Prince Mohammad Bin Fahd University
College of Business Administration
Business Department
Fall 2018/19
FINA4316 Capital Budgeting
Section: 101
Dr. Emmanuel Ntui
8/10/2018
Case 1
Student’s Name and ID:
Saleh Al sarraf 201600384
Omar Alshallali 201502970
Bassel Alharbi 201501292
Fahad Alrumaihi 201202603
Abstract
This case focus chosen investment where The Villard Electric
Company decide to re-estimate the cash flow of the investment,
based on the assumption of manager Fred Taylor. We will use
Microsoft Excel sheet that was used on the original estimation, in
order to re-estimate the cash flows. The result shows that the
original cash flow did not have the best net cash flow, other
estimations have better net cash flow. We recommend that Villard
Electric Company to decrease the cost of the system by 20% or
increase the expenses by 20%
Table of Content
Introduction ……………………………………………………………………………………3
Analysis………………………………………………………………………………………...4
Conclusion ……………………………………………………………………………………..7
Recommendation ………………………………………………………………………………8
References ……………………………………………………………………………………...9
Appendix.……………………………………………………………….……………………...10
Introduction:
Investment can be classified based on: the company economic
life, level of risk, and dependence. Companies usually focus on the
investment cash flow and operating cash flow specifically when it
comes to cash flow. Investment cash flow calculate the amount that
the company will spend to start an investment. However, the
operating cash flow which represent the revenue or we can say the
amount that company will gather from the investment. Also, they
focus on the life of the project and the life of the equipment that
they will use on the project. Villaed Electric Company has chosen
an investment which is computer system and he estimate the cash
flow for four years. Which he estimates the cost of system and
installation $200,000 and the life of project is 5 years using
Modifies Accelerated Cost Recovery System (MACRS) method and after
5 years the equipment will be sold for $50,000. Also he estimates
that the expenses will be 50,000 every year. Moreover, the tax rate
will be 36% but there is not working capital.
The company ask their employee to prepare additional estimation
for the investment which include: The cost of the system 20% higher
than original estimation and 20% lower. The increase the expenses
by 30% higher a0nd 20% lower than anticipated. Also, tax rate may
be lowered to 30% instead of 36%
Analysis:
Appendix A: The original estimated cash flow
As it is mentioned in appendix A that manager Fred Taylor
estimated the cash flow for computer system project. It is
mentioned that the purchase of computer system will cost them
$200,000 and the expenses will be $50,000 per year. However, we can
see that operation cash flow for 2018 was $46,400, year 2019 it was
$55,040, year 2020 was $45,824 and 2021 it was $84,736. We can see
that the change in cash flow was $32,000.
Appendix B: The cost of the system may be as much as 20%
higher
As we can see that when we raise the cost of the system by 20%
which raise from $200,000 to $240,000 it is raise the cost flow on
year one, two, three and year four. However, the raise in the cash
flow does not compensate the increase of the system which mean that
the increase of the system is not a good idea for the project,
because we can see than in year 1 the cash flow $49,280 which is
higher than the original by $2880, and in year 2 it was $59,648
which is higher than the original by $4608 and in year 3 it was
$48,589 which is higher than original by $2765 also on last year it
was $88,883 after we add the sale of computer system and tax in
sale of computer system which is higher than original by $4147 if
we add all these raises on cash flow it would not compensate the
increase if system, because the net cash flow will be ($6400). We
see that the change cash flow has decrease by (4%) it small
different but it does not worth to raise to cost of system.
Appendix C: The cost of the system may be as much as low as 20%
lower
As it is mentioned in appendix B that there is decrease on the
cost of the system by 20% which it reduced to $160,000. When we
decrease the cost of the system we see that the change in
depreciation also decreased. Moreover, we see in year 1 there was
decrease in cash flow by (6.20%), in year 2019 there was also
decrease in cash flow by (8.372%) which it was $55,040 and decrease
to $50,432 in year 3 there was also decrease from $45,824 to
$43,059 which about (6.03%) and on year 4 there was decrease by
(5%). However, we can see that those decrease was small, compare to
the cost of the computer system. Also, we see that the net cash
flow increased from $40,000 to $57,600 which approximately about
80%. So, we see when the cost of the system decrease the net cash
flow will increase.
Appendix D: The change in expenses may be 30% higher
We know that we use deduct depreciation from revenue to use it
as tax shield, so we can prevent some revenue from taxes. So, the
increases on the expenses will lead to increases in the net cash
flow. As we can see on appendix D cash flow for year 1 was $56,000
which is higher than the original by 20.68%, also in year 2 it
increases by 17.44% which about $9600 higher. In year 3, it
increases by $9600 and in year 4 in increases by 11.33% which
increases to $94,336. We can see this estimation has the best cash
flow compare to all another estimation, which it was $70,400 which
is higher than the original by 120%. We can say the best way is to
increases to the expenses.
Appendix E: The change in expenses may be 20% lower than
anticipated
We mentioned that we deduct depreciation from revenue to
prevented from taxes. In this appendix we that we decrease the
expenses by 20% which lead to decrease in net cash flow. We see
that in year 2018 the expenses and depreciation are $40,000 so
there was not tax on the income because there was not income.
