This is a very comprehensive example, that shows you all the steps and issued involved. For each capital budgeting problem, the goal is to get to the Cash Flow from Assets, or, in the case of project evaluation, the Cash Flows from the Project. This is done by looking at all relevant and incremental cash flows, on an after-tax basis, that are directly associated with the project. From the first weeks of class we learned that:
Cash Flow from Assets = Operating Cash Flows - Additions to Net Working Capital - Net Capital Spending
and:
Operating Cash Flow = EBIT + Depreciation - Taxes
The first goal is then to set up the pro forma income statement for each year, which allows you to find the numbers relevant for finding the Operating Cash Flow:
Income Statement
Revenues
Expenses (-)
Depreciation (-)
EBIT
Taxes (-)
Net Income*
* Interest payments are irrelevant
cash flows in capital budgeting problems.
$100,000 consultancy fee = sunk cost = irrelevant cash flow
$75,000 marketing research
costs = sunk cost = irrelevant cash flow
$50,000 cost of building
in 1985 = sunk cost = irrelevant cash flow
$60,000 market value of
building = opportunity cost = relevant cash flow
increase in coconut shakes
= side effect = relevant cash flow
method of financing (bonds)
= irrelevant
Remember to make sure that all included cash flows should be reported on an incremental and after-tax basis!
Pro Forma Income
Statements
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Revenues |
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Variable Costs (-) |
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Opportunity Costs (-) |
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Side Effects (-) |
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Depreciation (-) |
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EBIT |
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Tax (-) |
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Net Income |
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Operating Cash Flow |
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(a) The alternative to using the building
for the project is to sell if for the market price of $60,000. Because
the book value of the building is $0, the profit you make from selling
it is $60,000, which is taxable. So, the after-tax cash flow is (1 - 0.34)
* $60,000 = $39,600
(b) The incremental effect on the sales
of coconut shakes is 10% of $1 million = $100,000.
(c) Straight-line depreciation is $900,000
/ 3 years = $300,000 per year. Using the half-year convention, only $150,000
is used for year 1, and the final $150,000 will occur in year 4. However,
in year 3 we can sell the machine, so we won't take the depreciation in
year 4.
Additions to
Net Working Capital
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(d) 12% of $1,600,000 (revenues)
(e) recovery of investments in NWC
Cash Flows
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(f) Value from selling the machine in year 3. Note that the book value is still $150,000 in year 3 so there is no taxable profit in this case from selling it for $150,000. You only pay taxes on the difference between the market price and the book value.
Net Present Value
r = 21%
NPV = (964,600) + [266,800 / 1.21] + [388,800 / (1.21)2] + [922,800 / (1.21)3] = $42,348.04 > 0 => Accept the Project!