Question

The company Smart Inc. is a company that produces T-shirts in Toronto area. The results of the company which has been mediocre for the past couple of years have been presented in the annual financial statement.

Sales (1 million units x 16$) 16 000 000$

Fixed Costs (10 000 000)

Variable Costs (1 million units x 10$) (10 000 000)

Depreciation (3 000 000)

Annual Profit (loss) (7 000 000)

According to the experts, this loss has been caused by the poor performance of the equipment in the factory. They suggest to the board of directors to replace the old equipment by new ones. Considering following information, the board of directors asks you to evaluate this project for the company.

• The new equipments would increase the level of production and allow the company to avoid this loss entirely, but there is no projection concerning any profit. The purchase (including the installation) of the new equipment requires an initial investment for an amount of 18 000 000$. The old equipment can be sold in the beginning of project on the market for 1 500 000$ (For simplification, consider this amount as an exchange value).

• The new equipment will be sold for 2 000 000$ in 10 years (end of project). The purchase of the equipment requires a new issue of long term bonds with a coupon rate of 8% over 10 years. The project also requires major renovation of the old building for the amount of 500 000$ and an additional investment in heavy machinery for the total amount of 1 000 000$ at the end of 5^th year (Both amounts are depreciable with declining method under the tax law).
• The project requires the purchase of a land for 1 200 000$ which will be sold in 10 years (end of project) for 2 200 000$. Suppose that at this moment 50% of capital gains are tax-free under tax law.

• The company also has to build a new building for an amount of 2 400 000$ which will be sold at the end of the project for 3 200 000$. This amount is depreciable with declining method.

• The project also requires an additional investment in new Computers and furniture for a total amount of 400 000$ in the beginning of project. Computers and furniture have to be replaced by new ones after 5 years for the amount of 600 000$. The do not have any salvage value.

• At the present time, supplier account and client account are at 1 000 000$ each. The project would increase client account and decrease supplier account by 50%. All related accounts will return to zero at the end of project.

• At the present time, Smart Inc is renting a warehouse for the annual rent of 50 000$ (paid at the end of year). If the company undertakes the new project, they will need to cancel the lease of the old warehouse and to rent a larger warehouse for the annual rent of 200 000$ (to be paid annually at the end of each year). The cancellation of the old lease does not cause any penalty.

• The project also requires 5 new technicians today with annual salary of 60 000$ for each and 5 other technicians in 5 years for annual salary of 75 000$ each. Given the performance of new equipment, Smart Inc could lay off 80 employees whose annual salaries is 40 000$. The lay-offs will oblige the company to pay lay-off premiums in the amount of 10 000$ to each employee which will be tax deductible.

The corporate tax rate is at 40%. The new equipment and new heavy machinery are in the category with a depreciation of 20%, the major renovations are depreciated at 25%, the new building is depreciated at 10%, all items depreciations are calculated with decreasing (declining) method. The computers and furniture are depreciated by linear method at 20%. Investors require 12% return on this type of project. Given this information, answer the following questions:

Questions:

1. Identify ONE BY ONE each item of the investment and calculate separately the present value of the total investment in this project.
2. Identify ONE BY ONE and calculate separately the present value of each periodical cash flow (annual incomes and expenses) during the project.
3. Identify ONE BY ONE and calculate separately the present value of each cash flow of the end of the project.
4. Calculate the Net Present Value of this project (You just have to add up your responses in 1, 2 and 3 for this one).
5. Calculate the maximum price that Smart Inc can afford to invest in the new equipment in the beginning of project in order to keep the project profitable. (That means the additional investment at the end of 5^th year and other items in the initial investment remain the same).
6. Calculate the Operational Cash Flow (OCF) of the 3^rd year of this project.

Answer 1

Step I:-	Calculation of the present value of the total investment in this project
Sr No.	Particulars	0	1	2	3	4	5	6	7	8	9	10	Total
1	New Equipment Cost in exchange of old Equipment	$    16,500,000.00											$    16,500,000.00
2	Major Renovation of Old Building	$          500,000.00											$          500,000.00
3	Additional Investment in heavy machinery						$    1,000,000.00						$       1,000,000.00
4	Purchase of land	$      1,200,000.00											$       1,200,000.00
5	New Building	$      2,400,000.00											$       2,400,000.00
6	Investment in Computer & Furniture	$          400,000.00					$        600,000.00						$       1,000,000.00
7	Increase in Accounts Receivable (100000*0.5)	$          500,000.00											$          500,000.00
8	Decrease in Accounts Payable (100000*0.5)	$          500,000.00											$          500,000.00
9	Total investment in this project	$    22,000,000.00	$                          -	$                          -	$                          -	$                          -	$    1,600,000.00	$                          -	$                          -	$                          -	$                          -	$                          -	$    22,600,000.00
10	Discounting Factor @ 12%	1	0.8929	0.7972	0.7118	0.6355	0.5674	0.5066	0.4523	0.4039	0.3606	0.322	$       6,600,000.00
11	Present value of the total investment in this project	$    22,000,000.00	$                          -	$                          -	$                          -	$                          -	$        907,840.00	$                          -	$                          -	$                          -	$                          -	$                          -	$    22,907,840.00

