4. Additional Example

To practice the computation of net cash flows once more, let us consider the following example:

Food-Fly Company is considering purchasing a set of drones to deliver food in the greater Rochester area. To this end, the firm has collected the following information:

  • The drones cost 400'000 today and will be depreciated linearly over their useful life of 4 years.
     
  • The project is expected to generate the following revenues:
    • Year 1: 150'000
    • Year 2: 300'000
    • Year 3: 400'000
    • Year 4: 500'000
       
  • Operating expenses (excluding depreciation) amount to 60% of revenues.
     
  • The tax rate is 20%. Possible losses can be compensated with Food-Fly's profits from other projects.
     
  • To operate the drones, additional net working capital of 80'000 is required today. This net working capital will be used up linearly over the 4 years (20'000 per year).
     
  • The drones are expected to have zero salvage value.

 

Should the company launch the project if the cost of capital is 10%?

  

To find out, we can compute the project's net cash flows based on the above information (see also the accompanying Excel file): 

  

  Today Year 1 Year 2 Year 3 Year 4
Revenues 150’000 300’000 400’000 500’000
- Operating expenses (excluding Depreciation) 90’000 180’000 240’000 300’000
- Depreciation 100’000 100’000 100’000 100’000
EBIT   -40’000 20’000 60’000 100’000
- Taxes -8’000 4’000 12’000 20’000
EBIAT   -32’000 16’000 48’000 80’000
+ Depreciation 100’000 100’000 100’000 100’000
- ΔNWC 80’000 -20’000 -20’000 -20’000 -20’000
Operating Cash Flow (OCF) -80’000 88’000 136’000 168’000 200’000
- Net investments 400’000
Net Cash Flow (NCF) -480’000 88’000 136’000 168’000 200’000

 

Again, a few points are worth mentioning before valuing the cash flows:

  • Negative taxes:
    • In year 1, the taxable income is negative (-40'000). Our assumption was that losses from the project can be compensated with profits from other projects of the firm. Consequently, the loss of 40'000 in year 1 reduces the firm's overall tax bill by 8'000 [=0.2 × 40'000].
    • If the firm has no other profitable projects, the assumption of negative taxes is not very realistic, as losses usually do not translate into a immediate cash compensation from the IRS. In such a scenario, it would be more realistic to set taxes = 0 and then carry the loss forward to future years with profits.

  • Net Working Capital: We have assumed that the additional NWC is 80'000 today and that this NWC will be used up linearly over the 4 years of the project:
    • Each year, the firm therefore frees 20'000 of the capital that is tied up in the NWC. This corresponds to a cash inflow.
    • In the cash flow statement, we subtract increases in the NWC. Over the years 1 to 4, we observe a negative increase of 20'000 per year. Consequently, we subtract a negative value (which is a very complicated way of adding that value). 
    • For example, in year 1, the EBIAT is -32'000, Depreciation is 100'000 and ΔNWC is -20'000. Consequently, the operating cash flow is:

      OCF1 = EBIAT + Depreciation −ΔNWC = − 32'000 + 100'000 − (−20'000) = 88'000.
       
Project valuation

Assuming a cost of capital of 10%, the NPV of the project is -24'780:
 

\(NPV=\sum^4_{t=0} \frac{NCF_t}{(1+k)^t}\)

\(NPV=-480'000 +\frac{88'000}{1.1}+\frac{136'000}{1.1^2}+\frac{168'000}{1.1^3}+\frac{200'000}{1.1^4}=-24'780\)

 

It is therefore a bad project. The future cash inflows are not sufficient to cover the cost of capital of 10%. If the company proceeds with the project, its value will drop by roughly 25'000.
 

Another way to see that it is a bad project is to compute its Internal Rate of Return (IRR). The IRR is roughly 8% and therefore lower than the cost of capital.