Question

Colsen Communications is trying to estimate the first-year net operating cash flow (at Year 1) for a proposed project. The financial staff has collected the following information on the project:

Sales revenues	$25 million
Operating costs (excluding depreciation)	17.5 million
Depreciation	5 million
Interest expense	5 million

The company has a 40% tax rate, and its WACC is 11%.

Write out your answers completely. For example, 13 million should be entered as 13,000,000.

1. What is the project's operating cash flow for the first year (t = 1)? Round your answer to the nearest dollar.
2. If this project would cannibalize other projects by $2.5 million of cash flow before taxes per year, how would this change your answer to part a? Round your answer to the nearest dollar.
   The firm's OCF would now be?
3. Ignore Part b. If the tax rate dropped to 30%, how would that change your answer to part a? Round your answer to the nearest dollar.
   The firm's operating cash flow would increase or decrease? By how much?

Answer 1

a). OCF = [(Sales - Operating Costs - Depreciation - Interest Expense) x (1 - t)] + Depreciation

= [(25 - 17.5 - 5 - 5) x (1 - 0.40)] + 5 = -1.5 + 5 = 3.5, or $3,500,000

b). OCF = $3.5 million - [Opportunity Cost x (1 - t)]

= $3.5 million - [$2.5 million x (1 - 0.40)] = $3.5 million - $1.5 million = 2, or $2,000,000

c). OCF = [(Sales - Operating Costs - Depreciation - Interest Expense) x (1 - t)] + Depreciation

= [(25 - 17.5 - 5 - 5) x (1 - 0.30)] + 5 = -1.75 + 5 = 3.25, or $3,250,000

If the tax rate decreased to 30%, the operating cash flow in year 1 will decrease by $250,000