Step II:-	Calculation of the present value of each periodical cash flow (annual incomes and expenses) during the project.
Sr No.	Particulars	0	1	2	3	4	5	6	7	8	9	10	Total
1	Sales (10,00,000 units @ $16)		$ 16,000,000.00	$ 16,000,000.00	$ 16,000,000.00	$ 16,000,000.00	$ 16,000,000.00	$ 16,000,000.00	$ 16,000,000.00	$ 16,000,000.00	$ 16,000,000.00	$ 16,000,000.00	$ 160,000,000.00
2	Variable Cost (10,00,000 units x 10$)		$ 10,000,000.00	$ 10,000,000.00	$ 10,000,000.00	$ 10,000,000.00	$ 10,000,000.00	$ 10,000,000.00	$ 10,000,000.00	$ 10,000,000.00	$ 10,000,000.00	$ 10,000,000.00	$ 100,000,000.00
3	Contribution (1-2)		$    6,000,000.00	$    6,000,000.00	$    6,000,000.00	$    6,000,000.00	$    6,000,000.00	$    6,000,000.00	$    6,000,000.00	$    6,000,000.00	$    6,000,000.00	$    6,000,000.00	$    60,000,000.00
4	Current Fixed Cost		$ 10,000,000.00	$ 10,000,000.00	$ 10,000,000.00	$ 10,000,000.00	$ 10,000,000.00	$ 10,000,000.00	$ 10,000,000.00	$ 10,000,000.00	$ 10,000,000.00	$ 10,000,000.00	$ 100,000,000.00
5	Increase in Rent (200000-50000)		$        150,000.00	$        150,000.00	$        150,000.00	$        150,000.00	$        150,000.00	$        150,000.00	$        150,000.00	$        150,000.00	$        150,000.00	$        150,000.00	$       1,500,000.00
6	New Technician Salary (5 tech * $60000 )		$        300,000.00	$        300,000.00	$        300,000.00	$        300,000.00	$        300,000.00	$        300,000.00	$        300,000.00	$        300,000.00	$        300,000.00	$        300,000.00	$       3,000,000.00
7	New Other Tech salary (5 Tecf *$75000)		$        375,000.00	$        375,000.00	$        375,000.00	$        375,000.00	$        375,000.00	$                          -	$                          -	$                          -	$                          -	$                          -	$       1,875,000.00
8	Net Saving fron Lay off Employees [80 Emp* (40000-10000)]		$ (2,400,000.00)	$ (3,200,000.00)	$ (3,200,000.00)	$ (3,200,000.00)	$ (3,200,000.00)	$ (3,200,000.00)	$ (3,200,000.00)	$ (3,200,000.00)	$ (3,200,000.00)	$ (3,200,000.00)	$ (31,200,000.00)
9	Depreciation on New Equipment		$    3,300,000.00	$    2,640,000.00	$    2,112,000.00	$    1,689,600.00	$    1,351,680.00	$    1,081,344.00	$        865,075.20	$        692,060.16	$        553,648.13	$        442,918.50	$    14,728,325.99
10	Depreciation on Additional Investment in heavy machinery							$        200,000.00	$        160,000.00	$        128,000.00	$        102,400.00	$          81,920.00	$          672,320.00
11	Depreciation on Major Renovation of Old Building		$        125,000.00	$          93,750.00	$          70,312.50	$          52,734.38	$          39,550.78	$          29,663.09	$          22,247.31	$          16,685.49	$          12,514.11	$             9,385.59	$          471,843.24
12	Depreciation on New Building		$        240,000.00	$        216,000.00	$        194,400.00	$        174,960.00	$        157,464.00	$        141,717.60	$        127,545.84	$        114,791.26	$        103,312.13	$          92,980.92	$       1,563,171.74
13	Depreciation on Computer & Furniture		$          80,000.00	$          80,000.00	$          80,000.00	$          80,000.00	$          80,000.00	$        120,000.00	$        120,000.00	$        120,000.00	$        120,000.00	$        120,000.00	$       1,000,000.00
14	Total Net Cash Inflow (3-4 to 13)		$ (6,170,000.00)	$ (4,654,750.00)	$ (4,081,712.50)	$ (3,622,294.38)	$ (3,253,694.78)	$ (2,822,724.69)	$ (2,544,868.35)	$ (2,321,536.90)	$ (2,141,874.37)	$ (1,997,205.01)	$ (33,610,660.98)
15	Discounting Factor @ 12%	1	0.8929	0.7972	0.7118	0.6355	0.5674	0.5066	0.4523	0.4039	0.3606	0.322	$                       5.65
16	Total Present value of each periodical cash flow		$ (5,509,193.00)	$ (3,710,766.70)	$ (2,905,362.96)	$ (2,301,968.08)	$ (1,846,146.42)	$ (1,429,992.33)	$ (1,151,043.96)	$      (937,668.75)	$      (772,359.90)	$      (643,100.01)	$ (21,207,602.10)

Step III:-	Calculation of the present value of each cash flow of the end of the project.
Sr No.	Particulars	Working			10
1	Sale of new Equipment				$    2,000,000.00
2	Tax on Sale of Equipment	(2000000-16500000+14729326)*40%			$        (91,730.00)
3	Sale of Land				$    2,200,000.00
4	Tax on Sale of land	[(2200000-1200000)*0.5*40%]			$      (200,000.00)
5	Total cash Inflow				$    3,908,270.00
6	Discounting Factor @ 12%				$                     0.32
7	Present value of end of period cash flow				$    1,258,462.94

Step IV:-	Calculation of NPV (Net Present value) of the Project:
	Particulars	Amount
	Present value of the total investment in this project	$ (22,907,840.00)
	Total Present value of each periodical cash flow	$ (21,207,602.10)
	Present value of end of period cash flow	1258462.94
	NPV (Net Present value) of the Project	$ (42,856,979.16)