Question

Use the following information to answers questions 9 to 11. (Short Answer – Chapter 6) The Down Towner is considering a project with a life of 4 years that will require $165,000 for fixed assets. Current assets are expected to increase by $22,400 and current liabilities will decrease by $20,000. The fixed assets will be depreciated straight-line to a zero book value over 5 years. At the end of the project, the fixed assets can be sold for $37,500 cash and current assets and liabilities will return to their original level. The project is expected to generate annual sales of $195,000 and costs (excluding depreciation) of $117,500. The tax rate is 24 percent and the required rate of return is 13 percent.

1.What is the initial investment at time 0 for the project?

2. What is the annual operating cash flow for the project?

3. What is the terminal cash flow for the project?

Answer 1

Investment in Fixed Assets = $165,000
Useful Life = 5 years

Annual Depreciation = Investment in Fixed Assets / Useful Life
Annual Depreciation = $165,000 / 5
Annual Depreciation = $33,000

Book Value at the end of Year 4 = $165,000 - 4 * $33,000
Book Value at the end of Year 4 = $33,000

After-tax Salvage Value = Salvage Value - (Salvage Value - Book Value) * tax
After-tax Salvage Value = $37,500 - ($37,500 - $33,000) * 0.24
After-tax Salvage Value = $37,500 - $1,080
After-tax Salvage Value = $36,420

Increase in NWC = Increase in Current Assets + Decrease in Current Liabilities
Increase in NWC = $22,400 + $20,000
Increase in NWC = $42,400

Initial Investment = Investment in Fixed Assets + Increase in NWC
Initial Investment = $165,000 + $42,400
Initial Investment = $207,400

Annual Sales = $195,000
Annual Costs = $117,500

Annual Operating Cash Flow = (Annual Sales - Annual Costs) * (1 - tax) + tax * Annual Depreciation
Annual Operating Cash Flow = ($195,000 - $117,500) * (1 - 0.24) + 0.24 * $33,000
Annual Operating Cash Flow = $77,500 * 0.76 + 0.24 * $33,000
Annual Operating Cash Flow = $66,820

Terminal Cash Flow = After-tax Salvage Value + Recovery of Investment in NWC
Terminal Cash Flow = $36,420 + $42,400
Terminal Cash Flow = $78,820