Question

Extremely Wild Wings (EWW) is considering introducing a new level of super hot wings called 911 Wings. The 911 Wings would require a special prepartion process and new equipment. The cost of the new equipment is $50,000 and falls into the 3-Year MACRS Depreciation Class (yr 1: 33%, yr 2: 45%, yr 3: 15%, yr 4: 7%) and would require an increase in net working capital of $3,000. The expected life of the project is 3 years. EWW has already spent $1,500 on a marketing analysis that shows that sales would increase $40,000 in year 1 of the project, $30,000 in year 2, and $18,000 in year 3. Additional operating costs other than depreciation will be 20% of sales. The expected salvage value at the end of the project’s 3 year life is $10,000 and any increases in net working capital during the life of the project will be recovered or liquidated at the end of the project’s expected life. The company’s marginal tax rate is 40% and the company will have enough other taxable income to more than offset any taxable losses from the 911 Wings project. EWW’s WACC is 10%.

What is the terminal (non-operating) cash flow at the end of year 3 for the 911 Wings project?

Answer 1

terminal (non-operating) cash flow at the end of year 3 = after-tax expected salvage value + recovery of net working capital

after-tax expected salvage value = salvage value - tax on salvage value

tax on salvage value = (salvage value - book value)*marginal tax rate

expected life of the project is 3 years. so, 4th year's depreciation will remain unapplied and book value will be: cost of new equipment*4th year's depreciation rate

tax on salvage value = [$10,000 - ($50,000*7%)]*40% = ($10,000 - $3,500‬)*40% = $6,500‬*40% = $2,600‬

after-tax expected salvage value = $10,000 - $2,600 = $7,400‬

terminal (non-operating) cash flow at the end of year 3 = $7,400‬ + $3,000 = $10,400