Business Finance FINS1613: Tutorial Week 6

BUSINESS FINANCE
FINS1613
Tutorial
Week 6
Capital Budgeting III
Cash Flow Calculations & Advanced NPV Calculations
1
CONTACT DETAILS
Your Tutor + Tutor-in-Charge:
Peter Andersen
peter.andersen@unsw.edu.au
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FINS1613 — Peter Kjeld Andersen (2014-S1)
CASH FLOWS
So far in this course we’ve just given you the cash flows for each year.
Now it’s time to calculate them.
Q. Broadly, what cash flows should be included in project evaluation?

A. All incremental cash inflows or outflows flows that result from our acceptance
of the project.
Q. What cash flows should be excluded?

A. Sunk costs
– These have already paid or committed to be paid prior to accepting the
project (i.e. they’re not incremental).
A. Interest expenses
– These are accounted for in the discount rate (in WACC).
3
CASH FLOWS
CASH FLOW CALCULATIONS
Revenue
Less: Variable Costs
Less: Fixed Costs
Less: Depreciation
= EBIT (or pre-tax operating profit)
Less: Taxes on EBIT @ ??%
= NOPAT (after-tax operating profit)
Add: Depreciation
= Operating Cash Flows
Less: Δ Non-cash Working Capital
Less: Capital Expenditure
= Project Net Free Cash Flows
In addition to your OCF, in any year of the project you could also have changes in working
capital AND capital expenditure occurring. These things can happen anytime, not just at the
start/end of the project. 4
CASH FLOW THEORY QUESTION 1
Q. Which of the following best defines incremental cash flows?
a) The cash flows from a particular project, evaluated independently from
how the project may affect a firm’s other lines of business
b) The cash flows arising from all projects that a company plans to
undertake in a fixed timespan
c) The net present value (NPV) of net operating profits that a firm is
expected to receive as the result of an investment decision
d) The amount by which a firm’s cash flows are expected to change as the
result of an investment decision
A. The answer is d).

Incremental cash flows need to consider the impact on other lines of business,
so A is not the answer.
B is the total cash flows for the firm. C has two issues. It is concerned with the
Net Present Value and looks at operating profits. However, we are concerned
with cash flows, not accounting profits.
5
CASH FLOW EXAMPLE 1
Wernham-Mifflin is considering launching a new line of rhombus-shaped paper.
You have the following information:
• The project will make use of an existing paper mill, built 15-years ago at a
cost of $100 million. The mill is being depreciated over a useful life of 35
years.
• Wenham-Mifflin expects the new project will generate $47 million in
revenues. Cost of goods both with and without the rhombus project will
be $3.4 million.
• Training the quality assurance staff to accurately validate rhombus shaped
paper will cost $6 million in the first year of the project.
• Sales of existing paper products are expected to decrease by $4 million
after the launch of the project. However, half of this sale loss will occur
with or without the new project as when its competitor cuts its prices.
• The project has no effect on working capital.
Q. If Wernham-Mifflin’s marginal tax rate is 35%, what are the expected
incremental cash flows in the first year from this project? 6
CASH FLOW EXAMPLE 1
INCREMENTAL CASH FLOWS (t=1)
+ Increase in Sales Revenue + $47 million
– Increase in Costs – $6 million

(for training)
– Lost Sales Revenue – $2 million

($4m / 2)
= EBIT = $39 million

– Taxes – $13.65 million
(EBIT x 35%)
= NOPAT = $25.35 million
= Total Incremental Cash Flow = $25.35 million (at t=1)
The emphasis in this question is on understanding the word “INCREMENTAL”.

We ignore the cost of goods, the depreciation, and half of the lost sales in our
calculation.
This is because these costs would occur anyway. We only care about the
additional cash in or outflows resulting from the decision to accept the project.
7
MFL QUESTION 1
Home Builder Supply, a retailer in the home improvement industry, currently
operates seven retail outlets in NSW. Management is contemplating building
an eighth retail store across town from its most successful retail outlet.
The company already owns the land for this store, which currently has an
abandoned warehouse on it.
Last month, the marketing department spent $15,000 on market research to
determine the extent of the customer demand for the new store.
Now Home Builder Supply must decide whether to build and open the new
store.
Which of the following should be included as part of the incremental earnings
for the proposed new retail store?
Q. The original purchase price of the land where the store will be located?
A. No, this is a sunk cost. It is non-incremental.

It is not an additional cash inflow or outflow that results for the company from
the decision to say yes to building the new retail store.
8
MFL QUESTION 1
Q. The cost of demolishing the abandoned warehouse and clearing the lot.
A. Yes. This is an incremental cash outflow that will occur if the company decides
to build the new retail store, but that won’t occur if they don’t.
Q. The loss of sales in the existing retail outlet, if customers who previously
drove across town to shop at the existing outlet become customers of the
new store instead.
A. Yes. This is incremental cash outflow is an example of a negative side effect /

negative externality. It’s often called cannibalization or erosion of sales.
Q. The $15,000 in market research spent to evaluate customer demand.
A. No, as this is again an example of a non-incremental sunk cost.

Regardless of whether the company says yes or no to the retail store, that
money has already been spent. What is relevant are the future cash flows that
are contingent on the decision to say yes. 9
MFL QUESTION 1
Q. Construction costs for the new store.
A. Yes. As these costs would only occur if the firm chose to develop the store,
they are incremental.
Q. The value of the land if sold.
A. Yes. This is an opportunity cost.

We are assuming that this is the base-case scenario for the land if the project is
to be rejected. By subtracting this out as a cash flow forgone at time t=0, the
NPV of the project will better represent the value that the retail store project
adds to the firm itself. Alternatively, instead of subtracting the value of the land
out, we can compare NPVBuild Store to NPVSell Land and choose the higher.
Q. Interest expense on the debt borrowed to pay the construction costs.
A. No, as this is a financing cash flow, which will be incorporated into our
weighted-average cost of capital (“WACC”... the discount rate). 10
MFL QUESTION 2
Linksys is considering the development of a wireless home networking
appliance, called HomeNet, which will provide both the hardware and
software necessary to run an entire home from any Internet connection.
HomeNet’s lab will be housed in a warehouse space that the company could
have otherwise rented out for $214,000 per year during years 1 to 4. The tax
rate for Linksys is 38%.
Q. How does this opportunity cost affect HomeNet’s incremental earnings?
A. The after-tax impact of a decrease in revenue can be calculated as:

