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Problem Set
Question 1
MultiAlpha is considering replacing an old machine with a new one. Two months ago their chief
engineer completed a training workshop on the new machines operation and efficiency. The cost of
RM4000 cost for this workshop session has already been paid. If the new machine is purchased, it
would require RM5000 in installation and modification costs to make it suitable for operation in the
factory.
The old machine originally cost RM90000 five years ago and is being depreciated by RM15000 per year.
The new machine will cost RM80000 before installation and modification. It will be depreciated by
RM5000 per year. The old machine can be sold today for RM10000. The marginal tax rate for the firm
is 28%.
1
Question 2
Canggih Sdn. Bhd. is considering a new product. The company currently manufactures several lines of
school uniform. The new product, Canggih Jean, is expected to generate sales of RM1.0 million per year
for the next 5 years. They expected that during this five-year period, they will lose about RM250000 in
sales of existing line of jean. The new line will require no additional equipment or space in the plant
and can be produced in the same manner as the apparel products. The new project will, however,
require that the company spend an additional RM80000 per year on insurance for raw materials. Also
an additional marketing manager would be hired to oversee the line at a salary of RM45000 per year in
salary and benefits, in additional to the current manager who is earning RM60000 per year in salary and
benefits. Depreciation of RM100000 of existing plant and machinery is expected to remain the same.
If the marginal tax rate is 28%, compute the incremental after tax cash flow for
years 1-5.
2
Question 3
You have been asked by the president of your company to evaluate the proposed acquisition of new
equipment. The equipments basic price is RM193,000, and shipping costs will be RM7,700. It will cost
another RM23,200 to modify it for special use by your firm and an additional RM13,500 to install the
equipment. The equipment falls in the MACRS 3-year class, and it will be sold after 3 years for
RM30900. The equipment is expected to generate revenue of RM178,000 per year with annual
operating costs (excluding depreciation) of RM84,000. The firms tax rate is 28% and its cost of capital
is 10%..
What is the firms initial investment of the machine and what is the operating cash flow forom Year 1 -
3? Should the company invest in this new equipment?
Note: Under the MACRS 3-year class, depreciation is 33% in first year, 45% in second year, 15% in third
year and 7% in fourth year.
3
Question 4
A machine was purchases 10 years ago at a cost of RM15000. The expected life of the machine was 15
years. Its salvage value was and is still zero. The machine is depreciated using the straight-line basis.
A new machine can be purchased for RM24000, which will result in cost savings for the firm of RM6000
per annum over the 5 year useful life. The new machine can be sold for RM4000 in 5 years time. The
old machines market value is RM2000, which is below its RM5000 book value. If the new machine is
purchased, the existing one will be sold immediately. The tax rate is 28%. Net working capital
requirements will increase by RM2000 at the time of replacement. The new machine falls into the 3-
year MACRS class (Depreciation in Year 1 33%; Year 2 45%; Year 3 15%; and, Year 4 - 7% on costs).
The cost of capital is 12%.
4
28%
Profit After Tax (662.40) (2736) 2448 3830.40 5040
Add: Depreciation 6920 9800 3600 1680 (1000)
Net Cash Flow 6257.60 7064 6048 5510.40 4040
PV Factor Due, 12%, 0.8929 0.7972 0.7118 0.6355 0.5674
PV of Future Cash Inflow 5587.41 5631.42 4304.97 3501.86 2292.30
Present Value of Future 21317.95
Cash Inflows
Question 5
5
Bina Mahjaya Sdn. Bhd. is a medium-sized manufacturing company that plans to increase capacity by
purchasing new machinery at an initial cost of RM3m. The following are the most recent financial
statements of the company:
2002 2001
RM000 RM000
The investment is expected to increase annual sales by 5,500 units. Investment in replacement
machinery would be needed after five years. Financial data on the additional units to be sold is as
follows:
RM
Selling price per unit 500
Production costs per unit 200
Variable administration and distribution expenses are expected to increase by RM220,000 per year as a
result of the increase in capacity. In addition to the initial investment in new machinery, RM400,000
would need to be invested in working capital. The investment on working capital is released at the end
of year 5. The full amount of the initial investment in new machinery of RM3 million will give rise to
capital allowances on a 25% per year reducing balance basis. The tax benefit is as follows:
Year 1 2 3 4 5
RM000 RM000 RM000 RM000 RM000
Capital Allowance 750 563 422 316 949
Tax Benefits (Saving) 225 169 127 95 284
The scrap value of the machinery after five years is expected to be negligible.
