Cash Flow Estimation Problem Set Question 1

MultiAlpha is considering replacing an old machine with a new one. Two months ago their chief engineer completed a training workshop on the new machines operation and efficiency. The cost of RM4000 cost for this workshop session has already been paid. If the new machine is purchased, it would require RM5000 in installation and modification costs to make it suitable for operation in the factory. The old machine originally cost RM90000 five years ago and is being depreciated by RM15000 per year. The new machine will cost RM80000 before installation and modification. It will be depreciated by RM5000 per year. The old machine can be sold today for RM10000. The marginal tax rate for the firm is 28%. Compute the relevant initial outlay in this capital budgeting decision. Suggested Solutions: RM73600 Initial Investment (Cash Outflow) Y0 RM Price of Equipment 80000 ADD: Cost of Training 0 Shipping costs 0 Modification costs 0 Installation 5000 Initial Outlay 85000 Less: Cash Inflow Upon Sale of (10000) Existing Machine Tax Saving on Disposal of (1400) Existing Machine Net Cash Flow for Investment 73600 Remark

Sunk costs

Sale of Existing Machine Cost Of Equipment Less: Accumulated Depreciation RM15000 x 5 years Book Value Disposal Price Loss on Disposal Tax Saving 28%

RM 90000 (75000) 15000 10000 5000 1400

Cash Flow Upon Disposal Of Existing Machine

10000 1400

Question 2
Canggih Sdn. Bhd. is considering a new product. The company currently manufactures several lines of school uniform. The new product, Canggih Jean, is expected to generate sales of RM1.0 million per year for the next 5 years. They expected that during this five-year period, they will lose about RM250000 in sales of existing line of jean. The new line will require no additional equipment or space in the plant and can be produced in the same manner as the apparel products. The new project will, however, require that the company spend an additional RM80000 per year on insurance for raw materials. Also an additional marketing manager would be hired to oversee the line at a salary of RM45000 per year in salary and benefits, in additional to the current manager who is earning RM60000 per year in salary and benefits. Depreciation of RM100000 of existing plant and machinery is expected to remain the same. If the marginal tax rate is 28%, compute the incremental after tax cash flow for years 1-5.

Suggested Solutions: RM450000 per year Yearly Cash Inflow Revenue Operating Expenses: Additional Insurance New Marketing Manager Lost in Current Sale (Opportunity Costs) Depreciation (non-relevant costs) Net Profit Before Tax (Tax Payable) / Tax Saving 28% Profit After Tax Add: Depreciation Net Cash Flow Y1 1000000 (80000) (45000) (250000) 625000 (175000) 450000 450000 Y2 1000000 (80000) (45000) (250000) 625000 (175000) 450000 450000 Y3 1000000 (80000) (45000) (250000) 625000 (175000) 450000 450000 Y4 1000000 (80000) (45000) (250000) 625000 (175000) 450000 450000 Y5 1000000 (80000) (45000) (250000) 625000 (175000) 450000 450000

Question 3
A machine was purchases 10 years ago at a cost of RM15000. The expected life of the machine was 15 years. Its salvage value was and is still zero. The machine is depreciated using the straight-line basis. A new machine can be purchased for RM24000, which will result in cost savings for the firm of RM6000 per annum over the 5 year useful life. The new machine can be sold for RM4000 in 5 years time. The old machines market value is RM2000, which is below its RM5000 book value. If the n ew machine is purchased, the existing one will be sold immediately. The tax rate is 28%. Net working capital requirements will increase by RM2000 at the time of replacement. The new machine falls into the 3-year MACRS class (Depreciation in Year 1 33%; Year 2 45%; Year 3 15%; and, Year 4 - 7% on costs). The cost of capital is 12%. Determine the NPV of the replacement decision.

