Question

Savory Technology Limited produces a range of hi-tech kitchen utensils for industrial use. As a new product has been developed and patented, Savory plans to build a new production plant in Greater Bay Area, China. To stream-line the management control, Savory will close down all the existing production facilities at the M & H Island if the new production plant project in Greater Bay Area is confirmed to proceed. The management of Savory decides to use a seven-year planning horizon for all of its capital budgeting decisions.

The following cash flows are noted for the project

(i) Savory will purchase a piece of land at a cost of $40 million to build the new production plant. It is anticipated that the land will be worth $60 million in 7 years.

(ii) The production plant wil be constructed at a cost of $35 million. The production plant will be depreciated at its full cost on a straight-line basis over its estimated useful life of 7 years. The production plant could be sold for a salvage value of 5 million at the end of Year 7

(iii) Machinery will have to be purchased for the new production plant at a cost of $10,500,000. For tax purpose, machinery will be fully depreciated at its full cost on a straight-line basis over its estimated useful life of 7 years. Salvage value of the machinery at the end of Year 7 will be $1,100,000

(iv) Equipment will also have to be purchased at a cost of $7,000,000. Equipment will also be depreciated at its full costs on a straight-line basis over its estimated usefu fe of 7 years. The salvage value is estimated as equal to zero.

(v) An initial investment of $3 million in working capital is required today. The working capita will be fully recovered at the end of the project.

The management of Savory believes that the new production plant will generate pre-tax cash operating income of $18 million per annum at the end of each of the 7 years of operation. In comparison, the current pre-tax cash operating income produced by the existing production facilities at the M & H Island is $6 million annually Savory's corporation tax rate is 40% and ts cost of capital is 10%. Further, it is assumed that there is no capital gain tax imposed on the sale of land. Round vour answer to nearest dollar

(a) Calculate the cost of investment.

(b) Calculate the present value of after-tax cash operating income.

(c) Calculate the present value of tax savings from depreciation for the production plant, machinery and equipment.

(d) Calculate the present value of after-tax salvage value for the production plant, machinery and the piece of land.

(e) Based on the net present method, should the project be undertaken?

Answer 1

a Calculation of cost of investment and sale of terminal value
S.No.	Particulars	Cost of Investment $ Million	Sale or terminal Value
1	Piece of land	40	60
2	Production plant	35	5
3	Machinery	10.5	1.1
4	Equipment	7	0
5	Workin capital Investment	3	3
	Total	95.5	69.1
b Present value of after tax cash operating income
Calculation of Depreciation
S.No.	Particulars	Cost of Investment $ Million	Sale or terminal Value	Depreciable Value	Per annum Depreciation
A	B	C	D	E	F=E/7
1	Production plant	35	5	35	5.00
2	Machinery	10.5	1.1	10.5	1.50
3	Equipment	7	0	7	1.00
	Total	52.50	6.10	52.50	7.50
Year	Pre Tax Operating income		Total	Tax	After tax operating income	Depreciation	Cash operating income	PVF @10%	Present value of Cash operating income
	Current	New
A	B	C	D=B+C	E	F=D-E	G	H=F+G	I	J=H X I
0	6.00		6.00	2.40	3.60		3.60	1.0000	3.60
1	6.00	18.00	24.00	9.60	14.40	7.50	21.90	0.9091	19.91
2	6.00	18.00	24.00	9.60	14.40	7.50	21.90	0.8264	18.10
3	6.00	18.00	24.00	9.60	14.40	7.50	21.90	0.7513	16.45
4	6.00	18.00	24.00	9.60	14.40	7.50	21.90	0.6830	14.96
5	6.00	18.00	24.00	9.60	14.40	7.50	21.90	0.6209	13.60
6	6.00	18.00	24.00	9.60	14.40	7.50	21.90	0.5645	12.36
7	6.00	18.00	24.00	9.60	14.40	7.50	21.90	0.5132	11.24
Total	48.00	126.00	174.00	69.60	104.40	52.50	156.90		110.22
c Present value of Tax saving on depreciation
Year	Depreciation	Tax @ 40%	Tax Saving on depreciation	PVF @10%	Present Value
A	B	C	D	E	F=D X E
0.00	0.00	0.40	0.0000	1.0000	0.0000
1.00	7.50	0.40	3.0000	0.9091	2.7273
2.00	7.50	0.40	3.0000	0.8264	2.4793
3.00	7.50	0.40	3.0000	0.7513	2.2539
4.00	7.50	0.40	3.0000	0.6830	2.0490
5.00	7.50	0.40	3.0000	0.6209	1.8628
6.00	7.50	0.40	3.0000	0.5645	1.6934
7.00	7.50	0.40	3.0000	0.5132	1.5395
Total			21.0000	5.8684	14.6053
d Present value of after tax salvage value doe production plant, machinery and piece of land
S.no.	Particulars	Salvage Value	Tax Rate- 40%/nil	Tax Amount	After tax Value	Present value of 7 th year	Present Value
A	B	C	D	E=C x D	F=C-E	G	H=F X G
1	Production plant	5	0.4	2	3.00	0.5132	1.54
2	Machinery	1.1	0.4	0.44	0.66	0.5132	0.34
3	Piece of land	60	0	0	60.00	0.5132	30.79
	Total	66.10		2.44	63.66		32.67
e Calculation of NPV
S.No.	Year	Cash outflow	Operating Cash inflow	Tax	Depreciation	Net cash flow	PVF	Present value
A	B	C	D	E=D*.40 OR CALCULATED ABOVE	F	G=C+D-E+F	H	I=G X H
1	0	-95.5				-95.5	1.0000	-95.5
2	1		18.00	7.2	7.50	18.3	0.9091	16.63636
3	2		18.00	7.2	7.50	18.3	0.8264	15.12397
4	3		18.00	7.2	7.50	18.3	0.7513	13.74906
5	4		18.00	7.2	7.50	18.3	0.6830	12.49915
6	5		18.00	7.2	7.50	18.3	0.6209	11.36286
7	6		18.00	7.2	7.50	18.3	0.5645	10.32987
8	7		18.00	7.2	7.50	18.3	0.5132	9.390794
9	8		69.10	2.44		66.66	0.5132	34.20712
	NPV					66.66		27.79918