Question

2. Suppose Blue Thumb Tools is considering the introduction of a new, heavier hammer to be used for driving spikes. The new hammer will cost $490,000. The cost will be depreciated straight-line to zero over the project’s five-year life, at the end of which the new hammer can be scrapped for $40,000. The new hammer will save the firm $146,000 per year in pretax operating costs, and it required an initial investment in net working capital of $35,000. The tax rate of the firm is 30%. What are the cash flows of firm’s new project (using a time line)?

Answer 1

Time line		0	1	2	3	4	5
Cost of new machine		-490000
Initial working capital		-35000
=Initial Investment outlay		-525000
Savings			146000	146000	146000	146000	146000
-Depreciation	Cost of equipment/no. of years		-98000	-98000	-98000	-98000	-98000
=Pretax cash flows			48000	48000	48000	48000	48000
-taxes	=(Pretax cash flows)*(1-tax)		33600	33600	33600	33600	33600
+Depreciation			98000	98000	98000	98000	98000
=after tax operating cash flow			131600	131600	131600	131600	131600
reversal of working capital							35000
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)						28000
+Tax shield on salvage book value	=Salvage value * tax rate						0
=Terminal year after tax cash flows							63000
Total Cash flow for the period		-525000	131600	131600	131600	131600	194600