Question

After reading a demographic study on the habits and modern lifestyles of the American public, TI Inc. decided   launching a new product, Gizmo ™. TI’s CEO has asked you to determine whether or not to go ahead with the introduction of a new product. You have the following information:

• TI’s business plan is based on estimates provided by Hanover Consulting two months ago. Truman has to pay consulting fee of $60,000 for this service.
• TI pre-paid $100,000 JCH Marketing for advertising campaign of a new product. This fee is fully reimbursable, if Truman chooses to cancel contract with JCP within 90-day period.
• Production line for the product will be placed in a currently unused building owned by TI Inc. with a current after-tax market value of $800,000. The warehouse has already been depreciated so its book value is zero.
• The new equipment will cost $1,000,000. The equipment will be depreciated on a straight line basis over 10 years to zero.
• You have just received the results of a marketing survey that indicates that revenues from sale of Gizmo ™ will be $700,000 per year for 10 years.
• Variable costs will be 50% of sales per year.
• Fixed costs will be $120,000 per year.
• It is expected that at the end of year 10 you can sell this business for $400,000.
• TI’s marginal tax rate is 30%.

3.

a) What is the appropriate amount to use as the initial cash flow (CFo)?

b) What is the appropriate amount to use as the annual operating cash flows from the project (OCF)?

c) Determine the after-tax salvage value of the project (the cash flow at the end of the project that comes from the sale of the project’s assets).

Answer 1

3. a. Initial cash flow : - $ 1,900,000

Cost of Equipment	$ 1,000,000
Opportunity cost of using building	800,000
Advertising cost ( reimbursable )	100,000
Initial Cash Outflow	$ 1,900,000

b. The appropriate amount to use as the annual operating cash flows from the project : $ 191,000

EBITDA = $ 700,000 x 50 % - $ 120,000 = $ 230,000.

Annual depreciation = $ 1,000,000 / 10 years = $ 100,000

Annual operating cash flows = 230,000 x ( 1 - 0.30 ) + 100,000 x 0.30 = 191,000

c. The after tax salvage value of the project = 400,000 * ( 1 - 0.30) = $ 280,000.