ACF214 Principles of Finance

Workshop Solutions 2017-2018

Alexey Akimov
Tutorial Solutions1 – Week 2

1. Explain the difference between a sunk cost and an opportunity cost and give an example of
each.

Answer:
Sunk costs are costs that have been incurred and cannot be recouped, such as repairs made to a car
last week, the fee for market research before undertaking a project, the cost of the travel to see
whether you want to buy a new building, etc.

An opportunity cost is the value of the next best alternative should an investment be selected. An
example would be the market value of a building that could be received if the building was not going
to be utilized for a new project.

2. The Green Shingle purchased a parcel of land 6 years ago for £299,500. At that time, the firm
invested £64,000 grading the site so that it would be usable. Since the firm wasn't ready to use
the site itself at that time, it decided to lease the land for £28,000 a year. The Green Shingle is
now considering building a hotel on the site as the rental lease is expiring. The current value of
the land is £347,500. The firm has no loans or mortgages secured by the property. What value
should be included in the initial cost of the hotel project for the use of this land?

Answer:
The relevant cost is the opportunity cost of £347,500. This is the opportunity cost of building the
hotel – selling the land is the next most valuable use for the land.

3. Great Woods sells specialised equipment for mountain climbers. Its sales for last year included
£238,000 of tents and £411,000 of climbing gear. For next year, management has decided to
sell specialised sleeping bags also. As a result of this change, sales projections for next year are
£254,000 of tents, £426,000 of climbing gear, and £51,000 of sleeping bags. How much of next
year's sales are derived from the side effects of adding the new product to its sales offerings?

Answer:
NB: question makes it clear that changes in sales are “as a result of” introducing sleeping bags –
hence they are definitely side effects, not just changes for other reasons.

Side effects = (£254,000 + £426,000) − (£238,000 + £411,000) = £31,000

1Most answers are stated briefly here. You will be expected to write more fully and with more
examples where required to gain high marks in examinations.
4. Aaron's Market is implementing a project that will initially increase accounts payable by £3,600,
increase inventory by £4,800, and decrease accounts receivable by £800. All net working capital
will be recouped when the project terminates. What is the cash flow related to the net working
capital for the last year of the project?

Answer:
Net working capital – a reminder:

Working capital = cash + inventory + accounts receivable − accounts payable

At the start of the project it would be normal to:

Buy inventory (a cash outflow)
Allow customers to pay on credit – i.e. increase accounts receivable (a cash outflow)
Save some cash for emergencies (a cash outflow)
Pay some of your suppliers slowly – i.e. increase accounts payable (a cash inflow)
At the end of the project it would be normal to:
Sell inventory (a cash inflow)
Require customers who have paid on credit to pay their bills – i.e. reduce accounts receivable
(a cash inflow)
Not require any cash to be kept for emergencies so return cash to the firm (a cash inflow)
Need to pay back all your suppliers – i.e. reduce accounts payable (a cash outflow)

However, in this question:

At the start of the project, you
Increase inventory – a cash outflow (-4,800)
Increase accounts payable – a cash inflow (+3,600)
Reduce accounts receivable – i.e. get some of your customers to pay early (e.g. pre-orders) –
cash inflow – this is the opposite to a normal project (+800)
To answer the question: what is the cash flow relating to working capital at the end of the project,
you need to reverse all the flows above that occurred at the start of the project:
Sell inventory – a cash inflow (+4,800)
Reduce accounts payable – a cash outflow (-3,600)
You increase accounts receivable – a cash outflow (-800)
This leaves you with a positive cash flow of 4,800-3,600-800=400
5. The following table presents sales forecasts for a new business venture that is expected to last
for 4 years. The unit price of each sale is £40. The unit cost is £25.

Year Unit Sales

1 22,000
2 30,000
3 14,000
4 5,000

An outlay of £200,000 on plant and equipment will be needed immediately. In addition, working
capital will be needed at the beginning of each year equal to 20 percent of sales during the year.
The firm’s tax rate is 40 percent. The plant and equipment will be depreciated for tax purposes
on a straight-line basis over 4 years. All working capital investment will have been liquidated
and the plant and equipment will have zero salvage value at the end of the venture’s life. The
cost of capital appropriate for the venture is 20 percent.

REQUIRED

(i). Calculate the net present value of the project.