Earnings  Revenue1  tax% 
 $214,0001  0.38  $132,680
The easiest way to think of after-tax changes with a 38% rate is as follows:
• Every $1 of new revenue increases your earnings by $0.62
– There is no difference between increasing revenue by $1 or cutting expenses by $1
• Every $1 of lost revenue decreases your earnings by $0.62
– Losing $1 of revenue has the same effect as increasing expenses by $1
11
MFL QUESTION 3
Your projected income statement shows:
• Sales of $992,000
• Cost of goods sold as $478,000
• Depreciation expense of $105,000
• Taxes of $122,700 (due to a 30% tax rate)
Q. What are your projected earnings? What is your projected free cash flow?
A. Generally, free cash flow (FCF) in a particular year can be calculated as:
FCF  EBIT1  tax%   Depreciation  Working Capital  Capital Expenditure
In this question, we have no working capital changes or capital expenditure,

and our EBIT calculation has no SG&A. So we can calculate FCF as:
FCF  EBIT1  tax%   Depreciation
 Sales  COGS  Depreciation 1  tax%   Depreciation
 $992,000  $478,000  $105,0001  0.30   $105,000
 $391,300
12
OTHER INCREMENTAL CF EXAMPLE
Sounds Music Company is considering the sale of a new sound board used in
recording studios.
The new board would sell for $27,000 and the company expects to sell 1,600
per year. Sounds currently sells 2,000 of its existing model per year. If the
new model is introduced, sales of the existing model will fall to 1,850 units
per year.
The old board retails for $22,500. Variable costs are 55% of sales,
depreciation on the equipment to produce the new board will be $1,500,000
per year, and fixed costs are $1,300,000 per year.
Q. If the tax rate is 30%, what is the annual OCF for the project?
A.
Revenue  New Revenue  Lost Revenue  1, 600  $27, 000   150  $22,500   $39,825,000
Costs  Variable Costs  Fixed Costs   55%  $39,825, 000   $1,300, 000  $23,203,750
OCF   Revenue  Costs  Depreciation  (1  Tax%)  Depreciation

OCF  $39,825, 000  $23, 203, 750  $1,500,000 (1  30%)  $1,500,000  $12,084,875 13
THEORY Q ON DEPRECIATION METHODS
Q. Given the choice, would a firm prefer to use diminishing value depreciation
or straight line depreciation? Why?
A. Diminishing value depreciation causes larger amounts of the asset to be

depreciated in earlier years.
This reduces the taxable profit in earlier years.
This reduces the tax paid in earlier years.
This, in turn, increases the cash flow received in earlier years.
We know from the time value of money that we prefer to receive cash flows
sooner, rather than later, as they have a higher present value.
Simply, if I have the choice between the following two options:

A: Save $50 of tax in Year 1 and save $50 of tax in Year 2.
B: Save $75 of tax in Year 1 and save $25 of tax in Year 2.
…I would choose option B even though the total tax saved is the same,
because of the time value of money.
14
MFL QUESTION 4
Daily Enterprises is purchasing a $9.9 million machine.
• It will cost $50,000 to transport and install the machine.
• The machine has a depreciable life of five years using straight-line
depreciation and will have no salvage value.
• The machine will generate incremental revenues of $4.1 million and costs
of $1.4 million per year. Daily’s marginal tax rate is 30%.
Q. What are the incremental free cash flows associated with the new machine?
A. As before, FCF can be generally expressed as:

FCF  EBIT1  tax%   Depreciation  Working Capital  Capital Expenditure
In this question, we have no working capital changes. However, we do have

capital expenditures and other expenses occurring at time t=0, followed by
cash inflows over the machine’s life. Note: The shipping/installation costs
Today, at time t=0, the FCF would be: are required by the tax office to be
added as a capital expenditure to the
FCF0  $50,000  $9,900,000 cost of the purchase of the machinery
 $9,950,000 and then depreciated over the 5yrs. 15
MFL QUESTION 4
A. The FCF in years 1-5 would be:
FCF1– 5  EBIT1  tax%   Depreciation  Working Capital  Capital Expenditure
 Revenue  Costs  Depreciation 1  tax %   Depreciation
 $4,100,000  $1,400,000  $1,990,0001  0.30  $1,990,000
 $2,487,000 per year
In the above, the total capital expenditure at t=0 of $9.95m is depreciated over
5 years (1/5 or 20% per year).
Capital Expenditure1-5
Depreciation1-5 
# Years depreciable life
$9,950,000
  $1,990,000
5
If there are other NON capital expenditure items at t=0 (e.g. changes in
working capital, lost revenue from production being interrupted, etc.), you
would NOT depreciate these.
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MFL QUESTION 4
A. The FCF calculation presented in table format:
INCREMENTAL CALCS t=0 t=1 t=2 t=3 t=4 t=5

Revenue $4,100k $4,100k $4,100k $4,100k $4,100k
Less: Costs $1,400k $1,400k $1,400k $1,400k $1,400k
Less: Depreciation $1,990k $1,990k $1,990k $1,990k $1,990k
= EBIT $710k $710k $710k $710k $710k
Less: Tax @ 30% $213k $213k $213k $213k $213k
= NOPAT $497k $497k $497k $497k $497k
Add back: Depreciation $1,990k $1,990k $1,990k $1,990k $1,990k
Less: ΔWorking Capital
Less: Capital Expenditure $9,950k
= FCF –$9,950k $2,487k $2,487k $2,487k $2,487k $2,487k
Note that the $50k shipping and installation costs are capitalised onto the balance sheet at
t=0 and then depreciated $10k per year from years 1 to 5.
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WORKING CAPITAL CHANGES
A lot of students get confused about how changes in operating working capital
(i.e. short-term non-cash current assets & liabilities) affect cash flow. The
below summarizes:
• If Current Assets (i.e. Accounts Receivable or Inventory) INCREASE in a particular
period, this is a USE of cash (or a cash OUTFLOW).
• If Current Assets (i.e. Accounts Receivable or Inventory) DECREASE in a particular
period, this is a SOURCE of cash (or a cash INFLOW).
• If Current Liabilities (i.e. Accounts Payable) INCREASE in a particular period, this is a

SOURCE of cash (or a cash INFLOW).
• If Current Liabilities (i.e. Accounts Payable) DECREASE in a particular period, this is a
USE of cash (or a cash OUTFLOW).
Common mistakes:
The usual problem is that people think “Oh hey if Accounts Receivable went up I must have sold
more so that means a cash inflow”. No. If accounts receivable went up, some of whatever you did
sell wasn’t paid to you in cash and that’s why we subtract increases in AR from our working capital.
Other people think “Oh if Accounts Payable go up then I owe more money to people, which means
cash outflow”. No. If accounts payable increase, some of the money the stuff you bought from your
suppliers and recorded as an expense this year wasn’t actually paid for in cash by you this year, so
it’s a GOOD thing for cash flow. 18
MFL QUESTION 5
Q. Suppose that Linksys’ receivables are 15.5% of sales and its payables are
15.8% of COGS. Forecast the required investment in net working capital for
HomeNet assuming that sales and cost of goods sold will be as below.
t=0 t=1 t=2 t=3 t=4
Sales revenue $23,644 $26,536 $23,946 $8,699
Cost of goods sold $9,558 $10,727 $9,680 $3,517
A. t=0 t=1 t=2 t=3 t=4