Question 4
Bina Mahjaya Sdn. Bhd. is a medium-sized manufacturing company that plans to increase capacity by purchasing new machinery at an initial cost of RM3m. The following are the most recent financial statements of the company: Profit and Loss Accounts for years ending 31 December 2002 RM000 Sales Production Costs Gross Profit Administration and Distribution Expenses Profit before Interest and Tax Interest Profit before Tax Tax Profit after Tax Dividends Retained Earnings 5,000 3,100 1,900 400 1,500 400 1,100 330 770 390 380 2001 RM000 5,000 3,000 2,000 250 1,750 380 1,370 400 970 390 580

The investment is expected to increase annual sales by 5,500 units. Investment in replacement machinery would be needed after five years. Financial data on the additional units to be sold is as follows: RM 500 200

Selling price per unit Production costs per unit

Variable administration and distribution expenses are expected to increase by RM220,000 per year as a result of the increase in capacity. In addition to the initial investment in new machinery, RM400,000 would need to be invested in working capital. The investment on working capital is released at the end of year 5. The full amount of the initial investment in new machinery of RM3 million will give rise to capital allowances on a 25% per year reducing balance basis. The tax benefit is as follows:

Year Capital Allowance Tax Benefits (Saving)

1 RM000 750 225

2 RM000 563 169

3 RM000 422 127

4 RM000 316 95

5 RM000 949 284

The scrap value of the machinery after five years is expected to be negligible. Tax liabilities are paid in the year in which they arise and Bina Mahjaya Sdn. Bhd. pays tax at 30% of annual profits. The Finance Director of Bina Mahjaya Sdn. Bhd. has proposed that the RM34 million investment should be financed by an issue of debentures at a fixed rate of 8% per year. Bina Mahjaya Sdn. Bhd. uses an after tax discount rate of 12% to evaluate investment proposals. In preparing its financial statements, Bina Mahjaya Sdn. Bhd. uses straight-line depreciation over the expected life of fixed assets. Required: Calculate the net present value of the proposed investment in increased capacity of Bina Mahjaya Sdn. Bhd. , clearly stating any assumptions that you make in your calculations.

2 (a) Calculation of tax benefits of capital allowances Year 1 2 RM000 RM000 Capital allowance 750 949 Tax benefits 225 169 Calculation of NPV of proposed investment: Year Sales Production costs Admin expenses Net revenue Tax payable Tax benefits Working capital Investment Project cash flows (400) (3,000) (3,400) 0 RM000 1 RM000 2,750 (1,100) (220) 1,430 (429) 225 1,226 1,226

3 RM000 563 127

4 RM000 422 95

5 RM000 316 284

2 RM000 2,750 (1,100) (220) 1,430 (429) 169 1,170 1,170

3 4 RM000 RM000 2,750 2,750 (1,100) (1,100) (220) (220) 1,430 1,430 (429) (429) 127 95 1,128 1,096

RM000 2,750 (1,100) (220) 1,430 (429) 284 1,285 400* 1,128 1,096 1,685

Discount factors Present values

1000 (3,400)

0893 1,095

0797 9325

0712 803

0636 697

0567 9555*

The net present value is approximately RM1,083,000

Question 5
You buy a transporter for $50 million. It will cost another $5 million to install. You will depreciate it over 10 years, (10% each year). You expect to make $15 million each year in revenues. Operating costs will be $2 million each year. Increase in working capital is expected to be $30 million which will be reversed at the end of 10 years when you get out of the transporting business. At the end of 10 years, the transporter will be salvaged for $10 million. You are in the 30% tax bracket. 1. What is your initial outlay? 2. What is your net income for the first nine years? 3. What is your operating cash flow each year? 4. What is your terminal cash flow at the end of year 10? Do not include the operating cash flow. ( 4 marks) Soln: 1. 50 + 5 + 30.= $85 milliom 2. Operating income $15 $2 = $13 depreciation (10% of 55 = 5.5) = $7.5 million before tax. $7.5(1-.3) = $5.25 million after tax. 3. Operating cash flow is 5.25 + 5.5(depreciation) = $10.25 million. 4. Sell for $10 million, book value is zero at this time so you have a gain of $10 million minus $3 million in taxes for $7 million. Add back working capital of $30 million (no longer will need it so working capital is now reduced by $30 million) so terminal cash flow is $37 million.

