Question

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The CFO of Vandelay Industries is considering the launch of a new child's bike seat that...

The CFO of Vandelay Industries is considering the launch of a new child's bike seat that will revolutionize the industry. It has been estimated that the project will last 5 years. The machine that will manufacture the bike seat costs $2 million, and will be depreciated using the straight line method to zero book value over 10 years. Projected sales are $700,000 in each year. Annual costs are estimated to be $140,000. The CFO believes that the manufacturing machine can be sold at the end of the project for $600,000. It is estimated that working capital requirements will be constant at $90,000 in each year starting today. Working capital will be recovered at the end of the project. If the project is taken, it will use an existing office space for which the company paid $550,000 three years ago, and that can be rented today for $56,000 a year (after tax), to be paid at the end of each year. The tax rate is 20%.

  1. What is the cash flow today if the project is undertaken?
  2. How much are paid or saved in taxes as a result of the sale of the machinery in the final year?
  3. What is the cash flow of the project in its last year?
  4. Draw the timeline (or table) of cash flows for the project.
  5. What is the NPV of the project if the discount rate is 10%?

Solutions

Expert Solution

1]

Cash outflow today = cost of machine + investment in working capital

Cash outflow today = $2,000,000 + $90,000 = $2,090,000

The amount paid to buy the office space 3 years ago is a sunk cost, and should not be included in the cash flow analysis.

2]

loss on sale of equipment at end of year 5 = book value - sale price

book value = original cost - accumulated depreciation

after-tax salvage value = salvage value + tax benefit on loss on sale of equipment (the loss is tax deductible, and hence reduces the tax outgo. This is treated as a cash inflow)

tax benefit on loss on sale of equipment = $80,000

3]

Cash flow in year 5 = $1,202,000

Operating cash flow (OCF) each year = income after tax + depreciation

4] and 5]

The after tax rent of the office space is an incremental cash flow, and should be included in the cash flow analysis.

NPV is calculated using NPV function in Excel

NPV is $25,729

jeff jeffy answered 1 year ago
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