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

		Polycorp Steel Division
		Imvestment details				Depreciation table at 46.14%
		Cost of Machinery	$     1,830,000			Year 1	Depreciation	Book Value at year end
		Installation cost	$           90,000			=(1920000*46.139%)	$        885,869	$ 1,034,131
		Total cost of Machinery	$     1,920,000			Year 2
		Salvage value	$        300,000			=1034112*46.139%	$        477,129	$     557,002
						Year 3
		Depreciation rate as per				=556973*46.139%	$        256,982	$     300,020
		Diminishing value method=1-(Salavage cost/Investment)^1/n
		here n= life of machine=3 Years
		Depreciation rate=1-(300000/1839000)^(1/3)
		=46.139%
		There is no capital gain in salvage value , so no tax applicable

Sales Details	Year1	Year2	Year3
Units (with 4% growth yr 1 & 2)	40,000	41,600	43,264
Sales Revenue @151/unit	$     6,040,000	$           6,281,600	$              6,532,864
Cash operating exp @75% of sales	$     4,530,000	$           4,711,200	$              4,899,648

	Qa	Net Cash flow Table
		Inintial Investments	Year0	Year1	Year2	Year3
		Machinery	$   (1,830,000)
		Installation cost	$         (90,000)
		Total cost of Machinery	$   (1,920,000)
		Investment Alloawance @20%	$        384,000
		Net Investment	$   (1,536,000)
		Investment in current Asset	$         (85,000)
	1	Total Investment	$   (1,621,000)
		Operating Income estimate
		Sales Revenue		$           6,040,000	$              6,281,600	$                  6,532,864
		Cash Operating Expense		$           4,530,000	$              4,711,200	$                  4,899,648
		Extra Marketing & Admin cost		$              128,000	$                 128,000	$                     128,000
		HO Admin cost allocation		$              180,000	$                 180,000	$                     180,000
		Depreciation expense		$              885,869	$                 477,129	$                     256,982
		PBT		$              316,131	$                 785,271	$                  1,068,234
		Tax @29%		$                91,678	$                 227,729	$                     309,788
		PAT		$              224,453	$                 557,542	$                     758,446
		Add back depreciation		$              885,869	$                 477,129	$                     256,982
		Add back HO admin cost allocation		$              180,000	$                 180,000	$                     180,000
	2	Cash flow from Operating Activities		$           1,290,322	$              1,214,671	$                  1,195,428
		Treaminal Cash flows
		Investment in current Asset				$                       85,000
		Machine Salvage value				$                     300,000
	3	Total Terminal Cash flow				$                     385,000
	4	Net Cash flow after Tax =1+2+3	$   (1,621,000)	$           1,290,322	$              1,214,671	$                  1,580,428
	5	Discount Rate @14.1% =1/1.141^n	1.000	0.876	0.768	0.673
		PV of Cash flows=4*5	$   (1,621,000)	$           1,130,322	$                 932,868	$                  1,063,628
Ans b		Sum of PV of Cash flows =NPV=	$     1,505,818

Ans d
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