Farouqi Football Club (FFC) of London plans to invest £10 million in a project that will increase operating income (excluding depreciation) by £4 million annually for two years. The project will be fully depreciated using the straight-line method over two years, and the initial investment is expected to be worthless at the end of Year 2. FFC’s overall cost of capital is 10 percent. FFC’s tax rate is 40 percent. For capital budgeting purposes, after-tax operating cash flow in Year 1 is closest to:
The solution given on Wiley was to use (S-C-D)(1-t) + D formula to get (4m-5m)(1-.4) + 5m = 4.4m
I’ve asked the instructor and they don’t seem to get my point that using the solution seems to be just blindly following the formula whereas in reality there shouldn’t really be a need to multiply it by (1-t) if there is a loss on the project. Otherwise it makes it seem like the Govt is subsidizing the loss being made on the project which doesn’t really make sense?
In other words I don’t see why the answer wouldn’t just be 4m? ( made a loss of 1m on the project which because it’s a loss there is no tax adjustment and then adding the depreciation would give a positive after tax CF of 4m)
Any help would be much appreciated maybe there’s just something simple I’m missing.