ADVANCED CORPORATE FINANCE

Lecture 3

PROJECT
APPRAISAL:
REPLACEMENT
DECISION
Learning Outcomes
 Compute and appraise project cash flows in relation to
replacement decision
 Apply Equivalent Annual Cost (EAC) techniques in deciding
a replacement decision.
 Apply EAC in appraising cost of excess capacity.
 Apply EAC in appraising optimum timing of investment.
 Apply EAC in appraising fluctuating load factors situations.
MAKING USE OF THE NPV RULE IN A
REPLACEMENT DECISION
 Example - Replacement decision
Prime cost

 Capital cost of a new 5-year equipment = $30,000 C0

 Salvage value of new machine in Year 5 = $5,000 C5**

 Current salvage of old equipment = $4,000 C0 (**tax effect)

 Current book value of old machine = $7,000

 Initial working capital = $ 2,500 C0 (Working capital) C5 recovery

 Increase in working capital in year 1 to 3 are $1,000, $800 and

$500 respectively. C1,C2 & C3 (Working capital) C5 recovery

 Existing warehouse space to install the new machine can be

sold for $10,000 after-tax C0 (opportunity cost)
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 An example continued
C1,C2, C3 ,C4 and
 Increase in revenue before tax = $9,500 p.a. C5 (incremental)

 Increase in before-tax operating costs = $2,000 p.a.

 Allocated overhead costs = $1,500 p.a. Ignore – not incremental!!!

 Annual depreciation of old machine = $1,300 Not cash flow

 Annual depreciation rate of new machine on straight-line prime

cost basis = 20% 20% X $30,000 = $6,000
 Tax rate = 30% Incremental tax shield after tax
C1,C2, C3 ,C4 and C5
 Cost of Capital (WACC)/Required rate of return = 10%
(6,000 – 1,300) X 30% = $1,410
Additional tax savings
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 CASH FLOW SPREADSHEET Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

1 Initial cost of new equipment (30,000) 5,000

2 Proceeds on sale of old machine 4,000
3 (Tax)/tax saving on sale (30%) 900 (1,500)
4 Working capital (2,500) (1,000) (800) (500) - 4,800
5 Opportunity cost warehouse (10,000)
6 Capital cash flow (37,600) (1,000) (800) (500) - 8,300

7 Increased revenue 9,500 9,500 9,500 9,500 9,500

8 Increased costs (2,000) (2,000) (2,000) (2,000) (2,000)
9 Increased depreciation** (4,700) (4,700) (4,700) (4,700) (4,700)
10 Profit before tax (EBIT) 2,800 2,800 2,800 2,800 2,800
11 Tax at 30% (840) (840) (840) (840) (840)
12 Profit after tax (Net Income) 1,960 1,960 1,960 1,960 1,960
13 Increased depreciation 4,700 4,700 4,700 4,700 4,700
14 Operating cash flow (12+13) 6,660 6,660 6,660 6,660 6,660
15 Total cash flow (6+14) (37,600) 5,660 5,860 6,160 6,660 14,960
Net Present Value (10%) (9,146)

** (20% x 30,000) -1,300

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APPLICATION
OF
EQUIVALENT
ANNUAL COST
(EAC)
 Example: EAC Application
As a result of improvements in product engineering, United Automation is
able to sell one of its two milling machines. Both machines perform the
same function but differ in age. The newer machine could be sold today
for $50,000. Its operating costs are $20,000 a year, but in 5 years the
machine would require a $20,000 overhaul. Thereafter the operating
costs would be $30,000 until the machine is finally sold in year 10 for
$5,000.

The older machine could be sold today for $25,000. If it is kept, it will
need an immediate $20,000 overhaul. Thereafter operating costs will be
$30,000 a year until the machine is finally sold in year 5 for $5,000.
Both machines are fully depreciated for tax purposes. The company pays
tax at 35%. Cash flows have been forecasted in real terms. The real cost
of capital is 12%.

