Question

ABC corporation has existing property and equipment that is not in use. The company is considering the use of this property and equipment. One option is to use the property and equipment to produce a new product. Estimates for demand of this product are 30,000 units annually for the first 5 years and 20,000 units annually for the following 6 years. Beyond that, the product is considered to be obsolete and production will cease. Price and variable costs would be $100 and $65, respectively. Fixed costs would be $225,000 per year. If they take this option, they must buy additional equipment for a total of $2 million. This equipment will be depreciated straight-line over a 15 year period of time. When the project is ended (in 11 years), it is expected they will be able to sell the equipment for $130,000. This option also requires an initial net working capital investment of $400,000. This initial NWC investment can be reduced to $300,000 when sales drop (i.e. from year 5 to year 6). The net working capital will be fully recouped at the end of the project. This project is riskier than the average project for the company. Management has determined that the appropriate discount rate is 16.18% and the tax is 40%

1. What is this project’s OCF for years 1-5?

2. What is this project’s OCF for years 6-11?

Answer 1

Calculation of operating cash flow:

	Years 1-5	Years 6-11
Sales per year	3,000,000	2,000,000
Less: Variable cost	1,950,000	1,300,000
Less: Fixed costs	225,000	225,000
Less: Depreciation	133,333.33	133,333.33
Income before tax	691,666.67	341,666.67
Tax -40%	276,666.67	136,666.67
Income after tax	415,000	205,000
Add: Depreciation (non-cash expense)	133,333.33	133,333.33
OCF	548,333.33	338,333.33