Question

Blue Ocean already spent $85,000 on a feasibility study for a machine that will produce a new product. The machine will cost $2,575,000 and it will require modifications costing an additional amount of $365,000. Blue Ocean will need to invest $75,000 for additional inventory. The project will last for 7 years and the machine will be depreciate using straight line method with no residual value.

This machine is expected to produce an output of 20,000 units annually with the estimated selling price of $100. Operating variable cost will be 25% of revenues, operating fixed cost is estimated to be $400,000. Additional administrative expense is about $200,000. Blue Ocean's tax rate is 30%.

a.     Calculate the project's initial investment

b.     Calculate the project's annual cash flows from year 1 to year 5.

Answer 1

Calculation of initial investment

Cost of machine 2575000

Required modifications cost 365000

Investment in Inventories 75000

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3015000

So initial Investment is $3,015,000

Calculation of annual cash flows

Annual revenue(20000*100) 2000000

less : operating variable cost 25%of revenue -500000

less: fixed cost -400000

less: administrative cost. -200000

less : Depreciation((2575000+365000)/7). -420000

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Profit before tax 480000

less: tax @ 30%. -144000

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Profit after tax v 336000

Add: Depreciation. 420000

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Annual free cash flow 756000

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So annual cash flows from year 1 to year 5 is $756000

note: feasibility study expenses had already been incurred. So it is irrelevant.

Depreciation is deducted only for tax calculation. it does not generate Cash outflow. so it will be added back.

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