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hello tutor
may you please help me. i am not sure of the treatment of depriciation and interest payments in a situation like the question below.
Zimsprock Enterprises is considering a capital project about which the following information is available:
The investment outlay on the project will be $100 million. This consists of $80 million on plant and machinery and $20 million on working capital. The entire outlay will be incurred at the beginning of the project.
The project will be financed with $45 million of equity capital, $5 million of preference capital, and $50 million of debt capital. Preference capital will carry a dividend rate of 15%; debt capital will carry an interest rate of 15%
The life of the project is expected to be 5 years. At the end of 5 years, fixed assets will fetch a net salvage value of $30 million whereas net working capital will be liquidated at its book value.
The project is expected to increase the revenues of the firm by $120 million per year. The increase in costs on account of the project is expected to be $80 million per year. (This includes all items of cost other than depreciation, interest, and tax). The effective tax rate will be 30%.
Plant and machinery will be depreciated at the rate of 25% per year as per the written down value method.
REQUIRED:
Show the estimated cash flows of the project.is it the correct treatment if for example i calculate as follows for year 1
revenue 120
costs (80)
depriciation (20)
interest (7.5)
profit 12.5
tax @30% 3.75
profit after tax 8.75
add back depriciation 20
project cashflow 28.75You must surely have an answer in the same book in which you found this question, and so in future ask about whatever it is in the answer you are not clear about.
This question could not be asked in Paper MA – it does not all become relevant until Paper FM.
However what you have done is correct, except that we do not subtract interest, The reason is that the cash flows will be discounted at the weighted average cost of capital, and the calculation of the WACC takes the interest into account – to show it in the cash flows as well would be accounting for it twice. (But calculations of the WACC are not examinable until Paper FM)Thank you. My apologies i did not notice that i asked under MA. I am studying for paper AFM former P4.
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