calculate incremental relevant cash flows ( machine A- old machine ) and ( machine B-old machine )

Solution to the other parts

Corporate Finance and Investment EMBA Case Study 2) Capital budgeting, and CAPM Deadline is: January, 06, 2021 Should be covered and submitted before deadline to Ms Naz in Room S17 The Shell Company plans to expand its capacity and growth through the acquisition of a new Drilling machine which is expected to add value in the company. Making a valuation on capital investment is a standard process. The general management needs to evaluate the two drilling machines as alternative purchases, to replace an old one. Being in the decision making phase, it is the financial manager's responsibility to follow a certain methodology and perform a number of calculations in order to evaluate each machine separately as an independent project. Then, each project is evaluated and compared with the other. In the end, the financial manager demonstrates the results and makes the recommendation. The financial management starts the evaluation with the determination of values for the evaluation of each machine. This is done through: (1) the development of incremental cash flows (2) initial investment cash flows for all machines, (3) the calculation of incremental operating cash flows, (4) the calculation of terminal cash flows and (5) the calculation of discount rate. The managers decide to apply capital budgeting techniques such as: (a) the payback period (PB). (b) the net present value (NPV) and (c) the internal rate of return (IRR). Moreover, the parameter of risk is incorporated in the calculations. It is important to take into consideration the uncertainty. Risk can affect seriously the process of evaluating the investment and then may alter final decisions. The required data for analysis has been gathered by financial manager, which is presented as bellow: Old Machine: The machine has a current installed cost of Yearo --S 400,000 and a remaining economic life of 6 years (if the company decides to keep it). Its current net price is $ 400,000. We assume that if the company would decide to purchase it, this would cost the amount of 400,000 S in year (O). Below are given the relevant annual depreciation amounts: Year 1 2 3 Annual Depreciation 100,000 130,000 50,000 55,000 50,000 15000 400,000 Total If the old machine will be kept, it is expected that the machine could be sold at the end of year 6 for $ 40,000, according to the initial estimation. The tax rate for the company is 35 % or (0.35). Machine A 2 This new machine costs $ 1000,000. It has an additional installation cost of $ 100,000. Thus, the installed cost is Yearo- $ 1100,000. This machine could be sold at the end of year 6 for Year. =S 150,000. The purchase of this machine is expected to increase the net working capital of the company by 50,000 at the year. (Time of purchase). The machine has an installed cost of Yearo= $ 1100,000 and an estimated economic life of 6 years. Below are given the annual depreciation amounts: Year 1 2 3 Annual Depreciation 200000 300000 250000 150000 150000 50000 1100000 4 5 6 Total The tax rate for the company is 35% (0.35). 2) Cost of Capital: When evaluating an investment, it is required to take into consideration (a) the time value of money to be invested (opportunity cost) and (b) the risk taken in the investment (risk premium). The Capital Asset Pricing Model (CAPM) is used as a formula to estimate the cost of capital 4 which is the key input in the capital budgeting process and the valuation of an investment, financial manager will follow CAPM to calculate the cost of capital which is actually the required rate of return. It is worth to mention that all percentages are given by the general manager and they are based on assumptions. a. Rp=4.5 % b. Rm 10 % c. B = 1.5 Initial investment for the replacement decision for Machine A = initial investment of Machine A - current market price of old machine = (machine cost + installation cost) of Machine A - current market price of old machine = (1000,000+100,000) - 400,000 = 700,000 Similarly, initial investment for the replacement decision for Machine B = (machine cost + installation cost) of Machine B - current market price of old machine = (550,000+20,000) - 400,000 = 170,000 B D E F G H 1 A 1 Old Machine to Machine A 2 Year 2 3 4 5 6 3 Incremental Inflows $190,000.00 $ 155,000.00 $185,000.00 $ 290,000.00 $232,000.00 $150,000.00 4 Incremental Depreciation $100,000.00 $170,000.00 $200,000.00 $ 95,000.00 $100,000.00 $ 35,000.00 5 EBT $ 90,000.00 $ (15,000.00) $ (15,000.00) $195,000.00 $ 132,000.00 $115,000.00 6 Tax '$ 31,500.00 '$ (5,250.00)' $ (5,250.00)' $ 68,250.00 '$ 46,200.00 $ 40,250.00 7 Net Income $ 58,500.00 $ (9,750.00) $ (9,750.00) $126,750.00 $ 85,800.00 $ 74,750.00 8 Add Back Depreciation $100,000.00 $170,000.00 $200,000.00 $ 95,000.00 $100,000.00 $ 35,000.00 9 Incremental Operating Cash Flow $158,500.00 $160,250.00 $190,250.00 $221,750.00 $185,800.00 $ 109,750.00 10 11 Old Machine to Machine B 12 Year 1 2 3 4 5 6 13 Incremental Inflows $ 60,000.00 $ 122,000.00 $135,000.00 $ 210,000.00 $160,000.00 $150,000.00 14 Incremental Depreciation $ 20,000.00 $ 70,000.00 $ 50,000.00 $5,000.00 $ 10,000.00 $ 15,000.00 15 EBT $ 40,000.00 $ 52,000.00 $ 85,000.00 $ 205,000.00 $150,000.00 $135,000.00 16 Tax $ 14,000.00 $ 18,200.00 $ 29,750.00 $ 71,750.00 $ 52,500.00 $ 47,250.00 17 Net Income $ 26,000.00 $ 33,800.00 $ 55,250.00 $133,250.00 $ 97,500.00 $ 87,750.00 18 Add Back Depreciation $ 20,000.00 $ 70,000.00 $ 50,000.00 $5,000.00 $ 10,000.00 $ 15,000.00 19 Incremental Operating Cash Flow $ 46,000.00 $ 103,800.00 $105,250.00 $138,250.00 $ 107,500.00 $102,750.00 20 21 Bookt Excel Tell me what you want to de Home Page Layout Formulas Data Review Vw Sign Shure NG G 6 2 250000 95000 - 130000 300000 C3 C4 *5*0.35 *CS.CO *C4 C7.08 3 275000-90000 =250000 50000 -03-04 05'0 35 DS-26 04 -07-08 380000 90000 = 150000 55000 3-4 ES*0.35 -ES-EG 2317000 85000 150000 50000 F3-4 F5*0.35 #F5 FG =14 -F748 200000-50000 =50000 15000 0164 G50.35 G5 G6 +64 67.68 1 Old Machine to Machine A Year 3 Incremental Intlows 300000 110000 4 Incremental Depreciation = 200000 100000 5 EDT -B3-04 6 Tax BS 0.35 7 Net Income *85 86 8 Add Back Depreciation 384 Incremental Operating Cash Flow -07.88 10 11 Old Machine to Machine 12 Year 13 Incremental inflows -170000-110000 14 Incremental Depreciation =120000-100000 15 EOT -513-814 16 Tax 66150.35 17 Net Income -B15 B16 18 Add Back Depreciation 2014 19 Incremental Operating Cash Flow B17+818 20 21 22 23 217000-95000 -120000 200000 *13-14 15*0, 35 *C15 C16 2014 WC17-C18 225000 90000 100000 50000 2013-014 015*0.35 2015-016 2014 0174D18 300000 90000 =60000 55000 13-14 E15*0.35 E15 16 E14 E17-18 5 245000 85000 360000-50000 F13-714 F15*0,3 =F1S F14 F17-F18 200000-50000 =30000 15000 -G13-614 1615035 GIS-G16 G14 .617.G18