Three Questions That Net Present Value Analysis Can Help You Answer

Part 1 Should I offer an additional product line? Should I replace an old piece of equipment? Will an extra service pay off? One technique that can help you answer these questions in dollars-and-cents terms is Net Present Value (NPV). This article will use three case studies to show how to use the NPV formula to get answers. Case Study 1: Adding a New Product Line Let's say that you are the manager of the Sure-Fire Sportswear Company. You are thinking about introducing a new sports applique to your product line. You believe that the demand for this new applique will be great for five years but will evaporate after that. (Sports fans can be fickle.) Over that five year period you feel you can make reasonable guesses about your expenses and revenues. You estimate that extra sales for Surefire from the applique will look like this:   Year 1 Year 2 Year 3 Year 4 Year 5 Cash-Flows-ln $15,000 $20,000 $25,000 $20,000 $15,000 After you have made a reasonable estimate of the additional cash-flows-in, you need to estimate the extra commissions, labor, material and other expenses that Surefire will incur to produce those extra sales. These make up the additional cash-flows-out. Additional cash-flows-out for a company could include increases in expenses like these: labor, supplies, commissions, advertising, insurance, utilities, maintenance or income taxes. These additional cash-flows-out should not include the costs to start a project, such as the purchase price of equipment, a franchise or a license. Startup or initial costs will figure into the NPV calculations separately. Additional cash-flows-out are the kinds of costs that a business would have throughout the life of the project. Look at the new applique at the sportswear company again. Surefire would have some additional costs on a regular basis throughout the five years that it manufactured the new applique. When you total the extra materials, labor, commissions, income taxes and advertising that Surefire would have to pay to bring the applique to its customers, the best estimates of the extra costs look like this:   Year 1 Year 2 Year 3 Year 4 Year 5 Cash-Flows-Outs $12,000 $13,000 $13,000 $11,000 $8,000 Always remember to include extra income taxes that would be due as part of the cash flows-out. An increase in income taxes from the extra profits Surefire will have on the new applique has been included in the cash-flows-out that are shown. Two Exceptions Two items that you might often think of as expenses have not been mentioned as a cash-flows-out. Most businesses borrow money occasionally or they may have revolving-type credit lines. Because of this, many businesses have interest expenses. Interest expense was not mentioned in the cash-flows-out for Surefire The other missing expense is depreciation. Almost all businesses with vehicles, equipment or buildings "on the books" are showing a depreciation expense on their income tax forms and financial statements. Why aren't these two expenses included as cash-flows-out? If you included the interest expense in the additional cash-flows-out, it would be double counting. Why? Interest expenses are computed and included automatically in the discount rate you use to adjust the net cash flows. Depreciation expense is not listed because it is a "non-cash" expense; NPV includes only cash items. Yes, you bought and may have paid for the vehicle, equipment or building in cash. However, depreciation laws require that the cost of that sort of purchase be spread over several years on the books and for tax purposes. Like interest expense, net present value does include depreciation as an expense. AU the startup costs are included as initial costs. For example, when you buy equipment and pay for it, you are not allowed to show all the cost of the equipment as an expense for the year that you bought the equipment on your income tax forms. You and your accountant or tax advisor have to set up a depreciation schedule. With the depreciation schedule, you deduct the equipment's cost; but the cost is divided up and spread over several years. Eventually you deduct all the equipment's cost through depreciation expenses. Depreciation is called an expense each year at tax time although no additional cash has changed hands. Because no cash changes hands, depreciation is not included in cash-flows-out. Even though neither interest nor depreciation are included as a cash-flow-out, they do have an important part in net present value calculations. Both must be calculated to determine what income taxes are due. This will be shown later. Net cash flows After cash-flows-in and cash flows-out are estimated, determining the net cash flows is a straight forward step. Subtract the cash-flows-out from the cash-flows-in. For instance, the net cash flows for the Surefire Sportswear Company from the new applique are:   Year 1 Year 2 Year 3 Year 4 Year 5 Cash-Flows-ln $15,000 $20,000 $25,000 $20,000 $15,000 Cash-Flows-Outs $12,000 $13,000 $13,000 $11,000 $8,000 Net Cash Flows $3,000 $7,000 $12,000 $9,000 $7,000 Obviously, all those net cash flows are not coming into Surefire at the same time. What is not so obvious is that if cash comes to a business later rather than sooner, it is worth less to the business. Adjusting dollars for timing and for their cost is where the time value of money applies to the NPV calculations. Adjusting for the Time Value of Money The decisions you make about which opportunities to pursue will probably