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Solution to Case 03 Cash Flow Analysis

The Lazy Mower: Is it really worth it? Questions: 1. Prepare a Pro Forma Statement showing the annual cash flows resulting from the Lazy Mower project. (See table on next page)

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0 Sales (units)

1 30,000

2 34,000

3 38,800

4 38,000

5 36,000

6 36,000

7 35,500

8 35,000

9 34,500

10 34,000

Adjusted Sales 1,000

1,000

Revenues

30,000,000 34,000,000

1,000

38,800,000

36,100,000 34,200,000

34,200,000 33,725,000 31,500,000 31,050,000 30,600,000

Variable Cost

12,000,000 13,600,000

15,520,000

15,200,000 14,400,000

14,400,000 14,200,000 14,000,000 13,800,000 13,600,000

Price

Fixed Costs Rent ($10,000 per month)

1,500,000

1,500,000

120,000

120,000

16,380,000 18,780,000

EBIT

1,500,000

950

1,500,000

120,000 120,000 21,660,000

950

1,500,000 120,000

19,280,000 18,180,000

1,500,000

120,000 120,000

900

1,500,000 120,000

Depreciation

2,858,000

4,898,000

3,498,000

2,498,000

1,786,000

1,786,000

1,786,000 890,000

Taxes

4,597,480

4,719,880

6,175,080

5,705,880

5,573,960

5,573,960

5,480,460

11,782,520 14,060,120

15,484,920

Net Working Capital (5% of Revenues)

900,000

Investment in WC

(900,000) (600,000)

Capital Investment Total Cash Flow

1,500,000

1,700,000 (200,000)

1,940,000 (240,000)

13,574,120 12,606,040 1,805,000 135,000

1,710,000 95,000

(20,000,000) (20,900,000)

900

1,500,000 120,000

900

1,500,000 120,000

18,180,000 17,905,000 15,880,000 15,630,000 15,380,000

0.245

OCF

0.089

1,500,000

950

0.143

MACRS Rates

0.175 0.125

950

0.089 0.089

0.045

5,096,600

5,314,200

5,229,200

12,606,040 12,424,540 10,783,400 10,315,800 10,150,800 1,710,000

1,686,250

- 23,750

1,575,000

1,552,500

111,250 22,500

1,530,000 1,552,500 2,640,000

11,182,520 13,860,120

15,244,920

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13,709,120 12,701,040

12,606,040 12,448,290 10,894,650 10,338,300 14,343,300

2. Use a scenario analysis to show how the cash flows would change if the sales forecasts were 15% worse (Pessimistic) and 15% better (Optimistic) than the stated forecast (base). Scenario NPV Base $ 46,162,736.36 Pessimistic $ 36,143,876.79 Optimistic $ 60,917,016.49

IRR 60.806% 51.733% 74.153%

3. Realizing that the CIC will demand some kind of sensitivity analyses, how should Dave and Rick prepare their report? Which variables or inputs are obvious ones that need to be analyzed using multiple values? Explain by performing suitable calculations. The variables that are vulnerable to economic and market factors such as competition, inflation, and recession are selling price per unit and variable cost per unit. To some extent fixed costs can be sensitive as well. Price per unit has been adjusted over the years to allow for downward trends due to competitive pressure. However, cost sensitivity needs to be analyzed. Variable cost per unit can be increased by 10% up to 30% and the impact on cash flows and Net Present Value and IRR can be analyzed. 4. How should the interest expenses be treated? Explain. The interest expense should not be deducted when calculating the annual cash flows. Interest is a financing expense and is included in the discount rate (cost of capital) used to calculate the NPV. If we deduct interest expenses we will be double counting. 5. Using the base case estimates calculate the cash, accounting, and financial breakeven of the Lazy Mower project. Interpret each one. Price per unit = $1000 (upto 102,000 units) Variable cost per unit = $400 Annual Fixed Operating Cost = $1,620,000 (includes opportunity cost of rent) Depreciation = 2,000,000 (assuming straight line depreciation over 10 years) Accounting Break-Even = (Fixed Cost + Depreciation)/(Price – Variable Cost) = $(3,620,000/$600) = 6,033 mowers

