Question

Colsen Communications is trying to estimate the first-year cash flow (at Year 1) for a proposed project. The assets required for the project were fully depreciated at the time of purchase. The financial staff has collected the following information on the project:

Sales revenues	$20 million
Operating costs	16 million
Interest expense	1 million

The company has a 25% tax rate, and its WACC is 13%.

Write out your answers completely. For example, 13 million should be entered as 13,000,000.

1. What is the project's operating cash flow for the first year (t = 1)? Round your answer to the nearest dollar.
   $   
2. 
   
3. If this project would cannibalize other projects by $1 million of cash flow before taxes per year, how would this change your answer to part a? Round your answer to the nearest dollar.
   The firm's OCF would now be $   .

Answer 1

(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 – 0.40)] + Depreciation Expenses

= [($20,000,000 - $16,00,000 - $0) x (1 – 0.25)] + $0

= [$4,000,000 x 0.75] + $0

= $3,000,000 + $0

= $3,000,000

(b)-Change in cash flow if this project would cannibalize other projects by $1 million of cash flow before taxes per year

If this project would cannibalize other projects by $1 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)]

= $3,000,000 – [$1,000,000 x (1 – 0.25)]

= $3,000,000 – [$1,000,000 x 0.75]

= $3,000,000 - $750,000

= $2,250,000

“Hence, the firm's OCF would now be $2,250,000”