In: Finance
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
Solution:
a) Calculation of NCFAT
Particulars | Y0 | Y1 | Y2 | Y3 |
Sales (units) | 40000 | 41600 | 43264 | |
Price | 151 | 151 | 151 | |
1) Sales revenue | 6040000 | 6281600 | 6532864 | |
cash operating exp.(.75* revenue) | 4530000 | 4711200 | 4899648 | |
H.O allocation expenses(Assumption 1) | 180000 | 180000 | 180000 | |
Marketing exp. | 128000 | 128000 | 128000 | |
Investment allowance(Assumption 2) | 384000 | 0 | 0 | |
Depreciation (W/N 1) | 640000 | 426666.66 | 284444.44 | |
2) EBIT | 178000 | 835733.34 | 1040771.56 | |
3) EBIT(1-t) | 126380 | 593370.67 | 738947.80 | |
Add : | ||||
Depreciation | 640000 | 426666.66 | 284444.44 | |
H.O allocation expenses | 180000 | 180000 | 180000 | |
Investment allowance | 384000 | |||
Net cash at end of the project | 378002.52 | |||
4) cash flow after tax | 1330380 | 1200037.33 | 1581394.76 | |
Machine cost | -1830000 | |||
Installation cost | -90000 | |||
Working capital | -85000 | 85000 | ||
R&D exp. | -200000 | |||
5) Total Net cash flow after tax (NCFAT) | -2205000 | 1330380 | 1200037.33 | 1666394.76 |
Assumptions
1) It was assumed that H.O allocated exp. is allowed for calculating tax.
2) It was assumed that investment allowance is allowed in 1st year of production & sales.
W/N 1) In calculating depreciation installation cost is also capitalized.
As depreciation is assumed to be a diminishing value method & the useful life of is 3Years the rate of depreciation will be 33.33%.
WDV at end of 3rd year = 1920000 * (0.6667)3 = 568974.22
WDV | 568974.22 |
salvage value | 300000 |
loss | 268974.22 |
tax [email protected] | 78002.52 |
Net cash flow in 3rd year | 378002.52 |
b) NPV = Present value NCFAT discounted at after tax cost of capita - Initital cash outflow
= [1330380/(1.141) + 1200037.93/(1.141)2 + 1666394.76/(1.141)3]- 2205000
= 3209563.84 - 2205000
= $ 10,04,563.84
c) If operating expenses increases by 1% of sales i.e 76%, then NPV decreases by 9.36%
cash flow after tax will be
Y1 = 1287496, Y2=1155437.97, Y3= 1620011.43
then NPV = 3106496 - 2205000 = $ 910496
% change in NPV = 1004563.84-910496 / 1004563.84 *100 = 9.36%
If cost of capital changes increases by 1% then cost of capital is 15.1% So,
NPV = $ 949500
% decrease in NPV = 1004563.84 -949500.4 / 1004563.84 *100 = 5.48%
if cost of capital Increases by 1% then NPV decreases by 5.48%
d) I have calculated cash flows according to the details given in question and by taking relevant assumptions which are stated above.
cash flow after taxes are calculated after taking into account all tax deductible expenses.