Question

A company has invested over $300 million in recent years and plans further capital expenditure to increase financial returns. The two substantial cash outflows associated with the expansion are the cost of the building and equipment. The company owns a block of land adjacent to the existing factory on which they plan to construct the new building. In 2001 when the company constructed the original $7 million facilities they leased the land to a dairy farmer for $140,000 each year. At that time the company also purchased A equipment at a cost of $300,000. At the time this equipment was determined to have a twenty-year life for taxation purposes and an assumed zero salvage value for depreciation calculations. Before the expansion can proceed the company must terminate the lease agreement and sell the equipment. The equipment has a scrap value today of $80,000. This year’s financial statements show the equipment is being depreciated at $15,000 per year and the balance sheet indicates a carrying value of $45,000. Because the $300,000 cash flow relating to the equipment has already occurred the accountants suggests it be treated as a sunk cost in the analysis.

The capital cost of the building is budgeted to be $4.8 million today. The company proposes to use $2 million of the $3,573,000 cash on its balance sheet to pay for the building to reduce the casting cost to just $2.8 million. For taxation purposes, the new building has a twenty-year life. However, the company will perform the financial analysis of the expansion over a ten-year time period. This expansion will also require $2 million worth of B equipment today. The taxation office confirms that the B equipment has an eight-year tax life. In company’s experience, if B equipment is maintained properly it be operated effectively for ten years before requiring replacement. Company’s management accountants depreciate all assets over ten years to match the lifespan of the factory expansion.

Throughout 2017 the company incurred $260,000 of expenses on external architectural plans relating to an enlarged facility. To ensure this expense has not wasted the directors plans to include it in the analysis as a cash outflow in 2018. This approach will ensure the historical business expenses can be recovered and allow it to generate the required return.

There is an anticipated expense of $180,000 to install the equipment associated with the expansions, and a $50,000 cost to upgrade the electricity supply required to commence operations. According to the taxation office, both of these items are classified as a business expense. The manager of the facility would prefer to classify these expenses as assets and therefore depreciate them over the ten-year project life to give the appearance of higher profitability for the 2018 financial year. The manager is budgeting to achieve a net profit for 2018 of $1.22 million and increasing it by $150,000 for 2019.

You assume that the building can be sold for $1.9 million in the year 2028, and at any point in time, the equipment will have a resale value of $650,000. In ten years’ time the company assumes the it will have cash holding of $12 million. You note the tax office regulation that all non-current assets be depreciated to zero.

Substantial amounts of capital have been invested at the facility site in recent years, including $1.75 million on packaging machinery. The facility has existing repairs and maintenance expense is budgeted at $400,000 for each of the next five years, increasing to $500,000 for the following five years. If they dose expand operations then a $1,500,000 expense will be incurred in five years’ time for repairs and maintenance of the equipment and building.

The company has an annual sales of $2.5 million. The expansion will bring ongoing higher sales of $250,000 p.a. The company currently has $3.5 million of inventory and $570,000 of this amount is situated at the existing facility. Account receivables at the moment are $2.3 million. If the board of directors approves the new facility expansion you anticipate that accounts receivables will be $2.3 million and an additional $1.1 million of inventory will be necessary. Account payable will increase by $600,000 to $4.4 million.

The company’s required return is 9%. Assume the company tax rate will remain at 30%.

Question: Present an itemized breakdown (and the total) for the cash flows at the start, over life, and at the end.

Answer 1

		Cash flow at the start:
		Salvage value of equipment	$80,000
		Book value	$45,000
		Gain on sale	$35,000
		Tax	$10,500	(0.3*35000)
	A	After tax cash flow from salvage	$69,500	(80000-10500)
	B	Cash flow for building construction	($4,800,000)	(25 years life)
	C	Cash flow for equipment purchase	($2,000,000)	(8 years life)
	D	External architectural plans	($260,000)
	E	Installation of equipment	($180,000)	(business expense)
	F	Upgradation of electric supply	($50,000)	(business expense)
	G	Increase in accounts receivable	$0
	H	Increase in inventory	($1,100,000)
	I	Increase in accounts payable	$600,000
	J=A+B+C+D+E+F+G+H+I	Total Cash Flow at the start	($7,720,500)
		CASH FLOW OVER LIFE:
		YEAR	1	2	3	4	5	6	7	9	10
	A	Increase in Sales	$250,000	$250,000	$250,000	$250,000	$250,000	$250,000	$250,000	$250,000	$250,000
	B	Repairs and maintenance					($1,500,000)
	C=(4800000/25)	Depreciation of Building(4800000/25)	$        192,000	$ 192,000	$     192,000	$   192,000	$     192,000	$    192,000	$   192,000	$ 192,000	$    192,000
	D=C*0.3	Depreciation tax shieldof building	$          57,600	$    57,600	$        57,600	$     57,600	$        57,600	$       57,600	$      57,600	$    57,600	$      57,600
	E=(2000000/8)	Depreciation of Equipment	$        250,000	$ 250,000	$     250,000	$   250,000	$     250,000	$    250,000	$   250,000	$ 250,000	$    250,000
	F=E*0.3	Depreciation tax shieldof Equipment	$          75,000	$    75,000	$        75,000	$     75,000	$        75,000	$       75,000	$      75,000	$    75,000	$      75,000
	G=A+B+D+F	Net Cash flow over life	$382,600	$382,600	$382,600	$382,600	($1,117,400)	$382,600	$382,600	$382,600	$382,600
		CASH FLOW AT THE END
	A	Before tax Salvage of Building	$1,900,000
	B	Before tax Salvage of Equipment	$650,000
	C=A*(1-0.3)	After tax Salvage of Building	$1,330,000
	D=B*(1-0.3)	After tax Salvage of Equipment	$455,000
	E	Release of working capital	$500,000	(1100000-600000)
	F=C+D+E	Net Cash Flow at the end	$2,285,000