Question

Canyon Buff Corp. has developed a new construction chemical that greatly improves the durability and weatherability of cement-based materials. After spending $500,000 on the research of the potential market for the new chemical, Canyon Buff is considering a project that requires an initial investment of $9,000,000 in manufacturing equipment.

• The equipment must be purchased before the chemical production can begin. For tax purposes, the equipment is subject to a 5-year straight-line depreciation schedule, with a projected zero salvage value. For simplicity, however, we will continue to assume that the asset can actually be used out into the indefinite future (i.e., the actual useful life is effectively infinite).

• Canyon Buff anticipates that the sales will be $30,000,000 in the first year (Year 1). They expect that sales will initially grow at an annual rate of 6% until the end of sixth year. After that, the sales will grow at the estimated 2% annual rate of inflation in perpetuity.

• The cost of goods sold is estimated to be 72% of sales.

• The accounting department also estimates that at introduction in Year 0, the new product's required initial net working capital will be $6,000,000. In future years accounts receivable are expected to be 15% of the next year sales, inventory is expected to be 20% of the next year’s cost of goods sold and accounts payable are expected to be 15% of the next year’s cost of goods sold.

• The selling, general and administrative expense is estimated to be $6,000,000 per year, but $1 million of this amount is the overhead expense that will be incurred even if the project is not accepted.

• The market research to support the product was completed last month at a cost of $500,000 to be paid by the end of next year.

• The annual interest expense tied to the project is $1,000,000

• Canyon Buff has a cost of capital of 20% and faces a marginal tax rate of 30% and an average tax rate is 20%.

QUESTION:

Use Excel to construct six-year pro forma income statements and calculate the incremental unlevered net income for the first six years.

Answer 1

Part (1)

Income Statement
Years		1	2	3	4	5	6
Sales $ (with 6% growth )		30000000	31800000	33708000	35730480	37874309	40146767
Less: Cost of goods sold (72% of sales)		21600000	22896000	24269760	25725946	27269502	28905672
Gross profit	(A)	8400000	8904000	9438240	10004534	10604806	11241095
Less: Overheads
Depreciation (9000000 / 5 years )		1800000	1800000	1800000	1800000	1800000	1800000
Annual interest		1000000	1000000	1000000	1000000	1000000	1000000
selling and admin expense		6000000	6000000	6000000	6000000	6000000	6000000
Fixed overhead expense		1000000	1000000	1000000	1000000	1000000	1000000
Total overheads	(B)	9800000	9800000	9800000	9800000	9800000	9800000
Net Profit (A -B)		-1400000	-896000	-361760	204534.4	804806.5	1441095
Less:Tax @ 20%		0	0	0	40906.88	160961.3	288219
Profit after Tax		-1400000	-896000	-361760	163627.5	643845.2	1152876
Assumption and Notes
1.It is assumed that Opening inventory value and closing inventory has already been adjusted in Cost of goods sold (72% ) of sales value ,since the formula for calculating cot of goods sold is (Opening stock + purchase ) -closing stock
2. Accounts receivable and payable does not have any impact in income statement
3.Market research expense is sunk cost hence not considered for income statement

Part (2)

Incremental unlevered income statement
Years		1	2	3	4	5	6
Sales $ (with 6% growth )		30000000	31800000	33708000	35730480	37874309	40146767
Less: Cost of goods sold (72% of sales)		21600000	22896000	24269760	25725946	27269502	28905672
Gross profit	(A)	8400000	8904000	9438240	10004534	10604806	11241095
Less: Overheads
Depreciation (9000000 / 5 years )		1800000	1800000	1800000	1800000	1800000	1800000
Annual interest		1000000	1000000	1000000	1000000	1000000	1000000
selling and admin expense		6000000	6000000	6000000	6000000	6000000	6000000
Total overheads	(B)	8800000	8800000	8800000	8800000	8800000	8800000
Incremental Revenue	(A- B)	-400000	104000	638240	1204534	1804806	2441095
Less :Tax @ 30%		0	31200	191472	361360.3	541441.9	732328.5
Profit after tax		-400000	72800	446768	843174.1	1263365	1708766
Add Back
Depreciation (9000000 / 5 years )		1800000	1800000	1800000	1800000	1800000	1800000
Annual interest		1000000	1000000	1000000	1000000	1000000	1000000
Cashflow (incremental income )		2400000	2872800	3246768	3643174	4063365	4508766
Note :Fixed cost anyhow going to be incurred and not taken for incremental cashflow calculations