CASE 2: CAPITAL BUDGETING

DISCOUNTED CASH FLOW

S y n d i c a t e 2 S y n d i c a t e 2
 1

SYNDICATE 2
OUR BEST
TEAM Investment
Project Analysisi

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OUR AGENDA

WHAT WHY HOW

 WHAT
exactly
Discounted
Cash Flow is??
 D I S C O U N T E D C A S H F L O W

DEFINITION(S)
valuation method used to estimate the attractiveness of an investment opportunity.
The analysis uses future free cash flow projections and discounts them to
arrive at a present value, which is then used to evaluate the potential
investment.
OUR AGENDA

WHAT WHY HOW

 So

?
WHY
is it
important
Company’s ultimate worth is
cash in Investor’s Pocket
OUR AGENDA

WHAT WHY HOW

CASE
#1
A company buys a machine for $500,000 and depreciates it on a straight-line
basis over a five-year period for tax purposes. The investment would result
in cash cost savings of $200,000 per year, before taxes, for five years. At the
end of five years, it was estimated that the machine would be sold for
$75,000. The gain on the sale of the machine would be taxed at a 40% rate.

Is the investment in the machine attractive in economic terms, given all of

the cash flows? Please assume that the cash flows occur at the end of each
year, that the tax rate is 40%, and that the appropriate discount rate is 8%.
What is the net present value? the internal rate of return? the payback
period?
1 Data :
Machine Price / Investment (500,000.00) Salvage Value -
Depreciation (100,000.00)
Cash Cost Saving 200,000.00 per year
Selling Price 75,000.00
Tax on Gain of Machine
Sale 40%
Tax Rate 40%
Discount rate 8%

Solution :

Cash Flow

Year 0 1 2 3 4 5
Investment (500,000.00)
Cash Cost Saving 200,000.00 200,000.00 200,000.00 200,000.00 200,000.00
Depreciation (100,000.00) (100,000.00) (100,000.00) (100,000.00) (100,000.00)
EBIT (500,000.00) 100,000.00 100,000.00 100,000.00 100,000.00 100,000.00
Taxes 40,000.00 40,000.00 40,000.00 40,000.00 40,000.00
Net Income (500,000.00) 60,000.00 60,000.00 60,000.00 60,000.00 60,000.00
Depreciation 100,000.00 100,000.00 100,000.00 100,000.00 100,000.00
OCF (500,000.00) 160,000.00 160,000.00 160,000.00 160,000.00 160,000.00
After Tax Salvage Value 45,000.00
After Tax Total Net CF (500,000.00) 160,000.00 160,000.00 160,000.00 160,000.00 205,000.00
Present Value (500,000.00) 148,148.15 137,174.21 127,013.16 117,604.78 139,519.56
NPV 169,459.85
IRR 20%
Payback Period 3.13
CASE #1
IS THE
INVESTMENT
ATTRACTIVE?

INVESTMENT
ATTRACTIVENESS
NPV = 169.459,85, NPV is (+)

IRR 20% > I 8%

YES
PAYBACK PERIOD : 3,13 The Investment in the machine
is attractive in economic terms
CASE
#2
Schmidt AG is considering the replacement of three hand-loaded
block milling machines with an automatic milling machine. The three
hand-loaded machines are only three years old and were purchased
at a total cost of DM 300,000. The useful life of the machines at the
same time of their purchase was estimated to be fifteen years. The
salvage value at the end of the fifteen years was estimated to be
zero.

Is the investment economically attractive?

What are the actual after-tax cash flows for each of the two
alternatives?
What is the NPV of the actual cash flows for each of the two
alternatives?
Scenario 1 - Continue using existing
machine
1 2 3 4 5 6 7 8 9 10 11 12
Year 4 5 6 7 8 9 10 11 12 13 14 15
Depreciation $20,000.00 $20,000.00 $20,000.00 $20,000.00 $20,000.00 $20,000.00 $20,000.00 $20,000.00 $20,000.00 $20,000.00 $20,000.00 $20,000.00
Tax Shield $8,000.00 $8,000.00 $8,000.00 $8,000.00 $8,000.00 $8,000.00 $8,000.00 $8,000.00 $8,000.00 $8,000.00 $8,000.00 $8,000.00
CF $8,000.00 $8,000.00 $8,000.00 $8,000.00 $8,000.00 $8,000.00 $8,000.00 $8,000.00 $8,000.00 $8,000.00 $8,000.00 $8,000.00
PV $7,476.64 $6,987.51 $6,530.38 $6,103.16 $5,703.89 $5,330.74 $4,982.00 $4,656.07 $4,351.47 $4,066.79 $3,800.74 $3,552.10
NPV $63,541.49

