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Example: Blooper Industries

Now that we have examined many of the pieces of a cash-flow analysis, let s try to put them together into a coherent whole. As the newly appointed financial manager of Blooper Industries, you are about to analyze a proposal for mining and selling a small deposit of high-grade magnoosium ore.4You are given the forecasts shown in Table 4.3. We will walk through the lines in the table.

Capital Investment (line 1). The project requires an investment of $10 million in mining machinery. At the end of 5 years the machinery has no further value.

Working Capital (lines 2 and 3). Line 2 shows the level of working capital. As the project gears up in the early years, working capital increases, but later in the project s life, the investment in working capital is recovered. Line 3 shows the change in working capital from year to year. Notice that in Years 1 4 the change is positive; in these years the project requires a continuing investment in working capital. Starting in Year 5 the change is negative; there is a disinvestment as working capital is recovered.

Revenues (line 4). The company expects to be able to sell 750,000 pounds of magnoosium a year at a price of $20 a pound in Year 1. That points to initial revenues of 750,000 АГАз 20 = $15,000,000. But be careful; inflation is running at about 5 percent a year. If magnoosium prices keep pace with inflation, you should up your forecast of the second-year revenues by 5 percent. Third-year revenues should increase by a further 5 percent, and so on. Line 4 in Table 4.3 shows revenues rising in line with inflation. The sales forecasts in Table 4.3 are cut off after 5 years. That makes sense if the ore deposit will run out at that time. But if Blooper could make sales for Year 6, you should include them in your forecasts.

We have sometimes encountered financial managers who assume a project life of (say) 5 years, even when they confidently expect revenues for 10 years or more. When asked the reason, they explain that forecasting beyond 5 years is too hazardous. We sympathize, but you just have to do your best. Do not arbitrarily truncate a project s life.

Expenses (line 5). We assume that the expenses of mining and refining also increase in line with inflation at 5 percent a year.

Depreciation (line 6). The company applies straight-line depreciation to the mining equipment over 5 years. This means that it deducts one- fifth of the initial $10 million investment from profits. Thus line 6 shows that the annual depreciation deduction is $2 million.

Pretax Profit (line 7). Pretax profit equals (revenues expenses depreciation).

Tax (line 8). Company taxes are 35 percent of pretax profits. For example, in Year 1, Tax = .35 АГАз 3,000 = 1,050, or $1,050,000

Profit after Tax (line 9). Profit after tax equals pretax profit less taxes.

STRAIGHT-LINE DEPRECIATION Constant depreciation for each year of the asset s accounting life.

4 Readers have inquired whether magnoosium is a real substance. Here, now, are the facts. Magnoosium was created in the early days of TV, when a splendid-sounding announcer closed a variety show by saying, This program has been brought to you by Blooper Industries, proud producer of aleemium, magnoosium, and stool. We forget the company, but the blooper really happened.