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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.

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Solution Preview

This question is not very clear as to what happened with the old trawler - so you'll have to make certain assumptions to answer this question.

I would suggest the following.
- BFG sells the old trawler for the $140,000 - the current second hand price stated in the question.

Additionally, I would assume that where it says "future catches are likely to increase significantly by 6,000 tons in the first year" it really means to 6,000 tons in the first year - since this is the only way this question makes any sense.

Since the new trawler will be used over a 12 year period - it would be best to do this question on a spreadsheet. I've included an Excel template for you to use.

When calculating the initial cost of the new trawler - I would also suggest you include the $15,000 required for fitting, since this is a required cost order to get the trawler in usable order in order to gain revenue.

Also, since the old trawler will be sold for $140,000. Remember that the book value of the old trawler has been depreciated using the 10%straigh-line method - so it's current book value is not $140,000. ...

Solution Summary

The solution first lists the facts and assumptions used to set up the problem. Following is a detailed explanation of the process of working through the problem including a partial set of answers.