We are considering the introduction of a new product. Currently we are in the 34% tax bracket with a 15% discount rate. This project is expected to last five years and then, because this is somewhat of a fad project, it will be terminated. The following information describes the new project:
Cost of new plant and equipment: $ 7,900,000
Shipping and installation costs: $ 100,000
Unit sales:
Year Units Sold
1 70,000
2 120,000
3 140,000
4 80,000
5 60,000
Sales price per unit: $300/unit in years 1–4 and $260/unit in year 5.
Variable cost per unit: $180/unit
Annual fixed costs: $200,000 per year
Working capital requirements: There will be an initial working capital requirement of $100,000 just to get production started. For each year, the total investment in net working capital will be equal to 10% of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5.
Depreciation method: Straight-line over 5 years assuming the plant and equipment have no salvage value after 5 years.
What are the incremental cash flows for the project in years 1 through 5 and how do these cash flows differ from accounting profits or earnings?
To determine the incremental cash flows for the project in years 1 through 5, we need to consider various components such as sales revenue, variable costs, fixed costs, depreciation, working capital investment, and tax payments. Let's break down each year separately:
Year 1:
Sales revenue: 70,000 units * $300 per unit = $21,000,000
Variable costs: 70,000 units * $180 per unit = $12,600,000
Fixed costs: $200,000
Depreciation: ($7,900,000 + $100,000) / 5 = $2,000,000
Profit before tax: $21,000,000 - $12,600,000 - $200,000 - $2,000,000 = $6,200,000
Tax payment: 34% * $6,200,000 = $2,108,000
Net operating profit after tax: $6,200,000 - $2,108,000 = $4,092,000
Add back depreciation: $2,000,000
Working capital investment: 10% * $21,000,000 = $2,100,000 (increase)
Incremental cash flow: $4,092,000 + $2,000,000 + $2,100,000 = $8,192,000
Year 2:
Follow the same steps as Year 1 using the corresponding numbers for Year 2.
Incremental cash flow for Year 2 = ?
Year 3:
Follow the same steps as Year 1 using the corresponding numbers for Year 3.
Incremental cash flow for Year 3 = ?
Year 4:
Follow the same steps as Year 1 using the corresponding numbers for Year 4.
Incremental cash flow for Year 4 = ?
Year 5:
Sales revenue: 60,000 units * $260 per unit = $15,600,000
Variable costs: 60,000 units * $180 per unit = $10,800,000
Fixed costs: $200,000
Depreciation: ($7,900,000 + $100,000) / 5 = $2,000,000
Profit before tax: $15,600,000 - $10,800,000 - $200,000 - $2,000,000 = $2,600,000
Tax payment: 34% * $2,600,000 = $884,000
Net operating profit after tax: $2,600,000 - $884,000 = $1,716,000
Add back depreciation: $2,000,000
Working capital investment: 10% * $15,600,000 = $1,560,000 (decrease)
Incremental cash flow: $1,716,000 + $2,000,000 - $1,560,000 = $2,156,000
The incremental cash flows for each year, from Year 1 to Year 5, can be calculated using the above steps. These cash flows represent the additional cash generated or used by the project in each year due to its operations. They take into account not only the profit before tax but also tax payments, depreciation, and changes in working capital.
It's important to note that accounting profits or earnings only consider the revenue, costs, and expenses recorded in the income statement based on the accrual accounting method. Cash flows, on the other hand, take into account the actual cash inflows and outflows occurring in each period. Accounting profits do not consider factors like timing of cash receipts and payments, non-cash expenses like depreciation, and changes in working capital. Incremental cash flows provide a more accurate representation of the project's financial impact on the company's cash position.