However, at the end of year 1 the cash flow was $40,000. Which is
lower than the original by $6400. In year 2 we see the depreciation
was $64,000 which is higher than the expenses by $24,000, so the
tax on income was in minus. However, the cash flow was $48,640
which also lower than the original estimated by $6400. In year 3
the cash flow was $39,424 which lower than the original by (14%).
In year 4, the cash flow was $78,336 also the lower by $6400. In
general, the decrease in expenses will lead to decrease on the net
cash flow. In this case the net cash flow was $6,400.
Appendix F: The tax rate may be lowered to 30%
As we can see that om appendix F it was the same as the original
estimation but we decrease to tax rate from 36% to 30% and it has
impact on the cash flow, because we prevent 6% of revenue from the
tax which is good enough. In year 1 taxable income was $10,000 and
tax was $3000 which we protect 600 from being taxable. In year 2,
the taxable income was $-14,000 and tax was $4,200 and the cash
flow was $54,200 which is lower than the original by $8040. In year
3 we see that the net cash flow was higher than original by 1.51%.
in year 4, the cash flow was $87,280 and the original was $84,736.
Generally, the net cash flow increased by 5.158% compared to
original estimation. Which increases from $32,000 to $35,000 about
9.35%,
this is due to the decrease of the tax rate from 36% to 30%.
Conclusion
In conclusion, Fred Taylor who is the manager of Villaed
Electric Company selected an investment which is computer system
and he estimate the cash flow for four years and ask their employee
to estimate another cash flow in which the cost of system increases
by 20%, decrease the cost of system by 20%, the expenses increase
by 30%, expenses decrease by 20%, and the tax rate decrease to
30%.
According to the estimated cash we can see that the original
estimation was not the best estimation based on the net cash flow.
When we increase the cost of the system by 20% the net cash flow
was $11,912 which is lower than the original. When we decrease the
cost of system the net cash flow was $68,089 which is one of the
best estimation which is higher than original cash flow by 70.25%.
When we estimate that the expenses will increases by 30% the net
cash flow was $78,400 which is the best cash flow and the best
decision. However, when we decrease the expenses the net cash flow
would decrease to $14,400 which is lower than the original, so we
can say it not good idea to use this estimation. Finally, when we
estimate the tax rate decreased to 30% instead of 36% the net cash
flow was $42,047 which is higher than the original or when the tax
rate was 36% by $2,074
Recommendation:
According to the estimated cash flow, we can see the original
cash flow has net cash flow of $32,000 and it was not the best
estimation according to other estimations, because we can see on
appendix C and D that the nest cash flow are higher than original
cash flow. I recommend that Villaed Electric Company has two
choices between these estimations which are the best between all
estimations; either to increase expenses by 20% which will lead the
net cash flow to become $70,400 or to decrease the cost of the
system 20% which the net cash flow will be $57,600. These choices
would provide the highest net cash flow which is higher than the
original estimate cash flow over 70%.
References
Peterson, P. P., & Fabozzi, F. J. (2002).Capital budgeting:
Theory and practice. Chichester Wiley-Academy.
Jan, O. (n.d.). Straight-line Method of Depreciation. Retrieved
from https://accountingexplained.com
Appendices:
(A) Original Estimated Cash Flow
Item
Base
First year
Second year
Third year
Fourth year
Initial
2018
2019
2020
2021
2017
Purchase of computer system
$200,000
Sale of computer system
$50,000
Tax on sale of computer system
$5,558
Acquisition and disposition cash flows
$200,000
$0
$0
$0
$44,442
Change in expenses
$50,000
$50,000
$50,000
$50,000
Change in depreciation
$40,000
$64,000
$38,400
$23,040
Change in taxable income
$10,000
$14,000
$11,600
$26,960
Less: change in tax
$3,600
($5,040)
$4,176
$9,706
Change in income after tax
$6,400
($8,960)
$7,424
$17,254
Change in depreciation
$40,000
$64,000
$38,400
$23,040
Change in operating cash flows
$46,400
$55,040
$45,824
$40,294
Change in net cash flows
$200,000
$46,400
$55,040
$45,824
$84,736
Change in Cash Flow
$32,000
(B) The cost of the system may be as much as 20% higher
Item
Base
First year
Second year
Third year
Fourth year
Initial
2018
2019
2020
2021
2017
Purchase of computer system
$240,000
Sale of computer system
$50,000
Tax on sale of computer system
$3,070
Acquisition and disposition cash flows
$240,000
$0
$0
$0
$46,930
Change in expenses
$50,000
$50,000
$50,000
$50,000
Change in depreciation
$48,000
$76,800
$46,080
$27,648
Change in taxable income
$2,000
($26,800)
$3,920
$22,352
Less: change in tax
$720
($9,648)
$1,411.20
$8,046.72
Change in income after tax
$1,280
$17,152
$2,509
$14,305
Change in depreciation
$48,000
$76,800
$46,080
$27,648
Change in operating cash flows
$49,280
$59,648
$48,589
$41,953
Change in net cash flows
$240,000
$49,280
$59,648
$48,589
$88,883
Net impact in Cash flow
$6,400
(C) The cost of the system may be as much as low as 20%
lower.
