Question

You are the Financial manager of XYZ, Inc., a retailer of the exercise machine and related accessories. Your firm is considering opening up a new store in Beirut. The store will have a life of 20 years. It will generate annual sales of 5,000 exercise machines, and the price of each machine is $2,500. The annual sales of accessories will be $600,000, and the operating expenses of running the store, including labor and rent, will amount to 50 percent of the revenues from the exercise machines. The initial investment in the store will equal $30 million and will be fully depreciated on a straight-line basis over the 20-year life of the store. Your firm will need to invest $2 million in additional working capital immediately, and recover it at the end of the investment. Your firm’s marginal tax rate is 30 percent. The opportunity cost of opening up the store is 10 percent. What are the incremental cash flows from this project at the beginning of the project as well as in years 1-19 and 20? Should you approve it? Aa

Answer 1

Answer:

XYZ, Inc.

Incremental Cash Flows:

                                                           Year 0       Year 1 - 19         Year 20

a) Annual Machine Sales

      (5,000 x $2,500)                               $0  $237,500,000  $12,500,000

b) Annual Sales of accessories                 0        11,400,000          600,000

Operating Expenses (50% of a)                0     -118,750,000     -6,250,000

Investment                               -30,000,000

Working Capital investment     -2,000,000                                2,000,000

Income Taxes                                             0      -30,495,000    -1,605,000

Incremental Cash flows        -$32,000,000    $99,655,000  $7,245,000

b) I should approve the budget based on the incremental cash flows.

Explanation:

The incremental cash is cash flow that a company obtains when it takes on a new project.

a) Annual machine sales = $12,500,000 (5,000 x $2,500).  For 19 years, it will total $237,500,000 ($12,500,000 x 19).

b) Annual sales of accessories is $600,000 while for 19 years it is $11,400,000.

c) Annual operating expenses equal 50% of sales of machines.  This is equal to $6,250,000 ($12,500,000 x 50%).  For 19 years, it is $118,750,000 ($6,250,000 x 19).

d) Income taxes are applied after deducting tax depreciation from the annual revenue less operating expenses.  Based on the straight-line method, the annual depreciation is $1,500,000 ($30,000,000/20).

e) There is no tax on the working capital recovered in the 20th year.  It is possible to discount the cash flows to their present values, using the cost of capital as 10%.  The resulting figure is compared to the initial investments.  However, this may not be a requirement of this question.