Introduction to Finance

Incremental After-tax Operating Cash Flows
For simplicity, assume that the incre-
mental sales and costs arising from the plant addition project will be constant over the fi ve-
year life of the addition. Sales are expected to rise by $3.0 million and costs will increase 
by $0.635 million. Using straight-line depreciation, the depreciable outlays of $4.5 million 
will increase the fi rm’s depreciation expense by $4.5 million/5 years, or $0.90 million 
per year. 
The expected increase in sales volume and production will require more working capital. 
Net working capital is expected to rise by $0.1 million in year one as the plant goes online. In 
year fi ve, the plant addition will cease operations and the fi rm will recover the $0.1 million.
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Table LE17.2
presents these data in income statement format and calculates the operating 
cash fl ows using equation 17-4.
Salvage Value
In year fi ve, the project will generate a cash infl ow as the fi rm receives 
the after-tax salvage value of the plant addition and the resale value of equipment from the 
addition. These items will be fully depreciated by the end of year fi ve, that is, their book values 
will be zero. Their collective market value was given as $1.0 million, so the after-tax salvage 
value cash fl ow is the following:
Price − 
t
(Price − BV) = $1.0 million − 0.4($1.0 million − 0) = $0.600 million
Is the Project Benefi cial to Shareholders?
Table LE17.3
summarizes the expansion 
project’s incremental cash fl ows. The net initial outlay, after-tax operating cash fl ows, and 
salvage value determine if the project will increase shareholder wealth. Table LE17.3 uses this 
information to compute the PVs of the cash fl ows, using a 10 percent required return, for the 
NPV calculation. Since the project’s NPV is positive, the plant expansion project should be 
undertaken; shareholders will benefi t from it.
Calculating the project’s operating cash fl ow through direct application of equation 17-4, 
we have the following:
(Sales – Costs – Depreciation) (1 – 
T
) + Depreciation – Change in net working capital 
= ($3.000 − 0.635 − $0.900) (1 − 0.40) + $0.900 − $0.100 = $1.679 for year one
With no further changes in net working capital, the operating cash fl ow for years two through 
four is the following:
OCF = ($3.000 − 0.635 − $0.900) (1 − 0.40) + $0.900 − $0 = $1.779