Question

Your company has spent $180,000 on research to develop a new computer game. The firm is planning to spend $40,000 on a machine to produce the new game. Shipping and installation costs of $5,000 for the machine will be capitalized and depreciated. The machine has an expected life of five years, a $25,000 estimated resale value, and falls under the MACRS five-year class life. Revenue from the new game is expected to be $200,000 per year, with costs of $100,000 per year. The firm has a tax rate of 35 percent, an opportunity cost of capital of 14 percent, and it expects net working capital to increase by $50,000 at the beginning of the project. What will be the operating cash flow (OCF) for year two of this project?

MACRS rates:

   Year 1: 20.00%

   Year 2: 32.00%

   Year 3: 19.20%

   Year 4: 11.52%

   Year 5: 11.52%

   Year 6: 5.76%

Answer 1

Time line		0	1	2
Cost of new machine		-45000
Initial working capital		-50000
=Initial Investment outlay		-95000
5 years MACR rate			20.00%	32.00%
Sales			200000	200000
Profits	Sales-variable cost		100000	100000
-Depreciation	=Cost of machine*MACR%		-9000	-14400
=Pretax cash flows			91000	85600
-taxes	=(Pretax cash flows)*(1-tax)		59150	55640
+Depreciation			9000	14400
=after tax operating cash flow			68150	70040
reversal of working capital
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)
+Tax shield on salvage book value	=Salvage value * tax rate
=Terminal year after tax cash flows
Total Cash flow for the period		-95000	68150	70040