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BF BFC2140 CORPORATE FINANCE I TUTORIAL SET 9 - SOLUTIONS CAPITAL BUDGETING III Que Question stion On One e Which of the following is a reason why incremental earnings may be different from incremental cash flows? (a) Changes in accounts receivable reflects non-cash sales present in incremental earnings that are not incremental cash flows. (b) Depreciation is a cash expense, but does not appear in incremental earnings. (c) Capital expenditures appear on the income statement. However, as these costs are depreciated over time, they should not be present in incremental cash flows. (d) Firms pay taxes based on incremental cash flows, not incremental earnings. (e) After-tax salvage is not important to incremental cash flows, but does factor into revenues on the income statement. Answer: a Que Question stion Two In 2016, Project Soothsayer is expected to produce incremental earnings (after taxes and depreciation) of $19.2 million. The expected depreciation charge in that fiscal year is $2.6 million. Expected capital expenditures total $9.0 million and after tax salvage is expected to be $3.2 million. The project’s net working capital needs (in millions of dollars) from 2015 through 2016 are given in the table below: Year Net working capital

2015 $1.00

2016 $5.60

2017 $5.00

What are the expected cash flows from the project in 2016? Incremental cash flows are computed as Incremental cash flows = Incremental earnings (af ter taxes and depreciation) + Depreciation — Capital expenditures + After tax salvage 1

— Change in working capital Therefore, Incremental cash flows = $19.2 + 2.6 − 9.0 + 3.2 − (5.6 − 1.0) = $11.4 million Que Question stion Three A firm expects a project to have the following incremental Income Statement (all values in millions of dollars): Fiscal year 2015 2016 2017 Revenues $56.70 $69.60 $61.80 Costs -34.8 -42.7 -37.9 Depreciation -1.9 -1.9 -1.9 EBIT 20 25 22 The project’s incremental pro-forma balance sheet is expected to contain the following working capital items at the end of those fiscal years (all values in millions of dollars): Assets Liabilities Fiscal year 2015 Inventories $2.80 Accounts payable $2.00 Accounts receivable 1.3 Fiscal year 2016 Inventories 3.5 Accounts payable Accounts receivable 1.6

2.5

Fiscal year 2017 Inventories 3.1 Accounts payable Accounts receivable 1.4

2.2

In 2016, expected incremental capital expenditures total $2.9 million and incremental after tax salvage is expected to be $5.0 million. The tax rate for the project is 30%. What are the expected incremental cash flows from the project in 2016? Use the indirect method: Incremental cash flows = Incremental earnings - capital expenditures + depreciation + after-tax salvage - change in net working capital Incremental earnings = EB IT − taxes = 25.0 − 25.0 × 0.3 = 17.5. Capital expenditures, depreciation, and after tax salvage are given. So, all that remains is to compute the change in net working capital. NWC = Accounts receivable + Inventories −Accounts payable.

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Therefore, 2016 NWC is 2.6 and 2015 NWC is 2.1. So, the change in net working capital is 2.6-2.1 =0.5. Therefore, incremental cash flows = 17.5 -2.9 + 1.9 + 5.0 - 0.5 = 21.0 Que Question stion Four Wernham-Mifflin is considering launching a new line of pentagonal-shaped paper. You have the following information:  Revenues due to the sale of the new product are expected to be $90 million annually.  Total paper production costs will increase from the current level of $22 million annually to $63 million annually after the product launch.  Top sales agent Michael Scarn will be reassigned from other projects to sell the new product line. Sales of those other products are expected to decline by $12 million annually.  The project will make use of an existing paper mill, built last year at a cost of $38 million. The mill is being depreciated using prime cost over a useful life of 16 years.  Wernham-Mifflin currently pays taxes at a marginal rate of 26%.  Total annual incremental cash flows for the project are expected to remain constant for the next 16 years. After this period, the project’s total incremental cash flows will decline at a rate of 5% annually and will be received in perpetuity. What is the present value of the project if the annual project discount rate is 6.0%?

Incremental costs for the project are $63 - 22 = $41 million. After tax side effects are $12 − (12 × 0.26) = $8.88 million. The plant is a sunk cost and is not incremental to the project. Similarly, the plant’s depreciation is also not incremental and should be ignored. Therefore, incremental earnings for the project is determined as follows: Incremental revenues Incremental costs Pre-tax side-effects EBIT Taxes Incremental earnings

$90.00 -41.00 -12.00 37.00 -9.62 27.38

No adjustments are necessary due to capital expenditures, depreciation, after-tax salvage, or change in net working capital. Therefore, incremental cash flows are $27.38 million. The investment is a 16 year annuity, and a perpetuity that makes its first payment in 17 years. The annuity value can be found using the annuity table: Annuity Value = Incremental cash flow

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× Annuity Factor (16 periods, 6% discount rate) = 27.38 × 10.1059 = 276.70 𝐶𝐹

The growing perpetuity formula, 𝑟−𝑔gives the value of a perpetuity one period before the first payment is received. Therefore, it will give the value at t = 16. This must be discounted 16 years to get the present value. The growth rate is g = -0.05 as the cash flows are declining at 5% annually. The initial cash flow at t = 17 is equal to the t = 16 cash flow after a 5% decline, 27.38*(1-0.05) = 26.011. 1

𝐶𝐹17

Perpetuity Value = (1+𝑟) 16 × 𝑟−𝑔 =

1 1.0616

×

26.011 0.06−(−0.05)

Therefore, the present value of the investment is: 276.70 + 93.08 = $369.78 million.

4

= 93.08...