FREE online courses on Capital Budgeting Analysis - Calculating the
Discounted Cash Flows - Examples
Example 3 - Make or Buy Decision
You have the option to manufacture your own parts or purchase
them from outside suppliers. If we purchase the parts, it will cost $ 50.00 per
part. Our factory is operating at 70% of capacity and our total cost to
manufacture parts is:
Direct Materials
$ 15.00 / part
Direct Labor
$ 19.00 / part
Overhead - Variable
$ 14.00 / part
Overhead - Fixed
$ 12.00 / part
Total Costs
$ 60.00 / part
Since we are operating at 70% capacity, we do not expect an
increase in fixed overhead; this is a sunk cost. We would manufacture the parts
since it is $ 2.00 / part cheaper:
Purchase $ 50.00 vs. Manufacture $ 48.00 ($ 15.00 + $ 19.00 +
$ 14.00)
Example 4 - Discontinue a Product
You are considering dropping product GX-4 from your product
line because the Income Statement for GX-4 shows the following:
Traditional Relevant
Sales Revenues
$ 10,000
$ 10,000
Cost of Goods Sold - Variable
( 6,000) ( 6,000)
Cost of Goods Sold - Fixed (
2,000)
Operating Expenses - Variable
( 2,500)
(2,500)
Operating Expenses - Fixed (
600)
Income (Loss)
$ ( 1,100) $ 1,500
Conclusion: We should continue selling GX-4 since it earns $
1,500 of Income.
Example 5 -
Accept a Special Offer
A customer has offered you $ 15.00 for 5,000 units of your
product. You normally sell your product for $ 25.00. Should you accept this
offer?
You currently produce and sell 40,000 units with a maximum
capacity of 50,000 units. Total manufacturing costs are $ 18.00 per unit,
consisting of $ 12.50 variable and $ 5.50 fixed.
Change in Revenues
$ 75,000
(5,000 x $ 15.00)
Change in Expenses
( 62,500)
(5,000 x $ 12.50)
Net Change
$ 12,500
Conclusion: You should accept the special offer since it
results in $ 12,500 of additional income.
So far, we have covered present values and relevancy within
capital budgeting. We now can proceed to calculate the present value of relevant
cash flows. Once we have determined the present value of cash flows, we will
have a basis for comparing our initial investment. Both values (future cash
flows and initial investment) will be expressed in current values. The net of
these two amounts will tell us how much value we will create or destroy by
investing in a project.
Example 6 - Calculate Relevant Cash Flows for Capital Project
We plan on purchasing a new assembly machine for $ 25,000..
It will cost $ 2,000 to have the new machine installed and we expect a $ 1,000
net increase in working capital. By making the investment, we will reduce our
annual operating costs by $ 7,000 and we expect to save $ 500 a year in
maintenance. The new machine will require $ 750 each year for technical support.
We will depreciate the machine over 5 years under the straight-line method of
depreciation with an expected salvage value of $ 5,000. The effective tax rate
is 35%.
Annual Savings in Operating Costs $
7,000
Annual Savings in Maintenance
500
Annual Costs for Technical Support
( 750)
Annual Depreciation
( 4,000) *
Revenues
$ 2,750
Taxes @ 35%
( 962)
Net Project Income 1,788
Add Back Depreciation (non cash item)
4,000
Relevant Project Cash Flow
$ 5,788
* $ 25,000 - $ 5,000 / 5 years = $ 4,000
We will receive $ 5,788 of cash flow each year by investing
in this new assembly machine. Since we have a salvage value, we have a terminal
cash flow associated with this project.
Example 7 -
Calculate Terminal Cash Flow for Capital Project
Estimated Salvage Amount in 5 Years $ 5,000
Less Taxes
(1,750)
Terminal Cash Flow
$ 3,250
