CLA 1 Paper - Financial Management

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Ross_12e_PPT_Ch10.pptx

MAKING CAPITAL INVESTMENT DECISIONS

CHAPTER 10

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9.1

Determine the relevant cash flows for a proposed project

Evaluate whether a project is acceptable

Explain how to set a bid price for a project

Evaluate the equivalent annual cost of a project

Key Concepts and Skills

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9.2

Project Cash Flows: A First Look

Incremental Cash Flows

Pro Forma Financial Statements and Project Cash Flows

More about Project Cash Flow

Alternative Definitions of Operating Cash Flow

Some Special Cases of Discounted Cash Flow Analysis

Chapter Outline

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The cash flows that should be included in a capital budgeting analysis are those that will only occur (or not occur) if the project is accepted.

These cash flows are called incremental cash flows.

The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows.

Relevant Cash Flows

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9.4

Section 10.1 (A)

Lecture Tip: It should be strongly emphasized that a project’s cash flows imply changes in future firm cash flows and, therefore, in the firm’s future financial statements.

You should always ask yourself “Will this cash flow occur ONLY if we accept the project?”

If the answer is “yes,” it should be included in the analysis because it is incremental.

If the answer is “no,” it should not be included in the analysis because it will occur anyway.

If the answer is “part of it,” then we should include the part that occurs because of the project.

Asking the Right Question

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9.5

Section 10.1 (B)

Lecture Tip: You might find it useful to clearly delineate the link between the stand-alone principle and the concept of value additivity. By viewing projects as “mini-firms,” we imply that the firm as a whole constitutes a portfolio of mini-firms. As a result, the value of the firm equals the combined value of its components. This is the essence of value additivity, and it is assumed to hold generally whether we are discussing the cash flows in a simple time-value problem, the value of a project, or the value of the firm. Note also that an understanding of this concept paves the way for the analysis of mergers and acquisitions. For a merger to “create value,” the value additivity principle must be violated. (Violations take the form of production efficiencies, economies of scale, etc.) Perhaps a key value of this approach is that it places the burden of proof on those proposing the merger, just as the capital budgeting process places the burden of proof on those proposing investment in the project.

Sunk costs – costs that have accrued in the past

Opportunity costs – costs of lost options

Side effects

Positive side effects – benefits to other projects

Negative side effects – costs to other projects

Changes in net working capital

Financing costs

Taxes

Common Types of Cash Flows

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9.6

Section 10.2

With each of these types of cash flows, you should ask the class the question on the previous slide so that they can start to determine if the cash flows are relevant.

Personal examples of sunk costs often help students understand the issue. Ask the students to consider a hypothetical situation in which a college student purchased a computer for $1,500 while in high school. A better computer is now available that also costs $1,500. The relevant factors to the decision are what benefits would be provided by the better computer to justify the purchase price. The cost of the original computer is irrelevant.

Opportunity costs – the classic example of an opportunity cost is the use of land or plant that is already owned. It is important to point out that this is not “free.” At the very least we could sell the land; consequently, if we choose to use it, we cost ourselves the selling price of the asset.

A good example of a positive side effect is when you will establish a new distribution system with this project that can be used for existing or future projects. The benefit provided to those projects needs to be considered. The most common negative side effect is erosion or cannibalism, where the introduction of a new product will reduce the sales of existing, similar products. A good real-world example is McDonald’s introduction of the Arch Deluxe sandwich. Instead of generating all new sales, it primarily reduced sales in the Big Mac and the Quarter Pounder.

It is important to consider changes in NWC. We need to remember that operating cash flow derived from the income statement assumes all sales are cash sales and that the COGS was actually paid in cash during that period. By looking at changes in NWC specifically, we can adjust for the difference in cash flow that results from accounting conventions. Most projects will require an increase in NWC initially as we build inventory and receivables. Then, we recover NWC at the end of the project.

We do not include financing costs. Students often have difficulty understanding why when it appears that we will only raise capital if we take the project. It is important to point out that because of economies of scale, companies generally do not finance individual projects. Instead, they finance the entire portfolio of projects at one time. The other reason has to do with maintaining a target capital structure over time, but not necessarily each year. Finally, financing cost is included in the required return, thus including the financing-related cash flows would be double counting.

Taxes will change as the firm’s taxable income changes. Consequently, we have to consider cash flows on an after-tax basis. The lower tax rate just approved by the Tax Cuts and Jobs Act of 2017, all else equal, will increase after-tax incremental cash flows from a project and potentially lead to an increase in overall investment spending

Capital budgeting relies heavily on pro forma accounting statements, particularly income statements.

