Question
In: Finance
Base price ($260,000) Modifications ($15,000) Increase in NWC ($22,500) Increase in sales revenue 220,000 Operating costs...
| Base price | ($260,000) | |
| Modifications | ($15,000) | |
| Increase in NWC | ($22,500) | |
| Increase in sales revenue | 220,000 | |
| Operating costs | 150,000 | |
| Salvage value | 8,500 | |
| Required rate of return | 13% | |
| Tax rate | 40% | |
| MACRS class life (years) | 5 | |
| Useful life (years) | 8 | |
|
Golden State Bakers, Inc. (GSB) has an opportunity to invest in a new bread-making machine. GSB needs more productive capacity, so the new machine will not replace an existing machine. The new machine is priced at $260,000 and will require modifications costing $15,000. It has an expected useful life of 10 years, will be depreciated using the MACRS method over its 5-year class life, and has an expected salvage value of $12,500 at the end of Year 10. (See Table 10A.2 for MACRS recovery allowance percentages.) The machine will require a $22,500 investment in net working capital. It is expected to generate additional sales revenues of $125,000 per year, but its use also will increase annual cash operating expenses by $55,000. GSB’s required rate of return is 10 percent, and its marginal tax rate is 40 percent. The machine’s book value at the end of Year 10 will be $0, so GSB will have to pay taxes on the $12,500 salvage value. a. What is the NPV of this expansion project? Should GSB purchase the new machine? b. Suppose GSB’s required rate of return is 12 percent rather than 10 percent. Should the new machine be purchased in this case? c. Should GSB purchase the new machine if it is expected to be used for only five years and then sold for $31,250? (Note that the model is set up to handle a five-year life; you need enter only the new life and salvage value.) d. Would the machine be profitable if revenues increased by only $105,000 per year? Assume everything else is as originally presented and evaluated in part a. |
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Solutions
Expert Solution
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a. Year |
0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
| Additional sales revenue | 125,000.00 | 125,000.00 | 125,000.00 | 125,000.00 | 125,000.00 | 125,000.00 | 125,000.00 | 125,000.00 | 125,000.00 | 125,000.00 | |
| Additional operating costs | 55,000.00 | 55,000.00 | 55,000.00 | 55,000.00 | 55,000.00 | 55,000.00 | 55,000.00 | 55,000.00 | 55,000.00 | 55,000.00 | |
| Depreciation per annum | 55,000.00 | 88,000.00 | 52,800.00 | 31,680.00 | 31,680.00 | 15,840.00 | 0.00 | 0.00 | 0.00 | 0.00 | |
| PBT | 15,000.00 | -18,000.00 | 17,200.00 | 38,320.00 | 38,320.00 | 54,160.00 | 70,000.00 | 70,000.00 | 70,000.00 | 70,000.00 | |
| Tax @ 40% | 6,000.00 | -7,200.00 | 6,880.00 | 15,328.00 | 15,328.00 | 21,664.00 | 28,000.00 | 28,000.00 | 28,000.00 | 28,000.00 | |
| PAT | 9,000.00 | -10,800.00 | 10,320.00 | 22,992.00 | 22,992.00 | 32,496.00 | 42,000.00 | 42,000.00 | 42,000.00 | 42,000.00 | |
| Cash flows: | |||||||||||
| Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