Receivables (15.5% rev) $0 $3,664.82 $4,113.08 $3,711.63 $1,348.35
Payables (15.8% cogs) $0 $1,510.16 $1,694.87 $1,529.44 $555.69
Net Working Capital (NWC)  Receivables  Inventory  Payables

NWC1  NWC1  NWC0
t=0 t=1 t=2 t=3 t=4

Net Working Capital $0 $2154.66 $2418.21 $2182.19 $792.66
ΔNWC $2154.66 $263.56 -$236.02 -$1389.53
19
MFL QUESTION 6
Mobile Access Limited is a mobile telephone service provider that:
• Reported $240.6 million of net profit for the most recent financial year
• Had depreciation expense of $102.1 million
• Had capital expenditure of $209.7 million
• Had net working capital increase by $9.8m
• Interest expense is $0.
Q. Calculate the free cash flow (FCF) for the company in this year
A.
Net Profit   EBIT  Interest  1  tax% 
Net Profit  EBIT 1  tax%   NOPAT
...ONLY if Interest Expense = $0 like in this question
i.e. if a firm has no financing expenses like interest, then its net profit is also its operating profit.
FCF  NOPAT  Depreciation  Working Capital  Capital Expenditure

 $240.6m  $102.1m  $9.8m  $209.7m  $123.2m
20
NET SALVAGE VALUE: EXAMPLE 1
Q. Consider an asset that costs $1,000,000 and is depreciated straight-line to
zero over its ten-year useful tax life.
The asset is also to be used in a seven-year project, at the end of which the
asset can be sold for .
If the relevant tax rate is 35%, what is the after-tax cash flow from the sale of
the asset?
A. After seven years, we will have used 70% of the asset value, leaving 30% or
$300,000 of book value according to the tax office.
NSV  Salvage Value  Salvage Value  Book Value  tax rate

$1,000,000
 $500,000  $500,000  $300,000 0.35

 $430,000
Salvage = $500,000
We only pay tax on the

BV7 = $300,000
capital gain! NOT on
$0 the full sale price.
T=0 T=7 T=10
(project start) (project end) (asset tax life)
21
NET SALVAGE VALUE: EXAMPLE 2
Q. Consider an asset that costs $1,000,000 and is depreciated straight-line to
zero over its ten-year useful tax life.
The asset is also to be used in a seven-year project, at the end of which the
asset can be sold for .
If the relevant tax rate is 35%, what is the after-tax cash flow from the sale of
the asset?
A. After seven years, we will have used 70% of the asset value, leaving 30% or
$300,000 of book value according to the tax office.
NSV  Salvage Value  Salvage Value  Book Value  tax rate

$1,000,000
 $200, 000   $200, 000  $300, 000   0.35

 $235,000
Because of our capital loss, we receive

BV7 = $300,000
Salvage = $200,000 a tax shield ($35k) on that loss that we
$0 can use to reduce our taxes from other
T=0 T=7 T=10
(project start) (project end) (asset tax life) projects in that year.
22
MFL QUESTION 8
You purchased a machine for $1,170,000 three years ago and have been
applying straight-line depreciation to zero for a seven-year life.
Your tax rate is 40%.
Q. If you sell the machine right now (after three years of depreciation) for
$735,000, what is your incremental cash flow from selling the machine?
A. 3 out of the 7 years of the machine’s useful tax life have been depreciated.
This means 4/7 of its original $1.17m value is left.
i.e. the book value today is $668,571.43.
Incremental Cash Flow = Salvage Value  Capital Gains Tax
= Salvage Value   Salvage Value  Book Value   tax rate 
= $735,000   $735,000  $668,571.43  0.40 
 $708, 428.57
23
CASH FLOW & NPV EXAMPLE 1
Kawazuki-Harlison, a major fictitious motorcycle manufacturer, is planning on
launching a new high-performance motororised unicycle appropriately called the
Crashcycle. You have the following information:
• To produce the Crashcycle, equipment will be purchased at the start of
the project (t = 0) for $150 million. It will be depreciated over a useful life
of 20 years.
• Without the Crashcycle, the firm expects annual sales to be $100 million
and annual costs of goods to be $80 million in the next fiscal year. With
the Crashcycle, sales are expected to be $122 million and costs to be $85
million.
• Total firm cash flows are expected to grow at 5% per year. Cash flows for
the Crashcycle are expected to grow at 6% per year. The project will end
after 20 years, requiring an expected shut- down cost of $15 million.
• The marginal tax rate for the firm is 32%.
Q. What is the NPV of the Crashcycle project if the project discount rate is 15%
annually? What does the NPV rule say you should do? 24
A. This question can be broken down to several steps:
1. Work out the initial cash outlay/investment at time t=0.
2. Work out the first cash inflow at time t=1.
3. Turn the cash flow in Step 2 into a 20-year annuity that grows at 6%.
Step 1: Initial Investment

The only initial startup cost to this project is the $150m purchase of the
machinery. So this is our cash outflow at time t=0.
If there were initial changes in working capital or sale of old machinery, this
would also be factored in here.
25
Step 2: Cash inflow in year 1
INCREMENTAL CASH FLOWS (t=1)
+ Increase in Sales Revenue + $22 million
($122m – $100m)
– Increase in Costs – $5 million

($85m – $80m)
– Increase in Depreciation – $7.5 million

($150m / 20 years)
= EBIT = $9.5 million

– Taxes – $3.04 million
(EBIT x 32%)
= NOPAT = $6.46 million
+ Increase in Depreciation + $7.5 million
= Total Incremental Cash Flow = $13.96 million (at t=1)
26
Step 3: PV of future cash flows as a 20yr growing annuity and NPV
1   1  g n 
PV0,annuity  CF1   1    
r  g   1  r  
1   1  0.06 20 
 $13.96m   1      $129.96m is the PV today of the 20yr annuity
0.15  0.06   1  0.15  
NPV0,  Initial Outlay  PV of Future CFs from Project  PV of Terminating Cashflow
$15m
 $150m  $129.96m 
(1  0.15) 20
 $20.96m
At a discount rate of 15%, we would reject the above project as the negative NPV of
-$20.96m indicates that it would destroy value from our firm.
27
MFL QUESTION 10
• One year ago, your company purchased a machine for $90,000
• You have learned that a new machine is avialable that offers many
advantages; you can purchase it for $150,000 today.
• It will be depreciated on a straight-line basis over 10 years and has no
salvage value.
• You expected that the new machine will produce a gross margin
(revenues minus operating expenses other htan depreciation) of $50,000
per year for the next ten years.
• The current machine is expected to produce a gross margin of $21,000
per year.
• The current machine is being straight-line depreciated over a useful life
of 11 years, and has no salvage value, so depreciation expense for the
current machine is $8,182 per year.
• The market value today of the current machine is $60,000.
• Your company’s tax rate is $40% and the cost of capital is 12%
Q. Should your company replace its year-old machine?
28
MFL QUESTION 10
A. There are two cash flows you need to work out:
I. The net free cash flow that occurs at t=0 from buying the new machine
and selling the old machine
II. The net free cash flow that occurs in t=1 to t=10 from getting the new
machine’s FCF but giving up the old machine’s FCF.
• The old machine was bought one year ago with an 11 year life (i.e. 10 years
remaining) and the new machine will operate for 10 years.
• These identical remaining lifespans mean that there will be no difference
between the incremental FCF in t=1 to that in t=10.
29
MFL QUESTION 10
I. The net free cash flow that occurs at t=0 from buying the new machine and
selling the old machine
Net Salvage ValueOld  Salvage Value  Capital Gains Tax
 Salvage Value  Salvage Value  Book Value Tax%
 $60,000  $60,000  ($90,000  $8,182)  0.40
 $68,727.27
CF0  Cost of New Machine  Net Salvage Value of Old Machine

