Question

NexxGen is a Pharmaceutical Company which is considering investing in a new production line
of portable electrocardiogram (ECG) machines for its clients who suffer from cardiovascular diseases.
The company has to invest in equipment which costs $2,500,000 and falls within a MARCS
depreciation of 5 years, and is expected to have a scrap value of $200,000 at the end of the project.
Other than the equipment, the company needs to increase its cash and cash equivalents by $100,000,
increase the level of inventory by $30,000, increase accounts receivable by $250,000 and increase
accounts payable by $50,000 at the beginning of the project. Healthy Options expects the project to
have a life of five years. The company would have to pay for transportation and installation of the
equipment which has an invoice price of $450,000.

The company has already invested $75,000 in Research and Development and therefore expects a
positive impact on the demand for the new product line. Expected annual sales for the ECG machines
in years one to three are $1,200,000, and $850,000 in the following two years. The variable costs of
production are projected to be $267,000 per year in years one to three and $375,000 in years four and
five. Fixed overhead is $180,000 per year over the life of the project.

The introduction of the new line of portable ECG machines will cause a net decrease of $50,000 in
profit contribution after taxes, due to a decrease in sales of the other lines of tester machines produced
by the company. By investing in the new product line Healthy Options would have to use a packaging
machine which the company already has and which will be sold at the end of the project for $350,000
after-tax in the equipment market. The company has a marginal tax rate of 25%.

1) What is the initial investment cash-flows?

2) What is the after-tax operating cash-flows?

3) Determine that tax on salvage value of the equipment, then show the terminal year cash-flows.

Answer 1

Depreciation rates are not given. Since MARCS should have depreciation rates assuming Depreciation 20%,32%,19%,12% and 12% for years 1,2,3,4 and 5 respectively.

1) Initial Investment cash flows Particulars Cost of asset= Transportation & Installation=1 Working capital costs (100000+30000+250000- 50000) Total Amount $ 2,500,000 450,000 330,000 3,280,000 2) Calculation of annual depreciation Depreciation Cost Dep Rate Depreciation Cost * Dep rate Year-1 Year-2 Year-3 Year-4 Year-5 Total $ 2,950,000 $ 2,950,000 $ 2,950,000 $ 2,950,000 $ 2,950,000 20.00% 32.00% 19.00% 12.00% 12.00% $ 590,000 $ 944,000 $ 560,500 $ 354,000 $ 354,000 $ 2,802,500 Calculation of annual operating cash flow Sale Less: Operating Cost Contribution Less: Fixed cost Less: Depreciation Profit before tax (PBT) Tax@25% Profit After Tax (PAT) Add Depreciation Cash Profit after-tax Year-1 Year-2 Year-3 Year-4 Year-5 $ 1,200,000 $ 1,200,000 $ 1,200,000 $ 850,000 $ 850,000 $ 267,000 $ 267,000 $ 267,000 $ 375,000 $ 375,000 $ 933,000 $ 933,000 $ 933,000 $ 475,000 $ 475,000 $ 180,000 $ 180,000 $ 180,000 $ 180,000 $ 180,000 S 590,000 $ 944,000 $ 560,500 $ 354,000 $ 354,000 $ 163,000 $ (191,000) $ 192,500 $ (59,000) $ (59,000) $ 40,750 $ (47,750) $ 48,125$ (14,750) $ (14,750) $ 122,250 $ (143,250) $ 144,375 $ (44,250) $ (44,250) S 590,000 $ 944,000 $ 560,500 $ 354,000 $ 354,000 $ 712,250 $ 800,750 $ 704,875 $ 309,750 $ 309,750 PBT*Tax rate PBT - Tax PAT + Dep 3) Calculation of after-tax salvage value Cost of machine $ 2,950,000 less: Depreciation $ 2,802,500 WDV Cost less accumulated depreciation $ 147,500 Sale price $ 200,000 Profit/(Loss) Sale price less WDV $ 52,500 Tax Profit/(Loss)*tax rate $ 13,125 Sale price after-tax Sale price less tax $ 186,875

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