Question

Suppose Blue Thumb Tools is considering the introduction of a new, heavier hammer to be used for driving spikes. The new hammer will cost $490,000. The cost will be depreciated straight-line to zero over the project’s five-year life, at the end of which the new hammer can be scrapped for $40,000. The new hammer will save the firm $146,000 per year in pretax operating costs, and it required an initial investment in net working capital of $35,000. The tax rate of the firm is 30%. What are the cash flows of firm’s new project (using a time line)?

Answer 1

Step 1: Annual Operating cash flows

Savings in pretax costs = 146000

Less: depreciation = 490000/5 = 98000

Pre tax Income = 48000

Less: Tax = 30% = 14400

After tax income = 33600

Add back depreciation = 98000

OCF = 131600

Step 2: Cash flows

Year 0 = Purchase price+ NWC

= -490000-35000 = -525000

Year 1 to 4 : OCF

= 131600

Year 5: OCF+NWC + After tax salvage

= 131600+35000+40000*(1-0.30)

= 194600

Timeline

Year                    0                          1                          2                          3                            4                          5

Cash flow      -525000               131600               131600               131600 131600    194600