Assume you have just graduated from college with a degree in finance and you are

Question

Assume you have just graduated from college with a degree in finance and you are trying to explain to your boss the importance of identifying and using the appropriate cash flows when you make financial decisions. He is considering investing in a project and he has identified the following cash flows and information that he considers relevant.

-Forecast net income for years 1 through 8 of $450,000 per year.

-Initial investment in equipment and facility of $2,200,000

-Value of equipment and facility at project’s termination $200,000

-The equipment will be fully depreciated by the project’s end. For simplicity assume equal amounts every year.

-The company’s marginal tax rate is 15%

-Your boss expects to allocate 20% of his time to the new project and he makes $250,000 per year.

-The company’s required return on the project is 10%.

-Your boss has not included any additional funds for net working capital.

-Your boss is basing his forecasts on the results from a product test market that the firm paid $245,000 to have conducted.

Please answer questions and show work.

1. Explain incremental cash flows to your boss and identify the main categories of incremental cash flows.

2. Identify the relevant cash flows in this project. Justify your answers.

3.Should you consider making adjustments for net working capital?

4. What is the after-tax terminal value of the facility and equipment?

5. Explain how the cash flows might differ if this were a replacement project.

Explanation / Answer

1. Main Categories of incremental cash flows are :

Increase in sale/revenue each year due to products increased demand.

As economy of sales are achieved costs will decrease and bottom line i.e. net income/ profit wil increase. In simple words as production increases costs will be distributed over larger number of products thus decreasing overall operatings costs.

2. Money paid to product test firm is a sunk cost and not a relevant cash flow. Sunk costs are those costs which are already spent and can not be recovered.

Even taking into considertion amount of time boss allocates is irrelevant because that money will be considered in operating costs already while arriving at net income. Thus that should be ignored.

Net income earned each year, Initial Value of plant and euipment, terminal value of plant and equipment,depreciation and net working capital are the relevant cash flows.

3. Adjustments for net working capital is of utmost importance because to run a project we need to spend dollars for day to day operations which are termed as working capital requirments. Thus it is mandatory to do it.

4. After tax terminal value of facility and euipment= (Sale of asset-book value of asset)*(1-tax rate)

=(200000- 0)*(1-0.15)

=$170000

5. If this were replacement projec, Initial investment formula would change

Initial Investment = Fixed Capital Investment + Working Capital Investment – Sale of Old Equipment + ((Sale of Old Equip – Book Value of Old Equip)(tax rate))

Here we need information of sale of old equipment to go ahead with. All other calculations will remain same.

Also for replacement product two considerations that must be made:

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