 ($150,000)  $68,727.27
 $81,272.73
At t=0, you spend $150,000 to buy the new machine, receive $60,000 in the
market for disposing of the old machine, and save $8,727.27 in tax because of
the capital loss on the sale of the old machine.
The net free cash flow at t=0 is therefore an outflow of $81,272.73.
30
MFL QUESTION 10
I. The net free cash flow that occurs in t=1 to t=10 from getting the new
machine’s FCF but giving up the old machine’s FCF
NEW OLD
Gross Profit $50,000 $21,000
Less: Depreciation $15,000 $8,181.82
= EBIT $35,000 $12,818.18
Less: Tax @ 40% $14,000 $5,127.27
= NOPAT $21,000 $7,690.91
Add Depreciation $15,000 $8,181.82
Less: ∆WC - -
Less: Cap Exp - -
= FCF $36,000 $15,872.73
Going from the old machine to the new machine gives up $15,872.73 of FCF
per year in order to receive $36,000 per year, which is an incremental amount
of $20,127.27.
31
MFL QUESTION 10
A. Working out the NPV is the easy bit.
You have one incremental net cash outflow ($81,272.73) at time t=0, followed
by the same incremental cash inflow every year ($20,127.27) for 10 years from
t=1 to t=10 (i.e. an annuity)
1  1  0.12 10 
NPV0  $81,272.73  $20,127.27  
 0.12 
 $32,450.83 i.e. NPV  $0, therefore replace old machine
32
CASH FLOW & NPV EXAMPLE (MR SUDS)
Mr Suds is considering introducing a new detergent. The firm has collected
the following information about the proposed product from various
divisions within the firm and through a market research survey that cost
$45,000.
The project has an anticipated economic life of 4 years.
The machine for the project will cost (t = 0) $2 million. The machine will be
depreciated on a straight-line basis over 4 years. The company anticipates
that the machine will last for four years, and that after four years, its salvage
value will equal zero.
If the company goes ahead with the proposed product, it will have an effect
on the company's net operating working capital. At the outset, t = 0,
inventory will increase by $140,000 and accounts payable will increase by
$40,000. At t = 4, the net operating working capital will be recovered after
the project is completed.
(question continued on next slide) 33
The detergent is expected to generate sales revenue of $1 million the first
year (t = 1), $2 million the second year (t = 2), $2 million the third year (t = 3),
and $1 million the final year (t=4). Each year the operating costs (not
including depreciation) are expected to equal 50 percent of sales revenue.
The company's interest expense each year will be $100,000.
The new detergent is expected to reduce the after-tax cash flows of the
company's existing products by $250,000 a year (t = 1, 2, 3, and 4).
The company's overall WACC is 10 percent. However, the proposed project is
riskier than the average project of the firm; the project's WACC is estimated
to be 12 percent.
The company's tax rate is 40 percent.
Q. What is the project's net present value (NPV)?
34
DEPRECIATION SCHEDULE
0 1 2 3 4
Cost of Fixed Assets 2,000,000
Less: Depreciation 500,000 500,000 500,000 500,000
= Value of Fixed Assets 2,000,000 1,500,000 1,000,000 500,000 0
35
INITIAL CASH FLOWS
at t = 0
Cost of New Machine: –$2,000,000
Increase in Inventory –$140,000
Increase in Accounts Payable +$40,000
Total Initial Cash Flow –$2,100,000
TERMINAL CASH FLOWS

at t = 4
Net Salvage Value: +$0
Recovery of Inventory Costs +$140,000
Payment of Accounts Payable –$40,000
Total Terminal Cash Flow +$100,000
36
OPERATING CASH FLOW SCHEDULE
1 2 3 4
Revenue 1,000,000 2,000,000 2,000,000 1,000,000
Less: Operating Costs (50% Rev) 500,000 1,000,000 1,000,000 500,000
Less: Depreciation 500,000 500,000 500,000 500,000

“Earnings Before Interest + Tax”
= EBIT (pre-tax operating income) 0 500,000 500,000 0
Less: Taxes EBIT at 40% 0 200,000 200,000 0

“Net Operating Profit After Tax”
= NOPAT (after-tax operating income)
0 300,000 300,000 0
Add Back: Depreciation 500,000 500,000 500,000 500,000
Less: After-Tax Side Effect 250,000 250,000 250,000 250,000

= Net Operating Cash Flow 250,000 550,000 550,000 250,000
37
NET CASH FLOW SCHEDULE
0 1 2 3 4
Initial Cash Outlay –2,100,000
Plus: OCFs (incl. side effects) 250,000 550,000 550,000 250,000
Plus: Terminal Cash Flows 100,000
= Net Cash Flows –2,100,000 250,000 550,000 550,000 350,000
PV of Net Cash Flows (12%) –2,100,000 223,214 438,457 391,479 222,431

NPV = Sum of PVs –$824,419
38
ANOTHER CASH FLOW & NPV EXAMPLE
Consider the following proposal to enter a new line of business:
The new business will require the company to purchase additional fixed
assets that will cost $600,000 at t = 0. For tax and accounting purposes,
these costs will be depreciated on a straight-line basis over three years.
(Annual depreciation will be $200,000 per year at t = 1, 2, and 3.)
At the end of three years, the company will get out of the business and will
sell the fixed assets at a salvage value of $100,000.
The project will require a $50,000 increase in net operating working capital
at t = 0, which will be recovered at t = 3.
The company's marginal tax rate is 35 percent.
The new business is expected to generate $2 million in sales each year (at t =
1, 2, and 3). The operating costs excluding depreciation are expected to be
$1.4 million per year.
The project's cost of capital is 12 percent.
Q. What is the project's net present value (NPV)?
39
DEPRECIATION SCHEDULE
0 1 2 3
Cost of Fixed Assets 600,000
Less: Depreciation 200,000 200,000 200,000
= Value of Fixed Assets 600,000 400,000 200,000 0
“…purchase additional fixed assets that cost $600,000 at t=0…”
“For tax and accounting purposes, these costs will be depreciated on a straight line basis over
three years”
&
“Depreciation will be $200,000 per year at t=1, 2, and 3”
40
INITIAL CASH FLOWS
at t = 0
Capital Expenditure: –$600,000
Increase in Net Working Capital –$50,000
Total Initial Cash Flow –$650,000
(this excess is capital gain)