The gross margin is £15 per unit. Depreciation is £200,000/4 = £50,000 and the associated tax
shield is 0.4 × 50,000 = £20,000 per year.

Working capital needed at the start of each year:

- Year 1: 0.2×40×22K = £176K

- Year 2: 0.2×40×30K = £240K
- Year 3: 0.2×40×14K = £112K
- Year 4: 0.2×40×5K = £40K

Thus, investment in working capital is £176K @ t = 0 and £64K @ t = 1, and reductions of working
capital of £128K @ t = 2, £72K @ t = 3 and £40K @ t = 4.

Cash flows are as follows:

0 1 2 3 4
Gross Profit 330 450 210 75
Tax on Profit (132) (180) (84) (30)
Depreciation Tax Shield 20 20 20 20
OCF 218 290 146 65
CapEx -200
Increase in NWC 176 64 -128 -72 -40
FCF -376 154 418 218 105

154 418 218 105

𝑁𝑃𝑉 = −376 + + + + = 219.41
1.20 1.202 1.203 1.204
 6. Dovedale plc is considering producing a new range of handbags, the “Croc” to accessorise
their line of crocodile skin shoes. The new bags will also be made of crocodile skin in
identical colours to the shoes. To decide whether to proceed with this project, the company
has commissioned a report from a consultant. The consultant has identified the following
likely outcomes if they choose to go ahead.

Sales of “Croc” handbags are likely to be 3,500 in the first year and increase by 15 percent
per year each year until a new range will be needed to replace them at the end of 4 years.
As a result of selling the new bag, they expect to increase the sales of the matching shoes
from 1,200 pairs per year to 2,000 pairs per year for the 4 years of the project.

A selling price of £800 per bag has been agreed on after market research which cost the
firm £10,000. The cost of crocodile skin to make the bag is likely to be £140 per bag with
other variable costs of production likely to come to £250 per bag. The crocodile skin shoes
currently have a selling price of £450 and variable costs of production of £280.

An issue of concern is that selling the “Croc” will reduce sales of their snakeskin bags the
“Boa”. The consultant estimates that sale of “Boa” bags could go down from 6,000 per year
to 4,200 per year. The “Boa” sells for £950 and has a variable cost of production of £625.

To produce the new bags, a machine costing £900,000 will be acquired, and depreciated on
a straight line basis to zero over the 4 years of the project but will be sold for £18,000 at
that time. The company intends to use an unused office to market the shoes which they
bought 10 years ago for £60,000 and which has a current market value of £75,000. The
market value of the office is not expected to change over the term of the project. The
company will invest £10,000 in working capital to cover the need for credit sales at the start
of the project which will be refunded at the end of the project. The company currently has
fixed costs of £200,000 and these are expected to increase to £245,000 per year if the new
bag is produced. Taxes are 33 percent and the company’s required rate of return is 10
percent.

REQUIRED

(i). Identify the costs which should be used to make the decision whether to proceed with
the project or not and give reasons for why you are including or excluding a specific cost.

(ii). Calculate the operating cash flows for the duration of the project.

(iii). Calculate the NPV of the project. Advise the firm as to whether it should go ahead with
the project.
Answer:
(i). Costs to be included: relevant cash flows of the project

- sales less variable costs of new handbag

- market research – sunk cost so exclude
- also increased sales of the matching shoes of 800 per year – this is a positive side
effect/spillover cost
- reduction in sales of Boa snakeskin bag by 1,800 bags per year– this is a negative side effect
- capital expenditure of £900,000 for a new machine plus cash inflow of £18,000 scrap value
- opportunity cost of using the office – use current market value £75,000
- net working capital £10,000 should be included
- fixed costs – include £45,000 only because they are the only relevant part – the rest of the
fixed costs would be incurred anyway

(ii). Operating cash flows:

- Depreciation = £900,000/4 =£225,000 per year

- sales less variable costs of new handbag = £410 per bag
- extra fixed costs £45,000 per year
- positive side effect – additional shoes sold, 800 pairs per year at operating profit of £170
per pair, 800 x 170 = £136,000 per year
- negative side effect – less Boa bags sold, 1800 bags at operating profit of £325 each =
£585,000 per year

