# You are considering two machines. A and B that can be used for the same purpose. Machine A costs...

## Question:

You are considering two machines. A and B that can be used for the same purpose. Machine A costs $250,000, will reduce costs by $75,000 per year needs working capital of $20,000 at time zero which will be release at the end of the project has a 5-year straight line depreciable life and can be sold at the end of the projects life for $50,000. Machine B costs $320,000, will reduce costs by $70,000 per year, has net working capital of $40,000 at time zero will be released at the end of its life, has a ten-year straight line depreciable life and can be sold at the end for 60,000. Assume that the tax rate is 34% and the discount rate is 10%.

A) What are the relevant per year operating cash flows with machine A year 1 through 5?

a. $52,800

b. $69,800

c. $72,400

d. $63,200

e. $78,200

B) What are the relevant per year operating cash flows with machine B year 1 through 5?

a. $69,800

b. $63,680

c. $68,630

d. $32,000

e. $57,080

## Operating cash flow (OCF)

Operating cash flow is calculated as the net cash generated by the business, from its normal course of activity. It is calculated as:

*Operating Cash Flow = Net Income + Non-Cash Expenses - Increase in Working Capital (if any)*

OCF is used in the financial modelling to get the value of the business, as along with the capital expenditure, OCF derives the quantum of free cash flow of the project in each year through its operating life. with in discounted by the cost of capital of the project, generates the value of the business.

## Answer and Explanation:

**A) What are the relevant per year operating cash flows with machine A year 1 through 5? **

Cost of the machine {eq}= $250,000 {/eq}

Annual depreciation {eq}= ($250,000 - $50,000)/5 = $ 40,000 {/eq}

Depreciation tax shield {eq}= $ 40,000*34\% = $ 13,600 {/eq}

After tax effective reduction of cost {eq}= $75,000*(1-34\%) = $ 49,500 {/eq}

So, net relevant per year OCF {eq}=$ 13,600 + $ 49,500 = $ 63,100 {/eq}

Option (d) correct.

**B) What are the relevant per year operating cash flows with machine B year 1 through 5?**

Cost of the machine {eq}= $320,000 {/eq}

Annual depreciation {eq}= ($320,000 - $60,000)/5 = $ 52,000 {/eq}

Depreciation tax shield {eq}= $ 52,000*34% = $ 17,680 {/eq}

After tax effective reduction of cost {eq}= $70,000*(1-34\%) = $ 46,200 {/eq}

So, net relevant per year OCF {eq}=$ 17,680 + $ 46,200= $ 63,880 {/eq}

Option (b) correct.

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from Finance 101: Principles of Finance

Chapter 10 / Lesson 4