1

BFW2631

FINANCIAL MANAGEMENT

TUTORIAL SET 5 – WEEK 6

CAPITAL BUDGETING: CASH FLOW ANALYSIS

IMPORTANT: The questions that we encounter within the tutorial set throughout the

semester are an indication of the standard that you will face in the final examination. You

are required to attempt all tutorial questions on your own prior to attending class.

Question 1

Billy was asked to choose between the following mutually exclusive projects.

Expected Net Cash Flows

Year Project S Project L

0 ($100,000) ($100,000)

1 60,000 33,500

2 60,000 33,500

3 33,500

4 33,500

The projects provide a necessary service and whichever one is selected, it is expected to be

repeated into the foreseeable future. Both projects have a 10.0 percent cost of capital.

a) Compare the two projects by calculating the NPV for both the projects.

b) Compare the two projects by calculating the Equivalent Annual Annuity (EAA or EAC)

approach.

Question 2

International Foods (IFC) currently processes seafood with a unit it purchased several years

ago. The unit, which originally cost $500,000, currently has a book value of $250,000. IFC is

considering replacing the existing unit with a newer, more efficient one. The new unit will cost

$700,000 and will also require an initial increase in net working capital of $40,000.

Additionally, in order to make the new unit operational shipping and installation costs will

require a further $50,000 investment.

The new unit will be depreciated on a straight-line basis over 5 years to a zero balance. The

new unit will have a salvage value of $75,000 at the end of the projects life in 5 years. The

existing unit is being depreciated at a rate of $50,000 per year. IFC can sell the existing

machine today for $275,000. Assume IFC’s tax rate is 30 percent.

If IFC purchases the new unit, annual revenues are expected to increase by $100,000 in annuity

(due to increased capacity), and annual operating costs (exclusive of depreciation) are expected

to decrease by $20,000 in annuity. IFC estimates that in addition it will need to make ongoing

contributions to net working capital in years 1, 2, 3 and 4 in the amount of $10,000.

Accumulated net working capital will be recovered at the end of 5 years. IFC has a company

cost of capital that can be used for discounting purposes of 12%.

In addition, the company has to borrow $100,000 to fund the new project. The loan is interest

only requiring monthly payments at an interest rate of 18% per annum. Repayment of the

principal will occur after the sale of the new unit.

Required: Advise whether the company should replace the unit or not? [use an incremental

analysis and/or an isolation approach to solve this cash flow analysis].