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Harper Ferry Company operates a high-speed passenger ferry service across the

Mississippi River. One of its ferryboats is in poor condition. This ferry can be renovated
at an immediate cost of $200,000. Further repairs and an overhaul of the motor will be
needed five years from now at a cost of $80,000. In all, the ferry will be usable for 10
years if this work is done. At the end of 10 years, the ferry will have to be scrapped at a
salvage value of $60,000. The scrap value of the ferry right now is $70,000. It will cost
$300,000 each year to operate the ferry, and revenues will total $400,000 annually.

As an alternative, Harper Ferry Company can purchase a new ferryboat at a cost of


$360,000. The new ferry will have a life of 10 years, but it will require some repairs
costing $30,000 at the end of 5 years. At the end of 10 years, the ferry will have a scrap
value of $60,000. It will cost $210,000 each year to operate the ferry, and revenues will
total $400,000 annually.

Harper Ferry Company requires a return of at least 14% before taxes on all investment
projects.

Find out whether the company renovate or buy the ferry. Ignore depreciation.
Relevant cash flows

Why cash flows rather than profits?

Cash flows should be used in investment appraisal rather than profits as this more
closely reflects the impact on shareholders wealth.

Rarely profit in any year of the project's life equal the cash flow

Income statements might show $ 100,000 for sales, the actual cash receipts may be
much less as some cash is still to be received, i.e. there are receivables

From a wealth point of view shareholders will be interested in when cash goes out
and when it is returned to them in the form of dividends, i.e. the amount and
timing of the flows are important to them.

All of the costs for a period will be reflected in the income statement i.e. they will
influence the profit, they may not all be relevant cash flows for a particular decision,
e.g. depreciation.
Profits to cash flows

If income statement information is provided, there are two adjustments which should be
made to convert to cash flows:

Depreciation: depreciation is not a cash flow and should be added back.

Working capital: A project may involve not only investment in land, buildings etc
but also investment in working capital (inventory + receivables payables).
Increases in net working capital represent an outflow, decreases an inflow.
Example:
G Limited expects the following sales from a new project over its three year life:
Year 1 $ 150,000
Year 2 $ 175,000
Year 3 $ 200,000

Working capital equal to 10% of annual sales is required and it needs to be in


place at the start of each year only to the extent of incremental flow of cash
over previous year. At the end of project the working capital is assumed to be
recovered.

Find out the working capital cash flow requirement


Figure 2:

A company plans to make sales of CU 100,000 at T1, increasing by 10% per


annum until T4. Working Capital Equal to 15% of annual sales is required at the
start of each year.

Requirement:
What are the working capital cash flows?
Relevant cash flows

The general rule is to include only those costs and revenues which can affect the
decision or be affected by it.

Typical items which are excluded from the analysis:


Sunk costs money already spent, e.g. when trying to determine whether an
existing machine which cost $ 250,000 three years ago should be used on a new project,
the analysis should ignore the $ 250,000 as nothing can be done about it; instead, the
machine's current worth (either scrap value or cash benefits from retention) should be
included.
Accounting entries e.g. depreciation (as discussed above) is not a cash
flow
Book values e.g. FIFO/LIFO inventory values. This is similar to sunk costs
above as the FIFO/LIFO conventions merely deal with the treatment of money
already spent

Unavoidable costs money already committed, e.g. a non-cancellable lease


or apportioned fixed costs.
Example
A new contract requires the use of 50 tonnes of metal X. This metal is used
regularly on all the firm's projects. At the moment there are in inventory 100
tonnes of X, which were bought for $ 200 per tonne. The current purchase price is
$ 210 per tonne, and the metal could be disposed of for net scrap proceeds of $
150 per tonne. With what cost should the new contract be charged for the X?

Solution
The use of the material in inventory for the new contract means that more X must be bought
for normal workings. The cost to the organisation is therefore the money spent on purchase,
no matter whether existing inventory or new inventory is used on the contract.
Assuming that the additional purchases are made in the near future, the relevant cost to the
organisation is current purchase price, i.e. 50 tonnes X $ 210 = $ 10,500.

Example: Material with no alternative use


Suppose the organisation has no alternative use for the X in inventory. What is
the relevant cost of using it on the new contract?

Solution:
Now the only alternative use for the material is to sell it for scrap. To use 50
tonnes on the contract is to give up the opportunity of selling it for 50 X $150 = $
7,500. The contract should therefore be charged with this amount.
Example: Material with a scrap value
Suppose again there is no alternative use for the X other than a scrap sale, but that
there are only 25 tonnes in inventory.

Solution:
The relevant cost of 25 tonnes is $ 150 per tonne. The organisation must then
purchase a further 25
tonnes and, assuming this is in the near future, it will cost S 210 per tonne.

The contract must be charged with:

25 tonnes @ $ 150 3,750


25 tonnes @ $ 210 5,250
9,000
Example: Relevant cost of labour
A mining operation uses skilled labour costing $ 8 per hour, which generates a
contribution of $ 6 per hour, after deducting these labour costs.

A new project is now being considered which requires 5,000 hours of skilled labour.
There is a shortage of the required labour. Any labour use on the new project must
be transferred from normal working.

What is the relevant cost of using the skilled labour on the project?

Solution:
What is lost if the labour is transferred from normal working?

Contribution per hour lost from normal working 6


Labour cost per hour which is not saved 8
Cash lost per hour as a result of the labour transfer 14

The contract should be charged with 5,000 X $14= $ 70,000


Example: Relevant cost of labour
Facts as in the previous Worked example, but there is a surplus of skilled labour
sufficient to cope with the new project. The idle workers are being paid full wages.

Solution:
What revenue is lost if the labour is transferred to the project from doing nothing?
Answer is Nothing.
The relevant cost is zero.
Home Work:
You are the Financial Analyst of Jamuna Group. Your Finance Director has meet the Board
of Directors and the Board wants to make some expansion which will eventually have some
capital investment. There are two projects that Jamuna Groups Board of Directors can
choose; Project X and Project Y. Both the project has a cost of $ 10,000 and the required
rate of return for each project is 12%.
The projects expected net cash flows are as follows:
Expected Net Cash Flows
Year Project X Project Y
0 ($10,000) ($10,000)
1 6,500 3,500
2 3,000 3,500
3 3,000 3,500
4 1,000 3,500

A. Calculate each projects payback period (PB), Net Present Value (NPV) and Internal
Rate of Return (IRR)
B. Which project or projects should be accepted if they are independent?
C. Which project should be accepted if they are mutually exclusive?