Question

1. Mr. Kent is working on the evaluation of a new project for his company. In year 3 of his evaluation, he estimates that sales and cost of sold would be $5.8 million and $3.48 million, respectively. The cost of the machine is $1 million, and it would depreciate using the straight line method for a useful life of 5 years. The corporate tax rate is 35 percent. Moreover, he expects an increase in working capital from $210,000 in year 2 to $305,000 in year 3. What are the pro forma earnings and cash flows for year 3?

Answer 1

Sales = $5.8 million

Cost of goods sold = $3.48 million

Machine cost = $1 million

Depreciation (Straight line over 5 years) = $1 million / 5 years = $0.2 million

Increase in working capital from 0.210 to 0.305 million results in a cash outflow = 0.305 - 0.210 = $0.095 million

Pro forma earnings for year 3

Earnings before depreciation and tax = Sales - Cost of goods sold

= 5.80 - 3.48

= $2.32 million

Earnings before tax = Earnings before depreciation and tax - Depreciation

= 2.32 - 0.20

= $2.12 million

Corporate tax rate = 35% or 0.35

Hence post-tax earnings or earnings after tax = 1 - 0.35 = 0.65

Earnings after tax = 0.65 x Earnings before tax

= 0.65 x 2.12

= $1.378 million

Pro forma earnings for year 3 = $1.378 million

Cash flows for year 3

Cash flows for year 3 = Pro forma earnings + Non-cash expenditure like depreciation - Net increase in working capital + Net decrease in working capital

(Note:

1. Non cash expenditure like depreciation added back to earnings after tax, since while it reduced earnings, it never resulted in a cash outflow

2. Since an increase in working capital would due to conversion of cash into non-cash working capital and results in a cash outflow, it is deducted and a decrease would be due to conversion of non-cash working capital into cash resulting in a cash inflow, it is added.)

Cash flows for year 3 = 1.378 + 0.200 - 0.095 + 0.000

= $1.483 million

Net cash inflow for year 3 = $1.483 million