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Published by Afrianto Budi Aan
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Published by: Afrianto Budi Aan on Nov 17, 2012
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CHAPTER 7, Case #1
 To analyze this project, we must calculate the incremental cash flows generated by the project. Sincenet working capital is built up ahead of sales, the initial cash flow depends in part on this cashoutflow. So, we will begin by calculating sales. Each year, the company will sell 600,000 tons under contract, and the rest on the spot market. The total sales revenue is the price per ton under contracttimes 600,000 tons, plus the spot market sales times the spot market price. The sales per year will be:
Year 1 Year 2 Year 3 Year 4
Contract $20,400,000 $20,400,000$20,400,000$20,400,000Spot 2,000,000 5,000,0008,400,0005,600,000Total $22,400,000 $25,400,000$28,800,000$26,000,000The current aftertax value of the land is an opportunity cost. The initial outlay for net workingcapital is the percentage required net working capital times Year 1 sales, or:Initial net working capital = .05($22,400,000) = $1,120,000So, the cash flow today is:Equipment –$30,000,000Land –5,000,000 NWC –1,120,000Total –$36,120,000  Now we can calculate the OCF each year. The OCF is:
Year 1 Year 2 Year 3 Year 4 Year 5 Year
Sales $22,400,000 $25,400,000$28,800,000$26,000,000Var. costs 8,450,000 9,425,00010,530,0009,620,000Fixed costs 2,500,000 2,500,0002,500,0002,500,000$4,000,000 $6,000,000Dep. 4,290,000 7,350,0005,250,0003,750,000EBT $7,160,000 $6,125,000$10,520,000$10,130,000–$4,000,000 –$6,000,000Tax 2,720,800 2,327,5003,997,6003,849,4001,520,000 2,280,000Net income $4,439,200 $3,797,500$6,522,400$6,280,600–$2,480,000 –$3,720,000+ Dep. 4,290,000 7,350,0005,250,0003,750,000OCF $8,729,200 $11,147,500$11,772,400$10,030,600–$2,480,000 –$3,720,000 
CHAPTER 7 CASE #1 C-21Years 5 and 6 are of particular interest. Year 5 has an expense of $4 million to reclaim the land, andit is the only expense for the year. Taxes that year are a credit, an assumption given in the case. InYear 6, the charitable donation of the land is an expense, again resulting in a tax credit. The landdoes have an opportunity cost, but no information on the aftertax salvage value of the land is provided. The implicit assumption in this calculation is that the aftertax salvage value of the land inYear 6 is equal to the $6 million charitable expense. Next, we need to calculate the net working capital cash flow each year. NWC is 5 percent of nextyear’s sales, so the NWC requirement each year is:
Year 1 Year 2 Year 3 Year 4
Beg. NWC $1,120,000 $1,270,000$1,440,000$1,300,000End NWC 1,270,000 1,440,0001,300,0000 NWC CF –$150,000 –$170,000$140,000$1,300,000The last cash flow we need to account for is the salvage value. The fact that the company is keepingthe equipment for another project is irrelevant. The aftertax salvage value of the equipment should be used as the cost of equipment for the new project. In other words, the equipment could be soldafter this project. Keeping the equipment is an opportunity cost associated with that project. The book value of the equipment is the original cost, minus the accumulated depreciation, or:Book value of equipment = $30,000,000 – 4,290,000 – 7,350000 – 5,2502,000 – 3,750,000Book value of equipment = $9,360,000Since the market value of the equipment is $18 million, the equipment is sold at a gain to book value, so the sale will incur the taxes of:Taxes on sale of equipment = ($18,000,000 – 9,360,000)(.38) = $3,283,200And the aftertax salvage value of the equipment is:Aftertax salvage value = $18,000,000 – 3,283,200Aftertax salvage value = $14,716,800So, the net cash flows each year, including the operating cash flow, net working capital, and aftertaxsalvage value, are:
Time Cash flow
0 –$36,120,0001 8,579,2002 10,977,5003 11,912,4004 26,047,4005 –2,480,0006 –3,720,000 

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