Financial Exercises 7: Integrated Case

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by Clemens Werkmeister


Relevant cash flows for NPV-analyses

Five years ago (at year 0), Fluffy Devices prepared for an expansion of its manufacturing activities and paid 900.000 € for a warehouse, to be depreciated over 20 years. Soon after buying, a new air conditioning system was installed in the warehouse at a cost of 120.000 €. At the time, the proposal envisaged an additional investment in equipment of 800.000 €, to be depreciated like the air conditioning straight line over 10 years. Working capital was expected to correspond to 15 % of sales and to drop after year 10. The project was designed to have a lifetime of ten years. Sales of Fluffy devices were assumed to start at 3 mio € in the first year, increasing later by 10 % per year up to year 10, clearly more than the inflation rate of 5 %. Costs of goods sold were expected to be 70 % of sales, and other costs to be 400.000 € in year 1 and to increase in line with inflation. Since sales originating from this plant would have corresponded to an increase of 25 % of the total sales of Fluffy Devices, the project was charged with 20 % of Fluffy Devices’s total overhead cost of 500.000 € (in year 1) which was supposed to increase with inflation, too. At the time, a tax rate of 40 % applied and the cost of capital was 15 % per year.
After buying the warehouse and installing the air conditioning, but still before startup of further activities, the project was suspended due to the financial crisis. The warehouse was rented to a neighbour. The contract stipulated a rental charge of 90.000 € for year 1 and an annual increase by 5 %.

a. Prepare the cash flow analysis for the original project (before buying the warehouse and installing the air conditioning).

b. Explain the way you dealt with the different lifetime of the warehouse, the air conditioning and the additional investment.

c. How does depreciation enter your cash flow analysis?

d. How do you consider for inflation in your cash flow statements?

e. Calculate the NPV of the original project using nominal figures and considering for taxes based on straight line depreciation. What follows from your NPV?

f. In order to facilitate NPV-calculation, one can use the formula for growing annuities. For which positions of the NPV analysis the formula is applicable, for which not? Compare this approach to the above direct calculation.

g. What problem arises if we want to calculate NPV based on real figures? Find solutions to this problem and discuss the advantages and disadvantages of the approaches.

h. After buying the warehouse and installing the air conditioning, but before the additional capital investment, expected sales and cost of goods sales were cut down by 25 %. Compare the relevant cash flows and the NPV of the revised project to the rental contract. Assume that the warehouse is not to be sold anyway.

i. Today (at the end of year 5), since markets recovered, Fluffy Devices is considering to retake the project. Most figures of the original proposal are supposed to have increased in line with inflation at 5 % per year, over the last five years. Prepare the updated projections of relevant cash flows and calculate their NPV. Is the manufacturing project now better than renting the warehouse?


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References:
Financial Exercises
Financial Resources Formulary