Question: Wining Corporation feels that it must diversify its product lines in order to grow. The vice-president of finance has been looking for suitable investments and has come up with two projects of apparently equal potential. The first of these projects would require outside financing of approximately $400,000, whereas the second, a much larger undertaking, would require $ 1,300,000. In either case, the new projects could be financed entirely through debt, and because of the tax deductibility of interest this appeals to management. The first project could be financed by a 12-percent debt issue with sinking-fund requirements of $60,000 per year. The second, which has different financial backing, could be financed with debt bearing only 10-percent interest; sinking-fund requirements would be $ 160,000 per year.
In either case, it would take 2 years before the new projects would start to generate net inflows. Forecasts for the upcoming year suggest expected sales of $3,000,000 that could fluctuate by ± 10 percent. Variable costs have traditionally been 60 percent of sales, and fixed costs (excluding depreciation and interest on current debt) are $600,000 per year. Capital cost allowances on existing assets will be $200,000 for the coming year, while capital cost allowances on the new investments would be taken at a rate of 5 percent on a declining balance. Annual interest charges on debt currently outstanding are $ 1 50,000, with sinking-fund requirements of $200,000. Wining's tax rate is 40 percent.
(a) Compute the expected net cash flow for the coming year, excluding any financing for the new projects.
(b) Suggest to the vice-president whether either of these projects appears acceptable from a cash-flow point of view. Would 100-percent debt financing of either project be safe even if sales were at the low end of the anticipated range?