Evaluating Cost Cutting Proposals

One decision we frequently face is whether or not to upgrade existing facilities to make them more cost-effective. The issue is whether or not the cost savings are large enough to justify the necessary capital expenditure.

For example, suppose we are considering automating some part of an existing production process. The necessary equipment costs $80,000 to buy and install. The automation will save $22,000 per year (before taxes) by reducing labor and material costs. For simplicity, assume that the equipment has a five-year life and is depreciated to zero

334 PART FOUR Capital Budgeting on a straight-line basis over that period. It will actually be worth $20,000 in five years. Should we automate? The tax rate is 34 percent, and the discount rate is 10 percent.

As always, the first step in making such a decision is to identify the relevant incremental cash flows. First, determining the relevant capital spending is easy enough. The initial cost is $80,000. The aftertax salvage value is $20,000 X (1 - .34) = $13,200 because the book value will be zero in five years. Second, there are no working capital consequences here, so we don't need to worry about changes in net working capital.

Operating cash flows are the third component to consider. Buying the new equipment affects our operating cash flows in two ways. First, we save $22,000 before taxes every year. In other words, the firm's operating income increases by $22,000, so this is the relevant incremental project operating income.

Second, and it's easy to overlook this, we have an additional depreciation deduction. In this case, the depreciation is $80,000/5 = $16,000 per year.

Because the project has an operating income of $22,000 (the annual pretax cost saving) and a depreciation deduction of $16,000, taking the project will increase the firm's EBIT by $22,000 - 16,000 = $6,000, so this is the project's EBIT.

Finally, because EBIT is rising for the firm, taxes will increase. This increase in taxes will be $6,000 X .34 = $2,040. With this information, we can compute operating cash flow in the usual way:

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