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The Sisyphean Corporation is considering investing in a new cane manufacturing machine that has an estimated life of three years. The cost of the machine is $30 000 and the machine will be depreciated by the straight-line method over its three-year life to a residual value of $0.
The cane manufacturing machine will result in sales of 2 000 canes in year 1. Sales are estimated to grow by 10% per year for each of the three years. The price per cane that Sisyphean will charge its customers is $18 each and is to remain constant. The canes have a cost per unit to manufacture of $9 each.
Installation of the machine and the resulting increase in manufacturing capacity will require an increase in various net working capital accounts. It is estimated that the Sisyphean Corporation needs to hold 2% of its annual sales in cash, 4% of its annual sales in accounts receivable, 9% of its annual sales in inventory, and 5% of its annual sales in accounts payable. The firm is in the 30% tax bracket and has a cost of capital of 10%.
-CathFoods will release a new range of lollies which contain antioxidants. New equipment to manufacture the lollies will cost $2 million, which will be depreciated by straight-line depreciation over five years. In addition, there will be $5 million spent on promoting the new line. It is expected that the range of lollies will bring in revenues of $4 million per year for five years with production and support costs of $1.5 million per year. If CathFood's marginal tax rate is 30%, what are the incremental free cash flows in the second year of this project?
A)$2.015 million
B)$1.870 million
C)$2.500 million
D)$2.415 million

Question

Quizplus · Accepted Answer

To calculate the incremental free cash flows in the second year of the project, several steps must be taken:

1. Calculate the depreciation expense for the second year:
Depreciation per year = (cost of equipment - residual value) / useful life
Depreciation per year = ($2,000,000 - $0) / 5 years
Depreciation per year = $400,000
Depreciation in second year = $400,000 x 1/5 = $80,000

2. Calculate the taxes in the second year:
EBIT = Revenue - Production and support costs - Depreciation expense
EBIT = $4,000,000 - $1,500,000 - $80,000
EBIT = $2,420,000
Taxes = EBIT x Marginal tax rate
Taxes = $2,420,000 x 30%
Taxes = $726,000

3. Calculate the net cash flow in the second year:
Net cash flow = Revenue - Production and support costs - Depreciation expense - Taxes - Capital expenditures + Changes in net working capital
Capital expenditures = $2,000,000 + $5,000,000 = $7,000,000
Changes in net working capital = ($4,000,000 x 2%) + ($4,000,000 x 4%) + ($4,000,000 x 9%) + ($4,000,000 x 5%) = $840,000
Net cash flow = $4,000,000 - $1,500,000 - $80,000 - $726,000 - $7,000,000 + $840,000
Net cash flow = -$4,466,000

Therefore, the incremental free cash flows in the second year of the project are -$4,466,000. The best choice is B, as it is the only option provided.

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