Truman Industries is considering an expansion. The necessary equipment would be purchased for $8 million, and the expansion would require an additional $3 million investment in working capital. The tax rate is 40%. a. What is the initial investment outlay? b. The company spent and expensed $50,000 on research related to the project last year. Would this change your answer? Explain. c. The company plans to use another building that it owns to house the project. The building could be sold for $1 million after taxes and real estate commissions. How would that fact affect your answer?
a.Equipment$ 8,000,000
NWC Investment 3,000,000
Initial investment outlay$11,000,000
b.No, last year’s $50,000 expenditure is considered a sunk cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.
c.The potential sale of the building represents an opportunity cost of conducting the project in that building. Therefore, the possible after-tax sale price must be charged against the project as a cost.
#2 Washington Communications is trying to estimate the first-year net cash flow (at Year 1) for a proposed project. The financial staff has collected the following information on the project: Sales $9 million Operating costs (excluding depreciation) $6 million Depreciation $2 million Interest Expense $2 million The company has a 40% tax rate, and its WACC is 10%
a. What is the project’s net cash flow for the first year (t = 1)? b. If this project would cannibalize other projects by $1 million of cash flow before taxes per year, how would this change your answer to part a? c. Ignore Part
b. If the tax rate dropped to 30%, how would that change your answer to Part a?
a.Project cash flows: t = 1
Sales revenues$9,000,000
Operating costs 6,000,000
Depreciation 2,000,000
Operating income before taxes$ 1,000,000
Taxes (40%) 400,000
Operating income after taxes$ 600,000
Add back depreciation 2,000,000
Project cash flow$ 2,600,000
c.If the tax rate fell to 30%, the project’s cash flow would change to:
Operating income before taxes$1,000,000
Taxes (30%) 300,000
Operating income after taxes$ 700,000
Add back depreciation 2,000,000
Project cash flow$2,700,000
Thus, the project’s cash flow would increase by $100,000.
#3 Kennedy Air Services is now in the final year of a project. The equipment originally cost $25 million, of which 80% has been depreciated. Kennedy can sell the used equipment today for $7.5 million, and its tax rate is 35%. What is the equipment’s after-tax net salvage value?
Equipment’s original cost$25,000,000
Depreciation (80%) 20,000,000
Book value$ 5,000,000
Gain on sale = $7,500,000 – $5,000,000 = $2,500,000.
Tax on gain = $2,500,000(0.4) = $875,000.
AT net salvage value = $7,500,000 – $875,000 = $6,625,000.