Homework on Relevant Cash Flow Calculations: (20 Points)

Question 1: A Mini-case on Estimation of Cash Flows (8 Points)

A firm is considering replacing an old machine at a cost of $110,000. The new machine will to
last five years with zero salvage value. It will generate expected annual cost savings of $30,000.
The current machine will last for another 10 years. The discount rate is 10 percent. Assume that
tax rate is zero and the present machine is fully depreciated with a zero salvage value.
A. Should the firm replace the old machine? Show NPV calculations. (2 Points)
1

Cash Flow

T=0
(110,000)

2
3

Discount Rate
NPV

10%
3,721

T=1
$
30,000
0.9091

T=2
$
30,000
0.8264

T=3
$
30,000
0.7513

T=4
$
30,000
0.683

T=5
$
30,000
0.6209

B. Assume that existing equipment was bought for $80,000 five years ago and is being
depreciated on a straight line over ten years towards a zero book value. It continues to
have zero salvage value. Should the firm replace the machine? (No calculations are
necessary). Limit your answer to 20 words or less. (2 Points)

As tax rate is Zero hence the Loss of Depreciation (Tax Shield) of Old machine and the
tax shield due to Depreciation on New machine have no effect of the relevant cash inflow
related to project. Decision relating to replacement will still be the same as above.
C. The firm replaces the old machine with new machine. Two years later, an improved
machine becomes available which makes the existing machine obsolete with no
salvage value. The improved machine will cost $150,000 and last five years. The annual
additional cost savings over the previous machine is expected to be $40,000. This
machine will be depreciated on a straight line towards a zero book value. Other items
remain same. What should firm do? Show calculations. (2 Points)
T=0
1

Cash Flow

Discount Rate

NPV

T=1

$
(150,000)
@ 10%

T=2

$
40,000

$
40,000

$
36,364

$
33,056

T=3
$
40,000
$
30,052

T=4
$
40,000
$
27,320

T=5
$
40,000
$
24,836

$
1,628

The New Improved machine is costlier than its older counterparts. Though it gives more
annualized return still its NPV is less in compared to the previous replaced machine.
D. Was a mistake made to buy the machine two years ago? No calculations are needed.
Limit your answer to 50 words. (2 Points)

That was not a mistake as before 2 years the replaced machine was one of the new model.
And now it has become obsolete because of the improved one. In the above situation the
firm could have waited for a better option after some years as the old machine was not
Homework on Relevant Cash Flows

Suren Mansinghka

fully incapacitate at the time of replacement. The company has to incur the cost on the
new Improved machine.
The firm has suffered losses in terms of irrecoverable capital expenditure in relation to the second
machine as it has became obsolete after 2 years of its purchase

Question 2: A Mini-case on Relevant Cash Flows (6 Points)

A finance manager was presented with an analysis of a new project (see the table below) and
noted that there was no mention of the following items:
A. The cash flow projections did not include effect of accounts receivables and payables. The
average collection period for receivables and average payment period for payables are expected
to be 50 days, and 36 days respectively based on 365 days.
B. Standard charge of 1percent of sales for overhead has not been included.
C. The financing charge of 10 percent of book value of assets has been left out.

For each item show separately its incremental effect on NPV as appropriate.
1
2
3
4
5
6
7
8
9
10
11

Items (in thousands of dollars)

Revenues
Raw Material Costs
Direct costs
Depreciation
EBIT (1-2-3-4)
Tax Rate 40% of 5
NOPAT (5-6)
Increase in Inventories
Capital Expenditures
Cash Flow of Project (7+4+8+9)
NPV of line 10 @11%

T=0

-400
-20,000
-20,400
$1,274

T=1 to 4
12,000
4,000
1,000
4,000
3,000
1,200
1,800
0
0
5,800

T=5
12,000
4,000
1,000
4,000
3,000
1,200
1,800
400
0
6,200

A: Estimate incremental NPV by including accounts receivables and payables? Show

calculations. (2 Points)

B. Should standard charge of 1% of Sales for overhead be included? Why? Why not? 30 words
or less. (Show any calculations if appropriate) (2 Points)

According to the with/without principle the allocated overhead costs are irrelevant
because the firm have to bear them even if the project is not undertaken.so standard
charge of 1% of sales for Overhead should not be included in the relevant cash flow.

C. Should financing charge be included? Why? Why not? 30 words or less. (Show any
calculations if appropriate) (2 Points)

Financing costs are cash flows to the investors who fund the project, not cash flows from
the project.as project is being analyzed using the NPV approach the projects expected
cash flow stream is discounted at the projects cost of capital and which in turn is the cost
of financing the project i.e. projects Cost of Capital.
Homework on Relevant Cash Flows

Suren Mansinghka

So Financing costs should be ignored while estimating Relevant cash flow in order to
avoid double treatment of the same.
Question 3: This question is based on previous question. (6 Points)
The CFO is also concerned about following three additional items. First, it is expected
that the new product will cannibalize after tax cash flows of an existing product by as
much as $650,000 each year. Second, a currently unused building will be used to produce
the new product. The building can be rented for $100,000 (after tax) annually. Finally,
the firm paid $500,000 to a consultant for a marketing study for the new product. The
CFO has asked you to advise him for these items. For each item, show separately
incremental effect on NPV and provide calculations as necessary.
A. Cannibalization: (2 Points)
The relevant cash flows related to the project will be reduced by the Loss of sales of
existing product (relevant cost) $ 650000 p.a as the new product has a cannibalization
effect on the existing product .The relevant cash flows related to the new project will be
reduced. Hence the NPV will also get reduced.
B. Unused Building Rent: (2 Points)
The relevant cash flows to the project will be reduced by the amount of Opportunity cost
of Forgone post tax rent income i.e. $ 100000 related to the building.
NPV will be reduced, as the relevant inflows from the project will be reduced by the
amount of
Opportunity cost related to rent income foregone per annum.
C. The money spent on market research: (2 Points)
The money paid for market research of $500,000 to a consultant for a marketing study
for the new product is a sunk cost as it cannot be recovered if the project is not
undertaken.it is irrelevant to the decision to invest in the project.NPV will remain
unchanged in relation to the Marketing research expenses paid by the firm.

Homework on Relevant Cash Flows

Suren Mansinghka