Tax Assignment Solution

Question:

You are the financial manager for a company that produces cars. Currently you only produce sedans and hatchbacks. However,your manager has come to you with a proposal to produce a cheap four wheel drive model to broaden the customer base and ultimately make the company more money. It is estimated that the project willlast for 10 years. Your job is to decide whether the project is a good option to take. Information important for your decision is”
below.

Answers

Given information:

Number of sellable figures: 10000 units 1st year

Increments of 5% throughout the project of 10 years.

10000+5000 units

Market price of new model:  $28000

Price increment by 2% every year

Raw material: $6000 per unit

Labour cost: $4200 per unit

Factory cost: $100,000,000

After 10 years cost of factory will be $0

And return from land and scrap will be $500,000

Overhead cost: $25,000,000 per year

On introduction of new model, the decrement in sedan sale will be: 3000 unit per year

Price of each sedan: $35,000

Marketing cost every two years: $25,000,000

Tax: 35%

Cost of capital: 23%

Question 1: Evaluation Matrix

  1. Operating cash flow:

Operating Cash Flow = Operating Income (EBIT) + Depreciation – Taxes + Change in Working Capital.

As there is no such changes in work capital and it is meant to be constant so we can neglect that part.

So, we will focus on the main part with EBIT, depreciation and taxes.

Thus, putting things in prospective we have the following data derived from the given information:

For year 1: 25500000 – 9180000 – 10000000 = $26320000

For year 2: 4028000- 14500800- 10000000 = 35779200

For year 3: 462777600 – 16659936 -10000000 = $39617664

For year 4: 52395152 –18862254 -10000000 = $ 43532897.28

For year 5: 58635055 – 21108619 – 10000000= $ 47526435

Similarly,

For year 10: 91757215 – 33032597 – 10000000 = $ 68724617

  • Calculation of NPV:

Over a given time period, the net present value is the difference between the present value of your cash inflows and the present value of your cash withdrawals.

the project only has one cash flow, we can use the following net present value formula to calculate NPV:

NPV = Cash flow / (1 + i)t – initial investment.

However more simple way to think is:

NPV = Today’s value of the expected cash flows − Today’s value of invested cash

The NPV calculated for the project by multiplying cost capital percentage which is 23 % with the after-tax cash flows through out the project and summed with the original value of after-tax cash flow(initial investment in this case it is the factory).

NPV: $60373285.60

  • Calculation of IRR:

The internal rate of return, or IRR, is a tool for evaluating capital expenditures. The internal rate of return (IRR) is used to calculate the rate of return on the investment. Companies choose an end date and then use the IRR to calculate the percentage of profit or loss at that point in the project. IRR is calculated as a percentage rather than a monetary value. The IRR is a sophisticated statistic that is often used within the business community rather than as an external measure.

RR is expressed as a percentage. It offers the average rate of return on a project for the corporation over a set period of time.

The purpose of IRR is to calculate a project’s breakeven income level.

For calculation of IRR:

0 = NPV =ᵀC– C₀∑1 + IRRᵗᵗ⁼¹C = Net cash inflow during time period (t)

t = Time period

C₀ = Initial investment

The Internal rate of return calculated from this project is: 37.5018%

  • Calculation of Payback period:

The payback period calculator calculates how long it will take to recoup the cost of the investment. The following mathematical method may be used to calculate the payback period: Payback Period = Initial Investment / Annual Cash Flow

The payback period is calculated by sum of feasibility study + Capital expenditure + OCF + OCF 2nd year whole divided by OCF of 5th year + 2.

Thus we get: 2.961712432 that’s the period.

Question 2: Break Even Analysis

  1. Break even analysis of initial units

Break-even analysis is a financial tool that helps businesses determine the stage at which a business, new service, or product can be profitable. In other words, it is a financial calculation used by a company to determine how much of a good or service it must sell or provide to pay a cost (especially a fixed cost).

There is 5% increase in the units sold after one year which yields in 11550 units annually that is 450 units more than the first year.

Also, there is 2% inflation in price from 2nd year and applied year.

The expression used to calculate the breakeven number of initial units is :

(Initial units sold – The NPV of initial units sold)/ Sensitivity

Thus, final result is: 8775.759655

  • Calculation of breakeven price per unit:

Break-even pricing is a typical method used by most businesses to determine the price strategy for their product portfolio. It is computed by a company’s management in order to make educated decisions on whether to expand output or cut expenses. The corporation might opt to establish a price that is less than the break-even threshold. However, in such instance, the corporation would receive sales but not profits. As a result, rather than profit, the company’s primary goal would be to grow its market share. The majority of e-commerce businesses are still operating below their break-even point.

With change in revenue per unit with a rate of 2% per annum effective from 2nd year will yield by inflation rate thus the expression include: net revenue per unit + inflation amount on that year.

