Question

Th e Taylor Mountain Uranium Company currently has annual cash revenues of $1.2 million
and annual cash expenses of $700,000. Depreciation amounts to $200,000 per year.
Th ese fi gures are expected to remain constant for the foreseeable future (at least 15 years).
Th e fi rm’s marginal tax rate is 40 percent.
A new high-speed processing unit costing $1.2 million is being considered as a potential
investment designed to increase the fi rm’s output capacity. Th is new piece of equipment
will have an estimated usable life of 10 years and a $0 estimated salvage value. If the
processing unit is bought, Taylor’s annual revenues are expected to increase to $1.6 million
and annual expenses (exclusive of depreciation) will increase to $900,000. Annual
depreciation will increase to $320,000. Assume that no increase in net working capital
will be required as a result of this project. Compute the project’s annual net cash fl ows for
the next 10 years, assuming that the new processing unit is purchased. Also compute the
net investment (NINV) for this project.

Answer 1

Calculate the annual net cash flows. Net cash flows represent the difference between the annual cash outflows and inflows related to a project. Net cash flow equals the change in operating earnings after taxes plus the change in depreciation minus the change in net working capital:

In this case, the company has no change in net working capital, so this will not factor into its net cash flow.

The change in operating earnings after taxes equals the change in revenues minus the change in operating costs minus the change in depreciation times (1 minus the tax rate):

First, calculate the change in revenue. The change in revenue equals revenue with the project minus revenue without the project:

Revenue with the project is $1.6 million. Revenue without the project is $1.2 million. Substitute the values in the above formula:

The change in revenue is $400,000.

Calculate the change in operating expenses. The change in operating expenses equals operating expenses with the project minus operating expenses without the project:

Operating expenses with the project are $900,000. Operating expenses without the project are $700,000. Substitute the values in the above formula:

The change in operating expenses is $200,000.

Calculate the change in depreciation. The change in depreciation equals depreciation with the project minus depreciation without the project:

Depreciation with the project is $320,000. Depreciation without the project is $200,000. Substitute the values in the above formula:

The change in depreciation is $120,000.

Calculate the change in operating earnings after taxes. The change in revenue is $400,000. The change in operating costs is $200,000. The change in depreciation is $120,000. The tax rate is 40 percent, or 0.40. Substitute the values in the change in operating earnings after taxes formula:

Therefore, the change in operating earnings after taxes is $48,000.

Now, calculate the annual net cash flows. The change in operating earnings after taxes is $48,000. The change in depreciation is $120,000. There is no change in net working capital. Substitute the values in the net cash flow formula:

Therefore, the annual net cash flow is $168,000 . This net cash flow will remain constant for the next 10 years because the company’s revenues and expenses are expected to remain constant.

Calculate the net investment (NINV). Net investment is the initial net amount of cash a company spends on a project at time period zero. Net investment equals the asset’s cost plus shipping and installation costs plus any investment required in net working capital minus the proceeds from the sale of existing assets plus/minus taxes involved with the sale of existing assets:

The asset costs $1.2 million. There are no installation and shipping costs, investment in net working capital, or sale of existing assets. Therefore, the net investment is simply the $1.2 million cost of the asset.