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right now (year 0) and the salvage value of the entire working capital investment in year
4.
Table 5.3: From Operating Income to After-tax Cashflows
0 (Now) 1 2 3 4
After-tax Operating Income \$120,000 \$183,000 \$216,300 \$252,930
+ Depreciation \$250,000 \$250,000 \$250,000 \$250,000
- Change in Working Capital \$150,000 \$30,000 \$18,000 \$19,800 \$0
+ Salvage Value \$217,800

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After-tax Cashflows -\$1,150,000 \$340,000 \$415,000 \$446,500 \$720,730

Note that there is an initial investment in working capital, which is 10% of the first yearвЂ™s
revenues, invested at the beginning of the year. Each subsequent year has a change in
working capital that represents 10% of the revenue change from that year to the next.

5.4. в˜ћ: The Effects of Working Capital
In the analysis above, we assumed that Bookscape would have to maintain additional
inventory for its on-line book service. If, instead, we had assumed that Bookscape could
use its existing inventory (i.e.. from its regular bookstore), the cash flows on this project
a. will increase
b. will decrease
c. will remain unchanged
Explain.

Illustration 5.5: Estimating Incremental Cash Flows: Disney Theme Park
The theme parks to be built near Bangkok, modeled on Euro Disney in Paris, will
include a вЂњMagic KingdomвЂќ to be constructed, beginning immediately, and becoming
operational at the beginning of the second year, and a second theme park modeled on
Epcot Center at Orlando to be constructed in the second and third year and becoming
operational at the beginning of the fifth year. The following is the set of assumptions that
underlie the investment analysis:
1. The cash flows will be estimated in nominal dollars, even thought he actual cashflows
will be in Thai baht.
2. The cost of constructing Magic Kingdom will be \$3 billion, with \$ 2 billion to be
spent right now, and \$1 Billion to be spent one year from now. Disney has already
spent \$0.5 Billion researching the proposal and getting the necessary licenses for the
park; none of this investment can be recovered if the park is not built.
3. The cost of constructing Epcot II will be \$ 1.5 billion, with \$ 1 billion to be spent at
the end of the second year and \$0.5 billion at the end of the third year.
4. The revenues at the two parks and the resort properties at the parks are assumed to be
the following, based upon projected attendance figures until the tenth year and an

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expected inflation rate of 2% (in US dollars). Starting in year 10, the revenues are
expected to grow at the inflation rate. Table 5.4 summarizes the revenue projections:
Table 5.4: Revenue Projections: Disney Bangkok
Year Magic Kingdom Epcot II Resort Properties Total
1 \$0 \$0 \$0 \$0
2 \$1,000 \$0 \$250 \$1,250
3 \$1,400 \$0 \$350 \$3,000
4 \$1,700 \$300 \$500 \$4,250
5 \$2,000 \$500 \$625 \$5,625
6 \$2,200 \$550 \$688 \$6,563
7 \$2,420 \$605 \$756 \$7,219
8 \$2,662 \$666 \$832 \$7,941
9 \$2,928 \$732 \$915 \$8,735
10 \$2,987 \$747 \$933 \$9,242
Beyond Revenues grow 2% a year forever

Note that the revenues at the resort properties are set at 25% of the revenues at the
theme parks.
5. The operating expenses are assumed to be 60% of the revenues at the parks, and 75%
of revenues at the resort properties.
6. The depreciation will be calculated as a percent of the remaining book value of the
fixed assets at the end of each year. In addition, the parks will require capital
maintenance investments each year, specified as a percent of the depreciation that
year. Table 5.5 lists both these statistics by year:3
Table 5.5: Depreciation and Capital Maintenance Percentages
Year Depreciation as % of book value Capital Maintenance as % of /Depreciation
1 0.00% 0.00%
2 12.70% 50.00%
3 11.21% 60.00%
4 9.77% 70.00%
5 8.29% 80.00%
6 8.31% 90.00%
7 8.34% 100.00%
8 8.38% 105.00%

3 Capital maintenance expenditures are capital expenditures to replace fixed assets that break or become
obsolete. An example would be the replacement of a ride at Magic Kingdom.

