3. Introductory Example

Clean Vial Company is considering purchasing a new machine to clean vials that are used to store medication. We have collected the following information about the project:

  • The machine requires an investment of 600'000 today. This initial investment will be depreciated linearly over the useful life of the machine of 3 years (that is, depreciation charges equal 200'000 at the end of each year).
     
  • At the end of year 3, we expect to sell the machine for 40'000.
     
  • The expected revenues are 400'000 in year 1, 600'000 in year 2, and 800'000 in year 3.
     
  • Operating costs (excluding depreciation) amount to 40% of revenues.
     
  • The relevant tax rate is 20%.
     
  • To launch the project, the firm has to increase its net working capital by 100'000 today. This amount will be freed-up at the end of the project.
     
  • The relevant discount rate for the project's net cash flows is 15%.
     
  • Unless stated otherwise, all cash flows occur at year end.

 

Project Cash Flow Statement

With this information, we can use the template from the previous page and compute the net cash flows of the project. The result is shown in the table below as well as in the accompanying Excel file.

   

  Today Year 1 Year 2 Year 3
Revenues 400’000 600’000 800’000
− Operating expenses (excluding Depreciation) 160’000 240’000 320’000
− Depreciation 200’000 200’000 200’000
Earnings before interest and taxes (EBIT)   40’000 160’000 280’000
− Taxes 8’000 32’000 56’000
Earnings before interest after taxes (EBIAT or NOPLAT)   32’000 128’000 224’000
+ Depreciation 200’000 200’000 200’000
− Increases in project-specific net working capital (ΔNWC) 100’000 -100’000
Operating Cash Flow (OCF) -100’000 232’000 328’000 524’000
− Net investments 600’000 -32’000
Net Cash Flow (NCF) -700’000 232’000 328’000 556’000

 

Let's go through this cash flow statement step by step:

  • Revenues: The first line of the table shows the annual revenues as per our assumptions.
     
  • Operating Expenses: The annual operating expenses equal 40% of revenues. For example, in year one, revenues are 400'000 so that operating expenses are 160'000 [= 0.4 × 400'000].
     
  • Depreciation: The machine is depreciated linearly over 3 years. Given an initial investment of 600'000, annual depreciation charges are 200'000 [= 600'000/3].
     
  • EBIT = Revenues − Operating expenses (excluding Depreciation) − Depreciation.
     
  • Taxes: The assumed tax rate is 20%. In the first year, for example, EBIT is 40'000. Consequently, taxes are 8'000 [= 0.2 × 40'000]. 
     
  • EBIAT or NOPLAT = EBIT − Taxes. This corresponds to the project's net income, if we exclude all financing effects (in particular interest expenses).
     
  • Depreciation: We add back depreciation since it is not a direct cash flow. Consequently, the cash flow statement only reflects the tax savings from depreciation, the depreciation tax shield, namely:
      
         Depreciation tax shield = tax rate × Depreciation = 0.2 × 200'000 = 40'000.
      
    To see this, let us look again at year 1: If we ignored depreciation altogether, the firm's EBIT would be 240'000 in year 1, so that the associated tax burden would be 48'000 [= 0.2 × 240'000]. Because of the tax shield associated with depreciation charges, the actual tax bill is 40'000 lower, namely 8'000.
     
  • Increase in NWC: As per our assumptions, the firm increases its net working capital by 100'000 at the beginning of the project (today). This capital cannot be used elsewhere, which is why it is equivalent to a cash outflow. Consequently, we subtract 100'000 from the cash flow statement today. At the end of the project, in 3 years, we can liquidate the NWC and therefore capture an additional cash inflow of 100'000, as per our assumptions.
     
  • Operating Cash Flow = EBIAT + Depreciation - Increases in NWC.
     
  • Net investments: Today, the firm invests 600'000 into the new machine, which corresponds to a cash outflow.
     
  • Salvage value in 3 years: At the end of the project, we expect to sell the machine for 40'000. Note that, by then, the machine will be fully depreciated so that its book value will be zero. Selling the machine for 40'000 will therefore trigger an accounting profit of 40'000 (revaluation surplus), which constitutes taxable income. Consequently, the after-tax salvage value is 32'000:
      
    After-tax salvage value = Salvage value − Revaluation surplus × tax rate = 40'000 − 40'000 × 0.2 = 32'000.
     
  • Net Cash Flow = Operating Cash Flow − Net investments
         
Discussion of Net Cash Flows
  • The cash flow statement implies an initial capital requirement of 700'000—600'000 to purchase the machine and 100'000 to build up the net working capital.
     
  • Over the 3 years, the project then generates positive net cash flows for the providers of capital.
     
  • In particular, the last project year is expected to generate a net cash flow of 656'000. This cash flow has two primary origins, namely:
    • Ordinary business of year 3 (profits from revenues)
    • Liquidation of the project (cash proceeds from disposing of the net working capital and from selling the machine).

  

Project Valuation

Now that we know the net cash flows of the project, we can compute its net present value. In doing so, remember that the assumed cost of capital (k) is 15%. The NPV of the project cash flows is 115'333:

 

\(NPV = \sum_{t=1}^T \frac{NCF_t}{(1+k)^t} \)

 

\(NPV = -700'000 + \frac{232'000}{1.15}+\frac{328'000}{1.15^2}+\frac{556'000}{1.15^3}=115'333\)

 

Clean Vial Company should therefore proceed with the project and purchase the machine. In doing so, the value of the firm should increase by approximately 115'000. 

 

Another way to see that it is a good project is to compute its Internal Rate of Return (IRR). The IRR is roughly 23% and therefore well above the cost of capital.