CASH FLOW ESTIMATION
1. The typical cash flow pattern for business projects involves cash outflows first, then
inflows. However, it's possible to imagine a project in which the pattern is reversed. For example,
we might receive inflows now in return for guaranteeing to make payments later. Would the
payback, NPV, and IRR methods work for such a project? What would the NPV profile look like?
Could the NPV and IRR methods give conflicting results?
ANSWER: Payback wouldn't make sense for such a project, because there would be no initial
outlay to recover. The NPV and IRR methods would work because they're based on the present
value of future cash flows regardless of their pattern. The NPV profile would slope upward, because
higher rates would reduce the present values of the negative flows in the distant future more than
those of the positive short-term flows. This would result in a more positive NPV as the interest rate
rose. NPV and IRR could give conflicting results if the up-sloping profiles crossed in the first
quadrant just as in the case of the traditional patterns.
1. A project that is expected to last six years will generate a profit and cash flow contribution
before taxes and amortization of $23,000 per year. It requires the initial purchase of equipment
costing $60,000, which will be amortized over four years. The relevant tax rate is 25%. Calculate
the project’s cash flows. Round all figures within your computations to the nearest thousand dollars.
The initial outlay is just the cost of the equipment. So CF0 = ($60,000). The remaining cash
flows are calculated as follows ($000).
Year 1 2 3 4 5 6
Cash flow before interest
and amortization $23 $23 $23 $23 $23 $23
Amortization 15 15 15 15 - -
EBT 8 8 8 8 23 23
Tax (@ 25%) 2 2 2 2 6 6
EAT 6 6 6 6 17 17
Add back Amortization 15 15 15 15 - -
Cash Flow 21 21 21 21 17 17
2. Flextech Inc. is considering a project that will require new equipment costing $150,000. It
will replace old equipment with an original cost of $35,000 that can be sold on the secondhand
market for $75,000. Assume that 50% of the capital gain is taxable, and that the company’s tax rate
is 35%. Calculate the project’s initial outlay.
Sale of old equip $75,000 $75,000
Original cost 35,000
Capital gain 40,000
Taxable capital gain (50%) 20,000
Tax on gain 7,000 7,000
Cash flow from sale $68,000
Cost of new equipment $150,000
Less: cash from sale (68,000)
Initial outlay, CF0 $ 82,000