Question

1. Aruma Ltd. evaluating an investment project which requires the importation of a new machine at a cost of Shs. 2,700,000. The machine has a useful life of six years.

Additional information:

1. The following additional costs would be incurred in relation to the 1. machine:

	Shs.
Freight	225,000
Installation and Pre-production	375,000
Import Duty	900.000

2. The machine is expected to increase the company’s annual cash flows (before tax) as shown below:

Year	1	2	3	4	4	6
Increase in Cash flow (Shs.)	1,760,000	1,360,000	1,050,000	900,000	840,000	750,000

3. The machine is to be fully depreciated over its useful life using the 3. straight line method.
4. The corporate rate of tax is 30% while the cost of capital is 12%

5. The maximum acceptable payback period to the company for all capital projects is four years.

Answer 1

So, here we are going to calculate the worth of the machine and we will take an investment decision based on the final result. Here in the question itself, it is stated that the acceptable payback period to the company for all capital project is four years, therefore, we will also analyze the payback period of the machinery.

The investment decision is made on the NPV of the machinery the formula for calculating the NPV of the machinery is;

= cashflows / ( 1 + r) t

r = required rate of return. here it is the cost of capital @ 12%

t = useful life of the machinery = 6 years.

As per the information provided the initial cost to make machinery operating will be

initial cost + additional expenses incurred before production.

Total cost of the machinery before production = 2,700,000 + 225000 + 375000 + 900000

= Shs 4,200,000.

Depreciation for the machinery is done on straight line basis.

therefore 4,200,000 / 6 = 700,000

the cashflow for calculating the NPV of the machinery will be Cash inflow before depreciation and after-tax.

the question provides us various annual cash flow that will be generated by the machinery. But that amount is before tax. Since we need to decrease depreciation and tax at first and add back depreciated amount back to the cashflow. The reason why we do this is that depreciation of and assets is tax-deductible. And also depreciation is not actually a cash outflow but, just a provision. The calculations and final cash inflow for the calculation of NPV is as shown below:-

depreciation is under straight line method and we already calculated the same above.

this image shows how we arrived at CFBDAF. i.e., Cashflow before depreciation after tax.

to attain this;

1. first of we subtracted depreciation from annual cash flows provided.
2. then we calculated tax on the amount after depreciation (fourth column)
3. then we subtracted tax from the cashflow after depreciation
4. finally we added back depreciation to the after-tax cash flow

Next, we are going to calculate the NPV of the machine using CFBDAT and discounting factor. The image shown below explains that in detail:-

Discounted Cash Flow (DCF) is calculated here with the equation CF / ( 1 + r ) t

the total discounted cash inflow is 4,245,487.

The difference between cash outflow and cash inflow is the method of identifying a feasible investment project. Because NPV = Cash inflow - Cash outflow.

if the outflow is more than inflow we will reject the project and if the inflow is more we will accept it.

here outflow is = 4,200,000

and inflow is = 4,245,487

the difference of both will we 4245487 - 4200000 = 45,487 which is positive. Hence the project can be accepted.

But, it is mentioned in the question of every capital investment the maximum acceptable payback period is 4 years. Therefore we need to calculated whether the cash inflow can repay the outflow within 4 years

For this will need cumulative cash inflows.

in payback period method annual cash inflow means cash flow before depreciation and after-tax. Therefore. we can use CFBDAT. The calculation is as below;

so here we added up all the annual cash inflows.

we can clearly notice that the CCF for the 4th year is 4,389,000 which is higher than 4,200,000. By which we can conclude that the capital decision is worth investing.