3.4 Evaluating Cash Flow

3.4 EVALUATING CASH FLOW 7

3.4Evaluating Cash Flow

Discussinga Real Life Criminal Case

  1. Should you focus on cash flows or accounting profits in making the capital-budgeting decision? Should you be interested in incremental cash flows, incremental profits, total free cash flow, or total profits?

Whenmaking a decision on capital budgeting there are three tools used thepayback period, the internal rate of return and the net presentvalue, the payback period helps determine the duration it will taketo pay the opening investment that helped pursue the project. The netpresent value help determine the cash outflow which is the projectcost from the project inflows cash generated by the project. Theinternal rate of return is the expected amount to be realized from aparticular project. Capital budget mostly deals with creating andacquiring fixed assets that are important in attaining anorganization strategic plan. All investments are channeled towardsfinancing an asset and are anticipated to earn a return. To evaluatethe success of the project we compare the cash inflow from the cashoutflow. Thus cash flow is what we should use when making capitalbudgeting decision. Because these the cash flows that a companyreceives and will reinvest.

  1. How does depreciation affect free cash flow?

Depreciationaffects the taxes meaning that even though it is not a cash flow itemit does influence the differential cash flow that involves theproject. It is an expense and the more the depreciation the more theexpense. Therefore, the profit lowers, so does tax charged on thecash flow item.

  1. What is the project initial outlay?

Whena project need to increase money to finance its working capital themoney invested is part of the initial outlay that is associated withacceptance of the project. Since the funding is done on the workingcapital then it is never used, an offsetting cash inflow amounting tothe same working capital initial investment will take place when theproject is completed this correspond to taking back the workingcapital. This is the same as saying that time value of money is theonly thing that is lost which is associated with working capitalinvestment.

  1. How do sunk costs affect the determination of cash flows?

Thecash flow that have taken place are referred to as sunk cost, thesunk cost when evaluating a proposal for capital budgeting areignored. This is because the interest is on the incremental cash flowreceived after tax to the whole company. Sunk cost occurs despitedecision made about investment meaning that these are not incrementalcash flow therefore they are irrelevant.

  1. What are the differential cash flows over the projects life?

Thisinvolves the cash flow increase after tax which is as a result fromthe project in mind. Here when calculating the interest payment for issued bond when it increases it is not included the reason being thefunds needed for the project support are wholly accounted for throughdiscounting the project using the rate of return back to the present.

  1. What is the terminal cash flow?

Thisis the salvage value received after tax of an asset is calculated, itbring back the nonexpense outlays which have taken place during anasset initiation such as networking capital investment and any othercash flow linked to the project termination (Keown, 2004).

  1. Draw a cash-flow diagram for this project.

SectionI. Calculate the change in EBIT, Taxes, and Depreciation

Year 0 1 2 3 4 5

UnitsSold 70,000 120,000 140,000 80,000 60,000

SalePrice $300 $300 $300 $300 $260

SalesRevenue $21,000,000 $36,000,000 $42,000,000 $24,000,000 $15,600,000

Less:VariableCosts 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 $1,600,0000 $1,600,0000 $1,600,0000 $1,600,0000

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

SectionII. Calculate Operating Cash Flow

OperatingCash 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

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

SectionIII. Calculate the Net Working Capital

ChangeIn Net Working Capital:

Revenue: $21,000,000 $36,000,000 $42,000,000 $24,000,000 $15,600,000

InitialWorking Capital Requirement $100,000

NetWorking Capital Needs: $2,100,000 $3,600,000 $4,200,000 $2,400,000

$1,560,000

h. Whatis its net present value? =$16,731,096

i. Whatis its internal rate of return?= 77%

j.Shouldthe project be accepted? Why or why not? Yesthe project should be accepted because the net present value isgreater than zero and the internal rate of return is greater than 15%the expected rate of return.

k.Howdoes Genesis 47:18-19 relate to this project and cash flowmanagement?

Genesis47:18-19 talks of people who went to pharaoh and decided to sellthemselves to him and their lands so that he could pay them a certainpercent of the produce from the land he could buy from them thisrelate to the project in that it is being funded to simply benefitthe owners its value, profits will go back to the owners and theasset too.

Reference

Keown,A. J. (2004). Foundationsof Finance: The Logic and Practice of Financial Management Beijing:Qinghua University Press.