Question

Perfect Binding Ltd provides specialist binding services to the printing industry. The company’s production manager is investigating whether to replace an old burst binding machine and has provided you with the following information:

• The old binder was bought five-years ago for $90,000 and has been depreciated by $6,000 a year on a straight line (prime cost) basis for tax purposes. Analysis of the second-hand market for binders indicates that the old binder has a salvage value of $30,000 if it was sold today and $0 salvage value if it was sold at the end of its normal useful life.
  
• The new binder costs $100,000, has a useful life of ten years and is depreciated on a straight line basis over its useful life. The main advantage of the new binder is that it will generate additional cash revenues of $35,000 per year, although it also generates additional cash expenses of $12,000 per year. Finally, the new binder will have a salvage value of $10,000 at the end of its ten year life.
  
• Perfect Binding pays 30% tax in the year income is earned and uses a 10% p.a. discount rate for project evaluation. Finally, there will be no replacement of the burst binding machine in ten years’ time.

(a) In calculating the net present value (NPV) of this investment, why does the firm include depreciation when depreciation is not a cash flow?

(1 mark)

(b) Using the above information, prepare a detailed discounted cash flow analysis relevant to the manager’s decision. With your analysis, you must include advice on whether the company should replace the binder.

Answer 1

(a)

In calculating the Net Present Value (NPV) of this investment, we have to take into consideration the depreciation even though it is not a cash expense. Because of depreciation amount there will be change in tax savings amounts there by affecting cash flows. Thus we consider in calculation of NPV

(b)

Calculating NPV of decision purchasing new binder :

All amounts are in $

Particulars	Calculation	Amount
Inflows -
Sale Proceeds of old machinery		30,000
Excess Revenue	35,000 x 6.1446	215,061
Salvage value of new binder	10,000 x 0.3855	3,855
Tax savings on Depreciation	3,000 x 30% x 6.1446	5,530
Tax savings on loss on sale of old machine	30,000 x 30% x 0.9091	8,182
Total Inflows		262,628
Outflows -
Excess operating expenses	12,000 x 6.1446	73,735
Initial Cash outflow		100,000
Total Cashoutflows		173,735
NPV		88,893

Since the NPV is positive, we should get new binder.

Note :

1. There is a loss on sale of existing binder. The loss is 30,000 (Depreciable value - Sale value) (60,000-30,000).

2. Tax savings due to higher depreciation is also considered. New depreciation = (100,000-10,000)/10 = 9,000. Change in depreciation = 3,000 (9,000-6,000)

3. Present Value annuity factor for 10 years at 10% = 6.1446

4. Present value factor for 10th year at 10 = 0.3855

5. Present value factor for 1st year at 10% = 0.9091

6. Tax savings are always at the year end.