Question

Grand Touring Ltd paid $25,000 last quarter for a feasibility study regarding the demand for car customisation 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 $350,000 and will operate for five years and tax rules allow the machine to be depreciated to zero over a four-year life. The machine is expected to produce sales of $135,000 annually for the five years. GT Ltd has already agreed to sell the machine in five years’ time to an unrelated firm for $100,000. The project will result in a $35,000 increase in accounts receivable and require an increase in inventory levels by $25,000 to $95,000. Anchor has negotiated with its bank to borrow $250,000 to help pay for the project. Loan repayments are $57,700 each year for five years. If GT Ltd 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 $160,000 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.

(a) What are the relevant cash flows for each year of the new machine’s life? Assume the company tax rate is 30%.

(b) Assuming the nominal cost of capital for the project is 12% p.a, and inflation is currently 3% p.a, What is the NPV of the project?

(c) Should GT Ltd go ahead with the project? Why, why not? (1 mark)

Answer 1

a). Free cash flows:

Year 1: -499,100; Year 2 to Year 4: 120,750; Year 5: 269,500

b). NPV of the project = 20,581.47

c). Since NPV is positive, project can be accepted.

All calculations in the table below:

Note:

1). Amount spent on feasibility study is not part of NPV analysis as it is a sunk cost.

2). Since cash flows are nominal, nominal cost of capital is used to calculate the NPV.