Question

Corriedale Ltd plan to introduce a new line of organically produced wool for textile production. The new wool will generate incremental revenues of $57,000 per year for 8 years. The incremental operating costs of producing the wool are projected to be $20,000 per year. As a result of the new type of wool, demand for Corriedale’s other products will decrease significantly. Corriedale estimate that EBITDA from other product lines will fall by $10,000 per year as customers switch to the organic wool. The initial capital expenditure to purchase wool processing equipment will be $70,000. Producing and distributing the new wool will increase the working capital requirements of the business by $4,000 for the life of the project. This investment in working capital will be fully recovered when the new wool is discontinued in 8 years. For tax purposes, the wool processing equipment can be depreciated on a straight-line basis to zero over 8 years. Corriedale expect that at the end of the 8 years the scrap value of the equipment will be $12,000. Corriedale face a corporate tax rate of 30%. Compute the net incremental cash flow for the new organic wool for its final year (only the final year is required).

Answer 1

Initial capital expenditure = $70000, Life of project = 8 years,

Since the equipment will be depreciated to zero, hence book value of equipment at end of 8 years = 0

Annual straight line depreciation = (Initial capital expenditure - Book value of equipment at end of 8 years) / Life of project = (70000 - 0) / 8 = 70000 / 8 = 8750

Incremental EBITDA for final year or year 8 = EBITDA from wool equipment - fall in EBITDA of other products = (Incremental Revenues - Incremental operating costs) - Fall in EBITDA of other products = (57000 - 20000) - 10000 = 37000 - 10000 = 27000

After tax operating cash flow for year 8 = Incremental EBITDA(1-tax rate) + Depreciation x tax rate = 27000(1-30%) + 8750 x 30% = 27000 x 70% + 8750 x 30% = 18900 + 2625 = 21525

Salvage value of equipment at end of 8 years = 12000, Recovery of investment in net working capital at end of 8 years = 4000

Terminal cash flow in year 8 = Salvage value of equipment at end of 8 years + Recovery of investment in net working capital - Tax on gain from sale of equipment

Terminal cash flow in year 8 = Salvage value of equipment at end of 8 years + Recovery of investment in net working capital - Tax rate ( Salvage value of equipment at end of 8 years - Book value of equipment at end of 8 years)

Terminal cash flow in year 8 = 12000 + 4000 - 30%(12000 - 0) = 12000 + 4000 - 30% x 12000 = 12000 + 4000 - 3600 = 12400

Incremental cash flow for year 8 = After tax operating cash flow + Terminal cash flow in year 8 = 21525 + 12400 = 33925

Hence incremental cash flow for new organic wool in final year = $33925