𝑂𝐶𝐹 = (𝑆 − 𝐶 − 𝐷) × (1 − 𝜏𝑐 ) + 𝐷

1 2 3 4
Unit sales 3,500 4,025 4,629 5,323
Sales in £ 1,435,000.00 1,650,250.00 1,897,890.00 2,182,430.00
Extra fixed costs (45,000.00) (45,000.00) (45,000.00) (45,000.00)
Extra shoes sold 136,000.00 136,000.00 136,000.00 136,000.00
Less Boa bags 585,000.00 585,000.00 585,000.00 585,000.00
Sales - costs 941,000.00 1,156,250.00 1,403,890.00 1,688,430.00
Depreciation (225,000.00) (225,000.00) (225,000.00) (225,000.00)
EBIT 716,000.00 931,250.00 1,178,890.00 1,463,430.00
Tax @ 33% x EBIT (236,280.00) (307,312.50) (389,033.70) (482,931.90)
Net Income 479,720.00 623,937.50 789,856.30 980,498.10
OCF 704,720.00 848,937.50 1,014,856.30 1,205,498.10

(iii). To calculate NPV, need to calculate cash flows from assets (CFFA):

As well as OCF, net working capital is −£10,000 at time 0 and £10,000 at time 4, capital
expenditure is an outflow at time 0 of £900,000 and an inflow at time 4 of £18,000 × (1 − 𝜏𝑐 ) =
12,060. Also include the opportunity cost of the office used at £75,000 outflow at time 0. Assume
cost of office is returned in year 4 – unchanged market value.
 0 1 2 3 4
OCF 704,720.00 848,937.50 1,014,856.30 1,205,498.10
ΔNWC 10,000.00 (10,000.00)
CapEx 900,000.00 (12,060.00)
Opp.cost (75,000.00) 75,000.00
FCF (985,000.00) 704,720.00 848,937.50 1,014,856.30 1,302,558.10

704,720 848,937.5 1,014,856.3 1,302,558.1

𝑁𝑃𝑉 = −985,000 + + + + = 2,009,397
1.10 1.102 1.103 1.104

7. You are a manager at Percolated Fiber, which is considering expanding its operations in
synthetic fiber manufacturing. Your boss comes into your office, drops a consultant’s report
on your desk, and complains, “We owe these consultants $1 million for this report, and I
am not sure their analysis makes sense. Before we spend the $25 million on new equipment
needed for this project, look it over and give me your opinion.” You open the report and
find the following estimates (in thousands of dollars):

Project Year
1 2 … 9 10
Sales revenue 30,000 30,000 30,000 30,000
− Cost of goods sold 18,000 18,000 18,000 18,000
= Gross Profit 12,000 12,000 12,000 12,000
− General, sales & administrative expenses 2,000 2,000 2,000 2,000
− Depreciation 2,500 2,500 2,500 2,500
= EBIT 7,500 7,500 7,500 7,500
− Income Tax 2,625 2,625 2,625 2,625
= Net Income 4,875 4,875 4,875 4,875

All of the estimates in the report seem correct. You note that the consultants used straight-line
depreciation for the new equipment that will be purchased today (year 0), which is what the
accounting department recommended. The report concludes that because the project will increase
earnings by $4.875 million per year for 10 years, the project is worth $48.75 million. You think back
to your halcyon days in finance class and realize there is more work to be done!

First, you note that the consultants have not factored in the fact that the project will require $10
million in working capital upfront (year 0), which will be fully recovered in year 10. Next, you see
they have attributed $2 million of selling, general and administrative expenses to the project, but
you know that $1 million of this amount is overhead that will be incurred even if the project is not
accepted. Finally, you know that accounting earnings are not the right thing to focus on!
 a) Given the available information, what are the free cash flows in years 0 through 10 that
should be used to evaluate the proposed project?

0 1 2 … 9 10

= Net income 4,875 4,875 4,875 4,875

+ Overhead (after tax at 35%) 650 650 650 650
+ Depreciation 2,500 2,500 2,500 2,500
– Capex 25,000
– ΔNWC 10,000 –10,000

FCF –35,000 8,025 8,025 … 8,025 18,025

b) If the cost of capital for this project is 14%, what is your estimate of the value of the new
project?