affect your business's net cash flows for more than a year. It may be two years, three years, or even longer before all the effects of new projects that you have chosen can be realized. Unless all the benefits from a project would come in one year or less, the time value of money must be taken into account to get a true picture of the project's financial performance. The reason is that money received now has more value than the same amount of money if it is received later. For instance, in 1948 a new, fully-equipped luxury car could be bought for $8,000. In 1990, $8,000 would buy a new, modest economy car. The same $8,000 is not worth as much in 1990 as it was in 1948. To include the time value of money, the net cash flows are adjusted to reflect two things: (a) how long it will be before you actually get the net cash flows; and (b) what you determine is your required rate of return for the project. You have already made an estimate of when you would receive the net cash flows. You can make an estimate for the cost of money on your own, talk with your banker or financier, or confer with an advisor. The real value of a project can be determined only if you calculate what future cash flows are worth today, i.e., in current dollars. To adjust the net cash flows for a proposed project correctly, you must decide what your cost of money is. You may be able to take all necessary cash out of the operations of your current business, but that money is not free. If you or a partner put more money in the business as owners' equity specifically for the proposed project, that is not free either. Obviously if you borrow money, a cost is involved: interest charges. Several factors are used in determining the required rate of return. If you take money from your ongoing operations, the rate would include the return that you expect from your present business. If you get the money by increasing owners' equity, you or your partner have given up the opportunity to invest that money elsewhere. The required rate would then be the return on the alternative investment that you passed up plus an amount to compensate you for the risk involved in investing in this project. If you combine some of these sources to raise the money for a project, adjust the cost of money accordingly. Another approach to financing the project is borrowing the money. In this case, the interest paid on the loan would be a factor in your required rate of return decision. Regardless of the approach that you take, assume that all the money will be received at the end of each year. That makes the calculations easier. To illustrate how to make the adjustment to net cash flows, consider the sports applique example. The new applique that Surefire is considering would produce cash flows for five years. For the applique the net cash flows over five years will look like this:   Year 1 Year 2 Year 3 Year 4 Year 5 Net Cashflows $3,000 $7,000 $12,000 $9,000 $7,000 These amounts are the net cash flows that you will adjust because you will receive them after one or more years have passed. With the applique, you have decided to use a 15 percent required rate of return for Sure-Fire's investment. This is the rate at which the owners feel they would be compensated for the investment in the project as well as be able to pay back any debt incurred to finance the project. You can find the adjustment factors for the 15 percent return Surefire has decided on by using a business calculator or a printed table of these numbers. Or, you can calculate them for yourself. The adjustments values for 15 percent and net cash flows for the applique are:   Year 1 Year 2 Year 3 Year 4 Year 5 Net Cashflows $3,000 $7,000 $12,000 $9,000 $7,000 Adjustment 0.8696 0.7561 0.6575 0.5718 0.4972 cheap hotels in ReadingTo find the applique's adjusted net cash flow, multiply the net cash flows for each year by the adjustment for each year. After you have done the multiplication total the five years. This sum is the aggregate adjusted net cash flow. For the new applique the total adjusted net cash flow would be:   Year 1 Year 2 Year 3 Year 4 Year 5 Net Cashflows $3,000 $7,000 $12,000 $9,000 $7,000 Adjustment (at 15%) 0.8696 0.7561 0.6575 0.5718 0.4972 Adjusted Net Cash Flows (at 15%) $2,609 5,293 7,890 5,146 3,480   Total Adjusted Net Cash Flow (at 15%) $2,609 + 5,293 + 7,890 + 5,146 + 3,480 = $24,418 You might want to compare these figures to the unadjusted net cash flows. There is a significant difference, all of which is due to the time value of money.   Year 1 Year 2 Year 3 Year 4 Year 5 Net Cash Flows $3,000 $7,000 $12,000 $9,000 $7,000 Adjusted Net Cash Flows (at 15%) $2,609 5,293 7,890 5,146 3,480 Remember that the adjusted net cash flows reflect the value of the cash flows from the project in current (today's) dollars. Now that the adjusted net cash flows have been calculated, the next step in the NPV calculation is to look at the initial costs. Initial costs All the expenses required to get the new project, product, or equipment started are initial costs. These costs are one-time events. If you are showing the same cost more than once, it should be included in the cash-flows-out. The type of costs usually included as startup costs are: purchase price, installation expenses, freight-in or delivery, "roll-out" advertising and one-time training costs. Let's go back to the sportswear applique example. Sure-Fire's sports applique project would have some one-time startup costs like: sales training, operator training, new sewing machine attachments, and