Question

sercises 16.1 The SBX Construction Company is considering an investment of $50,000 for a horizontal boring machine. There is no increase in working capital require- ments and no tax credits. Depreciation is straight line and the salvage value is zero. The tax rate is 40 percent and the required IRR is 15 percent. Cash op- erating costs are $10,000 a year. Cash operating revenues are $30,000 per year. The estimated life of the boring machine is five years. a. Determine the EATCF stream. b. Determine NPV at 10 percent for the equipment investment. c. Determine the IRR for the investment. d. Is the boring machine a desirable investment? Explain your answer in a memo to the project manager.

Answer 1

Details given
Depreciation	SLM
Salvage value	0
Tax	40%
Required IRR	15%
Cash Opex (pa)	10,000
Cash revenue (pa)	30,000
Life of asset (yrs)	5
Investment	50,000

Answer

A)

Year ===>	1	2	3	4	5
EATCF Stream
Cash revenue	30,000	30,000	30,000	30,000	30,000
Cash opex	-10,000	-10,000	-10,000	-10,000	-10,000
Depreciation Cost of asset/life of asset 50,000/5	-10,000	-10,000	-10,000	-10,000	-10,000
Earnigs before tax (EBT)	10,000	10,000	10,000	10,000	10,000
Tax (EBT*40%)	-4,000	-4,000	-4,000	-4,000	-4,000
Earnings after tax	6,000	6,000	6,000	6,000	6,000
Add depreciation	10,000	10,000	10,000	10,000	10,000
EATCF	16,000	16,000	16,000	16,000	16,000

B)

NPV at 10%
Year ===>	0	1	2	3	4	5
Investment	-50,000
EATCF		16,000	16,000	16,000	16,000	16,000
Net cash flow	-50,000	16,000	16,000	16,000	16,000	16,000
Discount rate	10%	10%	10%	10%	10%	10%
Discount: 1/(1.10^year)	1.0000	0.9091	0.8264	0.7513	0.6830	0.6209
Discounted net cash flow Net cash flow*discount	-50,000	14,545	13,223	12,021	10,928	9,935
NPV (Sum of Discounted net cash flow	10,653

C)

IRR: It is the discount rate where the net present value of a project is zero. It has to be calculated on a trial and error basis. Below we have calculated the NPV, with three rates, 15%, 18% and 18.03%. Since the NPV at 18.03% is closest to zero, NPV is close to 18.03%

Year ===>	0	1	2	3	4	5
Net cash flows	-50,000	16,000	16,000	16,000	16,000	16,000
Discount rate	15%	15%	15%	15%	15%	15%
Discount	1.0000	0.8696	0.7561	0.6575	0.5718	0.4972
Discounted net cash flow at 15% Net cash flow*discount	-50,000	13,913	12,098	10,520	9,148	7,955
NPV	3,634
Discount rate	18%	18%	18%	18%	18%	18%
Discount	1.0000	0.8475	0.7182	0.6086	0.5158	0.4371
Discounted net cash flow at 18% Net cash flow*discount	-50,000	13,559	11,491	9,738	8,253	6,994
NPV	35
Discount rate	18.03%	18.03%	18.03%	18.03%	18.03%	18.03%
Discount	1.0000	0.8472	0.7178	0.6082	0.5153	0.4366
Discounted net cash flow at 18% Net cash flow*discount	-50,000	13,556	11,485	9,731	8,244	6,985
NPV	1

D) Memo to the project manager

Memorandum

To,

The project manager

From,

Name

Date,

24-Mar-2020

Subject:

Based on my analysis, I find that the investment in the boring machine can be undertaken. I am basing this decision on the IRR calculated, which is around 18.03%, which is more than the required IRR of 15%.