Module 14 CT Problems CASH FLOWS, OTHER TOPICS IN CAPITAL BUDGETING, INTERNATIONAL BUSINESS FINANCE CT 14 - 1 CALCULATING FREE CASH FLOWS Saudi Arabia Computers is introducing a new product and has an expected cahnge in EBIT of SAR 326,700. The company has a 28 percent marginal tax rate. The project will produce SAR 98,000 of depreciation per year. In addition, the project will cause the following changes in year 1: DATA Change in EBIT 326,700 Tax rate 28% Depreciation 98,600 Without Project With Project Change Accounts Receivable 59,600 74,000 14,400 Inventory 72,000 87,000 15,000 Accounts Payable 81,400 102,000 20,600 What is the project's free cash flow in year 1? Calculating Free Cash Flows: Change in EBIT Less:Change in taxes Plus:Change in depreciation LessChange in net working capital Less:Change in capital spending Free cash Flows CT 14 - 2 NEW PROJECT ANALYSIS UAE Manufacturing is considering the purchase of a new production machine for SAR 600,000. The purchase of this machine will result in an increase in earnings before interest and taxes of SAR 175,000 per year. To operate this machine properly, workers would have to go throught a brief training session that would cost SAR 30,000 after taxes. It would cost SAR 10,000 to install the machine properly. Also, because the machine is extremely efficient, its purchase would necessitate an increase in inventory or SAR 40,000. This machine has an expected life of 10 years, after which it will have no salvage value. Assume simplified straight-line decpreciation and that this machine is being depreciated down to zero, a 27 percent marginal tax rate, and a required rate of return of 12 percent. DATA Change in EBIT 141,000 Purchase Price 483,000 Training Session Fee 17,000 Installation Fee 14,500 Increase in Inventory 15,000 Life 10 Salvage Value 0 Depreciation 52,600 Tax Rate 27% Required rate of return 12% A) What is the initial outlay associated with this project? Outflows Purchase Price Training Session Fee Installation Fee Increased Working Inventory Net Initial Outlay B) What are the annual after-tax cash flows associated with this project for years 1 through 9? Differential Annnual Free Cash Flows (Years 1-9) Cash Flow Change in EBIT Change in taxes Change in depreciation Project's Free Cash Flows C) What is the terminal cash flow in year 10 (what is the annual after-tax cash flow in year 10 plus any additional cash flows associated with the termination of the project)? Terminal Free Cash Flow (Year 10) Inflows: Free Cash Flow in Year 10 Recapture of Working Capital (Inventory) Total Terminal Cash Flow D) Should the machine be purchased? Present Value of Free Cash Flows Years 1-9 Year 10 Less Initial Cost Net Present Value Decision: The machine should be purchased, the NPV > 0. CT 14 - 3 NEW PROJECT ANALYSIS World Global Corporation is considering the purchase of a new machine for SAR 336,000. The purchase of this machine will result in an increase in earnings before interest and taxes of SAR 32,000 per year. To operate this machine properly, workers would have to go throught a brief training session that would cost SAR 13,800 after taxes. It would cost SAR 5,900 to install the machine properly. Also, because the machine is extremely efficient, its purchase would necessitate an increase in inventory or SAR 22,800. This machine has an expected life of 10 years, after which it will have no salvage value. Finally, to purchase the new machine, it appears that the firm would have to borrow SAR 85,000 at 6 percent interest from a bank, resulting in additional interest payments of SAR 10,000 per year. Assume simplified straight-line decpreciation and that this machine is being depreciated down to zero, a 26 percent marginal tax rate, and a required rate of return of 7 percent. DATA Change in EBIT 32,000 Purchase Price 336,000 Training Session Fee 13,800 Installation Fee 5,900 Increase in Inventory 22,800 Life 10 Salvage Value 0 Interest payments 6,210 Depreciation 25,100 Tax Rate 26% Required rate of return 7% A) What is the initial outlay associated with this project? Outflows Purchase Price Training Session Fee Installation Fee Increased Working Inventory Net Initial Outlay B) What are the annual after-tax cash flows associated with this project for years 1 through 9? Differential Annnual Free Cash Flows (Years 1-9) Cash Flow Change in EBIT Change in taxes Change in depreciation Project's Free Cash Flows C) What is the terminal cash flow in year 10 (what is the annual after-tax cash flow in year 10 plus any additional cash flows associated with the termination of the project)? Terminal Free Cash Flow (Year 10) Inflows: Free Cash Flow in Year 10 Recapture of Working Capital (Inventory) Total Terminal Cash Flow D) Should the machine be purchased? Present Value of Free Cash Flows Years 1-9 Year 10 Less Initial Cost Net Present Value Decision: CT 12 - 4 RISK-ADJUSTED NPV The World Corporation is considering two mutually exclusive projects. Both require an initial outlay of SAR 17,800 and will operate for 5 years. Project A will produce expected cash flows of SAR 7,800 per year for years 1 through 5, whereas project B will produce expected cash flwos of SAR 9,900 per year for years 1 thorough 5. Because project B is the riskier of the two projects, management of Medina Corporation decided to apply a required rate of return of 14 percent to its evaluation but only a 11 percent required rate of return to project A. Determine each project's risk-adjusted net present value. Project A Project B Initial outlay (17,800) (17,800) Year 1 7,800 9,900 Year 2 7,800 9,900 Year 3 7,800 9,900 Year 4 7,800 9,900 Year 5 7,800 9,900 req. rate of return= 11% 14% NPVa= NPVb= CT 14 - 5 SPOT EXCHANGE RATES SAR 1 Quotes for Foreign Currencies Contract SAR per Country per day Currency Canada - dollar Spot 2.7215 30 2.8514 90 2.6543 Japan - yen Spot 0.0289 30 0.0290 90 0.0295 Switzerland - franc Spot 3.6572 30 3.7942 90 3.7815 A Saudi business needs to pay (a) 20,000 Canadian dollars, (b) 2.5 million Japanese yen, and (c) 30,000 Swiss francs to buinesses abroad. What are the SAR payments to the respective countries? DATA Saudi business pays in local currency: Canadian dollars 20,000 Japanese yen 2,500,000 Swiss francs 30,000 In SAR: a) Canadian payment b) Japanese payment c) Swiss payment UAE business pays SAR 49,500, SAR 57,100, and SAR 62,700 to suppliers in, respectively, Japan, Switzerland, and Canada. The Japanese supplier payment is due in 30 days, as is the Canadian supplier. The Swiss supplier is due in 90 days. How much, in local currencies, would the suppliers receive? DATA Saudi business pays in SAR: Japanese payment 49,500 Swiss payment 57,100 Canadian payment 62,700 In local currency: a) Japanese yen b) Swiss francs c) Canadian dollars CT 14 - 6 PURCHASING-POWER PARITY A pair of Men's Burton lace-up dress shoes cost SAR 475 in Saudi Arabia but costs GBP 79 in England. Assuming that purchasing-power parity (PPP) holds, how many SAR are required to purchase 1 GBP. Cost in Saudi Arabia = 475 SAR Cost in England = 79 GBP pair of Burton shoes SAR GBP SAR/shoes shoes/GBP GBP/SAR 1 475 475 1 79 SAR/GBP = (SAR/shoes)*(shoes/GBP) =