Question

Esfandairi Enterprises is considering a new three-year expansion project that requires an initial fixed asset investment of $2.18 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $1.645 million in annual sales, with costs of $610,000. The project requires an initial investment in net working capital of $250,000, and the fixed asset will have a market value of $180,000 at the end of the project. Assume that the tax rate is 21 percent and the required return on the project is 12 percent.

What are the net cash flows of the project for each year?

Answer 1

To calculate the net cash flows for each year of the project, we need to consider the sales, costs, depreciation, taxes, and changes in net working capital. Let's break it down year by year:

Year 0:

- Initial fixed asset investment: -$2.18 million

- Initial investment in net working capital: -$250,000

Net cash flow in Year 0: -$2.43 million

Year 1:

- Sales: $1.645 million

- Costs: -$610,000

- Depreciation: (Initial fixed asset investment - Salvage value) / Tax life

Depreciation = ($2.18 million - $180,000) / 3 = $666,667

- Taxable income: Sales - Costs - Depreciation

Taxable income = $1.645 million - $610,000 - $666,667 = $368,333

- Taxes: Taxable income * Tax rate

Taxes = $368,333 * 21% = $77,350

- Change in net working capital: $0 (no change)

Net cash flow in Year 1: Sales - Costs - Taxes + Depreciation + Change in net working capital

Net cash flow in Year 1: $1.645 million - $610,000 - $77,350 + $666,667 + $0 = $1.624 million

Year 2:

- Sales: $1.645 million

- Costs: -$610,000

- Depreciation: $666,667

- Taxable income: $368,333

- Taxes: $77,350

- Change in net working capital: $0 (no change)

Net cash flow in Year 2: $1.645 million - $610,000 - $77,350 + $666,667 + $0 = $1.624 million

Year 3:

- Sales: $1.645 million

- Costs: -$610,000

- Depreciation: $666,667

- Taxable income: $368,333

- Taxes: $77,350

- Change in net working capital: $0 (no change)

Net cash flow in Year 3: $1.645 million - $610,000 - $77,350 + $666,667 + $0 = $1.624 million

At the end of Year 3, the fixed asset has a market value of $180,000, but since it will be worthless, we do not include it in the net cash flow.

Therefore, the net cash flows for each year of the project are as follows:

Year 0: -$2.43 million

Year 1: $1.624 million

Year 2: $1.624 million

Year 3: $1.624 million