Group Assignment: Facts Your company's heating, ventilating, and A/C (HVAC) systems still work but are out-of-date A new system will cost $150,000, will last 20 years, and will be more energy-efficient It will save $22,500 in cash expenses each year It will provide tax-deductible depreciation expense each year (numbers for each year are provided) Your expected tax rate is 25% % Your hurdle rate for this project is 10% Projected After-Tax Cash Flows Present Value 2 Year o Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 19 Year 20 Year 21 3 Initial Investment $(150,000) S(150,000) 5 Annual cash expenses savings Less income tax @ 25% $22,500 $22,500 $22,500 $22,500 $22,500 $22,500 $22,500 $22,500 $22,500 5,625 5,625 5,625 5,625 5,625 5,625 5.625 5,625 5,625 $22,500 $22,500 5.625 5.625 6 7 After-tax expenses savings $ 143,666 $16,875 $16,875 $16,875 $16,875 $16,875 $16,875 $16,875 $16,875 $16.875 $16,875 $16.875 $ 8 Tax savings from depreciation tax shield: S. 1,278 10 Year 1 $ 1.406 11 Year 2 2,237 $ 2,707 12 Year 3 $ 2.504 1,881 1,583 13 Year 4 $ 2,317 14 Year 5 1,331 1.119 941 791 $ 2,143 $ 1,982 $ 1.833 $ 1,696 15 Year 6 16 Year 7 17 Year 8 18 Year 9 19 Year 10 20 Year 11 21 Year 12 710 $ 1.673 645 586 533 22 Year 13 485 23 Year 14 440 24 Yenr 15 400 25 Year 16 364 331 301 274 26 Year 17 27 Year 18 28 Year 19 29 Year 20 30 Year 21 31 Total PV of future cash flows $ 1,673 249 $ 1.673 113 $ 837 $ 160,258 $18,281 $19,582 $19,379 $19,192 $19,018 $18,857 $18,708 $18,571 $18,548 $18,548 $18,548 $ 837 32 Net present value S 10.25B Payback Method Analysis Annual After-Tax Cash Inflows Amount Required to Reach $150,000 Year 1.... 2... 3.. 4... 5... 6... 7.... 8... 9... $18,281 19,582 19,379 19,192 19,018 18,857 18,708 18,571 18,548 Cumulative Cash Payback $ 18,281 37,863 57,242 76,434 95,452 114,309 133,017 151,588 170,136 $131,719 112,137 92,758 73,566 54,548 35,691 16,983 Exhibit 12-10 Internal Rate of Return (IRR) Example A B D After-Tax Expense Savings Year Tax-Savings from Depr. Tax Shield Sum of Net After-Tax Cash Flows 2 0 3 1 2 5 3 $1,406 2,707 2,504 2,317 2,143 $16,875 16,875 16,875 16,875 16,875 16,875 16,875 16,875 16,875 16,875 5 $(150,000) 18,281 19,582 19,379 19,192 19,018 18,857 18,708 18,571 18,548 3 6 1,982 7 10 8 1,833 1,696 119 1,673 12 10 1,673 18,548 13 11 16,875 1,673 18,548 14 12 16,875 1,673 18,548 15 13 16,875 1,673 18,548 16 14 1,673 16,875 16,875 18,548 17 15 18 16 1,673 18,548 1,673 16,875 16,875 18,548 19 17 1,673 20 18,548 18 16,875 1,673 18,548 21 19 1,673 22 20 16,875 16,875 18,548 1,673 23 21 18,548 837 24 837 25 IAR 11.00% Group Assignment: Discussion questions The NPV analysis shows the expected return exceeds the hurdle rate. Are there important assumptions that make this analysis tenuous? If so, what specific assumptions? What factors go into determining the project's hurdle rate? Do you think this project's hurdle rate should be higher or lower than the company's cost of capital? Why? The Payback method analysis says it will take 8 years to recover the initial investment. Is there a flaw in this analysis? . Would you invest in something that took 8 years to pay back? Another investment, to develop a new product, also has an expected IRR of 11%. Which project would you choose? Why? . Would you choose to invest in this new HVAC system? Why or why