Question

Jack Tar, CFO of Sheetbend & Halyard, Inc., opened the company confidential envelope. It contained a draft of a competitive bid for a contract to supply duffel canvas to the U.S. Navy. The cover memo from Sheetbend?s CEO asked Mr. Tar to review the bid before it was submitted. The bid and its supporting documents had been prepared by Sheetbend?s sales staff. It called for Sheetbend to supply 100,000 yards of duffel canvas per year for 5 years. The proposed selling price was fixed at $30 per yard. Mr. Tar was not usually involved in sales, but this bid was unusual in at least two respects. First, if accepted by the navy, it would commit Sheetbend to a fixed-price, long-term contract. Second, producing the duffel canvas would require an investment of $1.5 million to purchase machinery and to refurbish Sheetbend?s plant in Pleasantboro, Maine. Mr. Tar set to work and by the end of the week had collected the following facts and assumptions: ? The plant in Pleasantboro had been built in the early 1900s and is now idle. The plant was fully depreciated on Sheetbend?s books, except for the purchase cost of the land (in 1947) of $10,000. ? Now that the land was valuable shorefront property, Mr. Tar thought the land and the idle plant could be sold, immediately or in the near future, for $600,000. ? Refurbishing the plant would cost $500,000. This investment would be depreciated for tax purposes on the 10-year MACRS schedule. ? The new machinery would cost $1 million. This investment could be depreciated on the 5-year MACRS schedule. ? The refurbished plant and new machinery would last for many years. However, the remaining market for duffel canvas was small, and it was not clear that additional orders could be obtained once the navy contract was finished. The machinery was custom-built and could be used only for duffel canvas. Its secondhand value at the end of 5 years was probably zero. ? Table 9?4 shows the sales staff?s forecasts of income from the navy contract. Mr. Tar reviewed this forecast and decided that its assumptions were reasonable, except that the forecast used book, not tax, depreciation. ? But the forecast income statement contained no mention of working capital. Mr. Tar thought that working capital would average about 10% of sales. Armed with this information, Mr. Tar constructed a spreadsheet to calculate the NPV of the duffel canvas project, assuming that Sheetbend?s bid would be accepted by the navy. He had just finished debugging the spreadsheet when another confidential envelope arrived from Sheetbend?s CEO. It contained a firm offer from a Maine real estate developer to pur- chase Sheetbend?s Pleasantboro land and plant for $1.5 millionin cash. Should Mr. Tar recommend submitting the bid to the navy at the proposed price of $30 per yard? The discount rate for this proj- ect is 12%. Year 1 2 3 4 5 1 Yards sold 100 100 1000 100 100 2 Price per yard 30 30 30 30 30 3 Revenue (1 x 2) 3000 3000 3000 3000 3000 4 cost of goods sold 2100 2184 2271.36 2362.21 2456.7 5 operating cash flow (3-4) 900 816 728.64 637.79 543.3 6 Depreciation 250 250 250 250 250 7 Income (5-6) 650 566 478.64 387.79 293.3 8 Tax at 35% 227.5 198.1 167.52 135.72 102.65 9 Net Income (7-8) $422.50 $367.90 $311.12 $252.07 $190.65 TABLE 9?4 Forecast income statement for the U.S. Navy duffel canvas project (dollar figures in thousands, except price per yard) Notes: 1. Yards sold and price per yard would be fixed by contract. 2. Cost of goods includes fixed cost of $300,000 per year plus variable costs of $18 per yard. Costs are expected to increase at the inflation rate of 4% per year. 3. Depreciation: A $1 million investment in machinery is depreciated straight-line over 5 years ($200,000 per year). The $500,000 cost of refurbishing the Pleasantboro plant is depreciated straight-line over 10 years ($50,000 per year.

MY QUESTION: What is the difference between profits and cash flow?What are the key factors affecting this decision that Mr. Tar should consider?

Thank you

Answer 1

Cash Flow	Profit
Outflow & inflow of money from operating, financing & investing activities.	The positive difference between sales & all costs. (net income)
It is concerned with the time at which the movement of money takes place .	The difference between income & expenses at a certain point of time .
Useful in the short term.	Should be considered when planning for the long term.
A product of cash basis of accounting.	A product of accrual basis of accounting.
Very critical for the firm's survival. Survival is not possible without a steady stream of cash flows.	A firm can survive without profits for some time.
Example: depriciation does not affect cash flows though it is an expense	Example: depreciation is taken into account when calculating profits.

For this, Mr Tar should be considering cash outflows and inflows to calculate the net present value. If the net present value is positive then it indicates that the project is having positive cash flows and can be taken up. The other thing that Mr Tar should consider is that entering into an agreement with navy would fix the prices for a long term which may be detrimental in later years when the costs of input may increase. One more thing is that the remaining market for duffel canvas is small and it is unsure whether Mr Tar would get orders after navy contract finishes.