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Bat has spent $2 million developing a new product and a further $800,000 on market research to find out whether a market launch would be worth undertaking. The findings of the market research were as follows.
(a) To launch the product on the market, the company would have to spend a further $800,000 on equipment. This would be depreciated over three years by the straight-line method, and would have an estimated resale value of $200,000 at the end of this time.(b) The product would have a life of just three years, and profits after depreciation would be $500,000 in the first year, $600,000 in the second year and $300,000 in the third year.
(c) There would be an initial investment of $120,000 in working capital in the first year and a further $140,000 of working capital would be needed in Year 2.
(d) Instead of investing in the product launch, the company could sell the rights to the product to another company for $500,000.
What are the estimated net cash flows from this project?
a $560,000
b $800,000
c $900,000
d $960,000Answer – C
Initial Investment = (2,000,000)
Spent on equipment to lauch = (800,000)
Resale vaue of above machine = 200,000
Profits Year 1,2 & 3 = 1,400,000
Working Capital Year 1&2 = (260,000)
Rights Selling = 500,000
Estimated Net Cash Flow = 960,000$60,000 is more in the answer. Could you help me on it?
The initial investment is a sunk cost and is therefore irrelevant.
The profits of 1,400,000 are after depreciation which is not a cash flow. The profits before depreciation are 1,400,000 + (800,000 – 200,000) = 2,000,000
The sale of the rights are an opportunity cost of 500,000 (because doing to project will mean they will not get the 500,000).
The working capital flows are irrelevant because they will be recovered at the end of the project.
So the net cash flow = 2,000,000 + 200,000 – 800,000 – 500,000 = 900,000
I don’t know where you found this question but it is a very poor question for F9 (it is more a F5 type question). F9 questions will involve discounting the cash flows.
Have you watched the free lectures on relevant cash flows for investment appraisal?
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