Question

Q.1:-Claross, Inc. wishes to determine the relevant operating cash flows associated with the proposed purchase of a newpiece of equipment having an installed cost of $10 million and falling into the 5-year MACRS asset class. The firm's financial analyst estimated that the relevant timehorizon for analysis is6 years. She expectsthe revenues attributable to the equipment to be $15.8 million in the first year and to increase at 5% per year through year 6. Similarly,she estimates all expenses otherthan depreciation attributableto theequipment to total $12.2 million in the first year and to increase by 4% per year through year6. She plans toignore any cash flows after year 6. The firm has a marginal tax rate of 40% and its required return on the equipment investment is 13%. (Note: Round all cash flow calculations to the nearest $0.01 million.)

Answer 1

“Incremental cash flow”:

“Incremental cash flow” is termed as additional cash flow earned from new business operations. The positive outcome of “incremental cash flow” helps to understand the potential of investment to generate income. Hence, the organization will accept new project if the result shows the positive values.

“Net present value” (NPV):

Net present value” is the “present value” of cash inflow expected for a future period after deducting cost. Hence, NPV is the net “present value” of cash inflow minus “present value” of cash outflow

a)

Formulas to calculate the “incremental cash flow”:

“Earnings Before Depreciation and Tax” (EBDT) is calculated by deducting expenses from revenue. The depreciation is calculated under the method of “Modified Accelerated Cost-Recovery System “(MACRS) is given below.

EBDT = Revenue - Expense

Earnings After Tax (EAT) is calculated by deducting tax (40%) from (Earning Before Tax) EBT. EBT is the value derived from deducting (Earnings Before Depreciation and Tax) EBDT from depreciation.

EAT = EBDT - Depreciation -Tax

Total cash inflow is the sum of EAT and depreciation.

Total cash flow = EAT + Depreciation

Calculate depreciation for 6 years:

The “Modified Accelerated Cost-Recovery System” (MACRS) table is used to calculate depreciation. Refer to table number 9.1 to understand the yearly rate of depreciation (Rate column).

Year	Rate	Cost	Depreciation
1	0.2000	10.0	2.00
2	0.3200	10.0	3.20
3	0.1920	10.0	1.92
4	0.1152	10.0	1.15
5	0.1152	10.0	1.15
6	0.0576	10.0	0.58
Total			10.00

Calculate the “incremental cash flow”:

It is given that expected revenue for the first year is $15.80 million and an increase of 5% revenue each year. The expense for the first year is $12.20 million and an increase of expense 5% for each year.

Year:	0	1	2	3	4	5	6
	Amount in millions ($)
Initial- investment	-10
Revenue (5% per year)		15.80	16.59	17.42	18.29	19.21	20.17
Less: Expenses (4% per year)		12.20	12.69	13.20	13.72	14.27	14.84
EBDT		3.60	3.90	4.22	4.57	4.94	5.33
Less: Depreciation*		2.00	3.20	1.92	1.15	1.15	0.58
EBT		1.60	0.70	2.30	3.42	3.79	4.75
Less: Taxes (40% from EBT)		0.64	0.28	0.92	1.37	1.52	1.90
EAT		0.96	0.42	1.38	2.05	2.27	2.85
Add Depreciation*		2.00	3.20	1.92	1.15	1.15	0.58
Total cash flow	-10	2.96	3.62	3.30	3.20	3.42	3.43

Hence, “incremental cash flows” are $2.96 million for the first year,  $3.62 million for the second year,  $3.30 million for the third year,  $3.20 millionfor fourth year,  $3.42 million for the fifth year,  $3.43 million, and for the sixth year.

Finding for “incremental cash flow”:

The “incremental cash flow” is positive for all the given years. Moreover, it shows an increasing trend from year to year. Hence, this investment can generate good incremental inflows. So, this investment is recommended.

b)

Formula to calculate NPV:

NPV is the value derived by deducting net cash inflow from the outflow. It is calculated by dividing net cash flow from one plus rate of return powered with a number of periods. Then, the value of net cash inflow is deducted from the initial investment.

Here,

R refers to “Rate of return”

T refers to the “Number of periods”

Excel formula is substituted for the above formula to calculate NPV. It is calculated through the excel function PV (Present value).

.

Here,

“rate” refers to “Rate of return”

“nper” refers to “Number of time periods”

“pmt” refers to “Current payment” (investment)

“fv” refers to “Future value”

Calculate NPV using Excel function:

Therefore, the NPV at 13% is  $3.21.

“Internal Rate of Return” (IRR)

IRR is a “rate” at which “present value” of cash inflow and “present value” of cash outflow are equal. Up to that rate the investor will get positive NPV. The higher IRR projects will provide higher return rate for a project. Therefore, higher value of IRR means highly profitable.

Formula to calculate IRR:

The IRR is calculated using an excel formula. The formula is IRR (values[cash flows],guess).

Here,

Values refer to cash flows

guess refers to a probable value or zero

Calculate IRR using Excel formula:

Hence, IRR is 24%.

c)

Analysis of findings:

The above calculation shows $3.21 as NPV and  24% as IRR. NPV is $3.21 million under the discount rate of 13%. This means the current discount rate of the company is at 11% less than the discount rate to reach the break-even point. So, this investment is more profitable and safe for investors as per the NPV and IRR. Therefore, this investment can be accepted. It is favorable for CS Company to purchase new equipment in the next five years.