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Q: Long Term Financial Management Decisions ( Answered 5 out of 5 stars,   0 Comments )
Subject: Long Term Financial Management Decisions
Category: Business and Money > Finance
Asked by: kflyy76-ga
List Price: $40.00
Posted: 17 Aug 2005 15:58 PDT
Expires: 16 Sep 2005 15:58 PDT
Question ID: 556961
Can you please help me with the below questions? I need a response
back within 24 hours. Thanks.

A company expects to sell $950,000 of a new product in the first year
and $1,500,000 each year thereafter.  Direct costs including labor and
materials will be 55% of sales.  Indirect incremental costs are
estimated at $80,000 a year.  The project requires a new plant that
will cost a total of $1,000,000, which will be depreciated straight
line over the next five years. The new line will also require an
additional net investment in inventory and receivables in the amount
of $200,000.  The company?s marginal tax rate is 35%, and its cost of
capital is 10%.
1.	What would a statement look like that shows the incremental cash
flows for this project over an 8-year period?
2.	What is the calculation for the Payback Period (P/B) and the NPV
for the project?
3.	Based on your answer for question 2, do you think the project
should be accepted? Why? Assume Superior has a P/B (payback) policy of
not accepting projects with life of over three years.
4.	If the project required additional investment in land and building,
how would this affect your decision? Explain.
Subject: Re: Long Term Financial Management Decisions
Answered By: omnivorous-ga on 18 Aug 2005 08:39 PDT
Rated:5 out of 5 stars
Kflyy76 ?

The easiest way to set up these calculations is to use Excel, and the
linked spreadsheet should be viewable in your browser.  However, if
you have Excel you can download the spreadsheet and even change its
Superior Corp. Income Statement & Cash Flow

In the columns, we use the ?year zero? convention for cash being
invested up front.  None of this gets discounted, as it?s in today?s
dollars.  We?ve included both inventory/AR with the plant investment,
as it?s unchanged over the 8 years.

The cash flow statement includes the complete income statement:

Sales ? (direct products costs) ? indirect cost = GROSS PROFIT

EBIT (or earnings before interest and taxes) = GROSS PROFIT ? Depreciation

Depreciation is a ?non-cash? expense, used for taxation purposes and
to estimate capital expenses.  It gets ADDED BACK to net profits in a
cash-flow statement:

?Preparing Your Cash Flow Statement,? (Aug. 10, 2001)


The NPV factor then discounts cash flows for the cost of money each year:
Year 1: 1/(1.10)^1
Year 2: 1/(1.10)^2
Year 3: 1/(1.10)^3
Year 8: 1/(1.10)^8


PAYBACK: the payback period adds up the cash flows and sees how long
it takes for the project to pay for itself:

?Payback Period? (undated)

Using the NET CASH FLOW line, it?s late in year 3 that the project
pays back the $1.2 million invested (basically the last week of year
3).  So the payback period is 2.98 years.

TOTAL NPV is $1,021,091 over the 8-year period, a strong positive. 
But note that, unlike the payback method (which pays for the project
in 3 years) it?s almost 4 years before the present-value of the cash
flows pays back the initial investment.

Note too, that if this new product were to stop selling after year 8
(a very realistic assumption), we should be re-capturing the $200,000
in initial inventory and receivables ? making the NPV of the project
even stronger.


Any project with a positive NPV should be accepted, according to
financial theory.  Anything project above the cost of capital (here,
10%) for the corporation is adding to shareholders? wealth.  This has
a strong positive NPV.

The payback method just meets Superior?s 3-year criteria, but note the
weaknesses of using payback (outlined in the Investopedia article) --
it doesn?t account for the time value of money.


Any additional investment in land & building COULD change the
decision, depending on what value they?ll have at the end of the
project.  The building may have on-going value for the next version of
this project ? and land will almost certainly have value.  Indeed,
U.S. IRS rules would allow depreciation of the building ? but not

However, it?s important to note that by year 7, the dollars coming
back are being discounted by almost 50% -- so the sale of the plant
for scrap or even sale of real estate diminishes the NPV of cash flows
each year.

Google search strategy:
Depreciation + ?cash flow? + statement
?payback period?

If any part of this Google Answer is unclear, please let us know via a
Clarification Request.

Best regards,

kflyy76-ga rated this answer:5 out of 5 stars and gave an additional tip of: $3.00
Thanks, this answer helped me understand better.

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