvage value is

7. Qinglei Dai for FEUNL The Worksheet for Cash Flows of the Baldwin Company (continued) Year 0Year 1Year 2Year 3Year 4 Year 5 (2)Accumulated 20.0052.0071.2082.72 94.24 depreciation (10) Depreciation 20.00 32.00 19.20 11.52 11.52 ($ thousands) (All cash flows occur at the end of the year.) YearACRS % 120.00% 232.00% 319.20% 411.52% 511.52% 65.76% Total100.00%

8. Qinglei Dai for FEUNL A note on net working capital  For the 1st year, among the sales revenue of $100,000, $9,000 will be credit sales. The amount will be received at the end of the second year. Cash income of year 1: Account receivable of year 1: For the 1st year, among the costs of $50,000, $3,000 can be deferred. Cash disbursement of year 1: Account payable of year 1:

9. Qinglei Dai for FEUNL A note on net working capital  An inventory of $2,500 should be left on hand at the end of year 1 to avoid stockouts.  A cash buffer of $1,500 is kept for unexpected expenditures.  NWK at the end of year 1 =

10. Qinglei Dai for FEUNL The Worksheet for Cash Flows of the Baldwin Company (continued) Year 0 Year 1Year 2Year 3Year 4 Year 5 Income: (8) Sales Revenues100.00163.00249.72212.20 129.90 (9) Operating costs 50.00 88.00145.20 133.10 87.84 (10) Depreciation 20.00 32.00 19.20 11.52 11.52 (11) Income before taxes 30.00 43.20 85.32 67.58 30.54 [(8) – (9) - (10)] (12) Tax at 34 percent 10.20 14.69 29.01 22.98 10.38 (13) Net Income 19.80 28.51 56.31 44.60 20.16 ($ thousands) (All cash flows occur at the end of the year.)

11. Qinglei Dai for FEUNL Incremental After Tax Cash Flows of the Baldwin Company Year 0Year 1Year 2Year 3Year 4Year 5 (1) Sales Revenues $100.00$163.00$249.72$212.20$129.90 (2) Operating costs -50.00-88.00-145.20133.10-87.84 (3) Taxes -10.20-14.69-29.01-22.98-10.38 (4) OCF (1) – (2) – (3) 39.8060.5175.5156.1231.68 (5) Total CF of Investment –260. –6.32–8.653.75192.98 (6) Total CF [(4) + (5)] –260.39.8054.1966.8659.87224.66

12. Qinglei Dai for FEUNL NPV Baldwin Company r=10% r=15% r=4% r=15.67% r=20%