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Chapter 6: Problem 18

Cash Flow Valuation Phillips Industries runs a small manufacturing operation. For this fiscal year, it expects real net cash flows of \(\$ 155,000\). Phillips is an ongoing operation, but it expects competitive pressures to erode its real net cash flows at 5 percent per year in perpetuity. The appropriate real discount rate for Phillips is 11 percent. All net cash flows are received at year-end. What is the present value of the net cash flows from Phillips's operations?

Short Answer

Expert verified
The present value of the net cash flows from Phillips's operations is \(\$968,750\) using the present value of perpetuity formula with growth, given a discount rate of 11% and a constant growth rate of -5%.

Step by step solution

01

Calculate the constant growth rate of cash flows

As the cash flows erode by 5% each year, the constant growth rate (g) is -5%.
02

Identify the discount rate

The exercise states that the real discount rate is 11%, so we will use this as the discount rate (r) in our calculations.
03

Calculate the present value of the perpetuity

We will now use the present value of perpetuity formula with growth to calculate the present value of Phillips's net cash flows: PV = \(\frac{CF_1}{r-g}\) Here, PV is the present value, CF_1 is the cash flow for the first year, r is the discount rate, and g is the constant growth rate. Plugging in the values, we get: PV = \(\frac{\$155,000}{0.11-(-0.05)}\)
04

Solve for PV

Now we can solve for PV: PV = \(\frac{\$155,000}{0.16}\) PV = \(\$ 968,750\) The present value of the net cash flows from Phillips's operations is \(\$968,750\).

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Discount Rate
The discount rate is a pivotal component in cash flow valuation, influencing how future cash values are perceived today. It serves as a measure of the risk associated with future cash flows and the return required by investors. In our exercise, Phillips Industries uses a discount rate of 11%. This rate considers factors like inflation and investment risk, capturing the time value of money. A higher discount rate indicates greater uncertainty, whereas a lower one suggests a more secure investment. Understanding the discount rate is essential as it determines how cash flows are adjusted back to their present values.
Perpetuity
Perpetuity refers to a series of cash flows that continue indefinitely. In the context of Phillips Industries, their cash flows are expected to persist forever, despite decreasing by a certain percentage each year. Calculating the value of perpetuity involves assessing these endless cash flows and is useful in determining valuations for firms with predictable, ongoing operations. For Phillips, perpetuity means their cash flows will never cease, but they will diminish over time at a specified rate due to competitive pressures.
Growth Rate
The growth rate in this scenario is negative, indicating shrinking cash flows over time. For Phillips Industries, the growth rate is estimated at -5%, reflecting a decline due to market competition. This rate affects the present value calculation by reducing the future cash flow valuations. Understanding growth rates, whether positive or negative, helps in predicting how cash flows evolve, impacting the valuation and financial planning of businesses.
Present Value
Present value (PV) represents the current worth of future cash flows, considering the discount rate and growth rate. It allows businesses to assess the 'today's value' of expected finances. For Phillips Industries, the PV was calculated using the formula for a growing perpetuity: \[PV = \frac{CF_1}{r-g}\]In this case, with an expected cash flow of \(\\(155,000\), a discount rate of 11%, and a growth rate of -5%, the PV results in \(\\)968,750\). This computation is crucial for investment assessments, ensuring resources are allocated toward profitable ventures.
Net Cash Flows
Net cash flows are the actual funds available to a business after accounting for all operating expenses, taxes, and capital expenses. For Phillips Industries, the starting point for valuing cash flows was the projected net cash flow of \(\$155,000\). Estimating net cash flows accurately helps firms plan their finances, make investment decisions, and manage liquidity. In valuation terms, net cash flows represent the lifeblood of a company's operations, giving insight into its financial health and potential growth.

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Most popular questions from this chapter

Calculating NPV and IRR for a Replacement A firm is considering an investment in a new machine with a price of \(\$ 12\) million to replace its existing machine. The current machine has a book value of \(\$ 4\) million and a market value of \(\$ 3\) million. The new machine is expected to have a fouryear life, and the old machine has four years left in which it can be used. If the firm replaces the old machine with the new machine, it expects to save \(\$ 4.5\) million in operating costs each year over the next four years. Both machines will have no salvage value in four years. If the firm purchases the new machine, it will also need an investment of \(\$ 250,000\) in net working capital. The required return on the investment is 10 percent, and the tax rate is 39 percent. What are the NPV and IRR of the decision to replace the old machine?

Project Analysis and Inflation Sanders Enterprises, Inc., has been considering the purchase of a new manufacturing facility for \(\$ 150,000\). The facility is to be fully depreciated on a straightline basis over seven years. It is expected to have no resale value after the seven years. Operating revenues from the facility are expected to be \(\$ 70,000\), in nominal terms, at the end of the first year. The revenues are expected to increase at the inflation rate of 5 percent. Production costs at the end of the first year will be \(\$ 20,000\), in nominal terms, and they are expected to increase at 6 percent per year. The real discount rate is 8 percent. The corporate tax rate is 34 percent. Sanders has other ongoing profitable operations. Should the company accept the project?

Calculating a Bid Price Another utilization of cash flow analysis is setting the bid price on a project. To calculate the bid price, we set the project NPV equal to zero and find the required price. Thus the bid price represents a financial break-even level for the project. Guthrie Enterprises needs someone to supply it with 130,000 cartons of machine screws per year to support its manufacturing needs over the next five years, and you've decided to bid on the contract. It will cost you \(\$ 830,000\) to install the equipment necessary to start production; you'll depreciate this cost straight-line to zero over the project's life. You estimate that in five years this equipment can be salvaged for \(\$ 60,000\). Your fixed production costs will be \(\$ 210,000\) per year, and your variable production costs should be \(\$ 8.50\) per carton. You also need an initial investment in net working capital of \(\$ 75,000\). If your tax rate is 35 percent and you require a 14 percent return on your investment, what bid price should you submit?

Equivalent Annual Cost Bridgton Golf Academy is evaluating different golf practice equipment. The "Dimple-Max" equipment costs \(\$ 63,000\), has a three- year life, and costs \(\$ 7,500\) per year to operate. The relevant discount rate is 12 percent. Assume that the straight-line depreciation method is used and that the equipment is fully depreciated to zero. Furthermore, assume the equipment has a salvage value of \(\$ 15,000\) at the end of the project's life. The relevant tax rate is 34 percent. All cash flows occur at the end of the year. What is the equivalent annual cost (EAC) of this equipment?

Calculating Project NPV Scott Investors, Inc., is considering the purchase of a \(\mathbf{\$ 4 5 0 , 0 0 0}\) computer with an economic life of five years. The computer will be fully depreciated over five years using the straight-line method. The market value of the computer will be \(\$ 80,000\) in five years. The computer will replace five office employees whose combined annual salaries are \(\$ 140,000\). The machine will also immediately lower the firm's required net working capital by \(\$ 90,000\). This amount of net working capital will need to be replaced once the machine is sold. The corporate tax rate is 34 percent. Is it worthwhile to buy the computer if the appropriate discount rate is 12 percent?
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