Question

Star Inc. is considering a proposal to manufacture high-end protein bars used as food supplements by body builders. The project requires use of an existing warehouse, which the firm acquired three years ago for $1.2m and which it currently rents out for $120,000. Rental rates are not expected to change going forward. In addition to using the warehouse, the project requires an up-front investment into machines and other equipment of $1.5m. This investment can be fully depreciated straight-line over the next 10 years for tax purposes. However, Star Inc. expects to terminate the project at the end of eight years and to sell the machines and equipment for $200,000. Finally, the project requires an initial investment into net working capital equal to 10% of predicted first-year sales. Subsequently, net working capital is 10% of the predicted sales over the following year. Net working capital will be fully recoverable at the end of the project. Sales of protein bars are expected to be $4.8m in the first year and to stay constant for eight years. Total manufacturing costs and operating expenses (excluding depreciation) are 75% of sales, and profits are taxed at 30%.

Estimate the after-tax cash flows for the project. To do this you must present two tables. The first table should show the inputs of the accounting flows to determine the after-tax income. The second table should show the inputs to determine the after-tax cash flows. IMPORTANT: You must show each input in your table as a separate row. DO NOT group inputs together.

Only work out the second table!

Answer 1

After tax cash flows (Free cash flows) are calculated as follows,

Particulars	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8
Net income	-	651,000	651,000	651,000	651,000	651,000	651,000	651,000	651,000
Depreciation	-	150,000	150,000	150,000	150,000	150,000	150,000	150,000	150,000
Investment activities
Cost of Equipment	(1,500,000)	-	-	-	-	-	-	-	-
Working capital	(480,000)	-	-	-	-	-	-	-	480,000
After tax Salvage value	-	-	-	-	-	-	-	-	230,000
Free cash flows	(1,980,000)	801,000	801,000	801,000	801,000	801,000	801,000	801,000	1,511,000

Net income is calculated as follows,

Particulars	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8
Revenue:
Sales	-	4,800,000	4,800,000	4,800,000	4,800,000	4,800,000	4,800,000	4,800,000	4,800,000
Expenses:
Manufacturing cost & Operating expenses	-	3,600,000	3,600,000	3,600,000	3,600,000	3,600,000	3,600,000	3,600,000	3,600,000
Depreciation	-	150,000	150,000	150,000	150,000	150,000	150,000	150,000	150,000
Loss of rental income		120,000	120,000	120,000	120,000	120,000	120,000	120,000	120,000
Taxable income	-	930,000	930,000	930,000	930,000	930,000	930,000	930,000	930,000
Less: Tax @ 30%	-	279,000	279,000	279,000	279,000	279,000	279,000	279,000	279,000
Net income	-	651,000	651,000	651,000	651,000	651,000	651,000	651,000	651,000

Depreciation is calculated as follows,

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8
Book value at the beginning of the year	1,500,000	1,350,000	1,200,000	1,050,000	900,000	750,000	600,000	450,000
Depreciation	150,000	150,000	150,000	150,000	150,000	150,000	150,000	150,000
Book value at the end of the year	1,350,000	1,200,000	1,050,000	900,000	750,000	600,000	450,000	300,000
Total accumulated depreciation	1,200,000

After tax Salvage value is calculated as follows,

Particulars	Amount
Cost of Equipment	1,500,000
Total accumulated depreciation	1,200,000
Book value	300,000
Sale value	200,000
Loss on sale	100,000
Tax shield on loss @ 30%	30,000
After tax Salage value	230,000