Question

Beechtree Furniture Company is considering adding a new line to its product mix. The production line would be set up in unused space in Beechtree’s main plant. The machinery’s invoice price would be approximately $250,000; another $15,000 in shipping charges would be required; and it would cost an additional $18,000 to install the equipment. Further, the firm’s inventories would have been increased by $22,000 to handle the new line. The machinery has an economic life of 4 years and will be the depreciated fully using the straight-line method. The machinery is expected to have a salvage value of $10,000 after 4 years of use. The new line would generate $72,000 in incremental sales and $48,000 in incremental costs (before taxes and excluding depreciation) in each of the next 4 years. The firm’s tax rate is 25 percent, and its overall weighted average cost of capital is 12 percent.

A. What is Beechtree's net investment outlay on this project (yr 0)?

b. What are the net cash flows for the first year (yr 1) of the project?

C. If the project is terminated at the end of yr 4 and the machine is sold for the expected salvage value, what is the net cash flow at the time the project is terminated?

Answer 1

Time line		0	1	2	3	4
Cost of new machine		-283000
Initial working capital		-22000
=A. Initial Investment outlay		-305000
							100.00%
Sales			72000	72000	72000	72000
Profits	Sales-variable cost		24000	24000	24000	24000
-Depreciation	Cost of equipment/no. of years		-70750	-70750	-70750	-70750	0	=Salvage Value
=Pretax cash flows			-46750	-46750	-46750	-46750
-taxes	=(Pretax cash flows)*(1-tax)		-35062.5	-35062.5	-35062.5	-35062.5
+Depreciation			70750	70750	70750	70750
=b. after tax operating cash flow			35687.5	35687.5	35687.5	35687.5
reversal of working capital						22000
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)					7500
+Tax shield on salvage book value	=Salvage value * tax rate					0
=C. Terminal year after tax cash flows						29500.00