# Fresno Furniture Manufacturing Inc. currently earns annual revenues of $350,000 and incurs total...

## Question:

Fresno Furniture Manufacturing Inc. currently earns annual revenues of $350,000 and incurs total operating expenses (excluding depreciation and interest expense) of 45.00% of revenues. Its earnings are taxed at a rate of 40.00%.

Today, its budgeting committee is evaluating the purchase of a new lathe. The lathe is expected to cost $65,000, plus $4,000 in freight and setup expenses, and will be depreciated using straight-line depreciation.

It is expected that the lathe will have a useful life of five years and a salvage value equal to 25.00% of its purchase price of $65,000. It is expected that the lathe will be sold for its book value, such that no capital gain or loss will be realized. It is further expected that the lathe will cause a 25.00% increase in the firm's annual sales and total operating expenses (excluding depreciation and interest expense). If the lathe is purchased, the firm will require an additional $10,000 in net working capital (NWC). Given this information, answer the following questions:

a. What is the annual depreciation expense for the lathe?

b. What is the net investment (NINV) of the investment?

c. What are the net annual operating after-tax cash flows associated with this project?

d. What is the project's last year (terminal) cash flow?

## Operating cash flow of project:

Operating Cash Flow (OCF) is calculated as the amount of cash generated general operating activities of a business for a specific period of time (like, for an year).

*OCF = net income + non cash expenses -net increase in working capital if any *

Operating cash flow is an an important part of project feasibility analysis as it reflects the health of the core business or activity of the company. A company cannot remain solvent in the long run without a positive OCF from the business. OCF is also to used to compute the FCF(free cash flow) to derive the net present value of the business.

## Answer and Explanation:

**a. What is the annual depreciation expense for the lathe?**

Initial cost {eq}= $65,000 + $4,000 = $69,000 {/eq}

Tenure {eq}= 5 ~years {/eq}

Salvage value {eq}= 25\%*$69,000 = $ 17,250 {/eq}

So annual depreciation {eq}= ($69,000 - $ 17,250)/5 = $ 10,350 {/eq} per year

**b. What is the net investment (NINV) of the investment?**

Landed cost of the lathe {eq}= $69,000 {/eq}

Increase of W/C {eq}= $10,000 {/eq}

So, net investment {eq}= $69,000 + $10,000 = $79,000 {/eq}

**c. What are the net annual operating after-tax cash flows associated with this project?**

Existing sales {eq}= $350,000 {/eq}

Existing operating expenses {eq}= $350,000*45.00\% {/eq}

So existing gross income {eq}= $350,000*(1-45\%) {/eq}

As annual sales and operating expenses increase @25% so increased gross income

{eq}= $350,000*(1-45\%)*1.25 = $ 240,625 {/eq}

Considering the depreciation, net income {eq}=( $ 240,625 - $ 10,350)*(1-40\%) = $ 138,165 {/eq}

OCF = net income + depreciation added back {eq}= $ 138,165 + $ 10,350 = $ 148,515 {/eq}

**d. What is the project's last year (terminal) cash flow?**

Terminal cash flow = last year OCF + recovery of working capital + after tax salvage value

{eq}=$ 148,515 + $10,000 + $ 17,250 {/eq}

{eq}=$ 175,765 {/eq}

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from Finance 101: Principles of Finance

Chapter 10 / Lesson 4