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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

 

 

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