Fitzgerald Computers is considering a new project whose data are shown below. Th

Question

Fitzgerald Computers is considering a new project whose data are shown below. The required equipment has a 3-year tax life, after which it will be worthless, and it will be depreciated by the straight-line method over 3 years for a yearly rate of 33.333%. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's Year 1 cash flow?

Equipment cost (depreciable basis) $63,847

Sales revenues, each year $54,833

Operating costs (excl. deprec.) $24,097

Tax rate 35.0%

Explanation / Answer

We will not include depreciation in the cash flow because their is actually no cash payment involved with regards to deprecation. However, we take the cash saved on taxation due to depreciation or the tax shield of depreciation. Year 1 cash flows would be the net operating cash flows after tax plus tax shield of depreciation.

Year 1 depreciation = Equipment cost x depreciation rate = $63847 x 33.333% = $21282.12051 or $21282.12

Tax shield of depreciation = $21,282.12 x 35% = $7448.742 or $7448.74

Net Operating Cash flows after tax (excluding depreciation) = (sales - operating costs) x (1 - tax rate) = ($54833 - $24097) x (1 - 0.35) = $19978.40

Year 1 cash flows = Net Operating cash flows after tax + Tax shield of depreciation = $19978.40 + $7448.74 = $27427.14

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