Question

Question 1 (36 marks, 54 minutes)

Clean Inc. has been using a model 10 machine to manufacture and sell 2,000 pressure washers per month. Given that this machine is wearing out and, as a result of an increase in expected demand over the next several years, consideration is being given to the purchase of a larger model 20 machine. The currently owned model 10 machine will not be used in future operations but will be retained as a backup in case of unexpected breakdowns. The model 10 currently has a fair value of $40,000 and book value of $25,000 and a working capital investment of $10,000. The purchase price of the model 20 machine is $6,500,000 (25% down payment and the balance due in one year). The new model 20 machine is estimated to have a 6 year useful life, with an expected terminal salvage value of $50,000. The model 20 machine is able to produce up to 3,000 pressure washers per month but will require an immediate investment of an additional $14,000 for working capital. All working capital will be recovered in 6 years. The selling price for each pressure washer is expected to remain constant at $150 even though sales will increase to 25,000 pressure washers in years one through 4 and to 35,000 pressure washers in years five and six. Operating costs are expected to be 40% of the selling price. To make room for the new machine the company can lease the space next door for $250,000 per year for the next six years, payable at the beginning of each year. The cost for repairs on the new machine is estimated to be $400,000 per year, but as the model 20 machine is so efficient, one supervisor will be dismissed if the new machine is purchased. That person’s current monthly salary is $7,000. These facts were not included in the above 40% operating cost forecast. REQUIRED: (CCA = 20%; tax rate = 30%; required rate of return: 12%)

1. Calculate the new machine’s net present value. Should they purchase the model 20?

2. Comment on the internal rate of return for the new machine. Do not calculate. (1 mark)

3. Management is concerned that the estimate for repairs on the new machine may not be very accurate. Assume that the net present value of this model 20 acquisition is $100,000. Calculate what the annual repairs on the new machine could change by, so that management would be indifferent, from a net present value perspective, regarding the purchase of the new model 20 machine.

4. Assume that you are making this decision in September 2020. (a) Identify 3 qualitative factors that, in general, you would consider here when making this capital investment decision and briefly explain your reasoning for each factor. Point form is acceptable. (b) Further identify 2 qualitative factors that, specific to COVID 19, you would consider here when making this capital investment decision and briefly explain your reasoning for each factor. Point form is acceptable.

Answer 1

CCA of 20% means that in the first year only 10% depreciation can be taken and from year 2 onwards, 20% depreciation per year can be take on the remaining value.

Since Model10 is mention to have not been in use, we can assume that that WC of $10,000 can be used for Model20. It is also mentioned that additional $14,400 will be needed. Hence, total WC required is $24,400/-

It is mentioned that Lease Rental is done at the beginning of the year. It can also be shown to be done at the end of last year. Hence, 1st year lease rental is assumed to have been paid in year 0.

Since the supervisor's salary of $7000/month of $84,000/year is saved which is not mentioned in the COGS. We can expect that to be an inflow if we take up the project.

Assumption: Any loss made from selling asset can be adjusted in the current year Profit and Loss Account. Also actual cash inflow from the same is added to the cash flow calculation.

Based on the above the below cash flows are calculated

CCA	20%
Tax Rate	30%
Require Return Rate	12%
COGS	40%
Initial Investment	(16,25,000.00)	(48,75,000.00)
Working Capital	10,000	24,400	24,400	24,400	24,400	24,400	-
Number of Units		25,000	25,000	25,000	25,000	35,000	35,000
Price Per Unit		150	150	150	150	150	150
Book Value of Asset	65,00,000	58,50,000	46,80,000	37,44,000	29,95,200	23,96,160	19,16,928
Year	0	1	2	3	4	5	6
Revenue		37,50,000	37,50,000	37,50,000	37,50,000	52,50,000	52,50,000
Minus:COGS		15,00,000	15,00,000	15,00,000	15,00,000	21,00,000	21,00,000
Minus:Depreciation		6,50,000	11,70,000	9,36,000	7,48,800	5,99,040	4,79,232
Minus:Lease Rental	2,50,000	2,50,000	2,50,000	2,50,000	2,50,000	2,50,000
Minus: Repairs & Maintenance		4,00,000	4,00,000	4,00,000	4,00,000	4,00,000	4,00,000
Plus: Savings From Supervisor		84,000	84,000	84,000	84,000	84,000	84,000
Minus: Loss from Sale of Asset							18,66,928
PBT	(2,50,000)	10,34,000	5,14,000	7,48,000	9,35,200	19,84,960	23,54,768
Tax		3,10,200	1,54,200	2,24,400	2,80,560	5,95,488	7,06,430
PAT	(2,50,000)	7,23,800	3,59,800	5,23,600	6,54,640	13,89,472	16,48,338
Plus: Depreciation		6,50,000	11,70,000	9,36,000	7,48,800	5,99,040	4,79,232
Plus: Change in WC		(14,400)	-	-	-	-	24,400
Plus: Salvage Value							50,000
Initial Investment	(16,25,000.00)	(48,75,000.00)
Cash Flow	(18,75,000)	(35,15,600)	15,29,800	14,59,600	14,03,440	19,88,512	22,01,970
Discount Factor	1	0.892857143	0.797193878	0.711780248	0.635518078	0.567426856	0.506631121
NPV	3,80,366

2) The IRR can be expected to be above the Rate of Return as we have discount the cash flows by 12%. Hence, the IRR should be greater than 12%

3) If we do a trial and error method in the cash flow / goal seek, we find that the company would be indifferent to increase in repairs as long as it does not go above $4,97,417/year. I.e there is a safety margin of $97,417.