Corporate Finance, Autumn 2016

Tutorial 4 Cash Flows and Accounting Numbers

The problem sets must be submitted via Canvas by 18:30 on Monday, 19 th
September. Answers will be posted on Canvas later on the same day.
Question 1:
Consider the following investment opportunity which offers the following sure real cash
flows:
Revenue
Operating Costs
Capital
Investment

Sep 16
0
0
-6

Sep 17
11
-4
0

Sep 18
13
-5
0

Sep 19
15
-7
3

The cash flows are all real and the capital investment is depreciated at 3 years straight
line. How much is the project worth?
Assume:
1. Taxes are paid immediately (i.e. in Sep 16 for the Sep-16 Profits). The tax code where
you are doing this project allows you to carry forward any tax losses your firm may
incur.
2. The corporate tax rate is 40%.
3. Assume that the nominal rate of interest is 10%
4. Assume that the rate of inflation is 0%
T=0
Sep-16
Revenue
Operating Costs
Capital Investment
Depreciation
Gain on disposal of PPE
EBIT
FCF = EBIT * (1-T) + D
DCF
NPV

T=1
Sep-17
11
-4

T=2
Sep-18
13
-5

-2

-2

T=3
Sep-19
15
-7
3
-2
3
9

5
4.5

5.6
4.6

7.4
5.6

-6

8.7

ANSWER: the project is worth 8.7. Positive CAPEX in T=3 is treated as a gain on sales of
PPE and is included in EBIT. So, I tax this gain at the corporate income tax rate because I
assume it to be accounted for when arriving at EBIT. I apply the same principle across all
problems in the Tutorial.
Question 2:

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Corporate Finance, Autumn 2016

Consider now the case in which the investment requires an amount of working capital
equal to 10 and must be maintained at this level for the life of the project. At the end of
the project all of the working capital is sold.
(a) What is working capital? Give an example of working capital. Discuss the difference
between the stock of working capital and the flow of working capital.
Working capital = Current assets Current liabilities. E.g., WC includes such common items
as accounts receivables, accounts payables, inventory etc. Stock of working capital is the
snapshot at the point in time between current assets and current liabilities. Flow of working
capital is the difference from the previous year to the current year in WC and it shows what
the business earns and spends during a period of time.
(b) You determine that the following real cash flows apply as a result of this new
information. How much is the project worth now?

Revenue
Operating Costs
Capital Investment
Working Capital

Sep 16
0
0
-6
-10

Sep 17
11
-4
0

Sep 18
13
-5
0

Sep 19
15
-7
3

Assume:
1. Taxes are paid immediately (i.e. in Sep 16 for the Sep-16 Profits). The tax code where
you are doing this project allows you to carry forward any tax losses your firm may incur.
2. The corporate tax rate is 40%.
3. Assume that the nominal rate of interest is 10%
4. Assume that the rate of inflation is 0%
T=0
Sep-16
0

T=1
Sep-17
11

T=2
Sep-18
13

T=3
Sep-19
15

Operating Costs

-4

-5

-7

Capital Investment

-6

-2

-2

-2

Revenue

Depreciation
Working Capital

-10

-10

-10

Change in WC

10

-10

EBIT
FCF
DCF

-16

NPV

6.2

2 out of 7

5
5
4.5

6
5.6
4.6

9
17.4
13.1

Corporate Finance, Autumn 2016

ANSWER: the project is worth 6.2. Refer to the assumption re to the gain on sale of PPE (i.e.
3 at T=3) in Q1.
Question 3:
After a little while you decide that the previous scenario was a little bit unrealistic. You
determine that the inflation rate for the life of the project is going to 5% per annum.
How much is the project worth now? Below are the same real cash flows from before.
Sep 16
Revenue
Operating Costs
Capital
Investment
Working Capital

