Question

Quad Enterprises is considering a new three-year expansion project that requires an initial fixed asset investment of $2.85 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $2,130,000 in annual sales, with costs of $825,000. The project requires an initial investment in net working capital of $350,000, and the fixed asset will have a market value of $235,000 at the end of the project. If the tax rate is 34 percent, what is the project’s Year 0 net cash flow? Year 1? Year 2? Year 3?

Answer 1

In order to calculate the net cash flow, we will first calculate net profit by using the formula sales - cost - depreciation - tax. Then we will add back depreciation to net profit. Then we will deduct $350,000 as working capital investment during Year 0. Then we will deduct $2,850,000 as investment in fixed assets during Year 0. However since the fixed assets were sold at the end of the project, there would be cash inflow from such capital transaction. However we have to take taxability of such gains. Kindly note that the fixed assets were fully depreciated during three years. Hence salvage value was 0. Hence there will be capital gains on the full market value. The capital gains tax would be $235,000 * 34%. We will deduct this tax from market value to arrive at cash flows of $155,100 through capital transaction of during Year 5. Hence Net cash flow during Year 0, Year 1, Year 2, Year 3 would be $3,200,000, $1,184,300, $1,184,300, $1,339,400 respectively. The detailed workings are as follows:

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