Question

Tech Motor is a leading manufacturer of alloy wheels for car enthusiasts. Lee is the financial manager of the firm and is responsible for analysing the company’s financial issues. The production department has proposed the purchase of a new CNC One-stop Manufacturing System (COMS) to improve the production capacity and quality of its alloy wheels. The new manufacturing system is expected increase the firm’s net revenue (before taxes and depreciation expenses) by $240,000 in each of the next four years. Lee has also obtained the following information from the production manager:

	Proposed situation	Existing situation
Initial purchase price	$1,500,000	$1,000,000
Shipping and installation cost	$300,000	$200,000
Required net working capital	$430,000	$350,000
Annual cost of maintenance	$260,000	$320,000
Current market value (CMV)	Not applicable	$800,000
Expected salvage value	$0	$0
Existing usage	0 years	2 years
Expected economic life	4 years	6 years

Tech Motor uses the straight-line depreciation method on all its production machinery with the marginal tax rate of 18%.

Required:

a. Determine the initial outlay associated with this proposed purchase.

b. What are the annual after-tax cash flows associated with this project for Years 1 to 3? Also, determine the after-tax cash flow at the terminal year (Year 4)?

c. Discuss how the tax rules on depreciation affect the firm’s asset purchase investment decision.

Answer 1

a. Initial Outlay refers to the initial costs borne by the company to bring the eqipments to their working condition and and make the project operational.

Initial Outlay = Initial purchase price + Shipping and installation cost + Required net working capital - Resale Value of Old System

= $1,500,000 + $300,000 + $430,000 - $800,000

= $ 1,430,000

b.

Year	Additioanl Revenue	Reduction in Annual cost of maintenance (3.2 - 2.6) mn	Increase in Depreciation WN1	Net Profit Before Tax	Net Profit After Tax	After Tax Cash Flow (Add Depreciation)
1	2,40,000.00	60,000.00	2,08,333.33	91,666.67	75,166.67	2,83,500.00
2	2,40,000.00	60,000.00	2,08,333.33	91,666.67	75,166.67	2,83,500.00
3	2,40,000.00	60,000.00	2,08,333.33	91,666.67	75,166.67	2,83,500.00
4	2,40,000.00	60,000.00	2,08,333.33	91,666.67	75,166.67	2,83,500.00

WN1 Depreciation Schedule

Year	Old System	New System	Increase in Depreciation
1	1,66,666.67	3,75,000	2,08,333.33
2	1,66,666.67	3,75,000	2,08,333.33
3	1,66,666.67	3,75,000	2,08,333.33
4	1,66,666.67	3,75,000	2,08,333.33

c. Non- cash and non-operating expenses such as depreciation enjoy tax shield. This means that the depreciation is deducted from the revenue before charging tax and is added back to the profit after tax. This leads to tax saving on the value of the depreciation. In the calculation of NPV, taxation on depreciation plays an important part in making it profitable or loss making. As majority of the outflow is due to the initial overlay, such as equipment and systems, depreciation is charged on them and thus is expensed out on an annual basis throughout the life of the project. This helps in reducing the tax burden drastically and thus making the project more viable.