Tax liabilities are paid in the year in which they arise and Bina Mahjaya Sdn. Bhd. pays tax at 30% of
annual profits.
The Finance Director of Bina Mahjaya Sdn. Bhd. has proposed that the RM34 million investment should
be financed by an issue of debentures at a fixed rate of 8% per year.
Bina Mahjaya Sdn. Bhd. uses an after tax discount rate of 12% to evaluate investment proposals. In
preparing its financial statements, Bina Mahjaya Sdn. Bhd. uses straight-line depreciation over the
expected life of fixed assets.
6
Required:
Calculate the net present value of the proposed investment in increased capacity of Bina
Mahjaya Sdn. Bhd. , clearly stating any assumptions that you make in your calculations.
Year 0 1 2 3 4 5
RM000 RM000 RM000 RM000 RM000 RM000
Sales 2,750 2,750 2,750 2,750 2,750
Production costs (1,100) (1,100) (1,100) (1,100)
(1,100)
Admin expenses (220) (220) (220) (220) (220)
Net revenue 1,430 1,430 1,430 1,430 1,430
Tax payable (429) (429) (429) (429) (429)
Tax benefits 225 169 127 95 284
1,226 1,170 1,128 1,096 1,285
Working capital (400) 400*
Investment (3,000)
Project cash flows (3,400) 1,226 1,170 1,128 1,096 1,685
Discount factors 1000 0893 0797 0712 0636
0567
Present values (3,400) 1,095 9325 803 697
9555*
7
Question 6
You buy a transporter for $50 million. It will cost another $5 million to install. You will depreciate it over
10 years, (10% each year). You expect to make $15 million each year in revenues. Operating costs will
be $2 million each year. Increase in working capital is expected to be $30 million which will be reversed
at the end of 10 years when you get out of the transporting business. At the end of 10 years, the
transporter will be salvaged for $10 million. You are in the 30% tax bracket.
4. What is your terminal cash flow at the end of year 10? Do not include the operating cash flow.
( 4 marks)
Soln:
1. 50 + 5 + 30.= $85 milliom
2. Operating income $15 $2 = $13 depreciation (10% of 55 = 5.5) = $7.5 million before tax.
$7.5(1-.3) = $5.25 million after tax.
4. Sell for $10 million, book value is zero at this time so you have a gain of $10 million minus $3 million
in taxes for $7 million. Add back working capital of $30 million (no longer will need it so working capital
is now reduced by $30 million) so terminal cash flow is $37 million.
Year 1: 33%
Year 2: 45 Stock increase by $400000, Acc
Year 3: 15 receivables increase by $200000 and
Year 4: 7 payables by $100000
The expansion will require the company to increase its net operating working capital by
$500,000 today (t = 0). This net operating working capital will be recovered at the end of four
years (t = 4).
The equipment is not expected to have any salvage value at the end of four years.
The companys operating costs, excluding depreciation, are expected to be 60 percent of the
companys annual sales.
The expansion will increase the companys dollar sales. The projected increases, all relative to
current sales are:
8
(For example, in Year 4 sales will be $4 million more than they would have been had the project
not been undertaken.) After the fourth year, the equipment will be obsolete, and will no longer
provide any additional incremental sales.
The companys tax rate is 40 percent and the companys other divisions are expected to have
positive tax liabilities throughout the projects life.
If the company proceeds with the expansion, it will need to use a building that the company
already owns. The building is fully depreciated; however, the building is currently leased out. The
company receives $300,000 before-tax rental income each year (payable at year end). If the
company proceeds with the expansion, the company will no longer receive this rental income.
