Corporate Finance Q

Bargain groceries is considering an investment in a conveyor that costs \$100,000 and another \$25,000 to install. The conveyor is expected to sell for \$10,000 in five years. The project will require increase in new working capital of \$10,000. the asset will reduce costs by \$30,000 per year for five years. The company’s tax rate is 40% and they use the Straight Line Depreciation with no salvage value What are the time zero cash outflow and the total after-tax cash flow in year 5? a. 110K; \$40K b. 125K;40K c. 135K;44K d. 110K;44K I got the first part right…(135K = WC + COST + INSTALL), but how do you get to the 44k?

Terminal CF = (Sales - Depreciation)(1-t) + Depreciation + Return of NWC + (Salvage Value - Book Value)(1-t) = (30-25)(1-0.4) + 25 + 10 + (10-0)(1-0.4) = 3+25+10+6 = 44 You could also substitute the first part: Sales(1-t) + Depreciation(t)

what is new working capital?

So, u don’t pay tax on the returned W/C in yr 5?

i get the NWC part, but salvage value - book value?

What is new working capital and how did you know you have to return it?

reema, I typically see it called “net working capital” which is basically just “working capital” (i.e. current assets - current liabilities). Sometimes new projects require an investment in additional working capital, such as inventories. maparam, think of the indirect method of cash flow statement preparation. Non-cash charges are added back to net income, but also changes in current asset and current liabilities accounts are added/subtracted. For example, a decrease in accounts payable is a use of cash, whereas a decrease in inventories is a source of cash. Wiki has a good summary. http://en.wikipedia.org/wiki/Statement_of_cash_flows yickwong, When the conveyor is sold in the project’s final year, the company is obligated to pay taxes on the portion of the sales price that exceeds the conveyor’s book value. We know the conveyor is being depreciated assuming no salvage value (i.e. to zero), so that \$10k sales price is taxable income to the company. Conversely, if the company had assumed a salvage value of \$20k but the conveyor had sold for only \$10k, then it would be entitled to a tax credit (or rebate?). Think about the incentives here. If the company didn’t have to pay taxes on the salvage value, it would nearly always depreciate everything to zero, thus enjoying a hefty tax shield, then upon selling the PP&E, it could enjoy all those proceeds tax-free too. I think the idea here is to encourage firms to *attempt* to align accounting depreciation with true economic depreciation. LongOnCFA, At the end of the project, the additional investment in working capital is no longer required and the company can reduce working capital again. edit: added response to LongOnCFA.

Anyway, I’m surprised there’s so many questions on this. It was part of 2006 LI and is revisited at 2008 LII. If it’s not even mentioned in your 2007 LI material, then just ignore this sample question, you guys have enough on your plates for Saturday. Good luck!