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9 8.42% 110.00%
10 8.42% 110.00%

The capital maintenance expenditures are low in the early years, when the parks are
still new but increase as the parks age. After year 10, both depreciation and capital
expenditures are assumed to grow at the inflation rate (2%).
7. Disney will also allocate corporate general and administrative costs to this project,
based upon revenues; the G&A allocation will be 15% of the revenues each year. It
is worth noting that a recent analysis of these expenses found that only one-third of
these expenses are variable (and a function of total revenue) and that two-thirds are
fixed. After year 10, these expenses are also assumed to grow at the inflation rate of
2%.
8. Disney will have to maintain non-cash working capital (primarily consisting of
inventory at the theme parks and the resort properties, netted against accounts
payable) of 5% of revenues, with the investments being made at the end of each year.
9. The income from the investment will be taxed at DisneyвЂ™s marginal tax rate of 37.6%.
The projected operating earnings at the theme parks, starting in the first year of operation
(which is the second year) are summarized in Exhibit 5.1. Note that the project has no
income or expenses until year 2 when the first park becomes operational and that the
project is expected to have an operating loss of \$262 million in that year. We have
assumed that the firm will have enough income in its other businesses to claim the tax
benefits from these losses (37.3% of the loss) in the same year. If this had been a stand-
alone project, we would have had to carry the losses forward into future years and reduce
taxes in those years.
These operating earnings can be contrasted with the after-tax cash flows in exhibit
5.2, with the projected capital expenditures shown as part of the cash flows. In estimating
Added back the depreciation and amortization each year, since it is a non-cash charge
вЂў
Subtracted out the maintenance capital expenditures in addition to the primary capital
вЂў
expenditures since these are cash outflows
Added back the after-tax portion of the allocated general and administrative costs that
вЂў
are fixed and therefore not an incremental effect of the project.

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After-tax Fixed Allocated G&A = (2/3) (Allocated G&A Expense) (1 вЂ“ tax rate)
Subtracted out the working capital requirements each year, which represent the
вЂў
change in working capital from the prior year. In this case, we have assumed that the
working capital investments are made at the end of each year.
The investment of \$3 billion in Bangkok Magic Kingdom is shown at time 0 (as \$ 2
billion) and in year 1 (as \$ 1 billion). The investment of \$0.5 billion that will not be
recovered because it has already been spent is not considered because it is a sunk cost.

5.5. в˜ћ: Different Depreciation Methods for Tax Purposes and for Reporting
The depreciation that we used for the project above is assumed to be the same for both
tax and reporting purposes. Assume now that Disney uses more accelerated depreciation
methods for tax purposes and straight-line depreciation for reporting purposes. In
estimating cash flows, we should use
a. the depreciation numbers from the tax books
b. the depreciation numbers from the reporting books
Explain.

This spreadsheet allows you to estimate the cash flows to the firm on a project

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Exhibit 5.1: Operating Earnings at Disney Theme Parks in Bangkok

Now (0) 1 2 3 4 5 6 7 8 9 10
Magic Kingdom \$0 \$1,000 \$1,400 \$1,700 \$2,000 \$2,200 \$2,420 \$2,662 \$2,928 \$2,987
Second Theme Park \$0 \$0 \$0 \$300 \$500 \$550 \$605 \$666 \$732 \$747
Resort & Properties \$0 \$250 \$350 \$500 \$625 \$688 \$756 \$832 \$915 \$933
Total Revenues \$1,250 \$1,750 \$2,500 \$3,125 \$3,438 \$3,781 \$4,159 \$4,575 \$4,667
Magic Kingdom: Operating Expenses \$0 \$600 \$840 \$1,020 \$1,200 \$1,320 \$1,452 \$1,597 \$1,757 \$1,792
Epcot II: Operating Expenses \$0 \$0 \$0 \$180 \$300 \$330 \$363 \$399 \$439 \$448
Resort & Property: Operating
Expenses \$0 \$188 \$263 \$375 \$469 \$516 \$567 \$624 \$686 \$700
Depreciation & Amortization \$0 \$537 \$508 \$430 \$359 \$357 \$358 \$361 \$366 \$369
Allocated G&A Costs \$0 \$188 \$263 \$375 \$469 \$516 \$567 \$624 \$686 \$700
Operating Income \$0 -\$262 -\$123 \$120 \$329 \$399 \$473 \$554 \$641 \$657
Taxes \$0 -\$98 -\$46 \$45 \$123 \$149 \$177 \$206 \$239 \$245
Operating Income after Taxes -\$164 -\$77 \$75 \$206 \$250 \$297 \$347 \$402 \$412
Depreciation Calculations
Pre-project investment \$500
New Investment вЂ“ Magic Kingdom \$2,000 \$1,000 \$0 \$0 \$0 \$0 \$0 \$0 \$0 \$0 \$0
New Investment - Epcot II \$0 \$0 \$1,000 \$500 \$0 \$0 \$0 \$0 \$0 \$0 \$0
Capital Maintenance \$0 \$268 \$305 \$301 \$287 \$321 \$358 \$380 \$403 \$406
Depreciation as % of book value 12.5% 11% 9.5% 8% 8% 8% 8% 8% 8%
Depreciation \$0 \$537 \$508 \$430 \$359 \$357 \$358 \$361 \$366 \$369
Book Value of Fixed Assetsa \$2,500 \$3,500 \$4,232 \$4,529 \$4,400 \$4,328 \$4,292 \$4,292 \$4,310 \$4,347 \$4,384
a
Book value of fixed assets in year t = Book value of fixed assets in year t вЂ“1 + New Cap Ex + Capital Maintenance - Depreciation

