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Theta Widgets: Cash flow and compute its NPV using a given WACC.

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Theta Widgets Inc. is known for manufacturing some of the highest quality widgets in the country. One of the machines that Theta uses may need replacement. The following information is available to you:
? Revenues will not change if the machine is replaced.
? The present 'old' machine has a 'book value' of $50,000.
? The new machine will last 5 years and will have no disposal value in five years.
? The new machine will cost $1,750,000. It can be depreciated for tax purposes over a period of 5 years.
? if the new machine is purchased, the old machine will be disposed of right now for a disposal value of $200,000. The difference between the proceeds from the sale of the old machine and its 'book value' is taxable at Theta Widgets Inc. corporate tax rate of 34% (T = 0.34).
? The new machine will reduce operating costs by $490,000 per year (assume cash flows at the end of the years). Note that these annual cost savings are effectively taxable.

Assume that the Theta's Weighted Average Cost of Capital (WACC) is 7.25%.

Part 1: Construct the cash flow of the proposed investment. Then compute the net present value of the proposed investment using Theta's weighted average cost of capital. Write a short report to management stating whether the new machine should or should not be purchased.

Once done, check what is the NPV of the proposed project if Theta's WACC is:
(a) 2% ; (b) 4% ; (c) 6% ; (d) 8% ; (e) 10% ; (f) 12%

Write a short paragraph explaining what general conclusions you derive from the results of your repeated computations.

Part 2: Review the articles referred to in the Background Readings of the Module write a report discussing in detail the main features and complexities of the Capital Budgeting Decision. In particular refer to the problems of estimating the cash flow emanating from the proposed investment, and to the effects of possible future inflation on (1) the cost of capital and (2) on the future cash flow of an investment proposal. [You can read about inflation and financial decisions in the
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Module 05 - Session Long Project
A Capital Budgeting Decision of Microsoft Corporation.
Assume that Microsoft Corporation is contemplating an investment in an expansion project. A team of experts from different units of the company came up with the following projections regarding the required investment and schedule, costs and revenues emanating from the investment over the next several years: (all the numbers in the Table are in thousands of US dollars). Assume that all of the revenues and the expenses take place at the beginning of each period.
Year Investment in Machinery and equipment Purchase of
materials Direct and indirect labor Marketing expenses Revenues
0 22,000 0 0 600 0
1 0 1,600 4,800 800 9,400
2 0 2,400 5,700 790 14,400
3 0 2,400 5,700 790 14,400
4 0 2,400 5,700 790 14,400
5 0 2,400 5,700 790 14,400
6 0 2,400 5,700 790 14,400

Assume that the systematic risk coefficient of the proposed project is estimated to be equal to the operating systematic risk coefficient of your company.

Assume also that in computing taxable income, the company is allowed to depreciate the investment in machinery and equipment on a straight line basis over 4 years. The company is of the opinion that at the end of year "6" it may be able to sell the machinery and equipment US$8,000 thousand. (Note: this estimation has no bearing on the company's ability to depreciate the entire investment). The company's tax rate is the combined federal and state corporate income tax of 34% is applicable. (If your own company has accumulated large losses that appear on its balance sheet (where?) then the tax considerations are irrelevant.)

Here are the deliverables for this Module's SLP:
a. Prepare and present a side table of the effects of depreciation, year by year, on the company's future cash flow, including the tax shields of depreciation and the "tax rebates" emanating from the deductibility of depreciation for tax purposes.

b. Then construct the year-by-year after tax cash flow emanating from the proposed project report again and then use the WACC that you estimated and reported on in Part 4 of the Session Long Project (SLP4) and compute the net present value of the project for your own SLP Company.

c. Assess the Net Present Value of the proposed project and write a short memo to management recommending acceptance/rejection of the proposal by your company. Explain what cost of capital was used for the computation of the net present value of the proposed project.

d. Note that the projections in the table are in terms of "today's prices". Such projections are called "real terms cash flow". Answer the following question: In light of the rising concern about inflation in the coming years, what adjustments should be made to either the cash flow or to the cost of capital? Explain your answer.

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The solution uses cash flow to computes its NPV using a given WACC for Theta Widgets.

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