3. Assume that \'now is December 20X3. The senior managers of ABC company are re

Question

3. Assume that 'now is December 20X3. The senior managers of ABC company are reviewing the company's medium-term prospects. Inflation is expected to quickly move to approximately 10% per year. An increase in the level of inflation is likely to reduce the volume of sales of ABC. Projected financial data for the next five years, including expected inflation where relevant, are shown below.) 20X4 20X5 20X6 20X7 20X8 Operating cash flows (m): Sales Variable costs Fixed costs Other financial data Incremental working capital* Tax allowable depredation 30 18 24 15 20 12 26 16 16 (2) 3) A bracket signifies a decrease in working capital Tax allowable depreciation will be negligible after 20X8. Cash flows after year 20X8, excluding tax savings from tax allowable depreciation, are expected to be similar to year 20X8 cash flows for a period of five years, after which substantial new fixed investment would be necessary in order to continue operations. Working capital will remain approximately constant after the year 20X8. Corporate taxation is at a rate of 30% per year, and is expected to continue at this rate. Tax may be assumed to be payable in the year that the income arises. The company's required money rate of return is 18%. Required: Estimates of the present values of future cash flows from existing operations

Explanation / Answer

Annual cash flows Ref Particulars 20X4 20X5 20X6 20X7 20X8 20X9 20X10 20X11 20X12 20X13 a Sales revenue                          30                                  26                     24                     20                     16               16               16               16               16               16 Costs Variable costs                          18                                  16                     15                     12                     11               11               11               11               11               11 Fixed costs                            3                                    3                        4                        4                        4                 4                 4                 4                 4                 4 Depreciation                            4                                    3                        3                        2                        1                 1                 1                 1                 1                 1 Total costs                          25                                  22                     22                     18                     16               16               16               16               16               16 Profit before tax                            5                                    4                        2                        2                      -                  -                  -                  -                  -                  -   b less:tax@ 40%                          (2)                                  (2)                     (1)                     (1)                      -                  -                  -                  -                  -                  -   c=a-b profit after tax                            3                                    2                        1                        1                      -                  -                  -                  -                  -                  -   Add: non cash depreciation                            4                                    3                        3                        2                        1                 1                 1                 1                 1                 1 Annual operating cash flow after tax                            7                                    5                        4                        3                        1                 1                 1                 1                 1                 1 Working capital cash flow                    (1.00)                              2.00                  2.00                  3.00                  3.00                -                  -                  -                  -                  -   d Net cash flow                      6.00                              7.40                  6.20                  6.20                  4.00           1.00           1.00           1.00           1.00           1.00 e Present value factor@ 18% 0.847457627 0.71818443 0.608630873 0.515788875 0.437109216 0.370432 0.313925 0.266038 0.225456 0.191064 f=d*e Present value of cashflows 5.08 5.31 3.77 3.20 1.75 0.37 0.31 0.27 0.23 0.19

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