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# Strictly for course AB1201 internal circulation only.

AB1201 Financial Management
Tutorial 9: Cash Flow Estimation
(Common Questions)
Questions 1 to 3 will be presented by students while Question 4 will be presented by instructors.

1) Scenario analysis. Huang Industries is considering a proposed project whose estimated NPV is
\$12 million. This estimate assumes that economic conditions will be average. However, the
CFO realizes that conditions could be better or worse, so she performed a scenario analysis and
obtained these results:

## Recession 0.05 (\$70 million)

Below average 0.20 (25 million)
Average 0.50 12 million
Above average 0.20 20 million
Boom 0.05 30 million

Calculate the projects expected NPV, standard deviation, and coefficient of variation.

2) New project analysis. You must analyze a potential new product--a caulking compound that
Cory Materials' R&D people developed for use in the residential construction industry. Cory's
marketing manager thinks the company can sell 115,000 tubes per year for 3 years at a price of
\$3.25 each, after which the product will be obsolete. The required equipment would cost
\$150,000, plus another \$25,000 for shipping and installation. Current assets (receivables and
inventories) would increase by \$35,000, while current liabilities (accounts payable and accruals)
would rise by \$15,000. Variable costs would be 60% of sales revenues, fixed costs (exclusive of
depreciation) would be \$70,000 per year, and fixed assets would be depreciated under MACRS
with a 3-year life, with applicable depreciation rates 33%, 45%, 15%, and 7%. When production
ceases after 3 years, the equipment should have a market value of \$15,000. Cory's tax rate is 40%,
and it uses a 10% WACC for average-risk projects.
a) Assume that the project is of average risk, calculate the NPV.
b) Suppose you now learn that R&D costs for the new project were \$30,000 and that those costs
were incurred and expenses for tax purposes last year. How would this affect your estimate of
NPV?
c) If the new project would reduce cash flows from Corys other projects and if the new project
would be housed in an empty building that Cory owns and could sell, how would those factors
affect the projects NPV.

3) Scenario analysis. Your firm, Agrico Products, is considering a tractor that would have a net
cost of \$36,000, would increase pre-tax operating cash flows (i.e., sales operating costs
excluding depreciation) before taking account of depreciation by \$12,000 per year, and would be
depreciated on a straight-line basis to zero over 5 years at the rate of \$7,200 per year, beginning
the first year. (Thus annual cash flows would be \$12,000, before taxes, plus the tax savings that
result from \$7,200 of depreciation.) The managers are having a heated debate about whether the
tractor would actually last 5 years. The controller insists that she knows of tractors that have
lasted only 4 years. The treasurer agrees with the controller, but he argues that most tractors
actually do give 5 years of service. The service manager then states that some actually last for as
long as 8 years.

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Given this discussion, the CFO asks you to prepare a scenario analysis to determine the
importance of the tractors life on NPV. Use a 40 percent marginal federal-plus-state tax rate, a
zero salvage value, and a WACC of 10 percent. Assuming each of the indicated lives has the
same probability of occurring (probability = 1/3), what is the tractors expected NPV? (Hint:
Here straight-line depreciation is based on the MACRS class life of the tractor and is not affected
by the actual life. Also, ignore the half-year convention for this problem.)

4) Replacement Analysis. The Erley Equipment Company purchased a machine 5 years ago at a
cost of \$90,000. The machine had an expected life of 10 years at the time of purchase, and it is
being depreciated by the straight-line method by \$9,000 per year. If the machine is not replaced,
it can be sold for \$10,000 at the end of its useful life.
A new machine can be purchased for \$150,000, including installation costs. During its 5-year
life, it will reduce cash operating expenses by \$50,000 per year. Sales are not expected to change.
At the end of its useful life, the machine is estimated to be worthless. MACRS depreciation will
be used. The machine will be depreciated over its 3-year class life rather than its 5-year
economic life; so the applicable depreciation rates are 33%, 45%, 15%, and 7%.
The old machine can be sold today for \$55,000. The firms tax rate is 35%. The appropriate
WACC is 16%.
a) If the new machine is purchased, what is the amount of initial cash flow at Year 0?
b) What are the incremental project free cash flows that will occur at the end of Year 1 through
Year 5?
c) What is the NPV of this project? Should Erley replace the old machine? Explain.
___________________________________________________________________________

Self-practice Questions

Question 1
LeXing Ltd is a manufacturer of data modems. It has recently hired a marketing consultant at a cost
of \$200,000 to carry out a feasibility study on a new 4-year project to manufacture USB-Modems
for the export market. LeXing owns an industrial property that was bought 3 years ago at a cost of
\$1.2 million for investment purpose, and its original plan was to sell the property at the current
market value of \$1.3 million on an after-tax basis. Since the new project will be occupying the
premises, the company now plans to sell the property only at the end of 4 years, but at an estimated
value of \$1.4 million on an after-tax basis. The new project also requires \$400,000 investment in
fixed assets, which have an estimated salvage value of \$60,000 at the end of the project. The assets
will be depreciated fully on a straight-line basis over 4 years (ignore salvage value when computing
annual depreciation). Annual sales generated from this project are estimated as follows:

## Year 1 sales : \$2,000,000

Year 2 sales : \$2,500,000
Year 3 sales : \$3,000,000
Year 4 sales : \$4,000,000

Total annual operating costs (not including depreciation) are estimated to be 60% of sales. Due to
this new project, the companys current assets will increase by \$100,000, and accounts payable will
also increase by \$40,000. All other components of operating working capital are expected to stay
the same. The changes in operating working capital are expected to be completely recovered at the
end of the project. The project will also cause its after-tax cash flows from its desktop modem
products to decrease by \$30,000 per year. LeXings marginal corporate tax rate is 30%.