Item
Base
First year
Second year
Third year
Fourth year
Initial
2018
2019
2020
2021
2017
Purchase of computer system
$160,000
Sale of computer system
$50,000
Tax on sale of computer system
$8,047
Acquisition and disposition cash flows
$160,000
$0
$0
$0
$41,953
Change in expenses
$50,000
$50,000
$50,000
$50,000
Change in depreciation
$32,000
$51,200
$30,720
$18,432
Change in taxable income
$18,000
($1,200)
$19,280
$31,568
Less: change in tax
$6,480
($432)
$6,940.80
$11,364.48
Change in income after tax
$11,520
($768)
$12,339
$20,204
Change in depreciation
$32,000
$51,200
$30,720
$18,432
Change in operating cash flows
$43,520
$50,432
$43,059
$38,636
Change in net cash flows
$160,000
$43,520
$50,432
$43,059
$80,589
Net impact in Cash flow
$57,600
(D) The change in expenses may be 30% higher
Item
Base
First year
Second year
Third year
Fourth year
Initial
2018
2019
2020
2021
2017
Purchase of computer system
$200,000
Sale of computer system
$50,000
Tax on sale of computer system
$5,558
Acquisition and disposition cash flows
$200,000
$0
$0
$0
$44,442
Change in expenses
$65,000
$65,000
$65,000
$65,000
Change in depreciation
$40,000
$64,000
$38,400
$23,040
Change in taxable income
$25,000
$1,000
$26,600
$41,960
Less: change in tax
$9,000
$360
$9,576.00
$15,105.60
Change in income after tax
$16,000
$640
$17,024
$26,854
Change in depreciation
$40,000
$64,000
$38,400
$23,040
Change in operating cash flows
$56,000
$64,640
$55,424
$49,894
Change in net cash flows
$200,000
$56,000
$64,640
$55,424
$94,336
Net impact in Cash flow
$70,400
(E) The change in expenses may be 20% lower than
anticipated.
Item
Base
First year
Second year
Third year
Fourth year
Initial
2018
2019
2020
2021
2017
Purchase of computer system
$200,000
Sale of computer system
$50,000
Tax on sale of computer system
$5,558
Acquisition and disposition cash flows
$200,000
$0
$0
$0
$44,442
Change in expenses
$40,000
$40,000
$40,000
$40,000
Change in depreciation
$40,000
$64,000
$38,400
$23,040
Change in taxable income
$0
($24,000)
$1,600
$16,960
Less: change in tax
$0
($8,640)
$576.00
$6,105.60
Change in income after tax
$0
($15,360)
$1,024
$10,854
Change in depreciation
$40,000
$64,000
$38,400
$23,040
Change in operating cash flows
$40,000
$48,640
$39,424
$33,894
Change in net cash flows
$200,000
$40,000
$48,640
$39,424
$78,336
Net impact in Cash flow
$6,400
(F) The tax rate may be lowered to 30%.
Item
Base
First year
Second year
Third year
Fourth year
Initial
2018
2019
2020
2021
2017
Purchase of computer system
$200,000
Sale of computer system
$50,000
Tax on sale of computer system
$4,632
Acquisition and disposition cash flows
$200,000
$0
$0
$0
$45,368
Change in expenses
$50,000
$50,000
$50,000
$50,000
Change in depreciation
$40,000
$64,000
$38,400
$23,040
Change in taxable income
$10,000
($14,000)
$11,600
$26,960
Less: change in tax
$3,000
($4,200)
$3,480.00
$8,088.00
Change in income after tax
$7,000
($9,800)
$8,120
$18,872
Change in depreciation
$40,000
$64,000
$38,400
$23,040
Change in operating cash flows
$47,000
$54,200
$46,520
$41,912
Change in net cash flows
$200,000
$47,000
$54,200
$46,520
$87,280
Net impact in Cash flow
$35,000
(G) Modified Accelerated Cost Recovery System (MACRS)
Year
Depreciation rate for recovery period
3-year
5-year
7-year
10-year
15-year
20-year
1
33.33%
20.00%
14.29%
10.00%
5.00%
3.75%
2
44.45
32
24.49
18
9.5
7.219
3
14.81
19.2
17.49
14.4
8.55
6.677
4
7.41
11.52
12.49
11.52
7.7
6.177
5
11.52
8.93
9.22
6.93
5.713
6
5.76
8.92
7.37
6.23
5.285
7
8.93
6.55
5.9
4.888
8
4.46
6.55
5.9
4.522
9
6.56
5.91
4.462
10
6.55
5.9
4.461
11
3.28
5.91
4.462
12
5.9
4.461
13
5.91
4.462
14
5.9
4.461
15
5.91
4.462
16
2.95
4.461
17
4.462
18
4.461
19
4.462
20
4.461
21
2.231
16
