Financial Mangement (FIN 306)
Incremental Cash Flows
Lecture II
Chapter 10
Dr. Muhammad Asim Faheem
Department Of Banking and Finance
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Page 1
Lecture Outline
Projected Cash Flow for a New Project
A Case Study
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The Incremental Cash Flow
Project Decision Based on Cash flow Forecast
Eric Casting Corporation is considering adding a new line to its product mix, and the capital
budgeting analysis is being conducted by James Foxson, a recently graduated Financial
Analyst. The feasibility study was conducted by Mayers Corporation 2 years ago for a total
fee of $1600. The production line would be set up in unused space in EMC's main plant, the
space is otherwise useless. The machinery’s invoice price would be approximately $200,000,
another $10,000 in shipping charges would be required, and it would cost an additional
$30,000 to install the equipment. The machinery has an economic life of 4 years, and EMC
has obtained a special tax ruling that places the equipment in the MACRS 3-year class. The
machinery is expected to have a salvage value of $25,000 after 4 years of use.
The new line would generate incremental sales of 1,250 units per year for 4 years at an
incremental cost of $100 per unit in the first year, excluding depreciation. Each unit can be
sold for $200 in the first year. A decline of 125 units in the sale of old product is expected
due to this new product. The selling price and cost of old product is $160 and $80 per unit
respectively. All the sales price and costs are expected to increase by 3% per year due to
inflation. Further, to handle the new line, the firm’s net working capital would have to
increase by an amount equal to 12% of sales revenues. The firm’s tax rate is 30%, and its
overall weighted average cost of capital is 10%.
Make an incremental cash flow statement and based on the information, use the
capital budgeting techniques to decide about the project’s acceptance.
Assume MARCS rates of 33.33%, 44.45%, 14.81% and 7.41% for year 1-4.
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The Incremental Cash Flow
Step 1
Part I: Input Data
Equipment cost $200,000
Shipping charge $10,000
Installation charge $30,000
Economic Life 4
Salvage Value $25,000
Tax Rate 30%
Cost of Capital 10%
Units Sold 1,250
Sales Price Per Unit $200
Incremental Cost Per Unit $100
NWC/Sales 12%
Inflation rate 3%
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The Incremental Cash Flow
Step 2
Annual Depreciation Expense
Depreciable Basis = Equipment + Freight + Installation
Depreciable Basis = $240,000
Remaining
Year % x Basis = Deprecation Book Value
1 0.33 $240,000 $79,200 $160,800
2 0.45 240,000 108,000 52,800
3 0.15 240,000 36,000 16,800
4 0.07 240,000 16,800 0
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The Incremental Cash Flow
Step 3
Erosion Cost
Year 1 Year 2 Year 3 Year 4
Sale Unit Reduced 125 125 125 125
$160.00 $164.80 $169.74 $174.84
Sale Unit Price
Unit cost $80.00 $82.40 $84.87 $87.42
Erosion Cost $10,000 $10,300 $10,609 $10,927
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The Incremental Cash Flow
Step 4 Construct annual incremental operating cash flow statements.
Year 1 Year 2 Year 3 Year 4
Units 1,250 1,250 1,250 1,250
Unit price $200.00 $206.00 $212.18 $218.55
Unit cost $100.00 $103.00 $106.09 $109.27
Sales 250000 257500 265225 273181.8
Sales- Erosion Cost $240,000 $247,200 $254,616 $262,254
Costs 125,000 128,750 132,613 136,591
Depreciation
79,200 108,000 36,000 16,800
Operating income before $35,800 $10,450 $86,004 $108,864
taxes (EBIT)
Taxes (30%) 10,740 3,135 25,801 32,659
EBIT (1 – T) $25,060 $7,315 $60,202 $76,205
Depreciation
79,200 108,000 36,000 16,800
Net operating CF
$104,260 $115,315 $96,202 $93,005
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The Incremental Cash Flow
Step 5
Estimate the required net working capital for each year, and the cash flow due to investments in net
working capital.
Year 0 Year 1 Year 2 Year 3 Year 4
Sales $240,000 $247,200 $254,616 $262,254
NWC (% of sales) 28,800 29,664 30,554 31,471
CF due to investment in NOWC) -28,800 -864 -890 -917 31,471
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The Incremental Cash Flow
Step 6
Calculate the after-tax salvage cash flow.
Salvage value $25,000
Book value 0
Gain or loss $25,000
Tax on salvage value 7,500
Net terminal cash flow $17,500
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The Incremental Cash Flow
Step 7
Projected Net (incremental) Cash Flows
Year 0 Year 1 Year 2 Year 3 Year 4
Investment Outlay: Long Term Assets ($240,000)
Operating Cash Flows $104,260 $115,315 $96,202 $93,005
CF due to investment in NWC -28,800 -864 -890 -917 31,471
Salvage Cash Flows 17,500
Net Cash Flows ($268,800) $103,396 $114,425 $95,285 $141,976
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The Incremental Cash Flow
Project’s NPV, IRR and payback
Step 8
NPV $88,323
IRR 23.8%
Payback 2.5 Yrs
Decision = Project Accepted
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