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Exhibit 5.2: Operating Cash Flows at Disney Them Parks in Bangkok
Now (0) 1 2 3 4 5 6 7 8 9 10
-\$165 -\$77 \$75 \$206 \$251 \$297 \$347 \$402 \$412
Operating Income after Taxes
\$537 \$508 \$430 \$359 \$357 \$358 \$361 \$366 \$369
+ Depreciation & Amortization
\$2,000 \$1,000 \$1,269 \$805 \$301 \$287 \$321 \$358 \$379 \$403 \$406
- Capital Expenditures
\$0 \$0 \$63 \$25 \$38 \$31 \$16 \$17 \$19 \$21 \$5
- Change in Working Capital
\$0 \$78 \$110 \$157 \$196 \$216 \$237 \$261 \$287 \$293
+ Non-incremental Allocated Expense (1-t)
-\$2,000 -\$1,000 -\$880 -\$289 \$324 \$443 \$486 \$517 \$571 \$631 \$663
Cashflow to Firm

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Illustration 5.6: Estimating Cash Flows to Equity for a New Plant: Aracruz
Aracruz Cellulose is considering a plan to build a state-of-the-art plant to
manufacture linerboard. The plant is expected to have a capacity of 750,000 tons and will
have the following characteristics:
1. It will require an initial investment of 250 Million BR. At the end of the fifth year, an
additional investment of 50 Million BR will be needed to update the plant.
2. Aracruz plans to borrow 100 Million BR, at a real interest rate of 5.25%, using a 10-
year term loan (where the loan will be paid off in equal annual increments).
3. The plant will have a life of 10 years. During that period, the plant (and the additional
investment in year 5) will be depreciated using double declining balance depreciation,
with a life of 10 years.4 At the end of the tenth year, the plant is expected to be sold
for its remaining book value.
4. The plant will be partly in commission in a couple of months, but will have a capacity
of only 650,000 tons in the first year, 700,000 tons in the second year before getting
to its full capacity of 750,000 tons in the third year.
5. The capacity utilization rate will be 90% for the first 3 years, and rise to 95% after
that.
6. The price per ton of linerboard is currently \$400, and is expected to keep pace with
inflation for the life of the plant.
7. The variable cost of production, primarily labor and material, is expected to be 55%
of total revenues; there is a fixed cost of 50 Million BR, which will grow at the
inflation rate.
8. The working capital requirements are estimated to be 15% of total revenues, and the
investments have to be made at the beginning of each year. At the end of the tenth
year, it is anticipated that the entire working capital will be salvaged.

4 With double declining balance depreciation, we double the straight line rate (which would be 10% a year
in this case with a 10-year life) and apply that rate to the remaining book value. We apply this rate to the
investment in year 5 as well.

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Before we estimate the net income on this project, we have to consider the debt payments
each year and break them down into interest and principal payments. Table 5.6
summarizes the results:
Table 5.6: Debt Payments вЂ“ Aracruz Paper Plant
Year Beginning Debt Interest expense Principal Repaid Total Payment Ending Debt
1 R\$ 100,000 R\$ 5,250 R\$ 7,858 R\$ 13,108 R\$ 92,142
2 R\$ 92,142 R\$ 4,837 R\$ 8,271 R\$ 13,108 R\$ 83,871
3 R\$ 83,871 R\$ 4,403 R\$ 8,705 R\$ 13,108 R\$ 75,166
4 R\$ 75,166 R\$ 3,946 R\$ 9,162 R\$ 13,108 R\$ 66,004
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