Question

CAPITAL BUDGETING

Wells printing is considering the purchase of a new printing press. The total installed cost of the press is $2.2 million.This outlay will be partially offset by the sale of an existing press. The old press has zero net book value, cost $1milion ten years ago and can be sold currently for $0,2 million before taxes..As a result of acquiring the new press, sales in each of the next five years are expected to increase by $1.6 million but product costs, excluding depreciation will represented 50% of sales. The new press will require that creditors be upped by $400 000 and debtors increase by $600 000. The new press will also be depreciated using a straight line method to a residual value of $300 000 but will only fetch $250 000 on the market. Investing in such assets attracts a Special Initial Allowance (SIA) of 25% of the installed cost to be spread equally over the useful life of the asset. The firm is subject to 35% tax rate on both ordinary income and capital gains. Wells Printing cost of capital is 13%. Assume that depreciation is tax deductible

Required

Determine initial investment, ater tax relevant cash flow and terminal cashflows

Advise the company on whether to invest in the new asset or not, using thethe following

1. Net present value approach
2. Profitability index approach
3. Internal rate of return
4. Modifying internal rate of return
5. Payback period if the company requires one and half years.

Answer 1

Solution:

1.a)Computation of initial investment

Initial investment=Cost of new press+Net Increase in working capital-after tax proceeds of old press

after tax proceeds of old press=(Sale proceeds-Book value)*(1-tax rate)

=($200,000-$0)(1-0.35)=$130,000

Initial Investment=$2200,000+($600,000-$400,000)-$130,000

=$2270,000

b)After tax relevant cash flow and terminal cashflows

It is assumed that working capital will not revert back at the end of project life,thus Terminal cashflows is;

=After tax sale proceeds of new press at the end of 5th year

Since book value($300,000) is higher than the sale price($250,000),hence there is loss on disposal.Accordingly,no tax will be applicable.Therefore,Terminal cash flows at the end of 5th year is equal to sale proceed i.e $250,000

Depreciation for each year=($2200,000-$300,000)/5

=$380,000

Annual SIA=($2200,000*25%)/5

=$110,000

Statement showing after tax relevant cash flow for each year

Year	1-4($)	5($)
Increase in Sale	1600,000	1600,000
Less: Cost@50%	800,000	800,000
Net Revenue	800,000	800,000
Less:Annual depreciation	380,000	380,000
Less:Annual SIA	110,000	110,000
Income before tax	310,000	310,000
Less:Tax @35%	108,500	108,500
Income after tax	201500	201500
Add:Annual depreciation	380,000	380,000
Add:Annual SIA	110,000	110,000
Terminal cash inflows	-	250,000
After tax relevant cash flows	691,500	941,500