Finance Assignment: Depreciation, Tax Expenses, Free Cash Flow, Discount Rates

This finance assignment covers topics such as estimated annual depreciation, tax expenses on selling equipment, estimation of incremental free cash flow, annual depreciation tax shield, depreciation as noncash charge, and discount rates used to compute net present value.

FINANCE
ASSIGNMENT

1. Estimated annual depreciation and the tax expenses on selling the
equipment
Depreciation:
Value of the equipment = $150 Million
Salvage value = $50 Million
Life of the Machine = 4 Years
Annual Depreciation with straight line method = ($150 M - $50 M)/ 4 Years
= $25 Million per year
Tax expenses
Selling price of the equipment = $50 Million
Tax expense on equipment @35% = $50 Million * 0.35
= $17.5 Million
2. Estimation of incremental free cash flow
0 1 2 3 4
Initial
Investment
$150,000,00
0
Cumulative
gross profit (1
+ 2)
$155,960,0
00 $165,704,715
$176,041,611.04
09
$187,005,181.40
09
Less:
Preliminary
expenses
Test Marketing $15,000,000
R&D till date $60,000,000
R&D $10,000,000
Less:
Depreciation
$25,000,00
0 $25,000,000 $25,000,000 $25,000,000

Less: Working
Capital (25% of
sales from year
1) $11,000,000
$130,960,0
00 $41,426,179 $44,010,403
Add: Working
Capital
$227,396,581.51
02
Add: Selling of
Equipment $50,000,000
Net Profit
-
$246,000,00
0
-
$25,000,00
0 $99,278,536 $107,031,208
$439,401,762.91
11
Less: Corporate
tax@35% -$8,750,000
$34,747,487.68
75
$37,460,922.898
2
$153,790,617.01
89
Net Profit after
tax
(Incremental
free cash
flows)
-
$16,250,00
0
$64,531,048.56
25
$69,570,285.382
4
$285,611,145.89
22
3. Annual depreciation tax shield
Annual depreciation tax shield = Depreciation * Corporate tax
= $25 M * 35%
= $8.75 Million
4. Depreciation as noncash charge
As the depreciation is treated as non-cash charge because it doesn’t affect cash flows directly but
reduce the value of equipment which in future can help in calculating actual profit gain through
selling or disposing such equipment.
Capital budgeting process is based on projection of cash inflows through investment in particular
project and it also estimates total return from project; hence it also includes salvage value of
particular assets to identify real cash inflow from that project. Therefore, depreciation is
considered while doing capital budget process. As depreciation doesn’t impacts cash inflows
directly but it reduces value of a fixed asset which is the part of capital budgeting process.

5. Discount rates use to compute the net present value.
Present value is the indication of reduction of value of money with time. Firms usually calculates
net present value by taking discount rates based on returns expected by shareholders or interest
expenses by firms on loans. Discount rates are used to know whether firm is generating positive
cash inflows after covering required rate of return or interest expenses.
In this given case, previously used discount rates were 12% for all tyres. But due to the fact that
given project is 2% higher than that of previous one; the expected rate of return by stakeholders
has been increased by 4% to compensate the perceived risk. Hence, the new discount rate will
be:
= Old discount rate + 4%
= 12% + 4% = 16%
6. Application of various techniques:
NPV (Net Present Value):
Net Profit
-
$246,000,000 $66,970,000 $99,278,536 $107,031,208
$347,431,762.911
1
Less:
Corporate
tax@35% $23,439,500 $34,747,487.6875
$37,460,922.898
2
$121,601,117.018
9
Net Profit
after tax $43,530,500 $64,531,048.5625
$69,570,285.382
4
$225,830,645.892
2
Add:
Depreciatio
n $25,000,000 $25,000,000 $25,000,000 $25,000,000
Net cash
inflows $68,530,500 $89,531,049 $94,570,285 $250,830,646
Present
value@16% 0.8621 0.7432 0.6407 0.5523
Net cash
inflows at
present
value $59,078,017.2414 $66,536,153.8069
$60,587,179.019
2
$138,531,532.801
9
Net Present
Value
-
186,921,982.7586
-
120,385,828.9518 -59,798,649.9325 78,732,882.8694

Interpretation: The NPV for the given project is positive ($78.7 Million). Therefore, a positive
NPV is favorable for the business and hence it will be accepted.
Payback Period
Yea
r Cash Inflows Cumulative cash inflows
1 $43,530,500 $43,530,500
2 $64,531,048.5625 $108,061,548.56
3 $69,570,285.3824 $177,631,833.94
4 $225,830,645.8922 $403,462,479.84
Interpretation: In the above payback period method; the initial investment is coverable in less
than 3 years and the motive of Mr. Jones is also to get back initial investment in less than 3
years. Therefore the project is acceptable, but on the other hand if other factors like working
capital, R&D costs, etc. are taken as initial investment than it is coverable in 4th year and hence
not acceptable.
Discounted payback period
Yea
r Cash Inflows Cumulative cash inflows
1 $59,078,017.2414 $59,078,017
2 $66,536,153.8069 $125,614,171.05
3 $60,587,179.0192 $186,201,350.07
4 $138,531,532.8019 $324,732,882.87
Interpretation: Initial investment is equivalent to $246 Million (working capital and R&D costs
has been included); this amount is coverable before the end of 4th year and hence payback period
is less than 4 years and based on requirement, this project is acceptable.