New Project Cash Flows You work for a small business that does silk screening fo
ID: 2757384 • Letter: N
Question
New Project Cash Flows You work for a small business that does silk screening for T-shirts. Your boss is considering purchasing a computer graphics system, produced by IBM, that would automate the silk screening process and would replace an old manually operated print system. Automation would reduce your turn-around time enabling you to increase sales of T-shirts by 20,000 shins per year. The information associated with this project is as follows: ? Initial Equipment Cost: $100,000. ? Life of System: 5 years. ? Depreciation method: Straight line Depreciation. ? Retail price of a silk-screened T-shirt: $9 per shirt ? Raw material cost: $5 per shirt ? Salary of new computer system operator: $30,000 per year. ? Increase in net working capital necessary to support increased sales: $60,000 ? Marginal Tax Rate on income and capital gains: 35% ? Predicted Salvage Value of Computer Graphics System at year 5: $25,000. ? Current salvage value of old manual print system $6,000 ? Current book value of old manual print system $2,000 What are the incremental after-tax cash flows associated with this project (in thousands) for years 0 through 5? -155.4/59.5/59.5/59.5/59.5/99 -160/59.5/59.5/59.5/59.5/115.75 -160/39.5/39.5/39.5/39.5/55.75 -155.4/39.5/39.5/39.5/39.5/115.75Explanation / Answer
Cost of new machine = $100,000
Increase in net working capital = $60,000
Salvage value of old machine =-6000
Tax on old machine (6000-2000) x35% = 1400
Total initial investment = $155,400
Therefore, either option A or option D is correct. Now calculating year 1 cash flow:
Depreciation = 100,000/5 = $20,000
Depreciation tax shield =20,000 x 35% = $7,000
Cash EBIT = 20,000 x (9-5) – 30,000 = 50,000
CFAT = Cash EBIT x (1- t) + Depreciation tax shield
= $50,000 x (1-0.35) + $7,000
= $39,500
Therefore, option with initial investment of $155,400 and year 1 cash flow of $39,500 is correct. That is option D. So option D is correct.