CMA Study Group

Please Can You Confirm if the Answer is Correct? (CMA Part 3 Strategic Management)

  • 1.  Please Can You Confirm if the Answer is Correct? (CMA Part 3 Strategic Management)

    Posted 11-16-2010 07:25 AM

    Question

    Kell Inc. is analyzing an investment for a new product expected to have annual sales of 100,000 units for the next 5 years and then be discontinued. New equipment will be purchased for $1,200,000 and cost $300,000 to install. The equipment will be depreciated on a straight-line basis over 5 years for financial reporting purposes and 3 years for tax purposes. At the end of the fifth year, it will cost $100,000 to remove the equipment, which can be sold for $300,000. Additional working capital of $400,000 will be required immediately and needed for the life of the product. The product will sell for $80, with direct labor and material costs of $65 per unit. Annual indirect costs will increase by $500,000. Kell's effective tax rate is 40%.

    In a capital budgeting analysis,what is the expected cash flow at time=5(fifth year of operations) that Kell should use to compute the net present value?

    Answer:$1,120,000

    (I worked it out as below, please will somebody have a look and confirm if this is correct; as I am not sure if my working is correct.)

    My Working

    Gain from Sale of Equipment: $300,000

    Equipment Removal Exp       : $100,000

    Balance                                : $ 200,000

    Tax on Above  (40%)           :    $80,000

    Net Gain /Cash Flow            : $120,000.......................................................(A)

    Cash Flow 5th Yr

    Sale = $80 x 100,000 units =      $8,000,000

    V.Cost=$65 x 100,000 units=    ($6,500,000)

    Release of W.Capital =                   $400,000

    Indirect Exp=                                ($500,000)

    Subtotal                                       $1,400,000

    Tax 40%        $560,000

    Less

    D.Tax Asset   $160,000                   $400,000 

      Total Cash Flow                         $1,000,000.........................................(B)

    (A) + (B) =$120,000 + $ 1,000,000=$1,120,000    

    Deferred Tax Asset Calculation

                                           Financial Reporting                   Tax Purpose

    Depreciation                   $300,000                                    $500,000

    Tax Savings 40%            $120,000                                    $200,0000

    Therefore Excess take as tax in Financial Reporting =80,000 per year for 3 yrs

    If $80,000 was adjusted in the 4th year, Balance remaining to be adjusted =$160,000

     




  • 2.  Re: Please Can You Confirm if the Answer is Correct? (CMA Part 3 Strategic Management)

    Posted 11-16-2010 11:28 AM

    Koshy,

    The key is in knowing where Kell's cash flows will be coming from.

    Cash source #1 (operations) - Net after tax cash inflows is {[(100,000 units X (US$80-65) - 500,000] X 60%}. Here, you will calculate US$600,000.

    Cash source #2 (Net cash inflows from disposal of asset) - Proceeds is US$300,000 but you will need to spend $100,000. Hence, your net cash proceeds is US$200,000. You'll pay 40% tax because that US$200,000 is Net Gain on disposal. So, your Net cash inflow here is US$120,000.

    Cash source #3 (Realization of working capital) - As you know in any Capital Budgeting scenario, the additional working capital required at the initial stage is realized back as cash at the termination of the project. Hence, in Yr5, you will also have cash inflow of US$400,000.

    This is how I would solve the problem in arriving at the correct answer US$1,120,000. Please let me know if you need any clarification.



  • 3.  RE: Re: Please Can You Confirm if the Answer is Correct? (CMA Part 3 Strategic Management)

    Posted 4 days ago

    What if they were asking for the cash flow at year 3 of operation ?! 


    It would be $800,000 but I failed to figure how was that calculated precisely. 


    100,000 units * ($80-$60) - $500,000 = $1,500k

    minus depreciation (($1,200k+$300k) less $200k scrap over 5 years= ($260k)

    EBT= $1500 - 260 = 1240k

    NI= $1240k * 0.6 = $744k

    Add depreciation= $744k + $260k = $1,004k

    I think I am calculating the depreciation wrong



    ------------------------------
    Jumana Alsaleh
    Accountant
    Dammam
    Saudi Arabia
    ------------------------------



  • 4.  Re: Please Can You Confirm if the Answer is Correct? (CMA Part 3 Strategic Management)

    Posted 11-16-2010 01:49 PM

    Thanks Angel! I understand it better now.

    Thanks A Lot!

    Regards,