miscellaneous costs. The total of these initial costs for the applique would be $15,000. It is not necessary to adjust any of the initial costs. You are spending all the money now, not next year or the year after that. Since the money would be spent currently, it requires no adjustment; a dollar today is worth a dollar. Net present value Now Surefire has all the estimates to calculate the net present value of manufacturing the applique. Adjusted net cash flows for the applique were $24,418 and initial costs were $15,000. The NPV for the applique project for Surefire would be: Adjusted Net Cash Flow - Initial Costs = Net Present Value $24,418 - 15,000 = $9,418 Since the NPV of the new sports applique would be $9,418, it is definitely a good opportunity. Surefire would cover all costs including the 15 percent required rate of return on the project, and, in addition to that, it would make $9,418 in today's dollars. There are some reasons why Surefire might not make the applique. Something even better could come along. It also might be impossible to raise the $15,000 initial costs from inside the business, or to get additional contributions from owners, or to borrow it. Surefire might be able to borrow the money if it were willing to pay more to get the money. However, one important thing to remember is: Any change in the cost of money changes the value of a project. Different Costs of Money If the cost of money changes, the value of any project will change. The rate you use for adjusting the cash flow will account for all of the change. In this way a project's value can increase or decrease even though net cash flows and initial costs have not changed. Sure-Fire's applique project can illustrate this point. For example, let's say that everything about the applique is the same except the required rate of return has changed. Initial costs for the applique are $15,000 and the net cash flow will last for five years at $3,000, $7,000, $12,000, $9,000 and $7,000. However, your banker has decided to lend you money for the applique at a lesser rate. In other words, your required rate of return can be lowered to, say, 10 percent. That lower rate will change the adjustment used to discount the net cash flows, and ultimately the NPV of the applique project. Look at what happens to the value of the applique. Keep in mind that the net cash flows over the next five years and the initial costs for the applique are the same. The one change for the applique would be the rate that Surefire uses to adjust the net cash flows. When you use an adjustment for a 10 percent required rate of return, these are the figures:   Year 1 Year 2 Year 3 Year 4 Year 5 Net Cashflows $3,000 $7,000 $12,000 $9,000 $7,000 Adjustment (at 10%) 0.9091 0.8264 0.7513 0.5718 0.6209 Adjusted Net Cash Flows (at 10%) $2,727 5,785 9,016 6,147 4,346   Total Adjusted Net Cash Flow (at 10%) $2,727 + 5,785 + 9,016 + 6,147 + 4,446 = $28,021 When the net cash flows are adjusted at a 10 percent rate, the sum is higher than if the net cash flows are adjusted at a 15 percent rate. This is because the required rate of return has been lowered from 15 percent to 10 percent. The difference in the two adjusted net cash flow totals is caused only by the different adjustment rates that reflect the change in the cost of money. The ultimate measure of the applique's value is the money that Surefire will net from the project, the NPV. Since the required return has decreased, NPV will increase. Adjusted Net Cash Flow - Initial Costs = Net Present Value $28,021 - $15,000 = $13,021 The applique's net present value is higher by $3,603. The $3,603 increase in value between the NPV's at a 15 percent versus a 10 percent rate is caused only by the change in the required rate of return. The net cash flows were exactly the same before they were adjusted. Notice that the difference in the adjusted net cash flows is the same as the difference in the NPV'S.   Adjusted Net Cash Flow Initial Costs Net Value Adjusted at 10% $28,021 - $15,000 = $13,021 Adjusted at 15% 24,418 -15,000 = 9,418 Difference $ 3,603 - 0 $ 3,603 The initial costs did not change; those dollars are spent now. Since the purpose of adjusting dollar amounts is to determine what they are worth now, the present value of money that you spend now is 100 percent. On the other hand, if the required rate of return increases due to such factors as an increased borrowing rate, poor economic conditions, or a perceived high level of risk from the project being considered, the value of an investment will fall. Go back to the applique and see what happens when Surefire adjusts the net cash flows at a 20 percent rate. The unadjusted net cash flows are the same over five years and the initial costs are the same. Only the adjustment rate is changed because the required rate of return has changed. Here is how Sure-Fire's applique evaluation will change because of the higher required return:   Year 1 Year 2 Year 3 Year 4 Year 5 Net Cashflows $3,000 $7,000 $12,000 $9,000 $7,000 Adjustment (at 20%) 0.8333 0.6944 0.7513 0.4823 0.4019 Adjusted Net Cash Flows (at 20%) $2,500 4,861 6,944 4,341 2,813 Sum of the Adjusted Net Cash Flows (at 20%) $2,500 + 4,861 + 6,944 + 4,341 + 2,813 = $21,459 The sum of the adjusted net cash flows is lower at 20 percent than at 15 percent. At 15 percent that sum was $24,418 and at 20 percent the sum is $21,459. All of the $2,959 decrease in the applique's value is caused by an increase in the required rate of return from 15 percent to 20 percent. The difference of $2,959 in the two sums will carry through to the NPV'S. Adjusted Net Cash Flow - Initial Costs = Net Present Value $21,459 - 15,000 =$6,459 The net present value when money costs 20 percent is lower by $2,959 than when the discount rate was 15 percent. The $2,959 difference between the NPV'S at 15 percent and 20 percent is caused only by the rate used to adjust the net cash flows. This change reflects an increase in the required rate of return. The net cash flows were exactly the same before they were adjusted for this increase in required return. Again the difference in the adjusted net cash flows is the same as the difference in the net present values.   