2. Operating cash flows and depreciation McDermott Technologies is evaluating a

Question

2. Operating cash flows and depreciation McDermott Technologies is evaluating a new project that requires $800,000 In new equipment. McDermott estimates that the new project will generate $900,000 in annual sales at the end of each of the next four years and that operating costs (excluding depreciation) will equal $400,000. Suppose the firm depreciates the equipment using the straight-line method over four years and the firm?s tax rate is 40%. If the project?s WACC is 9.8%, what Is the present value of the project?s OCFs? $1,215,053.27 $1,207,160.99 $1,212,413.14 $1,217,702.83 $1,209,782.40 Suppose that McDermott uses Modified Accelerated Cost Recovery System (MACRS) depreciation rates instead. The applicable rates are 33%, 45%, 15% and 7%, respectively. Recalculate the firm?s OCFs and find their present value now (still assuming a WACC of 9.8%). $1,209,820.77 $1,227,464.95 $1,224,918.21 $1,222,380.25 $1,217,330.51

Explanation / Answer

2.

A

Correct Answer:

$1209782.40

Working Note:

B

Correct Answer:

$1222380.25

Working Note:

Year Investment Operating Cost Annual Sales Depreciation Cash flow before tax Tax @40% Net Operating Cash flows (including Depreciation) 0 800000 1 400000 900000 200000 300000 120000 380000 2 400000 900000 200000 300000 120000 380000 3 400000 900000 200000 300000 120000 380000 4 400000 900000 200000 300000 120000 380000 yearly depreciation (straight line Method) = Investment / No. of years = 800000/4 = 200000 Cash flow before tax = Annual Sales - Operating cost - depreciation Tax = Cash flow before tax*tax rate Net Operating Cash flows (including Depreciation) = Cash flow before tax - Tax + Depreciation WACC = 9.80% Present Value of Net operating Cash flows (OCF) = OCF1/(1+WACC) + OCF2/(1+WACC)^2 + OCF3/(1+WACC)^3 + OCF4/(1+WACC)^4 Present Value of Net operating Cash flows (OCF) = 380000/1.098 + 380000/1.098^2 + 380000/1.098^3 + 380000/1.098^4 Present Value of Net operating Cash flows (OCF) = $1209782.40 approx.

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