Computing cash flows – refresher

Operating Cash Flow (OCF) =

EBIT + depreciation – taxes

OCF = Net income + depreciation

(when there is no interest expense)

Cash Flow From Assets (CFFA) =

OCF – net capital spending (NCS) – changes in NWC

Pro Forma Statements and Cash Flow

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9.7

Section 10.3

Operating cash flow – students often have to go back to the income statement to see that the two definitions of operating cash flow are equivalent when there is no interest expense.

Lecture Tip: Students sometimes become disheartened at what they perceive as complexities in the various capital budgeting calculations. You may find it useful to remind them that, in reality, setting up timelines and performing calculations are typically the least burdensome portion of the task. Rather, the difficulties arise principally in two areas: (1) generating good investment projects and (2) developing reliable cash flow estimates for these projects.

Lecture Tip: Some students may still question why we are ignoring interest, since it is clearly a cash outflow. It should be strongly emphasized that we do not ignore interest expense (or any other financing expense, for that matter); rather, we are only evaluating asset related cash flows. It should be stressed that interest expense is a financing cost, not an operating cost.

Sales (50,000 units at $4.00/unit) $200,000
Variable Costs ($2.50/unit) 125,000
Gross profit $ 75,000
Fixed costs 17,430
Depreciation ($90,000 / 3) 30,000
EBIT $ 27,570
Taxes (21%) 5,790
Net Income $ 21,780

Table 10.1 Pro Forma Income Statement

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Section 10.3 (A)

9.8

Year
0 1 2 3
NWC $20,000 $20,000 $20,000 $20,000
NFA 90,000 60,000 30,000 0
Total $110,000 $80,000 $50,000 $20,000

Table 10.2 Projected Capital Requirements

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9.9

Section 10.3 (A)

Ask the students why net fixed assets is decreasing each year. It is important that they understand why this is happening when they go to compute the net capital spending in the next slide.

Year
0 1 2 3
OCF $51,780 $51,780 $51,780
Change in NWC -$20,000 20,000
NCS -$90,000
CFFA -$110,00 $51,780 $51,780 $71,780

Table 10.5 Projected Total Cash Flows

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9.10

Section 10.3 (B)

OCF = EBIT + depreciation – taxes = 27,570 + 30,000 – 5,790 = 51,780; or

OCF = NI + depreciation = 21,780 + 30,000 = 51,780

Note that in the Table in the book, the negative signs have already been carried throughout the table so that the columns can just be added. Ultimately, students seem to do better with this format even though the CFFA equation says to subtract the changes in NWC and net capital spending.

Change in NWC: We have a net investment in NWC in year 0 of 20,000; we get the investment back at the end of the project when we sell our inventory, collect on our receivables and pay off our payables. Students often forget that we get the investment back at the end.

Capital Spending: Remember that Net capital spending = change in net fixed assets + depreciation. So in year one NCS = (60,000 – 90,000) + 30,000 = 0; The same is true for the other years.

Lecture Tip: Capital spending at the time of project inception (i.e., the “initial outlay”) includes the following items: + purchase price of the new asset

- selling price of the asset replaced (if applicable)

+ costs of site preparation, setup, and startup

+/- increase (decrease) in tax liability due to sale of old asset at other than book value

= net capital spending

Now that we have the cash flows, we can apply the techniques that we learned in Chapter 9.

Enter the cash flows into the calculator and compute NPV and IRR.

CF0 = -110,000; C01 = 51,780; F01 = 2; C02 = 71,780; F02 = 1

NPV; I = 20; CPT NPV = 10,648

CPT IRR = 25.8%

Should we accept or reject the project?

Making The Decision

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9.11

Section 10.3 (C)

You can also use the formulas to compute NPV and IRR; just remember that the IRR computation is trial and error.

Click on the excel icon to go to an embedded spreadsheet that illustrates how the pro formas and cash flows can be set-up. It also computes the NPV and IRR.

Why do we have to consider changes in NWC separately?

GAAP requires that sales be recorded on the income statement when made, not when cash is received.

GAAP also requires that we record cost of goods sold when the corresponding sales are made, whether we have actually paid our suppliers yet.

Finally, we have to buy inventory to support sales, although we haven’t collected cash yet.

More on NWC

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9.12

Section 10.4 (A)

The first two items mean that our operating cash flow does not include the impact of accounts receivable and accounts payable on cash flow. The third item is very much like the purchase of fixed assets. We have to buy the assets (have the cash outflow) before we can generate sales.