Question 6: New project NPV

The expansion will require the company to increase its net operating working capital by $500,000 today (t = 0). This net operating working capital will be recovered at the end of four years (t = 4). The equipment is not expected to have any salvage value at the end of four years. The companys operating costs, excluding depreciation, are expected to be 60 percent of the companys annual sales. The expansion will increase the companys dollar sales. The projected increases, all relative to current sales are: Year 1: Year 2: $3.0 million 3.5 million

Year 3: Year 4:

4.5 million 4.0 million

(For example, in Year 4 sales will be $4 million more than they would have been had the project not been undertaken.) After the fourth year, the equipment will be obsolete, and will no longer provide any additional incremental sales. The companys tax rate is 40 percent and the companys other divisions are expected to have positive tax liabilities throughout the projects life. If the company proceeds with the expansion, it will need to use a building that the company already owns. The building is fully depreciated; however, the building is currently leased out. The company receives $300,000 before-tax rental income each year (payable at year end). If the company proceeds with the expansion, the company will no longer receive this rental income. The projects WACC is 10 percent. What is the proposed project's NPV? a. b. c. d. e. -$1,034,876 -$1,248,378 -$1,589,885 -$5,410,523 -$ 748,378

i.

New project NPV

Answer: b Diff: T

Year 1 2 3 4

Annual Depreciation $1,650,000 2,250,000 750,000 350,000 4 $4,000,000 2,400,000 350,000 $1,250,000 500,000 $ 750,000 350,000 $1,100,000 (180,000) $ 500,000 $1,420,000

The following table shows how to compute the cash flows: 0 1 2 3 Cost ($5,000,00 Net operating working capital (500,000) 0) Sales $3,000,000 $3,500,000 $4,500,000 Operating costs, excl. depr. (60%) 1,800,000 2,100,000 2,700,000 Depreciation 1,650,000 2,250,000 750,000 Operating income before taxes ($ 450,000) ($ 850,000) $1,050,000 Taxes (40%) (180,000) (340,000) 420,000 After-tax operating income Plus: Depreciation After-tax operating cash flows After-tax loss of rental income Recovery of net operating working capital Net cash flow ($5,500,000) ($ 270,000) 1,650,000 $1,380,000 (180,000) ($ 510,000) 2,250,000 $ 630,000 750,000

$1,740,000 $1,380,000 (180,000) (180,000)

$1,200,000

$1,560,000

$1,200,000

Enter the NCF amounts into the cash flow register (at 10%) and obtain the NPV of the cash flows is -$1,248,378. (10 MARKS )

Question 7
LitrakNPC Sdn. Bhd. is considering an investment proposal that requires initial investments of RM250000 in plant and machinery. Fully depreciate existing equipment may be disposed off for RM40000 before tax. The proposed project will have a five-year life, and is expected to produce additional revenue of RM80000 per year. Expenses other than depreciation will be RM15000 per year. The new plant and machinery will be depreciated to zero over the five year useful life, but it is expected to be sold for RM30000. The corporation tax rate is 28%. 1. What is the initial outlay for the proposed project? Cost of new P&M Cash inflow from disposal of existing asset = RM40000 (1-28%) Net Initial Outlay 2. What is the operating cash inflow from years 1-4? (2 marks) = RM250000 - 1 = (RM28800) 1 = RM221200 ( 3 marks)

Cash inflow Year 1-4 Amount (RM) Revenue 80000 - Less; Operating (15000) Depreciation (250000/5) (50000) - 1 PBT 15000 Tax 28% (4200) PAT 10800 Add: depreciation 50000 Cash inflow 60800

3.

What is the total cash flow at the end of year five (operating cash flow for year five plus terminal cash flow)? (2 marks) Cash inflow Year 5 Amount (RM) Cash inflow Disposal of Asset Book Value Sold Gain Tax 28% Cash inflow Gross Inflow 0 30000 30000 8400 30000 - 8400 21600 82400 60800

4.

What is the NPV for this project (cost of capital is 8%) PV 201375.68 56081.44 257457.12 (221200) 1 36257.12

(3 marks)

Item Cash Inflow Year 1- 4 Terminal Cash inflow YR5 Initial Outflow

60800 per year 82400

PV 8% 5 yrs 60800 x 3.3121 - 1 82400 x 0.6806 - 1

NPV

Question 8 Given the following information, calculate the NPV of a proposed project: Cost = $4,000; estimated life = 3 years; initial decrease in accounts receivable = $1,000, which must be restored at the end of the projects life; estimated salvage value = $1,000; earnings before taxes and depreciation = $2,000 per year; tax rate = 40 percent; and cost of capital = 18 percent. The applicable depreciation rates are 33 percent, 45 percent, 15 percent, and 7 percent. a. b. c. d. $1,137 -$ 151 $ 137 $ 544

