7/23/2019 Tutorial Set 06 - Week 06 Solutions

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BFW2631

FINANCIAL MANAGEMENT

TUTORIAL SET 6 -WEEK 6SOLUTIONS

CAPITAL BUDGETING: CASH FLOW ANALYSISQuestion One

a) Initial NPV without replication.

Project S

NPV (Project S) = 23.132,4$000,1001.1

60000

1.1

600002

OR

Using annuity formula as cash inflow is in ordinary annuity form

NPV(Project S) =000,100

2)10.1(

11

10.0

,000600

)1(

11

CF

CF

nkk

= $4,132.23

Project L

NPV (Project L) = 49.190,6$000,1001.133500

1.133500

1.133500

1.133500

432

OR

Using annuity formula as cash inflow is in ordinary annuity form

NPV(Project L) = 000,1004)10.1(

11

10.0

500,330

)1(

11

CF

CF

nkk

=$6,190.49

Decision: Choose Project L on the basis of higher NPV.

b) Equivalent Annual Annuity Method

Project S

95.380,2$

)10.1(

11

0.104132.23

)k1(

11

kNPVEAA

2n

S

Project L

7/23/2019 Tutorial Set 06 - Week 06 Solutions

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92.1952$

)10.1(

11

0.106190.49

)k1(

11

kNPVEAA

4n

L

Question Two

a) INCREMENTAL ANALYSIS (Replacement decision vs. Keeping the existing machine)

Initial Investment T=0 T=1 T=2 T=3 T=4 T=5

Cost of New UnitIncluding shipping +installation

-$750,000

Net working capitalcontribution

-$40,000

Sale of existing Plant $275,000

Tax Paid on Sale of Old Unit(Capital Gain) -$7,500

Net Initial Investment -$522,500

Operating Cash Flows T=0 T=1 T=2 T=3 T=4 T=5

Incremental Increase inRevenue (New-old)

$100,000 $100,000 $100,000 $100,000 $100,000

Incremental Costs (New-old) $20,000 $20,000 $20,000 $20,000 $20,000

Incremental Depreciation(Newold)

-$100,000 -$100,000 -$100,000 -$100,000 -$100,000

Incremental EBIT $20,000 $20,000 $20,000 $20,000 $20,000

TAX (30%) -$6,000 -$6,000 -$6,000 -$6,000 -$6,000

Incremental EAT $14,000 $14,000 $14,000 $14,000 $14,000

Add back

Incremental Depreciation $100,000 $100,000 $100,000 $100,000 $100,000NWC contributions -10,000 -10,000 -10,000 -10,000

Net Operating Cash Flows $104,000 $104,000 $104,000 $104,000 $114,000

Terminal Cash Flows T=0 T=1 T=2 T=3 T=4 T=5

Proceeds from Sale of Plant $75,000

Tax Paid on Sale of NewPlant

-$22,500

Recovery of Net workingcapital

$80,000

NET CASH FLOWS $(522,500) $104,000 $104,000 $104,000 $104,000 $246,500

NPV =512.1

500,246

412.1

000,104

312.1

000,104

212.1

000,104

12.1

000,104)500,522($ = - $66,744.95

Decision: Negative NPV therefore reject the decision to replace the existing unit with the new unit as

this decision fails to generate wealth for shareholders.

7/23/2019 Tutorial Set 06 - Week 06 Solutions

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ALTERNATIVE ONE (OLD): Keep the old machineT=0 T=1 T=2 T=3 T=4 T=5

Annual Before Tax Cash Inflow 0 0 0 0 0

Annual Depreciation -$50,000 -$50,000 -$50,000 -$50,000 -$50,000

EBIT -$50,000 -$50,000 -$50,000 -$50,000 -$50,000

Tax (30%) $15,000 $15,000 $15,000 $15,000 $15,000

EAT -$35,000 -$35,000 -$35,000 -$35,000 -$35,000

Add back depreciation $50,000 $50,000 $50,000 $50,000 $50,000NET CASH FLOW $0 $15,000 $15,000 $15,000 $15,000 $15,000

NPV = $54,071.64

ALTERNATIVE TWO (NEW): Replace the old machineInitial Investment T=0 T=1 T=2 T=3 T=4 T=5

Initial Cost (New)

Including shipping + installation

-$750,000

Sale of Old Unit $275,000

Tax Saving (Capital Gain) -$7,500

Annual Before Tax Cash Inflow $120,000 $120,000 $120,000 $120,000 $120,000

Annual Depreciation -$150,000 -$150,000 -$150,000 -$150,000 -$150,000

EBIT -$30,000 -$30,000 -$30,000 -$30,000 -$30,000

Tax (30%) $9,000 $9,000 $9,000 $9,000 $9,000

EAT -$21,000 -$21,000 -$21,000 -$21,000 -$21,000

Add Back Depreciation $150,000 $150,000 $150,000 $150,000 $150,000

Net working capital contribution -$40,000 -$10,000 -$10,000 -$10,000 -$10,000

Recovery net working capital $80,000

After Tax Salvage (New Unit)

SV $75,000 Gain 30% tax $52,500

NET CASH FLOW -$522.500 $119,000 $119,000 $119,000 $119,000 $261,500

NPV = -12,673.30

NPV (OLDNEW) = $54,071.65 - - $12,673.30

= $66,744.95

Decision: Do not replace as the new unit fails to generate wealth for shareholders

OR

NPV (NEWOLD) = -$12,673.30 - $54,071.65

= - $66,744.95

Decision: Do not replace as the new unit fails to generate wealth for shareholders