Question

As part of its planning for the coming Christmas season, Criswell Motorsports is considering whether to expand its product line that currently consists of skateboards to include gas-powered skateboards. The company feels it can sell 2,000 of these per year for 10 years (after which time this project is expected to shut down, with solar-powered skateboards taking over). Each gas-powered skateboard would have variable costs of $40 and sell for $200; annual fixed costs associated with production would be $160,000. In addition, there would be a $450,000 initial expenditure associated with the purchase of new production equipment. It is assumed that the simplified straight-line method would be used to depreciate this initial expenditure down to zero over 10 years. The project would also require a one-time initial investment of $50,000 in net working capital associated with inventory, and this working-capital investment would be recovered when the project is shut down. Finally, the firm’s marginal tax rate is 34 percent.

a. What is the initial outlay associated with the project?

b. What are the annual net cashflows associated with this project for Year 1 through 9?

c, What is the terminal cashflow in year 10 (that is what is the free cashflow in Year 10 plus any additional cash flow associated with termination of the project?)

Please no excel. Thank you!

Answer 1

Ans

Part a) Calculation of Initial Outlay associated with project

Particulars	Amount
Cost of new equipment	$450,000.00
Add: Investment in working capital	$50,000.00
Total Initial Outlay	$500,000.00

(Note: Investment in working capital involves commitment of companies current assets towards the project and it is treated as cash outflow just like any capital expenditure.)

Part b) Calculation of annual net cash flows associated with this project for Year 1 through 9

Particulars	Amount
Unit sales per year	2,000 units
Selling Price pu ...a	$200.00
Variable Cost pu ...b	$40.00
Contribution pu ,...a - b	$160.00
Contribution ($) (Note 1)	$320,000.00
Less: Annual Fixed cost	($160,000.00)
Less: Depreciation (Note 2)	($45,000.00)
Earnings before tax	$115,000.00
Less: Tax @ 34%	($39,100.00)
Earnings after tax	$75,900.00
Add: Depreciation (note 2)	$45,000.00
Annual Net Cash inflows	$120,900.00

Annual net cash flows associated with this project for Year 1 through 9 = $120,900.00. The annual net cash flows shall remain constant over the life of project.

Note

1. Contribution ($) = Contribution pu * Unit sales per year

2. Calculation of Depreciation

Cost of equipment    ....a	$450,000.00
Life ....b	10 years
Depreciation as per SLM ....a / b	$45,000.00

3. Since, Depreciation is a non cash expenditure it will be added back to earnings after tax to calculate the cash flows.

Part c) Calculation of terminal cashflow in year 10

Particulars	Amount
Annual net cash inflows	$120,900.00
Add: Recovery of working capital	$50,000.00
Terminal cashflow in year 10	$170,900.00

(Working capital released from shutting of the project is treated as a cash inflow)