Question

Polycorp Steel Division is considering a proposal to purchase a new machine to produce a new product for a three-year contract. The new machine will cost $1.83 million. The machine has an estimated life of 3 years for accounting and taxation purposes. Installation will cost a further $90,000. The contract will not continue beyond three years and the equipment has an estimated salvage value at the end of three years of $300,000. The tax rate is 29 percent and is payable in the year in which profit is earned. An investment allowance of twenty percent on the outlay plus installation costs is available. The after-tax cost of capital is 14.1%pa. Addition current assets of $85,000 are required immediately for working capital to support the project. Assume that this amount is recovered in full at the end of the life of the project. The new product will be charged $180,000 of allocated head office administration costs each year even though head office will not actually incur any extra costs or cash flows to manage the project. This is in accordance with the firm’s policy of allocating all corporate overhead to divisions. The Division will incur extra marketing and administration cash outflows of $128,000 per year for the project. An amount of $200,000 has been spent on a pilot study and market research for the new product. The projections provided are based on this work. Projected sales in the first year for the new product are 40,000 units at $151 per unit per year. Unit sales are expected to increase by 4%pa for years 2 and 3. Cash operating expenses are estimated to be 75 % of sales (excludes marketing and administration, and head office items). Except for initial outlays, assume cash flows occur at the end of each year (unless otherwise stated). Assume diminishing value depreciation for tax. Required (a) Construct a table showing net cash flow after tax (NCFAT). (b) Calculate the NPV.  

Answer 1

	Total Cash Outflow
	Initial Investment	1830000
	Installation Cost	90000
	Increase in Working Capital	85000
A)		Total	2005000

	Cash inflow
	Year	1	2	3
	Sale Units	40000	41600	43264
	Selling Price p.u.	151	151	151
	Total Sales	6040000	6281600	6532864
-	Cash operating exp. @75%	4530000	4711200	4899648
-	Marketing & Adm cost	128000	128000	128000
-	Investment Allowance @ 20% of (1830000+90000)	384000
-	Depreciation	576000	403200	282240
	PBT		422000	1039200	1222976
-	Tax @ 29%	122380	301368	354663
	PAT		299620	737832	868313
+	Investment Allowance	384000	0	0
+	Depreciation	576000	403200	282240
	Cash PAT		1259620	1141032	1150553
+	WC Recovered			85000
+	Sale of Investment			300000
	Total Cash Inflow	1259620	1141032	1535553
	PV Factor @ 14.1%	0.8764	0.7681	0.6732
	Pv of Cash inflow	1103931	876426.7	1033734
B)	Total of PV of Cash inflow (NCFAT)		3014092
	NPV (A-B)			1009092

Depreciation Chart

It assumed the rate is 30%.

Year	1	2	3
Opening Bal.	1920000	1344000	940800
Depreciation @ 30%	576000	403200	282240
Closing Bal.	1344000	940800	658560

Note: 1.Allocated head office cost of $ 180000 is irrelevant cost & will not be considered for decision making

2. Market Research & Pilot Study cost = $200000 is sunk cost as it is already incurred before the project. Therefore it will not be considered.