Question

1. The Sturgeon Corp. has developed a new line of spinning reel it plans to produce and sell in the United States. The cost of the necessary equipment will be $2.8 million plus $340,000 for installation and delivery. The equipment falls into the MACRS 7-year class. The equipment will be scrapped when the project is finished in 5 years for an estimated $700,000. Sturgeon estimates that sales in the first year of production will be 110,000 units at $30 apiece. Due to intense marketing and word-of-mouth advertising, they believe sales will increase by 50% in the second year. Sales are estimated to grow at 10% in the third year. Sales in year 4 and 5 will be the same as in year 3. Variable production costs will be 65% of sales. Fixed costs will be $250,000 in year 1, and will increase at 4% per year. The sales price of the spinning reel is estimated to increase at 4% per year over the life of the project also. Net operating working capital requirements will be 6% of sales. If Sturgeon is in the 40% tax bracket, what will be the cash flows for each year of this project (don’t forget time 0 and the extra terminal year cash flows) Also calculate the NPV assuming Sturgeon has a 12% cost of capital. Should Sturgeon Accept the project?  

2. Explain the major differences between cash flows for replacement (cost cutting) projects versus cash flows for expansion projects.

3. What are substitutionary and complementary effects in the context of capital budgeting cash flow analysis? Give an example of each.  

4. What are opportunity costs in cash flow analysis?  

Answer 1

NPV Calculations	Year 0	1	2	3	4	5
Initial cost+Installation	-3140000
NWC introduced in the yr.		-198000	-99000	-29700	0	0
NWC recovered						326700
After-tax salvage						700214
CAPEX & NWC cash flows----1	-3140000	-198000	-99000	-29700	0	1026914
Operating Cash Flows:
Total sale value		3300000	4950000	5445000	5445000	5445000
Less: Variable prodn. Costs(65%*Sales)		2145000	3217500	3539250	3539250	3539250
Less: Fixed costs		250000	260000	270400	281216	292465
Less: Depreciation		448706	768986	549186	392186	280402
EBT		456294	703514	1086164	1232348	1332883
Less: Tax at 40%		182518	281406	434466	492939	533153
EAT		273776	422108	651698	739409	799730
Add Back: Depn.		448706	768986	549186	392186	280402
Annual Operating cash flow---2		722482	1191094	1200884	1131595	1080132
Total annual cash flows(1+2)	-3140000	524482.4	1092094	1171184	1131595	2107046
PV F at 12%	1	0.89286	0.79719	0.71178	0.63552	0.56743
PV at 12%	-3140000	468288	870611	833626	719149	1195594
NPV	947268
As the project's NPV is POSITIVE,Sturgeon should ACCEPT the same.
WORKINGS:
Sales in units		110000	165000	181500	181500	181500
Selling price/unit		30	30	30	30	30
Total sale value		3300000	4950000	5445000	5445000	5445000
NWC reqd. at 6%*sales		198000	297000	326700	326700	326700
NWC introduced in the yr.		198000	99000	29700	0	0
After-tax salvage			MACRS Rates
Initial cost	3140000		14.29
Less:Acc. Depn. Upto yr.5(77.69%*3140000)	2439466		24.49
Carrying/Book value	700534		17.49
Less:Salvage	700000		12.49
Loss on salvage	534		8.93
Tax saved on loss(534*40%)	214		8.92
So, cash inflow on salvage(700000+214)	700214		8.93
			4.46
			100

NPV Calculations	Year 0	1	2	3	4	5
Initial cost+Installation	-3140000
NWC introduced in the yr.		-198000	-99000	-29700	0	0
NWC recovered						326700
After-tax salvage						700214
CAPEX & NWC cash flows----1	-3140000	-198000	-99000	-29700	0	1026914
Operating Cash Flows:
Total sale value		3300000	4950000	5445000	5445000	5445000
Less: Variable prodn. Costs(65%*Sales)		2145000	3217500	3539250	3539250	3539250
Less: Fixed costs		250000	260000	270400	281216	292465
Less: Depreciation		448706	768986	549186	392186	280402
EBT		456294	703514	1086164	1232348	1332883
Less: Tax at 40%		182518	281406	434466	492939	533153
EAT		273776	422108	651698	739409	799730
Add Back: Depn.		448706	768986	549186	392186	280402
Annual Operating cash flow---2		722482	1191094	1200884	1131595	1080132
Total annual cash flows(1+2)	-3140000	524482.4	1092094	1171184	1131595	2107046
PV F at 12%	1	0.89286	0.79719	0.71178	0.63552	0.56743
PV at 12%	-3140000	468288	870611	833626	719149	1195594
NPV	947268
As the project's NPV is POSITIVE,Sturgeon should ACCEPT the same.
WORKINGS:
Sales in units		110000	165000	181500	181500	181500
Selling price/unit		30	30	30	30	30
Total sale value		3300000	4950000	5445000	5445000	5445000
NWC reqd. at 6%*sales		198000	297000	326700	326700	326700
NWC introduced in the yr.		198000	99000	29700	0	0
After-tax salvage			MACRS Rates
Initial cost	3140000		14.29
Less:Acc. Depn. Upto yr.5(77.69%*3140000)	2439466		24.49
Carrying/Book value	700534		17.49
Less:Salvage	700000		12.49
Loss on salvage	534		8.93
Tax saved on loss(534*40%)	214		8.92
So, cash inflow on salvage(700000+214)	700214		8.93
			4.46
			100

2.Cash flows for replacement (cost cutting) projects

Replacement projects are mostly ubdertaken to reduce the current cost-levels

so,it reduces the cash outflow --thus resulting in increased cash flow within the business

for example, improvised new machines help to reduce labor costs as well as wastages in production.

Whereas,

cash flows in expansion projects

are new & additional cash outflows or expenses equally matched by cash inflows or incomes.

4.Opportunity costs in cash flow analysis

Opportunity costs are income sacrificed or foregone, by choosing to undertake a different project , in the place of an already available one.

As for example, the rental income possible in a building is sacrificed , when the same building is utilised in a different & new project.

The rent income foregone is the opportunity cost for the new project-ie. Cost of positive opportunity lost.

3. Substitutionary and complementary effects in the context of capital budgeting cash flow analysis with an example of each.

Substitutionary effect of a new project is also called cannibalisation effect , where by, the existing income is reduced directly due to the undertaking of the new project.

ie. Sale of an older version of an equipment getting reduced due to introduction of a new model.

Complementary effect is achieved when the existing income is accelerated or facilitated due to the introduction of a new project/product.

As for example, the sale of accessories for a particular model of car picks up as more & more that model cars are sold.