By looking at changes in NWC, we can incorporate the increased investment in receivables and inventory that are necessary to support additional sales. Because we look at changes in NWC, and not just current assets, we also incorporate the increase in our payable accounts that partially pays for the investment in inventory and receivables.

The NWC discussion is very important and should not be overlooked by students. It may be helpful to reemphasize the point of NWC and operating cash flow through accounting entries.

The depreciation expense used for capital budgeting should be the depreciation schedule required by the IRS for tax purposes.

Depreciation itself is a non-cash expense; consequently, it is only relevant because it affects taxes.

Depreciation tax shield = D × T

D = depreciation expense

T = marginal tax rate

Depreciation

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Section 10.4 (B)

Lecture Tip: With the lower tax rate of 21%, the benefit of the tax-deductibility of depreciation will be reduced.

9.13

Straight-line depreciation

D = (Initial cost – salvage) / number of years

Very few assets are depreciated straight-line for tax purposes.

MACRS

Need to know which asset class is appropriate for tax purposes

Multiply percentage given in table by the initial cost.

Depreciate to zero

Mid-year convention

Computing Depreciation

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9.14

Section 10.4 (B)

The MACRS percentages are given in Table 10.7.

Lecture Tip: Ask the students why a company might prefer accelerated depreciation for tax purposes to the simpler straight-line depreciation.

If the salvage value is different from the book value of the asset, then there is a tax effect.

Book value = initial cost – accumulated depreciation

After-tax salvage = salvage – T × (salvage – book value)

After-tax Salvage

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Section 10.4 (B)

9.15

You purchase equipment for $100,000, and it costs $10,000 to have it delivered and installed.

Based on past information, you believe that you can sell the equipment for $17,000 when you are done with it in 6 years.

The company’s marginal tax rate is 21%.

What is the depreciation expense each year and the after-tax salvage in year 6 for each of the following situations?

Example: Depreciation and After-tax Salvage

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Section 10.4 (B)

9.16

Suppose the appropriate depreciation schedule is straight-line.

D = (110,000 – 17,000) / 6 = 15,500 every year for 6 years

BV in year 6 = 110,000 – 6(15,500) = 17,000

After-tax salvage = 17,000 - .21(17,000 – 17,000) = 17,000

Example: Straight-line

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Section 10.4 (B)

9.17

Year MACRS percent D
1 .3333 .3333(110,000) = 36,663
2 .4445 .4445(110,000) = 48,895
3 .1481 .1481(110,000) = 16,291
4 .0741 .0741(110,000) = 8,151

Example: Three-year MACRS

BV in year 6 = 110,000 – 36,663 – 48,895 – 16,291 – 8,151 = 0

After-tax salvage = 17,000 - .21(17,000 – 0) = $13,430

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9.18

Section 10.4 (B)

Note that with MACRS you do not subtract the expected salvage from the initial cost.

Also note that the MACRS % is multiplied by the initial cost every year. For some reason, students want to multiply by the book value.

Year MACRS Percent D
1 .1429 .1429(110,000) = 15,719
2 .2449 .2449(110,000) = 26,939
3 .1749 .1749(110,000) = 19,239
4 .1249 .1249(110,000) = 13,739
5 .0893 .0893(110,000) = 9,823
6 .0892 .0892(110,000) = 9,812

Example: Seven-Year MACRS

BV in year 6 = 110,000 – 15,719 – 26,939 – 19,239 – 13,739 – 9,823 – 9,812 = 14,729

After-tax salvage = 17,000 – .21(17,000 – 14,729) = 16,523.09

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Section 10.4 (B)

9.19

Original Machine

Initial cost = 100,000

Annual depreciation = 9,000

Purchased 5 years ago

Book Value = 55,000

Salvage today = 65,000

Salvage in 5 years = 10,000

New Machine

Initial cost = 150,000

5-year life

Salvage in 5 years = 0

Cost savings = 50,000 per year

3-year MACRS depreciation

Required return = 10%

Tax rate = 21%

Example: Replacement Problem

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Section 10.4 (C)

(Note, this problem is an additional one to that included in this section in the textbook. Here we focus specifically on replacement.)

9.20

Remember that we are interested in incremental cash flows.

If we buy the new machine, then we will sell the old machine.

What are the cash flow consequences of selling the old machine today instead of in 5 years?

Replacement Problem – Computing Cash Flows

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Section 10.4 (C)

(Note, this problem is an additional one to that included in this section in the textbook. Here we focus specifically on replacement.)