The projects WACC is 10 percent.
a. -$1,034,876
b. -$1,248,378
c. -$1,589,885
d. -$5,410,523
e. -$ 748,378
9
i. New project NPV Answer: b Diff: T
MACRS
Depreciation Annual
Year Rates Depreciation
1 0.33 $1,650,000
2 0.45 2,250,000
3 0.15 750,000
4 0.07 350,000
(10 MARKS )
Question 8
LitrakNPC Sdn. Bhd. is considering an investment proposal that requires initial investments of RM250000 in
plant and machinery. Fully depreciate existing equipment may be disposed off for RM40000 before tax. The
proposed project will have a five-year life, and is expected to produce additional revenue of RM80000 per
year. Expenses other than depreciation will be RM15000 per year. The new plant and machinery will be
depreciated to zero over the five year useful life, but it is expected to be sold for RM30000. The corporation
tax rate is 28%.
3. What is the total cash flow at the end of year five (operating cash flow for year five plus terminal cash
flow)? (2 marks)
Cash inflow Year 5Amount (RM)Cash inflow60800 Disposal of AssetBook Value0Sold30000Gain 30000
Tax 28%8400 Cash inflow30000 - 840021600 Gross Inflow82400
4. What is the NPV for this project (cost of capital is 8%) (3 marks)
ItemPV 8% 5 yrs PVCash Inflow Year 1- 460800 per year60800 x 3.3121 - 1201375.68Terminal Cash
inflow YR58240082400 x 0.6806 - 156081.44257457.12Initial Outflow(221200) 1NPV36257.12
Question 9
Given the following information, calculate the NPV of a proposed project: Cost = $4,000; estimated life = 3
years; initial decrease in accounts receivable = $1,000, which must be restored at the end of the projects
life; estimated salvage value = $1,000; earnings before taxes and depreciation = $2,000 per year; tax rate =
40 percent; and cost of capital = 18 percent. The applicable depreciation rates are 33 percent, 45 percent,
15 percent, and 7 percent.
a. $1,137
b. -$ 151
c. $ 137
d. $ 544
Question 10: Relevant Cash Flows and Calculation of NPV and Payback Period. (14 marks)
a. The management of SevenDragon Restaurant has been experiencing losses in the most recent months and
is considering converting the operations to drive-in fast food takeaways.
The fitting-out of the premise will cost RM40,000, and the equipment will have a life of ten years with disposal
value of RM1000. However, RM8,000 overhaul is necessary at the end of the fifth (5 th) year.
Currently the restaurant incurred RM30,000 per annum to operate and did breakeven in this past year. The new
service will save RM10,000 of these costs.
Projected sales are 1,000 units per week, for full 52 weeks per year except in year 5 when the overhaul will force
a 4-weeks shutdown. Each unit will provide a contribution of RM0.20.
Ignore Tax
REQUIRED:
i. The annual cash inflows (and outflows) expected from the new project over the life of the asset..
ii. The Net Present Value of the operations if management is expecting a 20% rate of return.
(Ignore taxes)
(10 marks)
b. Calculate the Payback Period using the above example. (4 marks)
Solutions:
a.i.
Yr0Yr1Yr2Yr3Yr4Yr5Yr6Yr7Yr8Yr9Yr10Initial
Investment(40000)/Saving10000//100001000010000100001000010000100001000010000Sales
1000 x 0.20 x 52 weeks
1000 x 0.20 x 48 weeks10400//104001040010400
(4 marks)
Question 11
DIGITAL TWO plc, a software company, has developed a new game, Narugo, which it plans to launch in the
near future. Sales of the new game are expected to be very strong, following a favourable review by a popular
PC magazine. DIGITAL TWO plc has been informed that the review will give the game a Best Buy
recommendation. Sales volumes, production volumes and selling prices for Narugo over its four-year life are
expected to be as follows.
Year 1 2 3 4
Sales and production (units) 150,000 70,000 60,000 60,000
Selling price (RM per game) RM25 RM24 RM23 RM22
Advertising costs to stimulate demand are expected to be RM650,000 in the first year of production and
RM100,000 in the second year of production. No advertising costs are expected in the third and fourth years of
production. Narugo will be produced on a new production machine costing RM800,000. Although this
production machine is expected to have a useful life of up to ten years, government legislation allows DIGITAL
TWO plc to claim the capital cost of the machine against the manufacture of a single product. Capital allowances
will therefore be claimed on a straight-line basis over four years.
