Problems on Estimation of Cash Flows

Problem 1
Brown Box Company Ltd. is considering the manufacture of new customized
corrugated boxes for one of its clients who had associated with the company for
more than a decade. The customized boxes could be manufactured by new
equipment as the existing equipment would not support the necessary design
requirements. Hence, the capital equipment required for manufacturing these boxes
is 60 million. The equipment is subject to depreciation at the rate of 25 percent as
per the WDV method for tax purposes and the useful life of the equipment is seven
years. The equipment would fetch a salvage value of 12.5 million at the end of
seven years.

The working capital associated for the project is expected to be 25 percent of sales.
The company adjusts the working capital level at the beginning of the year in
relation to the adjusted sales for the year. The working capital is expected to be
liquidated at par, exclusive of an estimated loss of 2 million on account of bad
debt which, of course, would be a tax-deductible expense. The company has the
following estimation of sales for the next seven years.
Year 1 2 3 4 5 6 7
Sales ( in Millions) 40 60 80 100 80 60 40

The finance controller of the firm has provided the following estimates for the cost
of manufacturing customized boxes. The raw material cost would be 30 percent of
sales; variable manufacturing cost would be 10 percent of sales; variable selling
expenses would be 10 percent of sales; overhead allocation would be 10 percent of
sales. However, the incremental overhead attributable to the overhead is expected
to be only 5 percent of sales. The fixed annual operating and maintenance costs
would be 5 million.

The controller also reveals that by manufacturing customized boxes, the sales of
existing boxes thereby reducing its contribution margin by 5 million per year. The
tax rate applicable to the company is 30 percent.

a) You are required to estimate the post tax incremental cash flows for the
project to manufacture new customized corrugated box.
b) What is the NPV of the project if the cost of capital is 10 percent? Advise
the controller on the acceptance of the project.
Problem 2
Sangeeta Enterprises is determining the cash flow for a project involving
replacement of an old machine by a new machine. The old machine bought a few
years ago has a book value of 28,00,000 and it can be sold to realise a post-tax
salvage value of 22,00,000. It has a remaining life of five years after which its net
salvage value is expected to be 9,00,000. It is being depreciated annually at a rate
of 30 percent the WDV method. The working capital associated with this machine
is 10,00,000.

The new machine costs 80,00,000. It is expected to fetch a net salvage value of
35,00,000 after five years. The depreciation rate applicable to it is 25 percent
under the WDV method. The new machine is expected to bring a saving of
10,00,000 annually in manufacturing costs (other than depreciation). The
incremental working capital associated with the new machine is 6,00,000. The tax
rate applicable to the firm is 33 percent.

(a) Estimate the cash flow associated with the replacement project.
(b) What is the NPV of the replacement project if the cost of capital is 14 percent?

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