UNIVERSITY OF TECHNOLOGY, JAMAICA

SCHOOL OF BUSINESS ADMINISTRATION

CORPORATE FINANCE

February 6-13, 2011 Tutorial Sheet 3A: Cash Flow Estimation

Students are encouraged to attempt all questions prior to class. It may not be possible for tutors to discuss all tutorial questions. 1. Operating cash flows rather than accounting profits are used in cash flow estimation. What is the basis for emphasis on cash flows as opposed to net income?

2. Explain why sunk costs should not be included in a capital budgeting analysis, but opportunity costs and externalities should be included.

3. Explain how net operating working capital is recovered at the end of a projects life and why it is included in a capital budgeting analysis.
4. Johnson Industries is considering an expansion project. The necessary equipment

could be purchased for $9 million, and the project would also require an initial $3million investment in net operating working capital. The companys tax rate is 40 percent. What is the projects initial investment outlay? (11-1) 5. Nixon Communications is trying to estimate the first year operating cash flow (at t=1) for a proposed project. The financial staff has collected the following information. Projected sales Operating costs (not including depreciation) Depreciation Interest expense $10 million $ 7 million $ 2 million $ 2 million

The companys tax rate is 40 percent. What is the projects operating flow for the first year (t=1). (11-2)
6. Carter Air Lines is now in the terminal year of a project. The equipment originally

cost 20 million, of which 80 percent has been depreciated. Carter can sell the used

equipment today to another airline for $5 million, and its tax rate is 40 percent. What is the equipments after tax net salvage value? (11-3)
7. The Campbell Company is evaluating the proposed acquisition of a new milling

machine. The machines base price is $108,000, and it would cost another $12, 500 to modify it for special use by your firm. The machine falls into the MACRS 3-year class, and would be sold after three years for $65,000. The applicable depreciation rates are 33 percent, 45 percent, 15 percent, and 7 percent. The machine would require an increase in net operating working capital (inventory) of $5,500. The machine would have no effect on revenues, but is expected to save the firm $44,000 per year in before tax operating costs, mainly labor. Campbells marginal tax rate is 35 percent. (11-8) a. What is the net cost of the machine for capital budgeting purposes (That is what is Year 0 net cash flow? b. What are the net operating cash flows in Years 1, 2, and 3? c. What is the terminal cash flow? d. If the projects cost of capital is 12 percent, should the machine be purchased? 8. Holmes Manufacturing Company is considering the purchase of a new machine for $250,000 that will reduce manufacturing costs by $90,000 annually. Holmes will use the MACRS accelerated method to depreciate the machine, and it expects to sell the machine at the end of the 5 year operating life for $23,000. The applicable depreciation rates are 33%, 45%, 15%, 7%. The firm will need to increase net operating working capital by $25,000 when the machine is installed, but required operating working capital return to the original level when the machine is sold after 5 years. Holmes marginal tax rate is 40%, and it uses a 10% cost of capital to evaluate projects of this nature.

(a) What is the projects NPV? (b) Assume the firm is unsure about the savings to operating costs that will occur with the new machines acquisition. Management believes these savings may deviate from their base-case value ($90,000) by as much as plus or minus 20%. What is the NPV of the project under both situations? 9. Maple Media is considering a proposal to enter a new line of business. In reviewing the proposal, the companys CFO is considering the following facts: The new business will require the company to purchase additional fixed assets that will cost $600,000 at t = 0. For tax and accounting purposes, these costs will be depreciated on a straight-line basis over three years. (Annual depreciation will be $200,000 per year at t = 1, 2, and 3.)

 At the end of three years, the company will get out of the business and will sell the fixed assets at a salvage value of $100,000. The project will require a $50,000 increase in net operating working capital at t = 0, which will be recovered at t = 3. The companys marginal tax rate is 35 percent. The new business is expected to generate $2 million in sales each year (at t = 1, 2, and 3). The operating costs excluding deprecia-tion are expected to be $1.4 million per year. The projects cost of capital is 12 percent. What is the projects net present value (NPV)?