Question

Operating cash inflows A firm is considering renewing its equipment to meet increased demand for its product. The cost of equipment modifications is $1.94 million plus $115,000 in installation costs. The firm will depreciate the equipment modifications under MACRS, using a 5-year recovery period (see table :). Additional sales revenue from the renewal should amount to $1.27 million per year, and additional operating expenses and other costs (excluding depreciation and interest) will amount to 41% of the additional sales. The firm is subject to a tax rate of 40%. (Note: Answer the following questions for each of the next 6 years.) a. What incremental earnings before depreciation, interest, and taxes will result from the renewal? b. What incremental net operating profits after taxes will result from the renewal? c. What incremental operating cash inflows will result from the renewal?

Answer 1

Depreciation schedule:

Year	Depreciation rate	Depreciation	BV at the end of the year
1.00	20.00%	$    3,65,000.00	$     14,60,000.00
2.00	32.00%	$    5,84,000.00	$        8,76,000.00
3.00	19.00%	$    3,46,750.00	$        5,29,250.00
4.00	12.00%	$    2,19,000.00	$        3,10,250.00
5.00	12.00%	$    2,19,000.00	$           91,250.00
6.00	5.00%	$       91,250.00	$                           -

Following is the calculations for years 0-6

Particulars	Remark	0	1	2	3	4	5	6
Sales	Given		$ 12,70,000.00	$ 12,70,000.00	$ 12,70,000.00	$ 12,70,000.00	$ 12,70,000.00	$ 12,70,000.00
Total Expenses	41% of sales		$    5,20,700.00	$    5,20,700.00	$    5,20,700.00	$    5,20,700.00	$    5,20,700.00	$    5,20,700.00
EBITDA	Sales-Total Expenses		$    7,49,300.00	$    7,49,300.00	$    7,49,300.00	$    7,49,300.00	$    7,49,300.00	$    7,49,300.00
Depreciation	MACRS		$    3,65,000.00	$    5,84,000.00	$    3,46,750.00	$    2,19,000.00	$    2,19,000.00	$       91,250.00
EBT	EBITDA-Depreciation		$    3,84,300.00	$    1,65,300.00	$    4,02,550.00	$    5,30,300.00	$    5,30,300.00	$    6,58,050.00
Tax	0.40% x EBT		$    1,53,720.00	$       66,120.00	$    1,61,020.00	$    2,12,120.00	$    2,12,120.00	$    2,63,220.00
EAT	EBT-Tax		$    2,30,580.00	$       99,180.00	$    2,41,530.00	$    3,18,180.00	$    3,18,180.00	$    3,94,830.00
Depreciation	Added back as non cash		$    3,65,000.00	$    5,84,000.00	$    3,46,750.00	$    2,19,000.00	$    2,19,000.00	$       91,250.00
OCF	EAT+Depreciation		$    5,95,580.00	$    6,83,180.00	$    5,88,280.00	$    5,37,180.00	$    5,37,180.00	$    4,86,080.00
FCINV	Given	$ -18,25,000.00
FCF	OCF+FCINV	$ -18,25,000.00	$    5,95,580.00	$    6,83,180.00	$    5,88,280.00	$    5,37,180.00	$    5,37,180.00	$    4,86,080.00

• EBITDA = incremental earnings before depreciation interest and taxes
• EAT is the net operating profit after taxes
• OCF is the net operating CF for years 1-6 and for year 0 we cant say it is operating as the initial outflow is an investing activity