Question
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First Health Company which is considering investing in a new production line of portable electrocardiogram (ECG)...
First Health Company which is considering investing in a new production line of portable electrocardiogram (ECG) machines for its clients who suffer from cardiovascular diseases. The company has to invest in equipment which costs $2,500,000 and falls within a MARCS depreciation of 5 years, (This means depreciation 20%,32%,19%,12% and 12% for years 1,2,3,4 and 5 respectively),and is expected to have a scrap value of $200,000 at the end of the project. Other than the equipment, the company needs to increase its cash and cash equivalents by $100,000, increase the level of inventory by $30,000, increase accounts receivable by $250,000 and increase accounts payable by $50,000 at the beginning of the project. First Healthy expects the project to have a life of five years. The company would have to pay for transportation and installation of the equipment which has an invoice price of $450,000. The company has already invested $75,000 in Research and Development and therefore expects a positive impact on the demand for the new product line. Expected annual sales for the ECG machines in years one to three are $1,200,000, and $850,000 in the following two years. The variable costs of production are projected to be $267,000 per year in years one to three and $375,000 in years four and five. Fixed overhead is $180,000 per year over the life of the project. The introduction of the new line of portable ECG machines will cause a net decrease of $50,000 in profit contribution after taxes, due to a decrease in sales of the other lines of tester machines produced by the company. By investing in the new product line First Healthy would have to use a packaging machine which the company already has and which will be sold at the end of the project for $350,000 after-tax in the equipment market.
The Company has an Weighted Average Cost of Capital of 8% and a marginal tax rate of 25%.
1. Calculate the initial investment cash flows.
2. Calculate the after-tax operating cash-flows
3. Determine the tax on salvage value of the equipment, then show the terminal year cash-flows
4. Identify three (3) relevant cash flows which were mentioned in the case and how they should be treated in the capital budgeting decision.
5. Taking into consideration all the information given, determine the Net Present Value of the project and advise the company on whether to invest in the new line of product.
Solutions
Expert Solution
| Tax rate | 25% | |||||||
| Calculation of annual depreciation | ||||||||
| Depreciation | Year-1 | Year-2 | Year-3 | Year-4 | Year-5 | Total | ||
| Cost | $ 2,950,000 | $ 2,950,000 | $ 2,950,000 | $ 2,950,000 | $ 2,950,000 | |||
| Dep Rate | 20.00% | 32.00% | 19.00% | 12.00% | 12.00% | |||
| Depreciation | Cost * Dep rate | $ 590,000 | $ 944,000 | $ 560,500 | $ 354,000 | $ 354,000 | $ 2,802,500 | |
| Calculation of after-tax salvage value | ||||||||
| Cost of machine | $ 2,950,000 | |||||||
| Depreciation | $ 2,802,500 | |||||||
| WDV | Cost less accumulated depreciation | $ 147,500 | ||||||
| Sale price | $ 200,000 | |||||||
| Profit/(Loss) | Sale price less WDV | $ 52,500 | ||||||
| Tax | Profit/(Loss)*tax rate | $ 13,125 | ||||||
| Sale price after-tax | Sale price less tax | $ 186,875 | ||||||
| Calculation of annual operating cash flow | ||||||||
| Year-1 | Year-2 | Year-3 | Year-4 | Year-5 | ||||
| Sale | $ 1,200,000 | $ 1,200,000 | $ 1,200,000 | $ 850,000 | $ 850,000 | |||
| Less: Operating Cost | $ 267,000 | $ 267,000 | $ 267,000 | $ 375,000 | $ 375,000 | |||
| Contribution | $ 933,000 | $ 933,000 | $ 933,000 | $ 475,000 | $ 475,000 | |||
| Less: Fixed cost | $ 180,000 | $ 180,000 | $ 180,000 | $ 180,000 | $ 180,000 | |||
| Less: Depreciation | $ 590,000 | $ 944,000 | $ 560,500 | $ 354,000 | $ 354,000 | |||
| Profit before tax (PBT) | $ 163,000 | $ (191,000) | $ 192,500 | $ (59,000) | $ (59,000) | |||
| Tax@25% | PBT*Tax rate | $ 40,750 | $ (47,750) | $ 48,125 | $ (14,750) | $ (14,750) | ||
| Profit After Tax (PAT) | PBT - Tax | $ 122,250 | $ (143,250) | $ 144,375 | $ (44,250) | $ (44,250) | ||
| Add Depreciation | PAT + Dep | $ 590,000 | $ 944,000 | $ 560,500 | $ 354,000 | $ 354,000 | ||
| Cash Profit after-tax | $ 712,250 | $ 800,750 | $ 704,875 | $ 309,750 | $ 309,750 | |||
| Calculation of working capital movement | ||||||||
| Increase in cash | $ 100,000 | |||||||
| Increase in inventory | $ 30,000 | |||||||
| Increase in AR | $ 250,000 | |||||||
| Increase in AP | $ (50,000) | |||||||
| Net increase in working capital | 330,000 | |||||||
| Calculation of NPV | ||||||||
| 8.00% | ||||||||
| Year | Capital | Packaging machine | Lost contribution | Working capital | Operating cash | Annual Cash flow | PV factor, 1/(1+r)^time | Present values |
| 0 | $ (2,950,000) | - | $ (330,000) | $ (3,280,000) | 1.0000 | $(3,280,000) | ||
| 1 | (50,000) | $ - | $ 712,250 | $ 662,250 | 0.9259 | $ 613,194 | ||
| 2 | (50,000) | $ - | $ 800,750 | $ 750,750 | 0.8573 | $ 643,647 | ||
| 3 | (50,000) | $ - | $ 704,875 | $ 654,875 | 0.7938 | $ 519,861 | ||
| 4 |
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