A Mini-Case on Estimation of Cash Flows

Homework on Relevant Cash Flow Calculations: (20 Points)

Question 1: A Mini-case on Estimation of Cash Flows (8 Points)

A firm is considering replacing an old machine at a cost of $110,000. The new machine will to last five years with zero salvage value. It will generate expected annual cost savings of $30,000. The current machine will last for another 10 years. The discount rate is 10 percent. Assume that tax rate is zero and the present machine is fully depreciated with a zero salvage value.

A. Should the firm replace the old machine? Show NPV calculations. (2 Points)

T=0 T=1 T=2 T=3 T=4 T=5

1 Cash Flow -110000 30000 30000 30000 30000 30000

2 Discount Rate 10%

3 NPV 3,724

NPV = $3,724, which is greater than 0

Firm should replace the old machine

B. Assume that existing equipment was bought for $80,000 five years ago and is being depreciated on a straight line over ten years towards a zero book value. It continues to have zero salvage value. Should the firm replace the machine? (No calculations are necessary). Limit your answer to 20 words or less. (2 Points)

“Replace” the machine

80k is the sunk cost &

The depreciation of old m/c has no impact as tax rate is zero

C. The firm replaces the old machine with new machine. Two years later, an improved machine becomes available which makes the “existing” machine obsolete with no salvage value. The improved machine will cost $150,000 and last five years. The annual additional cost savings over the previous machine is expected to be $40,000. This machine will be depreciated on a straight line towards a zero book value. Other items remain same. What should firm do? Show calculations. (2 Points)

T=0 T=1 T=2 T=3 T=4 T=5

1 Cash Flow -150,000 40,000 40,000 40,000 40,000 40,000

2 Discount Rate 10%

3 NPV 1,632

NPV = 1,632, which is greater than 0

Firm should replace the machine

D. Was a mistake made to buy the machine two years ago? No calculations are needed. Limit your answer to 50 words. (2 Points)

NPV for m/c B (for 2 years) = -57,934

NPV for m/c C (for 5 years) = 115,355

(m/c B is obsolete, hence consider 70k as CF, and 0 from m/c B)

It clearly shows, buying m/c B which is useful only for 2 years was a bad decision

Question 2: A Mini-case on Relevant Cash Flows (6 Points)

A finance manager was presented with an analysis of a new project (see the table below) and noted that there was no mention of the following items:

A. The cash flow projections did not include effect of accounts receivables and payables. The average collection period for receivables and average payment period for payables are expected to be 50 days, and 36 days respectively based on 365 days.

B. Standard charge of 1percent of sales for overhead has not been included.

C. The financing charge of 10 percent of book value of assets has been left out.

For each item show separately its incremental effect on NPV as appropriate.

Items (in thousands of dollars) T=0 T=1 to 4 T=5

1 Revenues 12,000 12,000

2 Raw Material Costs 4,000 4,000

3 Direct