By using the EAC method, which machine should United Automation sell? .

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Option 1 : Sell the newer machine & keep the older machine (with tax)
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Proceeds 50,000
from sale of
new machine

Tax on gain (17,500)

@ 35%

Overhaul of (20,000)
old machine

Operating costs (30,000) (30,000) (30,000) (30,000) (30,000)

(old machine)

Proceeds 5,000
from old
machine

Tax on gain (1,750)

@35%

Cash Flow 12,500 (30,000) (30,000) (30,000) (30,000) (26,750)

Option 1 : Sell the new machine & keep the old machine (with tax)

Present Value
= 12,500 - 30,000 A40.12 - 26,750/1.125
= ($93,800) A 40.12 = (1 – 1.12 )/0.12
-4

Equivalent Annual Cost (EAC) for 5 years

Present Value = EAC1 X A50.12

93,800 = EAC1 X 3.605
EAC1 = 93,800/3.605= $26,020
A 50.12 = (1 – 1.12-5)/0.12 = 3.605
Option 2 : Sell the older machine & keep the newer machine (with tax)

Year 0 Year 1 to 4 Year 5 Year 6 to 9 Year 10

Proceeds 25,000
from sale of
old machine
Tax on gain @ (8,750)
35%
Operating costs (20,000) (20,000) (30,000) (30,000)
(new machine)
Overhaul (20,000)
expense
Proceeds 5,000
from sale of
new machine

Tax on gain (1,750)

@35%
Cash Flow 16,250 (20,000) (40,000) (30,000) (26,750)
Option 2 : Sell the old machine & keep the new machine (with tax)

Present Value
= 16,250 - 20,000 A40.12 – 40,000/1.125 –30,000/1.126
– 30,000/1.127 – 30,000/1.128 – 30,000/1.129
–26,750/1.1210 = ($127,510)

Equivalent Annual Cost (EAC) for 10 years

Present Value = EAC1 X A100.12

127,510 = EAC1 X 5.650
=>EAC1 = 127,510/5.650 = $22,570

➢ Sell the old machine as it has lower Equivalent Annual Costs.

Assume both machines are equally efficient
 Cost of excess capacity
 Suppose a new project requires heavy use of an existing
information system and will bring the purchase date of a
replacement system forward from year 4 to year 3.
 The new system has a life of five years, and at a discount rate of
6 percent the present value of the cost of buying and operating it
is $500,000.
 When the new system in turn wears out, we will replace it with
another.

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 Cost of excess capacity continued
 We begin by converting the $500,000 present value to an EAC of
$118,700 [= 500000 / ((1 - 1.06-5)/0.06)]

 As the new system will be continuously replaced with another, we

will have to pay $118,700 a year indefinitely

 If we undertake the new project, the series of expenses of

$118,700 begins in year 4; if we do not undertake it, the series
begins in year 5.

Replace in year 3- EAC starts one year after

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 Cost of excess capacity continued
 The new project therefore results in an additional cost of $118,700
in year 4 which has a present value of 118700/(1.06)4 or about
$94,020

 This cost must be properly charged against the new project for the
use of spare capacity

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 Optimal timing of investment
 A positive NPV project might be more
valuable if undertaken in the future

 A project with a currently negative NPV

might become a valuable investment if we
wait a bit

 Any project thus has two mutually exclusive

alternatives: Do it now, or wait and invest
later

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 Optimal timing of investment cont’d

 To determine the optimal timing of investment under conditions of

certainty:
▪ First examine alternative dates (t) for making the investment and
calculate its net future value as of each date
▪ Then find out which of the alternatives would add most to the firm’s
value today by working out

Net future value as of date t

(1 + r ) t

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 Optimal timing of investment cont’d

