Question

What is the operating cash flow for year 3 of project A that Red Royal Health should use in its NPV analysis of the project? The tax rate is 45 percent. During year 3, project A is expected to have relevant revenue of 81,000 dollars, relevant variable costs of 24,000 dollars, and relevant depreciation of 14,000 dollars. In addition, Red Royal Health would have one source of fixed costs associated with the project A. Yesterday, Red Royal Health signed a deal with Priya Advertising to develop a marketing campaign. The terms of the deal require Red Royal Health to pay Priya Advertising either 24,000 dollars in 3 years if project A is pursued or 12,000 dollars in 3 years if project A is not pursued. Finally, the equipment purchased for the project would be sold in 3 years for an expected after-tax cash flow of 3,000 dollars.

Answer 1

Operating cash flow if project A is pursued:

Revenue-Variable cost = Contribution

Contribution-Fixed cost = profit

Contribution= 81000-24000= 57000

Profit = 57000-24000= 33000

In calculation of operating cash flow we consider profit after tax but before depreciation. Therefore, we will first deduct depreciation from profit, then we will deduct tax from the remaining amount and then will add back depreciation to it.

Profit after depreciation = 33000-14000=19000

Profit after tax and after depreciation= 19000-45%(19000)=10450

Profit after tax but before depreciation= 10450+14000= 24450

Operating Profit if project A is not pursued:

Following same procedure,

Contribution = 81000-24000= 57000

Profit = 57000-12000 =45000

Profit after depreciation= 45000-14000= 31000

Profit after tax and after depreciation= 31000-45%(31000)= 17050

Profit after tax but before depreciation= 17050+14000= 31050