In: Finance
Anchor Ltd paid $15,000 last quarter for a feasibility study
regarding the demand for motorboat replacement parts which would
require the purchase of a new metal-shaping machine. Today, they
wish to conduct an analysis of the proposed project.
The machine costs $250,000 and will operate for five years and tax
rules allow the machine to be depreciated to zero over a five-year
life. The machine is expected to produce sales of $135,000 annually
for the five years. Anchor has already agreed to sell the machine
in five years’ time to an unrelated firm for $80,000.
The project will result in a $35,000 increase in accounts
receivable and require an increase in inventory levels by $20,000
to $95,000. Anchor has negotiated with its bank to borrow $180,000
to help pay for the project. Loan repayments are $48,000 each year
for five years.
If Anchor buys the machine they will be able to use some equipment
that they currently own. This is part of the driving force in the
decision making as it enables the company to save money in not
buying additional new equipment. This equipment was bought for
$120,000 six years ago and could be sold today for $63,000. This
equipment has been written off for tax purposes and would be
worthless in five years’ time.
If the company tax rate is 30% and the appropriate discount rate is
19.5%, should Anchor buy the new machine?
INITIAL INVESTMENT: | |
Cost of the machine | 250000 |
Increase in NWC = 35000+20000 = | 55000 |
After tax value of old equipments that can be used = 63000*(1-30%) = | 44100 |
Incremental initial investment | 349100 |
ANNUAL OPERATING CASH FLOWS: | |
Increase in sales | 135000 |
Depreciation (250000/5) | 50000 |
Incremental EBIT | 85000 |
Tax at 30% | 25500 |
Incremental NOPAT | 59500 |
Add: Depreciation | 50000 |
Incremental OCF | 109500 |
TERMINAL NON OPERATING CASH FLOWS: | |
Recovery of NWC | 55000 |
After tax salvage value = 80000*70% = | 56000 |
Terminal non operating cash flows | 111000 |
NPV: | |
PV of annual OCF = 109500*(1.195^5-1)/(0.195*1.195^5) = | 331108 |
PV of terminal cash inflow = 111000/1.195^5 = | 45549 |
PV of cash inflows | 376657 |
Less: Initial investment | 349100 |
NPV | 27557 |
AS THE NPV OF THE BUYING OF THE MACHINE IS POSITIVE, | |
THE MACHINE CAN BE BOUGHT. |