Scenario 2 - Replace existing machine after three

years

Year 0 1 2 3 4 5 6 7 8 9 10 11 12

Investment $(480,000.00)
Sale of old machine $100,000.00

Saving of Labor $135,000.00 $135,000.00 $135,000.00 $135,000.00 $135,000.00 $135,000.00 $135,000.00 $135,000.00 $135,000.00 $135,000.00 $135,000.00 $135,000.00
Out of Pocket Cash
Saving $25,000.00 $25,000.00 $25,000.00 $25,000.00 $25,000.00 $25,000.00 $25,000.00 $25,000.00 $25,000.00 $25,000.00 $25,000.00 $25,000.00
Saving by space $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00

Depreciation $(40,000.00) $(40,000.00) $(40,000.00) $(40,000.00) $(40,000.00) $(40,000.00) $(40,000.00) $(40,000.00) $(40,000.00) $(40,000.00) $(40,000.00) $(40,000.00)

Loss on Sale $(140,000.00)

EBIT $(17,000.00) $123,000.00 $123,000.00 $123,000.00 $123,000.00 $123,000.00 $123,000.00 $123,000.00 $123,000.00 $123,000.00 $123,000.00 $123,000.00
Income tax $(6,800.00) $49,200.00 $49,200.00 $49,200.00 $49,200.00 $49,200.00 $49,200.00 $49,200.00 $49,200.00 $49,200.00 $49,200.00 $49,200.00
Net income $(10,200.00) $73,800.00 $73,800.00 $73,800.00 $73,800.00 $73,800.00 $73,800.00 $73,800.00 $73,800.00 $73,800.00 $73,800.00 $73,800.00
add: depreciation 40,000 40,000 40,000 40,000 40,000 40,000 40,000 40,000 40,000 40,000 40,000 40,000
add: loss on sale 140,000.00

OCF $(380,000.00) $169,800.00 $113,800.00 $113,800.00 $113,800.00 $113,800.00 $113,800.00 $113,800.00 $113,800.00 $113,800.00 $113,800.00 $113,800.00 $113,800.00
99397.3272 86817.4751 81137.8272 75829.7450 70868.9206 61899.6599 57850.1494 54065.5602 50528.5609
PV $(380,000.00) 158691.5888 8 92894.69839 3 3 7 3 66232.6361 1 4 3 6
NPV $576,214.15
CASE #2
IS THE
INVESTMENT
ATTRACTIVE?

INVESTMENT
ATTRACTIVENESS
NPV for:

Hand-loaded Block =
YES
$63.541,49 The Investment in the automatic
machine is attractive in economic
Automatic = $ 576.214,15 terms
CASE
#3
Richard Pitkin, CFO of Draper Corporation, was concerned by the long-
term prospects for the Synectics product line. The product line had
performed well historically, but the impending loss of its patent
position seemed certain to attract new entrants and result in lower
product prices and flat unit sales through the year of 2004.

Management was considering the elimination of the product line as of

year-end 1997. Would you recommend that the Synectics product line
be discontinued at the beginning of 1998?
Period 1 2 3 4 5 6 7 8

Sales $20,000.00 $20,600.00 $21,000.00 $21,150.00 $21,250.00 $21,250.00 $21,000.00 $-

COGS $10,000.00 $10,300.00 $10,609.00 $10,927.27 $11,255.09 $11,592.74 $11,940.52
depreciation $1,057.00 $1,124.00 $1,204.00 $1,304.00 $1,404.00 $1,504.00 $1,504.00 $-
Selling, general & adm $7,000.00 $7,210.00 $7,426.30 $7,649.09 $7,878.56 $8,114.92 $8,358.37
EBIT $1,943.00 $1,966.00 $1,760.70 $1,269.64 $712.35 $38.34 $(802.89) $-
income tax $777.20 $786.40 $704.28 $507.86 $284.94 $15.34 $(321.16)
Net income $1,165.80 $1,179.60 $1,056.42 $761.78 $427.41 $23.00 $(481.73) $-
Add: depreciation $1,057.00 $1,124.00 $1,204.00 $1,304.00 $1,404.00 $1,504.00 $1,504.00 $-
OCF $2,222.80 $2,303.60 $2,260.42 $2,065.78 $1,831.41 $1,527.00 $1,022.27 $-
Less: Capex $400.00 $400.00 $400.00 $400.00 $300.00 $200.00 $- $-
Changes in WC $(108.00) $(111.00) $(79.00) $(40.00) $(33.00) $(17.00) $23.00 $3,957.00
FCF $1,714.80 $1,792.60 $1,781.42 $1,625.78 $1,498.41 $1,310.00 $1,045.27 $3,957.00
PV $1,531.07 $1,429.05 $1,267.98 $1,033.22 $850.24 $663.69 $472.83 $1,598.17
npv $8,846.23

If we discontinued at 1998
Recovery of WC $3,592.00
sale of fixed assets $3,000.00
tax shield $1,600.00
PV of CF $8,192.00
 Based on the PV of cash
SHOULD THE flows, continuing the
product have higher PV
PRODUCT LINE BE so it’ shouldn’t be
discontinue
DISCONTINUED ?