not? Group Assignment: Facts Your company's heating, ventilating, and A/C (HVAC) systems still work but are out-of-date A new system will cost $150,000, will last 20 years, and will be more energy-efficient It will save $22,500 in cash expenses each year It will provide tax-deductible depreciation expense each year (numbers for each year are provided) Your expected tax rate is 25% % Your hurdle rate for this project is 10% Projected After-Tax Cash Flows Present Value 2 Year o Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 19 Year 20 Year 21 3 Initial Investment $(150,000) S(150,000) 5 Annual cash expenses savings Less income tax @ 25% $22,500 $22,500 $22,500 $22,500 $22,500 $22,500 $22,500 $22,500 $22,500 5,625 5,625 5,625 5,625 5,625 5,625 5.625 5,625 5,625 $22,500 $22,500 5.625 5.625 6 7 After-tax expenses savings $ 143,666 $16,875 $16,875 $16,875 $16,875 $16,875 $16,875 $16,875 $16,875 $16.875 $16,875 $16.875 $ 8 Tax savings from depreciation tax shield: S. 1,278 10 Year 1 $ 1.406 11 Year 2 2,237 $ 2,707 12 Year 3 $ 2.504 1,881 1,583 13 Year 4 $ 2,317 14 Year 5 1,331 1.119 941 791 $ 2,143 $ 1,982 $ 1.833 $ 1,696 15 Year 6 16 Year 7 17 Year 8 18 Year 9 19 Year 10 20 Year 11 21 Year 12 710 $ 1.673 645 586 533 22 Year 13 485 23 Year 14 440 24 Yenr 15 400 25 Year 16 364 331 301 274 26 Year 17 27 Year 18 28 Year 19 29 Year 20 30 Year 21 31 Total PV of future cash flows $ 1,673 249 $ 1.673 113 $ 837 $ 160,258 $18,281 $19,582 $19,379 $19,192 $19,018 $18,857 $18,708 $18,571 $18,548 $18,548 $18,548 $ 837 32 Net present value S 10.25B Payback Method Analysis Annual After-Tax Cash Inflows Amount Required to Reach $150,000 Year 1.... 2... 3.. 4... 5... 6... 7.... 8... 9... $18,281 19,582 19,379 19,192 19,018 18,857 18,708 18,571 18,548 Cumulative Cash Payback $ 18,281 37,863 57,242 76,434 95,452 114,309 133,017 151,588 170,136 $131,719 112,137 92,758 73,566 54,548 35,691 16,983 Exhibit 12-10 Internal Rate of Return (IRR) Example A B D After-Tax Expense Savings Year Tax-Savings from Depr. Tax Shield Sum of Net After-Tax Cash Flows 2 0 3 1 2 5 3 $1,406 2,707 2,504 2,317 2,143 $16,875 16,875 16,875 16,875 16,875 16,875 16,875 16,875 16,875 16,875 5 $(150,000) 18,281 19,582 19,379 19,192 19,018 18,857 18,708 18,571 18,548 3 6 1,982 7 10 8 1,833 1,696 119 1,673 12 10 1,673 18,548 13 11 16,875 1,673 18,548 14 12 16,875 1,673 18,548 15 13 16,875 1,673 18,548 16 14 1,673 16,875 16,875 18,548 17 15 18 16 1,673 18,548 1,673 16,875 16,875 18,548 19 17 1,673 20 18,548 18 16,875 1,673 18,548 21 19 1,673 22 20 16,875 16,875 18,548 1,673 23 21 18,548 837 24 837 25 IAR 11.00% Group Assignment: Discussion questions The NPV analysis shows the expected return exceeds the hurdle rate. Are there important assumptions that make this analysis tenuous? If so, what specific assumptions? What factors go into determining the project's hurdle rate? Do you think this project's hurdle rate should be higher or lower than the company's cost of capital? Why? The Payback method analysis says it will take 8 years to recover the initial investment. Is there a flaw in this analysis? . Would you invest in something that took 8 years to pay back? Another investment, to develop a new product, also has an expected IRR of 11%. Which project would you choose? Why? . Would you choose to invest in this new HVAC system? Why or why not