Johnny's Lunches is considering purchasing a new, energy-efficient grill. The grill will cost...

Question:

Johnny's Lunches is considering purchasing a new, energy-efficient grill. The grill will cost {eq}\$38,000 {/eq} and will be depreciated straight-line over {eq}3 {/eq} years. It will be sold for scrap metal after {eq}5 {/eq} years for {eq}\$9,500 {/eq}. The grill will have no effect on revenues but will save Johnny's {eq}\$19,000 {/eq} in energy expenses. The tax rate is {eq}30 \% {/eq}.

Required:

A) What are the operating cash flows in each year?

B) What are the total cash flows in each year?

C) Assuming the discount rate is {eq}12 \% {/eq} calculate the net present value (NPV) of the cash flow stream. Should the grill be purchased?

Operating Cash Flow:

Operating cash flow is the cash flows generated by an entity's day to day operations. Positive cash flow shows the efficiency of the operations of the entity. It is computed by summing non-cash expenses and deducting non-cash revenues from the after-tax profit of the company.

Answer and Explanation:

Question (a)

Computation of operating cash flow in each year.

Particular Year 1 Year 2 Year 3 Year 4 Year 5
Saving in energy expenses 19,000 19,000 19,000 19,000 19,000
Less: Depreciation (12,666.67) (12,666.67) (12,666.67) 0 0
Savings before tax 6,333.33 6,333.33 6,333.33 19,000 19,000
Less: Tax @ 30% (1,900) (1,900) (1,900) (5,700) (5,700)
Savings after tax 4,433.33 4,433.33 4,433.33 13,300 13,300
Add: Depreciation 12,666.67 12,666.67 12,666.67 0 0
Operating cash flow 17,100 17,100 17,100 13,300 13,300

Question (b)

Computation of total cash flows in each year.

Particular Year 1 Year 2 Year 3 Year 4 Year 5
Operating cash flow 17,100 17,100 17,100 13,300 13,300
Add: Salvage value after tax - - - - 6,650
Total Cash Flow 17,100 17,100 17,100 13,300 19,950

Question (c)

Computation of Net Present Value.

{eq}\begin{align*}\text{Net Present Value}&=\text{Present Value of Future Cash Flows}-\text{Initial Investment}\\&=\$60,843.87-\$38,000\\&=\$22,843.87 \end{align*} {/eq}

Working Note:

Computation of Present value of future cash flows.

{eq}\begin{align*}\text{Present Value of Future Cash Flows}&=\dfrac{FCFF_1}{\left (1+r \right )}+\dfrac{FCFF_2}{\left (1+r \right )^2}+.....+\dfrac{FCFF_n}{\left (1+r \right )^n}\\&=\dfrac{\$17,100}{\left ( 1+.12 \right )}+\dfrac{\$17,100}{\left ( 1+.12 \right )^2}+\dfrac{\$17,100}{\left ( 1+.12 \right )^3}+\dfrac{\$13,300}{\left ( 1+.12 \right )^4}+\dfrac{\$19,950}{\left ( 1+.12 \right )^5}\\&=\$60,843.87\end{align*} {/eq}

Johnny's Lunches should purchased the grill as it generated a positive net present value


Learn more about this topic:

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Operating Cash Flow: Definition & Examples

from Finance 101: Principles of Finance

Chapter 10 / Lesson 4
10K

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