1 1 18.025
𝑁𝑃𝑉 = −35 + 8.025 × (1 − 9
)+ = $9.56
0.14 1.14 1.1410

8. Bauer Industries is an automobile manufacturer. Management is currently evaluating a

proposal to build a plant that will manufacture lightweight trucks. Bauer plans to use a cost
of capital of 12% to evaluate this project. Based on extensive research, it has prepared the
following incremental free cash flow projections (in millions of dollars):

Year 0 Years 1-9 Year 10

Revenues 100.0 100.0
− Manufacturing expenses (other than depreciation) 35.0 35.0
− Marketing expenses 10.0 10.0
− Depreciation 15.0 15.0
= EBIT 40 40
− Taxes (35%) -14.0 -14.0
= Unlevered Net income 26 26
+ Depreciation 15 15
− Increases in Net Working Capital 5 5
− Capital expenditures 150.0
+ Continuation Value 12
= Free Cash Flow -150.0 36 48
 a) For this base-case scenario, what is the NPV of the plant to manufacture lightweight trucks?

1 1 48
𝑁𝑃𝑉 = −150 + 36 × 0.12 (1 − 1.129 ) + 1.1210 = $57.3 million

b) Based on input from the marketing department, Bauer is uncertain about its revenue
forecast. In particular, management would like to examine the sensitivity of the NPV to the
revenue assumptions. What is the NPV of this project if revenues are 10% higher than
forecast? What is the NPV if revenues are 10% lower than forecast?

Initial Sales 90 100 110

NPV 20.5 57.3 94.0

c) Rather than assuming that cash flows for this project are constant, management would like
to explore the sensitivity of its analysis to possible growth in revenues and operating
expenses. Specifically, management would like to assume that revenues, manufacturing
expenses, and marketing expenses are as given in the table for year 1 and grow by 2% per
year every year starting in year 2. Management also plans to assume that the initial capital
expenditures (and therefore depreciation), additions to working capital, and continuation
value remain as initially specified in the table. What is the NPV of this project under these
alternative assumptions? How does the NPV change if the revenues and operating expenses
grow by 5% per year rather than by 2%?

Change in FCF/year 0% 2% 5%
NPV 57.3 72.5 98.1
 9. Orchid Biotech Company is evaluating several development projects for experimental
drugs. Although the cash flows are difficult to forecast, the company has come up with the
following estimates of the initial capital requirements and NPVs for the projects. Given a
wide variety of staffing needs, the company has also estimated the number of research
scientists required for each development project (all cost values are given in millions of
dollars).

Project Number Initial Capital Number of Research Scientists NPV

I 10.0 2 10.1
II 15.0 3 19.0
III 15.0 4 22.0
IV 20.0 3 25.0
V 30.0 12 60.2

a) Suppose that Orchid has a total capital budget of $60 million. How should it prioritize these
projects?

Capital Budget: $60 million. How to prioritise the projects? First, calculate Profitability Index:

Project Number Initial Capital NPV PI

I 10.0 10.1 1.01
II 15.0 19.0 1.27
III 15.0 22.0 1.47
IV 20.0 25.0 1.25
V 30.0 60.2 2.01

The PI rule selects projects V, III, II (Total NPV = 60.2 + 22 + 19 = 101.2). These are also the
optimal projects to undertake (as the budget is used up fully taking the projects in order).
 b) Suppose in addition that Orchid currently has only 12 research scientists and does not
anticipate being able to hire any more in the near future. How should Orchid prioritize these
projects?

Project Number Number of Research Scientists NPV PI

I 2 10.1 5.1
II 3 19.0 6.3
III 4 22.0 5.5
IV 3 25.0 8.3
V 12 60.2 5.0

The PI rule using the headcount constraint alone selects IV, II, III, I, and V, because the project with
the next highest PI (that is NPV/Headcount), V, cannot be undertaken without violating the resource
constraint. These projects are also feasible to do under the current capital budget because they
happen to require exactly $60 million in capital. The only other feasible possibility is to take only
project V, which generates a lower NPV, so this choice of projects is optimal.

c) If instead, Orchid had 15 research scientists available, explain why the profitability index
ranking cannot be used to prioritize projects. Which projects should it choose now?

Project Number Number of Research Scientists NPV PI

I 2 10.1 5.1
II 3 19.0 6.3
III 4 22.0 5.5
IV 3 25.0 8.3
V 12 60.2 5.0

By applying the rule strictly (ranking the projects), PI still selects IV, II, III, and I.

However, projects IV and V generate a total NPV of $85.2 million compared to the previous NPV of
$76.1 million. Thus, choose IV and V, but you don’t hit the constraint exactly.

PI rule might not work when resources are not used fully.