Question

XYZ, Inc. is considering a new three-year expansion project that requires an initial fixed assets investment of $1,500,000. The fixed asset will be depreciated using the MACRS 3-year class over its three year tax life. The fixed asset will have a market value of $325,000 at the end of the project. The project requires an initial investment in net working capital of $275,000. Net working capital will revert back to normal at the end of the project’s life. The project is estimated to generate $1,750,000 in annual sales, with annual costs of $575,000. The tax rate is 35%.

1. Calculate the initial investment (CF₀) for this project. (-$1,775,000)
2. Calculate the cash flows in years 1 and 2 for this project. (CF₁= $938,733, CF₂= $997,060)
3. Calculate the terminal cash flow and the total cash flow in year 3. (TCF= $525,152.5, CF₃= $1,366,707.5)

Answer 1

Initial Investment = $1,500,000
Useful Life = 3 years

Depreciation Year 1 = 33.33% * $1,500,000
Depreciation Year 1 = $499,950

Depreciation Year 2 = 44.45% * $1,500,000
Depreciation Year 2 = $666,750

Depreciation Year 3 = 14.81% * $1,500,000
Depreciation Year 3 = $222,150

Book Value at the end of Year 3 = $1,500,000 - $499,950 - $666,750 - $222,150
Book Value at the end of Year 3 = $111,150

After-tax Salvage Value = Salvage Value - (Salvage Value - Book Value) * tax rate
After-tax Salvage Value = $325,000 - ($325,000 - $111,150) * 0.35
After-tax Salvage Value = $250,152.50

Initial Investment in NWC = $275,000

Year 0:

Net Cash Flows = Initial Investment + Initial Investment in NWC
Net Cash Flows = -$1,500,000 - $275,000
Net Cash Flows = -$1,775,000

Year 1:

Operating Cash Flow = (Sales - Costs) * (1 - tax) + tax * Depreciation
Operating Cash Flow = ($1,750,000 - $575,000) * (1 - 0.35) + 0.35 * $499,950
Operating Cash Flow = $938,732.50

Net Cash Flows = Operating Cash Flow
Net Cash Flows = $938,732.50

Year 2:

Operating Cash Flow = (Sales - Costs) * (1 - tax) + tax * Depreciation
Operating Cash Flow = ($1,750,000 - $575,000) * (1 - 0.35) + 0.35 * $666,750
Operating Cash Flow = $997,112.50

Net Cash Flows = Operating Cash Flow
Net Cash Flows = $997,112.50

Year 3:

Operating Cash Flow = (Sales - Costs) * (1 - tax) + tax * Depreciation
Operating Cash Flow = ($1,750,000 - $575,000) * (1 - 0.35) + 0.35 * $222,150
Operating Cash Flow = $841,502.50

Terminal Cash Flow = NWC recovered + After-tax Salvage Value
Terminal Cash Flow = $275,000 + $250,152.50
Terminal Cash Flow = $525,152.50

Net Cash Flows = Operating Cash Flow + Terminal Cash Flow
Net Cash Flows = $841,502.50 + $525,152.50
Net Cash Flows = $1,366,655