Question

Fruity Ltd is a family owned company run by George and Sarah Watts. The Watts plan to retire in four years and were hoping that their son Angus would take over the business. However, Angus has just been hired as a graphic designer and has told his parents he is not interested in taking over the family firm. The Watts therefore have decided that they will close the business in four years when they retire. Fruity Ltd currently makes tinned peaches and pears but the Watts have heard that tinned apples are becoming more fashionable and are considering whether they should expand into this market in the years before they retire. They have asked you to help them to decide whether to expand into apples. They will need to buy a new machine which will cost $100,000 to process the apples. The machine would be depreciated straight line for 10 years to a terminal book value of zero. The Watts estimate that they will be able to sell it for $65,000 when they close the company. The Watts have already engaged Markitz, a marketing firm to survey the market about demand for the tinned apples. Markitz charged them $15,000 for this analysis. Marktiz estimates that they should be able to sell the apples at $4 a tin and should be able to sell about 10,000 tins per year. However, Markitz also estimate that they will lose about $2,000 in sales of their peaches and pears every year as some their current customers switch from buying their tinned peaches and pears to buying their apples. The Watts will need to hire two new employees to operate the apple machine and pack the tinned apples. They estimate the cost of these employees will be $10,000 per year. Expanding into apples will also result in an increase in operating costs of $2,000 per year. There will also need to be an initial investment of 1,000 in net working capital which will be fully recoverable at the end of the fourth year. The company tax rate is 30%.

Required:

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. (This means you should NOT use the tax shield approach). IMPORTANT: You must show each input in your table as a separate row. DO NOT group inputs together.

The next page is blank and should be used for your rough workings.

Use the tables on the 2 pages following the blank page for your answer - one table for each answer. (You do not need to use all the cells, just what you need for your answer).

Table 1: Accounting Flows;

Table 2: Cash Flows:

Answer 1

Table 1:Accounting cashflow

Sl.No	Year	1	2	3	4
i	Revenue from sales ($4*10,000units)	40,000	40,000	40,000	40,000
ii	Capital gain (Wno.2)				5,000
iii	Total revenue (i+ii)	40,000	40,000	40,000	45,000
iv	Increase in operating cost (given)	(2,000)	(2,000)	(2,000)	(2,000)
v	Employee cost (given)	(10,000)	(10,000)	(10,000)	(10,000)
vi	Market survey expenses (Wno.3)	(15,000)
vii	Total cost (iv+v+vi)	(27,000)	(12,000)	(12,000)	(12,000)
viii	EBITDA (iii+vii)	13,000	28,000	28,000	33,000
ix	Depreciation (Wno.1)	(10,000)	(10,000)	(10,000)	(10,000)
x	Profit before tax (viii+ix)	3,000	18,000	18,000	23,000
xi	Tax @ 30% (x*0.3)	(900)	(5,400)	(5,400)	(6,900)
xii	Profit after tax (x+xi)	2,100	12,600	12,600	16,100

Wno.1) Depreciation = cost/number of years = $100,000/10years = $10,000 per year

Wno.2) Book value of machine at the end of year 4 = Cost - accumulated depreciation in year 4 = $100,000-(4years*$10,000) = $100,000-$40,000 = $60,000

Capital gain = Sale value - book value = $65,000-$60,000 = $5,000. [Assumed capital gain is taxable at 30%]

Wno.3) Market survey expenses is allowed as deduction in year 1 itself for tax purpose. Actually cashflow occurs at time 0.

Table 2) Cashflows;

Sl.No	Year	0	1	2	3	4
i	Profit after tax (refer table 1)		2,100	12,600	12,600	16,100
ii	Loss of revenue (given)		(2,000)	(2,000)	(2,000)	(2,000)
iii	Depreciation (Wno.1)		10,000	10,000	10,000	10,000
iv	Capital gain (Wno.2)					(5,000)
v	Market survey cost (Wno.3)	(15,000)	15,000
vi	Purchase & sale of machinery (given)	(100,000)				65,000
vii	Net increase in working capital (given)	(1,000)
viii	Working capital recovered (given)					1,000
ix	After tax cash flows (i+ii+iii+iv+v+vi+vii+viii)	(116,000)	25,100	20,600	20,600	85,100