NO!!
THE PRODUCT
LINE SHOULD BE
CONTINUE
CASE
#4
 The VP of Marketing from Draper Corporation proposed to make a major
investment in market share by increasing promotional expenditures by $2,5
million during 1998-2000. Sales were forecast to increase by 250,000 units
per year throughout the 1994-2004 period. He also believed that some
economies would be realized in the area of selling, general & administrative
expenses.

Would you recommend approval of the program?

 1998 1999 2000 2001 2002 2003 2004 2005
Units 250 250 250 250 250 250 250 0
Unit Price $20.00 $20.60 $21.00 $21.15 $21.25 $21.25 $21.00 $19.00

1998 1999 2000 2001 2002 2003 2004 2005

working capital 925 953 973 983 991 995 989 0
changes 0 -28 -20 -10 -8 -4 6 989

0 1 2 3 4 5 6 7 8
1998 1999 2000 2001 2002 2003 2004 2005
Investment $(1,400.00)
Sales $5,000.00 $5,150.00 $5,250.00 $5,287.50 $5,312.50 $5,312.50 $5,250.00
COGS $2,500.00 $2,575.00 $2,652.00 $2,732.00 $2,814.00 $2,898.00 $2,985.00
depreciation $200.00 $200.00 $200.00 $200.00 $200.00 $200.00 $200.00
Selleing, gen & adm $1,250.00 $1,288.00 $1,326.00 $1,366.00 $1,407.00 $1,449.00 $1,493.00
Special promotion $1,000.00 $1,000.00 $500.00
EBIT $50.00 $87.00 $572.00 $989.50 $891.50 $765.50 $572.00
Tax $20.00 $34.80 $228.80 $395.80 $356.60 $306.20 $228.80
Net income $30.00 $52.20 $343.20 $593.70 $534.90 $459.30 $343.20
Add: depreciation $200.00 $200.00 $200.00 $200.00 $200.00 $200.00 $200.00
Changes in WC $- $(28.00) $(20.00) $(10.00) $(8.00) $(4.00) $6.00 $989.00
FCF $(1,400.00) $230.00 $224.20 $523.20 $783.70 $726.90 $655.30 $549.20 $989.00
PV $(1,400.00) $205.36 $178.73 $372.40 $498.06 $412.46 $332.00 $248.43 $399.44
NPV $1,246.88
 Since the NPV is (+), the
SHOULD THE investment in installing
market share by initiating
PROPOSAL BE the 2,5 million special
promotion should be

APPROVED ? approve

YES
THE PROPOSAL
SHOULD BE
APPROVED
CASE
#5
Management of Seagate Technologies is considering the investment of $350 million in manufacturing
capacity, start-up costs, and net working capital to exploit a unique new technology. The effectiveness
of the new technology-developed at a total cost of $80 million – remained highly uncertain. During
the project’s expected fifteen-year life, free cash flows were forecast at anywhere from $0 per year to
$98 million per year. Management believed that the effectiveness of the technology would be known
by the end of year one. The expected annual free cash flow was $49 million.

If the worst case scenario occurred, management planned to terminate the program at the end of
year 1 and expected to recover $170 million, including all tax savings resulting from any write-offs.
Similarly, management believed that it would be possible to invest an additional $350 million at the
end of year 1 if the technology proved to be highly successful. The free cash flows would be $98
million per year and would continue for fourteen years.

Would you recommend that management make the $350 million

investment?
Please assume that 13% is the appropriate discount rate.
Investment $350,000,000.00
Total cost $80,000,000.00
discount rate 13%

Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Investment $(350,000,000.00)
Total Cost $(80,000,000.00)
CF (most likely) $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00

OCF $(430,000,000.00) $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00 $49,000,000.00

PV $(430,000,000.00) $43,362,831.86 $38,374,187.49 $33,959,457.95 $30,052,617.66 $26,595,236.86 $23,535,607.84 $20,827,971.54 $18,431,833.22 $16,311,356.84 $14,434,829.06 $12,774,185.01 $11,304,588.50 $10,004,060.62 $8,853,150.99 $7,834,646.90

NPV $(113,343,437.66)

Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Investment $(350,000,000.00) $(350,000,000.00)

Total Cost $(80,000,000.00)
CF (Highly successful) $98,000,000.00 $98,000,000.00 $98,000,000.00 $98,000,000.00 $98,000,000.00 $98,000,000.00 $98,000,000.00 $98,000,000.00 $98,000,000.00 $98,000,000.00 $98,000,000.00 $98,000,000.00 $98,000,000.00 $98,000,000.00 $98,000,000.00

