1.
Overstatement of Profitability
Timing mismatch: The sales and expense figures used in Exhibit 1
reflect Year 3 performance, not the initial years. This ignores the
ramp-up period (Years 1 and 2), which includes lower sales and
higher marketing costs.
Impact: This inflates the contribution to profit and makes the payback
period look unrealistically short.
2. Inclusion of Existing Sales
The analysis includes 100,000 barrels of sales, but SSC is already
producing 50,000 barrels at the current facility.
Only the incremental 50,000 barrels should be considered when
evaluating the expansion.
Impact: Including existing sales overstates the benefits of the new
facility.
3. Working Capital Requirements Ignored
The analysis omits the additional working capital needed for the
expansion:
Year 1: +$305,000
Year 2: +$315,000
Year 3: +$301,000
Impact: This is a significant cash outlay that affects the investment’s
net cash flows and should be included in the capital budgeting
analysis.
4. Depreciation Miscalculation
The depreciation for new equipment is shown as a flat $131,500 per
year, but SSC uses ACRS depreciation for tax purposes.
Correct ACRS rates (for 5-year property) should be applied:
Year 1: 20%
Year 2: 32%
Year 3: 19%
Year 4: 12%
Year 5: 11%
Year 6: 6%
Impact: Incorrect depreciation affects tax savings and net income.
5. Salvage Value and Terminal Cash Flows Omitted
The analysis does not include the $500,000 after-tax salvage
value at the end of Year 5.
It also omits the recovery of working capital.
Impact: These terminal cash flows are important for NPV and IRR
calculations.
6. Payback Period Misleading
Garfield uses a simple payback period of 4.75 months, based on
Year 3 profits.
This ignores:
Time value of money
Cash flow timing
Initial years’ losses or lower profits
Impact: This is not a reliable decision metric for long-term
investments.
Question 2: Cash Flows vs. Accounting Flows
✅ Relevant Flows: Cash Flows
Why? Investment decisions are based on actual cash inflows and
outflows, not accounting profits.
Accounting flows (like net income) include non-cash items (e.g.,
depreciation) and can be manipulated by accounting policies.
Cash flows reflect the real economic impact of a project and are
used in NPV, IRR, and payback calculations.
Question 3: Total vs. Incremental Cash Flows
✅ Focus on Incremental Cash Flows
Why? Only the additional cash flows resulting from the decision
matter.
Including total cash flows (e.g., existing 50,000 barrels of syrup
production) distorts the analysis.
Incremental analysis isolates the effect of the decision and avoids
double-counting.
🔍 Risk of Error: Using total flows can lead to overestimating
benefits and approving unprofitable projects.
Question 4: Payback Period as a Decision Tool
❌ Limitations of Payback Period:
Ignores time value of money
Ignores cash flows after payback
Doesn’t measure profitability or value creation
✅ Better Alternatives:
Net Present Value (NPV): Measures value added to the firm.
Internal Rate of Return (IRR): Measures return relative to cost of
capital.
Discounted Payback Period: Accounts for time value of money.
📌 Conclusion: Payback can be a supplementary tool for liquidity
assessment, but not a primary decision criterion.
Question 5: Multi-Year Cash Requirement Implications
For SSC:
Needs external financing in early years due to working capital
demands.
Increases financial risk and reliance on capital markets.
Requires careful cash flow planning to avoid liquidity issues.
For a New Company:
Would face greater risk as it lacks other cash-generating projects.
Might struggle to raise capital or survive early losses.
Rule of Thumb for Growth:
A firm’s sustainable growth rate is limited by its ability to generate
internal cash.
A common rule:
Sustainable Growth Rate=ROE×Retention RatioSustainable Growth Rat
e=ROE×Retention Ratio
Firms that avoid external financing must limit growth to what internal
funds can support.
📉 Bias Risk: This rule may discourage long-gestation projects, even if
they are highly profitable in the long run.
Component Description
Sales Barrels Number of syrup barrels sold each year (0 in Year 0,
ramping up to 100,000)
Sales Revenue Based on $100 per barrel
Marketing Varies by year, higher in early years
Expenses
Variable Costs Based on cost per barrel, decreasing over time
Lease Fixed at $325,000 annually
Expenses
Other Fixed at $300,000 annually
Expenses
Depreciation Calculated using ACRS rates on $1,275,000 of new
equipment
Total Expenses Sum of all operating and depreciation costs
Working Increases in Years 1–3, recovered in Year 5
Capital
Cash Flows Revenue minus total expenses
Tax Savings From depreciation (40% of depreciation)
Net Income Cash flow minus tax
Net Cash Flows Net income adjusted for working capital and salvage in
Year 5
1. Salvage Value Reflects Residual Worth
At the end of a project’s life, some assets (like equipment or property)
may still have resale or scrap value.
This salvage value is a real cash inflow and should be included in
the final year’s cash flow.
Ignoring it would understate the project’s benefits.
💰 2. Terminal Cash Flows Capture Final Adjustments
These include:
Recovery of working capital: Funds tied up in inventory,
receivables, etc., are typically released at the end.
Final tax effects: Such as gains or losses on asset disposal.
One-time shutdown or cleanup costs (if any).
These flows can significantly affect the Net Present Value (NPV),
especially in capital-intensive projects.
📉 3. Impact on NPV and IRR
Terminal cash flows often occur in later years, and while they are
discounted, they still add value.
Excluding them can lead to underestimating NPV and misleading
IRR results.
this could make the project look less attractive in NPV terms, but more
attractive in payback terms—possibly aligning with Garfield’s intent to push
for quick approval.
In the context of the syrup facility expansion:
Working capital includes inventory, raw materials,
and receivables needed to support increased production and sales.
Faulkner estimated that:
Without expansion: $420,000 is sufficient.
With expansion: It rises to $1,341,000 by Year 3 due to higher
production and sales volume.
📌 Why It Matters
Too little working capital → Risk of cash shortages, missed payments.
Too much working capital → Inefficient use of resources (cash tied up
in inventory or receivables).
In capital budgeting, increases in working capital are treated as
cash outflows, and recoveries at the end are inflows.