Compute the relevant annual project free cash flows (i.e. cash flow for Year 0 to Year 4) for
evaluating this new project.

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Question 2

Creston Printing Corporation purchased a press printing machine 5 years ago for \$400,000. At the
time of purchase, the machine had an estimated useful life of 10 years. Depreciation is straight-line
over 10 years, and its estimated salvage value (before-tax) is \$20,000 at the end of its useful life.
This machine can be sold currently for \$220,000 (before tax).

Creston is considering whether to replace this old press printing machine with a new one. You were
sent to a trade show to source for whether there is a better and more advanced press printing
machine. The cost of sending you to the trade show was \$5,000.

At the trade show you collected the following details on a suitable new model of advanced press
printing machine:

## Purchase cost: \$350,000

Useful life: 5 years
Salvage value (before-tax): \$30,000

The new machine will have straight-line depreciation over its useful life. It will also reduce the
current pre-tax annual operating expenses (excluding depreciation expense) by \$40,000. Corporate
tax rate is 25%.

(a) What are the relevant initial cash flow, annual free cash flows, and terminal cash flow that
should be used to evaluate this replacement project? Assume that the new machine would
replace the old machine at the end of the 5th year of the old machines life if there is a
replacement.

(b) If Crestons weighted average cost of capital is 12%, calculate the NPV of this replacement
project. Should the company replace the old press printing machine with the new one?

(c) If Creston has 200,000 ordinary shares, what will be the expected increase or decrease in the
intrinsic value of its shares if the replacement project is accepted?

Question 3

## Valcon Corporation is considering purchasing a \$500,000 equipment. It intends to use the

equipment for 6 years. At the end of the 6th year, the equipment is expected to be sold, generating
an after-tax cash flow of \$X. For each of the 6 years, the equipment is expected to generate after-
tax cash flow with the following probabilities:

## Probability After-tax cash flow

0.10 \$ 50,000
0.20 \$100,000
0.40 \$150,000
0.30 \$200,000

Valcon's target capital structure is 35% debt, 15% preferred stock and 50% common stock.
Currently, its common stock is traded at a price of \$10 per share. The company has just paid
dividends of \$1.10 per share. The perpetual common dividend growth rate is constant at 5%. The
company's preferred stock is selling at \$30 and its required rate of return is 6% in the current
market. Flotation costs have been estimated at 6% for common stock and 3% for preferred stock.

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Valcon has bonds outstanding at 10% coupon rate, but interest rates for bonds of equal risk are
currently yielding 7% in the market. Valcon's tax rate is 30%.

(a) What is the expected annual after-tax free cash flow for the next 6 years?

(b) What is Valcons weighted average cost of capital (WACC) if it has to issue new preferred
stock and new common stock?

(c) If Valcon requires the expected Net Present Value for this project to be at least \$150,000,
what should be the after-tax cash flow from the sale of the machine, \$X, be?

(d) Assuming Valcon decides that at the end of the 6th year, instead of selling the equipment, it
will continue to operate the equipment to generate further after-tax cash flow of \$Y per year
for additional 3 years (after which the salvage value of the equipment will be zero), what
must the value of \$Y be if Valcon wants to achieve an expected Modified Internal Rate of
Return (MIRR) of 15%?

Question 1
Initial investment (Yr 0)
= Fixed assets investment + Opportunity costs of property + (Change in NOWC)
= 400,000 + 1,300,000 + (100,000 40,000) = \$1,760,000

OCF1 (Yr 1) = (Sales Op. costs Depreciation)(1 Tax Rate) + Depreciation Externality
= [2,000,000 0.6(2,000,000) 400,000/4](1 30%) + 400,000/4 30,000
= \$560,000

OCF2 (Yr 2) = (Sales Op. costs Depreciation)(1 Tax Rate) + Depreciation Externality
= [2,500,000 0.6(2,500,000) 400,000/4](1 30%) + 400,000/4 30,000
= \$700,000

OCF3 (Yr 3) = (Sales Op. costs Depreciation)(1 Tax Rate) + Depreciation Externality
= [3,000,000 0.6(3,000,000) 400,000/4](1 30%) + 400,000/4 30,000
= \$840,000

OCF4 (Yr 4) = (Sales Op. costs Depreciation)(1 Tax Rate) + Depreciation Externality
= [4,000,000 0.6(4,000,000) 400,000/4](1 30%) + 400,000/4 30,000
= \$1,120,000

## Terminal cash flow (Yr 4)

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= Recovery of NOWC + After-tax cash from sale of property + Cash from salvage of fixed assets
= 60,000 + 1,400,000 + (60,000)(1 30%) = \$1,502,000

