1. Kolby’s Korndogs is looking at a new sausage system with an installed cost

Question

1. Kolby’s Korndogs is looking at a new sausage system with an installed cost of $625,000. This cost will be depreciated straight-line to zero over the project’s five-year life, at the end of which the sausage system can be scrapped for $95,000. The sausage system will save the firm $183,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $41,000. If the tax rate is 34 percent and the discount rate is 8 percent, what is the NPV of this project?

2. Herrera Music Company is considering the sale of a new sound board used in recording studios. The new board would sell for $25,500, and the company expects to sell 1,400 per year. The company currently sells 1,900 units of its existing model per year. If the new model is introduced, sales of the existing model will fall to 1,720 units per year. The old board retails for $21,400. Variable costs are 55 percent of sales, depreciation on the equipment to produce the new board will be $1,350,000 per year, and fixed costs are $1,250,000 per year. If the tax rate is 38 percent, what is the annual OCF for the project?

Explanation / Answer

Definition of 'Net Present Value - NPV' The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield. NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative. For example, if a retail clothing business wants to purchase an existing store, it would first estimate the future cash flows that store would generate, and then discount those cash flows into one lump-sum present value amount, say $565,000. If the owner of the store was willing to sell his business for less than $565,000, the purchasing company would likely accept the offer as it presents a positive NPV investment. Conversely, if the owner would not sell for less than $565,000, the purchaser would not buy the store, as the investment would present a negative NPV at that time and would, therefore, reduce the overall value of the clothing company........................................................................................................Definition of 'Operating Cash Flow - OCF' In accounting, a measure of the amount of cash generated by a company's normal business operations. Operating cash flow is important because it indicates whether a company is able to generate sufficient positive cash flow to maintain and grow its operations, or whether it may require external financing. OCF is calculated by adjusting net income for items such as depreciation, changes to accounts receivable and changes in inventory. Financial analysts sometimes prefer to look at cash flow metrics because it strips away certain accounting effects and is thought to provide a clearer picture of the current reality of the business operations. For example, booking a large sale provides a big boost to revenue, but if the company is having a hard time collecting the cash, then it is not a true economic benefit to the company. On the other hand, a company may be highly profitable on a cash flow basis, but may not have a low net income if it has a lot of fixed assets and uses accelerated depreciation calculations.

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