Estimating Cash Flows
Assume that your company is considering the replacement of an automated milling machine with one of the new machines offered by three different manufacturers. Each of the three machines under consideration is expected to have an economic life of five years and will result in greater daily production capacity and therefore increased sales volume. The increased volume will require an increase in working capital during the first year to a level that will remain constant until the end of the five years. The decision of which specific machine to select will depend on a net present value analysis. The old machine has reached the end of its estimated useful life and can be sold at the salvage value that was projected when the machine was first installed.
Listed below are factors that may be essential for inclusion when estimating project cash flows. The factors may be required to correctly calculate either the initial investment, the operating cash flows, or the terminal value that would be analyzed to determine the net present value of the project. It is also possible that certain factors could be used in more than one of the three categories of cash flow. Another possibility is that the factor listed is not relevant to cash flow estimation for this specific scenario.
Your task is to identify whether the factor would be included in the calculation for the initial investment, or the operating cash flow, or the terminal value, or is not relevant to this decision. You must also explain whether failure to appropriately include the factor in the calculation would result in overstating or understating the net present value of the project.
FACTORS
Purchase price of capital asset
Incremental annual depreciation expense
Total company sales revenue
Cash realized from sale of the old machine at its estimated salvage value
Interest on the loan used to finance the asset purchase
Total annual depreciation expense
Increase in working capital
Decrease in working capital
Total net income before tax
Incremental net income before tax
Marginal income tax rate
Investment tax credit
Cost of shipping and installing the new equipment.