Question

1. Mr Michael Maguire lives in Wombat, in the central west of New South Wales. Michael owns a 3000 acre farm in Young, and the main crop he grows is cherries. He has decided he needs to acquire a better and more efficient spraying machine.
2. Some specialist spraying machines are available in Toronto, Canada at the firm Maple Partners Agricultural Supplies at the retail outlets of the pastoral company. Last month Michael flew to Toronto on Air Canada Flight AC31 for $2520 return. Michael stayed overnight in Toronto as a guest of Maple Partners Agricultural Supplies and so did not incur any accommodation expenses. In Toronto, Michael saw three different spraying machines, but he was unsure which one he should buy. They are all new and all manufactured in either Canada or United States.
3. One week ago Michael decided that the decision was a lot more complex than he could have imagined and decided to ask a consultant, Mrs Lynette Lowry, to advise on which of the three machines he should purchase. Lynette is an agricultural consultant, with an honours degree in Agricultural Economics although she did fail her second year accounting course. Michael has just received Mrs Lowry's report, which recommends the purchase of the Presetter 3000 Spraying Machine, which in Australian dollars will cost $400,000. Mrs Lowry charged $4,000 for his report, an expense which Michael can claim on tax. The Presetter 3000 machine is manufactured in Quebec, Canada.
4. Michael's next step is to determine if the purchase of the Presetter 3000 machine is financially viable, or whether he should stay with his existing machine, a Dutch machine.
5. If Michael buys the Presetter 3000 machine, he will fund it with $140,000 cash he has on hand plus a loan of $260,000 from Westpac. The loan will be at a fixed rate of 8% p.a. over 5 years, with interest only payable at the end of each year. The principal of $260,000 is repayable at the end of the fifth year.
6. Michael estimates that he would keep the Presetter 3000 machine for five years, after which time he should be able to sell it locally for $50,000. He therefore plans to depreciate it straight line to zero over five years, even though the Australian Tax Office has ruled that similar harvesters from Canada have an economic life of eight years.
7. The old machine was purchased five years ago and at that time was expected to have an economic life of nine years. It cost $180,000 and Michael has been depreciating it using straight-line depreciation over nine years. The Dutch machine is being depreciated to zero. If Michael buys the Presetter 3000 machine, he is confident of being able to sell his Dutch machine online on Gumtree. The sale on Gumtree would occur as soon as Michael receives the new Presetter 3000 machine (i.e. Period 0). Michael expects he will receive $70,000 if he sells the old machine. Michael believes the remaining economic life of the old machine is 4 years.
8. The Presetter 3000 machine is state-of-the-art, and much more efficient than the Dutch machine. The Dutch machine costs $160,000 per annum to operate, whereas the Presetter 3000 machine will only cost about $125,000 per annum to operate.
9. Due to the different manner in which the Presetter 3000 machine sprays, it will be necessary to purchase an additional $50,000 of inventory in year 0. Michael will be able to recover this cost when he disposes of the Presetter machine in five years' time.
10. One of the problems in Young is flying foxes, who love eating young cherries. For the last few years Michael has employed Mr Kelvin King, a professional flying fox trapper, to trap and remove flying foxes on a part-time basis. His annual salary is $14,000, which will stay the same if this new cherry spraying machine is purchased. Michael believes that this amount should be tax deductible.
11. Michael has thought very carefully about all the implications of buying the new machine. He is confident that if he does continue to use the Dutch machine (rather than buying the new Presetter 3000 one), then the Dutch machine will continue to work well, and in fact he could probably get about $20,000 when he disposes of it in the future. Michael is not sure how to handle this figure in his calculations
12. The appropriate required rate of return for these agricultural projects is 13% in nominal terms. The corporate tax rate is 15%. Assume tax is paid in the year of income. Inflation is projected to be 3.1% per annum for the foreseeable future. The cash flows given above are all in real terms.
13. The new machine will generate yearly revenue of $3m while the old machine was only able to generate annual revenue of $2m

The appropriate discount rate to use in deciding whether Michael should buy the new Presetter 3000 machine is?

The Cash Flow in period 0 is?

The Free Cash Flow in year 5 is?

Answer 1

Part1: Discount rate to be used

The Appropriate Discount rate that must be used is the weighted average cost of capital.

In our case, the total capital employed for the purchase of machinery is $400,000. Taking this as the base (some minor costs such as consultant cost etc. may be ignored presently), we can calculate the weighted cost of capital. This is funded out of own equitty capital of $140000 and a loan of $260,000 which bears 8%p.a.interest. The inflation rate is already built into rates for nominal returns as well as debt cost and is not taken separately.

The weighted average cost is calculated as:

= [Cost of Equity *(Equity capital/ Total Capital)] +[{Cost of Debt*(Debt Capital/Total Capital)}*(1-tax rate)]

=13%*(140000/400000)+ [{8%*(260000/400000)}*(1-15%)]

=4.55%+4.42%

=8.97%

Part 2: Cash flows at Period 0

Only the cash flows at the initial period are taken here. This includes all expenses made for purchase of machinery and the allied expenses. We cannnot include the revenue or operating costs as these will come in calculation of Period 1 cash flows and not at period 0.  Also, we can calculate both after-tax and before-tax cash flows. The taxation impact is there only on items which are of expense or revenue nature and not on investment/ realisation of investment.

The cash flows in period 0 are:

Part 3: Cash flows at Period 5

All the cash flows for the end period are taken here. All realisation values are to be taken for the machines. Also we must include the revenue and operating costs as these will come in calculation of Period 5 cash flows. Additionally, we need to ignore depreciation calculations at all times since they are non-cash items.