Cash Flow Estimation and Capital Budgeting

Case Assignment

Estimating Project Cash Flows

ABC Golf Equipment Corporation is considering venturing into the golf club manufacturing business with a new driver golf club.  As the CFO, it is your job is to add the financial perspective to the decision. It is estimated that the current cost (t=0) of the machinery to create the golf club would cost $2,050,000 including all installation expenses. The company also expects to have to maintain $100,000 of inventories associated with the manufacturing of the golf clubs.  The machinery is expected to last ten years. The production equipment is expected to last ten years.  The project's cash inflows are expected at begin during year 1 (t=1) and continue through all ten years (t=10).  The company expects to sell 500 golf clubs per year at an anticipated price of $500 per golf club.  Operating costs, excluding depreciation, are anticipated to be 75% of sales each year.  The project's cost of capital is 12% and the firm's tax rate is 35%.  Determine the project's cash flows for years t=0 to t=10.

Note: Don't forget to consider depreciation (use straight line) when doing the calculations.The equipment is expected to have a resale value of only $40,000 at the end of the tenth year, so this amount is the salvage for purposes of the analysis.

Before you start the analysis, you can work through the example below for guidance.

Acme Company is considering the purchase of new equipment that will be used to produce widgets.  As the CFO, you've been asked to complete a financial analysis of cash flows associated with this new purchase.  It is estimated that the cost (t=0) of the equipment will be $285,000, with shipping and installation costs of $25,000.  The machinery is expected to last 5 years, and is expected to sell for $30,000 at the end of the 5-year period (this remaining value is referred to as the "salvage value"). Assume that the salvage value of the equipment will be equal to the market value of the equipment (i.e., there will be no gain or loss on sale of the equipment at end of Year 5). The project's cash inflows will begin during year 1 (t=1) and will continue through all five years (t=5).  The company expects to sell 600 widgets each year at a price of $500 per widget. Operating costs, excluding depreciation, are anticipated to be 70% of sales each year.  The firm's tax rate is 35%.  Calculate:

1) The initial investment cash outlay

2) Straight-line depreciation

3) Operating cash flows for the 5-year period

1) Compute the initial investment cash outlay. This is the total cost of equipment purchase ($285,000), installation and shipping ($25,000), and change in net working capital ($20,000):

2) Calculate straight-line depreciation, where salvage value is $30,000 and useful life of the equipment is 5 years:

3) Calculate operating cash flows, where CF_t = (revenues - costs)*(1 - tax rate)

CF₁ = ($300,000 - $210,000)*(1 - 35%) = $58,500
CF₂ = ($300,000 - $210,000)*(1 - 35%) = $58,500
CF₃ = ($300,000 - $210,000)*(1 - 35%) = $58,500
CF₄ = ($300,000 - $210,000)*(1 - 35%) = $58,500
CF₅ = ($300,000 - $210,000)*(1 - 35%) = $58,500

Required:

Computations (use Excel).

Use Excel to estimate the project's cash flows. Presentation always matter, but you want to make sure that Mr. Hillbrandt can easily follow your work. He is a busy man.

Memo (use Word).

Write a memo to Mr. Hillbrandt and comment on the three questions below.  Limit the memo to four or five paragraphs since CEOs want an initial succinct explanation to accompany the financial calculations. Start with an introduction and end with a recommendation. Each of the four or five paragraphs should have a heading.

1. If the manufacturer plans on using debt to finance the project, should the estimated project cash flows be changed to reflect these interest charges?  Why or why not?

2. If the manufacturer spent $200,000 studying golf clubs last year, should that cost be taken into account with this analysis?  Why or why not?

3. If the manufacturer could rent out the factory that is storing the golf club machinery for $80,000 a year, should that be taken into account with this analysis?  Why or why not?

Short Essay (use Word).

If ABC Golf Equipment Corporation goes ahead with this new manufacturing venture, the company may no longer be allowed to represent a competing brand of golf clubs that currently accounts for 20% of its profits. Should this be considered in the analysis?  Why or why not? What other factors should be considered in making the decision?

Start with an introduction and end with a summary or conclusion. Use headings. Don't forget to reference your sources. Maximum length of two pages.