Question

Questions 1 to 4 based on the information below. Hermanto Ltd plans to buy new assets worth RM80,000. The assets require the cost of installing RM20,000 and RM50,000 for transportation and installation. It also increased working capital of RM25,000. The machine has a lifespan of 6 years and the value of zero scrap. Training costs of RM10,000 are needed to enable the machine to operate. It is depreciated on a straight line basis. Earnings before interest and tax (EBIT) are expected to be RM20,000 per year. After 6 years, the asset is sold at RM4,000. Tax rate is set at 40%.

1. Determine the initial investment cost (Initial investment) of the asset.

2. Determine Operating cash inflows of the asset RM37,000

3. Determine the final cash flow of the asset RM40,800

4. Determine the net present value (NPV) of the asset if the rate of return required 10%. Should this asset be purchased?

Answer 1

1. Initial investment = Purchase price + Transportation and installation + increase in working capital − disposal inflow if the asset is replaced

Since there is no replacement mentioned in the question so disposal inflow = 0

Hence initial investment = RM80,000 + RM20,000+RM50,000+RM25,000 = RM1,75,000

2. Operating cash inflows = EBIT -Taxes +Depreciation

Depreciation is calculated based on 6 year life of the assets, therefore depreciation = RM1,75,000 / 6 = RM29,166.67

	0	1	2	3	4	5	6
Initial investment	-150000
Working Capital	-25000
EBIT		20000	20000	20000	20000	20000	20000
tax		8000	8000	8000	8000	8000	8000
EBIT(1-tax)		12000	12000	12000	12000	12000	12000
Depreciation		29166.67	29166.67	29166.67	29166.67	29166.67	29166.67
Operating cash inflows		41166.67	41166.67	41166.67	41166.67	41166.67	41166.67
Working capital							25000
Operating cash flows		41166.67	41166.67	41166.67	41166.67	41166.67	66166.67

Final cash flow in 6th year will include working capital as well.

3. The final cash flow of the asset will be equal to RM66,166.67

4. To calculate NPV of the project present values of all the cash flows can be calculated using either excel formula where the rate of return is fed as 10% and cash flows are fed as the following

	0	1	2	3	4	5	6
Operating cash flows	-175000	41166.67	41166.67	41166.67	41166.67	41166.67	66166.67
NPV	RM16,730.38

Based on the formula, NPV is calculated as RM 16,730.38. Since the NPV comes out to be positive so it is ok to purchase the asset.

This value of NPV can be calculated by calculating the present values of individual cash flows and then calculating the net value. The discount factor to be used for calculating present values in 10%.