Question

Your company is considering a new machine which cost RM135,000. Two months ago, you sent your company engineer to a training workshop demonstrating the new machine's operation and efficiency. In addition, you also instructed the marketing team to survey the market for the next four years. In total, your company spent RM22,300. If the new machine is purchased, it will require RM8,800 of installation and modification cost. It will be depreciated for four years using straight line method. Net working capital is expected to increase by RM6,000 at startup and the full amount will be recovered at the end of year four. Earnings before interest and taxes (EBIT) will be RM32,000 annually throughout the four-year period. At terminal, this machine can be sold at RM15,000 only. Tax rate of your company is 28 percent.

Required :

(a) What is the initial cost of this project?

(b) Determine the annual cash flow of the project from year 1 to year 4.

(c) Calculate the terminal cash flow?

(d) Based on net present value (NPV) criterion, should you proceed to buy the new machine if your required rate of return is 18%? Explain your answer.

(e) You would like to know if the purchase can be proceeded if your company sets a maximum payback period of 2 years.

(f) If the NPV and payback period criterion lead to a conflicting result, which decision rule should you follow in making the investment decision? Give THREE (3) reasons to explain your answer.

Answer 1

.a). Calculation of Initial cost of the project:

The amount of RM 22,300 spent is a sunk cost.It is not relevant cost for evaluation of the project.

Initial Cost:

Cost of machine	135,000
Installation and modification cost	8,800
Net working capital increase	6,000
Total Initial Cost (RM)	149,800

Total Initial Cost =RM149,800

.b).Calculation of annualcash inflow in each year :

Annual Depreciation under straight-line method=(Cost-Salvage Value)/Useful life =(135000+8800-15000)/4=32,200

	A	B=A*28%	C=A-B	D	E=C+D
	Earning Before interest & Taxes	Tax Expenses	After tax Operating Income	Depreciation	Annual Cash Flow
Year	EBIT			Expense(Non Cash)
1	32,000	8,960	23,040	32,200	55,240
2	32,000	8,960	23,040	32,200	55,240
3	32,000	8,960	23,040	32,200	55,240
4	32,000	8,960	23,040	32,200	55,240

Annual Cash Flow =RM 55,240

.c) Calculation of terminal cash in flow:

Terminal cash flow is given below:

Salvage value of machine	15,000
Release of Net working capital	6000
Total terminal cash inflow	21,000

Terminal Cash Flow=RM21,000

.d)Calculation of Net cash flow in each year and the present value(PV) of net cash flow:

PV of cash flow=(cash flow)/((1+i)^A)

A=year of cash flow, i=Required return =18%=0.18

A	B	C	D	E=B+C+D	G=E/(1.18^A)
	initial cash	Annual	Terminal	Net	Present value
Year	flow	cash flow	Cash flow	Cash flow	PV of cash flow
0	-149,800			-149,800	-149,800
1		55,240		55,240	46,814
2		55,240		55,240	39,673
3		55,240		55,240	33,621
4		55,240	21,000	76,240	39,324
				TOTAL	9,631

NPV of the Project

RM 9,631

Yes, you should buy the machine. NPV is positive

.e) Payback Period =149800/55240=2.71 Years

If maximum payback period is two years you should not purchase

.f)You should follow NPV

Because,

• it takes into account time value of money, which Payback does not do
• NPV considers cash flow of entire period of project , whereas payback only considers cash flow up to the pay back period
• NPV indicates the wealth created for the shareholders .Payback period does not doso