Question

b. Wells Printing is considering the purchase of a new printing press. The total installed cost of the press is $2.2 million. This outlay would be partially offset by the sale of an existing press. The old press has zero book value, cost $1 million 10 years ago, and can be sold currently for $1.2 million before taxes. As a result of acquisition of the new press, sales in each of the next 5 years are expected to be $1.6 million higher than with the existing press, but product costs (excluding depreciation) will represent 50% of sales. The new press will not affect the firm’s net working capital requirements. The new press will be depreciated under MACRS, using a 5-year recovery period. The firm is subject to a 40% tax rate. Wells Printing’s cost of capital is 11%. (Note: Assume that the old and the new presses will each have a terminal value of $0 at the end of year 6.) [15 marks]

i. Determine the initial investment required by the new press. [2 marks]

ii) Determine the operating cash flows attributable to the new press. (Note: Be sure to consider the depreciation in year 6.) [6 marks]

1. iii) Determine the payback period. [2 marks]
2. iv) Determine the net present value (NPV) and the internal rate of return (IRR) related to the proposed new press. [4 marks]
3. v) Make a recommendation to accept or reject the new press, and justify your answer. [1 marks]

Answer 1

Statement showing Depreciation

Year	Opening balance	Depreciation Rates	Depreciation (purchase price x Depreciation rates)	Closing Balance
1	2200000	20.00%	440000	1760000
2	1760000	32.00%	704000	1056000
3	1056000	19.20%	422400	633600
4	633600	11.52%	253440	380160
5	380160	11.52%	253440	126720
6	126720	5.76%	126720	0

Statement showing initial cash flow and annual cash flow

Particulars	0	1	2	3	4	5	6
Installed cost of new press	-2200000
Sale of existing press =1200000(1-tax rate) =1200000(1-40%) =1200000(0.6) =720000	720000
Sales		1600000	1600000	1600000	1600000	1600000
Prodcut cost(50% of sales)		-800000	-800000	-800000	-800000	-800000
Depreciation		-440000	-704000	-422400	-253440	-253440	-126720
PBT		360000	96000	377600	546560	546560	-126720
Tax @ 40%		-144000	-38400	-151040	-218624	-218624	50688
PAT		216000	57600	226560	327936	327936	-76032
Add: Depreciation		440000	704000	422400	253440	253440	126720
Annual cash flow		656000	761600	648960	581376	581376	50688
Total cash flow	-1480000	656000	761600	648960	581376	581376	50688

Thus Ans

i) Initial investment = 1480000 $

ii) Annual cash flow

Particulars	1	2	3	4	5	6
Annual cash flow	656000	761600	648960	581376	581376	50688

iii)

Statement showing cummulative cash flow

Year	Annual cash flow	Cummulative cash flow
1	656000	656000
2	761600	1417600
3	648960	2066560
4	581376	2647936
5	581376	3229312
6	50688	3280000

Now using interpolation we can find payback period

Year	Cummulative cash flow
2	1417600.00
3	2066560.00
1	648960.00
?	62400.00

=62400/648960

=0.096

Thus paybacl period = 2+0.096 = 2.096 years

iv) Statement showing NPV

Particulars	Annual cash flow	PVIF @ 11%	PV
1	656000	0.9009	590990.99
2	761600	0.8116	618131.65
3	648960	0.7312	474513.96
4	581376	0.6587	382970.38
5	581376	0.5935	345018.36
6	50688	0.5346	27099.87
PV of total of cash inflow	2438725.21
Less : Initial Investment	1480000
NPV	958725

Thus NPV = $ 958725

IRR is rate at which NPV is 0, assume r = 35%

Then NPV

Particulars	Annual cash flow	PVIF @ 35%	PV
1	656000	0.7407	485925.93
2	761600	0.5487	417887.52
3	648960	0.4064	263764.67
4	581376	0.3011	175033.84
5	581376	0.2230	129654.70
6	50688	0.1652	8373.41
PV of total of cash inflow	1480640.07
Less : Initial Investment	1480000.00
NPV	640.07

Now assume r = 36%

Now using interpolation we can find IRR

r	NPV
35%	640.07
36%	-24982.77
1%	25622.83
?	640.07

=640.07 / 25622.83

= 0.025%

Thus IRR = 35 + 0.025 = 35.025%

v) new press should be accepted since NPV is positive and IRR is greater than required rate of return