Question

High Hills plc produce underwater turbines to generate energy and are considering introducing machinery that will reduce the labour hours required to produce a turbine from 5 hours to 2 hours for the remainder of the product life cycle of 3 years. The production volumes are forecast based on the state of the industry as follows:

Industry Year 1 Year 2 Year 3

Weak (probability 50%) 3,000 units 4,000 units 3,000 units

Strong (probability 50%) 5,000 units 6,000 units 7,000 units

The employees hourly rate for the coming year is £7.00 rising in year 2 and year 3 to £8.00 and £9.00 respectively. The machinery has a capital cost of £200,000 with an estimated residual value at the end of year 3 of £60,000 and capital allowances are at 25% on a reducing balance basis. The company pays corporation tax (income tax) at a rate of 30%. The company assesses projects of this type using a discount rate of 8%. Any difference between the written down value and proceeds from the sale may be claimed as a tax credit in the year of the sale. Taxes are considered one year in arrears. 20 Required:

a) Calculate the annual cost savings for years 1, 2 and 3.

b) Calculate the impact on taxable profits for years 1, 2 and 3.

c) Calculate the total cash flows for each year.

d) Calculate the expected present value of the project suggesting whether the company should invest in the new machinery.

e) Discuss how the company might consider risk in reviewing projects of this type

Answer 1

Part a)

Sl.No	Year	1	2	3
i	Production volume (Weak)	3000	4000	3000
ii	Production volume (Strong)	5000	6000	7000
iii	Expected production (i+ii)/2	4000	5000	5000
iv	Employees hourly rate	7	8	9
v	Hours saved	3	3	3
vi	Annual cost savings (iii*iv*v)	84000	120000	135000

Part b)

Capital allowance for year 1 = cost *25% = 200000*25% = 50,000

Capital allowance for year 2 = (cost-Capital allowance for year 1)*25% = (200000-50000)*25% = 150,000*25% = 37,500

Capital allowance for year 3 = (cost-Capital allowance for year 1 & 2)*25% = (200000-50000-37500)*25% = 112,500*25% = 28,125

Tax credit in year 3 = Written down value of asset in year 3 - proceeds from sale = (200000-50000-37500-28125) - 60,000 = 84375-60000 = 24,375

Part c)

Sl.No	Year	0	1	2	3	4
i	Annual cost savings (Part a)		84,000	120,000	135,000
ii	Capital allowance (Part b)		(50,000)	(37,500)	(28,125)
iii	Tax credit (Part c)				(24,375)
iv	Taxable profit (i+ii+iii)		34,000	82,500	82,500
v	Tax @ 30% (Previous year iv*0.3)			(10,200)	(24,750)	(24,750)
vi	Net income (iv+v)		34,000	72,300	57,750	(24,750)
vii	Add: capital allowance (ii)		50,000	37,500	28,125
viii	Add: Tax credit (iii)				24,375
ix	Capital cost (given)	(200,000)
x	Sale of caital asset (given)				60,000
xi	Total cash flows (vi+vii+viii+ix+x)	(200,000)	84,000	109,800	170,250	(24,750)
xii	PVF @ 8%	1.00	0.9259	0.8573	0.7938	0.7350
xiii	Discounted cash flow (xi*xii)	(200,000)	77,775.6	94,131.54	135,144.45	(18,191.25)

Part d)

NPV of the project = sum of all discounted cashflow = 88,860.34

Company should invest in the project because it gives positive present value for the project.

Part e)
Risk of not changing the wage rate, Expected volume of production & Change in tax rate