Question

Consider the following capital budgeting and cash flow estimation problem. You have developed a new energy drink that uses various vegetables. The drink is called V-DRINK. You have an existing building that you are using to produce V-DRINK. The building is fully depreciated. You determine a need to buy $400,000 in equipment. Shipping and installation is an additional $50,000. Additionally you determine you will need to have $16,995 in inventory. What is the total initial outlay associated with the project?

The equipment cost (equipment plus shipping and installation) can be depreciated at the rate of 32% the first year. The remaining 5 years (years 2-6) the depreciation will be equal to $30,000 per year. What is the amount of depreciation in year 1?

Based on some market research you expect to sell around 200,000 bottles of V-Drink a year at wholesale price of $1.9. Operating costs (excluding depreciation) are expected to be 50% of revenue. The firms tax rate is 40%. What is the annual operating cash flow associated with this project in year 2. (Note you will need to factor in $30,000 in depreciation in year 2 from the prior question).

Answer 1

Compute the total initial outlay, using the equation as shown below:

Initial outlay = Equipment cost + Installation cost + Inventory cost

                     = $400,000 + $50,000 + $16,995

                     = $466,995

Hence, the total initial outlay is $466,995.

Compute the depreciation expenses for year 1, using the equation as shown below:

Depreciation expenses = (Equipment cost + Installation cost)*Depreciation rate

                                    = ($400,000 + $50,000)*32%

                                     = $144,000

Hence, the depreciation expenses are $144,000.

Compute the contribution margin, using the equation as shown below:

Contribution = Units sold*Selling price*(1 – Variable cost percentage)

                     = 200,000*$1.90*(1 – 0.50)

                     = $190,000

Hence, the contribution margin is $190,000.

Compute the operating income after tax, using the equation as shown below:

Operating income = (Contribution – Depreciation)*(1 – Tax rate)

                             = ($190,000 - $30,000)*(1 – 0.40)

                             = $160,000*0.60

                             = $96,000

Hence, the operating income after tax is $96,000.

Compute the operating cash flow for year 2, using the equation as shown below:

Operating cash flow = Operating income + Depreciation

                                 = $96,000 + $30,000

                                 = $126,000

Hence, the operating cash flow is $126,000.