Adjusted Net Cash Flow Initial Costs Net Value Adjusted at 20% $21,459 - $15,000 = $6,459 Adjusted at 15% 24,418 -15,000 = 9,418 Difference - $2,959 - 0 - $2,959 These examples about Sure-Fire's new applique show more than the great difference that the cost of money can make. They also illustrate why interest expense is not included in the cash-flows-out to find the net cash flow; it would be double counting to include interest expenses in cash-flows-out beyond calculating the effect on income taxes. The required rate of return that you choose to adjust the net cash flows will take the tune value of money into account automatically whether you borrow the money, contribute equity, or take it out of your business. Whether the cost of money is 10 percent, 15 percent, or 20 percent, the applique is still a good investment for Surefire Although the NPV of the applique is different with each required rate of return, the NPV is always far greater than zero between rates of 10 percent and 20 percent. Note that if the new applique earned exactly a 20 percent return, the NPV would have been zero. Since the applique's NPV is greater than zero when. Money costs 20 percent, its return is greater than 20 percent. If through trial and error, a person increased the adjustment rate enough, he or she would find that the discount rate that would make the NPV of the project zero, is just under 35.67 percent. If you use an adjustment rate higher than this, the NPV of the applique will be negative. Clearly, projects NPV'S change with the rates of return that are used to adjust the net cash flows. The other factor that can change the NPV of the same project is the net cash flows timing. Alojamiento de lujo BojniceDifferent timing of net cash flows Net present value not only accounts for the cost of money, it accounts for the timing of net cash flows, too. Two projects could have the same total net cash flows, but differences in the timing of those cash flows could have a great effect on how valuable the project would be. Whether a project receives larger cash flows earlier or later in its life can make a great difference in the project's value. If a project receives larger cash flows sooner, it will be more valuable than a similar project that receives die same larger cash flows later. Sure-Fire's applique can illustrate this point. The applique has a total net cash flow of $38,000. A competitor has another applique that has the same total net cash flow, $38,000. However, the timing of the cash flows is different. Sure-Fire's applique would probably be a slower starter because it is for a fledgling hockey team. 'Me competitor's applique would probably have higher sales initially and have lower sales later. The competitor's applique is for a hockey team that is established and doing well now, but many of the players are about to pass their athletic prime.   Sure-Fire's Applique Net Cash Flows Competitor's Applique Net Cash Flows Year 1 $ 3,000 $7,000 Year 2 7,000 12,000 Year 3 12,000 9,000 Year 4 9,000 7,000 Year 5 7,000 3,000 Total Net Cash Flow $38,000 $38,000 Of course, none of these net cash flows have been adjusted for the time value of money. The required rate of return for the investment in appliques for both companies is 15 percent. When the adjustments are made and the net cash flows totaled, an interesting difference emerges.   Sure-Fire's Applique Net Cash Flows Adjustment (15%) Adjusted Net Cash Flows Year 1 $ 3,000 0.8696 $ 2,609 Year 2 7,000 0.7561 5,293 Year 3 12,000 0.6575 7,890 Year 4 9,000 0.5718 5,146 Year 5 7,000 0.4972 3,480 Total Net $38,000   $24,418     Competitor's Applique Net Cash Flows Adjustment (15%) Adjusted Net Cash Flows Year 1 $ 7,000 0.8696 $6,087 Year 2 12,000 0.7561 9,073 Year 3 9,000 0.6575 5,918 Year 4 7,000 0.5718 4,003 Year 5 3,000 0.4972 1,492 Total Net $38,000   $26,573 The Sure-Fire's applique has adjusted net cash flows that total $24,418. However the competitor's applique has a total adjusted net cash flows of $26,573. The difference in the adjusted net cash flows from the two appliques is caused only by a change in the timing of the net cash flows. The total unadjusted net cash flow and the adjustment rate are the same. Only the order in which the net cash flows are earned has changed, but this has made a $2,155 difference. $26,573 - 24,418 = $2,155 This same dollar amount difference, $2,155, would be found in the NPV'S of the two appliques because the initial costs were the same for both, at $15,000.   