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)
1
0 1 2 3 4 5 6 7 8 9 10
Sales (units)
30,000 34,000 38,800 38,000 36,000 36,000 35,500 35,000 34,500 34,000
Adjusted Sales
Price 1,000 1,000 1,000 950 950 950 950 900 900 900
e!enues 30,000,000 34,000,000 38,800,000 36,100,000 34,200,000 34,200,000 33,725,000 31,500,000 31,050,000 30,600,000
"ariable #ost 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
$ixed #osts 1,500,000 1,500,000 1,500,000 1,500,000 1,500,000 1,500,000 1,500,000 1,500,000 1,500,000 1,500,000
ent (%10,000 per &ont') 120,000 120,000 120,000

120,000

120,000 120,000

120,000

120,000

120,000 120,000
()*+ 16,380,000 18,780,000 21,660,000 19,280,000 18,180,000 18,180,000 17,905,000 15,880,000 15,630,000 15,380,000
,A#S ates 0.143 0.245 0.175

0.125

0.089 0.089

0.089

0.045
-epreciation 2,858,000 4,898,000 3,498,000 2,498,000 1,786,000 1,786,000 1,786,000

890,000 - -
+axes 4,597,480 4,719,880 6,175,080 5,705,880 5,573,960 5,573,960 5,480,460 5,096,600 5,314,200 5,229,200
.#$ 11,782,520 14,060,120 15,484,920 13,574,120 12,606,040 12,606,040 12,424,540 10,783,400 10,315,800 10,150,800
/et 0or1ing #apital (52 o3 e!enues) 900,000 1,500,000 1,700,000 1,940,000 1,805,000 1,710,000 1,710,000 1,686,250 1,575,000 1,552,500 1,530,000
*n!est&ent in 0# (900,000)

(600,000)

(200,000)

(240,000)

