Cash Flow Present Value After Tax

Question: Discuss about the Cash Flow for Present Value After Tax. Answer: 1. Present value of after tax cash flow from exiting old food maker Year Depreciation expense Tax benefit After tax cash flow Discount factor PV 1 ($4000) $1200 $2800 0.893 $2500.4 2 ($4000) $1200 $2800 0.797 $2231.6 3 ($4000) $1200 $2800 0.712 $1993.6 4 ($4000) $1200 $2800 0.636 $1780.8 5 ($4000) $1200 $2800 0.567 $1587.6 6 ($4000) $1200 $2800 0.507 $1419.6 7 ($4000) $1200 $2800 0.452 $1265.6 8 ($4000) $1200 $2800 0.404 $1131.2 9 ($4000) $1200 $2800 0.361 $1010.8 10 ($4000) $1200 $2800 0.322 $901.6 Total $15822.8 Present value of after tax cash flow from new Wonder food maker Year Depreciation expense Tax benefit After tax cash flow Discount factor PV 1 ($5000) $1500 $3500 0.893 $3125.5 2 ($5000) $1500 $3500 0.797 $2789.5 3 ($5000) $1500 $3500 0.712 $2492 4 ($5000) $1500 $3500 0.636 $2226 5 ($5000) $1500 $3500 0.567 $1984.5 6 ($5000) $1500 $3500 0.507 $1774.5 7 ($5000) $1500 $3500 0.452 $1582 8 ($5000) $1500 $3500 0.404 $1414 9 ($5000) $1500 $3500 0.361 $1263.5 10 ($5000) $1500 $3500 0.322 $1127 Total $19778.5 The after tax cash flow effect from depreciation of switching from old food maker to new wonder food maker is savings of $3955.7. This amount represents the increase in cash flow from the new food maker. Since depreciation is a non cash expense, an increase in depreciation will increase operating expense which will reduce the net profit and hence fewer taxes will be applied on the net profit. This savings in tax will increase the cash flow and thus the present value of total cash flows from new wonder food maker will increase. 2. NPV in $ million Probability Best case 10 0.2 Worst case -1 0.8 Expected NPV = best case NPV * probability of best case + worst case NPV * probability of worst case = (10*0.2) + (-1*0.8) = $ 1.2 million Number of outstanding shares = 1 million Market price per share = $50 Market value of the company before investment = 1 million *50 = $ 50 million With a NPV of 1.2 million, the value of the company will increase by 1.2 million, Hence, Value of company after investment = 50+1.2 = $51.2 million Market price of share after investment = value of company after investment / outstanding shares = 51.2 million / 1 million = $51.2 Hence, with the announcement of the investment, the share price of the company will increase by $1.2 and will increase to $51.2 per share. 3. Fixed cash expenses = $120000 EBIT = $130000 Accounting DOL = 2.5 DOL = Contribution Margin / EBIT 2.5 = Contribution Margin / 130000 Contribution margin = $325000 EBIT = Contribution margin - fixed costs Fixed costs = 325000 130000 = $195000 Total fixed cost = Fixed cash expenses + fixed non cash expenses (depreciation and amortisation) 195000 = 120000 + fixed non cash expenses (depreciation and amortisation) Therefore, Depreciation and Amortisation = $75000 Cash Flow DOL = 1 + Fixed costs / EBIT = 1 + 75000/130000 = 1.57 Therefore, Cash Flow DOL = 1.57 4. The various investments and their respective profitability index are given below: Project Investment ($) PI A 20000 2.5 B 50000 2 C 70000 1.75 D 10000 1 E 80000 0.8 Profitability Index (PI) is a capital budgeting tool which is calculated by dividing the present value of all future cash flows by the initial investment. For a project to be accepted as per this rule, it is necessary for the PI to be more than 1. A project having PI of 0 or less than 1 is not accepted. According to the above definition, all projects except E are acceptable since they all have PI more than 1. The company can undertake all the project investments simultaneously because the company has $500000 available for investments, whereas the total investment value of projects A to D is $150000 which is less than the amount available to the company. Hence all projects A, B, C, and D can be approved.