Chapter 10 Solutions - Cash Flow Estimation resources PDF

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Chapter 10 Cash Flow Estimation Questions 2. Why is depreciation expense added back to the net income of a company to find the operating cash flow? Depreciation expense is a non cash flow item in the income statement. It represents a portion of the original cost (cash outflow) of a capital asset that occurred in a previous period. The expense reduces taxable income and thus taxes so it is included in the income statement but must be added back to net income to find the operating cash flow. 3. Why are owners of a business interested only in incremental cash flow for a project and not the total cash flow of a project? Only the incremental cash flow of a project adds value to the company as a whole and therefore value to the owners. When a project has revenue that is the result of lost revenue from another project owners do not see an increase in total revenue. 4. Why are sunk cost excluded from the incremental cash flow of a project? Does this mean that they were wasted expenses? Why or why not? Sunk costs are costs that would be spent regardless of the decision to accept or reject a project so they are not part of the cash flow that will be used to make the decision on a project. They are not wasted expenses as they may have been used to gather vital information for the decision. For example, a market study to determine the potential market of a new product may be critical in determining future sales and thus is important in estimating future cash flow. However, the cost of the study is a sunk cost. 6. Give an example of an opportunity cost and explain how you would estimate the cost as it applies to a particular project. An opportunity cost is a foregone benefit due to the selection of a project. An example of an opportunity cost is the potential lost revenue from selling land that is used in a plant expansion when there was a market for the vacant land. The opportunity cost in this case is the fair market value of the land, the amount that the company could have received if it had chosen to sell the land instead of expanding the plant. 10. All six decision models from Chapter 9 rely on the appropriate timing and amount of cash flow. What are the potential errors a manager can make if this information is not accurate? If we use inappropriate amounts or an inappropriate timing of cash flow we can end up with one of two potential errors. We could reject good projects or we could accept bad projects. Both of these errors reduce the value of the company to the owners. 1

Problems 3. Opportunity costs. Revolution Records will build a new recording studio on a vacant lot next to the operations center. The land was purchased five years ago for $450,000. Today the value of the land has appreciated to $780,000. Revolutionary Records did not consider the value of the land (it had already spent the money to acquire the land long before this project was considered). The NPV of the recording studio was $600,000. Should Revolution Records consider the land as part of the cash flow of the recording studio? If yes, what value should be used, $450,000 or $780,000? How will the value affect the project? ANSWER The land needs to be included as part of the cash flow for the studio project because there is an opportunity cost here. If Revolution Records does not want to keep the land it can sell it for $780,000. So this current market value of $780,000 is the opportunity cost that the studio must cover. If the NPV without considering this cost is $600,000 for the studio, then Revolution Records should just sell the land and have $780,000 as cash income (unless there are taxes that would reduce the net cash flow below $600,000). 11. Operating cash flow. Grady Precision Measurement Tools has forecasted the following sales and costs for a new GPS system: annual sales of 48,000 units at $18 a unit, production costs at 37% of sales price, annual fixed costs for production at $180,000, and depreciation expense (straight-line) of $240,000 per year. The company tax rate is 35%. What is the annual operating cash flow of the new GPS system? ANSWER Revenue (48,000 × $18) COGS (48,000 × $18 × 0.37) Fixed Costs Depreciation EBIT Taxes ($124,320 × 0.35) Net Income Add Back Depreciation Operating Cash Flow (per year)

$864,000 319,680 180,000 240,000 $124,320 43,512 $ 80,808 240,000 $320,808

12. Operating cash flow. Huffman Systems has forecasted the sales for home alarm systems to be 63,000 units per year at $38.50 per unit. The cost to produce each unit is expected to be about 42% of the sales price. The new product will have an additional $494,000 fixed costs each year. The manufacturing equipment will have an initial cost of $2,400,000 and will be depreciated over eight years (straight-line). The company tax rate is 40%. What is the annual operating cash flow for the alarm systems if the projected sales and price per unit are constant over the next eight years? 2

