Question

A company is considering the acquisition of production equipment which will reduce both labour and material costs. The cost is $100,000 and it will be depreciated on a straight-line basis to zero over a four-year period. However, the useful life of the equipment is five years, and it will be sold for $20,000 at the end of the five years. Operating costs will be reduced by $30,000 in the first year and the savings will increase by $5,000 per year for years 2, 3 and 4. Due to increased maintenance costs, savings in year 5 will be $10,000 less than the year 4 savings. The equipment will also reduce net working capital by $5,000. Net working capital will revert back to normal at the end of the project's life. The firm's tax rate is 35% and the firm requires a 16% return.

Calculate the initial investment (CF0) for this project. (-$95,000)

Calculate the cash flows in years 1 through 4. (CF1=$28,250, CF2= $31,500, CF3= $34,750, CF4= 38,000).

Calculate the terminal cash flow and the total cash flow in year 5. (TCF= $8,000, CF5= $30,750)

Answer 1

	0	1	2	3	4	5
Investment	-100,000
NWC	5,000					-5,000
Salvage						20,000
Savings		30,000	35,000	40,000	45,000	35,000
Depreciation		-25,000	-25,000	-25,000	-25,000	0
EBT		5,000	10,000	15,000	20,000	35,000
Tax (35%)		-1,750	-3,500	-5,250	-7,000	-12,250
Net Income		3,250	6,500	9,750	13,000	22,750
Cash Flows	-95,000	28,250	31,500	34,750	38,000	30,750

Depreciation = 100,000 / 4 = 25,000

Cash Flows = Net Income + Depreciation + Investment + NWC + Salvage x (1 - tax rate)