Question

The Freeman Manufacturing Company is considering a new investment. Financial projections for the investment are tabulated below. The corporate tax rate is 34 percent. Assume all sales revenue is received in cash, all operating costs and income taxes are paid in cash, and all cash flows occur at the end of the year. All net working capital is recovered at the end of the project.
a. Compute the incremental net income of the investment for each year. (Do not round intermediate calculations.)
b. Compute the incremental cash flows of the investment for each year. (Do not round intermediate calculations. A negative answer should be indicated by a minus sign.)
c. Suppose the appropriate discount rate is 12 percent. What is the NPV of the project?

Answer 1

Complete question is given at the end of the question.

Answer with Explanation:

Requirement 1:

Net Income is an accounting profits which includes both cash flow items and non cash flow items. It can be calculated as under:

Net Income = (Sales  -  Cost  - Depreciation) -  (Income Before Tax * Tax Rate)

The computation is given in the Second excel sheet attached.

Requirement 2:

According to relevant costing principles if the cost is relevant then it must satisfy following conditions:

• Must be cash flow in nature.

• Must be Future related (no past commitments).

• Differential or must be incremental

So this means that the depreciation would not be taken into account as it is not a relevant cost and thus must not be included as an incremental cost.

Incremental Cash flow can be calculated using the following formula:

Incremental Cash Flow = Net Income  + Depreciation (Removing its impact) - Working Capital Injection + Working Capital Withdrawal

The calculation for each year is shown in the second attachment.

Requirement 3:

The NPV can be calculated by discounting each year cash flow by the rate of return which in this case is 12%.

The formula for calculating the NPV is as under:

NPV = Investment in year zero -  Net Cash Flow of Y1 / (1 + r)^1      -  Net Cash Flow of Y2 / (1 + r)^2     -  Net Cash Flow of Y3  / (1 + r)^3             -  Net Cash Flow of Y4 / (1 + r)^4

The computation of NPV is given in the second attachment given below: