CMA Study Group

292.

Kell Inc. is analyzing an investment for a new product expected to have annual sales of100,000 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?

a. $720,000.

b. $800,000.

c. $1,120,000.

d. $1,240,000.

The correct answer is c

I don’t know how this amount is calculated. Please show me the computation.

Thanks and Regards

Shariq Ghaznavi

There are 3 step calculations :

1. Cash flow from Sale of Equipment -

  Sales price (300000)- WDV as per Income Tax (Nil) + Additional Cost to remove (100000) =200000 

So after tax cash flow is 200,000x (1-0.40) =120000

2. Working Capital recovered = 400000 (no tax invlovement)

3. Recurring income for 5th Year for 100000 units

Sale price - 80

Mat. Cost - 65

Contribution =15 x 100000 =1500000

Less : Annual Ind. Cost = 500000

Net Profit = 1000000

Net profit after Tax = 1000000 *(1-.4)=600,000

Put together 1+2+3, the net cash flow is 120,000+400,000+600,000 = 1,120,000

Hope this will help you.

Thank you so much Mr. Hemendra Kumar Jadumani Parida and Mr.Hussein Jaber

Regards

Shariq Ghaznavi