Question
In: Accounting
Benny’s Restaurant Ltd is looking at replacing an old European model oven which was purchased four...
Benny’s Restaurant Ltd is looking at replacing an old European model oven which was purchased four years ago for $25,000 with a new Australian model oven costing $60,000. The cost of installing the new oven is $3000. The optimal replacement life of both models in terms of output is four years therefore the old European model is due to be replaced but it is still working and has a current salvage value of $4000.
Benny has just returned from a trip overseas where he was researching which ovens would best suit the restaurant’s needs. This overseas research trip cost $6000.
The new Australian oven will increase income by $40 000 in year 1 and this will increase by 50% in year 2 and remain constant for years 3 and 4. The increased cost of using the new oven will be $12 000 in year 1 and will increase by 25% in year 2 (as a result of greater usage and more frequent servicing costs) and remain constant for years 3 and 4.
The salvage value of the new Australian oven in year 4 is $10 000.
The deprecation rate for tax purposes is 20% straight line. The tax rate is 30% and the relevant discount rate is 12%. It may be necessary for Benny’s restaurant to borrow fund at 10 % to purchase the machine because it has temporary cash flow problems.
Required:
I. Prepare a table of cash flows for the years 0, 1, 2, 3, 4.
II. Using this table determine using THREE (3) alternative project
evaluation techniques
whether Benny should invest in the new Australian oven?
III. Explain simply to Benny using the results from Part II what he
should do and why.
Solutions
Expert Solution
| I. | |||||||
| INITIAL CASH FLOWS | |||||||
| YEAR 0 | |||||||
| OUTFLOW | |||||||
| R&d | $ 6,000.00 | ||||||
| MACHINE COST | $ 60,000.00 | ||||||
| INSTALLATION COST | $ 3,000.00 | ||||||
| LESS: SALE OF OLD MACHINE | $ (4,000.00) | ||||||
| LESS:LOAN | $ (60,000.00) | ||||||
| NET CASH OUTFLOW IN YEAR '0' | $ 5,000.00 | ||||||
| CASH INFLOWS | |||||||
| YEAR 1 | YEAR 2 | YEAR 3 | YEAR 4 | ||||
| INCOME | $ 40,000.00 | $ 60,000.00 | $ 60,000.00 | $ 60,000.00 | |||
| LESS: COST | $ (12,000.00) | $ (15,000.00) | $ (15,000.00) | $ (15,000.00) | |||
| LESS INTEREST | $ (6,000.00) | $ (6,000.00) | $ (6,000.00) | $ (6,000.00) | |||
| LESS : PRINCIPAL PAYMENT | $ (60,000.00) | ||||||
| ADD: SALVAGE VALUE OF MACHINE | $ 10,000.00 | ||||||
| CASH INFLOW IN YEARS | $ 22,000.00 | $ 39,000.00 | $ 39,000.00 | $ (11,000.00) | |||
| NET CASH INFLOW (OUT FLOW ) | $ (5,000.00) | $ 22,000.00 | $ 39,000.00 | $ 39,000.00 | $ (11,000.00) | ||
| NET CASH FLOW FOR TOTAL PERIOD | $ 84,000.00 | ||||||
| II. | |||||||
| CALCULATION OF NPV | |||||||
| NET PRESENT VALUE | CASH INFLOW / (OUTFLOW) | DISCOUNTING FACTOR @ 12 % | PRESENT VALUE | ||||
| YEAR 0 | -5000 | 1 | $ (5,000.00) | ||||
| YEAR 1 | 22000 | 0.892857143 | $ 19,642.86 | ||||
| YEAR 2 | 39000 | 0.797193878 | $ 31,090.56 | ||||
| YEAR 3 | 39000 | 0.711780248 | $ 27,759.43 | ||||
| YEAR 4 | -11000 | 0.635518078 | $ (6,990.70) | ||||
| NET PRESENT VALUE | $ 66,502.15 | ||||||
| CALCULATION OF IRR ( IGNORING LOAN) | |||||||
| FACTOR CALCULATION | = | INITIAL INVESTMENT/ AVERAGE CASH FLOW | |||||
| = | 65000/22250 | ||||||
| = | 2.95 | ||||||
| TIME | = | 4 YEARS | |||||
| PVIFA table at 4 years time line factor 2.95 | |||||||
| THE Irr should be bwtween 45% and 50% | |||||||
| NET CASH FLOW + INT + PRIRCNIPAL LOAN ETC. | PV FACTOR | PV | PV FACTOR | PV | |||
| 45.00% | 50% | ||||||
| YEAR | 1 | 28000 | 0.69 | $ 19,310.34 | 0.67 | $ 18,666.67 | |
| YEAR | 2 | 45000 | 0.48 | $ 21,403.09 |
0.44
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