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

Answer : Correct option is 125,928

Calculation of Incremental Cash Flow for year 4

Below is the table showing Calculation of Incremental Cash Flow

Annual Sales	500,000
Annual Cost	(400,000)
Depreciation for year 4 (200000 * 7.41%)	(14820)
Earning Before Taxes	85,180
Taxes @ 40% on 85180	(34,072)
Earning after Tax	51,108
Add : Depreciation ( Being Non Cash Item )	14820
Operating Cash Flow	65928
Net Proceeds from sale of Equipment (Working Note)	60000
Total Operating Cash Flow for year 4	125928

Working Note :

Book Value = 0 (Since it is fully Depreciated Salvage Value = 200000 / 2 = 100000

Gain on Sale = Salvage Value - Book Value

= 100000 - 0

= 100000

Tax on Gain on Sale = 100000 * 0.40 = 40000 Net Proceeds = Salvage Value - Tax on Gain on Sale = 100000 - 40000 = 60000

Note : Working Capital Requirement and Recapture will nullify its effect.