Calculate The Expected Cash Flows From The Android01 Project

Calculate the expected cash flows from the Android01 project based on the information provided

Another one of your responsibilities as CFO is to determine the suitability of new and current products. Your CEO has asked you to evaluate Android01. That task will require you to combine data from your production analysis from Project 2 with data from a consultant's study that was done last year. Information provided by the consultant is as follows: initial investment: $120 million composed of $50 million for the plant and $70 million net working capital (NWC) yearly expenses from year 1 to year 3: $30 million yearly revenues from year 1 to year 3: $0 yearly expenses from year 4 to year 10: $55 million yearly expected revenues from year 4 to year 10: $95 million yearly expenses from year 11 to year 15: $60 million yearly expected revenues from year 11 to year 15: $105 million Revenues will vary between $80 million (minimum) and $105 million (maximum) for years 4 to 10, and between $90 million (minimum) and $110 million (maximum) for years 11 to 15.

This concludes the information provided by the consultant. You also have the following information: The asset beta of the project is 1.5. The expected return to the market is 8 percent, and the market risk premium is 5 percent. Assume that both expenses and revenues for a year occur at the end of the year. NWC pays the bills during the year, but has to be replenished at the end of the year.

Android01 is expected to cannibalize the sales of Processor01 while also reducing the variable costs for the production of Processor01. From years 4 to 10, revenues are expected to fall by $5 million, whereas variable costs will go down by $1 million. Processor01 is to be phased out at the end of the 10th year. At the end of the 15th year, the plant will be scrapped for a salvage value of $10 million. NWC will be recovered.

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To evaluate the Android01 project’s financial viability, it is essential to accurately calculate the expected cash flows over its lifespan, considering initial investments, operational revenues and expenses, changes in working capital, and salvage value at project termination. These cash flows form the foundation for subsequent analysis, including Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period calculations, which aid in informed decision-making regarding project acceptance.

Initial Investment and Setup: The initial outlay for the project totals $120 million, comprising $50 million for plant construction and $70 million for net working capital (NWC). This upfront investment is crucial, as it reflects the capital committed at project inception, and impacts cash flow calculations in Year 0.

Operational Cash Flows (Years 1-3): During the first three years, the project incurs expenses of $30 million annually against no revenue generation. These expenses likely encompass overheads and operational costs necessary to establish the project. Since revenues are zero, these years primarily reflect investment phase costs and working capital commitments.

Years 4-10 – Revenue and Expense Dynamics: Starting from Year 4, revenues are projected at approximately $95 million annually, with variable expenses of $55 million, fixed expenses totaling $30 million over these years. However, the forecast accounts for an anticipated revenue reduction of $5 million annually due to cannibalization of Processor01 sales, shifting revenues downward by this amount. Similarly, variable costs decrease by $1 million annually owing to efficiency gains.

Years 11-15 – Extended Operations and Terminal Year: The project’s revenues are forecast to increase again, reaching around $105 million, with expenses of $60 million. During this period, revenues fluctuate between $90 million and $110 million, and expenses increase accordingly. At the end of Year 15, a salvage value of $10 million is realized from plant disposal, and NWC is recovered, contributing positively to net cash flows.

Estimating Cash Flows: To determine cash flows for each year, we account for revenues, expenses, and changes in net working capital. Operating cash flows are computed by adjusting net income for non-cash expenses and considering changes in working capital. Given revenues and expenses occur at year-end, the timing aligns for discounting purposes.

Incorporating Cost Reductions and Cannibalization: The revenue decrease of $5 million from years 4 to 10 reflects cannibalization of Processor01 sales, which means net cash flows must be adjusted downward. Meanwhile, the reduction of $1 million in variable costs improves profitability, increasing cash flows during these years.

Salvage and Working Capital Recovery: At project completion, the plant’s salvage value and the recoupment of net working capital are added to the final year’s cash flow, providing a substantial injection of liquidity that can offset project costs.

Conclusion: Calculating these cash flows involves translating the above assumptions into annual net cash contributions by considering revenue streams, cost savings, working capital changes, and terminal values. Accurate estimation of these figures is fundamental for subsequent valuation metrics like NPV, IRR, and Payback Period, each offering critical insights into the project’s financial viability and strategic fit for the company.

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