Topic 1 Cash Flows Estimation

Introduction:

Capital budgeting is the decision-making process used in the acquisition of long-term physical assets. Capital budgeting decisions are crucial to a firm's long-term financial health because successful capital budgeting projects usually generate a positive cash flow for a long period of time while unsuccessful capital budgeting projects do not return sufficient cash flow to justify the investment. Such projects usually continue to generate losses or are liquidated for a large one-time loss.

Cash flow estimation is a must for assessing the investment decisions in capital budgeting. To be consistent with wealth maximization principle, an evaluation of a project must be based on cash flows and not on accounting profits. This cash flow forecasting are some of the most difficult steps involved in the capital budgeting. Projects have failed or succeeded due to incorrect or correct estimates of the cash flows of the project. If cash flow estimates are incorrect, it doesn't matter which technique we use, the project is doomed to fail.

Learning Objectives:

After reading this chapter, students should be able to:

LO1 Explain the basic principles of cash flow estimation
LO2 Illustrate an expansion project and make a decision whether the project should be accepted on the basis of standard capital budgeting techniques.
LO3 Explain the terms: incremental cash flow, net operating working capital, sunk cost, opportunity cost, and externalities
Illustration:

You have been asked by the president of your company to evaluate the proposed acquisition of new equipment. The equipment's basic price is RM193000, and shipping costs will be RM7700. It will cost another RM23200 to modify it for special use by your firm and an additional RM13500 to install the equipment. The equipment falls in the MACRS 3-year class, and it will be sold after 3 years for RM30900. The equipment is expected to generate revenue of RM178000 per year with annual operating costs (excluding depreciation) of RM84000. The firm's tax rate is 28% and its cost of capital is 10%..

REQUIRED:

i. What is the firm's initial investment of the machine and
ii. What is the operating cash flow form Year 1 - 3?
iii. Should the company invest in this new equipment?

Note: Under the MACRS 3-year class, depreciation is 33% in first year, 45% in second year, 15% in third year and 7% in fourth year.

TUTORIAL ACTIVITIES

Question 1

MultiAlpha is considering replacing an old machine with a new one. Two months ago their chief engineer completed a training workshop on the new machine's operation and efficiency. The cost of RM4000 cost for this workshop session has already been paid. If the new machine is purchased, it would require RM5000 in installation and modification costs to make it suitable for operation in the factory.

The old machine originally cost RM90000 five years ago and is being depreciated by RM15000 per year. The new machine will cost RM80000 before installation and modification. It will be depreciated by RM5000 per year. The old machine can be sold today for RM10000. The marginal tax rate for the firm is 28%.

Compute the relevant initial outlay in this capital budgeting decision.

Question 2

Canggih Sdn. Bhd. is considering a new product. The company currently manufactures several lines of school uniform. The new product, Canggih Jean, is expected to generate sales of RM1.0 million per year for the next 5 years. They expected that during this five-year period, they will lose about RM250000 in sales of existing line of jean. The new line will require no additional equipment or space in the plant and can be produced in the same manner as the apparel products. The new project will, however, require that the company spend an additional RM80000 per year on insurance for raw materials. Also an additional marketing manager would be hired to oversee the line at a salary of RM45000 per year in salary and benefits, in additional to the current manager who is earning RM60000 per year in salary and benefits. Depreciation of RM100000 of existing plant and machinery is expected to remain the same.

If the marginal tax rate is 28%, compute the incremental after tax cash flow for years 1-5.

Question 3

3. Cash Estimation

(a) Rupab Sdn. Bhd has in issue five million shares with a market value of RM3•81 per share. The equity beta of the company is 1•2. The yield on short-term government debt is 4•5% per year and the equity risk premium is approximately 5% per year.

The debt finance of Rupab Sdn. Bhd consists of bonds with a total book value of RM2 million. These bonds pay annual interest before tax of 7%. The par value and market value of each bond is RM100.

Rupab Sdn. Bhd pays taxation one year in arrears at an annual rate of 25%. Capital allowances (tax- allowable depreciation) on machinery are on a straight-line basis over the life of the asset.

REQUIRED: Calculate the after-tax weighted average cost of capital of RupabSdn Bhd.

(b) Ruparb Sdn. Bhd is now considering a project where they would open a new facility in Johor Bharu. The company's CFO has assembled the following information regarding the proposed project:

It would costs RM500,000 today (t=0) to construct the new facility. The cost of the facility will be depreciated on a straight-line basis over five years.

If the company open the facility, it would need to increase its inventory by RM100,000 at t=0.
RM70,000 of this inventory will be financed by account payable.

The CFO has estimated that the project will generate the following amount of revenue over the next 3 years:
Year 1 Revenue = RM1.0 million Year 2 Revenue = RM1.2 million
o ear 3 Revenue = RM1.5 million
Operating costs excluding depreciation equal to 70 percent of revenue.

The company plans to abandon the facility after three (3) years. At terminal year, the project's estimated salvage value will be RM200,000.At the same time, the company will also recover the net operating working capital investment that it made at t=0.

The company tax rate is 27 percent.

The project cost of capital is as per calculated in 3(a) above.

REQUIRED: What is the project's net present value?

Attachment:- Cash Flow Estimation.pdf