Question

You would like to start your own business. You collect the following information on the initial costs:

Cost of Plant and Equipment = $ 500,000

Licensing and Legal Costs = $ 50,000

You can claim an investment tax credit of 10% on plant and equipment. You also have been left a tidy inheritance that will cover the initial cost, and your estimated opportunity cost is 10%. You estimate that you can sell 1 million bottles a year at $1 a bottle. You estimate your costs as follows:

Variable costs/bottle = 50 cents

Fixed Costs/ year = $ 200000

Adding up state, local, and federal taxes, you note that you will be in the 50% tax bracket.

A) To be conservative, you assume that you will terminate the business in 5 years and that you will get nothing from the plant and equipment as salvage (you also use straight line depreciation).

B) As a final consideration, you note that starting this business will mean that you will not be able to take the investment banking job you have been offered (which offered $ 75000 a year for the next 5 years). Should you take on the project?

Answer 1

Given data in the question

Cost of plant and equipment =$500000

Licensing and Legal costs = $ 50000

Sales = 1000000

Variable cost = 50% of Sales

Fixed Cost = $200000

Tax = 50% Deprication = SLM Life of the project = 5 years.

Statement Showing Cash flow from the project.

Sales	1000000
Less Variable cost @ 50%	500000
operating profit	500000
Less Fixed Cost	200000
Earnings before interest tax and depreciation	300000
Less Depreciation	100000
Earnings before interest and Tax	200000
Less Tax @ 50 %	100000
Earning After Tax	100000
ADD Depreciation (Noncash expense) NOTE	100000
Cash Flow (Per year)	200000

NOTE Depreciation(Non-Cash Expense) amount is added back to the Earning After Tax (EAT) to

Calculation of Depreciation

The total cost of equipment / Number of Year

$500000/5 = $100000

Life of the project = 5

Cash Flow from the project during the life = 200000 * 5 = $1000000

Cash Flow from Investment banking job = 750000 * 5 = $375000

YES, the project should be taken because of higher cash flow.