Use the following information to answer this question.

ABC Company is considering the purchase of new equipment. The following information is relevant to the decision:

The cost of the new machine is $220,000.
Installation will cost $10,000.
The company spent $10,000 on a market analysis 2 months ago.
The project will require an immediate increase in working capital of $10,000; the working capital will be fully recaptured at the end of the life of the project.
The project will increase annual revenues by $125,000 and annual operating costs by $45,000.
The project has an estimated life of 5 years.
The machine will be depreciated via straight-line depreciation to a salvage value of $0 over the 5-year life of the asset.
Realizable salvage value in 5 years is $50,000.
The cost of capital is 14%, and the marginal tax rate is 34%.
The old machine has a book value of $0.
The old machine will be thrown away at no cost.

What is the terminal cash flow of the project?

Question

Use the following information to answer this question.

ABC Company is considering the purchase of new equipment. The following information is relevant to the decision:

The cost of the new machine is $220,000. 
Installation will cost $10,000.
The company spent $10,000 on a market analysis 2 months ago.
The project will require an immediate increase in working capital of $10,000; the working capital will be fully recaptured at the end of the life of the project.
The project will increase annual revenues by $125,000 and annual operating costs by $45,000.
The project has an estimated life of 5 years.
The machine will be depreciated via straight-line depreciation to a salvage value of $0 over the 5-year life of the asset.
Realizable salvage value in 5 years is $50,000.
The cost of capital is 14%, and the marginal tax rate is 34%.
The old machine has a book value of $0.
The old machine will be thrown away at no cost.

What is the terminal cash flow of the project?

BlackTom AI · Accepted Answer

First, identify the key components of the terminal cash flow:
- Recovery of working capital: the project requires an immediate increase in working capital of 10,000, which will be fully recaptured at the end of the project life, so this adds +$10,000 at terminal.
- Salvage value and tax effects: realizable salvage value in 5 years is $50,000. The asset’s book value at the end of year 5 is zero (cost 230,000, straight-line depreciation over 5 years → annual depreciation 46,000, total 230,000; BV = 230,000 − (46,000 × 5) = 0). The sale thus generates a taxable gain of $50,000. Tax at 34% of 50,000 is 17,000. After-tax salvage value = 50,000 − 17,000 = 33,000.

Now evaluate each option:
- Option A: $10,000. This would reflect only the recovery of working capital and ignores the after-tax salvage proceeds, which is incomplete because the salvage tax effect and the salvage amount add additional cash at termination. Therefore, this is not correct.
- Option B: $60,000. This would suggest forgetting the tax on salvage or double-counting certain components. If you only added the full salvage value (50,000) and the WC recovery (10,000) you’d get 60,000, but you must subtract the taxes on the salvage gain, which reduces the salvage cash to 33,000. Hence 60,000 is too high.
- Option C: $27,000. This would imply either incorrectly handling the salvage proceeds or the working capital recovery. The correct after-tax salvage is 33,000 and the WC recovery is 10,000, totaling 43,000. 27,000 does not align with these components.
- Option D: $43,000. This combines the after-tax salvage value (33,000) with the recovery of working capital (10,000) to yield 43,000 in terminal cash flow, which matches the proper treatment of both components.

Summary of why the other choices are incorrect: each of A, B, and C misses or misallocates either the after-tax salvage amount or the full WC recovery, or double-counts salvage in a way that does not reflect tax implications. The correct aggregation is 33,000 from after-tax salvage plus 10,000 recovered WC, totaling 43,000.

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