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This indicates that net income will be zero at a sales level of 6,033 lazy mowers. Any sales above that point will result in profit for the year. Since the annual sales forecasts are considerably higher than this level the project seems acceptable. However, the cost of capital is not accounted for by the accounting break-even. Cash Break-Even = Fixed Cost/(Price-Variable Cost) = $1,620,000/$600 = 2,700 mowers Without including depreciation costs, the firm would need to sell only 2,700 mowers to break even i.e. to cover its fixed operating costs. At this point the operating cash flow would be zero. Cash-break even does not account for the cost of the project nor the cost of capital. Financial Break-Even = (Fixed Costs + Operating Cash Flow*) (Price – Variable Cost) Where Operating Cash Flow* = Level of Cash flow that results in a zero NPV

OCF* Initial Outlay(including NWC) PV of Salvage Value(including NWC) Net Investment

$3,790,003.98 $(20,900,000.00) $1,130,900.92 $(19,769,099.08)

PV = -$19,769,099.08; n=10; FV = 0; I/y = 14%; CPT PMT = $3,790,003.98 Financial Break-Even = ($1,620,000+$3,790,003.98)/$600 = 9,017 mowers Of the three break-even measures, the financial break-even is the most comprehensive and conservative measure. It calculates the sales level that has to be reached to get an NPV of zero. The firm would have to sell 9,017 units a year to get there. Even under the pessimistic scenario (15% lower sales than the the base case scenario), this sales level is way below the forecasted sales for each of the 10 years indicating that the Lazy Mower project should be undertaken. 6. Let’s say that the company had spent $500,000 in developing the prototype of the Lazy Mower. How should Dave and Rick treat this item in their report? Please explain.

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This is a sunk cost and should not be included in the analysis. The money was spent prior to making the decision whether or not to accept the project. 7. Calculate the IRR of the project. Based on your calculations what would you recommend? Why? Under the base case scenario, the IRR of the project is 61%. Since the weighted average cost of capital is 14%, the project is acceptable. The estimated cash flows indicate that the project will provide a rate of return that far exceeds the hurdle rate. Even under the worst case scenario, the IRR of 51.73% far exceeds the cost of capital. 8. How sensitive is the Net Present Value of the project to the cost of capital? The NPV profile shows the how sensitive the project’s NPV is to the cost of capital. (See graph on following page.)

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NPV Profile of Lazy Mower $100,000,000

$80,000,000

NPV

$60,000,000

$40,000,000

NPV Profile of Lazy Mow er

$20,000,000

$0%

10%

20%

30%

40%

50%

$(20,000,000) WACC

6

60%

70%

80%

90%

9. Calculate the operating leverage entailed by this project. What does it indicate? Degree of Operating Leverage = 1 + (Fixed Cost/Operating Cash Flow) Where Operating Cash Flow = (P - VC)*Q - FC So at 30,000 units, which is the base case forecast in year 1, OCF = -$1,620,000+($600)*30,000 = $16,380,000 DOL = 1+(1,620,000/16,380,000)=1.0989 The DOL indicates that a 10% increase in the output of lazy mowers will increase the operating cash flow by about 10.98% and vice-versa, The greater the DOL the more vulnerable the project will be to errors in forecasting. 10. What other types of contingency planning should Dave and Rick include to make the report comprehensive? Please explain the relevance of each suggestion. Dave and Rick should plan for the following types of contingencies: 1. The option to expand. What if the ‘lazy mower’ concept really takes off? Can production be increased without too much additional expenditure? Planning early can avoid later unnecessary costs. What about the effect on price? Can costs be reduced through economies of scale? 2. The option to abandon. Some discussion or planning must be included regarding what can be done in case the project does not break even on a cash flow basis. Could the operations be scaled back or abandoned and some of the investment recouped? 3. The option to suspend or contract operations . If there is excess inventory can operations be temporarily suspended or permanently scaled back and costs minimized?

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