Chapter 5 Net Present Value and Other Investment Criteria Value Year 4 2 3 140 140 55 140 55 140 55 your 's not clear which project is bele The high temperature procesas appears to be lewell cicnt. It has higher operating costs and generates less total revenue over the life of the project, but of course it generates more cash flow in years 1 to 5. CFO: Maybe the processes are equally good from a financial point of view. If so we'll stick with the low-temperature process rather than switching at the last minute. You We'll have to lay out the cash flows and calculate NPV for each process CFO: OK, do that. I'll be back in a half hour--and I also want to see each project's true, DCF rate 1. Revenue 2. Owing costs 140 5 SI 55 140 55 57 28 55 22 20 30 20 28 20 28 171 16.4% 40 ST 48.15 of return 24.8% 6. Book of return QUESTIONS 1. Are the book rates of return reported in Tables 5.1 and 52 useful inputs for the capital invest TABLE 5.1 Income statement and book rates of return for low-temperature extraction et hydrated zirconium ( thousands). 2. Calculate NPV and IRR for each process. What is your recommendatice Be ready to explain to the CFO Year 3 2 180 70 180 70 180 70 1. Revenue 2. Operating costs 1. 70 180 70 M 30 160 18.789 30 50 Sood 6. Book of return 30 240 12. 7. 9.45 38 ) TABLE 5.2 income statement and book rates of return for high temperature extraction of hydrated mirconium (thousands). down, because depreciation is higher Income for year 7 goes up because the depreciation for that year becomes rero. But there is no effect on year-to-year cash flows, because depreciation is not a cash outlay. It is simply the accountants device for spreading out the recovery of the up-front capital outlay over the life of the project CFO: So how do we get cash flows? You: la these cases it's easy. Depreciation is the only noncash entry in your spreadsheets (Tables 51 and 52), so we can just leave it out of the calculation. Cash flow cquals revenue minus operating costs. For the high-temperature process, annual cash flow is Cash flow revenue - operating cost = 180 - 70 - 110, or S110,000 CFO: In effect you're adding back depreciation, because depreciation is a noncush accounting expense You: Right. You could also do it that way Cash flow = net income + depreciation - 30+80 = 110, or $110.000 CFO: Of course. I remember all this now, but book returns sem important when someone shove them in front of your nos no 180 Year 2 3 4 5 6 7 140 140 140 140 140 55 140 55 57 140 55 55 55 55 57 57 57 57 57 57 1. Revenue 2. Operating costs 3. Depreciation 4. Net income 5. Start-of-year book value 6. Book rate of return ( 45) 28 28 400 7% 28 343 8.2% 28 286 9.8% 28 229 12.2% 28 171 16.4% 28 114 24.6% 57 49.1% > TABLE 5.1 Income statement and book rates of return for low-temperature extraction of hydrated zirconium (s thousands). Rounded. Straight-line depreciation over seven years is 400/7 = 57.14, or $57,140 per year. Capital investment is $400,000 in year 0. Year 1 2 3 5 180 70 180 70 80 180 70 180 70 70 80 80 80 1. Revenue 2. Operating costs 3. Depreciation 4. Net income 5. Start-of-year book value 6. Book rate of return ( 45) 80 30 400 7.5% 30 320 9.4% 30 240 12.5% 30 160 18.75% 30 80 37.5% > TABLE 5.2 Income statement and book rates of return for high-temperature extraction of hydrated zirconium (s thousands). * Straight-line depreciation over five years is 400/5 = 80, or $80,000 per year. Capital investment is $400,000 in year 0