FCF0 = -1,760,000
FCF1 = 560,000
FCF2 = 700,000
FCF3 = 840,000
FCF4 = 1,120,000 + 1,502,000 = 2,622,000

Question 2

## Book value of old machine = \$400,000 x (5/10) = \$200,000

Tax on salvage of old machine = (220,000 200,000)(0.25) = \$5,000
Net cash flow from selling old machine = 220,000 5,000 = 215,000

## Purchase price of new machine (\$350,000)

Net cash flow from old machine sales 215,000
FCF (\$135,000)

## Annual operating cash flows (OCF1 to OCF5)

Method 1:
Depreciation tax-shield:
Annual depreciation of new machine = \$350,000 x (1/5) = \$70,000
Increase in annual depreciation = 70,000 40,000 = \$30,000
Annual tax-shield on depreciation = 30,000(0.25) = \$7,500

## OCF1 to OCF5 = 7,500 + 30,000 = \$37,500

Method 2:
If the machine is not replaced:
CF1 to CF5 = (Sales 400,000/10 OP)*(1-0.25) + 400,000/10
= (Sales OP)*(1-0.25) + 400,000/10*0.25
= (Sales OP)*(1-0.25) + 10,000
*Note that OP indicates the operating expenses (excluding depreciation) under the old
machine.

## If the machine is replaced:

CF1 to CF5 = (Sales 350,000/5 OP)*(1-0.25) + 350,000/5
= (Sales (OP-40,000))*(1-0.25) + 70,000*0.25
= (Sales OP)*(1-0.25) + 40,000*(1-0.25) + 70,000*0.25
= (Sales OP)*(1-0.25) + 47,500

*Note that OP indicates the operating expenses (excluding depreciation) under the new
machine. Therefore, OP = OP-40,000 since under the new machine, other operating
expenses decrease by \$40,000.

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## The change in the cash flows, OCF1 to OCF5

= CF - CF
= (Sales OP)*(1-0.25) + 47,500 [(Sales OP)*(1-0.25) + 10,000]
= 37,500

## After-tax salvage of new machine = 30,000(1 0.25) = \$22,500

Foregone after-tax salvage for old machine = 20,000(1 0.25) = \$15,000

## (b) PV = -135,000 + 37,500/(1+12%) + 37,500/(1+12%)2 + 37,500/(1+12%)3

+ 37,500/(1+1%)4 + 37,500/(1+12%)5 + 7,500/(1+12%)5
= \$4,434.81

Since the NPV is positive, the company should replace the old press printing machine with
the new one.

Question 3

## (a) Expected annual cash flow

= 0.10 x \$50,000 + 0.20 x \$100,000 + 0.40 x \$150,000 + 0.3x\$200,000
= \$145,000

(b) Debt:
rd = 7% (1 0.30) = 4.90%

Preferred stock:
Flotation cost per preferred stock = 3% x \$30 = \$0.90
Dividend per preferred stock = 6% x \$30 = \$1.80
Therefore, rp = 1.80 / (30 0.90) = 6.186%

New Equity:
D1 = \$1.10 x 1.05 = \$1.155
Floatation cost per common stock = 6% x \$10 = \$0.60
rs = 1.155/(10 0.60) + 5% = 17.287%

## WACC = 0.35x4.90% + 0.15x6.186% + 0.50x17.287% = 11.286%

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(c) Step 1:
Using the WACC of 11.286%, find the PV of the 6-year \$145,000 ordinary annuity:

## PV = PMT [1 - 1/(1 + I)N ] / I

= 145,000 [1 1/(1 + 11.286%)6] / 11.286% = \$608,406.94

Step 2:
Find the PV f the salvage value \$X:

PV = X / (1 + 11.286%)6

Step 3:
Deducting investment cost of \$500,000 from the total PV, and equate to \$150,000:

## Solving for X = \$79,006.73

(d) 0 1 2 3 4 5 6 7 8 9
|---------|----------|----------|----------|----------|----------|----------|----------|----------|
-500K 145K 145K 145K 145K 145K 145K Y Y Y

Step 1:
Using the WACC of 11.286%, find the FV of the 6-year \$145,000 ordinary annuity at the
end of Year 6:

## FVA6 = {PMT (1 + I)N - 1} / I

= 145,000 {(1 + 11.286%)6 1} / 11.286% = \$1,155,679.36

Step 2:
Using WACC of 11.286%, compound FVA6 to end of Year 9:
FV9 = \$1,155,679.36 (1 + 11.286%)3 = \$1,592,791.59

Step 3:

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## Bring the last 3 cash flows of \$Y to end of Year 9:

FV3Y = Y(1 + 11.286%)2 + Y(1 + 11.286%) + Y = 3.3513Y

Step 4:
Total cash flow at the end of Year 9 = FV9 + FV3Y = 1,592,791.59 + 3.3513Y

With initial investment of \$500,000 and the given MIRR of 15%, solve for Y:
500,000(1 + 15%)9 = 1,592,791.59 + 3.3513Y
Y = \$49,576.75

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