Question

Marian runs a store selling decorative breathing masks. For obvious reasons, she has recently seen a sharp uptick in business and wants to increase her production capacity. To accomplish this, she wants to buy a new industrial sewing machine, which will allow her to increase her yearly EBIT by $15,000 per year for the next 4 years. The sewing machine costs $36,000, but if she makes this purchase, she will borrow $28,000 for 4 years at 6.5% to help pay the purchase price. Her tax rate is 36%, and her cost of levered equity is 15%.

2A. What is the NPV of buying the new sewing machine if Marian pays cash?

2B. Using the FTE method, what is the NPV of buying the new sewing machine if Marian takes out the loan?

Answer 1

Net Present Value (NPV)

   All future cash flows are discounted to the present value and then added

Present value = Future value * Discount factor(DF)

The NPV represents the surplus funds (after funding the investment) earned on the project, therefore ;

· If the NPV is positive – the project is financially viable

· If the NPV is zero – the project is breaks even

· If the NPV is negative – the project is not financially viable

2A)

Year	1	2	3	4
EBIT	15000	15000	15000	15000
Less : Tax @ 36%	-5400	-5400	-5400	-5400
Profit After Tax (PAT)	9600	9600	9600	9600
DF @ 15%	0.8696	0.7561	0.6575	0.5718
Cash Inflows	8347.826	7258.979	6312.156	5488.831

NPV

         Total Inflows   =27407.79

         Total Outflows = -36000

          NPV = -8592.208

This project is not financially viable as NPV is negative

2B)

Year	1	2	3	4
EBIT	15000	15000	15000	15000
Less : Interest	-1820	-1365	-910	-455
EBT	13180	13635	14090	14545
Less : Tax @ 36%	-4744.8	-4908.6	-5072.4	-5236.2
Profit After Tax (PAT)	8435.2	8726.4	9017.6	9308.8
Loan Repayment	-7000	-7000	-7000	-7000
Net Cash Inflow	1435.2	1726.4	2017.6	2308.8
DF @ 15%	0.8696	0.7561	0.6575	0.5718
Cash Inflows	1248	1305.406	1326.605	1320.064

NPV

         Total Inflows   =5200.075

         Initial Outflows = -8000                       

          NPV = -2799.925

This project is not financially viable as NPV is negative

Out of the two choices, it is better to take loan for payment of sewing machine as NPV is more beneficial in that case.