Question

1. Baraka Ltd. is considering investing in a new processing machine costing a. Sh25 million. The machine would be used for five years and thereafter be disposed off for Sh. 5 million at the end of the fifth year.

The following additional information is available:

1. Additional raw materials amounting to Sh5 million would be required 1. at the beginning of the five-year period. This would increase accounts payable by Sh2 million. These changes in working capital would reverse at the end of the fifth year.
2. The new machine would increase the company’s annual gross profit from Sh12 million to Sh24 million.
3. Incremental fixed costs would amount to Shs. 2,200,000 per annum.
4. Additional machine operators would be employed at a cost of Shs. 1,600,000 per annum.
5. The new machine would be depreciated on a straight-line basis.
6. The cost of capital is 12%.
7. The corporation rate of tax is 30%. Required:

Using the net present value (NPV) method, advice the company on whether to invest in the new machine

Answer 1

Tax rate		30%
Calculation of annual depreciation
Depreciation		Year-1	Year-2	Year-3	Year-4	Year-5	Total
Cost		$      25,000,000	$     25,000,000	$      25,000,000	$      25,000,000	$     25,000,000
Dep Rate		20.00%	20.00%	20.00%	20.00%	20.00%
Depreciation	Cost * Dep rate	$        5,000,000	$       5,000,000	$        5,000,000	$        5,000,000	$       5,000,000	$      25,000,000
Calculation of after-tax salvage value
Cost of machine			$     25,000,000
Depreciation			$     25,000,000
WDV	Cost less accumulated depreciation	$                     -
Sale price			$       5,000,000
Profit/(Loss)	Sale price less WDV		$       5,000,000
Tax	Profit/(Loss)*tax rate	$       1,500,000
Sale price after-tax	Sale price less tax		$       3,500,000
Calculation of annual operating cash flow
		Year-1	Year-2	Year-3	Year-4	Year-5
Incrmental revenue		$     12,000,000	$    12,000,000	$     12,000,000	$     12,000,000	$     12,000,000
Less: fixed cost		$        2,200,000	$       2,200,000	$        2,200,000	$        2,200,000	$       2,200,000
Less: Machine operator		$        1,600,000	$       1,600,000	$        1,600,000	$        1,600,000	$       1,600,000
Less: Depreciation		$        5,000,000	$       5,000,000	$        5,000,000	$        5,000,000	$       5,000,000
Profit before tax (PBT)		$       3,200,000	$       3,200,000	$       3,200,000	$       3,200,000	$       3,200,000
Tax@30%	PBT*Tax rate	$           960,000	$          960,000	$           960,000	$           960,000	$           960,000
Profit After Tax (PAT)	PBT - Tax	$       2,240,000	$       2,240,000	$       2,240,000	$       2,240,000	$       2,240,000
Add Depreciation	PAT + Dep	$        5,000,000	$       5,000,000	$        5,000,000	$        5,000,000	$       5,000,000
Cash Profit after-tax		$       7,240,000	$       7,240,000	$       7,240,000	$       7,240,000	$       7,240,000
Calculation of working capital movement
Increase in inventory		$        5,000,000
Increase in accounts payable		$        2,000,000
Net increase in working capital		$        3,000,000
Calculation of NPV
						12.00%
Year		Capital	Working capital	Operating cash	Annual Cash flow	PV factor, 1/(1+r)^time	Present values
0		$    (25,000,000)	$      (3,000,000)		$    (28,000,000)	1.0000	$    (28,000,000)
1			$                     -	$        7,240,000	$        7,240,000	0.8929	$        6,464,286
2			$                     -	$        7,240,000	$        7,240,000	0.7972	$        5,771,684
3			$                     -	$        7,240,000	$        7,240,000	0.7118	$        5,153,289
4			$                     -	$        7,240,000	$        7,240,000	0.6355	$        4,601,151
5		$        3,500,000	$       3,000,000	$        7,240,000	$      13,740,000	0.5674	$        7,796,445
					Net Present Value	$       1,786,854