Sure-Fire's Applique Competitor's Applique Total Adjusted Net Cash Flows $24,418 $26,573 (Less) Initial Costs 15,000 15,000 NPV $ 9,418 $11,573 Net present value is responsive to the cost of money and the timing of cash flows regardless of the type of investment decision for which it will be used. With NPV, products, equipment or services can be evaluated. NPV can also be used to make decisions about equipment replacements. Since this has been a popular use for NPV, let's look at a NPV analysis for an equipment replacement decision. Three Questions That Net Present Value Analysis Can Help You Answer Part 2 Case Study 2: Replacing Old Equipment Another use for net present value is evaluating whether replacing old equipment would be a valuable purchase or not. New technology can increase efficiency, and new equipment could give a business owner an ego boost; but will it be valuable to the business? To illustrate this use of NPV, let's go back to operations at Surefire Since you are the manager of Surefire, the owner has asked you to decide whether to replace an old press. A new press will not increase production by even one unit, but since Surefire bought the old press, the technology has changed drastically. The old press is incredibly durable, but a new press is much more efficient. Efficiencies from a new press would give you substantial savings in labor and maintenance over your old press. Should Surefire keep the old press or buy a new one? To get a definite dollars-and-cents idea of whether it would pay to replace that old press, use net present value. If you can get a new press, there will be additional cash-flows-in, cash-flows-out, and initial costs. These are different cash flows from those the business has currently. If you keep the old press, there are no additional cash flows that are different from those currently earned or paid. Nothing has changed if no new press is bought, and the old press is kept. Cash-Flows-In First you have to consider the cash-flows-in that the new press will produce. The new press would save Surefire about $6,600 yearly in labor and maintenance over the next five years. Those savings in operating costs will be the only cash-flow-in that a new press would generate. The next step in evaluating whether to replace the old press is to determine the cash-flows-out. Cash-Flows-Out The only cash-flow-out that you anticipate for a new press will be extra income taxes paid on the higher income Surefire will have because of the savings in operating costs from the new press. Before you can calculate the change in income taxes accurately, you will have to look at financing costs for the new press and depreciation for both the old and new presses. Depreciation affects the additional income taxes that would be due on higher income that Surefire would have with a new press. This has to be included to get a clear picture of how Surefire will be affected. Depreciation's tax effects The depreciation expense that is deducted on income tax returns and appears on financial statements is determined by a schedule that is set up based on an asset's "book value." By using depreciation, an asset's book value is deducted gradually over the useful life of the asset. An important point is that the depreciable book value of an asset may not be the same as the sticker price or the initial cost of the asset. Let's determine the 'book value" of the new press for Surefire The book value of a new press would include the actual purchase price, delivery charges, installation costs, and any one-time setup or operating training costs. The best sticker price that Surefire can find on a new press is $17,500. If Surefire buys that machine, installation costs will total another $2,500 before it can be used. Fortunately, you have been able to negotiate with the vendor to absorb the delivery and freight charges for shipping that new machine to Surefire If you had not been able to get those concessions from the vendor, the freight charges would be included in the book value. Another plus for the new press is that you will not have any downtime in the shop while the machine is installed; space for it is available and the installation will not disrupt Sure-Fire's production process. This is the calculation of the new press's book value: Book Value for Depreciation (New Press) Sticker Price $17,500 Installation 2,500 Delivery 0 Book Value $20,000 Under the current scenario, if you buy a new press, you would sell the old one. Because of their durability there is a good market for this kind of used press. Even though you can probably get about $2,000 when you sell the old press, the $2,000 cannot be subtracted from the book value of a new press. So the book value used for depreciating the new press is $20,000.1 The $20,000 book value of the new press is the amount that Surefire depreciates over the press's useful life, which is the next five years. The technology on this type of machine has been advancing rapidly and those advances are probably going to continue. So in five years, a press that Surefire could buy today would probably be worthless. At the end of the fifth year you could probably trade with someone to haul it away for the scrap value that they can get out of it. Since the new press would be worthless to Surefire in five years, the new press's entire book value can be depreciated. You have decided to depreciate the new machine using a straight-line technique. This means Surefire would deduct the same amount each year for the next five years. To calculate the amount of depreciation on the new press, divide the new press's book value by its useful life, five years. This is the amount of depreciation Surefire would deduct each year on income taxes and financial statements as depreciation expense for the new press. For this new press the depreciation each year would be: Book Value/Years of Asset Life = Annual Depreciation $20,000/5 = $4,000 Since the depreciation on the new press would be the same each of the next five years, Sure-Fire's depreciation schedule for the new press will look like this:   Year 1 Year 2 Year 3 Year 4 Year 5 Depreciation Schedule (New Press) $4,000 $4,000 $4,000 $4,000 $4,000 You also have to consider the depreciation you would give up if Surefire got rid of the old press. The book value of the old press is $2,000 and it will last another five years. 