StudySession11 Question

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chippp

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You have been asked by the president of your company to evaluate the proposed acquisition of a new special-purpose truck. The truck's basic price is $50,000, and it will cost another $10,000 to modify it for special use by your firm. The truck falls into the MACRS three-year class, and it will be sold after three years for $20,000. Use of the truck will require an increase in net working capital (spare parts inventory) of $2,000. The truck will have no effect on revenues, but it is expected to save the firm $20,000 per year in before-tax operating costs, mainly labor. The firm's marginal tax rate is 40 percent.

What is the operating cash flow in Year 1?

A) $21,737

B) $17,820

C) $20,121

D) $19,920

E) $18,254

Can somebody suggest to me why the answer is D? What happens to NWC ?
 
Hi chippp,

In this case increase in NWC cannot be considered an addition to the Cashflow from operating activities because any addition in the current assets (inventory of spare parts) is considered a reduction. It is assumed that the inventory rises against another current liability like creditors, no actual long term capital input. Thus, an increase in inventory shall appear as a negative figure in the cashflow statement under the operating activities. This nets off the effect, hence, not considered.

Well, i get $20,000 as net cash inflow. Can you send me the answers. How do you get $19,920.

Thanks in advance.
 
I think the cash flow will be $19,920. The calculation is as under:

Under MARCS schedule property gets depreciate : 33% in yr-1, 45% in yr-2 & 15% yr-3

Operating cash flow in yr 1:

= (20,000)*(1-0.4) + (60,000*0.33*0.4)

= $19,920

NWC capital is added back at the end of the project. So, it will not have any impact in this case.

Hope this helps.
 
The formula for Operating cash flow is:

= (Revenue - Cost) * ( 1 - Tax) + Depreciation * Tax

Revenue = 0

Reduces cost by 20,000 so, it is -20,000 in the above equation.

had they asked for Yr-3 cash flow you would have added back the increase in NWC + paid taxes on the gain of sale of the equipment (since it is fully depreciated) + Operating cash flow for yr-3 to arrive at the final cash flow
 
Hi satyaa


Operating cash flow in yr 1:

= (20,000)*(1-0.4) + (60,000*0.33*0.4)


I'm sorry but you are wrong above. Depriciation effect should be $40,000 *0.33* (1-0.4).

You are getting the same answer co-incidentally because u used 60K instead of 40K & 0.4 instead 0.6, which nets off the effect.

Lucky Chap !!
 
Hi Satyaa & Hellosubhash,

I guess there were 2 parts to this question that I didn't grasp. One would be the NWC which I still don't. And the other would be the MARCS depreciation which I never did come across in the Schweser Study guides.

But the answer for this question is exactly as Satyaa posted.

Question: If we consider NWC in the terminal year, why do we not consider NWC in Year 1 (or Year 0 for that matter) ?
 
Why do you think it will be 40k, the cost of the asset is the cost price plus any additional expenses that would make it operable. in that case it is 50k+10k = 60k.

I am not sure why would you use 40K?

The formula above is fine. If you are using Schweser look on page - 47 (for 2005 notes).

Thanks
 
In the terminal year the project gets over so you get back any increase in NWC. Increase or decrease in NWC is because of the project. At any time in between the project is still active, so you cannot claim NWC at that stage.
 
Hi Satyaa & Chippp

Hey guys, I'm absolutely sorry for misguiding, if i ever did, which I don't think happend because of the participation of satyaa. He's absolutely correct.

i am hapy that I took part in this discussion & shall be aware of such mistakes in the future.

well satyaa, it shall be really nice of you if you could throw some more light on the NWC issue, may be just elaborate it a bit. and, were I wrong in my 1st reply that i posted??

thanks so much!!
 
Guys,

Can somebody tell me how do they get these MACRS number. like first year 0.20, then 0.33 etc.

How can we calculate these number or will they be given.

Regards,
 
miku Wrote:
-------------------------------------------------------
> Guys,
>
> Can somebody tell me how do they get these MACRS
> number. like first year 0.20, then 0.33 etc.
>
> How can we calculate these number or will they be
> given.
>
> Regards,

It's kinda bullsh!t cuz nowhere in the Schweser readings did I see them lay out a 5-year MACRS schedule...but it is something I learned in undergrad intro finance. I can't remember what the percentages are each year, but it's something like 20%, 33%, 27%...15%...you get the idea. I guess we are expected to memorize those depreciation schedules.
 
I seriously doubt they'll ask us about this. I think in Schweser, it says that if we have to do MACRS, they'll probably give us the rates.

I wouldn't stress on it.
 
Quick question on this one

Based the calculations

$50,000 + $10,000 = $60,000 depreciable base X .33 = $19,800 depreciation expense

$20,000 savings goes right to EBITD

So 20,000 - 19,800 = 200 x (1-.40) = 120 in NI

120 + 19,800 = $19,920

But even though it is understood that you will receive the increase in WC back at term why don't you make the necessary adjustment of $2,000 which is an increase and thus a negative component of CFO

If 17,720....I would have picked that one.

Any feedback is appreciated...Thanks
 
nosekibitser ur right that the 2000 would decrease the cashflows.however this would occur at time o ie at the beginning of the project.the question asks for the year 1 cashflows which i assume is a year after the beginning of the project.

that MARC whaterver business i doubt if we are supposed to cram.
 
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