Unique Style Inc.is considering a five-year expansion project that requires an initial investment of $500,000 for the purchase of a new machine with a CCA rate of 30%.The projected sales revenue and related costs are $450,000 and $180,000 per year, respectively.The project's fixed costs are an additional $48,000 per year.The appropriate discount rate is 8%.The firm's marginal tax rate is 40%.What is the after-tax cash flow in year three, assuming half-year rule is applicable for CCA in year 1?

Question

Quizplus · Accepted Answer

To calculate the after-tax cash flow in year three, we need to first calculate the annual after-tax net income for each year from year 1 to year 3.

Year 1:

CCA rate of 30% on initial investment of $500,000 = $150,000 CCA
Taxable income = project revenue - project costs - CCA - fixed costs
= $450,000 - $180,000 - $150,000 - $48,000
= $72,000
Tax expense = 40% x $72,000
= $28,800
Net income = $72,000 - $28,800
= $43,200

To apply the half-year rule for CCA, we will take half of the CCA rate (i.e. 15%) for year 1.

Therefore, the after-tax cash flow for year 1 is:

After-tax net income = $43,200 - ($150,000 x 0.4 x 0.5)
= $16,200

Year 2:

Taxable income = project revenue - project costs - CCA - fixed costs
= $450,000 - $180,000 - ($500,000 x 0.3) - $48,000
= $22,000
Tax expense = 40% x $22,000
= $8,800
Net income = $22,000 - $8,800
= $13,200

The after-tax cash flow for year 2 is:

After-tax net income = $13,200
= $13,200

Year 3:

Taxable income = project revenue - project costs - CCA - fixed costs
= $450,000 - $180,000 - ($500,000 x 0.3) - $48,000
= $22,000
Tax expense = 40% x $22,000
= $8,800
Net income = $22,000 - $8,800
= $13,200

The after-tax cash flow for year 3 is:

After-tax net income = $13,200 + ($150,000 x 0.4 x 0.5)
= $16,890

Therefore, the total after-tax cash flow for year 3 is $16,890 or $16,900 rounded to the nearest hundred, which corresponds to choice (B).