Hi, Given the following table, the question asks to calculate Economic Income for Year 3. The formula is CF - Change in mkt value. So i used after-tax operating cashflow for CF but for change in market value won’t you use the salvage value, instead the answer given below the table uses the PV of after-tax operating cash flow from Year 3 to Year 5. Why? Exhibit 1: Cash Flow Projections Year 1 Year 2 Year 3 Year 4 Year 5 Sales $450,000 $517,500 $621,000 $807,300 $645,840 Operating Expenses 225,000 274,275 316,710 395,577 325,503 Depreciation 80,000 80,000 80,000 80,000 80,000 Operating Income 145,000 163,225 224,290 331,723 240,337 After-tax Operating CF 167,000 177,935 214,574 279,034 224,202 Salvage Value 26,667 After-tax Salvage Value 16,000 B is correct. Year 3 Economic income = Year 3 Cash Flow+Change in Market Value. Year 3 Cash Flow = $214,574. Beginning Market Value at Year 3 = PV of after-tax operating CFs discounted at 15%: CF0 = 0, CF1 = 214,574, CF2 = 279,034, CF3 = 224,202. I = 15, CPT NPV =? Beg MV = $544,992. Ending MV = PV of after-tax operating CFs discounted at 15%: CF1= 279,034, CF2 = 224,202. I = 15, CPT NPV =? End MV = 412,167. Change in MV = End MV−Beg MV=412,167−544,992=− $132,825. Economic Income = 214,574−132,825=$81,749
Market value is what you would get from a buyer for your project. If those project cashflows are certain (which is an assumption implicitly made here) then a buyer should be willing to pay you the net present value of the remaining cashflows of the project. If he is offering you less than that (e.g. salvage value) I hope you do not sell the project to him :-).
The only way you would sell the project at the end of year 3 for salvage value is if the NPV of the after tax cashflows in year 4, year 5 (including salvage value in year 5) is less than just getting the salvage value at the end of year 3. Given the cashflows above the discount rate would have to be >1726% for that to happen.
I still didn’t get it. why would we use after-tax operating cash flows as salvage value (market value) when we already have a salvage value? I am asking this because in other questions we didn’t have to use after-tax operating cash flows for market value.
Market value is not salvage value. Salvage value is what you get when you just stop the project (e.g. if your project was owning a containership and shipping cargo, then salvage value is what you get if you sell your ship to a scrapyard).
Market value is the price that you can get by selling your ship on the open market (e.g. to another ship operator). This should be equal to the discounted cashflows that can be expected from the project. This does include the scrap value at the end of the projects life. If the project is not at the end of its live the market value will generally be greater than salvage value (assume the project at least earns the required rate of return).