306 CHAPTER 8 Cash Flow Estimation and Risk Analysis
annual increases or reductions in NOWC must be included when calculating the
project’s annual cash flow.
3.Terminal year cash flow.At the end of the project’s life, some extra cash flow is
usually generated from the salvage value of the fixed assets, adjusted for taxes if the
assets are not sold at their book value. Any return of net operating working capital
not already accounted for in the annual cash flow must also be added to the termi-
nal year cash flow.The classification of cash flows isn’t always as distinct as we have indicated. For ex-
ample, in some projects the acquisition of fixed assets is phased in throughout the
project’s life, and for other projects some fixed assets are sold off at times other than
the terminal year. The important thing to remember is to include all cash flows in
your analysis, no matter how you classify them.
For each year of the project’s life, the net cash flow is determined as the sum of the
cash flows from each of the categories. These annual net cash flows are then plotted
on a time line and used to calculate the project’s NPV and IRR.
We will illustrate the principles of capital budgeting analysis by examining a new
project being considered by Regency Integrated Chips (RIC), a large Nashville-based
technology company. RIC’s research and development department has been applying
its expertise in microprocessor technology to develop a small computer designed to
control home appliances. Once programmed, the computer will automatically control
the heating and air-conditioning systems, security system, hot water heater, and even
small appliances such as a coffee maker. By increasing a home’s energy efficiency, the
computer can cut costs enough to pay for itself within a few years. Developments have
now reached the stage where a decision must be made about whether or not to go for-
ward with full-scale production.
RIC’s marketing vice-president believes that annual sales would be 20,000 units if
the units were priced at $3,000 each, so annual sales are estimated at $60 million. RIC
expects no growth in sales, and it believes that the unit price will rise by 2 percent each
year. The engineering department has reported that the project will require additional
manufacturing space, and RIC currently has an option to purchase an existing build-
ing, at a cost of $12 million, which would meet this need. The building would be
bought and paid for on December 31, 2003, and for depreciation purposes it would
fall into the MACRS 39-year class.
The necessary equipment would be purchased and installed in late 2003, and it
would also be paid for on December 31, 2003. The equipment would fall into the
MACRS 5-year class, and it would cost $8 million, including transportation and in-
stallation.
The project’s estimated economic life is four years. At the end of that time, the
building is expected to have a market value of $7.5 million and a book value of $10.908
million, whereas the equipment would have a market value of $2 million and a book
value of $1.36 million.
The production department has estimated that variable manufacturing costs
would be $2,100 per unit, and that fixed overhead costs, excluding depreciation, would
be $8 million a year. They expect variable costs to rise by 2 percent per year, and fixed
costs to rise by 1 percent per year. Depreciation expenses would be determined in ac-
cordance with MACRS rates.
RIC’smarginalfederal-plus-statetaxrateis40percent;itscostofcapitalis12per-
cent;and,forcapitalbudgetingpurposes,thecompany’spolicyistoassumethatoper-
atingcashflowsoccurattheendofeachyear.Becausetheplantwouldbeginoperations
onJanuary1,2004,thefirstoperatingcashflowswouldoccuronDecember31,2004.