Question 5. ABC Company is considering adding a new line to its product mix, and

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Question 5.

ABC Company is considering adding a new line to its product mix, and the capital budgeting analysis is being conducted by Sidney Johnson, a recently graduated MBA. The production line would be set up in unused space in ABC' main plant. The machinery’s invoice price would be approximately $100,000; another $20,000 in shipping and insurance charges would be required; and it would cost an additional $30,000 to install the equipment. The machinery has an economic life of 3 years, and ABC has obtained a tax ruling which places the equipment in the MACRS 3-year class. The machinery is expected to have a salvage value of $20,000 after 3 years of use.   

The new line would generate incremental sales of 5,000 units per year for three years at an incremental cost of $100 per unit in the first year, excluding depreciation. Each unit can be sold for $200 in the first year. The sales price and cost are expected to increase by 4% per year due to inflation. Further, to handle the new line, the firm’s net operating working capital(t) would have to increase by an amount equal to 5% of sales revenues (t+1). The firm’s tax rate is 30 percent, and its overall weighted average cost of capital is 10 percent.      

Year    Depreciation Rate

1                      33%

2                      45

3                      15

4                      7

What is Year 0 initial investment related cash flow?    (This amount will be used as depreciation basis.)            (5 points)

What is Year 2 cash flow related to net operating working capital?     (10 points)

What is Year 3 net terminal cash flow?                       (5 points)

(Hint: You have to include both market value of salvage value of the machine and tax effect of the transaction.)

What is Year 1 tax saving related to depreciation expense?     (5 points)

Explanation / Answer

1.What is Year 0 initial investment related cash flow?

Year 0 cashflow is $2,00,000 ( machinery’s invoice price $100,000 + Shipping and insurance charges $20,000 + installation $30,000 + $50,000 working capital as shown in 2 below )

2.What is Year 2 cash flow related to net operating working capital?

3.What is Year 3 net terminal cash flow?  

Terminal cash flow = Salvage value after tax + working capital recovered in 3rd year

= $20,000(1-0.3)+$54,080

=$14,000+$54,080

=$68,080

4.What is Year 1 tax saving related to depreciation expense?

in thousand$

Year 1 tax saving related to depreciation =$49,500*30% tax = $14,850

Year 1 Year 2 Year 3 Units             5,000             5,000             5,000 Unit Price$           200.00           208.00           216.32 Unit Cost $           100.00           104.00           108.16 Sales $       1,000,000       1,040,000       1,081,600 Costs $         500,000         520,000         540,800 Year 0 Year 1 Year 2 Year 3 Sales $       1,000,000       1,040,000 1,081,600 NOWC(5% OF SALES) $           50,000           52,000           54,080 0 CF due to NOWC $          (50,000)            (2,000)            (2,080)       54,080

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