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Topic 4 Capital Budgeting

Question 44 The Salte Corporation is an Australian-based company with a large proportion of foreign shareholders. Its core business is the production of machinery used in the heavy-industry sector. It has recently completed a $400,000 two year marketing study on whether to introduce a new machine to the market. Based on the results of the study, Salte has estimated that 10,000 of its new machines can be sold annually over the next six years at a price of $9,615 each. Variable costs per machine are $7,400 and fixed costs total $12 million a year. Working capital specifically for this project is estimated to be $2 million and will be returned at the end of the projects life. The cost of the machine includes $40 million to build production facilities and $2.4 million in land. The $40 million investment will be depreciated to zero over the life of the project. At the end of the project the facilities, including the land, will be sold for an estimated $8.4 million. The market value of the land, which is not tax-deductible, is not expected to change. Finally, start-up costs also entail fully tax-deductable expenses of $1.4 million, which are deductable at the end of the first year of production. The tax rate applicable to Salte is 30%. The after-tax discount rate is 10%. Calculate the NPV of the project and advise Salte whether it should proceed with the project.

Question 1 (cont.) Step 1: Depreciation: $40 million/6 years = $6,666,667 p.a. Step 2: Gain on sale: book value of facilities at end Yr. 6 book value of land at end of Yr. 6 total salvage value gain on sale Step 3: P&L Statement: Salte Corp. 0 $000 Start-up costs Revenue Variable costs Fixed costs Depreciation expense Gain on sale of facility Profit Tax (@30%) Step 4: Cash-Flow Statement: Salte Corp. 0 $000 Tax Initial investment (40,000) Land (2,400) Start-up costs (1,400) Revenue Variable costs Fixed costs Working capital (2,000) Sale of facility & land Net cash-flow (45,800) 1 $000 (625) 2-5 $000 (1,045) 6 $000 (2,845) 1 $000 ($1,400) 96,150 (74,000) (12,000) (6,667) 2-5 $000 96,150 (74,000) (12,000) (6,667) 6 $000 96,150 (74,000) (12,000) (6,667) 6,000 2,083 625 3,483 1,045 9,483 2,845 = $0 = $2,400,000 = $8,400,000 = $6,000,000

96,150 (74,000) (12,000)

96,150 (74,000) (12,000)

96,150 (74,000) (12,000) 2,000 8,400 17,705

9,525

9,105

Step 5: NPV Year 0 1 25 NCF $ (45,800,000) 9,525,000 9,105,000 28,861,029 6 17,705,000 PVIF PV $ (45,800,000) 8,659,091

(1+0.10)-1 [1 (1+0.10)-4]/0.10 3.1698 (1+0.10)-1 0.9090 26,237,299 (1+0.10)-6 0.5644 9,994,010 NPV = (909,600)

Therefore, since NPV is negative, Salte should not undertake the project.

Question 45 A company has the opportunity of buying a new high-tech metal cutter that will save the company $14,000 each year in labour costs. This metal cutter will cost $70,000 and will have a useful life of 7 years. It is expected to have a salvage value of $16,000 and will be depreciated using a straight-line method of depreciation. If the company purchases the metal cutter it can sell its old cutter for $5,000, even though it has a book value for tax purposes of $8,000. The new machine will require a working capital injection of $4,500 for the acquisition of additional scrap metal. The working capital will be recovered at the end of the 7 year period. The companys required rate of return is 10% and the tax rate is 30%. Should the company acquire the new metal cutter?

Question 2 (cont.) Step 1: Depreciation: $70,000/7 years = $10,000 p.a. Step 2: Gain on sale: Old Machine: book value at T0 salvage value at T0 book loss on sale = $8,000 = $5,000 = $3,000 = $0 = $16,000 = $16,000

New Machine: book value at end of Yr. 7 salvage value end of Yr. 7 book gain on sale Step 3: P&L Statement 0 $ Net annual cash saving Depreciation Gain on sale new machine Loss on sale old machine Profit Tax (@ 30%) Step 4: Cash-Flow Statement 0 $ Tax Net annual cash saving Salvage value Working capital Investment Net cash-flow Step 5: NPV Year 0 16 7 NCF $ (68,600) 12,800 28,500 PVIF

1-6 $ 14,000 (10,000) (3,000) (3,000) (900) 4,000 1,200

7 $ 14,000 (10,000) 16,000

20,000 6,000

1-6 $ 900 5,000 (4,500) (70,000) (68,600) (1,200) 14,000

7 $ (6,000) 14,000 16,000 4,500 12,800 28,500

PV $ (68,600)

[1-(1+0.10)-6]/0.10 4.3552 55,747 -7 (1+0.10) 0.5131 14,623 NPV = 1,770

Therefore, since NPV is positive, the company should invest in the new metal cutter.

Question 46 You have been observing the surge in health awareness in Australia for some time and realise the time is right to start and run an aerobic fitness centre. Your family owns a wharehouse which will meet your needs, and is currently being rented out at $48,000 p.a.You estimate you will need to spend $100,000 in total, made up of an initial cost of $50,000 to renovate the premises, $45,000 for new equipment, and $5,000 to install the equipment. You have done a market survey, at a cost of $3,000, which leads you to believe that you will get 500 memebers each paying $1,000 p.a. You have also found five instructors you can hire at $30,000 each p.a. For tax reasons you will expense the renovation costs immediately and depreciate the equipment 9including the installation cost) over ten years using the straight-line method. Howver, you will expect the equipment to be fully functional for 15 years, which is the life of the operation. Due to the nature of fitness equipment it will be unlikely to have a salvage value at the end of ten years. Assume the initial investment is made today and all cash-flows are received or paid at the end of each year. Your discount rate is 15% and your tax rate is 40%. Should you invest in the project?

Question 3 (cont.) Step 1: Depreciation: $50,000/10 = $5,000 p.a. (Note: $50,000 = $45,000 for new equipment + $5,000 installation cost) Step 2: Gain/loss on sale: book value at end of Yr. 15 salvage value at end of Yr. 15 gain on sale = $0 = $0 = $0

Step 3: P&L Statement 0 $ Revenue Instructors costs Depreciation Rent revenue foregone Renovation costs Gain/loss on sale Profit Tax (@ 40%) Step 4: Cash-flow Statement 0 $ Tax Revenue Instructors costs Rent revenue foregone Renovation costs Equipment Salvage value Net cash-flow Step 5: NPV Year 0 1-10 11-15 NCF $ (80,000) 183,200 181,200 600,587 PVIF [1 (1+0.15)-10]/0.15 5.0187 [1-(1+0.15)-5]/0.15 3.3145 (1+0.15)-10 0.2472 PV $ (80,000) 919,426 20,000 1 - 10 $ (118,800) 500,000 (150,000) (48,000) 11 15 $ (120,800) 500,000 (150,000) (48,000) 1 - 10 $ 500,000 (150,000) (5,000) (48,000) (50,000) (50,000) (20,000) 297,000 118,800 0 302,000 120,800 11 15 $ 500,000 (150,000) (48,000)

(50,000) (50,000) (80,000) 183,200 0 181,200

148,465 NPV = 987,891

Therefore, since NPV is positive, should proceed with the project.