Question

Midtown Co. plans a 4-year capital investment project, where it requires an asset that costs $540,000. The asset will be depreciated using the 3-year MACRS (use these schedule: 34%, 45%, 14%, and 7% for years 1 to 4, respectively). The company expects that the asset will be worth $120,000 at the end of the project. Incremental sales are expected to be $420,000, $440,000, $460,000 and $480,000 for year 1 to 4, respectively. Corresponding variable expenses are expected to be 40% of the sales, and the fixed costs are $50,000 a year. The company will need to invest $16,000 at time=0 in net working capital, which will increase by $1,000 each year. The cost of capital is 14% and the corporate tax rate is 30%. The company will have to use a building that it bought 12 years ago for $180,000. This building could generate lease income of $20,000 a year if the project is not undertaken. It also spent $70,000 in R&D to develop the new product for this project. To partly finance the project, the company plans to borrow $200,000 at a 10% interest rate for the duration of the project. Develop the cash flows for the project.

Answer 1

$ 70000 R&D spend is sunk cost and irrelevant for the question

Initial outflow in year 0
Asset Price	540,000
Increase in working capital	16,000
Total	556,000

Annual Cash Flow After Tax

Particulars	Year 1	Year 2	Year 3	Year 4
Sales	420,000	440,000	460,000	480,000
Less : Variable Cost	168,000	176,000	184,000	192,000
Less : Fixed Cost	50,000	50,000	50,000	50,000
Less : Opportunity cost from building rent	20,000	20,000	20,000	20,000
Less : Depreciation	183,600	160,380	27,443	11,800
Earning Before Tax	236,400	279,620	432,557	468,200
Tax @ 30%	70,920	83,886	129,767	140,460
Earning after tax	165,480	195,734	302,790	327,740
Add : Tax benefit on depreciation	55,080	48,114	8,233	3,540
Less : Increase in Working Capital	1,000	1,000	1,000	-
Cash flow after tax	219,560	242,848	310,023	331,280

Terminal Value in Year 4

Sale Value of Fixed Assets	120,000
Add : Tax benefit (120,000 - 156777)* 0.3	11,033
Cash flow from Sale of fixed assets	108,967
Recovery of working capital	19,000
	127,967