Fin 370 Week 3 Team Assignment

Topics: Net present value, Internal rate of return, Cash flow Pages: 6 (1371 words) Published: May 19, 2013
FIN370 WK3
Solutions Guide:

1.We focus on free cash flows rather than accounting profits because these are the flows that the firm receives and can reinvest. Only by examining cash flows are we able to correctly analyze the timing of the benefit or cost. Also, we are only interested in these cash flows on an after tax basis as only those flows are available to the shareholder. In addition, it is only the incremental cash flows that interest us, because, looking at the project from the point of the company as a whole, the incremental cash flows are the marginal benefits from the project and, as such, are the increased value to the firm from accepting the project. 2.Although depreciation is not a cash flow item, it does affect the level of the differential cash flows over the project's life because of its effect on taxes. Depreciation is an expense item and, the more depreciation incurred, the larger are expenses. Thus, accounting profits become lower and in turn, so do taxes which are a cash flow item. 3.When evaluating a capital budgeting proposal, sunk costs are ignored. We are interested in only the incremental after-tax cash flows, or free cash flows, to the company as a whole. Regardless of the decision made on the investment at hand, the sunk costs will have already occurred, which means these are not incremental cash flows. Hence, they are irrelevant.

Solution to Integrative Problem, parts 4, 5, & 6.

Section I. Calculate the change in EBIT, Taxes, and Depreciation (this become an input in the calculation of Operating Cash Flow in Section II). Year| 0| 1| 2| 3| 4| 5|
Units Sold| | 70,000| 120,000| 140,000| 80,000| 60,000| Sale Price| | $300 | $300 | $300 | $300 | $260 | | | | | | | |
Sales Revenue| | $21,000,000 | $36,000,000 | $42,000,000 | $24,000,000 | $15,600,000 | Less: Variable Costs| | 12,600,000| 21,600,000| 25,200,000| 14,400,000| 10,800,000| Less: Fixed Costs| | $200,000 | $200,000 | $200,000 | $200,000 | $200,000 | Equals: EBDIT| | $8,200,000 | $14,200,000 | $16,600,000 | $9,400,000 | $4,600,000 | Less: Depreciation| | $1,600,000 | $1,600,000 | $1,600,000 | $1,600,000 | $1,600,000 | Equals: EBIT| | $6,600,000 | $12,600,000 | $15,000,000 | $7,800,000 | $3,000,000 | Taxes (@34%)| | $2,244,000 | $4,284,000 | $5,100,000 | $2,652,000 | $1,020,000 |

Section II. Calculate Operating Cash Flow (this becomes an input in the calculation of Free Cash Flow in Section IV). Operating Cash Flow:| | | | | | |
EBIT| | $6,600,000 | $12,600,000 | $15,000,000 | $7,800,000 | $3,000,000 | Minus: Taxes| | $2,244,000 | $4,284,000 | $5,100,000 | $2,652,000 | $1,020,000 | Plus: Depreciation| | $1,600,000 | $1,600,000 | $1,600,000 | $1,600,000 | $1,600,000 | 272

Equals: Operating Cash Flow| | $5,956,000 | $9,916,000 | $11,500,000 | $6,748,000 | $3,580,000 |

Section III. Calculate the Net Working Capital (This becomes an input in the calculation of Free Cash Flows in Section IV). Change In Net Working Capital:| | |
Revenue:| | $21,000,000| $36,000,000| $42,000,000| $24,000,000| $15,600,000| Initial Working Capital Requirement| $100,000| | | | | | Net Working Capital Needs:| | $2,100,000| $3,600,000| $4,200,000| $2,400,000| $1,560,000| Liquidation of Working Capital| | | | | | $1,560,000| Change in Working Capital:| $100,000| $2,000,000| $1,500,000| $600,000| ($1,800,000)| ($2,400,000)|

Section IV. Calculate Free Cash Flow (using information calculated in Sections II and III, in addition to the Change in Capital Spending). Free Cash Flow:| | | | | | |
Operating Cash Flow| | $5,956,000 | $9,916,000 | $11,500,000 |...
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