Welcome to Finance in Excel, video number 87.
If you want to download this workbook for Chapter 9,
click on the link directly below the video.
And scroll all the way down to the Finance Excel class
section.
Hey, in this video, we're going to look at a cost savings
example.
So far, we've been in this chapter, Chapter 9.
We're estimating cash flows for our net present value
calculation.
But all of the examples have been a sales example,
like we have a new product.
But here, what about when we get some equipment?
We buy some equipment or we're thinking about buying
equipment that costs 520,000.
And it's going to save us money because it's
much more efficient than some other process
we're currently using.
So this is a cost-saving example, as opposed
to a sale example.
Both have net marginal benefits.
All right, so here's the assumptions.
We have 520,000.
We're going to depreciate it over five years.
Even though we've done makers in the last couple examples, which
is the more relevant, we're going
to keep it simple in this one--
straight line down to zero.
That would make our depreciation cost
minus salvage divided by number of years, so down to zero.
So that's our annual depreciation.
We'll need that over here for our operating cash flows.
Sell price at the end of the life will be 40,000.
We'll have to do a calculation, take into consideration
the tax implications of that.
Since we're a straight line down to zero,
the book value will be zero.
So we'll have to look at the tax implication of that.
Again, makers is the more relevant one.
But we're keeping it simple.
Pre-taxed cost savings-- this is like a cash
in, because it's a savings, right?
We always look at the marginal differences,
the incremental cash flow.
And we're comparing cash flows with this project for the firm
and without.
Without this project, we would be spending 160,000
on normal operations, the normal costs.
When we get the new machine, these are the savings.
So this is the incremental cash flow we'll analyze.
Net working capital-- oh, but wait a second.
It says reduce net working capital.
Yeah, with a more efficient system,
we've estimated that this will actually
reduce our net working capital requirements.
So it's actually in time zero, going
to be included not as a negative but as a positive.
Our tax rate is 0.35.
And we have a required rate of return of 12 and 1/2 percent.
Those are our assumptions.
Let's go ahead and calculate our operating cash flow for periods
1 through 5.
Now, we're to use the taxed shield method here,
for calculating operating cash flows.
We saw a couple videos ago, we were doing the full pro forma
income statements.
But in the couple videos I showed you briefly,
this is an option.
And it gives you the exact same calculation
if we did the pro forma income statement.
So tax shield-- we're simply going
to take all of our revenues and expenses-- oh, but for us
we just have savings, which are like an incoming cash
flow to us.
So there we have it.
Now, we have to multiply that times 1 minus our tax rate.
So every $1 of benefit, we're going
to have to subtract out our taxes, which
is $0.35 on the dollar.
Now think about this.
What happened?
Before we had the project, we had
$160,000 worth of expenses we were putting on our tax return,
right?
And anytime you have an expense or a deduction on your tax
return, it saves you paying taxes.
But here, we're saving this.
So now this deduction will not be on our tax return any more.
So of course, it's like we're having to pay taxes on it.
And in fact, we will, because that deduction won't be there.
Now, that is the 1 minus the tax.
But we have to consider for cash flow depreciation.
And the tax shield method explicitly
says, hey, I'm going to take my depreciation.
And since I know that's a non-cash expense that has a tax
benefit, the taxes I'm going to save
are those right there-- whatever that is times that.
And that's the tax shield method of getting at operating cash
flows, which is particularly good for cost savings examples.
Now, I need to lock this.
So I'm going to hit the F4 and lock this.
I'm going to hit the F4, and also this one also,
and it looks like this one also.
I forgot all of them.
All of these, as we copy this down, need to be locked.
Control-Enter and double click, and send it down.
Now, net working capital--
it is going to be positive.
We're reducing our net working capital.
So at the beginning of this project,
in fact, it will be a positive cash flow.
At the end, since the project is going to close down,
we'll have to take it as a minus here.
Remember, this is reducing net working capital.
But when the project ends, it has to go back up to normal.
At least we're going to assume that.
So that's a subtraction at the end, positive at time zero.
That's the opposite of the way we were doing it
when we had sales examples.
Capital spending-- going to be a negative.
And then the selling price--
OK, so at the end, we're going to have
the selling price of 40,000.
We compare it to the book value of zero.
So we have to take it in consideration cash,
OK, so that's the cash coming into us when we sell it.
But we're paying taxes.
So we're going to do our same times--
1 minus our tax rate.
That gives us the effective cash flow in.
All the cash in, some of the taxes out--
26,000.
Now we can add all of our cash flows.
Copy it down.
And now we can do our net present value
calculation, our required rate of return, our values--
time 1 to whatever the last time is.
And then subtract out our cost, which is listed as a negative
there, or whatever the time 0 cash flow is.
So there it is.
We have a net present value positive.
That means we should probably look at our estimations
and make sure that they're reasonable, and then it's a go.
"I'm going to do my IRR also.
Cash flows times zero, and we can see-- oh, Yeah.
Look, our IRR, has to be.
If this is positive, it to be bigger than our required
rate of return.
All right that is a cost saving example.
In our next video, we'll look at scenario analysis
to help us spread out the numbers
for our net present value see next video.