10 However, when the old press was purchased four years ago at a cost of $10,000, a straight-line depreciation schedule was established assuming no salvage value at the end of its estimated useful life. As a result, the company has been depreciating $2,000 per year for this asset. The final $2,000 of book value will be depreciated over the next year, leaving the value on the books of the old press at $0 at the end of this year. Therefore, the depreciation expense that Surefire would show each year on its income tax returns and financial statements by keeping the old press is $2,000 next year and $0 for the next four years. The depreciation schedule for the old press would look like this:   Year 1 Year 2 Year 3 Year 4 Year 5 Depreciation Schedule (Old Press) $2,000 0 0 0   The point of all these depreciation calculations is to find the impact that these changes will have on Sure-Fire's before-tax income. Extra income taxes must be paid on the higher income Surefire will have from the operating savings that the new press will provide. Additional income before taxes must include giving up the old press's depreciation and at the same time getting the new press's depreciation as an expense. As you can see, the additional after-tax income in year one is $3,220 on the books. New Press Profit on the Books Year 1 Annual Savings $6,600 Depreciation (New) 4,000 (Less) Depreciation (Old) 2,000 (Less) Additional Depreciation 2,000 Additional Income before Taxes 4,600 (Less) Additional Income Taxes (30%) 1,380 Additional Income after Taxes $3,220 By year two, the situation will have changed due to the complete depreciation of the old press. New Press Profit on the Books Year 1 Annual Savings $6,600 Depreciation (New) 4,000 (Less) Depreciation (Old) 0 (Less) Additional Depreciation 4,000 Additional Income before Taxes 2,600 (Less) Additional Income Taxes (30%) 780 Additional Income after Taxes $1,820 The difference between years one and two relates solely to the amount of depreciation available for the old press. Now you can get a complete picture of how cost savings in operations and increased income taxes will affect the cash flows at Surefire It is interesting to compare the numbers on the books with cash flow. The new press will look different in terms of net cash flow than how it will appear on the books. Remember that NPV focuses on additional net cash flow. From either point of view, the annual operating expense savings will be the same, $6,600, a cash-flow-in. Year 1   New Press Profit on the Books New Press in Net Cashflow Annual Savings $6,600 $6,600 Depreciation (New) $4,000   Gry online(Less) Depreciation (Old) (Less Additional Depreciation) $2,000   Additional Income before Taxes   $4,600 (Less) Additional Income Taxes (30%) $1,380 $1,380 Additional Income after Taxes   $3,220 Additional Net Cash Flow $5,220     Year 2   New Press Profit on the Books New Press in Net Cashflow Annual Savings $6,600 $6,600 Depreciation (New) $4,000   (Less) Depreciation (Old) (Less Additional Depreciation) $4,000   Additional Income before Taxes   $2,600 (Less) Additional Income Taxes (30%) $780 $780 Additional Income after Taxes   $1,820 Additional Net Cash Flow $5,820   Extra taxes that Surefire must pay on the extra income are also the same because paying income taxes is a cash-flow-out. Savings from operations and additional income taxes paid are the only changes in cash flow that the new press would cause for Surefire Additional net cash flows from the new press will total $5,220 for year one and $5,820 for each of the next four years. Additional income on the books is $2,000 lower than additional net cash flow in year one and $4,000 lower over the remaining four years. Depreciation causes these differences. Depreciation shows only on Sure-Fire's "books;" this is where the difference between "book" income and new cash flow appears. However, to calculate any additional income tax liability, depreciation will always have to be calculated and included. Surefire would receive $5,220 additional net cash flow next year from the new press. Initial costs The initial costs of buying the new press versus continuing business with the old press is the next step in NPV calculations. As we said earlier, the sticker price on the new press is $17,500. Installation costs will total another $2,500. The vendor absorbed the delivery charges for shipping the new machine to Surefire If you had not been able to get those concessions from the vendor, the freight and delivery charges would be an initial cost also. There is no shop downtime while the machine is installed because space for it is open. The last item to include in the total initial cost is the money Surefire can get from selling the old press after the new press has been installed. The old press can be sold for $2,000. It is in good condition and there is an active "used" equipment market for this kind of press. The money that Surefire receives from the sale of the old press should be subtracted from the initial cost of the new press. Initial Cost (New Press) - Sticker Price $17,500 Installation $2,500 Delivery 0 (Less) Sale on Old Press $2,000 Total Initial Cost $18,000 The difference between book value and initial costs of the new press is $2,000 (the money from the sale of the old press). When an old asset is replaced by a new asset, the new asset's initial costs include all the cash costs and the cash received on the sale of the asset that it replaced. Net present value Now you can find the NPV for the new press at Surefire by adding the adjusted net cash flows and subtracting the initial costs. Adjust the net cash flows at 15 percent.   