 # Reversal in Working Capital

Jayco, Inc. is considering the purchase of a new machine for \$60,000 that will reduce manufacturing costs by \$5,000 annually.

• Jayco will use the 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. (The percentages for the 5-year MACRS class are, beginning with year 1 and ending with year 6, 20%, 32%, 19%, 12%, 11%, and 6%.)
• 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 6 years.
• Jayco’s marginal tax rate is 40%, and the firm uses a 12% cost of capital to evaluate projects of this nature.

What is the project’s terminal year after-tax non-operating cash flow?

A)

(\$9,000).

B)

(\$4,000).

C)

\$21,000.

Explanation

Terminal cash flow = [salvage price] − (tax rate) × [salvage price − book value] ± reversal of change in working capital.

= 10,000 − (0.40) × (10,000 − 0) − 15,000 = 10,000 – 4,000 − 15,000 = −9,000.

If the problem says working capital will reduce due to purchasing the equipment, why do we not add the \$15,000?

If working capital reduces, then that would be a source of cash (i.e. cash inflow) which will reduce your initial outlay.

So, in the terminal year, working capital will increase by \$15k (which will be a use of cash of \$15k, i.e. cash outflow)