Question

Sanghai Corporation is planning to purchase a cost efficient fully automated machine which will reduce acitivties perfomed manually to a great extent. Two alternative models are MA1 and MA2 are available The details of the models are as follows:

	MA1	MA2
	$	$
Cost of Machine	2,000,000	3,000,000
Estimate Life of Machine	5 years	5 years
Savings due to reduction of waste per year	120,000	200,000
Savings due to reduced Direct Wages per year	1,400,000	1,800,000
Indirect Expenses per year	80,000	100,000
Cost of Spares per year	600,000	800,000
Repairs and Maintenance Costs per year	90,000	170,000

Depreciation is to be provided on straight line basis. The company pays tax at the rate of 30%.

i.          Calculate the Annual CFAT for both the machines.

ii.          Evaluate both the machines based on NPV and give your recommendations. (The discounting

rate 12%)

Answer 1

I. Calculation of annual cash flow after tax:

	Particulars	MA 1	MA 2
	Inflows:
	Savings due to reduction of waste per year	120,000	200,000
	Savings due to reduced Direct Wages per year	1,400,000	1,800,000
	Outflows:
	Indirect Expenses per year	80,000	100,000
	Cost of Spares per year	600,000	800,000
	Repairs and Maintenance Costs per year	90,000	170,000
A	Annual CFAT before tax [Inflows - Outflows]	750,000	930,000
B	Annual Depreciation [2000000/5] and [3000000/5]	400,000	600,000
C	Annual profit before tax (A-B)	350,000	330,000
D	Tax @ 30%	105,000	99,000
E	Profit after tax (C-D)	245,000	231,000
F	Cash flows after tax = Profit after tax + Depreciation - since it is a non cash charge	645,000	831,000

ii. Calculation of NPV:

Present value of annual cash flows - Initial investment

Particulars		MA 1	MA 2
Annual cash flows		645,000	831,000
Present value
Year 1	0.893	575,893	741,964
Year 2	0.797	514,190	662,468
Year 3	0.712	459,098	591,489
Year 4	0.636	409,909	528,116
Year 5	0.567	365,990	471,532
Total present value of cash flows		2,325,081	2,995,569
Initial investment		2000000	3000000
NPV = PV of cash flows - Initial investment		325,081	-4,431

Recommendation: Since NPV of Machine 1 is positive, Sanghai corporation should purchase Machine 1.

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