Question

Question 5:

Ferris Industries is planning to replace its old equipment.

The old equipment cost was $350 000 five years ago. The old equipment is fully depreciated.

If the new equipment is purchased, arrangements will be made to sell the old equipment. The old equipment is expected to be sold for only $20 000 on 1 January 2021.

The new equipment will be placed in service on 1 January 2021. The details regarding the proposal are as follows:

• Expected acquisition cost $290 000
• Expected installation costs $20 000
• Expected investment allowance in Year 1:15%
• Estimated useful life: 7 years
• Expected salvage value which can be realised upon its disposal at the end of 7 years: $30 000

Expected increase in sales due to the special production run of the new equipment:

Year 1 to Year 7:

4000 units each year

• The selling price per unit is expected to remain at $300.
• The variable cost per unit is expected to be $250.
• Expected increase in annual fixed costs due to the special production run of the new equipment is $62 000.

It is assumed that all cash flows occur at the end of each year.

The taxation depreciation on the equipment would be 25% per annum using the straight-line method.

The company is subject to a 40% tax rate.

The company uses a 12% after-tax discount rate.

Required:

a) Calculate the incremental profit (before tax) for each year due to the expected increase in sales.

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b) Calculate the annual incremental after-tax cash flows for each year for Ferris Industries’ proposal to acquire the new equipment.

(Hint: prepare table of before- and after-tax annual cashflows, discount factor, present value of annual cashflows)

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c) Should Ferris Industries invest in the new equipment? Answer on the basis of your calculations. Calculate and interpret the following for the proposed investment, the after-tax:

i) Net present value

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ii) Internal rate of Return (Hint: use Goal Seek function in Excel or trial and error method)

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iii) Payback periods

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Answer 1

A) Calculation of the incremental profit (before tax) for each year due to the expected increase in sales :

Sales ( 4000 * 300)	$ 1,200,000
Less: Varible Costs ( 4000 * 250)	$ 1,000,000
Contribution 1st year	$ 200,000
Less: FIxed costs:	($ 62,000)
Less : Depreciation (Non cash expense) ( normal company depreciation) = [290,000 + 20,000 - 30,000] /7	($ 40,000)
Less : Investment allowance (15%of cost of new equipment) 15 % * ($ 290,000+20,000)	($46,500)
Net Profit ( Before tax) 1st year	$ 51,500

For year 2-7, Net profits = $ 98,000 ( as investment allowance is provided for year 1 only)

b) Calculation of the annual incremental after-tax cash flows for each year for Ferris Industries’ proposal to acquire the new equipment.

For 1st year

Profit before tax = $ 51,500

Profit after tax = $ 51,500 (1-0.40) = 30,900

Cash profit after tax ( adding back depreciation) = $ (30,900 + 40,000) = $ 70,900

For year 2-7

Before tax Profit = $ 98,000

After tax Profit = $ 98,000 * (1-0.40) = $ 58,800

After tax cash profit ( adding back depreciation) = $ (58,8000 + 40,000) = $ 98,800

at the end of 7th year after tax Cash inflow = $ (30,000 *60) = $ 18,000

at year 0, after tax cash inflow = 20000(1-0.40) = $ 12,000

Year	Cash Inflow /(Cash Outflow)	Factor (12%)	Amount
0	$ (290,000+20,000 - 12,000)	1	$ (298,000)
1	$ 70,900	0.89	$ 63,101
2	$ 98,800	0.79	$ 78,052
3	$ 98,800	0.71	$ 70,148
4	$ 98,800	0.63	$ 62,244
5	$ 98,800	0.56	$ 55,328
6	$ 98,800	0.51	$ 50,388
7	$ 98,800	0.45	$ 44,460
7	$ 18,000( salvage)	0.45	$ (8,100)

NPV = $ 117621