Question 10: Relevant Cash Flows and Calculation of NPV and Payback Period. (14 marks)

a. The management of SevenDragon Restaurant has been experiencing losses in the most recent months and is considering converting the operations to drive-in fast food takeaways. The fitting-out of the premise will cost RM40,000, and the equipment will have a life of ten years with th disposal value of RM1000. However, RM8,000 overhaul is necessary at the end of the fifth (5 ) year. Currently the restaurant incurred RM30,000 per annum to operate and did breakeven in this past year. The new service will save RM10,000 of these costs. Projected sales are 1,000 units per week, for full 52 weeks per year except in year 5 when the overhaul will force a 4-weeks shutdown. Each unit will provide a contribution of RM0.20. Ignore Tax REQUIRED: i. The annual cash inflows (and outflows) expected from the new project over the life of the asset.. ii. The Net Present Value of the operations if management is expecting a 20% rate of return. (Ignore taxes) (10 marks) b. Calculate the Payback Period using the above example. (4 marks)

Solutions: a.i. Initial Investment Saving Sales 1000 x 0.20 x 52 weeks 1000 x 0.20 x 48 weeks Overhaul Disposal Price Net Cash Inflow Discount Factor 20% / PV of inflows / NPV Yr0 (40000)/ Yr1 Yr2 Yr3 Yr4 Yr5 Yr6 Yr7 Yr8 Yr9 Yr10

10000// 10400//

10000 10400

10000 10400

10000 10400

10000

10000 10400

10000 10400

10000 10400

10000 10400

10000 10400

9600/

(8000)/ 1000 / (40000) 20400 0.8333 20400 0.6944 20400 0.5787 20400 0.4823 1600 0.4019 20400 0.3349 20400 0.2791 20400 0.2326 20400 0.1938 21400 0.1615

82161 (40000) 42161/ (10 marks)

Payback 1 + (40000-20400) = 1 + 19600 = 1.96 years 20400 20400 (4 marks)

Question9
DIGITAL TWO plc, a software company, has developed a new game, Narugo, which it plans to launch in the near future. Sales of the new game are expected to be very strong, following a favourable review by a popular PC magazine. DIGITAL TWO plc has been informed that the review will give the game a Best Buy recommendation. Sales volumes, production volumes and selling prices for Narugo over its four -year life are expected to be as follows.

Year Sales and production (units) Selling price (RM per game)

1 2 150,000 70,000 RM25 RM24

3 60,000 RM23 60,000

4 RM22

Financial information on Narugo for the first year of production is as follows: Direct material cost RM540 per game Other variable production cost RM600 per game Fixed costs RM600,000 per year Advertising costs to stimulate demand are expected to be RM650,000 in the first year of production and RM100,000 in the second year of production. No advertising costs are expected in the third and fourth years of production. Narugo will be produced on a new p roduction machine costing RM800,000. Although this production machine is expected to have a useful life of up to ten years, government legislation allows DIGITAL TWO plc to claim the capital cost of the machine against the manufacture of a single product. Capital allowances will therefore be claimed on a straight-line basis over four years.

DIGITAL TWO plc pays tax on profit at a rate of 30% per year and tax liabilities are settled in the year in which they arise. DIGITAL TWO plc uses an after-tax discount rate of 10% when appraising new capital investments. Ignore inflation. Required: (a) Calculate the net present value of the proposed investment and comment on your findings. (14marks)

Year Sales Revenue Direct materials Variable production Advertising Fixed costs Depreciation EBT Tax 30% EAT +Depreciation Net cash flow Discount 10% PV

Y1 000 3750 (810) (900) (650) (600) (200) 590 (177) 413 200 613 0.909 557.2 PV Initial Investment NPV

Y2 000 1680 (378) (420) (100) (600) (200) (18) 5.4 (12.6) 200 187.4 0.826 154.8 865.74 800 65.74

Y3 000 1380 (324) (360) (600) (200) (104) 31.2 (72.8) 200 127.2 0.751 95.53

Y4 000 1320 (324) (360) (600) (200) (164) 49.2 (114.8) 200 85.2 0.683 58.2

28 items @ = 14 marks.

