Cash flow analysis. Kary Kinnard has an opportunity to open a franchised pizza outlet. He can lease the building, so he needs to invest only in equipment, which he estimates will cost $60,000. For tax purposes, assume he will depreciate the full amount for the equipment over six years using the straight-line method. For purposes of this analysis, assume the equipment will last six years, after which Kinnard will sell it for $6,000. He will pay taxes at 40 percent on the taxable gain from the disposal at the end of Year 6. Kinnard estimates the following revenues, variable costs, and fixed costs from operations for the six-year period. He has included expected inflation in these estimates. Assume end-of-year cash flows. 1 2 3 4 5 6 $30,000 12,000 $36,000 $41,000 14,400 16,400 $45,000 18,000 $48,000 $50,000 19,200 20,000 Revenues... Variable Costs Fixed Costs (includes depreciation of $10,000 per year). . . . . . . 15,000 15,200 15,500 15,900 16,400 17,000 Use an after-tax cost of capital of 12 percent per year and an income tax rate of 40 percent for this analysis. The equipment will require a $60,000 cash outlay at the end of Year 0. Prepare an appropriate analysis of all cash flows. Should Kinnard make the investment? SUGGESTED SOLUTIONS TO PROBLEMS 8.1 AND 8.2 FOR SELF-STUDY Year Cash Inflows Revenues Disposal of Machinery. Less Cash Outflows (Years 1-6) 0 1 2 3 45 6 Purchase of Machinery ........ ($60,000) Variable Costs Fixed Costsa. Cash Flow before Taxes..... Depreciation Taxable Incomeb. Tax (40%) Net Cash Flows. Net Present Value (at 12%). Internal Rate of Return......... $30,000 $36,000 $41,000 $45,000 $48,000 $50,000 6,000 (12,000) (14,400) (16,400) (18,000) (19,200) (20,000) (5,000) (5,200) (5,500) (5,900) (6,400) (7,000) $13,000 $16,400 $19,100 $21,100 $22,400 $29,000 (10,000) (10,000) (10,000) (10,000) (10,000) (10,000) $ 3,000 $ 6,400 $ 9,100 $11,100 $12,400 $19,000 (1,200) (2,560) (3,640) (4,440) (4,960) (7,600) (60,000) $11,800 $13,840 $15,460 $16,660 $17,440 $21,400 3,899 14% aFixed costs less depreciation. Revenues less variable costs, fixed costs, and depreciation, plus disposal in Year 6. "Cash flow before taxes less taxes.