Question

The company X has spent total of $150,000 so far for research and development for this product A, and just paid another $100,000 to a consulting firm to do the marketing research. The consulting firm has estimated that the product will have a very short life of only 4 years.

It has also estimated that the annual sales volume will be 60,000 units and the selling price is $50 per unit. Further it has predicted that the sales volume of a current product will drop by 20,000 units because A can substitute the current product. The selling price for the current product is $35 per unit.

X has calculated that it needs a new machine for A production. The total costs, including installation and shipping, for the machine are $1,500,000. X uses the MACRS method to depreciate all of its assets (see depreciation rates in the table below), and it expects that the machine will last 5 years. The machine can be sold for $500,000 when Stanton stops using the machine. The variable costs for the current product and A are $15 and $30 per unit, respectively. The annual fixed operating costs and advertising expenses will increase (from the current level) by $200,000. The working capital will increase by $100,000 at the beginning of the project due to an increase in inventory, and it will be recovered at the end of the project. The company's marginal tax rate is 30%.

a) years of cash flow?

b) sunk costs?

c) initial investment?

d) cash flow from change in nwc at year 0

e) ocf year 1?

f) terminal cash flow?

g) total cash flow?

Answer 1

Tax rate		30%
Calculation of annual depreciation
Depreciation		Year-1	Year-2	Year-3	Year-4		Total
Cost		$    1,500,000	$   1,500,000	$    1,500,000	$    1,500,000
Dep Rate		20.00%	32.00%	19.20%	11.52%
Depreciation	Cost * Dep rate	$       300,000	$      480,000	$       288,000	$       172,800		$    1,240,800
Calculation of after-tax salvage value
Cost of machine			$   1,500,000
Depreciation			$   1,240,800
WDV	Cost less accumulated depreciation	$      259,200
Sale price			$      500,000
Profit/(Loss)	Sale price less WDV	$      240,800
Tax	Profit/(Loss)*tax rate	$        72,240
Sale price after-tax	Sale price less tax		$      427,760
Calculation of annual operating cash flow
		Year-1	Year-2	Year-3	Year-4
No of units		60,000	60,000	60,000	60,000
Selling price		$                50	$               50	$                50	$                50
Operating ost		$                30	$               30	$                30	$                30
Sale		$    3,000,000	$   3,000,000	$    3,000,000	$    3,000,000
Less: Operating Cost		$    1,800,000	$   1,800,000	$    1,800,000	$    1,800,000
Contribution		$    1,200,000	$   1,200,000	$    1,200,000	$    1,200,000
Less: contribution lost existing product	20000*(35-15)	$       400,000	$      400,000	$       400,000	$       400,000
Less: Fixed and Marketting cost		$       200,000	$      200,000	$       200,000	$       200,000
Less: Depreciation		$       300,000	$      480,000	$       288,000	$       172,800
Profit before tax (PBT)		$       300,000	$      120,000	$       312,000	$       427,200
Tax@30%	PBT*Tax rate	$         90,000	$        36,000	$         93,600	$       128,160
Profit After Tax (PAT)	PBT - Tax	$       210,000	$        84,000	$       218,400	$       299,040
Add Depreciation	PAT + Dep	$       300,000	$      480,000	$       288,000	$       172,800
Cash Profit after-tax		$       510,000	$      564,000	$       506,400	$       471,840
Calculation of NPV
Year		Capital	Working capital	Operating cash	Annual Cash flow
0		$ (1,500,000)	$     (100,000)		$ (1,600,000)
1				$       510,000	$       510,000
2				$       564,000	$       564,000
3				$       506,400	$       506,400
4		$       427,760	$      100,000	$       471,840	$       999,600
Sunk Costs
Research & development cost	$            150,000
Marketting research	$            100,000
Total sunk cost	$            250,000