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# After Tax Cash Flows

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After Tax Cash Flows
The Kiddie Toys Company must decide whether to manufacture a new product line -- Breakdance Doll.
The company has already spent \$460,000 (which was totally tax deductible) to design the product and
test the market. If the company decides to go ahead with production of Breakdance Doll, it expects to
spend an additional \$60,000 to further modify the product design. This \$60,000 outlay will occur
immediately and will be totally tax deductible.
To manufacture the Breakdance Doll, Kiddie Toys must purchase a new machine. The machine and the
new product line have an expected life of 5 years. For income tax purposes, the machine will be
depreciated as follows (to a zero residual value): 20% the first year, 30% the second year, 20% the third
year, 15% the fourth year, and 15% the fifth year . However, at the end of the fifth year, the machine is
expected to have an economic salvage value of \$15,000.
The company hired a consulting firm to project the before-tax operating cash flows for the new product
line. The consulting firm's fee was \$135,000 and was totally tax deductible. Their projections appear
below:
Incremental Incremental
End of Year Cash Receipts* Cash Outlays#
1 \$ 250,000 \$ 75,000
2 425,000 250,000
3 475,000 300,000
4 600,000 425,000
5 650,000 475,000
\$2,400,000 \$1,525,000
*Exclusive of the salvage value in year 5.
#Exclusive of other outlays mentioned earlier.
Kiddie Toys has an average income tax rate of 30% and a marginal income tax rate of 34%.
Required:
In helping to determine the maximum amount, P, that Kiddie Toys should pay for the new machine to
manufacture the Breakdance Doll, it is necessary to determine the relevant after-tax cash flows. Then, by
discounting these cash flows using an appropriate cost of capital one can find the price at which the Net
Present Value becomes zero. Anything more than this price would not be beneficial. Of course, less
would be better (Mies van der Rohe said something similar, I think).
Use the next page to set forth the relevant cash flows. The after-tax cash flows are the only items
necessary to answer this question, However, later in this course you will have to discount the cash
flows and solve for P.
You may assume that all cash flows take place at discrete points in time (Time 0, 1, etc.) and that any
losses/deductions generated by this project can be used to offset taxable income from Kiddie Toys' other
operations.
GRAHAM SCHOOL: CORPORATE FINANCE
Page

#### Solution Preview

The after tax cash flows are calculated as
After tax cash flow = After tax incremental cash flows + depreciation tax shield.
The tax rate to use is the marginal tax rate since that is the rate applicable to current income. The rate to use is 34%
After tax cash flow = before tax X (1-tax rate)

The cash flows are
Year 0 - In year zero \$60,000 would be spent to modify the product and this is totally tax deductible
After tax cash flow = -60,000 X (1-0.34) = ...

#### Solution Summary

The solution explains the calculation of after tax cash flows

\$2.19