Question

Explorer, Inc. is considering a new 4-year project that requires an initial fixed asset (equipment) investment of $200,000. The fixed asset is three-year MACRS property for tax purposes. In four years, the equipment will be worth about half of what we paid for it. The project is estimated to generate $500,000 in annual sales, with costs of $400,000. The firm has to invest $100,000 in net working capital at the start. After that, net working capital requirements will be 25 percent of sales. The tax rate is 40 percent. What is the incremental cash flow in year 4?

		$65,928
		$71,848
		$125,928
		$250,928
		$290,928

Answer 1

	Year 0	Year 1	Year 2	Year 3	Year 4
Annual Sales	-	500,000	500,000	500,000	500,000
Less: Costs	-	400,000	400,000	400,000	400,000
Earnings before Depreciation	-	100,000	100,000	100,000	100,000
Depreciation % (MACRS 3-year)	-	33.33%	44.45%	14.81%	7.41%
Less: Depreciation (Cost * Dep %)	-	66,660	88,900	29,620	14,820
Income before tax	-	33,340	11,100	70,380	85,180
Tax at 40%	-	13,336	4,440	28,152	34,072
Income after tax	-	20,004	6,660	42,228	51,108
Add back Depreciation*	-	66,660	88,900	29,620	14,820
Cash flow from operations	-	86,664	95,560	71,848	65,928
Initial Investment	(200,000)	-	-	-	-
Investment in NWC**	(100,000)	(25,000)	-	-	125,000
After tax cash flow from sale of asset***	-	-	-	-	60,000
Total Cash flow	(300,000)	61,664	95,560	71,848	250,928
Incremental cash flow in year 4 is	250,928

Notes:

*We add back depreciation because it is a tax deductible expense but also a non-cash expense. Meaning no cash outflow is there in depreciation expense.

**NWC stands for Net Working Capital. NWC is released at the winding up of the project. So we add it back in year 4.

*** Asset is worth half of the initial price, that is $200,000 / 2 = $100,000. Since asset is fully depreciated, this amount is gain on sale. So tax is calculated on $100,000.
That means after tax cash flow = Sale value - tax
= 100,000 - (40% of 100,000)
= 100,000 - 40,000
= $60,000

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