9.21

Year 1 2 3 4 5
Cost Savings 50,000 50,000 50,000 50,000 50,000
Depr.
New 49,995 66,675 22,215 11,115 0
Old 9,000 9,000 9,000 9,000 9,000
Increm. 40,995 57,675 13,215 2,115 (9,000)
EBIT 9,005 (7,675) 36,785 47,885 59,000
Taxes 1,891 (1,612) 7,725 10,056 12,390
NI 7,114 (6,063) 29,060 37,829 46,610

Replacement Problem – Pro Forma Income Statements

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Section 10.4 (C)

(Note, this problem is an additional one to that included in this section in the textbook. Here we focus specifically on replacement.)

9.22

Year 0

Cost of new machine = 150,000 (outflow)

After-tax salvage on old machine =

65,000 - .21(65,000 – 55,000) = 62,900 (inflow)

Incremental net capital spending =

150,000 – 62,900 = 87,100 (outflow)

Year 5

After-tax salvage on old machine =

10,000 - .21(10,000 – 10,000) = 10,000 (outflow because we no longer receive this)

Replacement Problem – Incremental Net Capital Spending

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9.23

Section 10.4 (C)

(Note, this problem is an additional one to that included in this section in the textbook. Here we focus specifically on replacement.)

The year 5 cash flow is the most difficult for students to grasp. It is important to point out that we are looking for ALL changes in cash flow associated with selling the machine today instead of in 5 years. If we do not sell the machine today, then we will have after-tax salvage of 10,000 in 5 years. Since we do sell the machine today, we LOSE the 10,000 cash flow in 5 years.

Year 0 1 2 3 4 5
OCF 48,109 51,612 42,275 39,944 37,610
NCS -87,100 -10,000
 In NWC 0 0
CFFA -87,100 48,109 51,612 42,275 39,944 27,610

Replacement Problem – Cash Flow From Assets

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9.24

Section 10.4 (C)

(Note, this problem is an additional one to that included in this section in the textbook. Here we focus specifically on replacement.)

OCF = EBIT – T + Depr

For Yr 1: 9,005 – 1,891 + 40,995 = 48,109

The negative signs in the CFFA equation were once again carried through the table. That way outflows are in the table as negative and inflows are positive.

Now that we have the cash flows, we can compute the NPV and IRR.

Enter the cash flows.

Compute NPV = $75,478

Compute IRR = 43.31%

Should the company replace the equipment?

Replacement Problem – Analyzing the Cash Flows

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9.25

Section 10.4 (C)

(Note, this problem is an additional one to that included in this section in the textbook. Here we focus specifically on replacement.)

Replace the equipment: NPV>0 and IRR>required return.

Bottom-Up Approach

OCF = NI + depreciation

Works only when there is no interest expense

Top-Down Approach

OCF = Sales – Costs – Taxes

Do not subtract non-cash deductions.

Tax Shield Approach

OCF = (Sales – Costs)(1 – T) + Depreciation × T

Other Methods for Computing OCF

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Section 10.5

9.26

Your company is considering a new computer system that will initially cost $1 million.

It will save $300,000 per year in inventory and receivables management costs.

The system is expected to last for five years and will be depreciated using 3-year MACRS.

The system is expected to have a salvage value of $50,000 at the end of year 5.

There is no impact on net working capital. The marginal tax rate is 21%. The required return is 8%.

Click on the Excel icon to work through the example.

Example: Cost Cutting

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9.27

Section 10.6 (A)

There are two worksheets. The first allows you to enter the information and work the example during class. The second provides the solutions. You may go directly to this one if you do not wish to show the students how to set up the spreadsheet during class time. The example is an additional one to that provided in the textbook.

Burnout Batteries

Initial Cost = $36 each

3-year life

$100 per year to keep charged

Expected salvage = $5

Straight-line depreciation

Long-lasting Batteries

Initial Cost = $60 each

5-year life

$88 per year to keep charged

Expected salvage = $5

Straight-line depreciation

Example: Equivalent Annual Cost Analysis

The machine chosen will be replaced indefinitely and neither machine will have a differential impact on revenue. No change in NWC is required.

The required return is 15%, and the tax rate is 21%.

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Section 10.6 (C)

9.28

How do we determine if cash flows are relevant to the capital budgeting decision?

What are the different methods for computing operating cash flow and when are they important?

What is equivalent annual cost and when should it be used?

Quick Quiz

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In an L.A. Law episode, an automobile manufacturer knowingly built cars that had a significant safety flaw.