 Suppose the net future value of a harvest at different dates is as

follows:
0 1 2 3 4 5
Net future value 50 64.4 77.5 89.4 100 109.4

Change in value 28.8 20.3 15.4 11.9 9.4

from previous
year (%)
NPV (10%) 50 58.5 64.0 67.2 68.3 67.9

Interest rate = 10%

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 Optimal timing of investment cont’d

 The optimal point to harvest is year 4 in order to maximise NPV

 Before year 4 the net future value increases by more than 10

percent a year, greater than the cost of capital that is tied up in
the project

 You maximise the NPV of your investment if you harvest as soon

as the rate of increase in value drops below the cost of capital

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 Optimal timing of investment cont’d

 The problem of optimal timing of investment under uncertainty is

much more complicated; there is rarely any way of knowing for
sure whether to invest now or to wait for a while
 The optimal investment timing under uncertainty can be examined
as real options

Lecture 2
21
 Fluctuating load factors
 Although a $10M machine may have a positive NPV, it should be
bought only if it has a higher NPV than a $9M alternative; i.e. the
NPV of the $1M marginal investment required to buy the more
expensive machine must be positive

 This important message is easily forgotten when equipment is

needed to meet fluctuating demand

Lecture 2
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 Fluctuating load factors continued
 A manufacturer operates two machines, each of which has a
capacity of 1000 units a year

 The machines have an indefinite life and no salvage value, and so

the only costs are the operating expenses of $2 per unit

 Each machine currently produces 750 units a year in order to meet

the combined demand of 1500 units

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 Fluctuating load factors continued
 The discount rate is 10 percent and the machines are kept
indefinitely:

Two Old Machines

Annual output per machine 750 units
Operating cost per machine 2 x 750 = $1,500
PV operating cost per machine 1,500 / .10 = $15,000
PV operating cost of 2 machines 2 x 15,000 = $30,000

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 Fluctuating load factors continued
 To replace with 2 new machines, each costs $6000 and $1
operating costs per unit, to meet peak demand:

Two New Machines

Annual output per machine 750 units
Capital cost per machine $6,000
Operating cost per machine 1 x 750 = $750
PV total cost per machine 6,000 + 750/.1 = $13,500
PV total cost of 2 machines 2 x 13,500 = $27,000

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 Fluctuating load factors continued
 As the present value of the costs of two new machines is $3,000
lower than the present value of two old machines, the firm buys
two new machines to replace the old ones

 Unfortunately the firm forgot to investigate another alternative: to

replace just one of the old machines and operate the new one with
a lower operating cost at full capacity all year but the old one at
half capacity

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 Fluctuating load factors continued
One old machine One new machine
Annual output per machine 500 units 1,000 units
Capital cost per machine 0 $6,000
Operating cost per machine 2 x 500 = $1,000 1 x 1,000 = $1,000
PV total cost per machine 1,000/.10 6,000 + 1,000/.10
= $10,000 = $16,000
PV total cost of both machines $26,000
 The NPV of the marginal investment in the first machine is $4,000
while the NPV of the marginal investment in the second machine is
-$1,000

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Old Old
Negative
$30,000
Marginal cost (1st)
= - 26,000- (-30,000)
= + $ 4000
Negative
Old New
$26,000
Marginal cost (2nd)
= - 27,000- (-26,000)
Negative = - $1000
New New
$27,000
 Summary/Checkpoint
▪ Capital budgeting and replacement decision
▪ Timing to replace the machine (i.e. when to replace old equipment)
▪ Cost of excess capacity
o New uses of existing facility may cause the need to replace earlier.
Need to assess immediate incremental cost of excess usage
compared with the incremental benefits.
▪ Optimal timing of investments
o Used to assess when it is best to harvest the investment
proceeds
▪ Fluctuating load factors
o Changes in demand may create an opportunity and need to alter the
use of existing facilities
o Involves evaluation of different alternatives to meet these
changes in demand to increase the NPV.
Remember : Please revise calculations in lectures and tutorials
 QUIZ 3
http://gg.gg/Quiz-3_August2020