Question

Your Company Limited (Your Company) is well known chocolate manufacturer. There is the opportunity for Your Company to enter into new overseas market that is eager for Australian chocolates. To assist in understanding this opportunity you have commissioned a $250,000 report into the viability of a new machine that will allow for higher levels of production.

The new project will require Your Company to locate the new machine on a floor of their building that is currently being rented out to a separate business. The rent that Your Company currently receives is $104,000 a year. Once the project is complete, the space will become available again and the business will seek a new tenant to rent that space.

There is also an existing machine from a previous project that has a written down value of $0. You were recently offered $5,000 to sell this asset but you believe that it can also be used in the new project. At the end of this project the machine will be discarded.

The new machine has been valued at $100,000 and a further $20,000 is required for the installation. The machine is expected to meet Your Company’s needs for 3 years but the Taxation Office advises the machine has an operational life of 4 years.

With increased output Your Company needs additional stock of $5,000. Initial advertising costs are expected to be $10,000 and the existing advertising budget will change from $20,000 to $30,000 per year. One less staff member is needed due to automation and salaries will change from $75,000 to $40,000 per year.

Revenue related to this project is expected to be $300,000 in the first year and grow by 10% each year for the remainder of the project. Material costs are expected to be 20% of sales in each year.

It is believed that the new higher quality product will reduce existing sales by $6,000 per year and related costs will fall by $2,000 per year.

At the end of the project, the new machine is to be sold for $45,000.

Cost of capital is 11% and a tax rate of 30% to apply. You are required to complete a capital budget to determine if this project is worth completing.

Answer 1

The following table gives the various data points given in the question:

Given data
Capex	Unit	Value
Report cost	$	2,50,000
Working capital	$	5,000
Initial advertising cost	$	10,000
Machine value	$	1,00,000
Machine installation	$	20,000
Depreciation period	Year	4
Project life	Year	3
Operating costs
Rent	$	1,04,000
Increament in advertising cost	$	10,000
Salary saving	$	35,000
Revenue	$	3,00,000
Revenue growth	%	10%
Material costs (% of sales)	%	20%
revenue fall	$	6,000
cost fall	$	2,000
Cost of capital	%	11%
Tax	%	30%

Based on the above data points, we develope a Profit & loss statement for the business and then find the cashflow to the Promotors. As the debt and equity break-up isn't mentioned, I have assumed that all the investment is made by the Promotors through equity at 11% cost of capital.

Profit & loss statement
Year	Unit	1	2	3
Revenue from new business	$	3,00,000	3,30,000	3,63,000
Revenue fall from other business	$	6,000	6,000	6,000
Net revenue	$	2,94,000	3,24,000	3,57,000
Cost of goods sold (fore new)	$	60,000	66,000	72,600
Cost saving because of revenue loss	$	2,000	2,000	2,000
Net Cost of goods sold	$	58,000	64,000	70,600
Operating cost	$	2,36,000	2,60,000	2,86,400
Salaries saving	$	35,000	35,000	35,000
Advertising cost (assumed constant)	$	10,000	10,000	10,000
Rent	$	1,04,000	1,04,000	1,04,000
EBITDA	$	1,57,000	1,81,000	2,07,400
Depreciation (Machine value + Installation)	$	30,000	30,000	30,000
Amortization (Report + increased cost & advertising)	$	88,333	88,333	88,333
EBIT	$	38,667	62,667	89,067
Tax	$	11,600	18,800	26,720
PAT	$	27,067	43,867	62,347

Now the cash flow table is as mentioned below:

Cash flow table
Cash flow	$	1,45,400	1,62,200	1,80,680
Capex	$	3,85,000

Now based on the Cash flow, we get the Net Present Value of the project as follows:

Year	0	1	2	3
Cash flow	-3,85,000	1,45,400	1,62,200	1,80,680
Cost of capital	11%
Net Present Value	$	8,782

As the net present value of the project is positive, its an value accretive project for the company ans it should go ahead with the same.