Question

AECjur each and explain which quote Salt Line should accept QUESTION7 (20 marks) After an extensive feasibility study on savings strategies that cost $25,000, Bright Ltdis consideringthe purchase of new equipmentcosting$500,000, which it will fully finance with a fixed interest loan of 10% per annum, with the principal repaid at the end of 4 years The new equipment will reduce the company's manufacturing costs by $190,000a year for 4 years. Bright will depreciate the equipment by the straight-ine method to zero salvage value over the 4 years. The company thinks thatit can sell the equi end of 4 years for $20,000 pmentat the Bright will install the equipment in a building whichis currentlybeingrented outfor 530,000 a year under a lease agreement with 4 yearlyrental payments to run, the next one being due atthe end of one year. Under the lease agreement, BrightLtd can cancel the lease by paying the tenanttoday compensation equal to one year's rental payment plus 10%, but this amount is not deductible for income tax purposes The company further estimates that it will have to spend $15,000 in 2 years' time overhauling the equipment. It will also require additions to current assets of $35,000 at the beginning of the project, which will be fully recoverable at the end of the fourth year BrightLtd's cost of capital is 12% The tax rate is 30%. Tax is paid in the year in which earnings are received a. Calculate the incremental cash flows 10 marks b. Calculate the payback period of the proposed purchase 2 marks c. Calculate the net present value, that is, the net benefit or netloss in present value terms of the proposed purchase 4 marks d. Calculate the present value index of the proposedpurchase 2 marks e. Should the company purchase the equipment? Explainwhy orwhy not 2 marks END OF ASSIGNMENT QUESTIONS

Answer 1

1)	calculation of incrementalcashflow
		Year	0	1	2	3	4
	a	Cost cancelling lease(30000*110%)	-33000
	b	Working capital (current assets)	-35000
	c
	d	Saving in cost		190000	190000	190000	190000
	e	Depreciation (500000/4)		125000	125000	125000	125000
	f	repairs			15000
	g	Interest(500000*10%)		50000	50000	50000	50000
	h	Oppurtunity cost (of building lease)		30000	30000	30000	30000
	i	Net benefit before tax(d-e-f-g-h)		-15000	-30000	-15000	-15000
	j	Tax@30%(i*30%)		-4500	-9000	-4500	-4500
	k	Net benefit after tax(i-j)		-10500	-21000	-10500	-10500
	l	Operating cashflow(k+e)		114500	104000	114500	114500
	m	Working capital realised					35000
	n	Post tax salvage value [20000*(1-0.3)]					14000
	o	Repayment of loan					-500000
	p	Total cashflow(l+m+n+o)	-68000	114500	104000	114500	-336500
	q	PVF@12 %	1	0.8929	0.7972	0.7118	0.6355
	r	Discounted CF (p*q)	-68000	102232.1	82908.16	81498.84	-213852
b)		Total cash out flow	=	68000+336500
			=	404500
		Total cash inflow	=	114500+104000+114500
			=	333000
		Since total cash out flow is more than total cash inflow,the payback period is more than 4 years (beyond project life)
c)		NPV	=	Sum of all cashflows
			=	-15212.7
d)		present value index	=	Sum of cashflow in year 1 to yr 4/initial year outflow
			=	(102232+82908+81498-213852)/68000
			=	0.776265
e)	The company should not purchase equipment as NPV is negative& PV index is less than 1
	Note
	$25000 on feasibility study is sunk cost & will not be considered