Question

IBM is considering a new expansion project and the finance staff has received information summarized below:

- The project require IBM to purchase $1,000,000 of equipment in 2013 (t=0)

- Inventory will increase by $100,000 and accounts payable will rise by $50,000

- The project will last for four years. The company forecasts that they will sell 1,000,000 units in 2014, 2,000,000 units in 2015, 3,000,000 units in 2016, and 4,000,000 units in 2017. Each unit will sell for $3.00

- The fixed cost of producing the product is $2 million each year

- The variable cost of producing each unit is $1.00 each year

- The equipment will be depreciated under the MACRS system using the applicable rates of 33%, 45%, 15%, and 7% respectively

- When the project is completed in 2017 (t=4), the company expects that it will be able to salvage the equipment for $100,000, and it expects that it will fully recover the NWC.

- The estimated tax rate is 40%

- Based on the perceived risk, the project's WACC is estimated to be 12%

What is the total investment amount at the start of the project?

What is the depreciation amount for each year? Create a depreciation schedule

Compute the book values for each year

Compute the after-tax salvage value

Calculate the net income during the project's life for each year and the Operating Cash Flows

Answer 1

a) total investment amount at the start of the project :

Purchase of equipment	1,000,000
Increase in net working capital [100000-50000]	50,000
Initial investment	1,050,000

b & c)

Year	Depreciation expense	Accumulated depreciation	Book value at end of year
1	1000000*33%= 330,000	330000	1000000-330000= 670000
2	1000000*45%= 450000	330000+450000=780000	1000000-780000= 220000
3	1000000*15%= 150000	780000+150000= 930000	1000000-930000= 70000
4	1000000*7%= 70000	1000000	0
Total	1,000,000

d)

After tax salvage value = sale value (1-tax rate)

                                      = 100000 (1-.40)

                                       = 100000*.60

                                       = $ 60000

e)

	2014	2015	2016	2017
Selling price per unit	3	3	3	3
less:variable cost per unit	1	1	1	1
contribution margin per unit	2	2	2	2
Number of units	1000000	2000000	3000000	4000000
Total contribution [contribution margin per unit *number of units]	2000000	4000000	6000000	8000000
less:Fixed cost	2000000	2000000	2000000	2000000
Income before tax	0	2000000	4000000	6000000
Less:Tax expense	0	-800000 [2000000*.40]	-1600000 [4000000*.40]	- 2400000 [6000000*.40]
Net income	0	1200000	2400000	3600000
Add:depreciation expense (non cash)	330000	450000	150000	70000
cash flow	330000	1650000	2550000	3670000

**Assuming fixed cost of 2million includes depreciation expense