I'm having a terrible time understanding how to estimate cash flow. My book only provides one example, and it's long and drawn out.
The question I'm working on is this:
A project that is expected to last six years will generate a profit and cash flow contribution before taxes and depreciation of $23,000 per year. It requires the initial purchase of equipment costing $60,000, which will be depreciated over four years. The relevant tax rate is 25%. Calculate the project's cash flows.
I don't even know where to start. Do I assume the depreciation is straight-line, or does that even matter? Do I take out the 60grand from the first year's cash flow? Where/when do I figure in the tax rate--the example in the book doesn't even mention this. Please help! This problem just feels like there isn't enough information, but I'm sure there is, and I'm just not getting it.
To estimate cash flow, you need to consider various elements such as profit before taxes and depreciation, equipment costs, depreciation, and tax rate. Here's how you can approach this problem step-by-step:
1. Start with the profit before taxes and depreciation, which is given as $23,000 per year. This represents the cash inflow generated by the project each year.
2. Next, consider the initial purchase of equipment costing $60,000. Since the equipment will be depreciated over four years, you need to calculate the annual depreciation expense. To do this, divide the initial cost by the number of years. In this case, $60,000 divided by 4 equals $15,000 of depreciation each year.
3. Now that you have the depreciation amount per year, you need to deduct it from the profit before taxes and depreciation. This is because depreciation is a non-cash expense, meaning it does not involve actual cash outflow. Therefore, subtract $15,000 from $23,000 to get the cash flow contribution before taxes.
4. Since the problem mentions a relevant tax rate of 25%, you need to consider the effect of taxes. Multiply the cash flow contribution before taxes by the tax rate of 25%, and subtract this amount from the cash flow contribution before taxes.
Let's apply these steps to calculate the project's cash flows for each year:
Year 1:
Cash flow contribution before taxes and depreciation: $23,000
Depreciation expense: $15,000
Cash flow contribution before taxes: $23,000 - $15,000 = $8,000
Tax at 25%: $8,000 * 0.25 = $2,000
Cash flow: $8,000 - $2,000 = $6,000
Years 2-6:
Cash flow contribution before taxes and depreciation: $23,000
Depreciation expense: $15,000
Cash flow contribution before taxes: $23,000 - $15,000 = $8,000
Tax at 25%: $8,000 * 0.25 = $2,000
Cash flow: $8,000 - $2,000 = $6,000 (same for each year)
Therefore, the project's cash flows for each year are $6,000.
Regarding the assumption of straight-line depreciation, unless otherwise specified, it is generally safe to assume straight-line depreciation for simplicity. However, it's always a good practice to clarify any assumptions or specific instructions provided in your course materials.
Remember, estimating cash flows involves considering various factors, such as profits, depreciation, taxes, and any other relevant information. By following these steps, you should be able to calculate cash flows for a project.