Question

Capital Budgeting 1:

Anchor Ltd paid $15,000 last quarter for a feasibility study regarding the demand for motorboat replacement parts which would require the purchase of a new metal-shaping machine. Today, they wish to conduct an analysis of the proposed project.

The machine costs $250,000 and will operate for five years and tax rules allow the machine to be depreciated to zero over a five-year life. The machine is expected to produce sales of $135,000 annually for the five years. Anchor has already agreed to sell the machine in five years’ time to an unrelated firm for $80,000.

The project will result in a $35,000 increase in accounts receivable and require an increase in inventory levels by $20,000 to $95,000. Anchor has negotiated with its bank to borrow $180,000 to help pay for the project. Loan repayments are $48,000 each year for five years.

If Anchor buys the machine they will be able to use some equipment that they currently own. This is part of the driving force in the decision making as it enables the company to save money in not buying additional new equipment. This equipment was bought for $120,000 six years ago and could be sold today for $63,000. This equipment has been written off for tax purposes and would be worthless in five years’ time.

What are the relevant cash flows for each year of the new machine’s life? Assume the company tax rate is 30%.

Answers: . CF(0): -$349,100, CF(1 to 4): +$109,500; CF(5): $220,500.)

Answer 1

Given :
Cost of New Machine	250,000
Useful life in years	5
Annual Depreciation	50,000
Tax rate	30%
Annual Depreciation Tax shield =50000*30%	15,000
Salvage value after 5 years	80,000
Tax on Capital gain from salvage value@30%	24,000
opp cost -Sales value of other Equipment	63,000
Less Tax on Capital gain on Equipment Sale@30%	18,900
Increase in AR	35,000
Increase in Inventory	20,000
Net Increase in Working Capital	55,000

	Relevant Cash flows for the replacement	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
	Initial Investment
	Machine cost	(250,000)
	Add : opp cost -Sales value of other Equipment	(63,000)
	Less Tax on Capital gain on Equipment Sale@30%	18,900
	Increase in Net working Capital	(55,000)
a	Total Initial Investment	(349,100)
	Cash flow from Operating Activities
	Sales Revenue		135,000	135,000	135,000	135,000	135,000
	Less Tax on Income @30%		40,500	40,500	40,500	40,500	40,500
b	After Tax Income		94,500	94,500	94,500	94,500	94,500
c	Annual Tax shield from Depreictaion		15,000	15,000	15,000	15,000	15,000
d	FCF from Operating Activities=b+c		109,500	109,500	109,500	109,500	109,500
e	Terminal Cash flow
	Salvage value of Machine Year 5						80,000
	Less : Tax on Capital Gain on Salvage @30%						(24,000)
	Add: Recovery of Net working Capital						55,000
f	Total Terminal Cash flow						111,000
g	Total Free Cash flow from Project=a+d+f	(349,100)	109,500	109,500	109,500	109,500	220,500

Ans : Relevant Cash flows :

CF (Year 0) =-$349,100

CF (Year 1 to 4) =+$109,500

Cf( Year 5) =+$220,500