| PAT | 0.00 | 9,000.00 | -10,800.00 | 10,320.00 | 22,992.00 | 22,992.00 | 32,496.00 | 42,000.00 | 42,000.00 | 42,000.00 | 42,000.00 |
| Add: Depreciation | 0.00 | 55,000.00 | 88,000.00 | 52,800.00 | 31,680.00 | 31,680.00 | 15,840.00 | 0.00 | 0.00 | 0.00 | 0.00 |
| Initial capital investment | -275,000.00 | ||||||||||
| W.Capital requirement | -22,500.00 | 22,500.00 | |||||||||
| Salvage net of tax | 7,500.00 | ||||||||||
| Net cash flows | -275,000.00 | 41,500.00 | 77,200.00 | 63,120.00 | 54,672.00 | 54,672.00 | 48,336.00 | 42,000.00 | 42,000.00 | 42,000.00 | 72,000.00 |
| PVF @ 10% | 1.0000 | 0.9091 | 0.8264 | 0.7513 | 0.6830 | 0.6209 | 0.5645 | 0.5132 | 0.4665 | 0.4241 | 0.3855 |
| PV | -275,000.00 | 37,727.27 | 63,801.65 | 47,422.99 | 37,341.71 | 33,947.01 | 27,284.41 | 21,552.64 | 19,593.31 | 17,812.10 | 27,759.12 |
| NPV | 59,242 |
WN-1:
| Depreciation schedule | ||
| Year | Rate of Dep. | Amount |
| 1 | 20.00% | 55000 |
| 2 | 32.00% | 88000 |
| 3 | 19.20% | 52800 |
| 4 | 11.52% | 31680 |
| 5 | 11.52% | 31680 |
| 6 | 5.76% | 15840 |
WN-2: Salvage net of tax:
Profit on sale = Salvage value- book value = 12500-0 = 12500
Tax on profit = 12500*0.40 = 5000
Salvage,net of tax = 12500-5000 = 7500
Since the NPV>0, the new machine should be purchased.
b)
| Year | Net cash flows | PVF @ 12% | PV |
| 0 | -275,000.00 | 1.0000 | -275,000.00 |
| 1 | 41,500.00 | 0.8929 | 37,053.57 |
| 2 | 77,200.00 | 0.7972 | 61,543.37 |
| 3 | 63,120.00 | 0.7118 | 44,927.57 |
| 4 | 54,672.00 | 0.6355 | 34,745.04 |
| 5 | 54,672.00 | 0.5674 | 31,022.36 |
| 6 | 48,336.00 | 0.5066 | 24,488.52 |
| 7 | 42,000.00 | 0.4523 | 18,998.67 |
| 8 | 42,000.00 | 0.4039 | 16,963.10 |
| 9 | 42,000.00 | 0.3606 | 15,145.62 |
| 10 | 72,000.00 | 0.3220 | 23,182.07 |
| NPV | 33,069.89 |
Since the NPVis still >0, the new machine should be purchased.
c)
| Year | 0 | 1 | 2 | 3 | 4 | 5 |
| Additional sales revenue | 125,000.00 | 125,000.00 | 125,000.00 | 125,000.00 | 125,000.00 | |
| Additional operating costs | 55,000.00 | 55,000.00 | 55,000.00 | 55,000.00 | 55,000.00 | |
| Depreciation per annum | 55,000.00 | 88,000.00 | 52,800.00 | 31,680.00 | 31,680.00 | |
| PBT | 15,000.00 | -18,000.00 | 17,200.00 | 38,320.00 | 38,320.00 | |
| Tax @ 40% | 6,000.00 | -7,200.00 | 6,880.00 | 15,328.00 | 15,328.00 | |
| PAT | 9,000.00 | -10,800.00 | 10,320.00 | 22,992.00 | 22,992.00 | |
| Cash flows: | ||||||
| Year | 0 | 1 | 2 | 3 | 4 | 5 |
| PAT | 0.00 | 9,000.00 | -10,800.00 | 10,320.00 | 22,992.00 | 22,992.00 |
| Add: Depreciation | 0.00 | 55,000.00 | 88,000.00 | 52,800.00 | 31,680.00 | 31,680.00 |
| Initial capital investment | -275,000.00 | |||||
| W.Capital requirement | -22,500.00 | 22,500.00 | ||||
| Salvage net of tax | 25,086.00 | |||||
| Net cash flows | -275,000.00 | 41,500.00 | 77,200.00 | 63,120.00 | 54,672.00 | 102,258.00 |
| PVF @ 10% | 1.0000 | 0.9091 | 0.8264 | 0.7513 | 0.6830 | 0.6209 |
| PV | -275,000.00 | 37,727.27 | 63,801.65 | 47,422.99 | 37,341.71 | 63,494.17 |
| NPV | -25,212 |
WN-1: Since life of the equipment is only 5 years, the depreciation
will be charges till year 5:Since the NOV is now -ve, the prjoect
is not profitable and should npt be selected.