Net Salvage Value  Salvage Value  Salvage Value  Book Value  tax rate
 $100,000   $100,000  $0   35%
 $65,000
41
INITIAL CASH FLOWS
at t = 0
Capital Expenditure: –$600,000

 $100,000   $100,000  $0   35%
 $65,000
TERMINAL CASH FLOWS

at t = 3
Net Salvage Value: +$65,000
Recovery of Working Capital +$50,000
42
OPERATING CASH FLOW SCHEDULE
1 2 3
Revenue 2,000,000 2,000,000 2,000,000
Less: Operating Costs 1,400,000 1,400,000 1,400,000
= EBIT (pre-tax operating income) 400,000 400,000 400,000
Less: Taxes EBIT at 35% 140,000 140,000 140,000

“Net Operating Profit After Tax”
= NOPAT (after-tax operating income) 260,000 260,000 260,000
Add Back: Depreciation 200,000 200,000 200,000

= Net Operating Cash Flow 460,000 460,000 460,000
43
NET CASH FLOW SCHEDULE
0 1 2 3
Initial Cash Outlay –650,000
Plus: Operating Cash Flows 460,000 460,000 460,000
Plus: Terminal Cash Flows 115,000
= Net Cash Flows –650,000 460,000 460,000 575,000
PV of Net Cash Flows (12%) –650,000.00 410,714.29 366,709.18 409,273.64

NPV 536,697.11
44
ADDITIONAL PROBLEM 8.3.14
Beryl’s Iced Tea currently rents a bottling machine for $54,000 per year, including
all maintenance expenses. It is considering purchasing a machine instead, and is
comparing two options.
I. Purchase the machine it is currently renting today for $160,000. The machine
will require $24,000 per year in ongoing maintenance expenses.
II. Purchase today a new, more advanced machine for $260,000. The machine
will require $19,000 per year in ongoing maintenance expenses and will
lower bottling costs by $14,000 per year. $39,000 will be spent up-front in
training the new operators of the machine.
Suppose the appropriate discount rate is 9% per year. Maintenance and bottling
costs are paid at the end of each year, as is the rental of the machine. Assume
also that the machines will be depreciated via the straight-line method over
seven years and that they have a ten-year life with a negligible salvage value .The
marginal corporate tax rate is 38%.
Q. Should Beryl’s Iced Tea continue to rent, purchase its current machine, or
purchase the advanced machine?
45
A. Renting:
Each year the rent is a cash out flow of $54,000.
The rental expense also saves us $54,000 x 38% = $20,520 each year.
Thus the net cash out flow from renting is only $54,000 x (1 – 0.38) = $33,480
each year for the next 10 years.
As the cash flow is of constant magnitude each year, the NPV for this option
can be calculated as a 10-year annuity with the 9% discount rate:
1 1
NPV0,annuity  CF1   1  1  r    $33, 480   1  1  0.09    $214,863.2
n 10
r   0.09  
46
A. Purchasing the current machine:
INCREMENTAL INFLOWS/OUTFLOWS YEARS 1–7 YEARS 8–10

Revenue $0 $0
Less: Operating Costs $24,000 $24,000
Less: Depreciation $22,857.14 $0
= EBIT (pre-tax operating profit) –$46,854.14 –$24,000
Less: Taxes EBIT at 38% –$17,805.71 –$9,120

= NOPAT (after-tax operating profit) –$29,051.43 –$14,880
Add Back: Depreciation $22,857.14 $0

= Net Cash Flow –$6,194.29 –$14,880
47
A. Purchasing the current machine:
The easiest way to NPV this project would be using 3 values:
I. The cash outflow at time t=0.
II. An annuity at time t=0 that present values the first 7 years of cash flows
III. An annuity at time t=7, that present values the three cash flows from
years 8–10, then discounted by 7 years back to time t=0.
CF810 
  
3
 1  1  r
CF17   
 1  1  r    r
7
NPV0  CF0 
r   1  r 
7
$14,880 
 1  1  0.09  
3
$6,194.29   
 1  1  0.09    0.09
7
 $160, 000 
0.09   1  0.09 
7
 $211,780
48
A. Purchasing the new advanced machine:
INCREMENTAL INFLOWS/OUTFLOWS YEARS 1–7 YEARS 8–10

Revenue $0 $0
Less: Operating Costs $5,000 $5,000
Less: Depreciation $37,142.86 $0
= EBIT (pre-tax operating profit) –$42,142.86 –$5,000
Less: Taxes EBIT at 38% –$16,014.29 –$1,900

= NOPAT (after-tax operating profit) –$26,128.57 –$3,100
Add Back: Depreciation $37,142.86 $0

= Net Cash Flow $11,014.29 –$3,100
49
A. Purchasing the current machine: (same method as for current machine)
CF810 
  
3
 1  1  r
CF17   
 1  1  r    r
7
NPV0  CF0 
r   1  r 
7
$3,100 
 1  1  0.09  
3
$11, 014.29   
 1  1  0.09    0.09
7
 $284,180 
0.09   1  0.09 
7
 $233, 038
Comparing the NPV of the 3 options:
I. Rent: –$214,863
II. Purchase current: –$211,780
III. Purchase advanced: –$233,038
We choose to purchase the current machine as the NPV is the least negative,
implying it is the least expensive of the three options.
The 4th option would be to choose neither of the 3, but then we’d have no bottles to sell our iced tea in, and
therefore lose all of our expected revenue, which would be even more massively NPV than the 3 above
alternatives. So we choose the option for the essential machine with the smallest negative NPV. 50
Billingham Packaging is considering expanding its production capacity by
purchasing a new machine, the XC-750. The cost of the XC-750 is $3.00 million.
Unfortunately, installing this machine will take several months and will partially
disrupt production. The firm has just completed a $50,000 feasibility study to
analyse the decision to buy the XC-750, resulting in the following estimates:
• Marketing: Once the machine is operating, the extra capacity is expected to
generate $12m per year in additional sales, which will continue for the 10yr
life of the machine.
• Operations: The disruption caused by the installation will decrease sales by
$5m this year (0). As with their existing products, the cost of goods for the
products produced by the machine is expected to be 70% of their sale price.
The increased production will require inventory on hand of $1.5m, to be
added in year 0 and depleted in year 10.
• Human Resourced: The expansion will require additional sales and
administrative personnel at a cost of $2m per year.
51
Accounting: The machine will be straight-line depreciated over 10 years. The firm
expects receivables from the new sales to be 12% of revenues and payables to be
10% of COGS. The marginal tax rate is 28%
Q. Determine the incremental earnings from the purchase of the machine.
Q. Determine the free cash flow (FCF) from the purchase of the machine.
Q. If the appropriate cost of capital is 14%, compute the NPV of the expansion.
Q. While the expected sales will be $12m, estimates range from a worst case of
$9.6m to a best case of $14.4m. What is the NPV under these scenarios?
52
A. Earnings, FCFs, and NPV:
BASIC REVENUE/COST CALCULATIONS ($)

