Question

XTC Corp. is considering the replacement of equipment used to produce zips. Last year, XTC produced and sold 100,000 zips at a unit price of $32. Operating expenses (excluding depreciation) with the old equipment are 30% of sales. XTC expects demand for zips to increase 10% per year over the next five years, but XTC currently has the capacity to produce only 112,800 zips per year with the existing equipment. The new equipment would increase capacity to 155,500 zips per year and would also reduce operating expenses to 28% of sales for all zips produced over the next five years. The sales price for zips is expected to increase at the expected inflation rate of 3% per year over the five-year life of the project.

The existing equipment was purchased five years at a price of $1 million. It is being depreciated using 5-year MACRS. It could be sold now for $20,000. The new equipment is expected to cost $2 million, including installation. It is being depreciated using 5-year MACRS and is expected to have zero salvage value five years from now. The $2 million cost of the new equipment will be financed with equal amounts of debt and equity. The debt will carry an annual interest rate of 6%; thus, the project will cause an increase in annual interest of $60,000 for XTC, computed as 0.06 x $1 million.

No increases in net operating working capital, NOWC, are expected for the project. However, the corporate accounting department has informed the division that produces zips that it will allocate an additional $12,650 of existing fixed overhead each year to the division if this project is accepted.

Assume the cost of capital for the project is 8%. Also assume that XTC has a 30% marginal tax rate. Compute the incremental cash flows after tax (CFAT) over the five-year life of the project. Compute the NPV and IRR and recommend whether the project should be accepted or rejected.

Note:

• Round all cash flows (except the price of zips) to the nearest dollar.

• All net cash inflows should be shown as positive numbers, and all net cash outflows should be shown as negative numbers in parentheses.

• Organize your work neatly.

• The more work you show, the greater the chance to earn partial credit.

Answer 1

	Calculation of tax saving on machine	=	(WDV-salvage value)*taxrate
		=	[(0.0576*1,000,000-$20000]*0.3
		=	$11,280
	Initial cost of machine	=	$2,000,000
	Net cash outflow	=	2,000,000-11280=	$1,988,720
			Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
	MACRS		0.2	0.32	0.192	0.1152	0.1152	0.0576
	Calculationof incremental cashflow
	Year	0	1	2	3	4	5
a)	Units sales (old machine)		110000	112800	112800	112800	112800
b)	Units sales (new machine)		110000	121000	133100	146410	155500
c)	Unit sales (incremental) (a-b)		0	8200	20300	33610	42700
D)	Price (3% increase every year)	32	32.96	33.95	34.97	36.02	37.10
e)	revenue (incremental) (c*d)		0	278380.16	709835.4592	1210507.235	1584032.095
f)	variable cost (incremental) (e*28%)		0	77946.44	198753.93	338942.03	443528.99
g)	saving in variable cost (total) (a*d*(30%-28%)		72512	76588.49	78886.15	81252.73	83690.31
h)	gross profit (e-f+g)		72512	277022.208	589967.6782	952817.9414	1224193.422
i)	Interest cost (incremental)		60,000	60,000	60,000	60,000	60,000
j)	depreciation (Cost of machine *applicable rate)		$400,000	$640,000	$384,000	$230,400	$230,400
k)	EBT (h-i-j)		($387,488)	($422,978)	$145,968	$662,418	$933,793
l)	taxes(k*30%)		($116,246.4)	($126,893.3)	$43,790.3	$198,725.4	$280,138.0
m)	Net income(k-l)		($271,241.6)	($296,084.5)	$102,177.4	$463,692.6	$653,655.4
n)	Incremental cashflow (m+j)		$128,758.4	$343,915.5	$486,177.4	$694,092.6	$884,055.4
o)	Net salvage value (cost * rate for 6th year)						$115,200
p)	Cost of machine (net)	($1,988,720)
q)	PVF @8%	1	0.925925926	0.85733882	0.793832241	0.735029853	0.680583197
r)	PV of cashflow (PVF * incre cash flow)	($1,988,720)	$119,220.74	$294,852.15	$385,943.27	$510,178.75	$601,673.25
	NPV	=sum of all cashflow in present value terms
		($76,852)
	IRR	=	-1%	(it can not be calculated manually.It has tobe guessed or calculted via excel)
	Since NPV & IRR are negative,we should not accept the project
	Notes
1)	The above solution is completely on incremental basis
2)	Head office exp allocated are not considered because they are just allocation not actualexpenditure
3)	In the 5th year although sale would increase to 161051 units but we have capacity of only 155500 units in new machine
4)	If we keepold machine beyond 1 year,it will produce 112800 units only though demand is more