Question

The following cash flow estimation has been prepared by Dani, an executive of Sunny Berhad.

	(RM, thousands)
YEAR	0	1 to 10
Initial cost	(1,000)
Units sold		100
Price/unit		15
Total revenue		1,500
(-) Cost of goods sold		800
Gross Profit		700
Operating expenses:
Depreciation		100
Interest expense		100
Income before tax		500
Tax at 40%		200
Income after tax		300

Dani has approached Danisha, his partner in the coming project to discuss on the figures. Their conversation are as follows:

“Danisha, here’s how I figure it: Boss says our corporate goal should be to increase earnings by at least 15% every year, and this project certainly increase earnings. It adds RM300,000 to net income after tax every year. My trusty calculator tells me that the rate of return on this project is 30% (RM300,000/RM1,000,000), well above our minimum target return of 10%. If you want to discount the value, its NPV discounted at 10% is around RM844.00. So, what do you think Danisha?”

“Well, Dani, it looks pretty good, but I do have few questions.”

“Shoot, Danisha.”

“What about increases in accounts receivable and stuff like that?”

“Not relevant. We will get that money back when the project terminates, so it ‘s equivalent to an interest-free loan, which is more of a benefit than a cost.”

“But, Dani, what about extra selling and administrative costs? Haven’t you left those out?”

“That is the beauty of this, Danisha. Given the recent recession, I figure we can handle the added business with existing personnel. In fact, one of the virtues of the proposal is that we should be able to retain some people we would otherwise have to terminate.”

“Well, you’ve convinced me, Dani. Now, I think it will be only fair if the boss puts you in charge of the existing new project.”

Required:

As students of Financial Management, discuss how many errors you can spot and explain briefly why each is an error. By giving your own assumptions when needed, prepare a new cash flow estimation for the next 10 years.

Answer 1

Following are the erros in the explanation provided by Dani to Danisha:

1. Cash-flows after tax is relevant and appropriate than income after tax : Dani has computed income after tax of 300 and comparing this with the initial cost. Income after tax includes depreciation of 100 which is a non-cash item and on which only the tax benefit is relevant. For evaluating a project, the appropriate and relevant metric is the cash-flow the project generates and not the accounting income.Thus, depreciation should have been added back to arrive at the cash-flows after tax

2. Target return incorrectly taken as 10% for computing NPV: NPV is computed considering Income after tax and at required rate of return of 10%. The corporate goal is to increase earnings by 15% every year and NPV needs to be computed considering the discount rate of 15% and not 10%

3. Rate of return incorrectly concluded as 30%: The rate of return is concluded by comparing the income after tax of 300 with the initial cost of 1000. However, rate of return needs to be considered after discounting the cash-flows at the required rate of 15%. Thus, required return needs to consider the time value of money.

4. Increase in accounts receivable to be considered: The increase in accounts receivable is the cash-outflow at the beginning of the project. Though it is recovered at the end of the project (at year 10), there will be difference in today's value if these are discounted at 15%. The increase in accounts receivable today will be higher than the decrease (recovery) of accounts receivable at the end of year 10 and hence needs to be considered for NPV and project evaluation.

5. Extra Selling and Administrative costs to be considered: Because of the project , existing personnel who would have otherwise be terminated will continue. Thus, without the project, there would be savings due to termination of this personnel which is not available now. Hence this is a relevant cash-outflow which needs to be considered for NPV and project evaluation.

Net Cash Flow Estimation and NPV :

Assumptions made:

a. Increase in accounts receivable (net working capital) in year 0= $200 (which will be recovered in year 10)

b. Selling and admnistrative costs at 10% of sales = $150

Workings: