Question

AO sam is discussing a new project amongst their management team. They want to build tankless water heaters. In order to do this, they will need to build a new assembly line that will cost them 1.5 million dollars to build. It costs $45,000 to get all the material shipped to AO sam. They will have to buy $107,000 worth of new inventory since tankless hot water heaters and normal hot water heaters use different parts. Accounts payable will increase by $75,000.

The chief marketing officer (CMO) estimates that they will sell 400 units a year for 5 years at a price of $16,000 each.

The chief operations officer (COO) estimates that the variable costs to build these will be 80% of revenue.

The chief financial officer (CFO) says the company will use the MACRS 3 year class for depreciation. He estimates that the assembly line will have salvage value of $100,000. He notes that AO sam's tax rate is 33% and that the normal WACC is 11%.

The CEO notes that they have already extended their manufacturing plant when they thought they’d be building larger water heaters at the plant so they have the room. This extension is already paid for and cost $225,000.

Use the data provided for A.O. Sam and their proposed project to answer this question.

What are the operating cash flows for year 5?

	A.	$857,600
	B.	$956,600
	C.	$957,600
	D.	$1,057,600

Answer 1

Let Operating cash flow for Year 5 be CF5

CF = (S-C-D)(1-T) + D

where, S= Sales; C=Cost; D= Depreciation; T= Tax rate

Since we are using MACRS 3 year Dep, the rates are 33%, 45%, 15% and 7% and hence no depreciation is accounted for in Year 5.

Therefore, CF = {(400*16000) - 80%(400*16000) - 0} * (1 - 33%) + 0

Hence by sloving this, we get CF5 = $857600 , that is Option A.

Note: We did not account for the salvage value of $100,000 because that will be a partof the Terminal Value and not Operating Value.