Written Assignment - Unit 3

Financial Management

THE CASE STUDY

You can borrow funds from your bank at 3%.

The cost to install the needed equipment will be $105,000 and this cost is incurred prior to any cash is received by the project.

The gross revenues from the project will be $25,000 for year 1, then $27,000 for years 2 and 3. Year 4 will be $28,000 and year 5 (the last year of the project)
will be $23,000.

The expected annual cash outflows (current project costs) are estimated at being $13,000 for the first year, then $12,000 for years 2, 3, and 4. The final year
costs will be $10,000.

Your tax rate is 30% and you plan to depreciate the equipment on a straight-line basis for the life of the equipment.

After 5 years the equipment will stop working and will have a residual (salvage) value of $5,000).

The discount rate you are assuming is now 7%.

1. DEFINITIONS

The following definitions can be useful for this case study:

The Cash inflow is a source of cash or an increase in the firm’s cash balance (n.a, 2015). 

The Cash outflow is a use of cash or a decrease in the firm’s cash balance (n.a, 2015). 

The Net working capital is the current assets less current liabilities (n.a, 2015). 

The Cash conversion cycle is the period of time that it takes a firm to convert purchases of raw
materials into cash received (n.a, 2015).

2. PAY BACK

For the first approach, I am checking the payback period (discounting inflow cash flows of an
average of $11,600/year). With an initial investment of $105,000 the payback for this case are 9
years (105,000/11,600=9 years).

According to Berman (2013) the payback method is simple and the result (period) should be less
than the period of the project (5 years). In this first approach the calculation of payback is 9 years,
therefore is not a good project.

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3. CALCULATION OF PRESENT VALUE PV1

year Revenue Costs C ERBITA Present ERBITA

R Value of Present
$1@7% Value
1 US$25 000 US$13 000 US$ 12 000 0,93458 US$ 11 215

2 US$27 000 US$12 000 US$ 15 000 0,87344 US$ 13 102

3 US$27 000 US$12 000 US$ 15 000 0,81630 US$ 12 245

4 US$28 000 US$12 000 US$ 16 000 0,76290 US$ 12 206

5 US$23 000 US$10 000 US$ 13 000 0,71299 US$ 9 269

Global PV1 US$ 58 036

Global PV1 by Formula B US$ 58 036
Global PV1 by Formula C US$ 58 036

For the next approach, I will calculate the NPV, discounting Cash Flow for 5 years. The Net present

value (NPV, or VAL in Portuguese: Valor Actual Líquido) method permits evaluate investments
adding the present value of all cash inflows and subtracts the present value of all future cash
outflows, the money I will invest (Gorman, 1998). On other words, is used to evaluate long-term
investments calculating adding the present value of all cash inflows and after subtracting the present
value of all cash outflows (Heisinger, 2012).

The formula is:

C0 is an initial investment, so C0 < 0.

Investment US$105 000
Less salvage US$100 000
Situation 1: with Straight-Line
depreciation
year Revenue R Costs C ERBIT (Net
Present ERBIT Present Depreciation Total cash Tax to pay
Cash Flows)
Value of Value less salvage flow 30%
$1@7%
1 US$ 25 000 US$ 13 000 US$ 12 000 0,93458 US$ 11 215 US$ 20 000 US$ (8 785) US$ 0
2 US$ 27 000 US$ 12 000 US$ 15 000 0,87344 US$ 13 102 US$ 20 000 US$ (6 898) US$ 0
3 US$ 27 000 US$ 12 000 US$ 15 000 0,81630 US$ 12 245 US$ 20 000 US$ (7 756) US$ 0
4 US$ 28 000 US$ 12 000 US$ 16 000 0,76290 US$ 12 206 US$ 20 000 US$ (7 794) US$ 0
5 US$ 23 000 US$ 10 000 US$ 13 000 0,71299 US$ 9 269 US$ 27 013 US$ (17 744) US$ 0
Global PV US$ 58 036 US$ 107 013 US$ (48976) US$ 0

Table 1: Present Value and Net Present Value

ERBITA: Earnings Before Interest, Taxes and Depreciation/Amortization

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There are 3 ways to calculate the Present Value (PV). All of 3 calculations have the same amount of
Present Value = $58,036.

