Practice questions for capital budgeting cash flows

Throughout, assume the following per year: $100 as the initial investment in the
machine; $100 as the baseline revenue; $50 as the baseline cash expenses; 20% as the
baseline depreciation; 20% of revenue as the baseline inventory; 50% of inventory as the
baseline accounts payable; and a tax rate of 40%.

For each of the following, figure out what the incremental effect on initial cash flow,
operating cash flow, or terminal cash flow would be. Do not cumulate the effects from
item to item. Instead, always start with the baseline figures above.

1. Inventory falls to 5% of revenue.

2. Accounts payable rises to 60% of inventory.
3. Cash expenses fall to $40.
4. Depreciation rises to 30% per year.
5. Taking the above project means that you can avoid a $10 repair expense on the
old project.
6. Revenue rises to $120.
7. Inventory rises to 30% of revenue.
8. Accounts payable falls to 40% of inventory.
9. Cash expenses rise to $60.
10. Depreciation falls to 10% per year.
11. Taking the above project requires the use of warehouse space that is currently
rented for $20 per year.
12. At the end of the project, you will have a salvage value of $10 and a book value
of $30.
13. Revenue falls to $90.
14. Taking the above project will enhance the sales of another product you have by
$10 per year.
15. Before starting this project, you pay a consultant $20 for a feasibility study.
16. If you take this project, you will have to pay a consultant $20.
17. The project requires that you always hold petty cash of $5.

The answers are on the next page.

Answers:

1. Inventory falls to 5% of revenue. Initial CF rises by $7.50 (WC = CA – CL =

inventory – A/P. WC goes from $10 to $2.50). This could be an operating CF
effect depending on when you did this.
2. Accounts payable rises to 60% of inventory. Initial CF rises by $2 (WC goes from
$10 to $8).
3. Cash expenses fall to $40. EBT rises by $10, but we only net an operating CF
increase of $6 after paying taxes.
4. Depreciation rises to 30% per year. EBT falls by $10, which means taxes fall by
$4. So operating cash flow increases by $4.
5. Taking the above project means that you can avoid a $10 repair expense on the
old project. Initial CF rises by $6, which is what that expense would have cost us
after tax savings from the expense.
6. Revenue rises to $120. The pure revenue effect is: Operating CF rises by $20*(1
– 0.4) = $12. But WC also rises by $2, so the net effect is an operating CF
increase of $10.
7. Inventory rises to 30% of revenue. Initial CF falls by $5 (WC = CA – CL =
inventory – A/P. WC goes from $10 to $15).
8. Accounts payable falls to 40% of inventory. Initial CF falls by $2 (WC goes from
$10 to $12).
9. Cash expenses rise to $60. Operating CF falls by $10 * (1 - 0.4) = $6.
10. Depreciation falls to 10% per year. EBT rises by $10, which means taxes rise by
$4, so operating CF falls by $4.
11. Taking the above project requires the use of warehouse space that is currently
rented to someone else for $20 per year. You give up this CF so your operating
cash flow is lower by $20*(1 – 0.4) = $12.
12. At the end of the project, you will have a salvage value of $10 and a book value of
$30. You will have a loss of $20, which means you save $8 in taxes. Your
terminal CF is then the $10 salvage value + $8 tax savings = $18.
13. Revenue falls to $90. The pure revenue effect is: Operating CF falls by $10*(1 –
0.4) = $6. But WC also falls by $1, so the net effect is an operating CF decrease
of $5.
14. Taking the above project will enhance the sales of another product you have by
$10 per year. Operating CF will rise by $10*(1 – 0.4) = $6.
15. Before starting this project, you pay a consultant $20 for a feasibility study. Sunk
cost, so no effect.
16. If you take this project, you will have to pay a consultant $20. This is the same
thing as saying you have a $20 expense. EBT falls by $20, but taxes fall by $8, so
you wind up with a reduction in CF of $12.
17. The project requires that you always hold petty cash of $5. Cash is a current asset,
so this increases WC by $5, which increases the initial CF outflow by $5. Note
that you don’t finance this cash by accounts payable.