Indirect Effects on Project Cash Flow
1. Provide an example of a Sunk Cost from your firm.
2. Provide an example of an Opportunity Cost that would arise in your firm when considering a new project.
3. Provide an example of Overhead Costs related to a hypothetical new project in your firm that would not generate incremental cash outflows, and another example of Overhead Costs that would generate incremental cash flows.
4. Provide an example of how a new product offering might lead to Cannibalization of an existing product in your firm.
5. Provide an example of a Project Externality that might lead to increased benefits in some other area of your firm's business.
Incremental Cash Flows
6. It is 1995 and Food For Less (FFL), a grocery store, is considering offering one hour photo developing in their store. The firm expects that sales from the new one hour machine will be $150,000 per year. FFL currently offers overnight film processing with annual sales of $100,000. While many of the one hour photo sales will be to new customers, FFL estimates that 60% of their current overnight photo customers will switch and use the one hour service. Calculate the incremental sales associated with introducing one hour photo service.
7. Suppose that of the 60% of FFL's current overnight photo customers who switch to one hour processing, half would start taking their film to a competitor that offers one hour photo processing if FFL fails to offer the one hour service. If FFL does offer one hour processing these customers will continue to use FFL. How does this additional assumption change the incremental sales calculation?
8. Discuss qualitatively how you might have incorporated the likely growth of digital photography in the sales projections developed above? (Remember hindsight is 20-20.)
What does this tell us about the impact on actual value added results from the estimates developed when making project projections?
NOWC and DCF Analysis
The Comstock Corporation is considering investing in a new floor mat manufacturing machine that has an estimated life of three years. The cost of the machine is $30,000 and the machine will be depreciated straight line over its three-year life to a residual value of $0.
The floor mat manufacturing machine will result in new sales of 2,000 floor mats in year 1. Sales are estimated to grow by 10% per year each year through year three. Comstock will charge customers $18 per floor mat for all three years. The floor mats have a cost per unit to manufacture of $9 each. Incremental Selling, General & Administrative expenses are estimated to be $2,000 annually. Comstock spent $7,000 over the last year on the design of the new floor mats.
Installation of the machine and the resulting increase in manufacturing capacity will require an increase in various net working capital accounts. It is estimated that the Comstock Corporation needs to hold 6% of its next year's annual sales in accounts receivable, 9% of its next year's annual sales in inventory, and 5% of its next year's annual sales in accounts payable.
The firm is in the 35% tax bracket, and has a cost of capital of 10%.
9. Calculate the required investment in NOWC for the three years of the project. Use these estimates of NOWC to calculate the Cash Flow from NOWC.
10. Use the 5 year financial projection template on Moodle to calculate the NOPAT, Free Cash Flow, NPV and IRR of the 3 year project using the NOWC estimates from above and changing depreciation to 1/3 each year.
11. Assume that Comstock must use the 5 year MACRS to depreciate the $30,000 machine, and will write it off after three years. Now the remaining depreciation and tax benefit must be recognized in year three. Calculate the new NOPAT, Free Cash Flow, NPV and IRR of the 3 year project. Explain the change in NPV.
Carlson Machine Shop is considering a four-year project to improve its production efficiency by purchasing a new machine press for $430,000. The machine press will result in $160,000 in annual pre-tax labor cost savings. The press will be depreciated using the 5 year MACRS depreciation schedule and they expect to be able to sell it for $70,000 at the end of four years.
The new press will require an initial inventory of $20,000 in spare parts for maintenance which will decrease by $4,000 a year over the four years. The $4,000 in unused spare parts inventory will be worthless at the end of the project but will still have a Net Book Value of $4,000.
Carlson has a 14% cost of capital and a 35% tax rate.
12. Use the Five Year Projection Worksheet to calculate the incremental Free Cash Flow and NPV. Should they buy the machine?
13. Recalculate the NPV assuming the machine press can only be sold for $45,000 at the end of year four. Does this change have an impact on their decision?