New Project Cash Flows You work for a small business that does silk screening fo
ID: 2757867 • 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 shirts 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 (Hint – scrapping the old equipment will generate an after-tax inflow at T=0 that partially offsets the purchase price of the new system) What are the incremental after-tax cash flows associated with this project (in thousands) for years 0 through 5?
Explanation / Answer
Solution:
1) Calculation of Annual Cash Flows
Incremental Sales (20,000 shirts x $9)
$180,000
Less: Raw Material Cost (20,000 shirts x $5)
($100,000)
Less: Salary of New System Operator
($30,000)
Less: Depreciation (note 3)
($15,000)
Operating Profit Before Tax
$35,000
Less: Tax @ 35%
($12,250)
Profit After Tax
$22,750
Add: Depreciation
$15,000
Incremental After Tax Cash Flows
$37,750
2) Calculation of Incremental After Tax Cash Flows associated with this project
Year
1
2
3
4
5
Incremental Annual After Tax Cash Flow
$37,750
$37,750
$37,750
$37,750
$37,750
Less: Working Capital Release at the end of project
$0
$0
$0
$0
($60,000)
Add: Salvage Value of Equipment after tax at the end of 5th year [($25,000 x (1-0.35)]
$0
$0
$0
$0
$16,250
Incremental After tax cash flows associated with the project for year 0 to 5
$37,750
$37,750
$37,750
$37,750
($6,000)
Note 3: Calculation of Annual Depreciation Amount using straight line method
Cost of Equipment (New)
$100,000
Life
5 Years
Salvage Value at the end of 5th year
$25,000
Annual Depreciation = (Cost of Equipment - Salvage Value) / life
$15,000
Note 4: Calculation of Initial Cash Outflow Requirement
Initial Equipment Cost
$100,000
Add: Increase in Net Working Capital
$60,000
Less: Sales Proceeds after tax from Old Manual Print System ($6000 x (1-0.35)
($3,900)
Net Initial Cash Outflow
$156,100
1) Calculation of Annual Cash Flows
Incremental Sales (20,000 shirts x $9)
$180,000
Less: Raw Material Cost (20,000 shirts x $5)
($100,000)
Less: Salary of New System Operator
($30,000)
Less: Depreciation (note 3)
($15,000)
Operating Profit Before Tax
$35,000
Less: Tax @ 35%
($12,250)
Profit After Tax
$22,750
Add: Depreciation
$15,000
Incremental After Tax Cash Flows
$37,750