Question

WhitePearl Berhad: Project Evaluation

It has been three months since you took a position as an assistant financial analyst at WhitePearl Berhad. Although your boss has been pleased with your work, he is still a bit hesitant about unleashing you without supervision. Your next assignment involves both the calculation of the cash flows associated with a new investment under consideration and the evaluation of several mutually exclusive projects. Given your lack of tenure at WhitePearl Berhad, you have been asked not only to provide recommendations but also to respond to several questions aimed at judging your understanding of the capital budgeting process. The memorandum you received outlining your assignment follows:

To: The Assistant Financial Analyst

From: Mr. Mark, CEO WhitePearl Berhad

Re: Cash Flow Analysis and Capital Rationing

We are considering the introduction of new product. Currently we are in the 27% tax bracket with a 10% discount rate. The project is expected to last five years and then, it will be terminated. The following information describes the new project:

Cost of new plant and equipment       RM 8,900,000

Shipping and installation costs           RM    400,000

Unit Sales:

Year	Units Sold
1	70,000
2	120,000
3	140,000
4	80,000
5	60,000

Sales price per unit:                RM300/unit in Years 1-4 and RM260/unit in Year 5

Variable cost per unit:             RM180/unit

Annual fixed costs:                 RM300,000 per year

Working capital requirements:

There will be an initial working capital requirement of RM100,000 just to get production started. For each year, the total investment in net working capital will be equal to 10% of the dollar value of sales for that year. Thus, the investment in working capital will increase during Years 1 through 3, then decrease in Year 4. Finally, all working capital is liquidated at the termination of the project at the end of Year 5.

Depreciation Method:

Straight line over five years assuming the plant and equipment have no salvage value after five years.

Questions:

1. Why should WhitePearl Berhad focus on project free cash flows as opposed to the accounting profits earned by the project when analyzing whether to undertake the project?
2. What are the incremental cash flows for the project in Year 1 through 5, and how do these cash flows differ from the accounting profits or earnings?
3. What is the project’s initial outlay?
4. Calculate the project’s net present value?
5. Should the project be accepted? Why or why not
6. The company realizes that some of these estimates are subjected to economic conditions. If estimated sales drop by 25%, should WhitePearl Berhad proceed with the project? Why or why not.

Answer 1

WhitePearl Berhad should focus on free cash flows instead of accounting profit because in capital budgeting, free cash flows reflects a clear picture of the funds that will be generated each year during the life of the project, which can be used for reinvestment purposes. Accounting profit, on the other hand, includes many non-cash items such as depreciation, which are not relevant when considering funds available for reinvestment.

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Cost of new plant&equipment(in RM)	8,900,000
Shipping & installation costs(in RM)	400,000
Annual sales units (in units)		70,000	120,000	140,000	80,000	60,000
Sale price per unit (in RM)		300	300	300	300	260
Estimated sales revenue(in RM)		21,000,000	36,000,000	42,000,000	24,000,000	15,600,000
Less: Variable costs(in RM)		12,600,000	21,600,000	25,200,000	14,400,000	10,800,000
Less: Annual fixed costs(in RM)		300,000	300,000	300,000	300,000	300,000
Less: Annual depreciation(in RM)		1,860,000	1,860,000	1,860,000	1,860,000	1,860,000
Earnings before interest&tax(in RM)		6,240,000	12,240,000	14,640,000	7,440,000	2,640,000
Less: Tax @27% (in RM)		1,684,800	3,304,800	3,952,800	2,008,800	712,800
Net after-tax income(in RM)		4,555,200	8,935,200	10,687,200	5,431,200	1,927,200
Add back: Depreciation(in RM)		1,860,000	1,860,000	1,860,000	1,860,000	1,860,000
After-tax cash flows(in RM)		6,415,200	10,795,200	12,547,200	7,291,200	3,787,200
Less: Working capital(in RM)	100,000	2,100,000	3,600,000	4,200,000	2,400,000	1,560,000
Free cash flows(in RM)		4,315,200	7,195,200	8,347,200	4,891,200	2,227,200
Add: Liquidation of working capital						13,960,000
Total free cash flows (in RM)		4,315,200	7,195,200	8,347,200	4,891,200	16,187,200
Present value interest factor @10%		0.909	0.826	0.751	0.683	0.621
Present value of cash flows		3,922,517	5,943,235	6,268,747	3,340,690	10,052,251
Net Present value	20,127,440

Based on above working, the incremental free cash flows in each year are:

		Year 1	Year 2	Year 3	Year 4	Year 5
Total free cash flows (in RM)		4,315,200	7,195,200	8,347,200	4,891,200	16,187,200

The accounting profits are:

		Year 1	Year 2	Year 3	Year 4	Year 5
Net after-tax income(in RM)		4555200	8935200	10687200	5431200	1927200

The free cash flows adds back non-cash expenses (Depreciation) and also considers working capital used in each year.

The initial outlay of the project is the cost of new plant and equipment, shipping and installation costs and the initial working capital requirement,i.e.

RM8,900,000 + RM400,000 + RM100,000

= RM9,400,000

The Net Present value = Present value of all cash flows from Year 1 to 5 less initial outlay

= RM29,527,440 – RM9,400,000

=RM20,127,440

The project should be accepted since the NPV is positive.

If sales units reduce by 25% in each year, the new NPV will be as follows: (Still the NPV is positive, so the project should be accepted)

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Cost of new plant&equipment(in RM)	8,900,000
Shipping & installation costs(in RM)	400,000
Annual sales units (in units)		52,500	90,000	105,000	60,000	45,000
Sale price per unit (in RM)		300	300	300	300	260
Estimated sales revenue(in RM)		15,750,000	27,000,000	31,500,000	18,000,000	11,700,000
Less: Variable costs(in RM)		9,450,000	16,200,000	18,900,000	10,800,000	8,100,000
Less: Annual fixed costs(in RM)		300,000	300,000	300,000	300,000	300,000
Less: Annual depreciation(in RM)		1,860,000	1,860,000	1,860,000	1,860,000	1,860,000
Earnings before interest&tax(in RM)		4,140,000	8,640,000	10,440,000	5,040,000	1,440,000
Less: Tax @27% (in RM)		1,117,800	2,332,800	2,818,800	1,360,800	388,800
Net after-tax income(in RM)		3,022,200	6,307,200	7,621,200	3,679,200	1,051,200
Add back: Depreciation(in RM)		1,860,000	1,860,000	1,860,000	1,860,000	1,860,000
After-tax cash flows(in RM)		4,882,200	8,167,200	9,481,200	5,539,200	2,911,200
Less: Working capital(in RM)	100,000	1,575,000	2,700,000	3,150,000	1,800,000	1,170,000
Free cash flows(in RM)		3,307,200	5,467,200	6,331,200	3,739,200	1,741,200
Add: Liquidation of working capital						10,495,000
Total free cash flows (in RM)		3,307,200	5,467,200	6,331,200	3,739,200	12,236,200
Present value interest factor @10%		0.909	0.826	0.751	0.683	0.621
Present value of cash flows		3,006,245	4,515,907	4,754,731	2,553,874	7,598,680
Net Present value	13,029,437