0 1–9 10 11
Revenue –5.0m +12.0m +12.0m $0
Costs of goods sold –3.5m +8.4m +8.4m $0
BALANCE SHEET CALCULATIONS ($)

0 1–9 10 11
Accounts Receivable (12% Rev) –0.60m +1.44m +1.44m 0
Inventory +1.5m +1.5m 0 0
Accounts Payable (10% COGS) –0.35m +0.84m +0.84m 0
= NCWC (AR + INV – AP) =1.25m =2.10m =0.60m 0
+0.85m –1.5m –0.60m
Δ NCWC +1.25m (year 1 only)
53
INCREMENTAL CFs YEAR 0 YEAR 1 YEARS 2-9 YEAR 10 YEAR 11
Revenue –5.0m 12m 12m 12m
Less: Operating Costs –3.5m 8.4m 8.4m 8.4m
Less: Personnel Costs 2.0m 2.0m 2.0m
Less: Depreciation 0.3m 0.3m 0.3m
= EBIT –$1.5m +$1.3m +$1.3m +$1.3m
Less: Taxes EBIT at 28% –0.42m 0.364m 0.364m 0.364m

= NOPAT –$1.08m +$0.936 +$0.936 +$0.936
Add Back: Depreciation 0.3m 0.3m 0.3m

Less: Capital Expenditure 3.0m
Less: Change in NCWC 1.25m 0.85m –1.5m –0.6m
= FREE CASH FLOW –$5.33m +$0.386m +$1.236m +$2.736m +$0.60m
54
CF29 
 1  1  r  
8
CF1 r   CF9 CF10
NPV0,Sales $12m  CF0    
1  r  1  r  1  r  1  r 
1 1 9 10
$1.236m 
 1  1  0.14  
8
$0.386m 0.14   $2.736m $0.60m
 $5.33m    
1  0.14  1  0.14  1  0.14  1  0.14 
1 1 9 10
 $0.918091m  $918, 091
Scenario analysis results:

NPV0,Sales $9.6m  $1, 709, 074
NPV0,Sales $14.4m  $3,545, 256
55
ANOTHER EXAMPLE (THE TRANSPORTER)
Q. CCL is considering an early replacement for an existing transporter that is
still in use by the firm. Given a discount rate of 15%, a tax rate of 30%, and
the following information, should it accept the replace the old transporter
with the new one?
New Transporter:
• Has an initial cost of $160,000 with depreciation of $22,000 per year and
a four-year life.
• The new transporter would increase revenue by $15,000 and cut cash
costs by $27,500 per annum.
• The estimated salvage value of the new transporter is $78,500 after year
4.
Old (current) Transporter:
• If sold today, the old transporter would have a salvage value of $37,500.
• But if sold after 4 years, the old transporter would be worthless.
• The current BV of the transporter is $36,000, with depreciation of $9,000
per annum. 56
INITIAL CASH FLOWS
Cost of New Transporter: –$160,000
Sale of Old Transporter: +$37,500

Tax on Sale of Old Transporter: –$450
($37,500 – $36,000)x30%
TERMINAL CASH FLOW
Sale of New Transporter +$78,500
Tax on Sale of New Transporter –$1,950

BV4 = BV0 – 4 x Depreciation
BV4 = $160,000 – 4 x $22,000
Tax on sale = (Sale Price – BV4)x30%

Tax on sale = ($78,500 – $72,000)x30%
= -$1,950
57
OPERATING CASH FLOWS
+ Increase in Sales Revenue + $15,000
+ Reduction in Variable Costs + $27,500

– Increase in Depreciation – $13,000
(22,000 – 9,000)
= EBIT = $29,500
– Taxes – $8,850
(EBIT x 30%)
= NOPAT = $20,650
+ Increase in Depreciation + $13,000
Total Operating Cash Flow p.a. $33,650
NPV0Replace  Initial Outlay  PV of OCFs  PV of Terminal Value

1  1  0.154  $76,550
NPV Replace
 $122,950  $33, 650  
 1  0.15
0 4
 0.15
NPV0Replace  $16,887.73
58
ADDITIONAL PRACTICE QUESTION 1
A company is considering a project to enter a new line of business. We have the
following information:
• The new business will require the company to purchase a new machine that
will cost $930,000.
• These costs will be depreciated on a straight-line basis to zero over three
years.
Q: How much will the annual depreciation be? A: ($930,000 / 3) = $310,000 per annum
• At the end of three years, the company will get out of the business and will
sell the machine at a market value of $70,000.
• Working capital of $50,000 will be required from the outset, which will be fully
recovered at the end of year 3.
• The project is expected to generate $1.6 million in sales each year.
• The operating costs, excluding depreciation, are expected to be $1.15 million
per year.
• The company tax rate is 30%, and the project’s required rate of return is 12%.
Q. What is the net present value of the project?
59
INITIAL CASH FLOWS
at t = 0
Cost of New Machine: –$930,000

 $70,000  $70,000  $0 30%
 $49,000
TERMINAL CASH FLOWS
at t = 3
Net Salvage Value: +$49,000
Recovery of Working Capital +$50,000
60
OCF  Sales  Variable Costs  Fixed Costs  Depreciation1  tax rate  Depreciation
t=1 t=2 t=3
Revenue 1,600,000 1,600,000 1,600,000
Less: Operating Costs 1,150,000 1,150,000 1,150,000
= EBIT (pre-tax operating income)
140,000 140,000 140,000
Less: Taxes on EBIT at 30% 42,000 42,000 42,000

= NOPAT “Net Operating Profit After Tax”
(after-tax operating income) 98,000 98,000 98,000
Add Back: Depreciation 310,000 310,000 310,000

= Net Operating Cash Flow 408,000 408,000 408,000
61
NET CASH FLOWS
0 1 2 3
Initial Cash Outlay –$980,000
Plus: Operating Cash Flows $408,000 $408,000 $408,000
Plus: Terminal Cash Flows $99,000
= Net Cash Flows –$980,000 $408,000 $408,000 $507,000
CF1 CF2 CF3

