Question

Eastern Inc. is considering one of the two machines available to produce garden tools. The Artic1 costs $360,000, has a four-year life and has to be depreciated on a straight-line method to zero. In order to operate Artic 1, it requires an initial working capital of $9,000. This working capital will be recovered at the end of the life of the asset. It is estimated that the Artic1 will generate a revenue of $150,000 in the first year, and the revenue will increase by 2.5% per year for its remaining life. It’s pretax operating cost is $40,000 per year. At the end of the fourth year, Artic1 can be sold of $28,000.

The other machine Eastern considering is TelestoneII. It costs $480,000, has a five-year life and has to be depreciated on a straight-line method to zero salvage value. It requires an initial working capital of $7,000. At the end of the fifth year the entire working capital will be recouped. It is estimated that TelestoneII will generate an annual revenue $175,000. Its pretax operating cost is $58,000. At the end of the fifth year, the machine will be sold for $41,500. The tax rate of Eastern is 35%, and the discount rate is 12%. Which do you prefer? Why?

1) Correct net investment of Artic1.

2) Correct net cash flow of Artic1 for each year.

3) Correct NPV of Artic1.

4) Correct net investment of TelestoneII.

5) Correct net cash flow of TelestoneII for each year.

6) Correct NPV of TelestoneII.

Which one do you prefer? Why?

Answer 1

Artic 1	Years
	0	1	2	3	4
Initial Investment	-360000
Initial WC	-9000				9000
Net Cash flow due to operation ( WN 1)		71500	73937.5	76435.94	78996.84
Sales of Artic 1 (WN 2)					18200
Gross total	-369000	71500	73937.5	76435.94	106196.8
Discounting facor @12%	1	0.892857	0.797194	0.71178	0.635518
PV	-369000	63839.29	58942.52	54405.59	67490.01
NPV	-124323
Telestonell	Years
	0	1	2	3	4	5
Initial Investment	-480000
Initial WC	-7000					7000
Net Cash flow due to operation ( WN 3)		76050	76050	76050	76050	76050
Sales of Telestonell ( WN 4)						26975
Gross total	-487000	76050	76050	76050	76050	110025
Discounting facor @12%	1	0.892857	0.797194	0.71178	0.635518	0.567427
PV	-487000	67901.79	60626.59	54130.89	48331.15	62431.14
NPV	-193578
WE WOULD NOT PREFER ANYONE AS BOTH ARE HAVING NEGETIVE NPV
WN 1: Computation of Cashflows after tax due to operation
	Year	1	2	3	4
Revenues		150000	153750	157593.8	161533.6
Operating cost		-40000	-40000	-40000	-40000
Benefit		110000	113750	117593.8	121533.6
Less Tax	35%	38500	39812.5	41157.81	42536.76
Net Cash Inflow		71500	73937.5	76435.94	78996.84
WN 2: Net proceed from Sale after Tax
Sale proceeds	28000
Less Tax	9800
Net Proceeds	18200
WN 3: Computation of Cashflows after tax due to operation
	Year	1	2	3	4	5
Revenues		175000	175000	175000	175000	175000
Operating cost		58000	58000	58000	58000	58000
Benefit		117000	117000	117000	117000	117000
Less Tax	35%	40950	40950	40950	40950	40950
Net Cash Inflow		76050	76050	76050	76050	76050
WN 4: Net proceed from Sale after Tax
Sale proceeds	41500
Less Tax	14525
Net Proceeds	26975