The company is considering purchasing one of the following computerized laser mo
ID: 2789296 • Letter: T
Question
The company is considering purchasing one of the following computerized laser models for cutting steel. Assala’s cost of capital is 12%. Its tax rate is 35%.
Model A
Model B
Cost of the machine
AED 500,000
AED 600,000
Life of machine
5 years
5 years
Salvage (resale) value – Year 5
AED 30,000
AED 40,000
Annual revenues
AED 140,000
AED 160,000
Annual operating expenses (including Depreciation)
AED 75,000
AED 85,000
Major repairs – year 3
AED 18,000
AED 20,000
Required 1.
With using the NPV, IRR and payback criteria, the company has asked you to analyze the two options and make some recommendations.
Model A
Model B
Cost of the machine
AED 500,000
AED 600,000
Life of machine
5 years
5 years
Salvage (resale) value – Year 5
AED 30,000
AED 40,000
Annual revenues
AED 140,000
AED 160,000
Annual operating expenses (including Depreciation)
AED 75,000
AED 85,000
Major repairs – year 3
AED 18,000
AED 20,000
Explanation / Answer
Initial outlay = FCinv + WCinv
Here the cost of machine model A is AED 500,000 and model B is AED 600,000 and no details about working capital is given thus:
Initial outlay for model A = 500,000 + 0 = 500,000
and for model B = 600,000 + 0 = 600,000
The life of machine is 5 years with salvage values as AED 30,000 and AED 40,000 respectively for model A and model B thus Depreciation per year:
Model A = 500,000-30,000 / 5 = 94,000
Model B = 600,000-40,000 / 5 = 112,000
After tax operating cashflow = (sales-cost-depreciation)*(1-tax)+Depreciation
For model A = (140000-75000-94000)*(1-0.35)+94,000
=75150
For model B = (160,000-85000-112000)*(1-0.35)+112000
=87950
Thus the above are the respective ATOCF for model A and model B from which in year 3 will deduct 18,000 and 20,000 respectively as Major repairs. Hence year 3 ATOCF for
model A = (140000-75000-18000-94000)*(1-0.35)+94,000
=63450
model B = (160,000-85000-20000-112000)*(1-0.35)+112000
=74950
Terminal year cashflow = Salvage+NWinv-Tax*(salvage-bookvalue)
For model A = 30000+0-0.35*(30,000-0)
=19500
For model B = 40,000+0-0.35*(40,000-0)
=26000
(this terminal year CF gets added to final year CF in this case in year 5)
Please see the excel below for NPV and IRR calculation:
You can also put in the below mentioned CFs in your financial calculator and press CPT and then NPV by inserting 12% for NPV and by pressing CPT and then I/Y for IRR.
Years
Model A
Model B
0
-500,000
-600,000
1
75150
87950
2
75150
87950
3
63450
74950
4
75150
87950
5
94650
113950
NPV at 12% cost of capital
-202,110.780
-247,732.123
IRR
-7.974%
-8.401%
Both the projects have negative NPV and thus non of the project should be accepted. Even the IRR<Cost of capital thus neither of the project should be selected.Initial outlay = FCinv + WCinv
Here the cost of machine model A is AED 500,000 and model B is AED 600,000 and no details about working capital is given thus:
Initial outlay for model A = 500,000 + 0 = 500,000
and for model B = 600,000 + 0 = 600,000
The life of machine is 5 years with salvage values as AED 30,000 and AED 40,000 respectively for model A and model B thus Depreciation per year:
Model A = 500,000-30,000 / 5 = 94,000
Model B = 600,000-40,000 / 5 = 112,000
After tax operating cashflow = (sales-cost-depreciation)*(1-tax)+Depreciation
For model A = (140000-75000-94000)*(1-0.35)+94,000
=75150
For model B = (160,000-85000-112000)*(1-0.35)+112000
=87950
Thus the above are the respective ATOCF for model A and model B from which in year 3 will deduct 18,000 and 20,000 respectively as Major repairs. Hence year 3 ATOCF for
model A = (140000-75000-18000-94000)*(1-0.35)+94,000
=63450
model B = (160,000-85000-20000-112000)*(1-0.35)+112000
=74950
Terminal year cashflow = Salvage+NWinv-Tax*(salvage-bookvalue)
For model A = 30000+0-0.35*(30,000-0)
=19500
For model B = 40,000+0-0.35*(40,000-0)
=26000
(this terminal year CF gets added to final year CF in this case in year 5)
Please see the excel below for NPV and IRR calculation:
You can also put in the below mentioned CFs in your financial calculator and press CPT and then NPV by inserting 12% for NPV and by pressing CPT and then I/Y for IRR.
Years
Model A
Model B
0
-500,000
-600,000
1
75150
87950
2
75150
87950
3
63450
74950
4
75150
87950
5
94650
113950
NPV at 12% cost of capital
-202,110.780
-247,732.123
IRR
-7.974%
-8.401%
Both the projects have negative NPV and thus non of the project should be accepted. Even the IRR<Cost of capital thus neither of the project should be selected.Initial outlay = FCinv + WCinv
Here the cost of machine model A is AED 500,000 and model B is AED 600,000 and no details about working capital is given thus:
Initial outlay for model A = 500,000 + 0 = 500,000
and for model B = 600,000 + 0 = 600,000
The life of machine is 5 years with salvage values as AED 30,000 and AED 40,000 respectively for model A and model B thus Depreciation per year:
Model A = 500,000-30,000 / 5 = 94,000
Model B = 600,000-40,000 / 5 = 112,000
After tax operating cashflow = (sales-cost-depreciation)*(1-tax)+Depreciation
For model A = (140000-75000-94000)*(1-0.35)+94,000
=75150
For model B = (160,000-85000-112000)*(1-0.35)+112000
=87950
Thus the above are the respective ATOCF for model A and model B from which in year 3 will deduct 18,000 and 20,000 respectively as Major repairs. Hence year 3 ATOCF for
model A = (140000-75000-18000-94000)*(1-0.35)+94,000
=63450
model B = (160,000-85000-20000-112000)*(1-0.35)+112000
=74950
Terminal year cashflow = Salvage+NWinv-Tax*(salvage-bookvalue)
For model A = 30000+0-0.35*(30,000-0)
=19500
For model B = 40,000+0-0.35*(40,000-0)
=26000
(this terminal year CF gets added to final year CF in this case in year 5)
Please see the excel below for NPV and IRR calculation:
You can also put in the below mentioned CFs in your financial calculator and press CPT and then NPV by inserting 12% for NPV and by pressing CPT and then I/Y for IRR.
Years
Model A
Model B
0
-500,000
-600,000
1
75150
87950
2
75150
87950
3
63450
74950
4
75150
87950
5
94650
113950
NPV at 12% cost of capital
-202,110.780
-247,732.123
IRR
-7.974%
-8.401%
Both the projects have negative NPV and thus non of the project should be accepted. Even the IRR<Cost of capital thus neither of the project should be selected.
Years
Model A
Model B
0
-500,000
-600,000
1
75150
87950
2
75150
87950
3
63450
74950
4
75150
87950
5
94650
113950
NPV at 12% cost of capital
-202,110.780
-247,732.123
IRR
-7.974%
-8.401%