Question

Question 5.

The Rubio’s Fantastic Cs is a medium-size, Los Angeles based company that has been in business for the last ten years. It specializes in manufacturing the air conditioners. Over the last two years, the Rubio’s has spent $20,000 developing a new energy efficient and eco-friendly air conditioner called EcoStar.

Suppose you are a financial consultant advising the Rubio’s on whether to build a new plant in San Diego that will manufacture the EcoStar. The current date is December 31, 2017. The plant will be built over the two years and will be ready to start production on January 1, 2020. The plant is expected to operate only for the two years and so it will cease production on December 31, 2021. The investment for the plant requires an outlay of $10 million to be paid at the end of 2017 year. The IRS rules prescribe that this expenditure is depreciated using the straight-line depreciation schedule (to 0$) over five years as soon as the plant starts producing. The plant is expected to be reselled for $5 million on December 31, 2021. The plant will be built on the land that could be rented out for $375,000 a year.

To launch the manufacture of the EcoStar, the firm would also need to acquire new equipment. The equipment will cost $1 million to be paid at the end of 2019 year and will be depreciated using the straight line depreciation over the two years the plant is manufacturing the EcoStar. After two-years of the manufacture the equipment has no salvage value.

The Fabio’s new plant will produce 100,000 air conditioners a year. The EcoStar air conditioner can be sold at $500 per unit. Raw materials costs are $220 per unit and total labor costs are $500,000 a year. These revenues and costs are expected to be the same for the two year the plant is producing.

The working capital required on December 31, 2019 to allow inventories to be financed during the first year of productions is $100,000. Working capital needs for the second year will be $200,000. When the plant ceases manufacture all the working capital will be recovered (i.e. working capital equals $0 on December 31, 2021).

The Rubio’s Fantastic Cs has a corporate tax rate of 20% and other profitable ongoing operations. The opportunity cost of capital for this kind of project is 10%.

For all questions state your solution in millions of dollars (i.e. instead of writing $1,000,000 write $1m).

Part (a) What are the depreciation tax shields associated with the purchase of new equipment?

Year     Depreciation Schedule    Depreciation Amount   Depreciation Tax Shields

2017
2018
2019
2020
2021

Part (b)

What are the depreciation tax shields associated with the new plant?

Year     Depreciation Proportion Depreciation Amount   Depreciation Tax Shields

2017
2018
2019
2020
2021

Part(c)

What is the book value of the equipment and plant in every year?

Year	Book Value of Equipment	Book Value of Plant
2017
2018
2019
2020
2021

Part (d)

What is the capital gain tax (capital loss tax credit) that the firm incurs on December 31, 2021 when selling the plant?

Part (e)

What is the plant’s salvage value (net of taxes)?

Part (f)

What are the firm’s NOPAT in every year if the firm builds the plant and starts manufacturing the EcoStar? First, give the answers to the following questions and then fill in the table.

1. What are the firm’s revenues in the first year of production?
2. What are the firm’s costs in the first year of production (excluding depreciation)?
3. What is the firm’s EBIT (earnings before interest and tax) in the the first year of production?
4. What is the firm’s income taxes in the first year of production?
5. What is the firm’s NOPAT (net operating profit after tax) in the first year of production?

		2017	2018	2019	2020	2021
+ - - -	Revenues Raw Materials Costs Labor Costs Depreciation
= -	EBIT Tax
=	NOPAT

Part (g)

What is the level of NWC (net working capital) required for the EcoStar manufacture in every year?

2017     2018       2019        2020     2021

Net Working Capital

Part (h)

What are the free cash flows of the firm in every year that the firm manufactures the EcoStar?

2017 2018 2019 2020 2021

Answer 1

Part-a--Year-wise depreciation tax shields associated with the purchase of new equipment

Year	Depn.%	Depn.amt.		Depn. Tax shields
2017
2018
2019
2020	50%	1000000*50%=	500000	500000*20%=	100000
2021	50%	1000000*50%=	500000	500000*20%=	100000

Part-b--Year-wise depreciation tax shields associated with the purchase of new plant

Year	Depn.%	Depn.amt.		Depn. Tax shields
2017
2018	20%
2019	20%
2020	20%	10000000*20%=	2000000	2000000*20%=	400000
2021	20%	10000000*20%=	2000000	2000000*20%=	400000

Part-c--Book value of equipment & plant in every year

Year	BV of eqpt.	BV of plant
2017
2018		10000000
2019		10000000
2020	500000	8000000
2021	0	6000000

Part-d
Sale value of plant On Dec 31, 2021	5000000
Book value, on Dec 31, 2021	6000000
Loss on sale	1000000
Capital loss tax credit(1000000*20%)	200000

Part-e.--Plant's salvage value net of taxes

Sale value+Tax credit on loss

5000000+200000=

5200000

i. The firm’s revenues in the first year of production
Revenues	100000*500=	50000000
ii.Firm's cost in the first year of production
Raw materials	100000*220=	22000000
Labor costs		500000
Total costs		22500000
iii.EBIT ---- Revenues-costs		27500000
iv. Income taxes in the first year of production
(EBIT-Depn.)*20%
Ie.(27500000-2500000)*20%=
5000000
v.NOPAT in first year of production
EBIT-Depn.-Income tax
Ie.(27500000-2500000)-5000000=
20000000

		2017	2018	2019	2020	2021
Revenues					50000000	50000000
Raw Materials Costs					-22000000	-22000000
Labor Costs					-500000	-500000
Depreciation					-2500000	-2500000
EBIT					25000000	25000000
Tax		-5000000	-5000000
NOPAT					20000000	20000000

Part-g
NWC reqd.				100000	200000	0
Change in NWC				-100000	-100000	200000

		2017	2018	2019	2020	2021
	Year	0	1	2	3	4
Part-h--Free cash flows, in every year
1.Investment in plant		-10000000
2.Investment in equipment				-1000000
3.After-tax plant salvage						5200000
4. NWC				-100000	-100000	200000
Operating cash flows
5.NOPAT					20000000	20000000
6.Add back:depn.					2500000	2500000
7.After-tax rentals lost(375000*(1-20%)					-300000	-300000
8.Incremental OCFs(5+6+7)					22200000	22200000
9.Annual Free cash flows		-10000000	0	-1100000	22100000	27600000
10.PV F at 10%		1	0.90909	0.82645	0.75131	0.68301
11.PV at 10%(9*10)		-10000000	0	-909090.91	16604057.1	18851171
12. NPV at 10%(sum of row 11)		24546137.56