Question

After reading a demographic study on the habits and modern lifestyles of the American public, TI Inc. decided   launching a new product, Gizmo ™. TI’s CEO has asked you to determine whether or not to go ahead with the introduction of a new product. You have the following information:

                            

·       Most of the numbers for your estimates come from a study by marketing consultant that you received two months ago. The consulting fee was $80,000.

·       You will locate the production line for the product in a currently unused building with a current after-tax market value of $600,000. The warehouse has already been depreciated so its book value is zero.

·       The new equipment you must buy will cost $900,000. The equipment will be depreciated on a straight line basis over 10 years to zero.

·       You have just received the results of a marketing survey that indicates that revenues from sale of Gizmo ™ will be $650,000 per year for 10 years.

·       Variable costs will be 40% of sales per year.

·       Fixed costs will be $170,000 per year.

·       It is expected that at the end of year 10 you can sell the warehouse and equipment for $120,000.

·       TI’s marginal tax rate is 30%.

a) What is the appropriate amount to use as the initial cash flow (CFo)?

b) What is the appropriate amount to use as the annual operating cash flows from the project (OCF)?

c) Determine the after-tax salvage value of the project (the cash flow at the end of the project that comes from the sale of the project’s assets).

Answer 1

a) Initial Cash flow

Purchase cost of new Equipment = 900000

Add: Market value of Building =600000

Total = 1500000

Notes :

1. The consulting fee paid to marketing survey is a sunk cost and not relevant for decision making

2. It the project is not undertaken the unused building can be sold for 600000. Hence, this is an    oportunity cost forgone and relevant for decision making

b. Annual operating cash flows

Revenue = 650000

Less: Variable cost = 260000

Fixed cost = 170000

Balance    = 220000

Less: Depreciation = 78000 (900000-120000) / 10

Cash flow before tax    = 142000

Tax @ 30%    = 42600

Cash flow after tax    =99400

Add: Depreciation = 78400

Annual operating cash flows =177800

Annual operating cash flow after tax is 177800

c. Salvage value of the asset = 120000

Less: Book value @ end of year 10 = 0 (Straight line method, Hence the book value = 0)

Profit = 120000

Less : tax @ 30% = 36000

After tax slvage value = 84000