Question

Please explain your answer clearly. Please show all the formulas and calculations (please do not use excel):

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 process because it allows the company to save cash and not pay for new equipment. The after-tax value of the equipment today is $44,100. This machinery 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%.

Answer 1

Anchor Ltd
Relevant cash flows
The feasibility study cost is a sunk cost , so not considered as relevant cash flow
Loan repayments are not relevant cash flow as those are to be taken care as cost
of capital for discounting cash flows.
The after tax value of the existing equipment is being treated as opportunity cost.

Machine cost	250,000
Full depreciation in years	5
Yearly depreciation	50,000
Salvage value	80,000
Tax rate	30%
Post tax salvage =	56,000.0

	Cash flow Details
	Initial Investment	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
	Machine cost	(250,000)
	Increase In inventory	(20,000)
	Increase in AR	(35,000)
	Opportunity cost of existing equipment (post tax)	(44,100)
1	Total Initial Investment	(349,100)
	Cash flow from Operations
	Sales		135,000	135,000	135,000	135,000	135,000
	Less Depreciation		50,000	50,000	50,000	50,000	50,000
	EBT		85,000	85,000	85,000	85,000	85,000
	Tax @ 30%		25,500	25,500	25,500	25,500	25,500
	PAT		59,500	59,500	59,500	59,500	59,500
	Add back depreciation		50,000	50,000	50,000	50,000	50,000
2	Total Cash flow from Operations		109,500	109,500	109,500	109,500	109,500
	Terminal Value
	Post Tax salvage						56,000
	Working Capital Release						55,000
3	Total Terminal Cash flow						111,000
	Total Cash flows=1+2+3	(349,100)	109,500	109,500	109,500	109,500	220,500