ANSWER Revenue (63,000 × $38.50) COGS (63,000 × $38.50 × 0.42) Fixed Costs Depreciation ($2,400,000 / 8) EBIT Taxes ($612,790 × 0.40) Net Income Add Back Depreciation Operating Cash Flow (per year)

$2,425,500 1,018,710 494,000 300,000 $ 612,790 245,116 $ 367,674 300,000 $ 667,674

13. NPV. Using the operating cash flow information in Problem 11, determine whether Grady Precision Measurement Tools should add the GPS system to its set of products. The initial investment is $1,440,000 and is depreciated over six years (straight-line). The GPS system will be sold at the end of five years for $380,000. The cost of capital is 10% and the tax rate is 35%. ANSWER First, find the after-tax cash flow at disposal of the equipment: Book value (Basis at end of five years): Original cost = $1,440,000 Depreciation expense per year is $1,440,000 / 6 = $240,000 Accumulated depreciation is 5 × $240,000 = $1,200,000 Basis = $1,440,000 – $1,200,000 = $240,000 Gain on disposal = $380,000 – $240,000 = $140,000 Tax on disposal = $140,000 × 0.35 = $49,000 After-tax cash flow at disposal = $380,000 – $49,000 = $331,000 ( ) ( )

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NPV = -$1,440,000 + $320,808 × 3.7908 + $331,000 × 0.6209 NPV = -$1,440,000 + $1,216,114.72 + $205,524.96 = -$18,360.32 Reject the project.

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14. NPV. Using the operating cash flow information in Problem 12, determine whether Huffman Systems should add the home alarm system to their set of products. The manufacturing equipment will be sold off at the end of eight years for $210,000 and the cost of capital for this project is 14%. ANSWER First, find the after-tax cash flow at disposal of the equipment: Book value (Basis at end of eight years): Original cost = $2,400,000 Depreciation expense per year is $2,400,000 / 8 = $300,000 Accumulated depreciation is 8 × $300,000 = $2,400,000 Basis = $2,400,000 – $2,400,000 = $0 Gain on disposal = $210,000 – $0 = $210,000 Tax on disposal = $210,000 × 0.40 = $84,000 After-tax cash flow at disposal = $210,000 – $84,000 = $126,000

1 8 1.14 $126,000 1   NPV  $2,400,000 $667,674 8  0.14 1.14 1

NPV = -$2,400,000 + $667,674 × 4.6389 + $126,000 × 0.3506 NPV = -$2,400,000 + $3,097,248.81 + $44,170.44 = $741,419.25 Accept the project.

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Self-Study 19. Project cash flows and NPV. The managers of Classic Autos Incorporated plan to manufacture classic Thunderbirds (1957 replicas). The necessary foundry equipment will cost a total of $4,000,000 and will be depreciated according to the following schedule: Depreciation

Year 1 $800,000

Year 2 $1,280,000

Year 3 $768,000

Year 4 $460,800

Year 5 $460,800

Projected sales in annual units for the next five years are 300 per year. If the sales price is $27,000 per car, variable costs are $18,000 per car, and fixed costs are $1,200,000 annually, what is the annual operating cash flow if the tax rate is 30%? The equipment is sold for salvage for $500,000 at the end of year five. What is the after-tax cash flow of the salvage? Net working capital increases by $600,000 at the beginning of the project (Year 0) and is reduced back to its original level in the final year. What is the incremental cash flow of the project? Using a discount rate of 12% for the project, determine whether the project be accepted or rejected with the NPV decision model? ANSWER Operating Cash Flows are: Annual Sales, 300 × $27,000 = $8,100,000 Annual COGS, 300 × $18,000 = $5,400,000 Operating Cash Flows in Thousands (rounded) Sales Revenue – COGS – Fixed Costs – Depreciation EBIT – Taxes (30%) Net Income + Depreciation Operating Cash Flows

