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FIN222 Lecture Notes - Lecture 8: Net Profit, Free Cash Flow, Cash Flow

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silverhound358
1 Aug 2018
School
UOW
Department
Finance
Course
FIN222
Professor
Aelee Jun

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Document Summary

Fin222 - review lecture 07: capital budgeting process = process of analyzing investment opportunities and deciding which ones to accept. Fcf = (revenue costs depreciation) (1 tc) + depreciation capex changes in nwc. = net profit that does not include interest expenses associated with debt or fcf = (revenue costs) (1 tc) + tc depreciation capex changes in nwc. In capital budgeting, depreciation is calculated for tax purpose, salvage value is not deducted. Thus, the asset is depreciated to zero, not to salvage value. In fin222 use straight-line method: nwc = current assets. = cash + inventories + receivables payables. The funds initially invested in nwc will eventually be recovered. In fin222, all nwc is to be recovered in the terminal year: other effects: a. Opportunity costs = value of a resource could have provided in its best alternative use include b. When sales of a new product displace sales of an existing product, the situation referred to as cannibalization.

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Related Questions

Gammy is considering building a facility to manufacture cupcakes to distribute nationally. Your assignment involves both the calculation of cash flows associated with the new investment under consideration and the evaluation of several mutually exclusive projects. Grammy wants you to meet with everyone involved and write a meeting report for the board of directors that includes your recommendation. In addition to the recommendation, you have been asked to respond to a number of questions aimed at understanding the capital-budgeting process. Grammy wants to be sure that she and the board of directors understand cash flow and capital budgeting.

We are considering constructing a building to manufacture cupcakes. Currently we are in the 34 percent marginal tax bracket with a 15 percent required rate of return or cost of capital. This project is expected to last 5 years and then, because this is somewhat of a fad product, be terminated. The following information describes the project:

Cost of new plant and equipment

$7,900,000

Shipping and installation costs

$ 100,000

Unit Sales

Year Units Sold

1 70,000

2 120,000

3 140,000

4 80,000

5 60,000

Sales price per unit

$300/unit in years 1 through 4, $260/unit in year 5

Variable cost per unit

$180/unit

Annual fixed costs

$200,000 per year in years 1 – 5

Working-capital requirements

There will be an initial working-capital requirement of $100,000 just to get production started. For each year, the total investment in net working capital will be equal to 10 percent of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5.

The depreciation method

Use the simplified straight-line method over 5 years. Assume the plant and equipment will have no salvage value after 5 years.

5. Answer the following questions:

a. Should you focus on cash flows or accounting profits in making the capital-budgeting decision? Should you be interested in incremental cash flows, incremental profits, total free cash flow, or total profits?

b. How does depreciation affect free cash flow?

c. How do sunk costs affect the determination of cash flows?

d. What is the project’s initial outlay?

e. What are the differential cash flows over the project’s life?

f. What is the terminal cash flow?

g. Draw a cash-flow diagram for this project.

h. What is its net present value?

i. What is its internal rate of return?

j. Should the project be accepted? Why or why not?

k. How does Genesis 47: 18 – 19 relate to this project and cash flow management?