Thus the price goes on from 30000 to 30600 to 31212 to 31836.24 to 32472.96 till 35852.777.

  • Calculation of break even for raw material cost:

The break-even point is calculated as the percentage of units sold divided by the unit selling price minus the  variable cost per unit. The unit contribution is then divided by the fixed cost to give the number of units needed to sell  to cover the total fixed cost.

 Breakeven is a moving target. Due to various costs and changes in  prices, the amount required to pay the total cost will fluctuate over time.

And perhaps the raw material is a fixed cost and it has a different effect unlike variable costs.

After certain changes the break even for raw material changes to $3610.959

Which is given by the expression of Initial raw materials cost – NPV of the raw materials cost whole divided by sensitivity.

  • Calculation of break even labour cost:

Break even of the labour cost implies to variable cost as the cost of labour to manufacture a product varies with time as per economic situation of the respective country and the government policies.

 The labour cost changes to 4100 and remains the same over the year.

Perhaps the break even labour cost is given by the expression: (Initial labour costs per unit – The NPV of initial labour cost per unit)/ Sensitivity.

Which yields the amount : $ 1810.959251.

Question 3:

  1. FCF which stands for fresh cash flow. The income statement depreciation expenditure is not a real cash cost, but rather a distribution of value from long-ago bought property, plant, and equipment. To calculate the operational cash flow, add the depreciation cost back to the net income (after taxes). This methodology, by the way, is often indicated in the cash flow statement created using the indirect method of estimating cash flow, i.e. from net income adjusted for non-cash costs (depreciation, depletion, and amortisation) to appropriate operational cash flow. Actual cash collections and expenditures are used to calculate direct cash flow statements (which are more comprehensive).

Profit and cash flow are two very distinct ideas with quite different outcomes. Profit is a fairly limited term that only considers revenue and costs at a specific point in time. Cash flow, on the other hand, is a more fluid concept. It is concerned with the flow of funds into and out of a firm. More crucially, it is concerned with the moment at which the money is sent.

To be honest, the notion of cash flow is more realistic. If we utilise the accrual accounting system, knowing how to convert accrual profit to cash flow profit is useful.

Profit is the amount of income remaining after deducting the company’s expenses, and cash flow is the amount of money entering and leaving the company at any given time. Profit is the best indicator of a company’s performance, but cash flow is more important to day-to-day operations. Profitability has a long-term detrimental effect on cash flow.

  • Difference between Sensitivity analysis and scenario analysis

Risk assessment approaches include sensitivity analysis and scenario analysis. Organizations can use sensitivity analysis and scenario analysis before making an investment to determine what risk they can take.

 These strategies are critical to your business. Because, as we all know, the only certainty is that there is no certainty.

 Scenario Analysis and Sensitivity Analysis are analytical techniques that can help investors determine the scope of risks and potential rewards. The difference between the two is that sensitivity analysis examines the effect of changing one variable at a time.

 Scenario analysis evaluates the effect of changing all variables at the same time.

For this project sensitivity analysis is more beneficial as it is not a long term project like over 15+ years where different scenarios come up and we need to analyse the different scenario to predict the future of investments, while in this project of 10 years sensitivity scenario is beneficial because in sensitivity analysis it observes the single change in variable and thus helps use predict the near future rather not a bigger scenario.

Individual Component:

Question 1: A Column Graph

Question 1: B. Bust Case Column Graph

Question 2:

Results of analysis in the individual component compared to the pre-determined scenario of the project.

As we can see the both the column graphs, while focusing on the first graph we can estimate and gives us a proper idea of how the business metrices will proceed based on the given conditions of the scenario. The scenario in the boom case while there is an increase in sales by 5% over the existing 5 sale thus giving an edge of 10% sale annually increment along with the inflation going 8% higher than the base case of 6% edge. Perhaps with increase in 9% cost of the raw material and 5% increase in the factory cost will eventually affect the revenue. Thus the situation comes toa point how certain is it and how likely will it be to affect our decision.

The NPV, IRR and pay back period as per the worked-out sheets implies to a great increase in figures over $10000000.00 and IRR of 56% thus resulting in the pay back period of about only 1.886868 year only.

Now looking at the bust case where the company have a certain chance of ending up in the loss and negative cash flow eventually the project may run in debt.

The NPV, IRR and payback period as per the worked out sheets implies to a great decrease in figures to -$7000000.00 and IRR drops to  26% thus resulting in the pay back period of about  4.56868 year which is 3 years more than the boom case and

Two years more than the base case.

Perhaps the certainty of net cash flow in this case is negative and adding on to the breakeven analysis of the labour cost, raw material , sales price and number of unit sales which plays a crucial part in redirecting the NPV and OCF of the project.

Thus the both scenario of the given boom and bust case the project will most  certainly shine as well as it may fall in the pits of loss, just depending of the volatility of the automobile market.

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