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Lecture 11

# AFM123 Lecture Notes - Lecture 11: Working Capital, Net Present Value, Fixed Cost

Department
Accounting & Financial Management
Course Code
AFM123
Professor
Peter Blake
Lecture
11

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Monday March 23rd 2015
Capital Budgeting
-time value of money means must analyze based on PV of cash flows (present value)
use tables to get factors to arrive at PV (cash flow x factor = PV)
-restate all cash flows to today
different tables - for Present Value of \$1 and for Present Value of an Annuity of \$1
(something they use in their manufacturing process)
Cost of the machine \$200,000
Machine will generate additional margins \$35,000 / year (of the next 8 years)
(sales - variable costs)
Machine will last 8 years but will need a major overhaul after 5 years.
Cost of the overhaul \$12,000
Scrap (after 8 years) \$15,000
Should the company buy the machine if the cost of capital is:
a) 12%
b) 5%
-for margins (12% at 8th period) - use annuity
-for overhaul - it’s not an annuity - so use the other table
Cash flows
When
Cash Effect
12% Factor
PV
PV 5%
Purcahse
Now
(200,000)
1.0
(200,000)
(200,000)
Margins
1-8
35,000
4.968
173,880
226,205
Overhaul
5
(12,000)
0.567
(6,804)
(9,408)
Scrap
8
15,000
0.404
6,060
10,155
Total
(162,000)
(26,864)
26,952

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Example 2: A 55 year old woman is deciding whether or not to open a business. She
wants to earn 12% on any investment. The business is sell a product & sell a service.
Sales and cost data are as follows:
1. Equipment cost \$200,000 required immediately and sold in 10 years for 5% cost
2. Working capital required \$15,000 immediately and will be recovered in 10 years
3. Business rental space 10 year lease for \$1,200 / month
4. Product selling price is \$12.50 and the service selling price is \$4.00
5. Variable costs: Product \$4.25 and Service \$0.75
sell it for \$12.50
6. Product sales are estimated at \$7,500 / month and 30% of the customers will use it
7. Monthly fixed costs above rent is \$900
convert everything into annual / monthly terms
Annual Cash Flows
Sales - product (7,500 x 12) 90,000
- service (7,500 / 12.50 = 600) 8,640
(600 customers x 30% x \$4 x 12 months)
Total 98,640
Variable Costs - product (600 x 4.25 x 12) 30,620
- service (600 x 30% x 0.75 x 12) 1,620
Contribution Margin 66,400
Fixed Costs - rent (1,200 x 12) 14,400
- other (900 x 12) 10,800
Cash in every year 41,220
now you calculate the net profit value (NPV)
Therefore, go ahead with the business bc you’re earning more than 12%.
Item
Value
When
Factor
PV
Equipment
200,000
today
1.0
(200,000)
Working
Capital
15,000
today
1.0
(15,000)
Annual Cash
Flows
41,220
1-10
use annuity table
5.650
232,893
Sell
Equipment
10,000
5% of 200,000
10
single payment so
NOT the annuity
table
0.322
3,860
W/C Recovery
15,000
10
0.322
4,830
Total
25,943