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

1. Construct a table showing net cash flow after tax (NCFAT). Use the method shown in lectures.
2. Calculate the NPV. Is the project acceptable? Why or why not?
3. Conduct a sensitivity analysis showing how sensitive the project is to operating expenses and to the cost of capital. Explain your results.
4. Write a short report explaining your calculation of relevant net cash flows after tax, justifying your selection of cash flows. Be sure to state clearly any assumptions made (implicit and explicit).

Answer 1

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.