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

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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}


Learn more about this topic:

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Operating Cash Flow: Definition & Examples

from Finance 101: Principles of Finance

Chapter 10 / Lesson 4
10K

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