135,000

95,000 -

23,750 111,250

22,500 1,552,500
#apital *n!est&ent

(20,000,000) 2,640,000
+otal #as' $lo4 (20,900,000) 11,182,520 13,860,120 15,244,920 13,709,120 12,701,040 12,606,040 12,448,290 10,894,650 10,338,300 14,343,300
5
2. se a scenario analysis to show how the cash flows woul! change if the sales
forecasts were 1"# worse $Pessimistic% an! 1"# &etter $'ptimistic% than the
state! forecast $&ase%.
(. )ealizing that the *+* will !eman! some ,in! of sensiti-ity analyses. how
shoul! /a-e an! )ic, prepare their report0 1hich -aria&les or inputs are
o&-ious ones that nee! to &e analyze! using multiple -alues0 23plain &y
performing suita&le calculations6
+'e !ariables t'at are !ulnerable to econo&ic and &ar1et 3actors suc' as
co&petition, in3lation, and recession are selling price per unit and !ariable cost
per unit6 +o so&e extent 3ixed costs can be sensiti!e as 4ell6 Price per unit 'as
been adjusted o!er t'e 7ears to allo4 3or do4n4ard trends due to co&petiti!e
pressure6 8o4e!er, cost sensiti!it7 needs to be anal79ed6 "ariable cost per unit
can be increased b7 102 up to 302 and t'e i&pact on cas' 3lo4s and /et Present
"alue and * can be anal79ed6
4. 5ow shoul! the interest e3penses &e treate!0 23plain.
+'e interest expense s'ould not be deducted 4'en calculating t'e annual cas'
3lo4s6 *nterest is a 3inancing expense and is included in t'e discount rate (cost o3
capital) used to calculate t'e /P"6 *3 4e deduct interest expenses 4e 4ill be
double counting6
". sing the &ase case estimates calculate the cash. accounting. an! financial
&rea,e-en of the Lazy Mower project. +nterpret each one.
Price per unit : %1000 (upto 105,000 units)
"ariable cost per unit : %400
Annual $ixed .perating #ost : %1,650,000 (includes opportunit7 cost o3 rent)
-epreciation : 5,000,000 (assu&ing straig't line depreciation o!er 10 7ears)
6ccounting 7rea,82-en 9 $Fi3e! *ost : /epreciation%;$Price < =aria&le
*ost%
9 >$(.?2@.@@@;>?@@%
9 ?.@(( mowers
Scenario /P" *
)ase % 46,165,;36636 6068062
Pessi&istic % 36,143,8;66;< 516;332
.pti&istic % 60,<1;,01664< ;461532
3
+'is indicates t'at net inco&e 4ill be 9ero at a sales le!el o3 6,033 la97 &o4ers6
An7 sales abo!e t'at point 4ill result in pro3it 3or t'e 7ear6 Since t'e annual sales
3orecasts are considerabl7 'ig'er t'an t'is le!el t'e project see&s acceptable6
8o4e!er, t'e cost o3 capital is not accounted 3or b7 t'e accounting brea1=e!en6
*ash 7rea,82-en 9 Fi3e! *ost;$Price8=aria&le *ost% 9 >1.?2@.@@@;>?@@
9 2.A@@ mowers
0it'out including depreciation costs, t'e 3ir& 4ould need to sell onl7 5,;00
&o4ers to brea1 e!en i6e6 to co!er its 3ixed operating costs6 At t'is point t'e
operating cas' 3lo4 4ould be 9ero6 #as'=brea1 e!en does not account 3or t'e cost
o3 t'e project nor t'e cost o3 capital6
Financial 7rea,82-en 9 $Fi3e! *osts : 'perating *ash FlowB%
$Price < =aria&le *ost%
1here 'perating *ash FlowB 9 Le-el of *ash flow that results in a zero
CP=
OCF* $3,790,003.98
nitial Outla!(in"lu#in$ %&C) $(20,900,000.00)
'( o) Sal*a$e (alue(in"lu#in$ %&C) $1,130,900.92
%et n*est+ent $(19,769,099.08)
P= 9 8>1D.A?D.@DD.@EF n91@F F= 9 @F +;y 9 14#F *PG PMG 9 >(.AD@.@@(.DE
Financial 7rea,82-en 9 $>1.?2@.@@@:>(.AD@.@@(.DE%;>?@@ 9 D.@1A mowers
.3 t'e t'ree brea1=e!en &easures, t'e 3inancial brea1=e!en is t'e &ost
co&pre'ensi!e and conser!ati!e &easure6 *t calculates t'e sales le!el t'at 'as to
be reac'ed to get an /P" o3 9ero6 +'e 3ir& 4ould 'a!e to sell <,01; units a 7ear
to get t'ere6 (!en under t'e pessi&istic scenario (152 lo4er sales t'an t'e t'e
base case scenario), t'is sales le!el is 4a7 belo4 t'e 3orecasted sales 3or eac' o3
t'e 10 7ears indicating t'at t'e >a97 ,o4er project s'ould be underta1en6
?. LetHs say that the company ha! spent >"@@.@@@ in !e-eloping the prototype of
the Lazy Mower. 5ow shoul! /a-e an! )ic, treat this item in their report0
Please e3plain.
4
+'is is a sun1 cost and s'ould not be included in t'e anal7sis6 +'e &one7 4as
spent prior to &a1ing t'e decision 4'et'er or not to accept t'e project6
A. *alculate the +)) of the project. 7ase! on your calculations what woul! you
recommen!0 1hy0
?nder t'e base case scenario, t'e * o3 t'e project is 6126 Since t'e 4eig'ted
a!erage cost o3 capital is 142, t'e project is acceptable6 +'e esti&ated cas' 3lo4s
indicate t'at t'e project 4ill pro!ide a rate o3 return t'at 3ar exceeds t'e 'urdle
rate6 (!en under t'e 4orst case scenario, t'e * o3 516;32 3ar exceeds t'e cost
o3 capital6
E. 5ow sensiti-e is the Cet Present =alue of the project to the cost of capital0
+'e /P" pro3ile s'o4s t'e 'o4 sensiti!e t'e project@s /P" is to t'e cost o3
capital6
(See grap' on 3ollo4ing page6)
5
NPV Profile of Lazy Mower
$(20,000,000)
$-
$20,000,000
$40,000,000
$60,000,000
$80,000,000
$100,000,000
0, 10, 20, 30, 40, 50, 60, 70, 80, 90,
WACC
N
P
V
%'( '-o) ile o) .a/! 0o1e-
6
D. *alculate the operating le-erage entaile! &y this project. 1hat !oes it
in!icate0
-egree o3 .perating >e!erage : 1 A ($ixed #ostB.perating #as' $lo4)
0'ere .perating #as' $lo4 : (P = "#)CD = $#
So at 30,000 units, 4'ic' is t'e base case 3orecast in 7ear 1,
.#$ : =%1,650,000A(%600)C30,000 : %16,380,000
-.> : 1A(1,650,000B16,380,000):160<8<
+'e -.> indicates t'at a 102 increase in t'e output o3 la97 &o4ers 4ill increase
t'e operating cas' 3lo4 b7 about 106<82 and !ice=!ersa, +'e greater t'e -.> t'e
&ore !ulnerable t'e project 4ill be to errors in 3orecasting6
1@. 1hat other types of contingency planning shoul! /a-e an! )ic, inclu!e to
ma,e the report comprehensi-e0 Please e3plain the rele-ance of each
suggestion.
-a!e and ic1 s'ould plan 3or t'e 3ollo4ing t7pes o3 contingenciesE
16 +'e option to expand6 0'at i3 t'e Fla97 &o4er@ concept reall7 ta1es o33G
#an production be increased 4it'out too &uc' additional expenditureG
Planning earl7 can a!oid later unnecessar7 costs6 0'at about t'e e33ect on
priceG #an costs be reduced t'roug' econo&ies o3 scaleG
56 +'e option to abandon6 So&e discussion or planning &ust be included
regarding 4'at can be done in case t'e project does not brea1 e!en on a
cas' 3lo4 basis6 #ould t'e operations be scaled bac1 or abandoned and
so&e o3 t'e in!est&ent recoupedG
36 +'e option to suspend or contract operations 6 *3 t'ere is excess in!entor7
can operations be te&poraril7 suspended or per&anentl7 scaled bac1 and
costs &ini&i9edG
;