Keiper, Inc., is considering a new three-year expansion project that requires an

Question

Keiper, Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of $3.00 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. The project requires an initial investment in net working capital of $400,000, and the fixed asset will have a market value of $260,000 at the end of the project. If the tax rate is 30 percent, what is the project

Explanation / Answer

The annual cash flows for the project will be calculated with the use of sales, costs and depreciation. Year 0 cash flow will comprise of initial investment and working capital. Terminal year cash flow will comprise of annual operating cash, recovery of working capital and market value (subject to tax). The formulas that can be dervied are as follows:

Year 0 Cash Flow = -Initial Investment - Working Capital

Year 1 and Year 2 Cash Flow = (Sales - Costs - Depreciation)*(1-Tax Rate) + Depreciation

Year 3 Cash Flow = (Sales - Costs - Depreciation)*(1-Tax Rate) + Depreciation + Working Capital Recovered + Market Value after Tax

Annual Depreciation = Initial Investment/Life

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Solution:

Annual Depreciation = $3,000,000/3 = $1,000,000

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Using the values provided in the question in the above formulas, we get,

Year 0 Cash Flow = -3,000,000 - 400,000 = -$3,400,000

Year 1 and Year 2 Cash Flow = (2,180,000 - 875,000 - 1,000,000)*(1-30%) + 1,000,000 = $1,213,500

Year 3 Cash Flow = [(2,180,000 - 875,000 - 1,000,000)*(1-30%) + 1,000,000] + 400,000 + 260,000*(1-30%) = $1,795,500

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Tabular Representation:

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