Sep 17
0
0
-6

Sep 18
11
-4
0

Sep 19
13
-5
0

15
-7
3

-10

Assume:
1. Taxes are paid immediately (i.e. in Sep 16 for the Sep-16 Profits). The tax code where
you are doing this project allows you to carry forward any tax losses your firm may
incur.
2. The corporate tax rate is 40%.
3. Assume that the nominal rate of interest is 10%
4. Assume that the rate of inflation is 5%
5. Assume that the working capital must be held constant in real terms.
T=0
Sep-16
0

T=1
Sep-17
11

T=2
Sep-18
13

T=3
Sep-19
15

Operating Costs

-4

-5

-7

Capital Investment

-6

-2

-2

-2

Revenue

Depreciation
Working Capital

-10

-10

-10

Change in WC

10

-10

EBIT
FCF
DCF

-16

NPV

9.0

real %

4.8%

3 out of 7

5
5
4.8

6
5.6
5.1

9
17.4
15.1

Corporate Finance, Autumn 2016

ANSWER: the project is worth 9. Refer to the assumption re to the gain on sale of PPE (i.e. 3
at T=3) in Q1.
Question 4:
As you examine the project more deeply, you discover that taxes are paid on a 1-year
lag. With the same assumptions as question 3, how much is the project worth?
T=0
T=1
T=2
T=3
T=4
Sep-16
Sep-17
Sep-18
Sep-19
Sep-20
Revenue
0
11
13
15
Operating Costs
0
-4
-5
-7
Capital Investment
-6
0
0
3
Depreciation
-2
-2
-2
Working Capital
-10
-10
-10
0
Change in WC
10
0
0
-10
EBIT
Annual tax (40%) as calculated
FCF (incl. taxes with 1 yr lag)
DCF

0
-16

NPV
real %

5
-2
7
6.7

6
-2.4
6
5.5

9
-3.6
18.6
16.2

-3.6
-3.0

9.3
4.8%

ANSWER: the project is worth 9.3. Refer to the assumption re to the gain on sale of PPE (i.e.
3 at T=3) in Q1.
And with the assumptions of question 2?

Revenue
Operating Costs
Capital Investment
Depreciation
Working Capital
Change in WC
EBIT
Annual tax (40%) as calculated
FCF (incl. taxes with 1 yr lag)
DCF
NPV

T=0
Sep-16
0
0
-6
-10
10

-16

6.8

4 out of 7

T=1
Sep-17
11
-4
0
-2
-10
0
5
-2
7
6.4

T=2
Sep-18
13
-5
0
-2
-10
0
6
-2.4
6
5.0

T=3
Sep-19
15
-7
3
-2
0
-10
9
-3.6
18.6
14.0

T=4
Sep-20

-3.6
-2.5

Corporate Finance, Autumn 2016

ANSWER: the project is worth 6.8. Refer to the assumption re to the gain on sale of PPE (i.e.
3 at T=3) in Q1.
Question 5:
Assuming that nothing else has changed since question 3 and 4 (combined) except that you
decided to depreciate your capital over 10 years (Straight line) instead of 3 years, how much
is the project worth? Would you make this change in accounting policy for your firm?
T=0

T=1

T=2

T=3

T=4

T=5

T=6

T=7

T=8

T=9

T=10

T=11

Sep-16

Sep-17

Sep-18

Sep-19

Sep-20

Sep-20

Sep-21

Sep-22

Sep-23

Sep-24

Sep-25

Sep-26

Revenue

11

13

15

Operating Costs

-4

-5

-7

-0.6

-0.6

-0.6

Capital Investment

-6

Depreciation

0
-0.6

0
-0.6

0
-0.6

0
-0.6

0
-0.6

0
-0.6

3
-0.6

Working Capital

-10

-10

-10

Change in WC

10

-10

6.4

7.4

7.4

0.0

0.0

0.0

0.0

0.0

0.0

2.4

-2.6

-3.0

-3.0

0.0

0.0

0.0

0.0

0.0

0.0

-1.0

7.0

5.4

15.0

-2.7

0.2

0.2

0.2

0.2

0.2

3.0

-1.0

6.7

5.0

13.1

-2.3

0.2

0.2

0.2

0.2

0.2

1.8

-0.6

EBIT
Annual tax (40%) as calculated
FCF (incl. taxes with 1 yr lag)