| Depreciation schedule | ||
| Year | Rate of Dep. | Amount |
| 1 | 20.00% | 55,000.00 |
| 2 | 32.00% | 88,000.00 |
| 3 | 19.20% | 52,800.00 |
| 4 | 11.52% | 31,680.00 |
| 5 | 11.52% | 31,680.00 |
| 259,160.00 | ||
WN-2: Salvage net of tax:
Book value = 260000+15000-259160 = 15840
Profit on sale = 31250-15840 = 15410
Tax on profit = 15410*0.40 = 6164.00
Salvage net of tax = 31250-6164 = 25086
d)
| Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
| Additional sales revenue | 105,000.00 | 105,000.00 | 105,000.00 | 105,000.00 | 105,000.00 | 105,000.00 | 105,000.00 | 105,000.00 | 105,000.00 | 105,000.00 | |
| Additional operating costs | 55,000.00 | 55,000.00 | 55,000.00 | 55,000.00 | 55,000.00 | 55,000.00 | 55,000.00 | 55,000.00 | 55,000.00 | 55,000.00 | |
| Depreciation per annum | 55,000.00 | 88,000.00 | 52,800.00 | 31,680.00 | 31,680.00 | 15,840.00 | 0.00 | 0.00 | 0.00 | 0.00 | |
| PBT | -5,000.00 | -38,000.00 | -2,800.00 | 18,320.00 | 18,320.00 | 34,160.00 | 50,000.00 | 50,000.00 | 50,000.00 | 50,000.00 | |
| Tax @ 40% | -2,000.00 | -15,200.00 | -1,120.00 | 7,328.00 | 7,328.00 | 13,664.00 | 20,000.00 | 20,000.00 | 20,000.00 | 20,000.00 | |
| PAT | -3,000.00 | -22,800.00 | -1,680.00 | 10,992.00 | 10,992.00 | 20,496.00 | 30,000.00 | 30,000.00 | 30,000.00 | 30,000.00 | |
| Cash flows: | |||||||||||
| Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
| PAT | 0.00 | -3,000.00 | -22,800.00 | -1,680.00 | 10,992.00 | 10,992.00 | 20,496.00 | 30,000.00 | 30,000.00 | 30,000.00 | 30,000.00 |
| Add: Depreciation | 0.00 | 55,000.00 | 88,000.00 | 52,800.00 | 31,680.00 | 31,680.00 | 15,840.00 | 0.00 | 0.00 | 0.00 | 0.00 |
| Initial capital investment | -275,000.00 | ||||||||||
| W.Capital requirement | -22,500.00 | 22,500.00 | |||||||||
| Salvage net of tax | 7,500.00 | ||||||||||
| Net cash flows | -275,000.00 | 29,500.00 | 65,200.00 | 51,120.00 | 42,672.00 | 42,672.00 | 36,336.00 | 30,000.00 | 30,000.00 | 30,000.00 | 60,000.00 |
| PVF @ 10% | 1.0000 | 0.9091 | 0.8264 | 0.7513 | 0.6830 | 0.6209 | 0.5645 | 0.5132 | 0.4665 | 0.4241 | 0.3855 |
| PV | -275,000.00 | 26,818.18 | 53,884.30 | 38,407.21 | 29,145.55 | 26,495.95 | 20,510.72 | 15,394.74 | 13,995.22 | 12,722.93 | 23,132.60 |
| NPV | -14,493 |
Since the NPV is now negetive, the project is not profitable.
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