Question

The Lee & Pearson Company is considering an expansion of its production facilities which will permit the firm to build and sell a new line of cell phones. The project requires a $10,000,000 capital investment and is expected to have a three-year economic life.

Other relevant information is:

• At the end of the project, the equipment can be sold for $300,000.
• The firm’s WACC is estimated at 8%.
• Incremental sales are projected to be $12,000,000 per year
• Annual costs (excluding depreciation) are estimated to be $3,000,000.
• The project requires a $2,000,000 initial investment in net operating working capital.
• The expected tax rate is 33%.

The MACRS depreciation schedule in the list below will be used.

• YEAR 1 = 0.4445
• YEAR 2 = 0.3333
• YEAR 3 = 0.1481
• YEAR 4 = 0.0741

A) What is the project cash flow for year 0

B) What is the project cash flow for year 1

C) What is the project cash flow for year 2

D) What is the project cash flow for year 3

Answer 1

Calculation of Project Cash Flows
Particulars	Year 0	Year 1	Year 2	Year 3
Initial Investment
Capital Investment	-10,000,000
Investment in net Working Capital	-2,000,000
Net Investment (A)	-12,000,000
Operating Cash Flows
Incremental Annual Sales (B)		12,000,000	12,000,000	12,000,000
Annual Costs (C)		3,000,000	3,000,000	3,000,000
Depreciation (D) $10,000,000*0.4445,0.3333,0.0.1481		4,445,000	3,333,000	1,481,000
Profit before tax (E = B-C-D)		4,555,000	5,667,000	7,519,000
Tax @33% (F = E*33%)		1,503,150	1,870,110	2,481,270
Profit After tax (G = E-F)		3,051,850	3,796,890	5,037,730
Depreciation (H = D)		4,445,000	3,333,000	1,481,000
Net Operating Cash Flows (I = G+H)		7,496,850	7,129,890	6,518,730
Terminal Value
Sale Value (J)				300,000
Less: unclaimed Depreciaiton (K) ($10,000,000*0.0741)				741,000
Profit on sale (L = J-K)				-441,000
Tax rebate on sale (M = L*33%)				-145530
Profit after tax (N = L-M)				-295,470
Add back Unclaimed Depreciation (O = M)				741,000
Net Sale Value (P = N+O)				445,530
Recovery of Working Capital (Q)				2,000,000
Net Terminal value (R = P+Q)				2,445,530
Total Cash Flow (S = A+I+R)	-12,000,000	7,496,850	7,129,890	8,964,260
Project Cash Flow in Year 0 is -$12,000,000
Project Cash Flow in Year 1 is $7,496,850
Project Cash Flow in Year 2 is $7,129,890
Project Cash Flow in Year 3 is $8,964,260