Question

INSTRUCTIONS:

1. Read the information below, including Parts a and b of Question 2.
2. Create a new Excel spreadsheet. Record your answers to all parts of the question into the spreadsheet. Use bold text to clearly label your responses to Part a and Part b. Save your work regularly.

Perfect Binding Ltd provides specialist binding services to the printing industry. The company’s production manager is investigating whether to replace an old burst binding machine and has provided you with the following information:

• The old binder was bought five-years ago for $90,000 and has been depreciated by $6,000 a year on a straight line (prime cost) basis for tax purposes. Analysis of the second-hand market for binders indicates that the old binder has a salvage value of $30,000 if it was sold today and $0 salvage value if it was sold at the end of its normal useful life.
  
• The new binder costs $100,000, has a useful life of ten years and is depreciated on a straight line basis over its useful life. The main advantage of the new binder is that it will generate additional cash revenues of $35,000 per year, although it also generates additional cash expenses of $12,000 per year. Finally, the new binder will have a salvage value of $10,000 at the end of its ten year life.
  
• Perfect Binding pays 30% tax in the year income is earned and uses a 10% p.a. discount rate for project evaluation. Finally, there will be no replacement of the burst binding machine in ten years’ time.

(a) In calculating the net present value (NPV) of this investment, why does the firm include depreciation when depreciation is not a cash flow?

(1 mark)

(b) Using the above information, prepare a detailed discounted cash flow analysis relevant to the manager’s decision. With your analysis, you must include advice on whether the company should replace the binder.

Answer 1

Year		1	2	3	4	5	6	7	8	9	10
Old Binder
Written down value		60,000
Present Market value	30,000
New Binder Investment	100,000
Additional cash revenue		35,000	35,000	35,000	35,000	35,000	35,000	35,000	35,000	35,000	35,000
Additional cash expenses		12,000	12,000	12,000	12,000	12,000	12,000	12,000	12,000	12,000	12,000
Depreciation		10,000	10,000	10,000	10,000	10,000	10,000	10,000	10,000	10,000	10,000
Sub-total		22,000	22,000	22,000	22,000	22,000	22,000	22,000	22,000	22,000	22,000
Earnings before tax		13,000	13,000	13,000	13,000	13,000	13,000	13,000	13,000	13,000	13,000
Tax		3,900	3,900	3,900	3,900	3,900	3,900	3,900	3,900	3,900	3,900
Net profit		9,100	9,100	9,100	9,100	9,100	9,100	9,100	9,100	9,100	9,100
Cash profit		19,100	19,100	19,100	19,100	19,100	19,100	19,100	19,100	19,100	19,100
Cash accrual		19,100	38,200	57,300	76,400	95,500	114,600	133,700	152,800	171,900	191,000
Salvage												10,000
Total cash accrual												201,000
a. Depreciation is considered to know the actual profit after depreciation.
b. The repayment period is under 6 years and the company can invest in the new Binder.