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# Determining Relevant Cash Flows Time Line

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For each of the following projects, determine the relevant cash flows, classify the cash flow pattern, and depict the cash flows on a time line.

a. A project that requires an initial investment of \$120,000 and will generate annual operating cash inflows of \$25,000 for the next 18 years. In each of the 18 years, maintenance of the project will require a \$5,000 cash outflow.

b. A new machine with an installed cost of \$85,000. Sale of the old machine will yield \$30,000 after taxes. Operating cash inflows generated by the replacement will exceed the operating cash inflows of the old machine by \$20,000 in each year of a 6 year period. At the end of year 6, liquidation of the new machine will yield \$20,000 after taxes, which is \$10,000 greater than the after tax proceeds expected from the old machine had it been retained and liquidated at the end of year 6.

c. An asset that requires an initial investment of \$2 million and will yield annual operating cash inflows of \$300,000 for each of the next 10 years. Operating cash outlays will be \$20,000 for each year except year 6, when overhaul requiring an additional cash outlay of \$500,000 will be required. The asset's liquidation value at the end of year 10 is expected to be zero.

#### Solution Preview

For each of the following projects, determine the relevant cash flows, classify the cash flow pattern, and depict the cash flows on a time line.

a. A project that requires an initial investment of \$120,000 and will generate annual operating cash inflows of \$25,000 for the next 18 years. In each of the 18 years, ...

#### Solution Summary

For each of the following projects, determine the relevant cash flows, classify the cash flow pattern, and depict the cash flows on a time line. Solution contains an attached Word document.

\$2.19

## After Tax Cash Flows - Capital Budgeting Problem for Kiddie Toys Company

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

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