Question

Question 1

John is the production manager of Kam Kee Limited, a famous soy sauce manufacturer in Hong Kong. Currently, he is reviewing the possibility of replacing the old brewing system in order to boost production volume. The old brewing system was purchased eight years ago with a total cost of $6,600,000. It has a 12-year economic life with four years remaining and zero salvage value. If this system were to be sold today, it would be worth $2,200,000. The firm’s cost of capital is 14% with a marginal tax rate of 20%. Kam Kee uses the straight line depreciation method on all production machinery. The new brewing system is proposed by Good Food Consulting, a wellknown consulting firm in the food production and processing field. The purchase price of the proposed system would be $7,800,000. In addition, the company would have to incur $200,000 shipping and installation costs and $400,000 investment in net working capital. The economic life of the new brewing system is four years with zero scrap value. It is expected that the new system can reduce before-tax operating expenses by $2,400,000 every year. In this replacement action, Kam Kee has already paid $30,000 to Good Food Consulting to obtain the recommendation report. Answer the following questions:

a) What is the initial outlay associated with this proposed purchase?

b) Find out the annual after-tax cash flows associated with this proposed purchase, for years 1–3.

c) Also, assess the amount of after-tax cash flow that should appear in the final year (year 4).

d) Determine the net present value (NPV) of this replacement decision. Would you accept or reject the purchase of the new brewing system?

Answer 1

A) The initial outlay is purchase price of the proposed system + shipping and installation costs + investment in net working capital = $7,800,000 + $200,000 + $400,000 = $8,400,000 (We will not add  $30,000 as that is sunk cost, Purchase price of equipment is $8,000,000 ($7,800,000 + $200,000)).

B) After tax Cash flow at year 1 end = Save in before-tax operating expenses - Depreceation - investment in net working capital = $2,400,000 - $2,100,000 - $400,000 (depreciation =  $8,000,000/4) = -$100,000

After tax Cash flow at year 2 end = Save in before-tax operating expenses - Depreceation = $2,400,000 - $2,100,000 = $300,000*0.8 = $240,000 (As, 20% is tax rate, so multiply by 0.8 for after tax)

After tax Cash flow at year 3 end = Save in before-tax operating expenses - Depreceation = $2,400,000 - $2,100,000 = $300,000*0.8 = $240,000

C) After tax Cash flow at year 4 end = Save in before-tax operating expenses - Depreceation + investment in net working capital  = $2,400,000 - $2,100,000 + $400,000 = $700,000*0.8 = $560,000

D) NPV = CF1/1.14 + CF2/1.14² + CF3/1.14³ + CF4/1.14⁴ , Since NPV is +ve, so we will accept this project