OCF $(430,000,000.00) $(252,000,000.00) $98,000,000.00 $98,000,000.00 $98,000,000.00 $98,000,000.00 $98,000,000.00 $98,000,000.00 $98,000,000.00 $98,000,000.00 $98,000,000.00 $98,000,000.00 $98,000,000.00 $98,000,000.00 $98,000,000.00 $98,000,000.00

PV $(430,000,000.00) $(223,008,849.56) $76,748,374.97 $67,918,915.90 $60,105,235.31 $53,190,473.73 $47,071,215.69 $41,655,943.09 $36,863,666.45 $32,622,713.67 $28,869,658.12 $25,548,370.01 $22,609,177.00 $20,008,121.24 $17,706,301.98 $15,669,293.79

NPV $(106,421,388.59)

Year 0 1

Investment $(350,000,000.00) $170,000,000.00

Total Cost $(80,000,000.00)
CF (worst case) $-

OCF $(430,000,000.00) $170,000,000.00

PV $(430,000,000.00) $150,442,477.88

NPV $(279,557,522.12)
WILL YOU
RECOMMEND
THE INVESTMENT?

NO!!
As can be seen, all scenario shows (-) NPV,
so we won’t recommend the investment
CASE
#6
Perpetuities are often used to value merger and acquisition targets.

a) What is the present value of a stable perpetuity of $100,000 per year that
starts at the end of year one and continues to infinity? The appropriate
discount rate is 10%.

b) What is the present value of a stable perpetuity of $100,000 per year that
starts at the end of year five and continues to infinity? The appropriate
discount rate is 10%.

a) What is the present value of a growing perpetuity that starts at $50,000 at the
end of year one and grows at a 4% annual rate? The appropriate discount rate
is 10%.

b) What is the present value of a growing perpetuity that starts at $50,000 at the
end of year five and grows at a 4% annual rate? The appropriate discount rate
is 10%.
 a b
CF $100,000.00 CF $100,000.00
d 10% d 10%
PV of Perpetuity $1,000,000.00 n 4
PV of Perpetuity $683,013.46

c d
CF $50,000.00 CF $50,000.00
d 10% d 10%
g 4% g 4%
PV of Perpetuity $833,333.33 n 4
PV of Perpetuity $569,177.88
CASE
#7
Lycos, Inc. was considering the acquisition of a smaller competitor in the hand tool
business. The target, Hampton Tool, had been reasonably successful; but sales growth
seemed very limited, and the controlling family was interested in ‘cashing out’.
Management of Lycos believed that the integration of the two firms would result in
significant cost savings. Specifically, purchasing economies should reduce cost of goods
sold by 1.5 percentage points over the next 2-3 years. It also seemed likely that
Hampton Tool’s Selling and Administrative costs would decline by 3.0 percentage points.

Management of Lycos, Inc. used discounted cash flow analyses to value mature
acquisition targets. As of late-1998, with inflation stable at a 2% annual rate,
management believed that a 10% discount rate was appropriate in valuing acquisitions
in the hand tool business.

What is the maximum price that Lycos should be willing to pay?

 1 2 3 4 5
1999 2000 2001 2002 2003 to infinity
Sales $61,000.00 $63,440.00 $65,978.00 $68,617.00 $71,361.00
COGS $29,890.00 $30,768.00 $31,669.00 $32,593.00 $33,896.00
Depreciation $4,000.00 $4,160.00 $4,326.00 $4,499.00 $4,679.00
Selling & adm $21,010.00 $21,570.00 $22,103.00 $22,232.00 $22,407.00
EBIT $6,100.00 $6,942.00 $7,880.00 $9,293.00 $10,379.00
Tax $2,135.00 $2,429.70 $2,758.00 $3,252.55 $3,632.65
Net income $3,965.00 $4,512.30 $5,122.00 $6,040.45 $6,746.35
Add: depreciation $4,000.00 $4,160.00 $4,326.00 $4,499.00 $4,679.00
OCF $7,965.00 $8,672.30 $9,448.00 $10,539.45 $11,425.35
Less: capex $4,938.00 $5,136.00 $5,341.00 $5,555.00 $5,777.00
changes in WC $(516.00) $(537.00) $(558.00) $(581.00) $(604.00)
FCF $2,511.00 $2,999.30 $3,549.00 $4,403.45 $5,044.35 $131,153.10
FCF to infinity $2,511.00 $2,999.30 $3,549.00 $4,403.45 $136,197.45
PV $2,414.42 $2,773.02 $3,155.05 $3,764.09 $111,944.38
NPV $124,050.96

Maximum price Lycos should to pay $124,050,956.15

 SYNDICATE 2

THANK YOU