Year 1 $8,100 $5,400 $1,200 $ 800 $ 700 $ 210 $ 490 $ 800 $1,290

Year 2 $8,100 $5,400 $1,200 $1,280 $ 220 $ 66 $ 154 $1,280 $1,434

Year 3 $8,100 $5,400 $1,200 $ 768 $ 732 $ 220 $ 512 $ 768 $1,280

Year 4 $8,100 $5,400 $1,200 $ 461 $1,039 $ 312 $ 727 $ 461 $1,188

Year 5 $8,100 $5,400 $1,200 $ 461 $1,039 $ 312 $ 727 $ 461 $1,188

The equipment is sold for salvage for $500,000 at the end of year five. It has a book value of $4,000,000 – $800,000 – $1,280,000 – $768,000 – $460,800 – $460,800 = $230,400  Gain on sale: $500,000 – $230,400 = $269,600  Tax on gain: $269,600 × 0.30 = $80,880  After-tax cash flow on disposal: $500,000 – $80,880 = $419,120. 5

Incremental Cash Flows for Project (in Thousands, $000) Account/Activity Investment NWC OCF Salvage Value Total Cash Flows (Incremental)

Year 0 -$4,000 -$ 600 -$4,600

Year 1

Year 2

Year 3

Year 4

$1,290

$1,434

$1,280

$1,188

$1,290

$1,434

$1,280

$1,188

Year 5 $ 600 $1,188 $ 419 $2,207

NPV @ 12% = -$4,600,000 + $1,290,000/1.12 + $1,434,000/1.122 + $1,280,400/1.123 + $1,188,240/1.124 + $2,207,360/1.125 = -$4,600,000 + $1,151,786 + $1,143,176 + $911,363 + $755,148 + $1,252,515 = $613,989 Accept the project because NPV is positive $613,989 (with rounding to nearest thousand). 20. Project cash flows and NPV. The sales manager has a new estimate for the sale of the Classic Thunderbirds in Problem 19. The annual sales volume will be as follows: Year 1: 240 Year 2: 280 Year 3: 340 Year 4: 360 Year 5: 280. Rework the operating cash flows with these new sales estimates and find the internal rate of return for the project using the incremental cash flows. ANSWER Operating Cash Flows are: Annual Sales: Year 1 Year 2 Year 3 Year 4 Year 5

= 240 × $27,000 = $6,480,000 = 280 × $27,000 = $7,560,000 = 340 × $27,000 = $9,180,000 = 360 × $27,000 = $9,720,000 = 280 × $27,000 = $7,560,000

Annual COGS: Year 1 Year 2 Year 3 Year 4 Year 5

= 240 × $18,000 = $4,320,000 = 280 × $18,000 = $5,040,000 = 340 × $18,000 = $6,120,000 = 360 × $18,000 = $6,480,000 = 280 × $18,000 = $5,040,000

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Operating Cash Flows in Thousands (rounded) Sales Revenue – COGS – Fixed Costs – Depreciation EBIT – Taxes Net Income + Depreciation Operating Cash Flows

Year 1 $6,480 $4,320 $1,200 $ 800 $ 160 $ 48 $ 112 $ 800 $ 912

Year 2 $7,560 $5,040 $1,200 $1,280 $ 40 $ 12 $ 28 $1,280 $1,308

Year 3 $9,180 $6,120 $1,200 $ 768 $1,092 $ 328 $ 764 $ 768 $1,532

Year 4 $9,720 $6,480 $1,200 $ 461 $1,579 $ 474 $1,105 $ 461 $1,566

The Incremental Cash Flows are: Incremental Cash Flows for Project (in Thousands, $000) Account/Activity Year 0 Year 1 Year 2 Year 3 Year 4 Investment -$4,000 NWC -$ 600 OCF $912 $1,308 $1,532 $1,566 Salvage Value Total Cash Flows -$4,600 $912 $1,308 $1,532 $1,566 (Incremental) The IRR is via calculator: CF0 = -4,600,000 C01 = 912,000 C02 = 1,308,000 C03 = 1,532,400 C04 = 1,566,240 C05 = 2,081,360 Solving for IRR = 15.97%. If the hurdle rate is still 12%, accept the project.

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Year 5 $7,560 $5,040 $1,200 $ 461 $ 859 $ 258 $ 601 $ 461 $1,062

Year 5 $ 600 $1,062 $ 419 $2,081...