DIGITAL TWO plc pays tax on profit at a rate of 30% per year and tax liabilities are settled in the year in which
they arise. DIGITAL TWO plc uses an after-tax discount rate of 10% when appraising new capital investments.
Ignore inflation.
Required:
(a) Calculate the net present value of the proposed investment and comment on your findings. (14marks)
(b) Operating cash flows rather than operating profit formed the basis for capital budgeting decisions.
Briefly explain THREE (3) types of costs that need to be considered in determining incremental cash
flows. (3 marks)
Sunk Costs
Opportunity Externalities.
(c) Lists THREE reasons why the net present value investment appraisal method is preferred to other
investment appraisal methods such as payback, return on capital employed and internal rate of return.
(3 marks)
Any Three
NPV considers cash flows
NPV considers the whole of an investment project
NPV considers the time value of money
NPV is an absolute measure of return
NPV links directly to the objective of maximising shareholders wealth
Question 12
LBD Bina Sdn. Bhd., a manufacturer of electronic equipment, has prepared the following draft financial
statements for the year ended 2006. These financial statements have not yet been made public.
Year 1 2 3 4
Sales volume (units) 70,000 90,000 100,000 75,000
Average selling price (RM/unit) 40 45 51 51
Average variable costs (RM/unit) 30 28 27 27
Fixed costs (RM/year) 500,000 500,000 500,000 500,000
The above cost forecasts have been prepared on the basis of current prices and no account has been taken of
depreciation, inflation of 4% per year on variable costs and 3% per year on fixed costs.
Working capital investment accounts for RM200,000 of the proposed RM1 million investment and machinery for
RM800,000. LBD Bina uses a four-year evaluation period for capital investment purposes, but expects the new
product range to continue to sell for several years after the end of
this period. Capital investments are expected to pay back within two years on an undiscounted basis, and within
three years on a discounted basis. The company pays tax on profits in the year in which liabilities arise at an
annual rate of 26% and depreciation on machinery on a 25% per year basis.
The ordinary shareholders of LBD Bina Sdn. Bhd. require an annual return of 12%. Its ordinary shares are
currently trading on the stock market at RM180 per share. The dividend paid by the company has increased at a
constant rate of 5% per year in recent years and, in the absence of further investment, the directors expect this
dividend growth rate to continue for the foreseeable future.
Required:
(a) (i) Calculate the current dividend per share of LBD Bina Sdn. Bhd. (2 marks)
(ii) Calculate the ordinary share price of LBD Bina Sdn. Bhd. predicted by the dividend growth model. (4
marks)
(ii) Share price predicted by dividend growth model = (15 x 105)/(012 005) = 225p
(b) (i) Using LBD Bina Sdn. Bhd.s current average cost of capital of 10%, calculate the net present value
of the proposed investment. (14 marks)
Exhibit 1
Present Value Present Value of an Annuity
of RM1 at the End of n Periods: of RM1 per Period for n Periods:
Total: 20 Marks
RM000
Sum of present values of future benefits 2,034
Less initial investment 1,000
Net present value 1034
Because the investment continues in operation after the four-year period, working capital is not recovered in
the above calculation. It is possible to make an assumption concerning incremental investment in working
capital to accommodate inflation, but no specific inflation rate for working capital is provided. An assumption
of 34% inflation in working capital would be reasonable given the expected inflation in variable and fixed
costs.
(ii) Calculate, to the nearest month, the payback period and the discounted payback period of the
proposed investment. (4 marks)
(iii) Discuss the acceptability of the proposed investment based on the calculation made in b(i) and b(ii)
and explain ways in which your net present value calculation could be improved.
(iii) The proposed investment has a positive net present value of RM833,000 over four years of operation
compared with an initial investment of RM1 million and so is financially acceptable. The company has
payback and discounted payback targets, but these are not a guide to project acceptability because of the
shortcomings of payback as an investment appraisal method. The proposed investment fails to meet the
payback target of two years, but meets the discounted payback target of three years. While discounted
payback counters the criticism that payback ignores the time value of money, it still ignores cash flows
outside of the discounted payback period and so cannot be recommended to evaluate
other than conventional investments.
