Question

ABC Corporation has hired you to evaluate a new FOUR year project for the firm. The project will require the purchase of a $771,900.00 work cell. Further, it will cost the firm $54,300.00 to get the work cell delivered and installed. The work cell will be straight-line depreciated to zero with a 20-year useful life. The project will require new employees to be trained at a cost of $71,000.00. The project will also use a piece of equipment the firm already owns. The equipment has been fully depreciated, but has a market value of $6,100.00. Finally, the firm will invest $10,200.00 in net working capital to ensure the project has sufficient resources to be successful. The project will generate annual sales of $925,000.00 with expenses estimated at 39.00% of sales. Net working capital will be held constant throughout the project. The tax rate is 38.00%. The work cell is estimated to have a market value of $497,000.00 at the end of the fourth year. The firm expects to reclaim 80.00% of the final NWC position. The cost of capital is 11.00%.

What is the cash flow to start the project in year 0?

Answer 1

Solution :

The cash flow to start the project in year 0 is

= - [ ( Employees training cost + Opportunity cost of Existing Equipment being used ) * ( 1 – tax rate ) ] – Purchase cost of work cell – Delivery and Installation cost of work cell – Initial Investment in working capital

As per the information available in the question we have

Employees training cost = $ 71,000 ; Opportunity cost of Existing Equipment being used = $ 6,100 ; Purchase cost of work cell = $ 771,900 ; Delivery and Installation cost of work cell = $ 54,300 ; Initial Investment in working capital = $ 10,200 ; Tax rate = 38 % = 0.38

Applying the above information in the formula we have the cash flow to start the project in year 0

= - [ ( $ 71,000 - $ 6,100 ) *( 1 – 0.38) ] - $ 771,900 - $ 54,300 - $ 10,200

= - [ ( $ 71,000 - $ 6,100 ) * 0.62 ] - $ 771,900 - $ 54,300 - $ 10,200

= - [ ( $ 77,100 ) * 0.62 ] - $ 771,900 - $ 54,300 - $ 10,200

= - $ 47,802 - $ 771,900 - $ 54,300 - $ 10,200

= - $ 884,202

Thus the cash flow to start the project in year 0 = - $ 884,202

Note :

1. Delivery and Installation cost of work cell is included in the cost of the asset and is treated as a capital expenditure.

2.As per the information given in the question, the project will also use a piece of equipment the firm already owns. The equipment has been fully depreciated, but has a market value of $6,100.00. This is an opportunity cost since the equipment could be sold at a certain price but is being used in the Project. This is a relevant cash flow and its after tax cash flow is to be used as an initial investment in fixed assets.

Since the equipment is depreciated to zero, the entire amount of market value is subjected to tax.

Thus Opportunity cost of machine being used = ( Market value – Depreciation )

= ( $ 6,100 - $ 0 ) = $ 6,100

3. The Employee training cost and salvage value of the existing equipment being used in the project qualify for a tax shield. Hence the after tax value of both Employee training cost and salvage value of the existing equipment is being used as a cash outflow in Year “0”.