Question

Max Factor company is considering to introduce a new cream. The manufacturing equipment will cost Rs. 5,60,000. The expected life of the equipment is 8 years. The company is thinking of selling the cream in a single standard pack of 50 grams at Rs. 12 each pack. It is estimated that variable cost per pack would be Rs. 6 and annual fixed cost Rs. 4,50,000. Fixed cost includes (straight line) depreciation of Rs. 70,000   and allocated overheads of Rs. 30,000. The company expects to sell 1,00,000 packs of the cream each year. Assume that tax is 45% and straight line depreciation is allowed for tax purpose. Evaluate the project of Max Factor and help them in applying the proper technique to calculate the cash flows.

Answer 1

Here we will have to compute the relevant cash flow associated with the project. As discount rate is not mentioned we do not have to determine NPV of the project.

First of all we will compute net income of this project. Then we will determine operating cash flow and then finally we will compute total cash flows.

	YEARS
	1	2	3	4	5	6	7	8
Sales (1,00,000*12)	1,200,000	1,200,000	1,200,000	1,200,000	1,200,000	1,200,000	1,200,000	1,200,000
Variable costs (1,00,000*6)	600,000	600,000	600,000	600,000	600,000	600,000	600,000	600,000
Fixed costs (excluding depreciation)	380,000	380,000	380,000	380,000	380,000	380,000	380,000	380,000
Depreciation	70,000	70,000	70,000	70,000	70,000	70,000	70,000	70,000
EBIT	150,000	150,000	150,000	150,000	150,000	150,000	150,000	150,000
Tax (45%)	67,500	67,500	67,500	67,500	67,500	67,500	67,500	67,500
Net income	82,500	82,500	82,500	82,500	82,500	82,500	82,500	82,500
STEP II: Computing operating cash flow
EBIT	150,000	150,000	150,000	150,000	150,000	150,000	150,000	150,000
Depreciation	70,000	70,000	70,000	70,000	70,000	70,000	70,000	70,000
Tax	-              67,500	-           67,500	-           67,500	-           67,500	-           67,500	-           67,500	-           67,500	-           67,500
Operating cash flow	152,500	152,500	152,500	152,500	152,500	152,500	152,500	152,500

Step III: Total cash flow:

	YEARS
	0	1	2	3	4	5	6	7	8
Operating cash flow		152,500	152,500	152,500	152,500	152,500	152,500	152,500	152,500
Capital spending	-           560,000
Total cash flow	-     560,000	152,500	152,500	152,500	152,500	152,500	152,500	152,500	152,500