Question

After an extensive feasibility study on savings strategies that cost $25,000, Bright Ltd is considering the purchase of new equipment costing $500,000, which it will fully finance with a fixed interest loan of 10% per annum, with the principal repaid at the end of 4 years.

The new equipment will reduce the company’s manufacturing costs by $190,000 a year for 4 years. Bright will depreciate the equipment by the straight-line method to zero salvage value over the 4 years. The company thinks that it can sell the equipment at the end of 4 years for $20,000.

Bright will install the equipment in a building which is currently being rented out for $30,000 a year under a lease agreement with 4 yearly rental payments to run, the next one being due at the end of one year. Under the lease agreement, Bright Ltd can cancel the lease by paying the tenant today compensation equal to one year’s rental payment plus 10%, but this amount is not deductible for income tax purposes.

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The company further estimates that it will have to spend $15,000 in 2 years’ time overhauling the equipment. It will also require additions to current assets of $35,000 at the beginning of the project, which will be fully recoverable at the end of the fourth year.

Bright Ltd’s cost of capital is 12%. The tax rate is 30%. Tax is paid in the year in which earnings are received.

1. Calculate the incremental cash flows.                                                    
2. Calculate the payback period of the proposed purchase.                       
3. Calculate the net present value, that is, the net benefit or net loss in present value terms of the proposed purchase.                                                    
4. Calculate the present value index of the proposed purchase.                   
5. Should the company purchase the equipment? Explain why or why not.

Answer 1

	Year	0	1	2	3	4
	Equipment is purchased via loan
1	Cost of cancelling lease (30000+10%)	-$33,000.00
2	Current assets	-$35,000.00
3	Saving in cost		$190,000.00	$190,000.00	$190,000.00	$190,000.00
4	Depreciation (500000/4)		$125,000.00	$125,000.00	$125,000.00	$125,000.00
5	Interest on loan		$50,000.00	$50,000.00	$50,000.00	$50,000.00
6	Repairs			$15,000.00
7	Net profit before tax(3-4-5-6)		$15,000.00	$0.00	$15,000.00	$15,000.00
8	Tax@ 30%(7*30%)		$4,500.00	$0.00	$4,500.00	$4,500.00
9	Profit after tax (7-8)		$10,500.00	$0.00	$10,500.00	$10,500.00
10	After tax salavge vlaue (20000*(1-0.3)					$14,000.00
11	Repayment of loan					-$500,000.00
12	CA realised					$35,000.00
a)	Cash flow (9+4+10+11+12)	-$68,000.00	$135,500.00	$125,000.00	$135,500.00	-$315,500.00
	Cummulative cash inflow		$135,500.00	$260,500.00	$396,000.00
	PVF @ 12 %	1	0.8929	0.7972	0.7118	0.6355
	PV of cashflow (Cash flow*PVF)	-$68,000.00	$120,982.14	$99,649.23	$96,446.22	-$200,505.95
b)	Payback period is when we recover the cash outflow
	Cash outflow	=	68000+200505
		=	$268,505.95
	We seethat cummulative cashflow in year 4 is morethan cash outflow,so
	payback period = 3 years+{(268505-260500)/135500}
	payback period = 3 years+0.059 yrs
	payback period = 3.059years
c)	NPV	=	sum of all cashflows
		=	$48,571.65
d)	PV index	=	PV of cashflow/Initial cost
	PV of cash flow	=	CF (Yr1 to yr 4)
		=	$116,571.65
	PV index	=	116571.65/68000
		=	1.71
e)	Yea the company should purchase as the NPV is positive