Net Present Value of Incremental Cash Flows for Sydney Harbour Fuel

Sydney Harbour Fuel has decided to shift from supply of petrol and light diesel fuel to sale of heavy diesel fuel. To do so, they need to purchase 8 new barges at a cost of $4 Mn each. The computation of incremental net cash flow and the net present value of the incremental cash flow is used to make the decision. The net present value of the incremental cash flows is $187 Mn, which implies that the company would be able to generate an additional amount of $187 Mn, as compared to the present scenario.

The entity, Sydney Harbour fuel (SBF), has decided to shift from supply of petrol and light diesel fuel to sale of heavy diesel fuel, as most of the
nautics vessels have started using light diesel instead of petrol. And also, since one competitor of Sydney harbor has failed recently, there is also
a scope to sell heavy diesel to the fleet of cruise liners, who earlier happened to be the customers of competitor. Since SBF didn’t have a
competitor, it didn’t have to go through the tendering process and directly obtained the order for high diesel fuel, for the fleet of cruise liners.
For the purpose of being able to sell light and heavy diesel fuel to the fleet, the entity would need to purchase 8 new barges, each at a cost of $ 4
Mn. The barges so purchased are expected to have a useful life of 10 years. In order to make a decision, as to whether the new proposal should
be accepted or not, the computation of incremental net cash flow and the net present value of the incremental cash flow, would be helpful.
We have decided to use the Net present value of incremental cash flows as the basis for decision. If the present value of incremental cash flows
from the project, arising during its lifetime, are unable to cover the investment required for the project, it is not advisable to invest in the project
and continue with existing vessels and vice versa.
Computation is as under:

Sydney Harbour Fuel

Year 0 1 to 9 10
Initial Cash Flows
Cost of vessels (32,000,000)
Sale of petrol 50,000
Sale of old and renovated barges 2,240,000
Redundancy payment (100,000)
Increase in working capital requirement due to stock (1,150,000)
Cash flows over the life of the project
Net Revenue 18,000,000 18,000,000
Operating Expenditure
Saving in salary - 200,000 200,000
Decrease in salary of Don Dotson - 50,000 50,000
Increase in salary of Dot Dotson - (50,000) (50,000)
Savings in insurance premium - 2,000 2,000
EBITDA 18,202,000 18,202,000

Depreciation and Salvage - 600,000 - 600,000
EBIT 17,602,000 17,602,000
Interest cost - (2,400,000) (2,400,000)
Taxation (4,920,600) (4,920,600)
NOPAT 10,281,400 10,281,400
Depreciation and amortisation 600,000 600,000
Cash Flow from Operations 10,881,400 10,881,400
Cash flows at the end
Release of working capital - - 1,150,000
Sale of barges - - 4,800,000
Cash flows -
PVF/PVAF 1.00000 6.37889 0.485193928
Present values
-
30,960,000 - -
Summary and NPV calculations
Cash flows
Cash flows
-
30,960,000 10,881,400 16,831,400
PVF/PVAF 1.00000 6.37889 0.485193928

Total NPV
-
30,960,000 69,411,221 8,166,493
NPV 46,617,714
Accept/Reject Project Accept
Note-1: Computation of incremental margin
Particulars New proposal Existing scenario
Sale (In litres)
- Petrol - 2,000,000
- Light diesel 5,000,000 4,000,000
- Heavy diesel 10,000,000 0
15,000,000 6,000,000
Margin on sale 30,000,000 12,000,000
Incremental margin 18,000,000
Note 2: Computation of incremental tax
Particulars Amount

Incremental margin 18,000,000
Saving in salary 200,000
Decrease in salary of Don Dotson 50,000
Increase in salary of Dot Dotson (50,000)
Interest cost (2,400,000)
Savings in insurance premium 2,000
Incremental depreciation 600,000
16,402,000
Tax effect 4,920,600
Note 3: Computation of real rate of interest
Real interest rate = Nominal interest rate - rate of inflation
7.500%
The computation of present value is made at the real rate of return, as the amounts given in the problem, were also in revised term.
Based on the above given computation, it is advisable for the entity, to buy 8 new barges and shift from selling petrol and light diesel to light and
heavy diesel as the net present value of the incremental cash flows from the project is $ 187 Mn, which implies, that the company would be able
to generate an additional amount of $ 187 Mn, as compared to the present scenario.
Though the net present value of incremental cash flows is positive, it is based on various underlying assumptions in the computation. Some of
the significant assumptions are:
i. Demand of diesel –

Demand for the diesel has been anticipated at 5 Mn litres of light diesel and 10 Mn litres of heavy diesel, such demand for the next
10 years, may or may not remain relevant and any significant movement in the demand for diesel will impact the computation of
cash flows, significantly.
ii. Margin on sale of fuel:
Presently the margin on sale of a liter of fuel, is anticipated to be $ 2, the amount of margin, might reduce significantly, which could
impact the decision of the management.
iii. Salvage value:
In the computation given above, the salvage value for new barges has been assumed to be 15% of the purchase price, if the
equipment wouldn’t be sold for 15% of purchase price, it would impact the cash flows from the project.
Sensitivity analysis:
1. Demand of light diesel is reduced to 2 Mn and 5 Mn liter of heavy diesel.
If the demand for light diesel is reduced to 2 Mn and to 5 Mn liter for heavy diesel, keeping the other things constant, the net present
value of the proposed project would reduce to negative 25.3 Mn. Thus, if the demand for the diesel is expected to reduce, the project
will not be advisable a it would result in a negative NPV. (Refer excel for computation)
2. Margin on sale of fuel is reduced to $ 1 per liter from existing margin of $ 2 per liter: