Question

A risk manager is considering the installation of new safety guards for the machines in the stamping process. The guards have an expected lifetime of 8 years and cost $250,000 to install. The presence of the guards have 3 negative effects: they increase annual maintenance costs by $5200 a year for the first 6 years and by $6000 a year for the last 2 years (because the machines are more difficult to service) and they increase production cost by $11,000 a year (because workers produce less output once the guards are installed). Both these expenses are realized at year end. Finally there is a training cost of $1000 a year at the beginning of the year to ensure that workers

Each year of their life, the guards are expected to reduce the employer’s retained work-injury costs and expenses related to employees injuring themselves on the production line by $10,000. These savings are realised at the end of each year. In addition the employer’s worker’s compensation insurance is willing to reduce the premium for coverage by $44,000 a year (payable at the beginning of the year) if the guards are installed. The employer faces a 34% tax rate on income and straight-line depreciation is used for the safety guards.

1. Calculate the annual after tax cash flows from installing the ventilating equipment.
2. If the firm’s cost of capital is 9%, should it install the safety guards?
3. Will the installation of the safety guards affect the firm’s cost of capital? Why or why not?

Answer 1

a)

	0	1	2	3	4	5	6	7	8
Setup Cost	250000
Maintenance Cost		5200	5200	5200	5200	5200	5200	6000	6000
Production Cost		11000	11000	11000	11000	11000	11000	11000	11000
Training Cost	1000	1000	1000	1000	1000	1000	1000	1000
Injury Expense Saving		10000	10000	10000	10000	10000	10000	10000	10000
Insurance Savings	44000	44000	44000	44000	44000	44000	44000	44000
Depreciation Adjustment		31250	31250	31250	31250	31250	31250	31250	31250
Taxable Income		5550	5550	5550	5550	5550	5550	4750	4750
Tax Rate 34%		1887	1887	1887	1887	1887	1887	1615	1615
After Tax Cashflow		-215087	34913	34913	34913	34913	34913	34385	34385

b) At 9% the NPV is -35896, but if we consider that firm has enough tax to be paid already then we can add the increased cashflow of tax payouts to the project. We don't use this for calculating post annual tax cash flows of earlier part as for project finance we consider only the project impact. But for decision of go no go we can consider the impact of tax as well. With that adjusted NPV will be $22910.52.

	0	1	2	3	4	5	6	7	8
Setup Cost	250000
Maintenance Cost		5200	5200	5200	5200	5200	5200	6000	6000
Production Cost		11000	11000	11000	11000	11000	11000	11000	11000
Training Cost	1000	1000	1000	1000	1000	1000	1000	1000
Injury Expense Saving		10000	10000	10000	10000	10000	10000	10000	10000
Insurance Savings	44000	44000	44000	44000	44000	44000	44000	44000
Depreciation Adjustment		31250	31250	31250	31250	31250	31250	31250	31250
Taxable Income		5550	5550	5550	5550	5550	5550	4750	4750
Tax Rate 34%		1887	1887	1887	1887	1887	1887	1615	1615
After Tax Cashflow		-215087	34913	34913	34913	34913	34913	34385	34385
Wacc 9%	1	0.917431	0.84168	0.772183	0.708425	0.649931	0.596267	0.547034	0.501866
Time Value	-207000	32030.28	29385.57	26959.24	24733.25	22691.05	20817.48	18809.77	-4323.58
Cashflow with Tax impact of depreciation	41777.98	38328.42	35163.69	32260.27	29596.58	27152.82	24622.01	1008.751
NPV	-35896.9
Adjusted NPV	22910.52

c) As we have assumed the cost of capital for discounting it implies that we are considering to finance it in the same proportion of debt and equity as the WACC.  In such case the installation shall have no impact on WACC. But in reality its difficult to maintain such ratio, and if financing for the project is done through some other source of funds then cost of capital gets impacts accordingly.