Question

Dimitra is projecting cash flows for her firm using the percentage of sales method. She projects that the sales will be growing at 5% per year from the current level of $1M (year 0). She also projects a constant $20K per year in depreciation for the next 5 years. The firm's Net PPE currently stands at $400K. What should be her forecast for Capital Investment in year 2?

A.

$44K

B.

$20K

C.

$41K

D.

$61K

E.

$20K

Answer 1

Solution:

Since cash flows are being forecasted as % of sales, they would grow at the same rate as the sales growth rate.

The Net PPE currently stands at $400K. Now, the PPE is 40% of sales at present. The sales are growing at 5%. Therefore, the net PPE balance will also growth 5% per annum so that the ratio to sales is maintained as per the requirement.

PPE balance at the end of year 1= $400,000*105%= $420,000

PPE balance at the end of year 2= $420,000*105%= $441,000

Now, we know the closing balances of PPE, so lets calculate the capital investment as follows:

PPE closing balance (Year 1)= PPE opening balance + capital investment (year 1) - depreciation

420,000= 400,000 + capital investment (year 1) - 20,000

Capital investment (Year 1)= $40,000

Similarly,

PPE closing balance (Year 2)= PPE opening balance (Year 1) + capital investment (year 2) - depreciation

441,000= 420,000 + capital investment (year 2) - 20,000

Capital investment (Year 2)= $41,000

Thus, the correct option is option C.