The net present value calculation could be improved in several ways. One obvious improvement would be the
consideration of project cash flows beyond the four-year evaluation period used by Hendil plc. The company
expects the new product range to sell for several years after the end of the evaluation period and if these
sales are at a profit, the net present value would be higher than calculated. Another improvement would be
more detailed information about the new product range, for which only average selling price and average
variable cost data are provided. The basis for these averages is not stated and it is not known whether the
products in the new range are substitutes or alternatives, or whether a constant product mix is being
assumed. The basis for the changing annual sales volumes should also be explained.
The assumption of constant annual inflation for variable and fixed costs is questionable. The information
provided implies that inflation may have been taken into account in forecasting selling prices, but the selling
price growth rates are sequentially 125%, 133% and zero, and so some factor other than inflation has also
been used in the selling price forecast. The net present value evaluation could be improved if the basis for
the forecast was known and could be verified as reasonable.
Question 13
You have been asked by the president of your company to evaluate the proposed acquisition of new equipment.
The equipments basic price is RM193000, and shipping costs will be RM7700. It will cost another RM23200 to
modify it for special use by your firm and an additional RM13500 to install the equipment. The equipment falls in
the MACRS 3-year class, and it will be sold after 3 years for RM30900. The equipment is expected to generate
revenue of RM178000 per year with annual operating costs (excluding depreciation) of RM84000. The firms tax
rate is 28% and its cost of capital is 10%..
REQUIRED:
Note: Under the MACRS 3-year class, depreciation is 33% in first year, 45% in second year, 15% in third year
and 7% in fourth year.
Question 14
3. Cash Estimation
(a) Rupab Sdn. Bhd has in issue five million shares with a market value of $381 per share. The equity beta of
the company is 12. The yield on short-term government debt is 45% per year and the equity risk premium is
approximately 5% per year.
The debt finance of Rupab Sdn. Bhd consists of bonds with a total book value of $2 million. These bonds pay
annual interest before tax of 7%. The par value and market value of each bond is $100.
Rupab Sdn. Bhd pays taxation one year in arrears at an annual rate of 25%. Capital allowances (tax-allowable
depreciation) on machinery are on a straight-line basis over the life of the asset.
REQUIRED: Calculate the after-tax weighted average cost of capital of RupabSdn Bhd. (6 marks)
The companys bonds are trading at par and therefore the before-tax cost of debt is the same as the interest rate
on the bonds, which is 7%.
After-tax cost of debt = kd (1 T)
After-tax cost of debt = 7 x (1 025) = 525%
(b) Ruparb Sdn. Bhd is now considering a project where they would open a new facility in Johor Bharu. The
companys CFO has assembled the following information regarding the proposed project:
It would costs RM500,000 today (t=0) to construct the new facility. The cost of the facility will be
depreciated on a straight-line basis over five years.
If the company open the facility, it would need to increase its inventory by RM100,000 at t=0. RM70,000
of this inventory will be financed by account payable.
The CFO has estimated that the project will generate the following amount of revenue over the next 3
years:
Year 1 Revenue = RM1.0 million
Year 2 Revenue = RM1.2 million
Year 3 Revenue = RM1.5 million
Operating costs excluding depreciation equal to 70 percent of revenue.
The company plans to abandon the facility after three (3) years. At terminal year, the projects estimated
salvage value will be RM200,000.At the same time, the company will also recover the net operating
working capital investment that it made at t=0.
The company tax rate is 27 percent.
The project cost of capital is as per calculated in 3(a) above.
Question 15
Roslan Rose, CFA, is a financial analyst with Langkawi Marina Sdn. Bhd. a manufacturer of sailboats and
sailing equipment. Roslan is evaluating a proposal for Langkawi Marina to build sailboats for a foreign competitor
that lacks production capacity and sells in a different market. The sailboat project is perceived to have the same
risk as Langkawi Marinas other projects.
