Question

ABC plc is considering starting two new projects. Projects 1 and 2 require investments of £2.5m and £3.2m, respectively. It is expected that both projects will generate revenue for the next 8 years; there will be no further income and costs. The revenues of both projects are £0.8m in the first year. Afterwards, the annual revenue will increase by 5% for Project 1 and 6% for Project 2. Variable costs will be 30% of revenues for both projects. Fixed costs are £120,000 per annum for Project 1 and £150,000 per annum for Project 2. The company’s total annual depreciation is expected to be £500,000 for the next 8 years; Projects 1 and 2’s annual depreciation amounts will be 20% and 25% of the total annual depreciation, respectively. The company’s market value of assets is £100m and the market value of equity is £60m. The company pays 10% for debt and 14% for equity. Both projects have the same level of risks as the company’s existing projects. The tax rate is 20%.

For both projects, calculate and tabulate relevant expected cash flows in each year.

Answer 1

The expected cash flows for Project 1 and Project 2 are calculated by considering the initial investment, revenue growth, variable and fixed costs, depreciation, and taxes for each year. The annual growth rates for revenue are 5% and 6%, respectively. Finally, net cash flows are determined by tabulating and deducting all costs and taxes from revenues.

Step-by-step explanation:

To calculate the relevant expected cash flows for both projects, we need to consider various financial aspects for each year. Starting with the initial investment, for Project 1 this is £2.5m and for Project 2 it is £3.2m. Both projects generate initial revenues of £0.8m, which grow annually by 5% and 6% respectively. We need to subtract the variable costs, calculated as 30% of revenues, and the fixed costs, which are £120,000 per annum for Project 1 and £150,000 for Project 2. Depreciation is also a non-cash expense considered in cash flow calculations, with Project 1 and Project 2 being allocated 20% and 25% of the total annual depreciation of £500,000, respectively. Lastly, taxes at a rate of 20% need to be accounted for in the calculation of net cash flows.

The process of tabulating these values involves listing out the revenues for each year, factoring in the growth rates, and deducting the variable and fixed costs, depreciation, and tax to gain a clear picture of the annual expected cash flows for both projects.