# Capital Budgeting

I have two inquiries in the below question from schweser material;

Mayco, Inc. is considering the purchase of a new machine for \$60,000. The machine will reduce manufacturing costs by \$5,000 annually. Mayco will use the modified accelerated cost recovery system (MACRS) accelerated method (5-year asset) to depreciate the machine and expects to sell the machine at the end of its 6-year operating life for \$10,000. Use the MACRS table in Figure 1. (Remember, you don’t have to memorize the MACRS tables!) The firm expects to be able to reduce net working capital by \$15,000 when the machine is installed, but required working capital will return to the original level when the machine is sold after six years. Mayco’s marginal tax rate is 40%, and it uses a 12% cost of capital to evaluate projects of this nature.

The first year’s operating cash flow and terminal year’s cash flow excluding the last year’s operating cash flow are closest to: A. \$4,800 OCF and –\$4,000 CF. B. \$7,800 OCF and –\$4,000 CF. C. \$7,800 OCF and –\$9,000 CF. Year 1 operating cash flow = [net income impact × (1 – t)] + (depreciation × t) = (\$5,000) (0.6) + (\$60,000)(0.2)(0.4) = \$7,800. Terminal year cash flow (excluding that year’s operating cash flow) = after-tax proceeds from sale of the new machine less working capital return = \$10,000 – [(\$10,000)(0.4)] – \$15,000 = –\$9,000.

Question:

1. How did we come up with the Net Income of \$5,000? is it through (reduced 5000 in cost + reduced 15000 from working capital-depreciation in first year of 10000)

2. When calculating operating cash flow, should not we add back all depreciation not only (depreciation × t)?