NPV0  CF0   
1  WACC1 1  WACC2 1  WACC3
408,000 408,000 507,000

 980,000   
1  0.121 1  0.122 1  0.123
 $70,413.40
62
In our evaluation of a new project, we have estimated the following
information:
The company estimates that the project will last for five years.
New machinery will be purchased that has an up-front cost of $300m. This
will be depreciated on a straight-line basis to zero over five years. The
machinery can be sold at an estimated price of $50m at the project’s end.
Production of the new product will take place in a recently vacated facility
that the company owns. Otherwise, the facility can be leased out to collect
$5m in rent per year for the company.
The project will require a $50m investment in inventory as well as an
increase in accounts payable of $10m. Both will be recovered at the project’s
end.
Sales of the new product will be $195m each of the next five years. The
operating costs, excluding depreciation, are expected to be $100m each year.
The company tax rate is 30%, and the project’s WACC is 10%.
Q. What is the net present value of the project? 63
INITIAL CASH FLOWS
at t = 0
Cost of New Machine: –$300m
Increase in Inventory –$50m
Increase in Accounts Payable +$10m
Total Initial Cash Flow –$340m
 $50m  $50m  $0m 30%
 $35m
TERMINAL CASH FLOWS

at t = 5
Net Salvage Value: +$35m
Recovery of Inventory Costs +$50m
Payment of Accounts Payable –$10m
Total Terminal Cash Flow +$75m

64
OCF  Sales  Operating Costs  Opportunity Costs  Depreciation1  tax rate  Depreciation
t=1 t=2 t=3 t=3 t=3
Revenue $195m $195m $195m $195m $195m
Less: Operating Costs $100m $100m $100m $100m $100m
Less: Opportunity Costs $5m $5m $5m $5m $5m
Less: Depreciation $60m $60m $60m $60m $60m
= EBIT $30m $30m $30m $30m $30m
Less: Taxes on EBIT at 30% $9m $9m $9m $9m $9m

= NOPAT $21m $21m $21m $21m $21m
Add Back: Depreciation $60m $60m $60m $60m $60m

= Net Operating Cash Flow $81m $81m $81m $81m $81m
65
NET CASH FLOWS
0 1 2 3 4 5
Initial Cash Outlay -$340m
Plus: Operating Cash Flows $81m $81m $81m $81m $81m
Plus: Terminal Cash Flows $75m
= Net Cash Flows –$340m $81m $81m $81m $81m $156m
CF1 CF2 CF3 CF4 CF5

NPV0  CF0     
1  WACC1 1  WACC2 1  WACC3 1  WACC4 1  WACC5
81 81 81 81 156
 340       $13.622m
1  0.11 1  0.12 1  0.13 1  0.14 1  0.15
66
NET CASH FLOWS
0 1 2 3 4 5
Initial Cash Outlay -$340m
Plus: Operating Cash Flows $81m $81m $81m $81m $81m
Plus: Terminal Cash Flows $75m
= Net Cash Flows –$340m $81m $81m $81m $81m $156m
1  1  WACC5  Terminal CF5

NPV0  Initial 0  OCF 
 WACC  1  WACC 5
1  1  0.15  75
 340  81    $13.622m
 1  0.1
5
 0.1
67
To win a contract, Titanic Shipbuilding Company may need to pay an up-front
fee to O&P Shipping Company. Estimates of the project are as follows:
The ship will take three years to build.
It will generate total revenue of $3m, paid in equal instalments of $10m at
the end of each of the next three years.
The project will require immediate establishment of a new shipyard at a cost
of $4m. The capital cost of the new yard can be depreciated at 20% p.a.
straight-line. The yard can be sold in three years for an estimated $3m.
Working capital of $1m will be required from the outset, the value of which
will rise with the rate of inflation.
Operating costs are estimated at $7m for the first year and are forecast to
rise at the rate of inflation (10% p.a.) thereafter.
The real after-tax rate of return (adjusted for risk) required by Titanic’s
management is 5%. Tax is payable at the rate of 30%.
Assume that the salvage estimate of $3m is quoted in real terms.
Q. What is the NPV? 68
INITIAL CASH FLOWS
at t = 0
Cost of New Shipyard: –$4,000,000
Increase in Working Capital –$1,000,000
Total Initial Cash Flow –$5,000,000
 
 $3,000,0001  0.1  $3,000,0001  0.1  $1,600,000  30%
3 3

 $3,993,000  $717,900  $3,275,100
TERMINAL CASH FLOWS

at t = 3
Net Salvage Value: +$3,275,100

$1m grown at 10%
Recovery of Working Capital +$1,331,000 inflation for three years
Total Terminal Cash Flow +$4,606,100
69
OCF  Sales  Operating Costs  Depreciation1  tax rate  Depreciation
t=1 t=2 t=3
Revenue $10,000,000 $10,000,000 $10,000,000
Less: Operating Costs $7,000,000 $7,700,000 $8,470,000
Less: Depreciation $800,000 $800,000 $800,000
= EBIT $2,200,000 $1,500,000 $730,000
Less: Taxes on EBIT at 30% $660,000 $450,000 $219,000

= NOPAT $1,540,000 $1,050,000 $511,000
Add Back: Depreciation $800,000 $800,000 $800,000

= Net Operating Cash Flow $2,340,000 $1,850,000 $1,311,000
70
NET CASH FLOWS
0 1 2 3
–$5,000,000
Initial Cash Outlay
Plus: Operating Cash Flows $2,340,000 $1,850,000 $1,311,000

Plus: Terminal Cash Flows $4,606,100
= Net Cash Flows –$5,000,000 $2,340,000 $1,850,000 $5,917,100
To discount these cash flows, we need to adjust the real required rate of return for
the effects of inflation
WACCnominal  1  WACCreal 1     1  1  0.05 1  0.10   1  15.5%
ρ = inflation
2,340, 000 2,340, 000 2,340, 000

NPV0  5,000,000     $2, 253, 035.22
1  0.155 1  0.155 1  0.155
1 2 3
71
Q. Set out the cash flows of the project in nominal dollars.
A. Done!
Q. Calculate the net present value of the project.

A. Done! $2,253,035.22
Q. Is the project worth doing?

A. Yes, as it has a positive NPV and is expected to add value
Q. What is the maximum amount that Titanic could pay by way of a bribe,
before the project becomes uneconomical?
A. $2,253,035.22. The company could pay up to the positive NPV of the project
as a bribe before the project becomes negative NPV and unprotifable.
72
SYDNEY ROOSTERS CHALLENGE PROJECT
The Sydney Roosters project has the following information:
The team expects to sell 20,000 roosters in the first year. Sales are expected
to grow by 40% each year until the third year. Rooster will sell for $100.
Variable costs, such as chicken coop maintenance and feed costs, are
expected to be $10 per each rooster sold.
The team will hire:
• Five chicken farmers at $75,000 per farmer annually
• Two geneticists (with questionable ethics) at $125,000 per geneticist
annually
The marketing group will be expanded from 20 to 22 employees, with an
average salary of $100,000 per year.
The firm will extend credit to buyers. It is expected that the ending year
accounts receivable balance will be 20% of annual sales.

