Question

Your firm is considering an overseas expansion. Below is the information that you have been given regarding the project: Initial Equipment Cost: $100m. Life of System: 5 years. Depreciation method: Straight line Depreciation. Expected overseas sales: $130m per year. Raw materials: $75m per year. Salaries for new workers: $25m per year. Net Working Capital necessary for plant to operate effectively: $25m (assume that this investment is required at the start of the project and is recovered when the plant shuts down after 5 years.) Marginal Tax Rate on income and capital gains: 40% Expected salvage value of equipment after 5 years: $30m. What will be the cash flows of this project in millions?

Answer 1

Solution :

1. Calculation of Depreciation per annum as per Straight line method of depreciation.

=( Purchase cost - Salvage value ) / Useful life

= ($ 100 Million - $ 30 Million) / 5 = $ 20 Million

Thus depreciation per annum = $ 20 Million

2. Calculation of Cash Flow after tax per annum.

Statement showing cash Inflows of the project per annum :

Sl.No.	Particulars	Amount in million Dollars
1	Sales	130
2	Less: Raw Materials	-75
3	Less : Salaries	-25
4	Less : Depreciation	-20
5	Earnings before Interest and Tax (EBIT)	10
6	Less: Tax @ 40 %	-4
7	Earnings after tax	6
8	Add back : Depreciation	20
9	Annual cash Inflow after tax	26

3.Statement showing cash flows of the project year wise :

1. Year 1 - Cash outflows

a. Initial Investment                 : 100 Million Dollars

b. Add : Initial Working capital : 25 Million Dollars

Total cash outflow during year 1 : - 125 Million Dollars   ( 100 + 25 = 125 )

Year 2 to Year 4 :

Net cash outflows Per annum during these years : 26 Million Dollars

Year 5 :

a. Net cash Inflow per annum : 26 Million Dollars

b. Add: Recovery of Initial Working Capital    : 25 Million Dollars

c. Add: After tax salvage vale of Equipment

   ( 30 Million dollars ( 1 - 0.4) ) = 18 Million Dollars   : 18 Million Dollars

d. Total Cash inflows in year 5 (26+25+18)           : 69 Million Dollars

Thus the answer is the last option -125/26/26/26/26/69