Financial Management

FINANCIAL MANAGEMENT 7

FinancialManagement

Theinitial investment (I) constitutes the total of the outlay in plantand equipment

Therefore,I = $1,000,000

WorkingCapital:

Workingcapital = $200,000

TheWorking Capital Change for every year Yi is:

Changein Working Capital = Previous Year working capital – Current workingcapital = 0 (for i=1 to 7) and

ChWC0= -$200,000

Theworking capital will be recovered this implies that for the end ofyear 8, change in working capital will be zero

Depreciation:

Forthe first five years

Depreciation= (Total Investment)/5 = 1,000,000/5 = $200,000

Depreciationwill be zero for years 6-8

Expenses:

Indirectincremental costs will be $95,000 for 1-8 years

Forevery year, the direct costs will be 0.45*Revenues (Ri)

Ei= $95,000 + 0.45*Ri,

Forthe first year, expenses will be

E= $95,000 + 0.45*$950,000 = $522,500

Foryear 2 – 8, Expenses for each year will be

$95,000+ 0.45*$1,500,000 = $770,000

Taxes:

Themarginal tax rate is 35%, then the taxes will be:

Tax= Tax rate* (Revenue – Expenses – Depreciation)

Taxfor year1 = 0.35*($950,000-$522,500-$200,000) = $79,625

Taxfor year 2-5 = 0.35*($1,500,000-$770,000-$200,000) = $185,500

Taxfor year 6-8 = 0.35*($1,500,000-$770,000-$0) = $255,500

Revenues:

Expectedrevenue for year1:

Revenuefor year1 = $950,000

Foryear 2-8, the expected revenue will be = $1,500,000

CashFlows Statement (in thousand $):

YEARS

0 1 2 34 5 6 7 8

1.Revenues 0 950 1500 1500 1500 1500 1500 1500 1500

2.Expenses 0 522.5770770770 770 770770 770

3.Depreciation0200 200200 200 20000 0

4.Incomebefore 0 227.5530530530 530 730730 730

tax,[1-(2+3)]

5.Taxes 0 79.625 185.5 185.5 185.5 185.5 255.5255.5 255.5

6.NetIncome0 147.875 344.5 344.5 344.5 344.5 474.5474.5 474.5

[4-5]

7.Cashflow

fromoperation 0 347.875 544.5 544.5 544.5 544.5 474.5 474.5 474.5

[1-2-5]

8.Investments-10000 0 00 0 0 0 0

9.Changein WC -200 0 0 000 00 200

10.Totalcash -1200 0 0 0 00 0 0200

flowfrom investment

[8+9]

11.Totalcash -1200 347.875 544.5 544.5 544.5 544.5 474.5 474.5 674.5

flow[7+10]

Paybackperiod

Thetotal initial investment (TI) is the sum of the investment in plantand equipment plus the initial Working Capital required.

TotalInitial Investment = $1,200,000

Atthe conclusion of year 2 the company has recovered:

$295,875+ $456,750 = $752,625

Unrecoveredcost at the beginning of third year U = $1,200,000 – $752,625 =$447,375

PaybackPeriod = 2 + 447,375/456,750

=2.98 years

PresentValue (PV):

CF1 CF2CF8

PV = – + — + …. + —

(1+ R)(1 + R)^2 (1 + R)^8

WhereR, is the required return.

PV= $2,229,365.07

NPV= $2,229,365.07 – $1,200,000 = $1,029,365.07

Thepayback period is less than the 3 years, which implies that theproject fits the limit policy of the company therefore, the projectshould be accepted. Besides, the project should be accepted since theNPV is attractive.

Additionalinvestment in building and land constitutes a relevant cash flow,which implies that it will need to be added to the initialinvestment. This may make the NPV to become negative a move thatwould make the project to be rejected. Besides, the payback period isnear the limit of 3 years additional investment may lead to anincrease in payback period. This will automatically result in therejection of the project.

References

Brigham,E. F.&amp Ehrhardt, M. C. (2013). Financialmanagement: Theory and practice.Mason, Ohio: South-Western.