The proposal covers a limited time horizonthree yearsafter which the competitor expects to be situated in a
new, larger production facility. The limited time horizon appeals to Langkawi Marina, which currently has excess
capacity but expects to begin its own product expansion in slightly more than three years.
Roslan has collected much of the information necessary to evaluate this proposal in Exhibits 1 and 2.
(RM millions)Initial fixed capital outlay60Annual contracted revenues 60Annual operating costs 25Initial working
capital outlay (recovered at end of the project) 10Annual depreciation expense (both book and tax accounting)
20Economic life of facility (years) 3Salvage (book) value of facility at end of project 0Expected market value of
facility at end of project 5
Exhibit 2 : Selected Data for Langkawi Marina
Roslan recognizes that Langkawi Marina is currently financed at its target capital structure and expects that the
capital structure will be maintained if the sailboat project is undertaken.
REQUIRED:
a. Determine the weighted cost of capital for Langkawi Marina (to the closest of),
b. Determine the projects net present value?
(The project cost of capital is as per calculated in (a) above.)
[Total 10 Marks]
b.
Year 0Year 1Year 2Year 3Initial Capital Outlay(60,000) /Initial WC(10,000) /Revenue60,000 /
60,00060,000Less:Operating costs(25,000) /(25,000)(25,000)Depreciation(20,000) /(20,000)
(20,000)EBT15,00015,00015,000Tax 35%(5250) /(5250)(5250)EAT9,7509,7509,750Add:
depreciation20,000 /20,00020,00029,75029,75029,750Recovery WC10,000 /Salvage Value5,000 /Less: tax
on Salvage Value(1750) /Cashflows(70,000)29,75029,75043,000PVIF, 11% /0.9009 0.81160.7312PV
Cash(70,000)26,80224,14531,442NPV(70000)+26802+24145+31442= 12389 /
Question 16
Harris SCIB Sdn. Bhd. is evaluating the proposed acquisition of a new milling machine. The
machines base price is RM108,000, and it would cost another RM12,500 to modify it for special use
by the firm. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for
RM65,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would
require an increase in net operating working capital (inventory) of RM5,500. The milling machine
would have no effect on revenues, but it is expected to save the firm RM44,000 per year in before-tax
and depreciation. Harriss marginal tax rate is 35%. The cost of capital for this project is 12%.
REQUIRED:
/ 12 @0.5 = 6 marks
Cash Flow
Net Salvage Value: Cost 120500
Acc Depr 93% [112065]
Book Value 8435
Sold 65000 65000
Gain 56565
Tax on gain 35% [19797.75] 19797.75
45202.25
b. i. Harris SCIB uses debt in its capital structure, so some of the money used to
finance the project will be debt. Given this fact, should the projected cash flows
be revised to show projected interest charges? Explain.
[1 mark]
No. The cost of capital already reflects the returns required by all investors in the
firm, including the bondholders. If we subtracted interest charges from revenues,
we
would essentially be counting the cost of debt twice.
ii. Suppose you learned that Harris SCIB had spent RM50,000 to renovate the
building last year, expensing these costs. Should this cost be reflected in the
analysis? Explain.
[1 mark]
No. The renovation expenses are a sunk cost and should not have any impact on
the decision to invest today.
iii. Now suppose you learn that Harris SCIB could lease its building to another party
and earn RM25,000 per year. Should that fact be reflected in the analysis? If so,
how?
[1 mark]
[Total 10 marks]
[a] The president of Fly Asia Airlines has asked you to evaluate the proposed acquisition of a new
airplane. The aircraft price is RM40,000 and it is classified in the 3-year MACRS class. The
purchase of the plane would require an increase in net working capital of RM2,000. The airplane
would increase the firm's before-tax revenues by RM20,000 per year, but would also increase
operating costs(excluding depreciation) by RM5,000 per year. The airplane is expected to be used
for 3 years and then sold for RM25,000. The firm's marginal tax rate is 40% and the project's cost
of capital is 12%. Use the following MACRS rates for 3-year property: 33%; 45%; 15%; 7%
[7 marks]
[b] A firm plans to expand into a new product line. In preparation, it has spent RM275,000 in
unrecoverable planning and systems work and another RM225,000 on land and
improvements, which could be sold now for RM200,000. The future cash flows of the
division were originally estimated to have a present value of RM580,000, well worth the
original RM500,000 investment. Now, with new information, it estimates that an additional
RM150,000 must be spent and the project will be delayed six months. Estimates of returns
once the new product line is available have not changed.
