Question 5.

ABC Company is considering adding a new line to its product mix, and the capital budgeting analysis is being conducted by Sidney Johnson, a recently graduated MBA. The production line would be set up in unused space in ABC' main plant. The machinerys invoice price would be approximately $100,000; another $20,000 in shipping and insurance charges would be required; and it would cost an additional $30,000 to install the equipment. The machinery has an economic life of 3 years, and ABC has obtained a tax ruling which places the equipment in the MACRS 3-year class. The machinery is expected to have a salvage value of $20,000 after 3 years of use.

The new line would generate incremental sales of 5,000 units per year for three years at an incremental cost of $100 per unit in the first year, excluding depreciation. Each unit can be sold for $200 in the first year. The sales price and cost are expected to increase by 4% per year due to inflation. Further, to handle the new line, the firms net operating working capital(t) would have to increase by an amount equal to 5% of sales revenues (t+1). The firms tax rate is 30 percent, and its overall weighted average cost of capital is 10 percent.

Year Depreciation Rate

1 33%

2 45

3 15

4 7

What is Year 0 initial investment related cash flow? (This amount will be used as depreciation basis.) (5 points)

What is Year 2 cash flow related to net operating working capital? (10 points)

What is Year 3 net terminal cash flow? (5 points)

(Hint: You have to include both market value of salvage value of the machine and tax effect of the transaction.)

What is Year 1 tax saving related to depreciation expense? (5 points)