FIN211 Financial Management Lecture Notes by wsDT1L



             FIN211 Financial Management Lecture Notes

File reference: 06B: Text reference: Chapter 12, Integrative problem, pages
360-361 (3rd edn: 352-353).

A spreadsheet solution of the integrative problem is provided on page 4 of these

Suggested Solution to integrative problem: pages 360-361 (3rd edn: 352-3)

1.   We should focus on project-driven cash flows rather than accounting profits.
     This is because forecast net cash inflows represent the magnitude and timing of
     resources the firm expects to receive from investing in the project. Future cash
     inflows can be used to service capital and to reinvest. Cash is the benefit that
     providers of capital, whether debt or equity, expect to receive, while reinvested
     cash helps maintain the long-term viability of the firm. Cash flows are therefore
     the most appropriate measure of project benefits.
     Project-driven cash flows are those that arise only if the project is undertaken
     and are sometimes described as differential, incremental or marginal cash
     flows. These are the cash flows that must be used to assess the impact of
     project acceptance on firm value.

2.   Although profits do not correctly measure the timing of the benefits of a
     project, they have a role to play in that they are the basis for assessing how
     much tax the firm must pay. This payment of tax is a cash flow and so – for
     relevant taxpaying entities such as Antipodes – it must be included in the
     project evaluation.

3.   Depreciation is an accounting expense, but not a cash flow. This is because
     depreciation merely represents an accounting book entry designed to expense
     periodically the cost of a non-current asset over its forecast life. In this case,
     Antipodes has outlaid $8,000,000 on the installed plant. The plant is expected
     to last for five years, so one-fifth of that outlay will be allocated as an expense
     in each of the five years: i.e. each year’s depreciation expense will be
     $1,600,000. Despite the fact that depreciation is not a cash flow, the amount
     of depreciation expense reduces the period’s profit and so reduces taxes
     payable in that period.

4.   Within the Australian taxation system any income tax paid by the company can
     be used (as ‘imputation credits’) by the company’s eligible shareholders to
     offset against their other income tax liabilities. Within this system, if the
     company increases its tax deductions and so decreases taxes payable, this in
     turn decreases the tax credits available to shareholders. However, the
FIN211                                                                                       06B

      Antipodes shareholder is the Occident Corporation, which is based overseas
      and therefore not eligible to receive imputed tax credits.
      The Occident Corporation will therefore benefit from tax deductions that
      occur within Antipodes. Such deductions reduce taxes payable and so increase
      distributable profits. Project benefits and costs should therefore be assessed on
      an after-tax basis. In this case we are interested in after-tax cash flows as
      only those flows are available to the shareholder.

5.    The initial outlay is $8,100,000, comprising the installed cost of the plant and
      equipment ($7,900,000 plus $100,000) plus an initial investment of $100,000
      in working capital.

6/7 The annual net cash flows (after-tax) are shown in the following worksheet,
    which also shows the determination of profit and taxes etc. used in computing
    the cash flows. When determining operating cash flow, depreciation expense is
    added back because this was deducted as an expense when computing profits
    and taxes, but as it is not a cash flow it must then be added back to convert
    after-tax profit to a cash-flow amount.

8.    Cash flows (in $’000):

      ($8,100)        $4,220        $8,920        $11,500       $8,860        $6,100

9.    NPV = $17,974,000 (to the nearest $’000)
      This NPV is the ‘Net Present Value’. It is an estimate of the net addition to the
      wealth of the company as a result of accepting this project. In effect, what we
      have done is to convert the future net cash flows into present value dollars
      (allowing for the time value of money, as measured by the 15% cost of capital).
      These present value amounts are then comparable with the initial outlay of
      $8,100,000 and are estimated to exceed that outlay by $17,974,000. This means
      that future cash flows are expected to be sufficient to meet the required return
      of 15% on funds invested and still leave a surplus equivalent to $17,974,000 in
      present day dollars.

10.      IRR = 81%
         The IRR stands for ‘Internal Rate of Return’. It is an estimate of the compound
         interest rate of return on the company’s funds invested in this project. The rate
         is well in excess of Antipodes 15% required rate of return (the cost of capital).

11.      Yes, this project should be accepted: NPV > 0 and IRR > the required rate of
         return. By either measure, this seems to be a very worthwhile project.

FIN211                                                                                      06B

      Spreadsheet model of Integrative problem, pages 360-361
                          Input                                              Output
Unit cost $                       Initial outlay                       NPV

Annual fixed costs $               Life in yrs                         IRR        #NUM!

Tax rate                           Initial WC                          MIRR       #DIV/0!

RROR                                 WC %


                                        1              2           3    4             5

Unit sales

                          $             $              $           $    $             $

Unit price

Sales revenue

Cost of sales

Fixed costs


Pre-tax profit


After-tax profit

Add back depreciation

Operating cash flow

Working capital

WC cash flow

Initial outlay

Net cash flow



IRR                     #NUM!

FV                       N/A

Sum FV

MIRR (Excel)            #DIV/0!

MIRR                    #DIV/0!

FIN211                                                                                                          06B

      Spreadsheet model of Integrative problem, pages 360-361
                           Input                                                                Output
Unit cost $                    -180   Initial outlay    -8,000,000                        NPV         17,974,315

Annual fixed costs $      -200,000     Life in yrs           5                            IRR            81%

Tax rate                  30%          Initial WC           -100,000                     MIRR            45%

RROR                      15%            WC %               10%


                           0                1                2               3             4              5

Unit sales                                  70,000          120,000         140,000        80,000         60,000

                           $                $                $               $             $              $

Unit price                                      300               300            300            300            260

Sales revenue                          21,000,000      36,000,000       42,000,000     24,000,000     15,600,000

Cost of sales                         -12,600,000      -21,600,000      -25,200,000    -14,400,000    -10,800,000

Fixed costs                              -200,000           -200,000        -200,000     -200,000       -200,000

Depreciation                           -1,600,000       -1,600,000       -1,600,000     -1,600,000     -1,600,000

Pre-tax profit                          6,600,000      12,600,000       15,000,000      7,800,000      3,000,000

Tax                                    -1,980,000       -3,780,000       -4,500,000     -2,340,000      -900,000

After-tax profit                        4,620,000          8,820,000    10,500,000      5,460,000      2,100,000

Add back depreciation                   1,600,000          1,600,000       1,600,000    1,600,000      1,600,000

Operating cash flow                     6,220,000      10,420,000       12,100,000      7,060,000      3,700,000

Working capital           -100,000     -2,100,000       -3,600,000       -4,200,000     -2,400,000     -1,560,000

WC cash flow              -100,000     -2,000,000       -1,500,000          -600,000    1,800,000      2,400,000

Initial outlay          -8,000,000

Net cash flow           -8,100,000      4,220,000          8,920,000    11,500,000      8,860,000      6,100,000

PV                      -8,100,000      3,669,565          6,744,802       7,561,437    5,065,734      3,032,778

NPV                     17,974,315

IRR                       81%

FV                        N/A           7,380,806      13,566,205       15,208,750     10,189,000      6,100,000

Sum FV                  52,444,761

MIRR (Excel)              45%

MIRR                      45%


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