Sales of a new product line for Petrus S.A. as of December 2013 are forecast at SFr. 2,400,000 per year, from which a sales commission of 15% would be paid to sales agents. Actual sales are to be made in sev eral different currencies, but all money measurements are stated in Swiss francs, the currency of the head office.
To add the new line of moulded plastic products to those already manufactured and distributed by Petrus S.A., the company, under the direction of Andre Andros, would have to buy new injection moulding equipment in order to maintain manufacturing quality control; none of the existing equipment could be adapted to perform the necessary operation.
Direct manufacturing costs are budgeted at SFr. 720,000 for materials and SFr. 1,080,000 for labour, leaving an annual cash flow before tax of SFr. 240,000. The new equipment would cost SFr. 720,000 delivered and installed, and was expected to have a useful life of 10 years, with a zero terminal disposal value. Petrus is able to borrow money at 8%.
REQUIRED
1. Ignoring the effect of taxes, what is the internal rate of return (IRR) on the proposed investment? Assume the new equipment would be installed by January 1, 2014, and begin producing on that date.
2. Assume for tax purposes, the equipment is amortized on a straight-line basis over ten years. The tax rate is expected to be 45%. What is the IRR on an after-tax basis?
3. Andros has stated that Petrus should be willing to purchase this machine as long as it yielded a return of 12% after taxation. Should he make the investment? Show your calculations.
4. Actually, to stimulate industrial development, the tax rules allow for amortization deductions up to one-third of the cost of any such investment to be deducted from reported earnings in the first year after the investment, and up to one-fifth of the remainder of the unamortized investment amount can be deducted in the second year. Thereafter, annual deductions are computed on a straight-line basis such that no more than the original cost of the equipment is amortized over its useful life. How, if at all, does this affect the attrac tiveness of the investment?
5. Petrus has learned that investment in working capital (receivables and inventories, less payables) amounts to approximately 15% of revenues. Will the additional SFr. 360,000 investment for the new line decrease the rate of return on investment to less than the 12% criterion Andros has been using?
6. In late December 2013, Petrus purchased the equipment, and the operating results turned out as forecast. A year later, Andros learned that the manufacturer of the new equipment had introduced new models that were more automated. The new equipment costs SFr. 1,200,000 and would permit labour savings of SFr. 240,000 per year, thus doubling the net operating cash flow on the product. As a result of the technological advance, Andros expected the one-year-old machine could be sold for only SFr. 240,000 despite the fact that its book value was SFr. 480,000. If Petrus buys the new machine and amortizes it using allowed tax amortization over ten years, would the investment meet the 12% after- tax criterion? Show your calculations.
7. If the one-year-old machine has a zero disposal price, would replacing it with the new machine still be desirable? Show your calculations.
8. Andros was loath to throw away a nearly new machine and thought he might be better off to keep it one more year and then replace it. Would he be better off? How would you go about addressing this issue? Explain.
9. During 2014 the rate of inflation remained low, and it was expected that it would average about 4% for the year. Andros wondered how Petrus's analysis should reflect this rate of inflation, which he expected might continue for several years. Should an assumed inflation rate change his decision? Explain.