Question

ABC Company is considering adding a new line to its product mix, and the capital budgeting
analysis is being conducted by Jameel, a recently graduated MBA. The production line would be
set up in unused space in the main plant. The machinery’s invoice price would be approximately Rs
5,000,000, another Rs 250,000 in shipping charges would be required, and it would cost an
additional Rs 750,000 to install the equipment. The machinery has an economic life of 4 years, and
ABC Company applicable depreciation rate are 33.33% for year 1, 44.45% for year 2, 14.81% for
year 3, 7.41% for year 4. The machinery is expected to have a salvage value of Rs 625,000 after 4
years of use. The new line would generate incremental sales of 1,250 units per year for 4 years at an
incremental cost of Rs 2500 per unit in the first year, excluding depreciation. Each unit can be sold for Rs 5,000 in the first year. The sales price and cost are both expected to increase by 3% per year
due to inflation. Further, to handle the new line, the firm’s net working capital would have to
increase by an amount equal to 12% of sales revenues. The firm’s tax rate is 40%, and its overall
weighted average cost of capital, which is the risk-adjusted cost of capital for an average project (r),
is 10%.
Required:
i. What are the annual depreciation expenses?
ii. Calculate the annual sales revenues and costs (other than depreciation). Why is it important to
include inflation when estimating cash flows?
iii. Construct annual incremental operating cash flow statements.
iv. Estimate the required net working capital for each year and the cash flow due to investments
in net working capital.
v. Calculate the after-tax salvage cash flow.
vi. Calculate the net cash flows for each year. Based on these cash flows and the average project
cost of capital, what are the project’s NPV

Answer 1

Part i)

Cost of asset or investment = Purchase cost+Shipping charges+Installation charges = 5million+0.25million+ 0.75million = 6million

Depreciation for year 1 = Cost of asset*depreciation rate = 6million*33.33% = 1,999,800

Depreciation for year 2 = Cost of asset*depreciation rate = 6million*44.45% = 2,667,000

Depreciation for year 3 = Cost of asset*depreciation rate = 6million*14.81% = 888,600

Depreciation for year 4 = Cost of asset*depreciation rate = 6million*7.41% = 444,600

Part ii)

Sales revenue for year 1 = 1250units*5000 = 6,250,000

Sales revenue for year 2 = Sales revenue for year 1*(1+Inflation rate) = 6,250,000*(1+0.03) = 6,250,000*1.03 = 6,437,500

Sales revenue for year 3 = Sales revenue for year 2*(1+Inflation rate) = 6,437,500*(1+0.03) = 6,437,500*1.03 = 6,630,625

Sales revenue for year 4 = Sales revenue for year 3*(1+Inflation rate) = 6,630,625*(1+0.03) = 6,630,625*1.03 = 6,829,544

Cost for year 1 = 1250units*2500 = 3,125,000

Cost for year 2 = Cost for year 1*(1+Inflation rate) = 3,125,000*(1+0.03) = 3,125,000*1.03 = 3,218,750

Cost for year 3 = Cost for year 2*(1+Inflation rate) = 3,218,750*(1+0.03) = 3,218,750*1.03 = 3,315,313

Cost for year 4 = Cost for year 3*(1+Inflation rate) = 3,315,313*(1+0.03) = 3,315,313*1.03 = 3,414,772

Due to inflation rate the cost of factor of production will increase & value of money will fall due which have to include inflation rate in while estimating future cash flows.

Part iii)

Sl.No	Year	1	2	3	4
i	Sales revenue (Refer part ii)	6,250,000	6,437,500	6,630,625	6,829,544
ii	Cost (Refer part ii)	3,125,000	3,218,750	3,315,313	3,414,772
iii	EBITDA (i-ii)	3,125,000	3,218,750	3,315,313	3,414,772
iv	Depreciation (Refer part i)	1,999,800	2,667,000	888,600	444,600
v	EBIT (iii-iv)	1,125,200	551,750	2,426,713	2,970,172
vi	Taxes @ 40% (v*0.4)	450,080	220,700	970,685	1,188,069
vii	Profit after tax (v-vi)	675,120	331,050	1,456,028	1,782,103
viii	Add: Depreciation	1,999,800	2,667,000	888,600	444,600
ix	Incremental operating cashflow (vii+viii)	2,674,920	2,998,050	2,344,628	2,226,703

Part iv)

Required net working capital for year 1 = Sales in year 1*12% = 6,250,000*12% = 750,000

Required net working capital for year 2 = Sales in year 2*12% = 6,437,500*12% = 772,500

Required net working capital for year 3 = Sales in year 3*12% = 6,630,625*12% = 795,675

Required net working capital for year 4 = Sales in year 4*12% = 6,829,544*12% = 819,545

Cash flow due to investments in net working capital for year 1 = Required net working capital for year 1 = 750,000

Cash flow due to investments in net working capital for year 2 = Required net working capital for year 2 - Required net working capital for year 1 = 772,500 - 750,000 = 22,500

Cash flow due to investments in net working capital for year 3 = Required net working capital for year 3 - Required net working capital for year 2 = 795,675 - 772,500 = 23,175

Cash flow due to investments in net working capital for year 4 = Required net working capital for year 4 - Required net working capital for year 3 = 819,545 - 795,675 = 23,870

Part v)

Before tax salvage value of machinery = 625,000

Tax on salvage value = Before tax salvage value of machinery*tax rate = 625,000*40% = 250,000

After tax salvage value of machinery = Before tax salvage value of machinery - Tax on salvage value = 625,000 - 250,000 = 375,000

Part vi)

Sl.No	Year	0	1	2	3	4
i	Incremental operating cashflow (refer part iii)		2,674,920	2,998,050	2,344,628	2,226,703
ii	After tax salvage value of machinery (refer part v)					375,000
iii	Incremental investment in net working capital (refer part iv)		-750,000	-22,500	-23,175	-23,870
iv	Investment in machinery or asset (refer part i)	-6,000,000
v	Net incremental cash flow (i+ii+iii+iv)	-6,000,000	1,924,920	2,975,550	2,321,453	2,577,833
vi	PVF @ 10% (1/1.1^year)	1	1/1.1 = 0.9091	1/(1.1^2) = 0.8265	1/(1.1^3) = 0.7514	1/(1.1^4) = 0.6831
vii	Present value of net incremental cash flow (v*vi)	-6,000,000	1,749,945	2,459,292	1,744,340	1,760,918

Net present value of the project = ΣPresent value of net incremental cash flow = 1,714,495