(b) Operating cash flows rather than operating profit formed the basis for capital budgeting decisions. Briefly explain THREE (3) types of costs that need to be considered in determining incremental cash flows. (3 marks) Sunk Costs 1 mark Opportunity costs 1 mark Externalities. 1 mark (c) Lists THREE reasons why the net present value investment appraisal method is preferred to other investment appraisal methods such as payback, return on capital employed and internal rate of return. (3 marks) Any Three NPV considers cash flows 1 mark NPV considers the whole of an investment project 1 mark NPV considers the time value of money 1 mark NPV is an absolute measure of return 1 mark NPV links directly to the objective of maximising shareholders wealth

Question 10
LBD Bina Sdn. Bhd., a manufacturer of electronic equipment, has prepared the following draft financial statements for the year ended 2006. These financial statements have not yet been made public. Profit and loss account RM000 Turnover 9,600 Cost of sales 5,568

Gross profit Operating expenses Profit before interest and tax Interest 156 Profit before tax Taxation Profit after tax Dividends Retained profit 468

4,032 3,408 624 140 328 300 28 RM000 1,000

3,100 4,100 LBD Bina Sdn. Bhd. plans to invest RM1 million in a new product range and has forecast the following financial information: Year Sales volume (units) Average selling price (RM/unit) Average variable costs (RM/unit) Fixed costs (RM/year) 1 70,000 90,000 40 45 30 500,000 500,000 2 3 100,000 75,000 51 51 28 27 500,000 500,000 4

Balance Sheet Capital and reserves: Ordinary shares, par value 50cents Profit and loss

27

The above cost forecasts have been prepared on the basis of current prices and no account has been taken of depreciation, inflation of 4% per year on variable costs and 3% per year on fixed costs. Working capital investment accounts for RM200,000 of the proposed RM1 million investment and machinery for RM800,000. LBD Bina uses a four-year evaluation period for capital investment purposes, but expects the new product range to continue to sell for several years after the end of this period. Capital investments are expected to pay back within two years on an undiscounted basis, and within three years on a discounted basis. The company pays tax on profits in the year in which liabilities arise at an annual rate of 26% and depreciation on machinery on a 25% per year basis.

The ordinary shareholders of LBD Bina Sdn. Bhd. require an annual return of 12%. Its ordinary shares are currently trading on the stock market at RM180 per share. The dividend paid by the company has increased at a constant rate of 5% per year in recent years and, in the absence of further investment, the directors expect this dividend growth rate to continue for the foreseeable future.

Required: (a) (i) Calculate the current dividend per share of LBD Bina Sdn. Bhd. (2 marks) (ii) Calculate the ordinary share price of LBD Bina Sdn. Bhd. predicted by the dividend growth model. (4 marks)

1 (a) (i) Number of ordinary shares = 1,000,000/05 = 2 million Current dividend per share = 100 x (300,000/2,000,000) = 15p (ii) Share price predicted by dividend growth model = (15 x 105)/(012 005) = 225p

(b) (i) Using LBD Bina Sdn. Bhd.s current average cost of capital of 10%, calculate the net present value of the proposed investment. (14 marks) Exhibit 1 Present Value of RM1 at the End of n Periods: Period 1 2 3 4 5 10% 0.9091 0.8264 0.7513 0.6830 0.6209 Present Value of an Annuity of RM1 per Period for n Periods: 10% 0.9091 1.7355 2.4869 3.1699 3.7908

Total: 20 Marks

(b) (i) Calculation of NPV Year Sales revenue Variable costs Contribution Fixed costs Depreciation Taxable cash flow Taxation - 26%

Depreciation After-tax cash flow 11% discount factors Present values

1 RM000 2,800 2,184 616 515 200 -99 26 -73 200 127 09091 116

2 RM000 4,050 2,722 1,328 530 200 598 -156 442 200 642 08264 531

3 RM000 5,100 3,024 2,076 546 200 1,330 -346 984 200 1,184 07513 890

4 RM000 3,825 2,349 1,476 563 200 713 -185 528 200 728 06830 497

RM000 2,034 1,000 Net present value 1034 Because the investment continues in operation after the four-year period, working capital is not recovered in the above calculation. It is possible to make an assumption concerning incremental investment in working capital to accommodate inflation, but no specific inflation rate for working capital is provided. An assumption of 34% inflation in working capital would be reasonable given the expected inflation in variable and fixed costs. Sum of present values of future benefits Less initial investment