Should the company continue the project? What costs and returns would you compare
and what considerations would you include?
[3 marks]
Solution:
RM500,000 are spent and cannot be recovered: RM275,000 + RM225,000 these
costs are SUNK COST / which are not relevant for the NPV analysis.
The relevant costs/ are the RM150,000 of new spending and the RM200,000 of recoverable
value on land and improvements(opportunity costs of not proceeding with the project),/
for a total of RM350,000. This is considerably less than the RM580,000 in estimated revenue,
so the project should be completed.
[Total 10 marks]
The company will have to purchase a new machine to produce the detergent. The machine has an
up-front cost of RM2.0 million. The machine is in the 4-year MACRS class (33%; 45%; 15%; 7%).
The company anticipates that the machine will have a salvage value will equal to RM175,000.
If the company goes ahead with the proposed product, it will have an effect on the company's net
working capital. At the outset, inventory will increase by RM140,000 and accounts payable will
increase byRM40,000. At year 4, the net working capital will be recovered after the project is
completed.
The detergent is expected to generate sales revenue of RM1 million the first year, RM2 million the
second year, RM4 million the third year, and RM8 million the final year. The project will add fixed
costs to the company of RM1,000,000. The variable cost of production (not including
depreciation)are expected to equal 50 percent of sales.
The new detergent is expected to reduce the sales of the company's existing products by
RM250,000 a year. These existing products have the same production cost factors as our new
detergent.
Because the project is expected to be profitable, the CEO has assigned the entire Companys
advertising budget to this project. Advertising is RM1,500,000 per year.
[Total 10 marks]
YoY1Y2Y3Y4Cost20000001000000200000040000008000000nwc [140-
40]100000FC1000000100000010000001000000VC500000100000020000004000
000INTEREST EXP0000OPP.COST250000250000250000250000ADvERT
COST1500000150000150000150000DEPRECIATION660000900000300000140000
PBT-2910000-13000003000002460000Tax 28%814800364000-84000-
688800PAT-2095200-
9360002160001771200DEPRECIATION660000900000300000140000-1435200-
360005160001911200Salvage Value175000Taxes-49000NWC100000Cash
Inflow2100000-1435200-360005160002137200PVIF
10%0.90910.82640.75130.683PV Cash Inflow2100000-1304740.32-
29750.4387670.81459707.6SUM512887.68initial Investment2100000NPV-
1587112.32Cost2000000Depreciation2000000Book
Value0Disposal175000Gain175000Tax49000
You are evaluating an investment that has an expected net income (net of all costs and taxes)
of RM250,000 per year over the next 15 years. The investment will require the purchase of
new machinery that will require an initial outlay of RM4,500,000. The machine can be
depreciated using a constant dollar amount (Straight Line) to an estimated salvage value of
zero. You estimate that you should be able to sell the machine at the end of the project for
RM750,000 even though it has been fully depreciated. For this analysis assume the
marginal tax rate is 40% on ordinary income. The firm is estimating its weighted average
after-tax cost of capital at 12%.
a. What yearly cash flows should be used to evaluate this investment in years 1-14?
The cash flow for this is equal to the Net Income plus Depreciation. Since depreciation
is a non-cash expense, it is added back to the Net Income. This treatment will result in
the tax shield from the depreciation being recognized as cash flow.
b. What is the expected cash flow from this investment in Year 15?
Depreciation should not be shown in the projected profit and loss accounts
since it is a non cash item but it is included due to its tax implication. But
nevertheless it is added back as part of the adjustment to determine the cash
inflow.
e. Why should you exclude interest from the cash flow analysis?
Interest, as a cost of fund has been imputed when deriving to the cost of capital.
To include interest in the cash analysis would have double effect on the
calculation.