CASE 3

CASH FLOW ANALYSIS

The Lazy Mower: Is it really worth it?

Questions:

1. Prepare a Pro Forma Statement showing the annual cash flows resulting from the
Lazy Mower project.

(See table on next page)

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 0 1 2 3 4 5 6 7 8 9 10
30 34, 38, 38 36 36 35 35 34 34
Sales (units) ,000 000 800 ,000 ,000 ,000 ,500 ,000 ,500 ,000
Adjusted Sales

Price 1,000 1,000 1,000 950 950 950 950 900 900 900

30,000,00 34,000,0 38,800,0 36,100, 34,200, 34,200,0 33,725, 31,500, 31,050, 30,600,
Revenues 0 00 00 000 000 00 000 000 000 000

12,000,00 13,600,0 15,520,0 15,200, 14,400, 14,400,0 14,200, 14,000, 13,800, 13,600,
Variable Cost 0 00 00 000 000 00 000 000 000 000

1,500,00 1,500,00 1,500,0 1,500,0 1,500,00 1,500,0 1,500,0 1,500,0 1,500,0

Fixed Costs 1,500,000 0 0 00 00 0 00 00 00 00

Rent ($10,000 per month) 120,000 120,000 120,000 120,000 120,000 120,000 120,000 120,000 120,000 120,000

16,380,00 18,780,0 21,660,0 19,280, 18,180, 18,180,0 17,905, 15,880, 15,630, 15,380,
EBIT 0 00 00 000 000 00 000 000 000 000

MACRS Rates 0.143 0.245 0.175 0.125 0.089 0.089 0.089 0.045

4,898,00 3,498,00 2,498,0 1,786,0 1,786,00 1,786,0

Depreciation 2,858,000 0 0 00 00 0 00 890,000 - -

4,719,88 6,175,08 5,705,8 5,573,9 5,573,96 5,480,4 5,096,6 5,314,2 5,229,2

Taxes 4,597,480 0 0 80 60 0 60 00 00 00

11,782,52 14,060,1 15,484,9 13,574, 12,606, 12,606,0 12,424, 10,783, 10,315, 10,150,
OCF 0 20 20 120 040 40 540 400 800 800

Net Working Capital (5% 1,700,00 1,940,00 1,805,0 1,710,0 1,710,00 1,686,2 1,575,0 1,552,5 1,530,0
of Revenues) 900,000 1,500,000 0 0 00 00 0 50 00 00 00

(200,00 (240,000 1,552,5

Investment in WC (900,000) (600,000) 0) ) 135,000 95,000 - 23,750 111,250 22,500 00

(20,000,0 2,640,0
Capital Investment 00) 00

(20,900,0 11,182,52 13,860,1 15,244,9

2 13,709, 12,701, 12,606,0 12,448, 10,894, 10,338, 14,343,
Total Cash Flow 00) 0 20 20 120 040 40 290 650 300 300
 2. Use a scenario analysis to show how the cash flows would change if the sales
forecasts were 15% worse (Pessimistic) and 15% better (Optimistic) than the
stated forecast (base).

Scenario NPV IRR

Base $ 46,162,736.36 60.806%
Pessimistic $ 36,143,876.79 51.733%
Optimistic $ 60,917,016.49 74.153%

3. Realizing that the CIC will demand some kind of sensitivity analyses, how
should Dave and Rick prepare their report? Which variables or inputs are
obvious ones that need to be analyzed using multiple values? Explain by
performing suitable calculations.

The variables that are vulnerable to economic and market factors such as
competition, inflation, and recession are selling price per unit and variable
cost per unit. To some extent fixed costs can be sensitive as well. Price per
unit has been adjusted over the years to allow for downward trends due to
competitive pressure. However, cost sensitivity needs to be analyzed.
Variable cost per unit can be increased by 10% up to 30% and the impact on
cash flows and Net Present Value and IRR can be analyzed.

4. How should the interest expenses be treated? Explain.

The interest expense should not be deducted when calculating the annual cash flows.
Interest is a financing expense and is included in the discount rate (cost of
capital) used to calculate the NPV. If we deduct interest expenses we will be
double counting.

5. Using the base case estimates calculate the cash, accounting, and financial
breakeven of the Lazy Mower project. Interpret each one.

