Question

Calculations must be done in Excel – You must create your own spreadsheet do not copy and paste someone else’s.

Polycorp Limited Steel Division is considering a proposal to purchase a new machine to manufacture a new product for a potential three year contract. The new machine will cost $1.9 million. The machine has an estimated life of three years for accounting and taxation purposes. Installation will cost a further $120,000. The contract will not continue beyond three years and the equipment has an estimated salvage value at the end of three years of $300,000. The tax rate is 30 percent and is payable in the year in which profit is earned. An investment allowance of twenty percent on the outlay plus installation costs is available. The after tax cost of capital is 14%pa. Addition current assets of $90,000 are required immediately for working capital to support the project.

Assume that this amount less $10,000 is recovered in full at the end of the three-year life of the project. The new product will be charged $170,500 of allocated head office administration costs each year even though head office will not actually incur any extra costs to manage the project. This is in accordance with the firm’s policy of allocating all corporate overhead costs to divisions. The Steel Division will incur extra marketing and administration cash outflows of $158,000 per year for the project. An amount of $200,000 has been spent on a pilot study and market research for the new product. The projections provided here are based on this work. Projected sales in the first year for the new product are 40,000 units at $150 per unit per year. Unit sales are expected to increase by 5%pa for years two and three. Cash operating expenses are estimated to be 75 percent of sales (excludes marketing and administration, and head office items). Except for initial outlays, assume cash flows occur at the end of each year (unless otherwise stated).

Assume diminishing value depreciation for tax purposes.

Required:

Construct a table showing net cash flow after tax (NCFAT). Do not forget to Calculate the NPV. Is the project acceptable? Why or why not? Conduct a sensitivity analysis showing how sensitive the project is to operating expenses and to the cost of capital. Explain your results. Write a short report explaining your calculation of relevant net cash flows after tax, justifying your selection of cash flows. Be sure to state clearly any assumptions made (implicit and explicit).

NOTE:

Method required is as follows this is just an example.

Method example
Beginners Method (two tables one for tax and one for cash flows)
TAX	0	1	2	3
Cash Benefits		16,000	20,000	12,000
Inv Allow 20%		-5,600
Deprec		-11,200	-6,720	-4,032
Loss on Sale				-5,548
Taxable Income		-800	13,280	2,420
Tax @ 30%		240	-3,984	-726
Cash Flows	0	1	2	3
Tax		240	-3,984	-726
Cash Benefits		16,000	20,000	12,000
Salvage Value				500
Outlay	-28,000
NCFAT	-28,000	16,240	16,016	11,774
DCF @ 15%	-28,000	14,122	12,110	7,742
NPV	5,974

Answer 1

Following points are worth noting
1) An investment allowance of twenty percent on the outlay plus installation costs is available
2) The contract will not continue beyond three years and the equipment has an estimated salvage value at the end of three years of $300,000
So the Depreciation will be provided for 3 years
3) An investment allowance of twenty percent on the outlay plus installation costs is available.
4) The after tax cost of capital is 14%pa.
5) Addition to current assets of $90,000 & Recovery is $80,000
6) $170,500 of allocated head office administration costs each year even though head office will not actually incur any extra costs
So it is Irrelevant for the computation
7) An amount of $200,000 has been spent on a pilot study and market research - So this also a Sunk Cost

Table to find out Cash benefits
Year>	0	1	2	3
Sales		$           6,000,000.00	$        6,300,000.00	$        6,615,000.00
Less:   Cash operating Expenses @ 75% of sales		$           4,500,000.00	$        4,725,000.00	$        4,961,250.00
Less:    Marketing and administration cash outflows		$              158,000.00	$            158,000.00	$            158,000.00
Cash Benefits per year		$           1,342,000.00	$        1,417,000.00	$        1,495,750.00

Table to find Tax Amount per year
Year>	0	1	2	3
Particulars-
Cash benefit		$           1,342,000.00	$        1,417,000.00	$        1,495,750.00
Investment Allowance @20%		$            (500,000.00)	$                             -	$                             -
Depreciation @ 33.333%		$            (673,333.33)	$         (673,333.33)	$         (673,333.33)
Profit on sale of Asset		$                                -	$                             -	$            300,000.00
Taxable Income		$              168,666.67	$            743,666.67	$        1,122,416.67
Tax @30%		$              (50,600.00)	$         (223,100.00)	$         (336,725.00)

Table to find out Net Cahs flow After tax & NPV
Year>	0	1	2	3
Particulars-
Tax		$              (50,600.00)	$         (223,100.00)	$         (336,725.00)
Cash Benefits		$           1,342,000.00	$        1,417,000.00	$        1,495,750.00
Salvage Value				$            380,000.00
Outlay	$        (2,110,000.00)
Net Cash Flow After Tax	$        (2,110,000.00)	$           1,291,400.00	$        1,193,900.00	$        1,539,025.00
Discounted Cash flow @14%	$        (2,110,000.00)	$           1,132,807.02	$            918,667.28	$        1,038,798.04
NPV ( Net Present Value)	$980,272.34

Sensitivity to operating Expense = 981272.34/ PVAnnuity Factor
PVAnnuity Factor = (((1+r)^n)-1)/ ((1+r)^n) (r)		2.3216320271
Annual Change (Sensitivity) to Operating Expense		$422,234.16

Which means, Annual increase in Operating cost till $422,234.16 will not adversely affect the organization. Increase in anual operating cost beyond this level will adversely affect the organization.

Sensitivity to Cost of Capital

New rate = 39.363%, that is 39.363%-14% = 25.363% .

that is Cost of capital can go upto 39.363% that is may go upto 25.363% over the expected rate of capital.

To find this We have to worked out the IRR. For IRR, we have to worked out Negative NPV by increasing the discount rate., then we will get NPV of -$17,569.6064139939.

Then we can intrapolate the Rate lying between 14% and 40%.

For this We can use the formulae = LR+((NPV@LR)/(NPV@LR - NPV@HR))* (HR-LR).

LR = 14%, HR = 40%, NPV@LR= $981,272.34, NPV@HR = -$17,569.6064139939.

So 14%+($981,272.34/($981,272.34 - -$17,569.6064139939.))*(40-14)

=39.363%