Lahore School of Economics

Financial Management II
Cash Flow Estimation and Risk Analysis – 1
Assignment 8

Problems for Assignment

Q1) a. Project cash flows: t = 1
Sales revenues $10,000,000
Operating costs 7,000,000
Depreciation 2,000,000
EBIT $ 1,000,000
Taxes (40%) 400,000
EBIT(1 – T) $ 600,000
Add back depreciation 2,000,000
Project cash flow = EBIT(1 – T) + DEP $ 2,600,000

b. The cannibalization of existing sales needs to be considered in this analysis on an after-tax basis, because the
cannibalized sales represent sales revenue the firm would realize without the new project but would lose if the
new project is accepted.

The after-tax effect would reduce the project’s cash flow by:
$1,000,000(1 – T) = $1,000,000(0.6) = $600,000.

The project’s cash flow would now be $2,000,000 rather than $2,600,000.

Q2) Equipment’s original cost $20,000,000

Depreciation (80%) 16,000,000
Book value $ 4,000,000

Gain on sale = $5,000,000 – $4,000,000 = $1,000,000.

Tax on gain = $1,000,000(0.4) = $400,000.
AT salvage value = $5,000,000 – $400,000 = $4,600,000.

Q3) a. The $5,000 spent last year on exploring the feasibility of the project is a sunk cost and should not be
included in the analysis.

b. The initial investment outlay at t = 0 is $126,000:

Price ($108,000)
Modification (12,500)
CAPEX ($120,500)
NOWC (5,500)
Initial investment outlay ($126,000)

CF0 = -$126,000.
 c. The annual project cash flows follow:
Project’s operating cash flows:
Year 1 Year 2 Year 3  
Savings $44,000 $44,000 $44,000
Depreciation 39,765 54,225 18,075
EBIT $ 4,235 ($10,225) $25,925
Taxes (35%) 1,482 (3,579) 9,074
EBIT(1 – T) $ 2,753 ($ 6,646) $16,851
Add Depreciation 39,765 54,225 18,075
EBIT(1 –T) + DEP $42,518 $47,579 $34,926

Terminal cash flows at time = 3:

Salvage value $65,000
Tax on salvage value 19,798
AT salvage value $45,202
NOWC = Recovery of NOWC 5,500
Project FCFs = EBIT(1 – T)
+ DEP – CAPEX – NOWC $42,518 $47,579 $85,628

(BV in Year 4 = $120,500(0.07) = $8,435.

Tax on SV = ($65,000 – $8,435)(0.35) = $19,798.)

d. The project has an NPV of $10,841; thus, it should be accepted.

Examples
Q1)
NPV = $78.82 IRR = 14.489%

MIRR:
Terminal value = NFV
CF0 = 0; CF1 = 500; CF2 = 400; CF3 = 300; CF4 = 100; I = 10%; NFV = $1579.5

PV of cost = -$1,000

N = 4; PV = -1000; FV = 1579.5; I = MIRR = 12.106%.

Payback:
0 1 2 3 4
| | | | |
-1,000 500 400 300 100
Cumulative CF: -1,000 -500 -100 200 300

Payback = 2 + $100/$300 = 2.33 years.