Price per unit = $1000 (upto 102,000 units)

Variable cost per unit = $400
Annual Fixed Operating Cost = $1,620,000 (includes opportunity cost of
rent)
Depreciation = 2,000,000 (assuming straight line depreciation over 10 years)

Accounting Break-Even = (Fixed Cost + Depreciation)/(Price – Variable

Cost)

= $(3,620,000/$600)

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 = 6,033 mowers

This indicates that net income will be zero at a sales level of 6,033 lazy
mowers. Any sales above that point will result in profit for the year. Since
the annual sales forecasts are considerably higher than this level the project
seems acceptable. However, the cost of capital is not accounted for by the
accounting break-even.

Cash Break-Even = Fixed Cost/(Price-Variable Cost) = $1,620,000/$600

= 2,700 mowers

Without including depreciation costs, the firm would need to sell only 2,700
mowers to break even i.e. to cover its fixed operating costs. At this point the
operating cash flow would be zero. Cash-break even does not account for the
cost of the project nor the cost of capital.

Financial Break-Even = (Fixed Costs + Operating Cash Flow*)

(Price – Variable Cost)

Where Operating Cash Flow* = Level of Cash flow that results in a zero
NPV

OCF* $3,790,003.98

Initial Outlay(including NWC) $(20,900,000.00)

PV of Salvage Value(including
NWC) $1,130,900.92

Net Investment $(19,769,099.08)

PV = -$19,769,099.08; n=10; FV = 0; I/y = 14%; CPT PMT = $3,790,003.98

Financial Break-Even = ($1,620,000+$3,790,003.98)/$600 = 9,017 mowers

Of the three break-even measures, the financial break-even is the most

comprehensive and conservative measure. It calculates the sales level that
has to be reached to get an NPV of zero. The firm would have to sell 9,017
units a year to get there. Even under the pessimistic scenario (15% lower
sales than the the base case scenario), this sales level is way below the

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 forecasted sales for each of the 10 years indicating that the Lazy Mower
project should be undertaken.

6. Let’s say that the company had spent $500,000 in developing the prototype of
the Lazy Mower. How should Dave and Rick treat this item in their report?
Please explain.

This is a sunk cost and should not be included in the analysis. The money was spent
prior to making the decision whether or not to accept the project.

7. Calculate the IRR of the project. Based on your calculations what would you
recommend? Why?

Under the base case scenario, the IRR of the project is 61%. Since the weighted
average cost of capital is 14%, the project is acceptable. The estimated cash
flows indicate that the project will provide a rate of return that far exceeds
the hurdle rate. Even under the worst case scenario, the IRR of 51.73% far
exceeds the cost of capital.

8. How sensitive is the Net Present Value of the project to the cost of capital?

The NPV profile shows the how sensitive the project’s NPV is to the cost of capital.

(See graph on following page.)

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 NPV Profile of Lazy Mower

$100,000,000

$80,000,000

$60,000,000

$40,000,000 NPV Profile of Lazy Mower

NPV

$20,000,000

$-
0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

$(20,000,000)
WACC

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9. Calculate the operating leverage entailed by this project. What does it
indicate?

Degree of Operating Leverage = 1 + (Fixed Cost/Operating Cash Flow)

Where Operating Cash Flow = (P - VC)*Q - FC

So at 30,000 units, which is the base case forecast in year 1,

OCF = -$1,620,000+($600)*30,000 = $16,380,000

DOL = 1+(1,620,000/16,380,000)=1.0989

The DOL indicates that a 10% increase in the output of lazy mowers will
increase the operating cash flow by about 10.98% and vice-versa, The
greater the DOL the more vulnerable the project will be to errors in
forecasting.

10. What other types of contingency planning should Dave and Rick include to
make the report comprehensive? Please explain the relevance of each
suggestion.

Dave and Rick should plan for the following types of contingencies:

1. The option to expand. What if the ‘lazy mower’ concept really takes
off? Can production be increased without too much additional
expenditure? Planning early can avoid later unnecessary costs. What
about the effect on price? Can costs be reduced through economies of
scale?
2. The option to abandon. Some discussion or planning must be
included regarding what can be done in case the project does not
break even on a cash flow basis. Could the operations be scaled back
or abandoned and some of the investment recouped?
3. The option to suspend or contract operations . If there is excess
inventory can operations be temporarily suspended or permanently
scaled back and costs minimized?