Year 1 Year 2 Year 3 Year 4 Year 5 Net Cash Flows $5,220 $5,220 $5,220 $5,220 $5,220 Adjustment (at 15%) 0.8696 0.7561 0.6575 0.5718 0.4972 Adjusted Net Cash flow (at 15%) $4,539 $4,401 $3,827 $3,328 $2,894     Year 1 Year 2 Year 3 Year 4 Year 5 Total Total Adjusted Net Cash Flow (at 15%) $4,539 $4,401 $3,827 $3,328 $2,894 $18,989 Adjusted Net Cashflow - Initial Costs = Net Present Value $18,989 - $18,000 = $989 The new press exceeds the 15 percent required rate of return and would therefore be considered a good investment if Surefire has the money and wants the new press. In other words, the new press will earn enough money to cover all costs including the 15 percent required rate of return and an additional $989 over and above all costs. We have evaluated new products, compared different costs of money, contrasted different cash flow timing, and examined replacing equipment by using net present value. Could NPV be used to evaluate a new service? Three Questions That Net Present Value Analysis Can Help you Answer Part 3 Case Study 3 Adding a new service Net present value can be useful for service businesses of all types. The best way to show this is with an example about a service business. Roho's Barbecue is a restaurant and catering service located in the same town as Surefire Roho is a friend of yours and has talked with you about starting a lunch delivery service. Customers who phone in orders by 10:30 a.m. could have their lunch delivered between 11:00 a.m. and 2:00 p.m. Roho believes this new service would generate dependable extra sales without cannibalizing his lunch walk-in trade. Unfortunately, Roho has learned that two new delivery trucks, a necessity for the lunch delivery service, will cost a total of $24,000. Roho is convinced that this kind of convenient, timesaving service will become popular in some parts of town. Several parts of town have high densities of shops or stores with owner/operators and office complexes. These are the people that Roho believes will represent most of the regular customer base for a lunch delivery service. Roho anticipates sales that average 50 meals a day, Monday through Friday, as a reasonable demand for the delivery service. To start the net present value analysis, Roho has to estimate cash-flows-in. Cash-Flows-In Roho believes that over the next five years the restaurant will deliver an average of 50 meals per day for 5 days a week on a year-round basis. Roho has decided that the average price per meal and minimum delivery purchase per stop will be the same at $8.50. Roho had two reasons for the $8.50 average delivered meal price. First, the average lunch menu item served in the restaurant is about $6.00. Roho figures that the time to drive from the parts of town with most of the shops and offices to the restaurant is worth far more than $2.50 to the potential customers. The second reason is related to the way in which the delivery and service personnel will be compensated. Delivery personnel will work for a low wage plus tips. Those tips will be shared with the service personnel who will arrive two hours earlier than usual at the restaurant to take the phone orders. Roho thinks that this Will give the delivery and service personnel an incentive to be pleasant with customers and accurate with orders. If the average meal price is $8.50, the tax is about 60 cents. That is an average total customer bill of $9.10. A delivery person would probably receive at least $10 for the combination of meal, tax and tip. A $ 10 bill would be easy, quick, convenient, and few people would not give the 90 cent tip on a $9.10 bill. Given the $8.50 average meal price and the expected demand level, cash-flows-in should be $110,500 for each of the next five years. 50 Meals/Day @ $8.50/Meal = $425/Day $425/Day X 260 Days/Year = $110,500. Cash-Flows-Out Extra cash-flows-out that Roho foresees for the lunch delivery service would be for: food; food preparation; three part-time delivery people; advertising, licenses; recyclable take-out containers, cutlery and condiments and truck operating expenses, like gasoline, maintenance and insurance. Since the business is expected to flourish, Roho expects to hire another prep/line cook for the first shift, to add higher-salaried-hours for two regular service personnel to take the orders and to compensate the day manager for the additional responsibility of the delivery service. Roho figures that a partial schedule of cash-flows-out over each of the next five years would be: Truck Maintenance/Operating Costs ($100/wk/truck) $10,400 Advertising ($25/wk) 1,300 Food (25% of receipts) 27,625 Food Preparation (30 hrs/wk @ $12/hr wage + benefits) 18,720 Containers/Condiments/Cutlery (@ $0.50/meal) 6,500 Service Personnel (20 hrs/wk @ $10/hr wage + benefits) 10,400 Delivery Personnel (12 hrs/wk @ $5/hr wage + benes) 9,360 Uniforms ($5/day/person) 3,900 Licenses/Fees 500 Total $88,705 These cash-flows-out, $88,705, only