Question

ABC limited is considering implementing a project X (New manufacturing machine). The following data has been provided in respect of the project

1. The cost of the project is Sh. 2 Million

2. The WACC of the company is 12%

3. The useful life of the project is 5 years

4. Depreciation method is straight line

5. Salvage value is expected to be Sh. 200,000

6. Incremental quantity produced and sold is 100,000 units

7. Variable cost per unit is Sh. 60

8. Tax rate is 30%

9. Contribution margin is Sh. 40

10. Fixed costs have been estimated at Sh. 500,000

Required: (i) Estimate the net cash flow from the project for years 1, 2, 3, 4 and 5

(ii) Estimate the Net Present Value of the project

(iii) Advise the company based on the Net Present Value (NPV)

Answer 1

Variable cost per unit is 60 & contribution is 40.

Hence Selling Price = 64+40= 100.

We know that depreciation is a tax-deductable expense.

Calculation of savings on Tax p.a due to depreciation:

(2,000,000-200,000) / 5years * 30% tax = 108,000

1) Calculation of Cash flow for year 1 to 5.

Particulars 1 2 3 4 5

Purchase machine (2,000,000)

Sales Made    2,000,000 2,000,000 2,000,000 2,000,000 2,000,000

(100,000/5*100)

Variable Cost p.a (1,200,000)    (1,200,000)   (1,200,000)    (1,200,000)   (1,200,000)

(100,000/5*60)

Fixed Cost    (500,000) (500,000) (500,000) (500,000) (500,000)

Savings on tax     108,000    108,000 108,000     108,000    108,000

Sale of Machine salvage - - - - 200,000

Net Cash Inflow   (1,592,000) 408,000 408,000 408,000 608,000

(Net Cashflow for all 5 years combined = Sh 240,000)

2) Calculation of NPV of the Project

Year Net Cashflow Discounting Factor @12% Present Value

1 (1,592,000) 0.893 (1,421,428)

2 408,000 0.797 325,255

3 408,000 0.712 290,406

4 408,000 0.635 259,291

5 608,000 0.567 344,995

NPV=   (201,481)

3) Advice to company on basis of NPV

As we can see from above calculations, even though we get a psoitive net cashflow of Sh. 240,000 over the period of 5 years... the Net Present Value (NPV) of the cashflows comes to Negative Sh. 201,481.

Hence the company is adviced to not continue with this project since NPV is negative.