1. a. Describe an incremental cash flow for a project.
b. Describe three (3) concepts we need to examine to help understand how to estimate the incremental cash flow of a project.
2. Benson Co. purchases an asset for $6,000. This asset qualifies as a seven-year recovery asset under MACRS. Benson has a tax rate of 30%. The seven-year expense percentages for years 1, 2, 3, 4, 5, and 6 are 14.29%, 24.49%, 17.49%, 12.49%, 8.93%, and 8.93%, respectively. If the asset is sold at the end of six years for $2,000, what is the cash flow from disposal? Show your work.
Part B
1. Briefly describe JIT inventory management.
2. Describe one (1) type of cost that is minimized with JIT control.
3. In order to use JIT, is it better to have high ordering costs or low? Provide one (1) supporting fact to justify your answer.
Part C
You are CEO of Acme, Inc. located in the United States. You use the discounted payback period method and accept all projects that payback in three years. You are considering a project that will cost $5,500,000 and will produce one cash flow that occurs in three years. However, the cash flow is in pesos since the project is an overseas project. The current indirect exchange rate is 13.5 pesos per dollar. The cash inflow in pesos is 100,000,000 in three years, and the discount rate is 11.5%. During this time, the anticipated annual inflation rate is 5% in the United States and 4% in Mexico.
Should you accept this project, using the discounted payback period method? Is this a good decision? Provide the six (6) steps you would utilize to determine whether or not this is a good decision.
C09.V.5.1 Principles of Finance
Assignment 08,
Management of Finance
Part A
1.
The increase in cash that a new project creates over the current cash flow with the addition of that particular new project is called Incremental cash flow. A positive incremental cash flow means that the organization's cash flow will grow higher when the company receive the project. There are various elements of incremental cash flow like initial outlay, terminal cost or value and the scale and timing of the project. There are seven concepts we need to examine to help understand how to estimate the incremental cash flow of a project. I am going to explain three of them. 1. Sunk costs: A sunk costs are those costs that an organization has already been incurred. They cannot be recovered or avoided. They can be costs that an organization has contracted, but it is not paid yet. Whether the project is accepted or rejected, the company will incur these costs. To accept or reject the project is not a part of a decision. 2. Opportunity costs: Opportunity costs means the loss of other alternative project when one alternative is selected. Normally, the project focused on incremental cash flow shows all the future cash inflows and outflows. There may, however, be a cash flow that never takes place for a new project but that an organization needs to join as a cost or outflow. This is called opportunity cost which is a profit without the organization's selection of a particular project. 3. Working capital: It is a measurement of both an organization's efficiency and its short-term financial health. The formula of calculating working capital is: Working Capital = Current Assets - Current Liabilities. The ratio of working capital shows that whether a organization has enough short term assets to cover its short term debt. It is also define as the financial metric that shows operating liquidity to a company or organization. Working capital is a part of operating capital long with fixed assets.
2.
Solution: For the six-year sale at $2,000, we must first establish the asset's book value to determine whether it has incurred a gain or loss at disposal. The depreciation schedule for the $6,000 asset is:
Year one: $6,000 × 0.1429 = $857.40
Year two: $6,000 × 0.2449 = $1,469.40
Year three: $6,000 × 0.1749 = $1,049.40
Year four: $6,000 × 0.1249 = $749.40
Year five: $6,000 × 0.0893 = $535.80
Year six: $6,000 × 0.0893 = $535.80
Accumulated depreciation = $857.40 + $1,469.40 + $1,049.40 + $749.40 + $535.80 + $535.80
Accumulated depreciation = $5,197.20
Book value of asset = $6,000.00 - $5,197.20 = $802.80
Gain on disposal = $2,000.00 - $802.80 = $1,197.20
Tax on gain = $1,197.20 × 0.30 = $359.16 (gain on disposal times tax rate)
After-tax cash flow at disposal = $2,000.00 - $359.16 = $1,640.84
Part B
Just in Time (JIT) is an inventory management which helps to reduce inventory carrying cost by having organizations work with both their suppliers and their customers to reduce the time of the finished goods in an inventory and overall amount of inventory that a organization carries. It is a set of principles and actions based on the philosophy that company should hold small-scale inventory beyond that needed for immediate production and distribution. In JIT process a company produce only needed goods to its customers in a given time. A company's output should be shipped goods to their clients as soon as possible after completion is finished. It is said that JIT process is the system of management which is focused on to maximizing cost efficiency, securing a competitive advantage and minimizing waste.
