DCF analysis Problem and solution 2

Question

A company has decided that one of its production facilities has reached the end
of its economically productive life, and it must therefore be upgraded or replaced.
Plan A, re-fitting and upgrading the existing facilities has been evaluated and the
results are:
NPV: € 1.2m
Payback: 1.8 years
Plan B, replacement of the production facilities has been estimated over the next
five years as follows:
€
Cost of dismantling/removal of existing plant 800,000
Scrap value of machinery (once out of the plant) 150,000
Cost of new plant 2,500,000
Installation time for new plant (i.e before production
can recommence) 1 year
Revenue per annum after restart 2,000,000
The new process will save on labour costs. It will, however, incur some
redundancy costs for those agreeing to leave when the refit begins.
€
Redundancy costs 300,000
Annual labour savings (from when the plant re-starts) 100,000
The allocated overhead charge for the facility under ‘Plan B’ would be € 150,000
a year or € 100,000 under ‘Plan A’. The actual indirect costs incurred by the
company will in fact be the same whichever Plan is chosen.
For ‘Plan B’ the estimated required return on capital is 8%; you may ignore tax
and inflation.

(a) Describe briefly the rules or criteria you would use to decide whether an item
should be included in a discounted cash flow analysis.
(4 marks)
(b) Giving your reasons, state whether the company should undertake Plan A or
Plan B
(12 Marks)
(c) In part (a) you were allowed, as a simplification, to “ignore tax”. Explain
briefly why, if you were to include taxation in your analysis of Plan B, you
would need to know something about the profitability of the whole company
(i.e. as well as of that of the project itself).
(3 Marks)
(d) A senior manager (but not finance expert) comments one day that:
“Discounted cash flow is all very well for assessing individual projects but to
value an entire company you have to use something like Book Value.”
Describe one point that would support the statement and one point that
would argue against the idea. State with one main reason whether you
agree or disagree with the manager’s view. There is not a ‘right’ or ‘wrong’
answer here – it is the link between your choice and your given reason
that is important.
(6 marks)

a)Sunk costs, opportunity costs, cash flows (Inflation and cost of capital), total time value of money(payment now or later? €100 value is only €80 in real terms), Assessment Horizon

Item	Project Plan B costs €000
Removal	-800
New plant	-2500
Scrap value (Assumed after 1 year)	150
Revenue per annum after delay of one year.	2000
Redundancy costs	-300
Annul labour saving after first year.	100
Overhead (Presumed throughout project)	-150

All the above costs are included as part of project B because they are within the time frame of the project and directly effect the cash flows.

b)

Plan A – NPV €1,2 million payback 1,8 years.

Plan B -

€000	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Fixed Cost Removal and Resale	-800	150	0	0	0	0
New plant	-2500	0	0	0	0	0
Labour	-300	0	100	100	100	100
Variable cost wrong	0	0	0	0	0	0
Revenue	0	0	2000	2000	2000	2000
Net Cash flow	-3100	150	2100	2100	2100	2100
Discount rate	1.000	0.926	0.857	0.794	0.735	0.681
PV	-3100	138.9	1799.7	1667.4	1543.5	1430.1
Cumulative cash flow	-3100	-2961.1	-1161.4	506	2049.5	3479.6
NPV	3479.6

So Plan B has NPV of €3479600 making a payback in 2 years and (12* 134.25/1548.3= 1month) . Plan B take 5 months longer but has a payback of 70% more. The extra 5 months cash flow will have to be considered by the firm though. Liquidity vs Cash.

c)

As in a) in relevant values the tax savings would have to be related to the project profit. The time value of money would also be effected as the tax will only be paid a year after. So one would need to know how much and what the tax shield applies to or if it is related to general profits this would involve further allocation of project costs.

d)

For book value

Book value is the current fiscal value of a business at a certain point in time. (accounting view during time)

Can show the current levels of activities and possible corrections to activities that are needed

Shows a short term presentation of business health.

Against book value

Doesn't include items such as real value or intangibles.

Some values are speculative such as Fixed(current value of fixed asset) or current assets(Could sometimes be seen as a fixed asset).

Time value of money is not included (Unlike DCF)