You have just been hired by Internal Business MachinesCorporation (IBM) in their capital budgeting division. Your firstassignment is to determine the free cash flows and NPV of aproposed new type of tablet computer similar in size to an iPad butwith the operating power of a high-end desktop system. Developmentof the new system will initially require an initial capitalexpenditure equal to 10% of IBM’s Property, Plant, and Equipment(PPE) at the end of fiscal year 2014. The project will then requirean additional investment equal to 10% of the initial investmentafter the first year of the project, a 5% increase after the secondyear, and a 1% increase after the third, fourth, and fifth years.The product is expected to have a life of five years. First-yearrevenues for the new product are expected to be 3% of IBM’s totalrevenue for the fiscal year 2014. The new product’s revenues areexpected to grow at 15% for the second year then 10% for the thirdand 5% annually for the final two years of the expected life of theproject. Your job is to determine the rest of the cash flowsassociated with this project. Your boss has indicated that theoperating costs and net working capital requirements are similar tothe rest of the company and that depreciation is straight-line forcapital budgeting purposes. Since your boss hasn’t been much help(welcome to the “real world”!), here are some tips to guide youranalysis: Obtain IBM’s financial statements. (If you really workedfor IBM you would already have this data, but at least you won’tget fired if your analysis is off target.) Download the annualincome statements, balance sheets, and cash flow statements for thelast four fiscal years from Yahoo! Finance (finance.yahoo.com).Enter IBM’s ticker symbol and then go to “financials.” You are nowready to estimate the Free Cash Flow for the new product. Computethe Free Cash Flow for each year using Eq. 8.5: Free Cash Flow =Unlevered Net Incomeî î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î “î ’î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ”î ‘ (Revenues − Costs − Depreciation ) × ( 1 − τ c ) + Depreciation −CapEx − Δ N W C Free Cash Flow=(Revenues−Costs−Depreciation)×(1−τc)︷Unlevered NetIncome+Depreciation−CapEx−ΔNWC Set up the timeline and computationof free cash flow in separate, contiguous columns for each year ofthe project life. Be sure to make outflows negative and inflowspositive. Assume that the project’s profitability will be similarto IBM’s existing projects in 2014 and estimate ( revenues − costs) (revenues−costs) each year by using the 2014 EBITDA/Sales profitmargin. Calculate EBITDA as EBIT + Depreciation EBIT+Depreciationexpense from the cash flow statement. Determine the annualdepreciation by assuming IBM depreciates these assets by thestraight-line method over a 5-year life. Determine IBM’s tax rateby using the income tax rate in 2014. Calculate the net workingcapital required each year by assuming that the level of NWC willbe a constant percentage of the project’s sales. Use IBM’s 2014NWC/Sales to estimate the required percentage. (Use only accountsreceivable, accounts payable, and inventory to measure workingcapital. Other components of current assets and liabilities areharder to interpret and not necessarily reflective of the project’srequired NWC—for example, IBM’s cash holdings.) To determine thefree cash flow, deduct the additional capital investment and thechange in net working capital each year. Use Excel to determine theNPV of the project with a 12% cost of capital. Also calculate theIRR of the project using Excel’s IRR function. Perform asensitivity analysis by varying the project forecasts as follows:Suppose first year sales will equal 2%–4% of IBM’s revenues.Suppose the cost of capital is 10%–15%. Suppose revenue growth isconstant after the first year at a rate of 0%–10%.

1.

Suppose your firm is considering investing in a project with the cash flows shown below, that the required rate of return on projects of this risk class is 7 percent, and that the maximum allowable payback and discounted payback statistics for the project are 3.5 and 4.5 years, respectively.

Time: 0 1 2 3 4 5 6
Cash flow –$4,800 $1,210 $2,410 $1,610 $1,530 $1,410 $1,210

Use the payback decision rule to evaluate this project. (Round your answer to 2 decimal places.)
Payback

years

2.

Suppose your firm is considering investing in a project with the cash flows shown below, that the required rate of return on projects of this risk class is 8 percent, and that the maximum allowable payback and discounted payback statistics for the project are 3.5 and 4.5 years, respectively.

Time: 0 1 2 3 4 5 6
Cash flow –$7,700 $1,110 $2,310 $1,510 $1,510 $1,310 $1,110


Use the IRR decision rule to evaluate this project. (Negative amount should be indicated by a minus sign. Round your answer to 2 decimal places.)


IRR %

3.

KADS, Inc., has spent $360,000 on research to develop a new computer game. The firm is planning to spend $160,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $46,000. The machine has an expected life of three years, a $71,000 estimated resale value, and falls under the MACRS 7-year class life. Revenue from the new game is expected to be $560,000 per year, with costs of $210,000 per year. The firm has a tax rate of 40 percent, an opportunity cost of capital of 13 percent, and it expects net working capital to increase by $80,000 at the beginning of the project.

What will the cash flows for this project be? (Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places.)
Year 0 1 2 3
FCF $ $ $ $

4.

Your firm needs a computerized machine tool lathe which costs $49,000 and requires $11,900 in maintenance for each year of its 3-year life. After three years, this machine will be replaced. The machine falls into the MACRS 3-year class life category. Assume a tax rate of 34 percent and a discount rate of 13 percent.

If the lathe can be sold for $4,900 at the end of year 3, what is the after-tax salvage value? (Round your answer to 2 decimal places.)
Salvage value after tax $

5.

You are evaluating a project for The Ultimate recreational tennis racket, guaranteed to correct that wimpy backhand. You estimate the sales price of The Ultimate to be $360 per unit and sales volume to be 1,000 units in year 1; 1,250 units in year 2; and 1,325 units in year 3. The project has a 3-year life. Variable costs amount to $205 per unit and fixed costs are $100,000 per year. The project requires an initial investment of $153,000 in assets, which will be depreciated straight-line to zero over the 3-year project life. The actual market value of these assets at the end of year 3 is expected to be $31,000. NWC requirements at the beginning of each year will be approximately 20 percent of the projected sales during the coming year. The tax rate is 39 percent and the required return on the project is 12 percent. (Use SL depreciation table)


What will the cash flows for this project be? (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Round your final answers to 2 decimal places.)


Year 0 1 2 3
Total cash flow $ $ $ $