Please explain how to find the answers indicated below
A company is considering the acquisition of production equipment which will reduce both labour and material costs. The cost is $100,000 and it will be depreciated on a straight-line basis to zero over a four-year period. However, the useful life of the equipment is five years, and it will be sold for $20,000 at the end of the five years. Operating costs will be reduced by $30,000 in the first year and the savings will increase by $5,000 per year for years 2, 3 and 4. Due to increased maintenance costs, savings in year 5 will be $10,000 less than the year 4 savings. The equipment will also reduce net working capital by $5,000. Net working capital will revert back to normal at the end of the project’s life. The firm’s tax rate is 35% and the firm requires a 16% return.
Calculate the initial investment (CF0) for this project. (-$95,000)
The initial investment at time t = 0 will have two components:
Calculate the cash flows in years 1 through 4. (CF1=$28,250, CF2= $31,500, CF3= $34,750, CF4= 38,000).
Operating costs will be reduced by $30,000 in the first year and the savings will increase by $5,000 per year for years 2, 3 and 4.
Annual depreciation = Cost of equipment / 4 years = 100,000 / 4 = 25,000
Tax rate, T = 35%
Depreciation tax shield per year = Annual depreciation x T = 25,000 x 35% = 8,750.
Please see the table below. Please see the column titled "Linkage" to understand how each row has been calculated.
Year |
Linkage |
1 |
2 |
3 |
4 |
Cost reduction & savings (pre tax) |
A |
30,000 |
35,000 |
40,000 |
45,000 |
Post tax cost reduction and savings (= pre tax figures x (1-Tax rate) |
B = A x (1 - tax rate) |
19,500 |
22,750 |
26,000 |
29,250 |
Depreciation |
D |
25,000 |
25,000 |
25,000 |
25,000 |
Depreciation tax shield |
C= D x Tax rate |
8,750 |
8,750 |
8,750 |
8,750 |
Incremental annual cash flows |
B + D |
28,250 |
31,500 |
34,750 |
38,000 |
Calculate the terminal cash flow and the total cash flow in year 5. (TCF= $8,000, CF5= $30,750)
The terminal cash flow will have two components:
Hence terminal cash flow = TCF = Post tax salvage value - Increase in working capital = 13,000 - 5,000 = $ 8,000
Total Cash flow for year 5
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