SingTel Ltd. is an Australian operated company with mainly Singaporean resident
ID: 2710823 • Letter: S
Question
SingTel Ltd. is an Australian operated company with mainly Singaporean resident shareholders. The company is currently in the process of comparing two mutually exclusive machines for use in a new project with Machine A costing $30,000, having a useful life of five years and machine B costing $45,000 and having a useful life of 10 years. Cash inflows from sales are expected to be $22,000 p.a. from each machine, while total cashbased operating costs are expected to be $10,000 and $8,000 respectively for each machine. All revenues and costs are assumed to occur at the end of the respective years for simplicity of assessment. Machine A is expected to have a salvage value of $4,000 at the end of 5 years, while at the end of 10 years machine B will be worthless. Depreciation for accounting and tax purposes is calculated on a straight-line basis on the original cost of each machine with no consideration in depreciation calculations for any expected salvage value. The company has an aftertax required rate of return of 14% and pays income tax at the rate of 40% in the year following the year of income (that is, taxes levied on year 1 income are paid at the end of year 2). a) Provide some reasons as to why the alternative machines are said to be mutually exclusive for the company. b) Record the relevant cash-flows for each machine on a time (cash-flow) diagram. c) Advise the company which machine (if any), should be purchased and justify all the processes you have used in order to reach your decision. d) (i) Why is NPV considered to be the best method for capital budgeting? What does the NPV tell you? (ii) When evaluating two mutually exclusive projects with unequal lives, is the project with the higher NPV better? Why or why not?
Explanation / Answer
a.the alternative machines are said to be mutually exclusive for the company because Both alternative have different life.
Summary of Project :
Particulars
Machine A
Machine B
SALES P.A
22000
22000
OPERATING COST PA
10000
8000
COST
30000
45000
USEFUL LIFE
5
10
SALVAGE
4000
0
DEPRECIATION PA
5200
4500
TAX RATE
0.4
0.4
DISCOUNT RATE
0.14
0.14
Computation of NPV :
NPV calculation
Machine A
SALES P.A
22000
OPERATING COST PA
-10000
DEPRECIATION
-5200
PBT
6800
ACTUAL CASH INFLOW
12000
DF 14%
3.433081
PV
41196.972
TAX 40%
2720
DF 14% (YEAR 2 TO 6)
3.0114745
PV OF TAX PAID
8191.2107
NET AFTER TAX PV
33005.761
ADD : PV OF SALVAGE
2077.4747
PV OF CASH INFLOW
35083.236
PV OF CASH OUTFLOW
30000
NPV
5083.2356
NPV calculation
Machine B
SALES P.A
22000
OPERATING COST PA
-8000
DEPRECIATION
-4500
PBT
9500
ACTUAL CASH INFLOW
14000
DF " 14%
5.2161156
PV
73025.619
tax @ 40%
3800
DF 14% (YEAR 2 TO 11)
4.57554
PV OF TAX PAID
17387.052
NET AFTER TAX PV
55638.567
PV OF CASH OUTFLOW
45000
NPV
10638.567
SINCE THE PROJECT LIFE IS NOT SAME , IT IS NOT POSSIBLE NOT COMPARE NPV OF PROJECTS DIRECTLY HENCE WE HAVE TO COMPUTE ANNUALISED CASH INFLOW FOR COMPARISION.
Annual equivalent cash flow
Machine A
Machine B
npv
1480.66
2039.56
[1-(1+r)^-n]/r
Hence Machine B is better.
D. (I)
NET PRESENT VALUE METHOD CALCULATES THE PRESENT VALUE OF THE CASH FLOWS BASED ON THE OPPORTUNITY COST OF CAPITAL
IT IS BETTER THAN PBP AS IT CONSIDERS TIME VALUE OF MONEY
IT IS BETTER THAN PBP AS IT CONSIDERS THE PERIOD AFTER PBP
NPV TALKS IN ABSOLUTE TERMS UNLIKE IRR AND PROFITABILITY INDEX
D. (II)
NO, BECAUSE THE DIRECT COMPARISION OF PROJECTS WITH DIFFERENT LIVES IS NOT PROPER HENCE IT IS TO BE CONVERTED INTO ANNUALISED EQUIVALENT CASHFLOW FOR COMPARISION AND DECISION MAKING
Particulars
Machine A
Machine B
SALES P.A
22000
22000
OPERATING COST PA
10000
8000
COST
30000
45000
USEFUL LIFE
5
10
SALVAGE
4000
0
DEPRECIATION PA
5200
4500
TAX RATE
0.4
0.4
DISCOUNT RATE
0.14
0.14