Question

1. Visible Fences is introducing a new product and has an expected change in net operating income of $900,000. Visible Fences has a 34 percent marginal tax rate. This project will also produce $300,000 of depreciation per year. In addition, this project will cause the following changes: Without the Project With the Project Accounts receivable $55,000 $63,000 Inventory 65,000 80,000 Account payable 70,000 94,000 What is the project's free cash flow for Year 1 2. Assume that a new project will annually generate revenues of $2,000,000 and cash expenses (including both fixed and variable costs) of $800,000, while increasing depreciation by $200,000 per year. In addition, the firm's tax rate is 34%. Calculate the operating cash flows for the new project. 3. The Chung Chemical Corporation is considering the purchase of a chemical analysis machine. Although the machine being considered will result in an increase in earnings before interest and taxes of $35,000 per year, it has a purchase price of $100,000, and would cost an additional $5,000 after tax to correctly install this machine. In addition, to properly operate this machine, inventory must be increased by $5,000. This machine has an expected life of 10 years, and after which it will have no salvage value. Also, assume simplified straight-line depreciation, that this machine being depreciated down to zero, a 34 percent marginal tax rate, and a required rate of return of 15 percent a. What is the initial outlay associated with this project? b. What are the annual after-tax cash flows associated with this project for Years 1 through 9? c. What is the terminal cash flow in Year 10(What is the annual after tax cash flow in Year 10 plus any additional cash flows associated with termination o the project)? d. Should this machine be purchased?

Answer 1

1]	Incremental NOI	$      9,00,000
	-Tax at 34%	$      3,06,000
	=NOPAT	$      5,94,000
	+Depreciation	$      3,00,000
	=OCF	$      8,94,000
	-Increase in NWC = (63000+80000-94000)-(55000+65000-70000) =	$           -1,000
	=Project's FCF for year 1	$      8,95,000
	Note:
	It is presumed that the change in NWC
	occurs at the end of year 1. Hence, it has
	been included as the cash flow for year 1.
2]	Incremental revenues	$    20,00,000
	-Cash expenses	$      8,00,000
	-Depreciation	$      2,00,000
	=NOI	$    10,00,000
	-Tax at 34%	$      3,40,000
	=NOPAT	$      6,60,000
	+Depreciation	$      2,00,000
	Operating cash flow for the new project	$      8,60,000
3]
a)	Cost of machine including cost of installation [100000+5000]	$      1,05,000
	Increase in NWC	$            5,000
	Initial outlay	$      1,10,000
b]	Increase in EBIT	$          35,000
	-Depreciation [105000/10]	$          10,500
	=Incremental NOI	$          24,500
	-Tax at 34%	$            8,330
	=NOPAT	$          16,170
	+Depreciation	$          10,500
	=Annual after tax cash flows for years 1 to 9	$          26,670
c]	Recovery of NWC	$            5,000
	After tax annual cash flows [as for years 1 to 9]	$          26,670
	Terminal cash flow for year 10	$          31,670
d]	PV of cash flow for years 1 to 9 = 26670*(1.15^9-1)/(0.15*1.15^9) =	$      1,27,258
	PV of cash flows for year 10 = 31670/1.15^10 =	$            7,828
	Sum of PVs of cash inflows	$      1,35,086
	Less: Initial outlay	$      1,10,000
	NPV	$          25,086
	As the NPV is positive, the machine can be purchased.