1. Using a table with a present value at 7% as observed in the table. Present Value =
$58,036

2. Global PV by Formula B was calculated by the computer (in Portuguese):

VAL(7%;12000;15000;15000;16000;13000)=Present Value = $58,036

3. Global PV by Formula C was calculated by the computer:

Present Value
=12000÷(1,07)^1+15000÷(1,07)^2+15000÷(1,07)^3+16000÷(1,07)^4+13000÷(1,07)^5=$58,036

The NPV1= PV1 - Investment = $58,036 - $105,000 = - $46,964 (NEGATIVE NPV)

2. AMOUNT AND TIMING OF THE CASH FLOWS

Based In the Case Study information, I used the present value in each of the 5 years based in the
table of present value at 7%. The sum of these income cash flow in both options (see table 1 above).

3. SITUATION 1: WITH STRAIGHT-LINE DEPRECIATION

Considering depreciation, the Present Value PV2=$107.013 and the tax to pay would be zero,
because the results are less than zero.

Table 2: Situation 1: PV2=$107.013 and with Straight-Line depreciation for Tax Shield

A tax shield is a reduction in the income tax when tax law permit an expense like for example:
depreciation or interest in a consequence of a deduction from taxable income (Obaidullah, 2019).
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In the 1st, 2nd, 3rd and 4th years the calculation of the depreciation:

100,000÷5=$20,000

In the 5th year the calculation of the depreciation:

(100,000÷5)+5000×(1,07)^5=$27,013

The NPV2= PV2 - Investment = $107,013 - $105,000 = $2,013 (POSITIVE NPV)

Investment US$105 000

Less US$100 000
salvage
Situation 1: with Straight-Line Situation 2: without
depreciation depreciation
year Revenue R Costs C ERBIT (Net Present ERBIT Depreciatio Total cash Tax to pay After Tax Tax payed
Cash Flows) Value of Present n less flow 30% 30%
$1@7% Value salvage
1 US$ 25 000 US$ 13 000 US$ 12 000 0,93458 US$ 11 215 US$ 20 000 US$(8 785) US$ 0 7 850 US$ 3 364

2 US$ 27 000 US$ 12 000 US$ 15 000 0,87344 US$ 13 102 US$ 20 000 US$(6 898) US$ 0 9 171 US$ 3 930

3 US$ 27 000 US$ 12 000 US$ 15 000 0,81630 US$ 12 245 US$ 20 000 US$(7 756) US$ 0 8 571 US$ 3 673

4 US$ 28 000 US$ 12 000 US$ 16 000 0,76290 US$ 12 206 US$ 20 000 US$(7 794) US$ 0 8 544 US$ 3 662

5 US$ 23 000 US$ 10 000 US$ 13 000 0,71299 US$ 9 269 US$ 27 013 US$(17 744) US$ 0 6 488 US$ 2 781

Global PV US$ 58 036 US$ 107 013 US$(48976) US$ 0 US$40 625 US$ 17 411

4. SITUATION 2: NPV 2 WITHOUT DEPRECIATION

Without depreciation, the NPV is negative and the tax would be $17,411.

5. COMPARISON BETWEEN RESULTS

Would be a good decision to start this investment only in a case of depreciation of the equipment
because the NPV is positive and tax payment would be zero.

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6. CONCLUSION

The Payback can be a fast test but it doesn’t consider the interest rate neither present value. In this
case study the result of cash back result would be negative for the project. So NPV is discounting
the cash flows along the 5 years of the project and the depreciation can be a turning point from a
bad to good project, like in this case study.

The NPV1 is negative (- $46,964), but considering depreciation the NPV2 would be positive ($
$2,013). Additionally to this last situation will not pay taxes.

When the interest rate increases NPV is reduced, and when interest rate decrease the NPL increase
(Berman, 2013). It is important to have a sensibility about the numbers variation in the NPV.

In conclusion, it is a good project.

References:

Obaidullah. (2019, May 28). Tax Shield. Retrieved from https://xplaind.com/715341/tax-shield

Heisinger, K., & Hoyle, J. (2012). Accounting for Managers. Retrieved https://
2012books.lardbucket.org.

Gorman, T. (1998). The complete idiot’s guide to MBA basics. Alpha books: Indianapolis.

Berman, K. (2013). Financial Intelligence, Revised Edition: A Manager's Guide to Knowing What
the Numbers Really Mean. (Boston, Massachusetts): Harvard Business School Publishing.

Finance for Managers (2015). Lardbucket Book Project. Licensed under a Creative Commons by-
nc-sa 3.0 (http://creativecommons.org/licenses/by-nc-sa/ 3.0/.).

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