Question

You are asked to calculate the cash flows associated with the following proposal to purchase a new machine.

This machine can be purchased for $1,000,000. Assume the machine will qualify for a 10% investment tax credit. Also assume it has a 10 year economic life.

In each of the 10 years, sales generated by this machine are estimated to be $ 300,000 a year. Operating expenses are estimated to be $100,000 a year for each of the 10 years. This machine will be depreciated on a straight line basis, there is no salvage value.

Assume a tax rate of 40%.

a. Calculate the net after tax cash outflow in year 0.

b. Calculate the net cash flows associated with this project for each of the years 1-10.

c. Suppose you’re told that this project will be financed with $600,000 of borrowed funds. If the interest expense
from the borrowed money will be $48,000 per year, how will this affect the net cash flow after tax you’ve
calculated? (No calculation is needed, just state the type of change)

Please detail your answer.

Answer 1

Requirement a
Cost of Machine purchased	$1,000,000
Less: Investment tax credit	100,000
Net after tax cash outflow in year 0	900,000
Requirement b
Sales	300,000
Operating expenses	-100,000
Annual Depreciation (900,000/10)	-90,000
Operating profit	110,000
Less Taxes @40%	-44,000
Net income	66,000
Add: Depreciation	90,000
Net cash flows for each of the years 1-10	156,000
Requirement c
Interest expense	48,000
Interest expense after tax (48000*(1-0.4))	28,800
If project is financed with borrowed funds, annual cash flows will be reduced by $28,800