# 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*

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from Finance 101: Principles of Finance

Chapter 10 / Lesson 4