The company is contemplating a new investment. It will be purchasing equipment f
ID: 2789520 • Letter: T
Question
The company is contemplating a new investment. It will be purchasing equipment for $1,000,000 that has a three-year life for tax purposes, and will be depreciated 33.33%, 44.45%, 14.81% and 7.41% over 4 years. Additionally, the company will be using equipment that is fully depreciated, initially cost $1,200,000 and has a current value of $500,000. The investment will generate sales of $730,000 in year 1, $770,000 in year 2, $760,000 in year 3 and $740,000 in year 4, Operating costs are anticipated to be 55% of sales. Assume a tax rate of36%. As part of the project the company will need to budget for yearly working capital equal to 8% of the next year's sales. Starting in year 5, sales are anticipated to be $148,000 annually, indefinitely. Cash flow from assets starting in year 5 is anticipated to be $41,810 each year The company requires a payback period of 4 years or less. Based on a required rate of retum of 6.5%, determine if this investment should be undertaken. The company also has the opportunity for a mutually-exclusive alternative investment. In that case the company would need to invest $3,000,000. The project would have an internal rate of return of 7.27%, a payback period of 3.623 years, a net present value of $64,842 and a profitability index of 1.0208. Also evaluate if this investment should be undertaken and if it is a better investment than the original proposalExplanation / Answer
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Item Year 0 1 2 3 4 5 onwards
1.Initial Investment (1,000,000) -- -- -- -- --
2.Book value of existing asset ( 500,000) -- -- -- -- --
3.Net Working Capital
(8% next yr sales) 58,400 61,600 60,800 59,200 11,840 11,840
4.Increase in working capital (58,400) (3,200) 800 1,600 47,360 ---
5.Sales 730,000 770,000 760,000 740,000 148,000
6.Operating cost (55%) -- 401,500 423,500 418,000 407,000 81,400
7.Depreciaiton -- 333,333 444,500 148,100 74,100 --
8.Income before tax(5-6-7) -4,833 -98,000 193,900 258,900 66,600
9. Tax @36% -- -- 69.804 93,204 23,976
10.Income after tax -4,833 -98,000 124,096 165,696 42,624
11.Cash Flow from operation (10+7) 328,500 346,500 272,196 239,796 42,624
12.Cash Flow from investment -- -- -- -- 41,810
13.Total cash flow(11+WC) (1,558,400) 325,300 347,300 273,796 287,156 84,434
Calculation of NPV
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Year PVF@6.5% CF PV of Cash flows
0 1 (1,558,400) (1,558,400)
1 0.9390 325,300 305,457
2 0.8817 347,300 306,214
3 0.8279 273,796 226,676
4 0.7773 2 87,156 223,206
5 onward 0.7773 1,298,984 1,009,700
NPV 512,853
Profitability Index = Total Present value of cashinflows/Initial outflow = 2,071,253/1558400 = 1.3290
Decision: Original investment is preferable as its NPV and Profitabiltiy index is more than proposed investment
Note: Perpetual cash flow from 5th year = 1,298,984
PVF = Present value factor
PVF can be calculated by applying the following formulas
First year = 1/(1+r)
Second year = 1/(1+r)2
Third year = 1/(1+r)3 etc., where r = Rate of return i.e 6.5% or 0.065