Hairy Maclary inherited his dairy farm from his father about ten years ago. His father had in turn inherited the farm from his father. The farm currently has 125 milking cows in the farm located in Casino, NSW. In order to be able to run this many cows and ensure they are milked in a timely manner the farm employs two farm hands on a part-time basis. These employees work 25 hours a week and are paid $20 an hour. They each work 48 weeks a year and receive superannuation at a rate of 9.5% of their gross pay.

In order to make his life a little easier on the farm, Maclary has decided to purchase an automatic rotor milking machine. The milking machine with the most potential is the Rotor 700. To facilitate this purchase, Maclary has employed the services of Schnitzel von Krumm to analyse the viability of such an investment. Von Krumms report is $50,000. $30,000 was paid before the report was prepared and a further $20,000 was to be paid if the decision was made to undertake the project. Other costs incurred by Mr Krumm include the cost of flights from Sydney to London and appropriate accommodation. He will fly first class and these flights will amount to $10,000. Economy class fares are $3,000. Accommodation, meals and incidentals will cost $3,000. These costs will be incurred before the decision is made.

Mr Maclarys tax advisor is Mr Hercules Morse CPA. He has advised that the entire cost of Krumms report is 100% tax deductible while 75% of the flights are tax deductible and the other costs associated with the report are 50% deductible.

The new machine will cost $500,000 and can be depreciated straight line over 10 years for tax purposes. Accounting depreciation is 15% reducing balance. Mr Morse has recommended that the 15% reducing balance depreciation rate be used for any analysis. Details of the project are as follows:

Mr Maclary will also need to build a new shed to house the milking machine. This will cost $100,000 and can be depreciated for tax and accounting purposes over 5 years straight line.

The area where the shed will be built previously housed a machinery parking lot. Currently this is leased to the next-door neighbour for $1000 per month but Maclary had renegotiated this with him and the neighbour was prepared to pay $1500 per month from now on.

Delivery and installation costs will be $100,000. Mr Morse believes that these should be expensed although the ATO has advised this need to be

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included in the value of the machinery for depreciation purposes. Mr Morse is adamant that these must be expensed and a 50% tax deduction is available.

Mr Bitzer Maloney will provide management of the new facility. He will be paid $75,000 per annum (inclusive of superannuation) and this will increase by 10% per annum. The two farm hands will no longer be needed and will be paid a redundancy of $10,000 each (with no superannuation payable) when the new machine is purchased. These redundancy payments are tax deductible immediately.

The new machine will be able to be sold for $50,000 at the end of the projects life in year 10. The shed will be worthless at the end of the project.

The advantage of the new machine is that the farm will be able to increase the number of cows from 125 to 250. It also means that the farm will be able to increase milk production from 1 million to 1.5 million litres. In year one, milk will sell for $1 per litre and increase by 10% per year from year 2 onwards. The farm will also be able to produce 200,000 litres of cream. This will sell for $2 per litre and is expected to increase by 5% per annum from year 2 onwards. In year 5, the number of cows will increase to 300. This will result in a 20% increase in output.

Sales of beef will, however, fall by $250,000 per year. Meat prices were expected to increase by 6% per year from year 2 onwards. This means that lost sales were also expected to increase by 6% per annum.

Mr Maclary will run tours of the new facility and these are expected to generate revenues of $100,000 per annum. The project is expected to need an increase in working capital from $100,000 to $200,000 initially.

Costs of production (farm costs) are 30% of net sales of milk, cream and beef.

Tools currently used in another part of the farm will be used with the new machine. These used tools have a market value of $10,000 but will need to be replaced with new tools. These are expected to cost $20,000. These are currently depreciated for tax purposes over 2 years and will have no salvage value.

The farm maintains a photo library at its office in the main street of Casino. The farm devotes one floor of its office to this library, which contains copies of some

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of the most beautiful photos taken in Casino over the last 50 years. The rent is currently $10,000 per year.

The farm plans to borrow 100% of the funds required to purchase the new machine from Westpac. Interest rates are expected to be 8% per annum fixed for the life of the loan. All interest payments are tax deductible. The loan will be an interest only 10-year loan with the full amount repaid in year 10.

The farm maintains a constant debt-to-equity ratio of 60%. The cost of debt for the farm is 8% per annum. The real rate of return of the ASX200 index is 10% pa and the real rate of return on government bonds is 3% pa. The beta of the farm is 1.5. Projects such as this typically require an additional 2.5% premium on top of the firms WACC.

Note:

The current rate of inflation is 3.0% p.a. Maclary pays tax at 30 cents in the dollar. All tax benefits are received in the year in which the expenditure is incurred unless otherwise stated. All amounts and interest rates are in real dollars and percentages. All analysis should be undertaken in real dollars.