** Hi all,**

**Can someone explain **

**1. Why after-tax advertisement expense is taken**

**2. The annual expected cash flow. shouldn't the depreciation tax shield be added to the after-tax cash flow to arrive at the annual cash flow?**

**I have included the question and answer as provided. **

Right-Way Stores is a chain of home improvement stores with 150 locations. Right-Way has identified an attractive site for a new store and Jim Smith, Director of Financial Planning, has been asked to prepare an analysis and make a recommendation for or against opening this proposed new store. In preparing his analysis, Smith has determined that the land at the proposed site will cost $500,000 and the new store will cost $3.5 million to build. The building contractor requires full payment at the start of construction, and it will take one year to build the store. Right-Way will finance the purchase of the land and construction of the new building with a 40-year mortgage. The mortgage payment will be $118,000 payable annually at year end. Fixtures for the store are estimated to cost $100,000 and will be expensed. Inventory to stock the store is estimated to cost $100,000. Concerned about the possibility of rising prices, the company expects to purchase the fixtures and inventory at the start of construction. Advertising for the grand opening will be $50,000, paid to the advertising agency on retainer at the start of construction. The new store will begin operations one year after the start of construction. Right-Way will depreciate the building over 20 years on a straight-line basis, and is subject to a 35% tax rate. Right-Way uses a 12% hurdle rate to evaluate projects. The company expects to earn aftertax operating income from the new store of $1,200,000 per year.

REQUIRED:

1. What is Right-Way's total initial cash outflow? Show your calculations.

2. Calculate the annual expected cash flow from the proposed new store. Show your calculations.

Answer provided :

1. 500,000 + 3,500,000 +100,000 + 100,000 + (50,000 * (1-.35) = $4,232,500 million.

2. The scenario tells us that the after-tax operating income is $1,200,000. We find the depreciation expense by dividing the building cost into the depreciation period, $3,500,000 / 20 = $175,000 annual depreciation expense. Assuming the interest on the mortgage is not considered when we discount a cash flow, or it is included in (taken out to arrive at) the $1.2 million, and no change in working capital, we can calculate the Cash Flow three ways:

a. Simply add the $1,200,000 and the $175,000 to get $1,375,000.

b. Find total net income: $1,200,000 after tax operating income / 1-.35 = $1,846,150 taxable income. The tax on this is 646,154, getting us back to 1,200,000 net income. Add back the 175,000 depreciation to get $1,375,000.

c. Use depreciation tax shield: Start with the $1,846,154 taxable income. Adding the 175,000 depreciation, we get before tax cash flow of $2,021,154. The tax on this is 707,404, but the depreciation tax shield is 61,250, resulting in 1,375,000 cash flow.