What is the hedging principle or principle of self-liquidating ...

[vicky]

What is the hedging principle or principle of self-liquidating debt?
 
  What will be an ideal response?

Question 2

LEE Corporation intends to purchase equipment for 1,500,000. The equipment has a 5-year useful life and will
  be depreciated on a straight-line basis. Addition of the equipment requires additional working capital of
  20,000.
 
  The 20,000 is expected to be recaptured at the end of the project. LEE's marginal tax rate is 40. Use of
  the equipment is expected to change the company's reported EBIT by 600,000 in year one, 700,000 in year two,
  550,000 in year three, 200,000 in year four, and 100,000 in year five. Due to changing market conditions, the
  equipment did have a salvage value of 100,000 at the end of year five.
  a. Calculate the initial outlay and the incremental free cash flows over the life of the project.
  b. If the risk-adjusted discount rate for this project is 20, calculate the project's net present value and internal
  rate of return and comment on the acceptability of the project.

[Christopher]

Answer to Question 1

The hedging principle, or principle of self-liquidating debt, involves matching the cash-flow-generating
characteristics of an asset with the maturity of the source of financing used to fund its acquisition.
For example, a seasonal expansion in inventories, according to the hedging principle, should be financed with a
short-term loan or current liability. The funds are needed for a limited period, and when that time has passed, the cash
needed to repay the loan will be generated by the sale of the extra inventory items.
Obtaining the needed funds from a long-term source (longer than 1 year) would mean that the firm would still have
the funds after the inventories they helped finance had been sold. In this case the firm would have excess liquidity,
which it would either hold in cash or invest in low-yield marketable securities until the seasonal increase in
inventories occurs again and the funds are needed. The result of all this would be lower profits.

Answer to Question 2

a. Initial Outlay = 1,500,000 + 20,000 = 1,520,000
Incremental Free Cash Flows:
Year 1 Year 2 Year 3 Year 4 Year 5
EBIT 600,000 700,000 550,000 200,000 100,000
Less Taxes (40) 240,000 280,000 220,000 80,000 40,000
Plus Depreciation 300,000 300,000 300,000 300,000 300,000
Operating Cash Flow 660,000 720,000 630,000 420,000 360,000
Free Cash Flow 660,000 720,000 630,000 420,000 360,000
Salvage Value 100,000
Minus Tax on Gain -40,000
Plus Recovery of
Working Capital
20,000
Terminal Cash Flow 80,000
Total Final Year Cash
Flow 440,000
b. NPV = 273,956 and the project is acceptable since the NPV is positive.
IRR = 28.73 and the project is acceptable since the IRR exceeds the required return.