Rather than redesigning the cars (at substantial additional cost), the manufacturer calculated the expected costs of future lawsuits and determined that it would be cheaper to sell an unsafe car and defend itself against lawsuits than to redesign the car.

What issues does the financial analysis overlook?

Ethics Issues

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A $1,000,000 investment is depreciated using a seven-year MACRS class life.

It requires $150,000 in additional inventory and will increase accounts payable by $50,000.

It will generate $400,000 in revenue and $150,000 in cash expenses annually, and the tax rate is 21%.

What is the incremental cash flow in years 0, 1, 7, and 8?

Comprehensive Problem

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9.31

Annual depreciation expense:

Year 1: .1429 × $1million = $142,900

Year 7: .0893 × $1million = $89,300

Year 8: .0446 × $1million = $44,600

Time 0 cash flow = -$1million investment – ($150,000 - $50,000) = -$1,100,000

Time 1 cash flow = ($400,000 - $150,000) × (1 - .21) + (.21 × $89,300) = $227,509

Time 7 cash flow = ($400,000 - $150,000) × (1 - .21) + (.21 × $142,900) = $216,253

Time 8 cash flow = ($400,000 - $150,000) x (1 - .21) + (.21 × $44,600) + $100,000 NWC = $306,866

(assumes zero salvage value)

End of Chapter

CHAPTER 10

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Sheet1

Pro Forma Income Statements
Year 0 1 2 3
Sales 200000 200000 200000
Variable Costs 125000 125000 125000
Gross Profit 75000 75000 75000
Fixed Costs 17430 17430 17430
Depreciation 30000 30000 30000
EBIT 27570 27570 27570
Taxes 5789.7 5789.7 5789.7
Net Income 21780.3 21780.3 21780.3
Cash Flows
Operating Cash Flow 51780.3 51780.3 51780.3
Changes in NWC -20000 20000
Net Capital Spending -90000
Cash Flow From Assets -110000 51780.3 51780.3 71780.3
Net Present Value $10,648.32
IRR 25.76%

Sheet2

Sheet3

Unworked

Initial Cost
Savings
Tax Rate
Expected Salvage
Discount Rate
MACRS Depreciation Schedule
Year 1 2 3 4 Book value year 5
Percentage 33.33% 44.45% 14.81% 7.41%
Depreciation Expense
Year 1 2 3 4
Operating Cash Flow
Net Capital Spending
Changes in NWC
Cash Flow from Assets
Net Present Value
Internal Rate of Return
Depreciation Expense = initial cost * percentage
Operating Cash Flow =(sales - costs)*(1 - tax rate) + depreciation*tax rate
note that sales = 0 and a cost savings is -costs
After-tax Salvage =salvage - tax rate(salvage - book value)

Solutions

Initial Cost 1,000,000
Savings 300,000
Tax Rate 21%
Expected Salvage 50,000
Discount Rate 8%
MACRS Depreciation Schedule
Year 1 2 3 4 Book Value year 5
Percentage 33.33% 44.45% 14.81% 7.41%
Depreciation Expense 333,300 444,500 148,100 74,100 0
Year 0 1 2 3 4 5
Operating Cash Flow 306,993 330,345 268,101 252,561 237,000
Net Capital Spending -1,000,000 39,500
Changes in NWC 0 0
Cash Flow from Assets -1,000,000 306,993 330,345 268,101 252,561 276,500
Net Present Value $154,118.72
Internal Rate of Return 13.90%
Depreciation Expense = initial cost * percentage
Operating Cash Flow =(sales - costs)*(1 - tax rate) + depreciation*tax rate
note that sales = 0 and a cost savings is -costs

Burnout

Burnout
Initial Cost 36 Tax Rate 21%
Operating Cost 100 Required Return 15%
Depreciation 10
Expected Salvage 5 After-tax salvage 5
Year 0 1 2 3
OCF -76.83 -76.83 -76.83
NCS -36.00 5.00
NWC 0.00 0.00
CFFA -36.00 -76.83 -76.83 -71.83
NPV -$208.13
EAC -$91.16

Long Lasting

Long-lasting
Initial Cost 60 Tax Rate 21%
Operating Cost 88 Required Return 15%
Depreciation 11
Expected Salvage 5 After-tax salvage 5
Year 0 1 2 3 4 5
OCF -67.21 -67.21 -67.21 -67.21 -67.21
NCS -60.00 5.00
NWC 0.00 0.00
CFFA -60.00 -67.21 -67.21 -67.21 -67.21 -62.21
NPV -$282.81
EAC -$84.37
Numbers in blue computed in Excel.