A company should have to do work with suppliers and customers. In a company JIT system tries to make sure that quality of goods meets the standard of the company's production and the shipment of the goods are on time, while working with suppliers. On the other hand, while working with customers a firm should deliver the finished product to their customer on the given time, without delay. Removing the uncertainty about the timing of deliveries of goods from suppliers to customers to make secure that it delivers finished products immediately minimizes the inventory carrying costs. JIT is the inventory management that aimed to produce only needed products with the necessary raw materials at the certain time, by reducing waste and improving productivity. It is also called "lean manufacturing."
JIT system was invented by Taiichi Ohno of the Toyota Motor Company in Japan and was quickly adopted by all companies in the world. There are two factors which drives JIT system: high-holding costs and low-ordering costs. Its aim is to satisfy its customers by delivering finished goods in a certain time. The main benefit of JIT is that it minimizes the total ordering cost and hold the large amounts of product inventory. The lower ordering cost is a feasible solution of financial problems in a medical practice. By using JIT system, it helps them to speed their inventory turnover and maximum utilize of the firm's liquid resource or cash. For example, as Alibaba reduces its handling and shipping costs, you reduce the size of your Digital Camera order because you prefer to order one Digital Camera at a time. If Alibaba were to eliminate the handling and shipping cost entirely, you would order one Digital Camera at a time. Wal-Mart is also a good example of a company that successfully has used the JIT system by minimizing its product-ordering costs, instead of having large holding costs. JIT system which is properly planned and applied helps to increase a practice's net profit.
Part C
Expected Pesos per dollar rate in 3 years = (13.5*1.04*1.04*1.04) / (1.05^3) = 13.1179
Convert 100,000,000 pesos received at end of 3 year in dollars
= 100,000,000 / (13.1179) = $7,623,171.39
Present value of $7,623,171.39 =7,623,171.39 / (1.115^3) = $5,499,346.47
Since the present value of cash inflow is less than initial investment discounted payback criterion is not met.
Calculating NPV = $5,499,346.47 – 5,500,000.00 = -653.53
Since NPV is negative project should not be accepted.
Thus, the decision to reject based on discounted payback period method is a good decision as NPV method also led to same conclusion.
The six (6) steps to determine whether or not this is a good decision.
Steps undertaken:
- Determining the expected FX rate 3 years from now.
- Converting Peso into Dollars at end of 3 years.
- Converting Dollar at year 3 in present value term.
- Compare converted dollar with initial investment to determine if discounted payback period is met.
- Compute NPV
- Apply NPV decision, if NPV >0 accept project.
References
Raymond M. Brooks (2012). Financial Management: Core Concepts (2nd Ed.). New Jersey: Pearson.
Sheridan Titman, John D. Martin & Arthur J. Keown (2010). Financial Management: Principles and Applications (11th Ed.). New Jersey: Prentice Hall.
Eugene F. Brigham & Joel F. Houston (2011). Fundamentals of Financial Management (7th Ed.). Ohio: South-Western College Publication.
Scott Besley & Eugene F. Brigham (2011). Principles of Finance (5th Ed.). Ohio: South-Western College Publication.
William Klein, John Coffee Jr & Frank Partnoy (2010). Business Organization and Finance: Legal and Economic Principles (11th Ed.). Minnesota: Foundation Press.
