In: Finance
Colsen Communications is trying to estimate the first-year cash flow (at Year 1) for a proposed project. The financial staff has collected the following information on the project:
Sales revenues | $25 million |
Operating costs (excluding depreciation) | 17.5 million |
Depreciation | 5 million |
Interest expense | 5 million |
The company has a 40% tax rate, and its WACC is 14%.
Write out your answers completely. For example, 13 million should be entered as 13,000,000.
(a)-The project's operating cash flow for the first year (t = 1)
The project's operating cash flow for the first year = EBIT(1 – Tax rate) + Depreciation Expenses
= [(Sales Revenue – Operating Costs – Depreciation Expenses) x (1 – Tax rate)] + Depreciation Expenses
= [($25,000,000 - $17,500,000 - $5,000,000) x (1 – 0.40)] + $5,000,000
= [$2,500,000 x 0.60] + $5,000,000
= $1,500,000 + $5,000,000
= $6,500,000
The project's operating cash flow for the first year will be $6,500,000
(b)-Change in cash flow if this project would cannibalize other projects by $2.50 million of cash flow before taxes per year
If this project would cannibalize other projects by $2.50 million of cash flow before taxes per year, then the Operating cash flow would be reduced to the extent of after-tax amount cannibalized.
Therefore, the firm's new Operating cash flow (OCF) = Old project's operating cash flow – [Amount cannibalized x (1 – Tax rate)]
= $6,500,000 - [$2,500,000 x (1 – 0.40)]
= $6,500,000 - [$2,500,000 x 0.60]
= $6,500,000 - $1,500,000
= $5,000,000
Hence, the firm's OCF would now be $5,000,000
(c)-Change in firm's project's cash flow if the tax rate dropped to 30%
Operating cash flow = [(Sales Revenue – Operating Costs – Depreciation Expenses) x (1 – Tax rate)] + Depreciation Expenses
= [($25,000,000 - $17,500,000 - $5,000,000) x (1 – 0.30)] + $5,000,000
= [$2,500,000 x 0.70] + $5,000,000
= $1,750,000 + $5,000,000
= $6,750,000
Therefore, the Change in Operating cash flow = $6,750,000 - $6,500,000
= $250,000
Hence, the firm's project's cash flow would Increase by $250,000