Question

ToneLock Ltd, security experts and lock manufacturers are considering entering into the

production of impenetrable combination safes. The company has called you, their trusted

financial advisor, to recommend whether to proceed with the project. The company tells you

that the cost of the machinery required to manufacture these safes is $560,000, with an

additional $40,000 to install.  The machinery will be depreciated straight line on an annual

basis over its entire useful life of 4 years to a salvage value of $30,000. The company also

estimates that the building in which the machine is to be installed requires renovation

expenses of $25,000 if the company is to go ahead with the project, which for tax purposes

will be expensed at the beginning of the project.  

The project will generate pre‐tax revenues in the first year of $200,000, with revenues

expected to grow at a rate of 20% p.a., thereafter. Pre‐tax expenses have been estimated to

be 15% of pre‐tax revenues.  ToneLock Ltd also believes that they can receive $10,000 for the

machinery at the end of its useful life. Given a required rate of return of 10% p.a. compounded

semi‐annually, and a corporate tax rate of 30%, do you recommend that ToneLock Ltd

proceed with this project and commence manufacturing impenetrable safes? Why or why

not? In answering this question, assume the initial investment is made today and cash flows

are received or paid as stated in the question.

Answer 1

1) Do you recommend that ToneLock Ltd proceed with the project for manufacturing the safes?

To answer this, we need to find out the viability of the project using various capital budgeting techniques. The widely used capital budgeting techinques are the Net Present Value (NPV) and Internal Rate of Return (IRR). To compute NPV & IRR, we need to determine the cash flows that the project is capable of generating and the Discounting factor.

Step 1: Cash flow generated by the project.

The below table shows the cash flow from the project for the next 4 years.

Particulars	Year 0	Year 1	Year 2	Year 3	Year 4
Sales - A		$      200,000	$      240,000	$      288,000	$      345,600
Operating expenses @15% of sales - B		$        30,000	$        36,000	$        43,200	$        51,840
Depreciation* - C		$      142,500	$      142,500	$      142,500	$      142,500
Renovation expenses - D		$        25,000	$               -	$               -	$               -
Earnings Before Tax (A-B-C-D)		$          2,500	$        61,500	$      102,300	$      151,260
Less: Tax @30%		$             750	$        18,450	$        30,690	$        45,378
Profit After Tax		$          1,750	$        43,050	$        71,610	$      105,882
Add: Depreciation		$      142,500	$      142,500	$      142,500	$      142,500
Add: Renovaion expenses**		$        25,000
Cash Flow		$      169,250	$      185,550	$      214,110	$      248,382
Capital expenditure	$    -600,000				$        10,000
Building renovation	$      -25,000
Free cash flow	$    -625,000	$      169,250	$      185,550	$      214,110	$      258,382

Note:

* Depereciation = (Cost of the machine - Salvage value)/Life of the machine = (600,000-30,000)/4 = $142,500.

** Renovation expenses are dedecuted as expenses in the first year for taxation purpose. It is added back while arriving at free cash flow as these expeneses are already considered as outflow in the Year 0.

Step 2: Arriving at the Discounting factor.

The Discounting factor given is 10% compounded semi-annually. We need to convert to the effective annual interest rate as the free cash flows are on annual basis.

Below is the formula to convert the semi-anually compounded interest to effective annual interest.  

Effective annual interest rate = [1 + (nominal rate / number of compounding periods)) ^ (number of compounding periods] - 1

Effective annual interest rate = [1+(10%/2)^2]-1 = 10.25% p.a

Step 3 : Calculate NPV.

Year	Free cash flow	Discounting Factor @10.25%	Present Value
Year 0	$        (625,000)	1.000	$        (625,000)
Year 1	$           169,250	0.907	$          153,515
Year 2	$           185,550	0.823	$          152,652
Year 3	$           214,110	0.746	$          159,772
Year 4	$           258,382	0.677	$          174,883
		NPV	$            15,822

Step 4: IRR

IRR is calculated based on the free cash flow. IRR for this project is 11.34% (computed using excel. Alternatively, it can be calculated using trial and error method).

Conclusion:

ToneLock Ltd, should go ahead with the manufacturing of safes as the NPV is positive and the IRR is more than the required rate of return for the company.