ABC Co. requires a 15% rate of return on its capital, and the firm is in the 35%
ID: 2616977 • Letter: A
Question
ABC Co. requires a 15% rate of return on its capital, and the firm is in the 35% marginal tax bracket. The company is considering a new project that involves the introduction of a new product. This project has a 5 year life; afterwards the product will cease to exist. Given the following information: Cost of new plant and equipment: 7,250,000 Unit sales: 80,000 (year 1), 110,000 (year 2), 110,000 (year 3), 80,000 (year 4), 60,000 (year 5) Price per unit: $230 Variable costs per unit: $140 Fixed costs: $500,000 per year Depreciation method: Straight line method over 5 years. Assume that the plant and equipment will have a salvage (market) value of $750,000 at the end of year 5. Working capital requirements: there will be an initial working capital requirement of $500,000 at the start of the project. At the end of the second year of the project, the firm will need an additional $250,000 working capital injection. Finally, all working capital is liquidated at the termination of the project at the end of year 5. Calculate the operating cash flow in year 3.
Explanation / Answer
0 1 2 3 4 5 Unit sales 80000 110000 110000 80000 60000 Contribution margin at $90 per unit 7200000 9900000 9900000 7200000 5400000 Fixed costs (other than depreciation) 500000 500000 500000 500000 500000 Depreciation = (7250000-750000)/5 = 1300000 1300000 1300000 1300000 1300000 Net operating income 5400000 8100000 8100000 5400000 3600000 Tax at 35% 1890000 2835000 2835000 1890000 1260000 NOPAT 3510000 5265000 5265000 3510000 2340000 Add: depreciation 1300000 1300000 1300000 1300000 1300000 Operating cash flow 4810000 6565000 6565000 4810000 3640000 Answer