Question

Hawaiian Coconut Milkshakes Inc. considers the following project. They would like to expand and add a pineapple branch. The firm has paid $95,000 to a consultant in order to find out more about the available projects and possibilities. The marketing department has done extensive consumer research on the potential demand for the new shakes. The total costs for this research has been $275,000. Based on this research, you are now considering opening up a Pineapple Juice division in the firm. The expected sales for this project are $1,600,000 per year for the next 2 years and $1,400,000 for the third and final year. Accepting the project would mean that you could use a currently owned empty storage unit. This storage unit consists of a 12,000 square feet building, for which you paid $50,000 in 1985. This storage unit has been fully depreciated and has a current market value of $90,000, which is expected to remain stable over time regardless of its use. Accepting the project would also mean that your current coconut shake sales are affected. In fact, you expect to see your current total after-tax cash flows (not revenues!) from coconut shakes (which are currently $1 million per year) increase by 14% (i.e., $1,140,000 yearly) when the pineapple project is operational as a result of this new project. These cash flows are expected to remain at this level for as long as the pineapple project is operational. Manufacturing plant and equipment for this project (other than the storage unit) will cost $900,000 and will be depreciated according to a straight-line method over the life of the project. The market value of the manufacturing plant and equipment at the end of the project (t = 3) is $175,000. Variable costs are projected at 75% of sales. There are no fixed costs associated with the project. Net working capital requirements are $55,000 at the start, and then respectively 12% and 18% of sales in t = 1, and t = 2. At t = 3 the NWC investments will be recovered. The required rate of return on this project is 18% and the corporate tax rate is 34%. [Hint: figure out for t = 0, 1, 2, 3 what the cash flows from the project are in each year (i.e., cash flow from assets, using the cash flow identity: CF from Assets = Operating CF - additions to NWC - Net Capital Spending, where Operating CF = EBIT + Depreciation – Taxes)]

Answer 1

$95,000 consultancy fee = sunk cost = irrelevant cash flow
$275,000 marketing research costs = sunk cost = irrelevant cash flow
$50,000 cost of building in 1985 = sunk cost = irrelevant cash flow
$90,000 market value of building = opportunity cost = relevant cash flow
increase in coconut shakes = side effect = relevant cash flow
Income Statement
	0	1	2	3
Revenues	-	$1,600,000	$1,600,000	1,400,000
Variable Costs 75% (-)	-	1,200,000	1,200,000	1,050,000
Opportunity Costs (-)	$59,400 (a)	-	-	-
Side Effects (-)	-	(140,000) (b)	-140,000	-140,000
Depreciation (-)	-	150,000 (c)	300,000	300,000
EBIT	-59,400	390,000	240,000	190,000
Tax 34%(-)	-	132,600	81,600	64,600
Net Income	-59,400	257,400	158,400	125,400
Operating Cash Flow	-59,400	407,400	458,400	425,400
(a) The alternative to using the building for the project is to sell if for the market price of $90,000. Because the book value of the building is $0, the profit you make from selling it is $90,000, which is taxable. So, the after-tax cash flow is (1 - 0.34) * $90,000 = $59,400
(b) The incremental effect on the sales of coconut shakes is 14% of $1 million = $140,000.
(c) Straight-line depreciation is $900,000 / 3 years = $300,000 per year. Using the half-year convention, only $150,000 is used for year 1, and the final $150,000 will occur in year 4. However, in year 3 we can sell the machine, so we won't take the depreciation in year 4.
Additions to Net Working Capital
Year	Total Net Working Capital	Incremental Cash Flow
0	$55,000	$55,000
1	192,000 (d)	137,000
2	252,000	60,000
3	-	(252,000)(e)
(d) 12% of $1,600,000 (revenues)
(e) recovery of investments in NWC
Year	Operating Cash Flow	- additions to NWC	- Net Capital Spending	Cash Flow from Project
0	($59,400)	$55,000	$900,000	($1,014,400)
1	407,400	137,000	-	270,400
2	458,400	60,000	-	398,400
3	425,400	-252,000	(166,500)(f)	843,900
(f) Value from selling the machine in year 3. Note that the book value is still $150,000 in year 3 so there is 25,000 taxable profit in this case from selling it for $175,000. You only pay taxes on the difference between the market price and the book value. salvage value net of tax 175000-25000*34% = 166500
Note: I have clearly mentioned assumptions, if there is any difficulty in matching answers, then please adjust
depreciation per year 300000 without half year convention, it will also help you in understanding the case properly
with the given format, stiil need any further help, please ask in comment.