You are proposing a new venture, to branch out into animals and cartoon characte
ID: 2633856 • Letter: Y
Question
You are proposing a new venture, to branch out into animals and cartoon characters but this will require some new equipment and a capital outlay. Pertinent financial information is given below.
BALANCE SHEET
Cash
2,000,000
Accounts Payable and Accruals
18,000,000
Accounts Receivable
28,000,000
Notes Payable
40,000,000
Inventories
42,000,000
Long-Term Debt
60,000,000
Preferred Stock
10,000,000
Net Fixed Assets
133,000,000
Common Equity
77,000,000
Total Assets
205,000,000
Total Claims
205,000,000
Cash
2,000,000
Accounts Payable and Accruals
18,000,000
Accounts Receivable
28,000,000
Notes Payable
40,000,000
Inventories
42,000,000
Long-Term Debt
60,000,000
Preferred Stock
10,000,000
Net Fixed Assets
133,000,000
Common Equity
77,000,000
Total Assets
205,000,000
Total Claims
205,000,000
Explanation / Answer
When you are trying to analyze cash flows in any capital budgeting problem you have to break them down into smaller parts otherwise you won't have a good place to start. There are 3 big groups to put your cash flows in that will organize this problem... 1. initial outlay 2. project life 3. terminal year.
Lets start with the initial outlay... These cash flows happen at year zero (or today) if we decide to do the project. They include things like initial investment, net working capital changes, and any other relevant cash flows that happen at time 0 of the project.
1. Initial Outlay
Initial Investment: -15,000,000 + -2,000,000 = -17,000,000
NWC change: -4,000,000
Total: -21,000,000
This next section is project life cash flows. These get a bit more tricky especially since we need to make sure that we don't use some of the irrelevant information given in the problem. Annual operating cash flows are going to include things like... revenue from the project, depreciation tax benefits, taxes we pay on project revenues, fixed/variable costs, etc. Since our revenues, depreciation, variable costs are changing every year we will need to calculate these cash flows year by year for years 1-6.
2. Project Life Cash Flows
Year 1
-Revenue: 5,000,000
-Depreciation benefit: 17,000,000 * MACRS rate 20% = 3,400,000
-Costs: -1,000,000 Fixed cost + -1,500,000 Variable costs (5M*.30) = -2,500,000
-taxes: 5,000,000 - 3,400,000 - 2,500,000 = -900,000 tax loss * .40 tax rate = +360,000 refund
Total year 1: 5,000,000 - 2,500,000 + 360,000 = 7,860,000
Year 2
-Revenue: 10,000,000
-Depreciation benefit: 17,000,000*MACRS rate 32% = 5,440,000
-Costs: -1,000,000 fixed cost + -3,000,000 variable cost (10M*.30) = -4,000,000
- taxes: 10,000,000 - 5,440,000 - 4,000,000 = 560,000 taxable income * .40 = -224,000
total year 2: 10,000,000 - 4,000,000 - 224,000 = 5,776,000
Year 3
Revenue: 14,000,000
Depreciation: 17,000,000*MACRS rate 19.2% = 5,440,000
Costs: -1,000,000 Fixed Cost + -4,200,000 Variable cost (14M*.30) = -5,200,000
- taxes: 14,000,000 - 5,440,000 - 5,200,000 = 3,360,000 taxable income * .40 = -1,344,000
total year 3: 14,000,000 - 5,200,00 - 1,344,000 = 7,456,000
Year 4
- Revenue: 16,000,000
- Depreciation: 17,000,000*MACRS rate 11.52% = 1,958,400
- Costs: -1,000,000 fixed cost + -4,800,000 variable cost = -5,800,000
- taxes: 16,000,000 -1,958,400 - 5,800,000 = 8,241,600 * .40 = -3,296,640
total year 4: 16,000,000 - 5,800,000 - 3,296,640 = 6,903,360
Year 5:
- Revenue: 12,000,000
- Depreciation: 17,000,000*MACRS rate 11.52% = 1,958,400
- Costs: -1,000,000 fixed cost + -3,600,000 variable cost = -4,600,000
- taxes: 12,000,000 - 1,958,400 - 4,600,000 = 5,441,600 * .40 = -2,176,640
total year 5: 12,000,000 - 4,600,000 - 2,176,640 = 5,223,360
Year 6:
- Revenue: 8,000,000
- Depreciation: 17,000,000*MACRS rate 5.76%= 979,200
- Costs: -1,000,000 fixed cost + -2,400,000 variable cost= -3,400,000
- taxes: 8,000,000 - 979,200 - 3,400,000 = 3,620,800 * .40 = -1,448,320
total year 6: 8,000,000 - 3,400,000 - 1,448,320 = 3,151,680
I want to note a few things here... I assumed that the 2M installation costs were capitalized. Generally most installation costs can be capitalized but this isn't always the case. Your problem should have said whether or not these would be capitalized, but what are you going to do... With depreciation you will also noticed that a 5 year MACRS asset still gets some depreciation in year 6. This is because of the half year convention for personal property cost recovery. Without getting into too much detail you get a 1/2 years worth of depreciation after the last "class year" of the asset (it's just the way the IRS does it).
3. Terminal Year cash flows
We only have 2 terminal year cash flows here... the salvage value and NWC.
Salvage Value 4,000,000 ... Book value 0, so we have a taxable gain of 4,000,000 * tax (.40) = 1,600,000
Get cash of 4,000,000 - 1,600,000 taxes = + 3,400,000 after tax salvage value
NWC will "come back" so we have an inflow of +4,000,000
year 6 terminal total: 4,000,000 + 3,400,000 = 7,400,000
Now have finally figured out all of the annual cash flows
year 0: -21,000,000
year 1: 7,860,000
year 2: 5,776,000
year 3: 7,456,000
year 4: 6,903,360
year 5: 5,223,360
year 6: 7,400,000+3,151,680 = 10,551,680
Alright this basically answers your question. Most of the bullets in your problem seem to hint that it may also want you to calculate the WACC. We could then use this rate to discount our cash flows and see if we have a positive or negative NPV.
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