Question

KB Machine Limited is considering investing $3 million in new machinery, Model X. If the new model is acceptable, the old machine will be disposed at $500,000 immediately. A feasibility study, completed by consultants at a cost of $300,000, has confirmed that the equipment will help increase output and improve quality. The expected sales so generated amount to $1 million per year over the life of the project. The equipment will depreciate on a straight-line basis to a zero book value over the estimated life of five years. Cost of goods sold and operating expenses related to the projects are predicted to be 20% of sales. An extra investment in inventory for spare parts and accessories of total $600,000 will be required at the beginning of the project and will be fully recovered at the end of the project The corporation tax rate is 20% payable at end of the relevant year. Assume the cost of capital is 10% (b) What is the initial investment outlay of the project? (c) i) What is the annual depreciation expense of the machinery? ii) What are the earnings before interest and tax (EBIT) and annual cash flow of the project for the years 1 to 4? iii) What is the terminal cash flow in Year 5? (d) Compute the net present value of the project and the internal of return of the project? and advise whether the project is acceptable or not?

Answer 1

Requirement (b) Cost of new machinery 30,00,000 (+) Working Capital at the beginning 6,00,000 (-) Sale Value of old machine -5,00,000 Net Initial Investment outlay 31,00,000 The cost for feasibilty study has already been paid. Hence, irrelevant for decision making. Requirement (c) 30,00,000 Cost of Machinery (-) Useful Life Depreciable Value Useful life Annual Depreciation (3000000/5) 30,00,000 5 years 6,00,000 $ The annual depreciation is $ 600,000. (ii) Annual Sales (-) Cost of Goods sold and other (1000000*20%) (-) Annual Depreciation EBIT (-) Tax (200000*20%) EAT (+) Depreciation Annual Cash Flows 10,00,000 -2,00,000 -6,00,000 2,00,000 -40,000 1,60,000 6,00,000 7,60,000 The EBIT is $ 200,000 and Annual cash flows from year 1 to year 4 is $760,000. Annual cash flow (+) Working capital recovered Terminal Cash Flow at the end of Year 5 7,60,000 6,00,000 13,60,000 The terminal cash flow in year 5 is $ 1,360,000.

Requirement (d) Year Cash flows -31,00,000 7,60,000 7,60,000 7,60,000 7,60,000 13,60,000 PVIF at 10% 1.00000 0.90909 0.82645 0.75132 0.68302 0.62093 Net Present Value $ Disc. Cash Flows -31,00,000 6,90,908 6,28,102 5,71,003 5,19,095 8,44,465 1,53,573 $ Year nM Cash flows -31,00,000 7,60,000 7,60,000 7,60,000 7,60,000 13,60,000 PVIF at 11% 1.00000 0.90090 0.81162 0.73119 0.65873 0.59345 Total Disc. Cash Flows -31,00,000 6,84,684 6,16,831 5,55,704 5,00,635 8,07,092 64,946 PVIF at 12% 1.00000 0.89286 0.79720 0.71179 0.63553 0.56744 Disc. Cash Flows -31,00,000 6,78,574 6,05,872 5,40,960 4,83,003 7,71,718 -19,873 IRR = 11% + (64946/(64946+19873) IRR = 11% +0.77% IRR = 11.77% Hence, the Net Present Value is $ 153,573 and Internal rate of return is 11.77%. The project may be acceptable due to following reasons- 1. The Net Present Value of the project is positive. 2. The Internal rate of return is more than the Cost of Capital.