Question

Calculating 'Cash flows at the start'

Dreamtime Jewellers Limited (DJL) is a small network of jewellery stores and DJL is considering building a new store. The new store costs $2.5 million and managers plan to partly fund the store with a $1 million five-year bank loan.

In addition, DJL must spend $150,000 on excavation before they build the new store. Because this expense will reduce the new store’s profitability, managers have suggested that the excavation expense be spread out equally over the five-year analysis period.

The ATO states that excavation qualifies as a business expense in the year incurred. DJL has already spent $100,000 conducting market research to determine the most lucrative location for a new store.

If the directors approve the new store DJL anticipates that it will require an additional $400,000 of inventory today on top of the existing level of $1.5 million, and accounts payable will increase by $270,000. The accounts receivable balance will increase from the current level of $5.4 million to $6.2 million if the new store proceeds.

DJL must dispose of $120,000 of redundant jewellery equipment today if the new store is approved. The equipment initially cost $300,000 four years ago and is fully depreciated for tax purposes. Assume the company tax rate is 30%.

What are the 'cash flows at the start'?

[Describe and list separately each cash flow and the corresponding amount on a new line, as in lecture and tutorial examples.]

Answer 1

Cash-flows at the start = $2,451,000 (net cash outflow)

Notes:

(a) Part of the cost of new store is funded by 5 year loan of $1,000,000. Hence, the net cash-outflow immediately is reduced to the extent of loan amount from the cost of new store of $2,500,000

(b) Excavation costs of $150,000 to be incurred at the start. Though the managers suggest to amortise these over 5-years, for cash-flow purposes, entire amount is considered at the start since it is incurred.

Also, ATO states that excavation costs can be tax deductible when it is incurred. Hence tax at 30% can be deducted on the entire costs of $150,000 as it is completely incurred.

(c) Additional inventory is a cash-outflow as the increase implies delay in converting the inventory to sales

Increase in accounts payable is a cash-inflow as the increase implies payment to vendors is delayed

Increase in accounts receivable ($6.4Million - $5.2 Million) is a cash-outflow as the increase implies collecton from customers is delayed.

(d) Since the redundant jewellery is fully depreciated, book value is now Zero. Hence the entire sale value is profit which will be taxed at 30%. Thus, net realisable value (after tax) is considered.

(e) All the above (a), (b) and (c) are cash-outflows and sale value of redundant jewellery is cash-inflow

(f) Market research spend of $100,000 is already incurred. It is a sunk cost and not relevant for the analysis.