(ii) Calculate, to the nearest month, the payback period and the discounted payback period of the proposed investment. (4 marks)

Payback = 2 + (1000 127 642 ) = 2.2 years 1184 Discounted Payback = 2 years + (1000 116 531 ) = 2.4 years 890 (iii) Discuss the acceptability of the proposed investment based on the calculation made in b(i) and b(ii) and explain ways in which your net present value calculation could be improved.

(iii) The proposed investment has a positive net present value of RM833,000 over four years of operation compared with an initial investment of RM1 million and so is financially acceptable. The company has payback and discounted payback targets, but these are not a guide to project acceptability because of the shortcomings of payback as an investment appraisal method. The proposed investment fails to meet the payback target of two years, but meets the discounted payback target of three years. While discounted payback counters the criticism that payback ignores the time value of money, it still ignores cash flows outside of the discounted payback period and so cannot be recommended to evaluate other than conventional investments. The net present value calculation could be improved in several ways. One obvious improvement would be the consideration of project cash flows beyond the four-year evaluation period used by Hendil plc. The company expects the new product range to sell for several years after the end of the evaluation period and if these sales are at a profit, the net present value would be higher than calculated. Another improvement would be more detailed information about the new product range, for which only average selling price and average variable cost data are provided. The basis for these averages is not stated and it is not known whether the products in the new range are substitutes or alternatives, or whether a constant product mix is being assumed. The basis for the changing annual sales volumes should also be explained. The assumption of constant annual inflation for variable and fixed costs is questionable. The information provided implies that inflation may have been taken into account in forecasting selling prices, but the selling price growth rates are sequentially 125%, 133% and zero, and so some factor other than inflation has also been used in the selling price forecast. The net present value evaluation could be improved if the basis for the forecast was known and could be verified as reasonable.

Question 11
You have been asked by the president of your company to evaluate the proposed acquisition of new equipment. The equipments basic price is RM193000, and shipping costs will be RM7700. It w ill cost another RM23200 to modify it for special use by your firm and an additional RM13500 to install the equipment. The equipment falls in the MACRS 3-year class, and it will be sold after 3 years for RM30900. The equipment is expected to generate revenue of RM178000 per year with annual operating costs (excluding depreciation) of RM84000. The firms tax rate is 28% and its cost of capital is 10%.. REQUIRED: i. ii. iii. What is the firms initial investment of the machine and What is the operating cash flow form Year 1 - 3? Should the company invest in this new equipment?

Note: Under the MACRS 3-year class, depreciation is 33% in first year, 45% in second year, 15% in third year and 7% in fourth year.

Initial Investment (Cash Outflow) Y0 RM Price of Equipment 193000 ADD:

Shipping costs Modification costs Installation Initial Outlay

7700 23200 13500 237400

Yearly Cash Inflow Revenue Operating Expenses Depreciation Net Profit Before Tax (Tax Payable) / Tax Saving 28% Profit After Tax Add: Depreciation Cash Inflow PV Factor, Lump Sum, 10% PV of Inflow

Y1 178000 (84000) (78342) 15658 (4384.24) 11273.76 78342 89615.76 0.9091 81469.69

Y2 178000 (84000) (106830) (12830) 3592.40 (9237.60) 106830 97592.40 0.8264 80650.36

Y3 178000 (84000) (35610) 58390 (16349.20) 42040.80 35610 77650.80 0.7513 58339.05

Total

220459.09

Terminal Year Cash Flow Y3 Cost Of Equipment Less: Accumulated Depreciation Book Value Disposal Price Gain on Disposal Tax on Gain 28% Net Gain Terminal Year Cash Inflow PV Factor, Lump Sum, 10% Present Value RM 237400 (220782) 16618 (30900) 14282 (4000) 10282

30900 (4000) 26900 0.7513 20201

Net Present Value RM Initial Outlay (237400) Present Value of Future Cash Inflows 220459.09 Present Value Terminal Cash Flow Y3 20201 NPV 3260.09 Decision invest in the new equipment since the NPV is positive.