Question

Dream High is purchasing a new machinery to make dream houses. It will cost $2,000,000 to buy the machine and $20,000 to have it delivered and installed. Building a clean room in the plant for the machine will cost an additional $2 million. The machine is expected to raise gross profits of $1,500,000 per year, starting at the end of the first year, with the costs of $0.5 million for each of those years. The machine is expected to have a working life of 10 years and will be depreciated using straight line method over those ten years. The marginal tax rate is 35%. What are the incremental free cash flows associated with the new machine in year 3 ? Multiple Choice $575.000; $720.700. ;$1,500,000.; $2,020,000

Answer 1

$720,000

Step-by-step explanation:

To calculate the incremental free cash flows associated with the new machine in year 3, we need to consider the cash inflows and outflows specific to that year. Let's break it down step by step:

1. Calculate the annual gross profit: The machine is expected to generate a gross profit of $1,500,000 per year, starting from the end of the first year.

2. Calculate the annual costs: The costs associated with the machine are $0.5 million per year.

3. Calculate the annual net profit: Subtract the annual costs from the gross profit to get the net profit for each year.

Annual net profit = Annual gross profit - Annual costs

Annual net profit = $1,500,000 - $0.5 million = $1,000,000

4. Calculate the depreciation expense: The machine will be depreciated over 10 years using the straight-line method. The total depreciation expense is the initial cost of the machine divided by its useful life.

Depreciation expense = Cost of the machine / Useful life

Depreciation expense = $2,000,000 / 10 = $200,000 per year

5. Calculate the taxable income: Subtract the depreciation expense from the net profit to calculate the taxable income.

Taxable income = Annual net profit - Depreciation expense

Taxable income = $1,000,000 - $200,000 = $800,000

6. Calculate the taxes: Apply the marginal tax rate of 35% to the taxable income.

Taxes = Taxable income * Marginal tax rate

Taxes = $800,000 * 0.35 = $280,000

7. Calculate the net cash flow before tax: Subtract the taxes from the net profit to calculate the net cash flow before tax.

Net cash flow before tax = Annual net profit - Taxes

Net cash flow before tax = $1,000,000 - $280,000 = $720,000

8. Calculate the incremental free cash flow: Deduct any additional cash outflows and add any cash inflows specific to year 3.

Incremental free cash flow = Net cash flow before tax - Additional cash outflows + Additional cash inflows

In this case, there is no specific information given about additional cash outflows or inflows in year 3, so the incremental free cash flow in year 3 would be equal to the net cash flow before tax:

Incremental free cash flow = $720,000

Therefore, the correct answer is $720,000.