Question

Rex Berhad is considering buying a new production machine. The proposed machine would cost the company RM85,000 and require an installation and modification cost of RM1,500 to be installed properly. In addition, the new machine would require an increase of inventory and account payable of RM 3 000 and RM1 700 respectively. The new machine will be depreciated over its five year life using the simplified straight line method. By using the new machine, sales is expected to increase by RM25 000 and annual maintenance cost for the new machine would be 10 percent of the incremental sales over the life of the asset. At the end of its life the firm expect to be able to sell the machine for RM10 000. The firm’s tax rate is 28 percent and its required rate of return is 12 percent.

A. Calculate the initial outlay associated with the new machine.

B. Calculate the annual cash flow.

C. Calculate the terminal cash flow.

Should the firm buy the machine? Justify your answer.

Answer 1

Calculation of the intial cash outlay :-

A) Initial cash outlay = Cost of machine + increase in working capital

cost of machine = purchase price of machine + Installation cost = 85,000 + 1,500 = 86,500

Increase in WC = Increase in Inventory + Increase in Account payable = 3,000+ 1,700 = 4,700

Intial cash outlay = 86,500 + 4,700 = 91,200

B) Annual cash inflows :-

Depreciation = cost of machine - salvage value / life of machine in years = 86,500 - 10,000 / 5 = 17,300

Particulars	Amount
Increase in Sales	25,000
Less- Maintenance cost @10% of sales	2500
less- depreciation	15,300
EBT	7,200
Less- Tax@28%	2016
Net income after tax	5,184
Add-Depreciation	15,300
Annual cash inflows	20,484

c) Calculation of the terminal cash inflows :-

Sales proceeds form the machine = 10,000

book value of machine at time of sale = 10,000

So, there is no gain on machinery sale.Hence there is no tax on sale proceeds

Terminal cash inflows = Net proceeds from sale + release in working capital = 10,000 + 4,700 = 14,700

d) Calculation of the NPV :-

Years	Annual cash inflows	Terminal cash inflows	Total cash inflows	PVF@12%	NPV
0	-91,200		-91,200	1	-91200
1	20,484		20,484	0.892857	18289.29
2	20,484		20,484	0.797194	16329.72
3	20,484		20,484	0.71178	14580.11
4	20,484		20,484	0.635518	13017.95
5	20,484	14,700	35,184	0.567427	19964.35
NPV	-9018.59

Here NPV is negative, So we reject the project.