-16.0

DCF

NPV

real %

8.5

4.8%

ANSWER: the projects is worth 8.5. Refer to the assumption re to the gain on sale of PPE
(i.e. 3 at T=3) in Q1. Also, I assumed that PPE was sold in T=10 (otherwise, it would not
make sense to depreciate asset till T=10 if PPE was sold in T=3), so in T=10 the gain from
sale of fully depreciated PPE was generated and it = 3, the taxes on this gain were paid in
T=11 as we assumed 1-year tax lag. During T=4-T=10 the company received depreciation
tax savings = 0.4*0.6 = 0.2.
Question 6:
Assume that you are a manufacturer that relies on imported raw materials from only
one country. All your sales are in the home country. Assume that your domestic
currency weakens against the currency of the country from which you import all of
your raw materials. What will be the effect on your working capital flow?
The supplies will become costly in local CCY: the value of inventory will increase if new
purchases of raw materials will continue; the company will need to spend more local CCY for
the same amount of purchases from the foreign supplier; the value of accounts payables if
they are denominated in foreign CCY and settled at the later date will increase in local CCY.
Generally, the amount of current assets purchased from the foreign supplier will increase, but
current liabilities in the local CCY will increase at a slower rate. However, the answer to the
Q6 depends on the initial balance of WC (positive or negative) and on the settlement terms

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Corporate Finance, Autumn 2016

with the supplier which were not specified in the Q6. Please refer to the below scenarios (line
Change in WC) for possible outcomes. All cases below show decrease in WC, however, if
the company buys inventory, pays cash simultaneously to the foreign supplier, and holds no
accounts payables, then there will be no changes in WC as of 31 Dec Year X vs 01 Jan Year
X.
(1) = 01 Jan Year X
(2) = 31 Dec Year X
Foreign Domestic CCY / Foreign
Domestic CCY / Foreign
CCY
CCY = 10
CCY = 50
100
1000
1000
0
0
0

BS item
inventory*
cash
accounts
payable*
100
1000
5000
WC
0
0
-4000
Change in WC
(2)-(1)
-4000
* Assumption: as of 31 Dec Year X, inventory was not used in production and
was accounted at the historical cost; accounts payables weren't redeemed.

Foreign Domestic CCY / Foreign

Domestic CCY / Foreign
BS item
CCY
CCY = 10
CCY = 50
inventory **
100
1000
1000
cash
95
950
950
accounts
payable **
5
50
250
WC
190
1900
1700
Change in WC
(2)-(1)
-200
** Assumption: as of 31 Dec Year X, inventory was not used in production
and was accounted at the historical cost; accounts payables weren't
redeemed.
Foreign Domestic CCY / Foreign
Domestic CCY / Foreign
CCY
CCY = 10
CCY = 50
100
1000
1000
0
0
0

BS item
inventory ***
cash
Accounts
payable ***
200
2000
10000
WC
-100
-1000
-9000
Change in WC
-8000
*** Assumption: 1st 100 items of inventory were delivered on 31 Jul Year X,
payment is deferred by 180 days, i.e. till 28 Feb Year XX (i.e. the following
year). 1st items of inventory were used in production on 01 Sep and on the
same day the manufacturer bought 2nd 100 items from the supplier with the
same settlement terms with delivery on 01 Sep. The 2nd 100 items were not
utilized in the production as of 31 Dec Year X. At 31 Dec Year X, the balance
sheet was represented by the above table. On 31 Dec Year X, domestic CCY
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Corporate Finance, Autumn 2016

depreciated (column 2) vs 01 Jan Year X (column 1).

7 out of 7