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CALCULATING BLOOPER S PROJECT CASH FLOWS

Table 4.3 provides all the information you need to figure out the cash flows on the magnoosium project. In Table 4.4 we use this information to set out the project cash flows. Capital Investment. Investment in plant and equipment is taken from line 1 of Table 4.3. Blooper s initial investment is a negative cash flow of $10 million.

Investment in Working Capital. We ve seen that investment in working capital, just like investment in plant and equipment, produces a negative cash flow. Disinvestment in working capital produces a positive cash flow. The numbers required for these calculations come from lines 2 and 3 of Table 4.3. Line 3 shows the increase in working capital. Therefore, the cash flow associated with investments in working capital is simply the negative of line 3.

Cash Flow from Operations. The necessary data for these calculations come from lines 4 9 of Table 4.3. We ve seen that there are at least three ways to compute these cash flows (using any of methods 1, 2, or 3). For example, using the net profit + depreciation approach, the first- year cash flow from operations (in thousands) is profit after tax + depreciation expense = 1,950 + 2,000 = 3,950 or $3,950,000. You can apply the same calculation to the other years to obtain line 3 of Table 4.3.

CALCULATING THE NPV OF BLOOPER S PROJECT

You have now derived (in the last line of Table 4.4) the forecast cash flows from Blooper s magnoosium mine. Assume that investors expect a return of 12 percent from investments in the capital market with the same risk as the magnoosium project. This is the opportunity cost of the shareholders money that Blooper is proposing to invest in the project. Therefore, to calculate NPV you need to discount the cash flows at 12 percent. Table 4.5 sets out the calculations. Remember that to calculate the present value of a cash flow in Year t you can divide the cash flow by (1 + r)t or you can multiply by a discount factor which is equal to 1/(1 + r)t. When all cash flows are discounted and added up, the magnoosium project is seen to offer a positive net present value of almost $3.6 million.

Now here is a small point that often causes confusion. To calculate the present value of the first year s cash flow, we divide by (1 + r) = 1.12. Strictly speaking, this makes sense only if all the sales and all the costs occur exactly 365 days, zero hours, and zero minutes from now. But of course the year s sales don t all take place on the stroke of midnight on December 31. However, when making capital budgeting decisions, companies are usually happy to pretend that all cash flows occur at 1-year intervals. They pretend this for one reason only simplicity. When sales forecasts are sometimes little more than intelligent guesses, it may be pointless to inquire how the sales are likely to be spread out during the year.5

A Spreadsheet Model for Blooper

You might have guessed that discounted cash-flow analysis such as that of the Blooper case is tailor-made for spreadsheets. The worksheet directly above shows the formulas from the Excel spreadsheet that we used to generate the Blooper example. The spreadsheet on the facing page shows the resulting values, which appear in the text in Tables 4.3 through 4.5.

The assumed values are the capital investment (cell B2), the initial level of revenues (cell C5), and expenses (cell C6). Rows 5 and 6 show that each entry for revenues and expenses equals the previous value times (1 + inflation rate), or 1.05. Row 3, which is the amount of working capital, is the sum of inventories and accounts receivable. To capture the fact that inventories tend to rise with production, we set working capital equal to .15 times the following year s expenses. Similarly, accounts receivables rise with sales, so we assumed that accounts receivable would be 1/6 times the current year s revenues. Each entry in row 3 is the sum of these two quantities.1 Net investment in working capital (row 4) is the increase in working capital from one year to the next.

Cash flow (row 12) is capital investment plus change in working capital plus profit after tax plus depreciation. In row 13 we discount cash flow at a 12 percent discount rate and in cell B14 we add the present value of each cash flow to find project NPV. Once the spreadsheet is up and running it is easy to do various sorts of what if analysis. Here are a few questions to try your hand.

Questions

1. What happens to cash flow in each year and the NPV of the project if the firm uses MACRS depreciation assuming a 3-year recovery period? Assume that Year 1 is the first year that depreciation is taken.

2. Suppose the firm can economize on working capital by managing inventories more efficiently. If the firm can reduce inventories from 15 percent to 10 percent of next year s cost of goods sold, what will be the effect on project NPV?