Question

The firm currently produces safety glasses using a machine called the Glasses-O-Matic. This existing machine is at the end of its useful life, so the firm would be required to buy a new machine immediately if they decide to proceed with this technology. The existing machine has been fully depreciated, however can be currently sold at a salvage value of $50,000. The new machine can be purchased at a price of $1,200,000. While the new machine requires an initial net working capital of $100,000, New York Ltd.’s current level of net working capital is only $80,000. The subsequent net working capital requirement will be 15% of sales revenue. The Glasses-O-Matic has an economic life of five years, and the table below summarises the number of units this machine is able to produce each year across its useful life:

Year 1	Year 2	Year 3	Year 4	Year 5
130,000	115,000	95,000	120,000	105,000

The Glasses-O-Matic has a variable cost of $4 per unit and a fixed cost of $250,000 per annum.

The modern technology that is available to manufacture safety glasses is the Glasses3000 machine. New York Ltd have already paid $500,000 to engage in a feasibility study, which determined that the Glasses3000 would be able to produce their existing product. This new machine costs $5,000,000 and has a useful life of four years. Due to modern technology, this machine would require less investment in net working capital which will be $70,000 initially and 10% of sales revenue in the subsequent years. As noted previously, New York Ltd.’s current level of net working capital is $80,000. The table below summarises the number of units this machine is able to produce each year across its useful life:

Year 1	Year 2	Year 3	Year 4
400,000	350,000	390,000	225,000

The Glasses3000 machine has a variable cost of $3 per unit and a fixed cost of $500,000 per annum.

The company manufactures all its products at the same rented factory on the outskirts of Newcastle. The current rent for this facility is $500,000 per annum. With the Glasses-O-Matic, the rent will increase to $600,000 per annum. However, as the Glasses3000 takes up significantly more floor space than the Glasses-O-Matic, Newcastle Ltd would need a larger factory if they decided to invest in this new machine. The landlord also owns an adjoining factory and has offered New York Ltd to rent both premises for a combined cost of $850,000 per annum. The CEO of New York  Ltd earns an annual salary of $650,000. Although the CEO’s salary does not increase irrespective of the company goes for Glasses-O-Matic or Glasses3000, 10% of the salary is attributed to the company’s safety glass producing project for the accounting purpose. The human resources department at New York Ltd costs $3,000,000 per annum to run. The department is very lean at this moment, therefore, its size needs to be increased by 10% if the company wants to continue with Glasses-O-Matic or goes for Glasses3000.

Regardless of which technology is used to produce safety glasses, they are expected to have a sale price of $12 per unit. All sales made by New York Ltd are cash only. Both machines are depreciated on an straight-line basis across their useful life and neither machine is expected to have a salvage value at the end of its life. New York Ltd has an effective corporate tax rate of 40% and capital gain tax rate of 35%. You have estimated that the required rate of return on both of these projects is 10% per annum.

Calculate the NPV for the Glasses-O-Matic and Glasses3000.

Answer 1

NPV analysis of Glasses-O-Matic
Year	0	1	2	3	4	5
1.After-tax salvage of existing m/c(50000*(1-35%)	32500
2.Initial cost	-1200000
a.Beg. NWC	80000	100000	207000	171000	216000	189000
b.End. NWC	100000	207000	171000	216000	189000	0
3.Change in NWC(a-b)	-20000	-107000	36000	-45000	27000	189000
Operating cash flows:
4.Units produced		130,000	115,000	95,000	120,000	105,000
5.Sale value at $ 12/unit(4*$12)		1560000	1380000	1140000	1440000	1260000
6.Variable costs at $ 4/unit(4*$4)		-520000	-460000	-380000	-480000	-420000
7. Fixed costs		-250000	-250000	-250000	-250000	-250000
8. Incremental rent(600000-500000)		-100000	-100000	-100000	-100000	-100000
9.Incl. HR costs(3000000*10%)		-300000	-300000	-300000	-300000	-300000
10. Depn.(1200000/5)		-240000	-240000	-240000	-240000	-240000
11. EBIT(Sum 5 to 10)		150000	30000	-130000	70000	-50000
12. Tax at 40%(11*40%)		-60000	-12000	52000	-28000	20000
13.EAT/NOPAT(11+12)		90000	18000	-78000	42000	-30000
14.Add back: depn.(line 10)		240000	240000	240000	240000	240000
15.Operating cash flow(13+14)		330000	258000	162000	282000	210000
16.Total Annual FCFs(1+2+3+15)	-1187500	223000	294000	117000	309000	399000
17. PV F at 10%(1/1.10^ yr.n)	1	0.90909	0.82645	0.75131	0.68301	0.62092
18.PV at 10%(16*17)	-1187500	202727.27	242975.21	87903.83	211051.16	247747.61
19. NPV at 10%(sum of Line 18)	-195094.92

NPV analysis of Glasses 3000
Year	0	1	2	3	4
1.After-tax salvage of existing m/c(50000*(1-35%)	32500
2.Initial cost	-5000000
a.Beg. NWC	80000	70000	420000	468000	270000
b.End. NWC	70000	420000	468000	270000	0
3.Change in NWC(a-b)	10000	-350000	-48000	198000	270000
Operating cash flows:
4.Units produced		400,000	350,000	390,000	225,000
5.Sale value at $ 12/unit(4*$12)		4800000	4200000	4680000	2700000
6.Variable costs at $ 3/unit(4*$3)		-1200000	-1050000	-1170000	-675000
7. Fixed costs		-500000	-500000	-500000	-500000
8. Incremental rent(850000-500000)		-350000	-350000	-350000	-350000
9.Incl. HR costs(3000000*10%)		-300000	-300000	-300000	-300000
10. Depn.(5000000/4)		-1250000	-1250000	-1250000	-1250000
11. EBIT(Sum 5 to 10)		1200000	750000	1110000	-375000
12. Tax at 40%(11*40%)		-480000	-300000	-444000	150000
13.EAT/NOPAT(11+12)		720000	450000	666000	-225000
14.Add back: depn.(line 10)		1250000	1250000	1250000	1250000
15.Operating cash flow(13+14)		1970000	1700000	1916000	1025000
16.Total Annual FCFs(1+2+3+15)	-4957500	1620000	1652000	2114000	1295000
17. PV F at 10%(1/1.10^ yr.n)	1	0.90909	0.82645	0.75131	0.68301
18.PV at 10%(16*17)	-4957500	1472727.27	1365289.26	1588279.49	884502.42
19. NPV at 10%(sum of Line 18)	353298.44