Topic 6: Capital budgeting: concepts, methods and cash flows Addtional qucation A proposal is made that = manufacturer produce a new product. An evaluation of the proposal is to bo made on the assumption that sales of the product will commence in year ] and terminate after 12 years. An mvestment Inmachinery and equipment of 51 (INIn required Anestimated lite of 17 year with $13/000 terminal savage value will be used in the cconomic study. Straight line depreciation will he used for fat pu notes The total of a group of mon-recurrent outlays at time zare is $20,020. All of these are chargeable as At time zero, an addition of 580,OUU to net working capital is required. It is assumed that this will be fully recovered at the and of the 12 y cars. Estimated receipts from the zele of the product are 200,000 in year 1, 520,000 in year 2, end $120,000 a year from yours ? to 12. Estimated operating costs are $-18,000 in year 1, $651000 in year 2, and $80 000 a year from yours ? to 12 I hese cost figures include materials, labour, current payments of indirect manufacturing expenses including rental of factoryspace, incremental costs off general administration, and marketing expenses. Ap income tax rate of 39 per cent is to be used in the study, tax is paid in this year of income. The additional finance will be obtained from a new share issue with issue costs being $6,CO0. The Cost of capital is 10 per cent (after tax). Roquired: Provide management with a recommendationss to whether or not to produce the new product. (this means do : NPY analysis)Depreciation = 1/12 * Purchase Price = 1/12 x 90,000 = 7,300 Depn Tex Shield = Depreciation x Tax Rate = 7,100 * 0.39 = 2.925 Book Value Book Gain = Salvage Value - Book Value = 12,000-0 = 12,000 Tex on Book Gain = Book Gain x Tex Rate = 12,000 * 0.39 = 4,680 Tex shield on Non-Recurrent Outley = Non-Recurrent Outlay x Tex Rate = 20,000 * 0.39 = 7,800 Tex shield on Share Issue Costs = Share Issue Costs * Tax Rate = 6,000 x 0.39 = 2,340 Year Receipts Tax Payable 1 50.000 60,000 x 0.39 = 23,400 2 90.000 90,000 x 0.39 = 35,100 3 - 12 120.000 120.000 x 0.39 = 46,800 Year Operating Costs Tax Payable 48.000 55.000 48,000 x 0.39 = 18.720 65,000 x 0.39 = 25.350 80.000 80,000 x 0.39 = 31,200 ITEM 1 3-11 17 Initial Outlay [90,000) Depreciation Tax Shield 2.925 2.925 2.925 2.925 Salvage Value Tax on gain on sale 12.000 Non-Recurent Outlay (20.0 00) 4.680) Tax Shield 7.800 Working Capital (30,000) 30.000 Sales Receipts 60,000 90.000 120.000 120.000 Tax Payable (23.400) (48,000) (35.100) (46,800) (46.800) Operating Costs Tax Shield 18, 720 25.350 31.200 31.200 Share Issue Costs (6,000) Tax Shield 2,340 Net Cash Flow (146.000) 20,385 18 175 27,325 64.645 The cash flow in years 3 - 11 represent a deferred annuity, a 9-year annuity deferred by 2 years. This is because the first payment in the ammuty is at the end of Year 3, and hence the present value of the annuity is at the beginning of the annuity period ie.the beginning of Year 3 or the end of Year 2. It must be discounted by a further 2 years in order to find the present value of the annuity at t=0. NPV - -146,000+ 20,385 18,175 (11) -+27.3254 x (1]) # 94,645 - -146,000 +. 20.385 18,175 (11) +27325 1-(10) -[xx(1)-# + 64,645 - -146.000 +18,532+15.021+. 157,365 08264) 130,054 -+20598 - -145,000 +184.205 - 38,205 AS the INPV is positive, the company should undertake the project