(page 2 of Q)
Feed providers will allow the Roosters six months to pay back any purchase.
The team expects to use this credit facility to its maximum level. Therefore,
the ending balance at the end of each year will be half the total feed cost for
the year. $5 out of the $10 variable costs are in feed.
The land used for farming costs $500,000 per year. This land is already being
leased by the team and is currently used as a practice pitch. The lease is
long-term and cannot be broken. The team will now practice for free at
UNSW.
By selling the singing roosters, the team will not market its new theme song,
“Y.M.R.A.” The song was expected to increase revenues by $80,000 per year
(and spark a silly dance craze). CD production, while outdated, was to cost
$10,000 per year.
Some fans are expected to attend fewer games and instead watch matches
on television in order to spend more quality time snuggling with their new
pet roosters. This is expected to reduce ticket revenues by $50,000 per year.
(page 3 of Q)
Initial capital expenditures on R&D are expected to be $1,200,000, which
includes a gene sequencer and other cool genetic research type stuff. The
equipment will be depreciated straight line with a 5 year useful life.
After 2-years, the genetic sequences will sold for $500,000. The geneticists
will remain on staff, receiving “hush money” in perpetuity.
Inventory will be $150,000, $500,000, and $600,000 at the ends of years 1, 2,
and 3, respectively.
For some reason, the project has three-years of abnormal growth life. After
that, the third year cash flow is expected to grow by 3% in perpetuity.
The tax rate is 40%.
Q. Calculate the net present value of the project.

(this difference is the capital gain)
After-Tax Salvage Value  Salvage Value  Salvage Value  Book Value  tax rate
 500,000   500,000  720,000   40%   588, 000
We only pay tax on

the capital gain!
NOT on the full sale
$1,200,000
price.
BV2 = $720,000 In this case we

capital loss make a capital LOSS
Salvage2 = $500,000 and receive an $88k
tax credit to use to
$0 reduce our firm’s
T=0 T=2 T=5
(project start) (sale of asset) (asset tax life) other tax
obligations in the
year

BASIC REVENUE/COST CALCULATIONS
0 1 2 3
$100 x 20 $100 x 20 x 1.40 $100 x 20 x 1.402
Revenue 0 =$2,000 =$2,800 =$3,920
$10 x 20 $10 x 20 x 1.40 $10 x 20 x 1.402
Variable Costs 0 =$200 =$280 =$392
BALANCE SHEET CALCULATIONS

0 1 2 3
Accounts Receivable (20% Rev) 0 400 560 784
Inventory 0 150 500 600
Accounts Payable 0 50 70 98
= NCWC 500 990 1286
Δ NCWC 500 490 296

CASH FLOW CALCULATIONS
0 1 2 3
Revenue 2000 2800 3920
Less: Variable Costs 200 280 392
Less: Fixed Costs 825 825 825
= Gross Profit 975 1695 2703
Less: Depreciation 240 240 0
Add/Less: Pre-Tax Side Effects 50 50 50
Less: Pre-Tax Opportunity Costs 70 70 70
= EBIT 615 1335 2583
Less: Taxes on EBIT @ 40% 246 534 1033.2

= NOPAT 369 801 1549.8
Add: After-Tax Salvage Value 588

Add: Depreciation 240 240 0
Less: Δ NCWC 500 490 296
Less: Capital Expenditure 1,200
= Project Free Cash Flows –1,200 109 1139 1253.8

1253,8 1  0.03
NPV0  1, 200 
109

1,139

1253,8
 0.18  0.03
1  0.18 1  0.18 1  0.18 1  0.18 
1 2 3 3
109 1,139 1253,8 8609.43

NPV0  1, 200    
1  0.18 1  0.18 1  0.18 1  0.18 
1 2 3 3
NPV0  5,713.45

THE END
80

Business Finance FINS1613: Tutorial Week 6

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BUSINESS FINANCE

Q. Broadly, what cash flows should be included in project evaluation?

Q. What cash flows should be excluded?

Less: Variable Costs

Less: Fixed Costs

= EBIT (or pre-tax operating profit)

Less: Taxes on EBIT @ ??%

= NOPAT (after-tax operating profit)

= Operating Cash Flows

Less: Δ Non-cash Working Capital

Less: Capital Expenditure

= Project Net Free Cash Flows

A. The answer is d).

– Increase in Costs – $6 million

– Lost Sales Revenue – $2 million

= EBIT = $39 million

= NOPAT = $25.35 million

= Total Incremental Cash Flow = $25.35 million (at t=1)

The emphasis in this question is on understanding the word “INCREMENTAL”.

A. No, this is a sunk cost. It is non-incremental.

A. Yes. This is incremental cash outflow is an example of a negative side effect /

Q. The $15,000 in market research spent to evaluate customer demand.

A. No, as this is again an example of a non-incremental sunk cost.

Q. The value of the land if sold.

A. Yes. This is an opportunity cost.

Q. Interest expense on the debt borrowed to pay the construction costs.

A. The after-tax impact of a decrease in revenue can be calculated as:

 $214,0001  0.38  $132,680

In this question, we have no working capital changes or capital expenditure,

OCF   Revenue  Costs  Depreciation  (1  Tax%)  Depreciation

A. Diminishing value depreciation causes larger amounts of the asset to be

Simply, if I have the choice between the following two options:

A. As before, FCF can be generally expressed as:

In this question, we have no working capital changes. However, we do have

 Revenue  Costs  Depreciation 1  tax %   Depreciation

 $4,100,000  $1,400,000  $1,990,0001  0.30  $1,990,000

 $2,487,000 per year

INCREMENTAL CALCS t=0 t=1 t=2 t=3 t=4 t=5

• If Current Liabilities (i.e. Accounts Payable) INCREASE in a particular period, this is a

A. t=0 t=1 t=2 t=3 t=4

Net Working Capital (NWC)  Receivables  Inventory  Payables

t=0 t=1 t=2 t=3 t=4

FCF  NOPAT  Depreciation  Working Capital  Capital Expenditure

NSV  Salvage Value  Salvage Value  Book Value  tax rate

 $500,000  $500,000  $300,000 0.35

We only pay tax on the

NSV  Salvage Value  Salvage Value  Book Value  tax rate

 $200, 000   $200, 000  $300, 000   0.35

Because of our capital loss, we receive

Step 1: Initial Investment

– Increase in Costs – $5 million

– Increase in Depreciation – $7.5 million

= EBIT = $9.5 million

= NOPAT = $6.46 million

+ Increase in Depreciation + $7.5 million

= Total Incremental Cash Flow = $13.96 million (at t=1)

NPV0,  Initial Outlay  PV of Future CFs from Project  PV of Terminating Cashflow

CF0  Cost of New Machine  Net Salvage Value of Old Machine

The net free cash flow at t=0 is therefore an outflow of $81,272.73.

Cost of New Machine: –$2,000,000

Increase in Inventory –$140,000

Increase in Accounts Payable +$40,000