A project will increase sales by $60,000 and cash expenses by $51,000.The project will cost $40,000 and be depreciated using straight-line depreciation to a zero book value over the 4-year life of the project.The company has a marginal tax rate of 35%.What is the operating cash flow of the project using the tax shield approach?

Question

Quizplus · Accepted Answer

First, we need to calculate the annual depreciation expense: 
Depreciation expense = (Cost of project - Salvage value)/Project life 
Depreciation expense = ($40,000 - $0)/4 years = $10,000 per year

Next, we calculate the earnings before interest and taxes (EBIT): 
EBIT = Sales - Cash expenses - Depreciation expense 
EBIT = $60,000 - $51,000 - $10,000 = -$1,000

Since the project is generating a loss, we do not need to consider taxes for the first year.

For year 2-4:
Tax shield = Depreciation expense * Tax rate 
Tax shield = $10,000 * 0.35 = $3,500

Operating cash flow (OCF) = EBIT + Depreciation expense - Taxes 
OCF = (-$1,000 + $10,000) * (1-0.35) + $3,500 
OCF = $5,850

Therefore, the option C is the correct answer.

A Project Will Increase Sales by $60,000 and Cash Expenses