Hi eco5912!!
1.Prepare a statement showing the incremental cash flows for this
project over an 8-year period.
First of all we need to order the data and do some preliminar calculations.
-Initial investment:
The total initial investment (I) is the sum of the invest in plant and
equipment.
I = $1,000,000
-Working Capital:
The additional net investment in inventory and receivables is the
working capital needed for the project:
WC = $100,000
Because we have no additional info about the WC we assume that it will
not change over the project's life. Then Working Capital Change for
each year Yi is:
ChWCi = Previous Year WC - Current WC = 0 (i=1 to 7)
and
ChWC0 = -$100,000
See the following definition:
"Working Capital: Sometimes projects need investment in
non-depreciable assets to support the operations required by the
project. Capital assets are depreciable and investment in capital
assets is a major fraction of initial investment. But money needed
for working capital is also part of the initial investment and is a
cash outflow. During the course of the project when the working
capital is returned or recovered, the money received by the company is
classified as cash inflow. If a project is successful and runs the
full course of its life, the initial investment in working capital is
recovered sometime during the life of the project. Hence working
capital can either be cash outflow or inflow."
From "Elements of cash flows" at Boise State University:
http://coen.boisestate.edu/mkhanal/elements_of_cash_flows.htm
As you can read the working capital is recovered so for the end of the
year 8 it will be zero or:
ChWC8 = $100,000
-Depreciation:
For the first five years Yi (i = 1 to 5):
Di = (Invest in plant and equipment) / 5 = $1,000,000/5 = $200,000
For the years 6 to 8 the depreciation will be zero.
-Revenues:
For the first year the expected revenues will be:
R1 = $900,000
For the years Yi (i=2 to 8)
Ri = $1,500,000
-Expenses:
For all years we will have indirect incremental costs of $80,000
For each year the direct costs are 0.55*Ri
For each year Yi (i=1 to 8):
Ei = $80,000 + 0.55*Ri then:
E1 = $80,000 + 0.55*$900,000 = $575,000
For i=2 to 8:
Ei = $80,000 + 0.55*$1,500,000 = $905,000
-Taxes:
The firm's marginal tax rate is 40%, then the taxes will be:
Ti = T * (Ri - Ei - Di) with T = 0.4 (i=1 to 8)
T1 = 0.4*($900,000-$575,000-$200,000) = $50,000
For i=2 to 5
Ti = 0.4*($1,500,000-$905,000-$200,000) = $158,000
For i=6 to 8
Ti = 0.4*($1,500,000-$905,000-$0) = $238,000
Now we can place the cash flows statement (in thousands):
YEARS
0 1 2 3 4 5 6 7 8
1.Revenues 0 900 1500 1500 1500 1500 1500 1500 1500
2.Expenses 0 575 905 905 905 905 905 905 905
3.Depreciation 0 200 200 200 200 200 0 0 0
4.Income before tax 0 125 395 395 395 395 595 595 595
[1-(2+3)]
5.Taxes 0 50 158 158 158 158 238 238 238
6.Net Income 0 75 237 237 237 237 357 357 357
[4-5]
7.Cash flow
from operation 0 275 437 437 437 437 357 357 357
[1-2-5]
--------------------------------------------------------------
8.Investments -1000 0 0 0 0 0 0 0 0
9.Change in WC -100 0 0 0 0 0 0 0 100
10.Total cash flow -1100 0 0 0 0 0 0 0 100
from investment
[8+9]
--------------------------------------------------------------
11.Total cash flow -1100 275 437 437 437 437 357 357 457
[7+10]
--------------------------------------------------------------
2.Calculate the Payback Period and the NPV for the project.
-Payback Period:
Payback (PB) calculation will give us an idea on how long it will take
for a project to recover the total initial investment.
Then if:
Y = the year before full recovery of total investment TI;
U = Unrecovered cost at the start of last year;
CFi = CF of the year Y+1;
PB = Y + U/CFi
We will consider the total initial investment (TI) as the sum of the
invest in plant and equipment plus the initial Working Capital
required.
TI = $1,100,000
At the end of the year 2 we have recovered:
$275,000 + $437,000 = $712,000
And U is:
U = $1,100,000 - $712,000 = $388,000 (less than CF3 so Y = 2)
PB = 2 + 388,000/437,000 = 2.89 years or 2 years and 11 months.
------------------------
-NPV:
First we need to define the Present Value (PV):
CF1 CF2 CF8
PV = --------- + ---------- + .... + ----------
(1 + R) (1 + R)^2 (1 + R)^8
where R is the required return.
Net Present Value:
NPV = PV - TI where TI = Total Initial Investment
Using a calculator we find that:
PV = $2,107,209.60
NPV = PV - TI = $2,107,209.60 - $1,100,000 = $1,007,209.60
----------------------------------------------------------
3.Based on your answer for question 2, do you think the project should
be accepted? Why? Assume ABC has a P/B policy of not accepting
projects with life of over three years.
Definition of Payback Criterion:
-Accept a project if its payback period is less than maximum
acceptable payback period.
-Reject a project if its payback period is longer than maximum
acceptable payback period.
Because the payback period is less than the 3 years limit policy of
ABC, the project is acceptable by this criterion.
Regarding to the NPV, it is positive and very atractive. The NPV
analysis discounts each year's cash flow according to timing; Net
Present Value (NPV) is the summation of all positive and negative
present values for an investment project. An investment project is
feasible if its NPV is positive. The NPV Decision Rule says:
-Accept a project if NPV >= 0.
So by this criterion the project is acceptable also.
The net present value criterion has considerable merits:
- it takes in to account the time value of money
- it considers the cash flow stream in its project life
Read the following:
"The goal of the firm is to maximize present shareholder value. This
goal implies that projects should be undertaken that result in a
positive net present value, that is, the present value of the expected
cash inflow less the present value of the required capital
expenditures. Using net present value (NPV) as a measure, capital
budgeting involves selecting those projects that increase the value of
the firm because they have a positive NPV. The timing and growth rate
of the incoming cash flow is important only to the extent of its
impact on NPV.
Using NPV as the criterion by which to select projects assumes
efficient capital markets so that the firm has access to whatever
capital is needed to pursue the positive NPV projects. In situations
where this is not the case, there may be capital rationing and the
capital budgeting process becomes more complex."
From "Capital Budgeting" at Internet Center for Management and
Business Administration:
http://www.netmba.com/finance/capital/budgeting/
-----------------------------------------------------------
4.If the project required additional investment in land and building,
how would this affect your decision? Explain.
This is a relevant cash flow, so it will be added to the initial
investment, and depending on the amount of money invested on this
topic the NPV could become negative and in that case the project will
be rejected via the NPV criterion.
Also note that the current payback period is very close to the limit
of 3 years, so any additional investment will increase the payback
period to a period greater than 3 years, this will activate the red
light for this project due the ABC's payback policy, and the project
will be rejected, despite of the possibility that the NPV remains
positive.
-----------------------------------------------------------
I hope that this helps you. Please do not consider this answer ended
until you feel satisfied with it. If you find something unclear,
imcomplete or wrong please let me know using the clarification feature
giving me the opportunity to complete, clarify, correct or improve
this answer if needed before you rate it. I will gladly respond to
your requests for further assistance on this.
Best regards.
livioflores-ga |
