Question

a) T&T Workshop is considering a four-year project to improve its production efficiency. Buying a new machine press for $560,000 is estimated to result in $210,000 in annual pre-tax cost savings. The press will be depreciated straight-line to zero over its four-year tax life. Assume the tax rate is 25 percent. Compute the operating cash flow and net present value for this new machine press. If the required return is 12 percent, should T&T Workshop buy in the new machine press?

b) Suppose the press also requires an initial investment in spare parts inventory of $20,000, and the press will have a market value of $80,000 at the end of the project. Compute the new net present value.

c) Suppose Antique Berhad is entering a four-year project and expected to enjoy improved growth in earnings and dividends when the project is completed. Last year, the company just paid a dividend of $3.40. It expects zero growth in the next year. In years 2 and 3, 15 percent growth is expected, and in year 4, 12 percent growth. In year 5 and thereafter, growth should be a constant 9 percent per year. Calculate the current share price of Antique Berhad if the required rate of return is 14 percent.

d) Discuss the relevant incremental cash flows associated with a new project. Provide relevant examples along your discussion if applicable.

Answer 1

a)

	1	2	3	4
Annual cost savings	$2,10,000	$2,10,000	$2,10,000	$2,10,000
(-) Depreciation	$1,40,000	$1,40,000	$1,40,000	$1,40,000
EBIT	$70,000	$70,000	$70,000	$70,000
(-) Tax @ 25%	$17,500	$17,500	$17,500	$17,500
Profit after tax	$52,500	$52,500	$52,500	$52,500
(+) Depreciation	$1,40,000	$1,40,000	$1,40,000	$1,40,000
Operating cash flows	$1,92,500	$1,92,500	$1,92,500	$1,92,500
Present value factor [1/(1+0.12)^n, n= 1,2,3,4]	0.89	0.80	0.71	0.64
Present value of cash flows (Operating cash flows X Present value factor)	$1,71,875	$1,53,460	$1,37,018	$1,22,337
Sum of present values	$5,84,690
(-) Initial investment	$5,60,000
NPV	$24,690

As the NPV is positive, T&T Workshop should buy the new machine press.

b)

	1	2	3	4
Annual cost savings	$2,10,000	$2,10,000	$2,10,000	$2,10,000
(-) Depreciation	$1,40,000	$1,40,000	$1,40,000	$1,40,000
EBIT	$70,000	$70,000	$70,000	$70,000
(+) Market value of press	$0	$0	$0	$80,000
Profit before tax	$70,000	$70,000	$70,000	$1,50,000
(-) Tax @ 25%	$17,500	$17,500	$17,500	$37,500
Profit after tax	$52,500	$52,500	$52,500	$1,12,500
(+) Depreciation	$1,40,000	$1,40,000	$1,40,000	$1,40,000
Operating cash flows	$1,92,500	$1,92,500	$1,92,500	$2,52,500
Present value factor	0.89	0.80	0.71	0.64
Present value of cash flows	$1,71,875	$1,53,460	$1,37,018	$1,60,468
Sum of present values	$6,22,821
(-) Initial investment ($560,000 + $20,000)	$5,80,000
NPV	$42,821

Hence, the new NPV is $42,821.