Question

HW15-1)

Fairfax Pizza is evaluating a project that would require an initial investment in equipment of 400,000 dollars and that is expected to last for 8 years. MACRS depreciation would be used where the depreciation rates in years 1, 2, 3, and 4 are 44 percent, 34 percent, 16 percent, and 6 percent, respectively. For each year of the project, Fairfax Pizza expects relevant, incremental annual revenue associated with the project to be 476,000 dollars and relevant, incremental annual costs associated with the project to be 392,000 dollars. The tax rate is 50 percent. What is (X plus Y) if X is the relevant operating cash flow (OCF) associated with the project expected in year 1 of the project and Y is the relevant OCF associated with the project expected in year 4 of the project?

Answer 1

Annual operating income after tax = (Incremental revenues - Incremental costs) x (1 - tax rate) = ($476,000 - $392,000) x (1 - 0.50) = $42,000

Year 1

Depreciation in Year 1 = Cost of equipment x MACRS rate for year 1 = $400,000 x 44% = $176,000

Depreciation Tax shield for year 1 = Depreciation x tax rate = $176,000 x 50% = $88,000

OCF for year 1 (X) = Annual operating income after tax + Depreciation tax shield for year 1 = $42,000 + $88,000 = $130,000

Year 4

Depreciation in Year 4 = Cost of equipment x MACRS rate for year 4 = $400,000 x 6% = $24,000

Depreciation Tax shield for year 4 = Depreciation x tax rate = $24,000 x 50% = $12,000

OCF for year 4 (Y) = Annual operating income after tax + Depreciation tax shield for year 4 = $42,000 + $12,000 = $54,000

X + Y = $130,000 + $54,000 = $184,000