Quad Enterprises is considering a new three-year expansion project that requires
ID: 2743894 • Letter: Q
Question
Quad Enterprises is considering a new three-year expansion project that requires an initial fixed asset investment of $3 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $2,180,000 in annual sales, with costs of $875,000. If the tax rate is 30 percent, what is the OCF for this project?
Quad Enterprises is considering a new three-year expansion project that requires an initial fixed asset investment of $3 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $2,180,000 in annual sales, with costs of $875,000. If the tax rate is 30 percent, what is the OCF for this project?
Explanation / Answer
Solution:
Life of Project = 3 Years
Fixed Asset Investment at year 0 (i.e. today) = $3,000,000
Straight Line Depreciation Annual Amount (Non Cash Item) = $3,000,000 / 3 = $1,000,000
Estimated Annual Operating Income = Estimated Annual Sales - Estimated Costs = $2,180,000 - $875,000 = $1,305,000
Operating Cash Flow (OCF) for the project = Net Income after tax + Depreciation (non cash item)
Calculation of Operating Cash Flow (OCF) for the project:
Year
Annual Operating Income
Depreciation
Income after depreciation
Tax @ 30% on Income After Depreciation
Net Income (Income After Depreciation - Tax)
Operating Cash Flow (Net Income + Depreciation (Non Cash Item)
1
$1,305,000
$1,000,000
$305,000
91500
$213,500
$1,213,500
2
$1,305,000
$1,000,000
$305,000
91500
$213,500
$1,213,500
3
$1,305,000
$1,000,000
$305,000
91500
$213,500
$1,213,500
$3,640,500
Total Operating Cash Flow (OCF) for the project = $3,640,500
Explanation:
Operating Cash Flow means Net Income of the project + Depreciation
For calculating Net Income we need to calculate first operating profit before depreciation and tax.
Depreciation is deducted from Operating profit in order to take tax benefit for depreciation. Since depreciation is non cash item so it is added back in net income to calculate Operating Cash Flow.
We will follow following steps to calculate Operating Cash Flow
Step 1: Calculate Operating profit before depreciation and tax = $2,180,000 - $875,000 = $1,305,000
Step 2: Calculate Operating Profit after depreciation before tax = $1,305,000 - $1,000,000 = $305,000
Step 3: Calculate Net Income (after tax) = $305,000 (1 - Tax Rate) = $305,000 x (1 - 0.30) = $213,500
Step 4: Calculate Operating Cash Flow = Net INcome + Depreciation = $213,500 + $1,000,000 = $1,213,500
Operating Cash Flow for the project = ANnual Operating Cash Flow x Project Life = $1,213,500*3 = $3,640,500
Year
Annual Operating Income
Depreciation
Income after depreciation
Tax @ 30% on Income After Depreciation
Net Income (Income After Depreciation - Tax)
Operating Cash Flow (Net Income + Depreciation (Non Cash Item)
1
$1,305,000
$1,000,000
$305,000
91500
$213,500
$1,213,500
2
$1,305,000
$1,000,000
$305,000
91500
$213,500
$1,213,500
3
$1,305,000
$1,000,000
$305,000
91500
$213,500
$1,213,500
$3,640,500