Question

Consider the following situation, in which the financial manager must decide whether to acquire new equipment that costs 55,000 and requires an outlay of 5000 to install. To make the decision, the financial manager must determine cash flow generated by the investment. The 5000 installation charge is a current cash outflow that is recaptured over the same five years that the equipment is depreciated. Estimated annual operating earnings generated by the equipment are 17,200 before the annual depreciation expense. In addition, the firm's investment in inventory rises by 2000 and its accounts receivable increases by 3000. These increases in inventory and accounts receivable are cash outflows that require additional funds. In the fifth year the inventory and accounts receivable are restored to their current levels (in other words, before the investment in the equipment). At that time the equipment is removed at a cost of 4,500. If the income tax rate is 20 percent, what are (1) the accounting earnings and (2) the cash inflow and outflows generated by the investment.

Answer 1

		0	1	2	3	4	5
1]	Annual operating earnings		$        17,200	$       17,200	$    17,200	$      17,200	$      17,200
	Depreciation [60000/5]		$        12,000	$       12,000	$    12,000	$      12,000	$      12,000
	Net operating income		$          5,200	$         5,200	$      5,200	$        5,200	$         5,200
	Tax at 20%		$          1,040	$         1,040	$      1,040	$        1,040	$         1,040
	Net income [Accounting earnings]		$          4,160	$         4,160	$      4,160	$        4,160	$         4,160
2]	Operating cash flow [Net income+Depreciation]		$        13,040	$       13,040	$    13,040	$      13,040	$      13,040
	Capital expenditure [55000+5000]	$         60,000
	Increase in NWC [2000+3000]	$           5,000
	After tax cost of removal [4500*(1-20%)]						$         3,600
	Recapture of NWC						$         5,000
	Cash flows generated by the project	$       -65,000	$        13,040	$       13,040	$    13,040	$      13,040	$      14,440