New Project Cash Flows You work for a small business that does silk screening fo

Question

New Project Cash Flows You work for a small business that does silk screening for T-shirts. Your boss is considering purchasing a computer graphics system, produced by IBM, that would automate the silk screening process and would replace an old manually operated print system. Automation would reduce your turn-around time enabling you to increase sales of T-shirts by 20,000 shirts per year. The information associated with this project is as follows: ? Initial Equipment Cost: $100,000. ? Life of System: 5 years. ? Depreciation method: Straight line Depreciation. ? Retail price of a silk-screened T-shirt: $9 per shirt ? Raw material cost: $5 per shirt ? Salary of new computer system operator: $30,000 per year. ? Increase in net working capital necessary to support increased sales: $60,000 ? Marginal Tax Rate on income and capital gains: 35% ? Predicted Salvage Value of Computer Graphics System at year 5: $25,000. ? Current salvage value of old manual print system $6,000 ? Current book value of old manual print system $2,000 (Hint – scrapping the old equipment will generate an after-tax inflow at T=0 that partially offsets the purchase price of the new system) What are the incremental after-tax cash flows associated with this project (in thousands) for years 0 through 5?

Explanation / Answer

Solution:

1) Calculation of Annual Cash Flows

Incremental Sales (20,000 shirts x $9)

$180,000

Less: Raw Material Cost (20,000 shirts x $5)

($100,000)

Less: Salary of New System Operator

($30,000)

Less: Depreciation (note 3)

($15,000)

Operating Profit Before Tax

$35,000

Less: Tax @ 35%

($12,250)

Profit After Tax

$22,750

Add: Depreciation

$15,000

Incremental After Tax Cash Flows

$37,750

2) Calculation of Incremental After Tax Cash Flows associated with this project

Year

1

2

3

4

5

Incremental Annual After Tax Cash Flow

$37,750

$37,750

$37,750

$37,750

$37,750

Less: Working Capital Release at the end of project

$0

$0

$0

$0

($60,000)

Add: Salvage Value of Equipment after tax at the end of 5th year [($25,000 x (1-0.35)]

$0

$0

$0

$0

$16,250

Incremental After tax cash flows associated with the project for year 0 to 5

$37,750

$37,750

$37,750

$37,750

($6,000)

Note 3: Calculation of Annual Depreciation Amount using straight line method

Cost of Equipment (New)

$100,000

Life

5 Years

Salvage Value at the end of 5th year

$25,000

Annual Depreciation = (Cost of Equipment - Salvage Value) / life

$15,000

Note 4: Calculation of Initial Cash Outflow Requirement

Initial Equipment Cost

$100,000

Add: Increase in Net Working Capital

$60,000

Less: Sales Proceeds after tax from Old Manual Print System ($6000 x (1-0.35)

($3,900)

Net Initial Cash Outflow

$156,100

1) Calculation of Annual Cash Flows

Incremental Sales (20,000 shirts x $9)

$180,000

Less: Raw Material Cost (20,000 shirts x $5)

($100,000)

Less: Salary of New System Operator

($30,000)

Less: Depreciation (note 3)

($15,000)

Operating Profit Before Tax

$35,000

Less: Tax @ 35%

($12,250)

Profit After Tax

$22,750

Add: Depreciation

$15,000

Incremental After Tax Cash Flows

$37,750

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