represent part of the total annual cash-flows-out. The day manager has to be compensated and motivated to run this delivery service well, and income taxes will be due on any additional income. The tax liability and the manager's compensation have to be added into the calculation of cash flows-out. Roho believes that 50 percent of the before tax-and-depreciation profit would be a good deal for the manager. Since the gross profit is $21,795, the day manager's compensation would be $10,898. Total Receipts $110,500 (Less) Cash-Flows-Out 88,705 Gross Profit Before Taxes or Depreciation 21,795 Manager's 50% 10,898 The manager's compensation is then added to the other cash-flows out. Cash-Flows-Out $88,705 Manager's 50% 10,898 Total Cash-Flows-Out except Taxes and Depreciation $99,603 In order to figure out what additional income taxes will be due, depreciation on the two new trucks has to be calculated and included on the books. Remember that expenses for tax purposes are not the same as cash-flows-out because depreciation expense is included for tax purposes. The two trucks cost $12,000 each and can be depreciated over three years on a straight line basis. This schedule allows $8,000 depreciation each year for the trucks over the first three years of the lunch delivery project. 2 Trucks @ $12,000 each = $24,000 $24,000/3 Years= $8,000 Annual Depreciation Now depreciation can be added to the other expense so that additional income taxes that would be due can be calculated. Annual Receipts $110,000 (Less) Expense (except Depreciation) 99,603 Gross Profit 10,897 (less) Depreciation 8,000 Additional Income Before Taxes 2,897 Additional Income Taxes (30%) 869 Additional Income after Taxes $ 2,028 During the three years that the trucks are depreciated, profits for income tax purposes will be different from net cash flows. The difference will be in depreciation. First Three Years of New Service   Profits on the Books Net Cash Flow Annual Receipts $110,500 $110,500 (Less) Expense (except Depreciation) 99,603 99,603 Gross Profit 10,897 10,897 (Less) Depreciation 8,000   Additional Income Before Taxes 2,897   Additional income Taxes (30%) 869 869 Additional Income after Taxes $2,028   Additional net cash flow   $10,028 For the first three years, Roho will get $10,028 per year in extra net cash flow, but will show income of only $2,028 on the books for income tax purposes. The $8,000 difference is the amount of depreciation taken as an expense. The last two years of the delivery service will have net cash flows that are the same as profits for income tax purposes because there will be no more depreciation expense. Final Two Years of New Service   Profits on the Books Net Cash Flow Annual Receipts $110,500 $110,500 (Less) Expense (except Depreciation) 99,603 99,603 Gross Profit 10,897 10,897 (Less) Depreciation 0   Additional Income (Less) Before Taxes 10,897   (Less) Additional income Taxes (30%) 3,269 3,269 Additional Income after Taxes $ 7,628   Additional Net Cash Flow $ 7,628   This illustrates the "tax shelter" effect of depreciation. Sometimes depreciation is known as a "tax shield." If you contrast the first three years with the final two years, you can see why. The cash flows before depreciation and taxes are the same all five years. However, for each of the first three years during which depreciation is paid, additional income tax liability is reduced to $869 per year due to the deduction taken for depreciation; but during the final two years, Roho will have no depreciation with which to reduce his tax liability and will thus incur a tax bill of $3,269 each year. Roho has to decide what the required rate of return would be for the delivery service. He is one of the bank's best and oldest customers. Roho has a great relationship with the loan officers and is widely respected in the community. Roho can get loans with a minimum size of $20,000 for 9 percent. That is great, but Roho's business is small and a $20,000 investment represents a large gamble relative to what he is currently making on his operations. Roho decides that to compensate himself for the large risk involved in this venture, he will require a 20 percent return. Now that Roho has calculated the net cash flows, and determined a 20 percent required return, the net cash flows can be adjusted and summed.   Year 1 Year 2 Year 3 Year 4 Year 5 Net Cash Flows $10,028 $10,028 $10,028 7,628 7,628 Adjustment (at 20%) 0.8333 0.6944 0.5787 0.4823 0.4019 Adjusted Net Cash Flows (at 20%) $ 8,356 6,963 5,803 3,679 3,066 Total Adjusted Net Cash Flow (at 20%) $8,356 + 6,963 + 5,803 + 3,679 + 3,066 = $27,867   Initial Costs Initial costs would be significant even though the coolers and kitchen could handle a higher volume of business, and the restaurant already has a rotary phone system. Two new delivery trucks would represent most of the initial costs for the new service, $24,000. The catering part of the business has five trucks that it has used primarily on weekends and at night. Roho intends to keep all those older, low-use trucks. All the catering trucks are old and wouldn't hold up to the hard running conditions and frequent stops that would be necessary for a lunch delivery service. Realistically, the catering trucks can be relied on only for the equivalent of one delivery per day. Other than the two new trucks, introductory advertising and charges for extra telephone lines would be the only initial costs. Total initial costs would probably look like this: Phone Service/Installation Charges $ 200 Advertising