Net Present Value and Salvage Value
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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
FINC5001 Capital Market and Corporate Finance
-------------------------------------------------
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