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The case project was a new product which a company was considering investing in. Several costs such as direct and indirect costs, inventory, and receivables were provided. I used this information to calculate the incremental cash flows of the project for 8 years. I then used these cash flows in appraising the project using both the pay-back period (P/B) and the net present value (NPV).
Incremental cash flows
Incremental cash flow refers to the increase in cash outflow related to operations that an organization will experience as a result of undertaking a new project (Investopedia, 2012). I began by calculating the cash flow from operations that the company would expect from the new project. To arrive at this, I used the sales figure for each year which was $950,000 for the first year and $1,500,000 for each subsequent year. I calculated the direct cost at 45% of sales, which resulted in a direct cost figure of $427,000 for the first year and $675,000 for each of the 7 subsequent years. The resultant figure after deducting the direct costs was the gross income.
I then deducted the annual depreciation of the plant from each of the five years of its useful life. I calculated the annual depreciation rate by dividing the value of the plant, $1,500,000, by its useful life of 5 years, which resulted in an annual depreciation rate of $300,000. I also deducted the indirect incremental cost of $95,000 per year. The result of these deductions was a net income of $127,000 for the first year, $430,000 for the second to the fifth year, and $730,000 for the sixth to the eighth year.
The tax rate was given at 35%. I calculated this from the net income to arrive at taxes of $44,625 for the first year, $150,000 for the second to the fifth year, and $255,000 for the sixth to the ninth year. After deducting the tax from each year, I arrived at an income after tax of $82875 for the first year, $279,500 for the second to the fifth year, and $474,500 for the sixth to the eighth year.
I then added back the depreciation amount to each of the first five years of the useful life of the plant, which resulted in cash flow from operations of $382,875 for the first year and $579,000 for the second to the fifth year. I arrived at the final figure of incremental cash flows by deducting the annual incremental cash outflow of inventory and receivables from the cash flow from operations. This resulted in incremental cash inflows of $182,875 for the first year, $379,500 for the second to the fifth year, and $274,500 for the sixth to the eighth year. I have presented the full statement with all calculations in the excel worksheet.
The pay-back period is the amount of time it takes for a project’s cash inflows to recover the initial outlay (Gitman & Zutter, 2012). To arrive at this, I deducted the annual incremental cash inflow from the initial outlay up to the fourth year. For the fifth year, the cash outflow was greater than the remaining balance of the initial outlay. I divided this balance by the cash outflow for the fifth year to arrive at the period remaining in months which resulted in a figure of 5.64. I rounded off this figure to 6 months. The total payback period was therefore 4 years and 6 months.
Net Present Value
The net present value is the difference between the present value of the future cash flows of a project and the project’s initial outlay (Baker, 2009). In order to arrive at the present value of the cash flows, the cash flows must be discounted using the formula 1/[(1+r)^n] where ‘r’ is the cost of capital and ‘n’ is the number of years since the initial outlay (Baker, 2009). I calculated the discounting factor for each year and then multiplied each cash flow by its respective discounting factor. I added up all the resultant figures to arrive at a present value of cash flows of $1,706,773 for the project. I then deducted the initial outlay of $1,500,000 from this figure to arrive at a net present value of $206,773.
Appraisal of the project
I appraised the project using both the P/B and NPV. The P/B of the project was approximately 4 years and 6 months. The company does not accept projects whose P/B is beyond 3 years. Based on this method, the project should not be accepted.
The NPV method, on the other hand, allows a project to be accepted only if its NPV is positive (Gitman & Zutter, 2012). The project’s NPV was $206,773. Since this figure is positive, the project should be accepted.
Increase in costs
The project, in this case, does not require any additional costs on land building. This is, perhaps, because the company had idle capacity. If this was not the case and the company had to incur costs to procure extra land and buildings, the company would have had to incur an extra initial outlay if the assets were to be purchased or extra annual cash outflows if the assets were to be leased or rented. This would have increased the payback period and reduced the NPV.
The P/B method had rejected the project before, therefore with an increased P/B, the project would still have been rejected hence no change in decision. For the NPV method, however, the increased costs would have resulted in a lower NPV which, depending on the magnitude, would have resulted in a rejection of the project if the NPV fell below zero and hence a change in decision.
Baker, S. L. (2009). NPV and IRR: Measures for evaluating investments. Web.
Gitman, L. J., & Zutter, C. J. (2012). Principles of Managerial Finance, 13th ed. Upper Saddle River, New Jersey: Prentice Hall.
Investopedia. (2012). Incremental Cash Flow. Web.