Lanfranco Corporation is considering a capital budgeting project that would requ
ID: 2470494 • Letter: L
Question
Lanfranco Corporation is considering a capital budgeting project that would require investing $160,000 in equipment with an expected life of 4 years and zero salvage value. Annual incremental sales would be $480,000 and annual incremental cash operating expenses would be $330,000. The project would also require an immediate investment in working capital of $10,000 which would be released for use elsewhere at the end of the project. The project would also require a one-time renovation cost of $100,000 in year 3. The company's income tax rate is 35% and its after-tax discount rate is 6%. The company uses straight-line depreciation. Assume cash flows occur at the end of the year except for the initial investments. The company takes income taxes into account in its capital budgeting. The total cash flow net of income taxes in year 3 is:
a.) $46,500
b.) $11,500
c.) $111,500
d.) $50,000
Explanation / Answer
We need to find out the total cash flow net of income taxes in year 3. There is no requirement to calculate NPV of the project, so after-tax discount rate of 6% is not relevant here. Let us understand the cash flows in the year 3.
Incremental Sales - $480,000 and Cash Operating expenses are $330,000. Net Cash flow is $480,000 - $330,000 = $ 150,000.
Tax rate is 35%. So after tax cash flow is $150,000 * (1-0.35) = $150,000 * 0.65 = $97,500
Cost of the equipment required for this project is $160,000. Salvage Value is $0. Life of the equipment is 4 years. Using Straight-line depreciation, annual depreciation is $160,000/4 = $40,000. Depreciation is a tax deductible expense. So the amount of depreciation that is tax deductible is $40,000 * 0.35 = $14,000
One-Time renovation in year 3 is $100,000
Now if we add all the three cash flows determined above, we will arrive at total cash flow net of income taxes in year 3
Net Cash Flow - $97,500
Annual Depreciation - $14,000
One-Time Renovation - ($100,000)
Total - $11,500
Hence the answer is b.) $11,500
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