Case Study

Read this case study and then answer the questions that follow.

1. Cathy Lim owns the Peterborough Clothing Company and is in need of a sewing machine as technology is quickly changing.
2. The best machines are available in both Croatia and Turkey. Cathy has taken advice from a friend and will purchase the AB11 from Turkey. Once the decision is made to purchase, she will need to travel to Turkey to undertake training. This will cost $17,000 and is tax deductible in year 0.
3. The AB11 will cost $350,000 and should be able to be sold for $25,000. The accountant has advised that the machine will be depreciated over 10 years. The ATO however requires depreciation over 6 years. It is expected that the machine will be kept for 5 years by Peterborough Clothing Company so any evaluation must be undertaken over a 5 year period. It will be sold after 5 years which is the projects life.
4. Cathy will need to borrow 100% of the value of the AB11 from the Western Bank. The loan will be at a fixed rate of 10% p.a. over 5 years, with interest only payable at the end of each year. The principal is repayable at the end of the fifth year.
5. The old machine was purchased three years ago and at that time was expected to have an economic life of 5 years. It cost $200,000 and Cathy has been depreciating it using straight-line depreciation over five years as required by the ATO. Cathy expects she will receive $50,000 if she sells the old machine. It is expected to be sold in period 0 if the new machine is purchased.
6. The AB11 machine is state-of-the-art, and much more efficient than the old machine. The old machine costs $350,000 per annum to operate, whereas the AB11 machine will only cost about $100,000 per annum to operate.
7. Due to the different manner in which the AB11 operates, it will be necessary to purchase an additional $80,000 of inventory in year 0.
8. Malcolm will need less staff as a result of the new machine. This will require a payout of $50,000 in year 0 and save wages of $75,000 per year. These amounts are tax deductible.
9. All cash flows are given in nominal terms.
10. The real rate of interest currently in the economy is 7% and inflation is 4%.
11. The corporate tax rate is 20%. Assume tax is paid in the year of income.
12. The new machine will generate yearly revenue of $4m while the old machine was only able to generate annual revenue of $2m.
13. Assume that all incremental revenues (as identified in line 12 above) and expenses (as identified in line 6 above) continue to year 5. That is, include these incremental amounts in your calculation in question 8.

1) What amount of the trip to Turkey should be included when undertaking the NPV analysis? (1 Mark) Answer: (Answer to the nearest Dollar)

2) The after tax impact from Western Bank to be included in the NPV calculation is: (1 Mark)

Answer: (Answer to the nearest Dollar)

3) The depreciation tax shield (tax benefit per annum) for the new machine is: (1 Mark) Answer: (Answer to the nearest cent).

4) The lost depreciation tax shield (tax benefit per annum) for the old machine is in year 4 is: (1 Mark) Answer : (Answer to the nearest Dollar)

5) Malcolm has to purchase additional inventory. The cash flow impact of this in year 5 will be? (1Mark)

Answer : $, InflowOutflow (Answer to the nearest Dollar)

6) The Cash Flow in period 0 is: (2 Marks)

Answer: (Answer to the nearest Dollar, a negative sign may be used in the answer)

7) The appropriate discount rate to use in deciding whether Malcolm should buy the new machine is? (1 Mark) Answer : (Answer as a Decimal to 4 decimal places)

8) The Free Cash Flow in year 5 is: (2 Marks)

Answer: (Answer to the nearest Dollar)