# BFG Co: Calculation of net cash flow and discount rate for a company

The BFG Company purchased a trawler 6 years ago for $420,000. It is currently being depreciated over its 10 year useful life at 10% straight-line for tax purposes. If BFG were to retain this boat it is anticipated that ultrasonic detection equipment would have to be installed in the second-last year of its life at a cost of $40,000.

However, the SUG Company has recently launched a faster, computer-assisted trawler that BFG is considering as a replacement. This trawler will cost $600,000, but will need immediate refitting to suit the purchaser's specifications at an additional cost of $15,000. It has an expected useful life of 12 years and may be depreciated by the reducing balance method at 20% for tax purposes.

If purchased, the new trawler is likely to increase cash operating costs by $10 per ton of fish that currently sells for $30 per ton. However, future catches are likely to increase significantly by 6,000 tons in the first year, and then at a rate of 1,000 tons per annum, stabilizing at 12,000 tons from Year 7 onwards. Due to intensive usage, it is anticipated that towards the end of the fifth year, the new trawler will require a minor engine overhaul at a cost of $30,000. Part of the purchase agreement also involves a maintenance contract with SUG covering the nets and trawling apparatus which will cost BFG $12,000, payable at the end of every fourth year.

Any replacements / additions may be written off in the year after acquisition for tax purposes. As a competitive strategy, SUG offers an optional financing package for up to 80% of the invoice price on any boat. The rate of interest on this amount is 12% per annum with the first payment deferred one year. If the financing package is adopted, BFG must undertake to sell the trawler back to SUG in 12 years' time for $50,000.

BFG estimates that the current second-hand price of its present trawler is only $140,000. It is estimated that the new trawler can be sold for $100,000 at the end of its useful life.

The company income tax rate of 33% is applicable to both capital gains and income. The nominal after-tax required rate of return is 30%.

a. Estimate the net cash flow after tax at the beginning of Year 1

b. Estimate the net cash flow after tax in Year 4

c. Management believes that relative to today's prices the average inflation rate is expected to be 8% per annum over the next 12 years. What is the Year 3 inflation-adjusted net cash flow after tax?

d. Estimate the appropriate discount rate to perform a net present value analysis in real terms.

#### Solution Preview

...This means it was depreciated by 10% of the purchase price every year for 6 years). The difference in the book value and selling price will be a capital gain/loss. You'll only have a capital gain or loss in the years you sell a capital asset - in this case Year 1 and possibly year 12 if you sell the new trawler back to SUG.

When calculating the depreciation for the new trawler, the question states to use the reducing balance method - which recognizes that depreciation in early life, should be greater than in later years.

So, let's say you had something you purchased for $28,000 and were depreciating at 40% using the reducing balance method:

Depreciation Allowance Book Value

Year 1 $28,000 X 40% = 11,200 $28,000-11,200 = 16,800

Year 2 $16,800 X 40% = 6,720 $16,800-6,720=10,080......

To calculate cash flows - remember that cash flow from assets has 3 components - operating cash flow, capital spending and additions to net working capital. So - We need an estimate of all of these.

If you decide that BFG should use the financing ...