Question

Mags Ltd. has purchased a new machine for a cost of $500,000. The machine has just been

installed and the cost of installation is $30,000. The internal auditors have advised that the

cost of installation cannot be depreciated. The machine’s suppliers have requested a 20%

deposit on installation with the remainder to be paid within six months. The current

estimated before-tax net operating cash revenue for the coming four years are $300,000 in

the first year, $320,000 in the second year, $340,000 in the third year and $360,000 in the

fourth year. The new machine is expected to increase the expected before-tax net operating

cash revenue for the next four years by 70% of the current estimated value. Mags will take

out a business loan to fund the purchase of the machine and the interest payments on the

loan will be $100,000 per annum. The machine will be sold at the end of the fourth year and

its estimated market value at that time is $65,000. The company tax rate is 30% and

reducing balance depreciation is permitted. The required rate of return is 13% per year and

the prevailing market interest rate is 6% per year.

Prepare a cash flow analysis for the useful economic life of the machine, and use the cash

flow analysis to estimate the machine’s net present value. Show all workings.

Answer 1

	CALCULATION OF DEPRECIATION TAX SHIELD
	Depreciation Rate=r=1-((S/C)^(1/n))
	S=Residual value=$65000
	C=Original Cost=$500000
	n= Life =4 years
	r=1-((65000/500000)^(1/4))=1-0.600462	1.0000000
	r=0.3995376
		A	B=A*0.3995376	C=A-B	D=B*30%
	Year	Beginning book Value	Depreiation Amount	Ending Book Value	Depreciation Tax Shield
	1	$500,000	$199,769	$300,231	$59,931
	2	$300,231	$119,954	$180,278	$35,986
	3	$180,278	$72,028	$108,250	$21,608
	4	$108,250	$43,250	$65,000	$12,975
	Annual Interest Tax Shield=100000*30%	$30,000
	Payment for installation in year 0=30000*20%	$6,000
	Balance Payment for installation at end of year=0.5	$24,000	(30000-6000)
	Present Value of balance Payment =24000/(1.13^0.5)	$22,577
	Present Value of initial Cash Flow =6000+22577=	$28,577
N	Year	0	1	2	3	4
A	Present Value of initial Cash out Flow	($28,577)
B	Interest Payment		($100,000)	($100,000)	($100,000)	($100,000)
C	Principal Payment					($500,000)
D	Salvage Value cash flow					$65,000
E	Before tax net operating cash revenue		$300,000	$320,000	$340,000	$360,000
F=E*70%	Increase in before tax revenue		$210,000	$224,000	$238,000	$252,000
G=F*(1-0.3)	Increase in After tax revenue		$147,000	$156,800	$166,600	$176,400
H	Depreciation tax shield		$59,931	$35,986	$21,608	$12,975
I	Interest Tax Shield		$30,000	$30,000	$30,000	$30,000
J=G+H+I	Net Increase in annual operating cash flows		$236,931	$222,786	$218,208	$219,375
K=A+B+C+D+J	NET CASH FLOW	($28,577)	$136,931	$122,786	$118,208	($315,625)	SUM
PV=K/(1.13^N)	Present Value of Net Cash Flow	($28,577)	$121,178	$96,160	$81,924	-$193,579	$77,105
NPV=sum of PV	NET PRESENT VALUE (NPV)	$77,105