ACC00152 Business Finance Topic 3 Tutorial Answers

1. Widget Pty Ltd is analysing the prospect of purchasing an additional (and very specialised) widget-making machine, the XX1000. The XX1000 costs $150,000 installed and has an effective life of 10 years. The company will use the prime cost depreciation method for tax purposes and management expects it will be able to sell the machine at the end of its effective life for about $20,000. It is estimated that the additional machine will increase annual revenues by $200,000 and operating expenses will be around 80% of revenues. The expansion will require an additional initial investment of $5,000 in its stock of raw materials, which will be recovered at the end of the project. The company's tax rate is 30% and the required return is 12%.
Prepare a schedule of the relevant cash flows generated by the new machine, calculate the NPV, and advise management as to whether they should invest the new machine.

Depreciation: For an effective life of 10 years, the prime cost depreciation rate is 10%. Therefore: 150000 x 10% = $15000 depreciation expense per year.

| Year 0 | Years 1-9 | Year 10 | Revenue | | $200 000 | $200 000 | Operating costs (200 000 x 80%) | | (160 000) | (160 000) | Depreciation | | (15 000) | (15 000) | Gain on sale of equipment* | | | 20 000 | EBIT | | 25 000 | 45 000 | Tax | | (7 500) | (13 500) | Incremental earnings | | 17 500 | 31 500 | Add back depreciation | | 15 000 | 15 000 | Subtract gain on sale of equipment | | | (20 000) | Salvage price cash flow | | | 20 000 | Cash flows due to working capital | (5 000) | 0 | 5 000 | Investment outlays – Long-term assets | ($150 000) | | | Net cash flow | ($155 000) | $32 500 | $51 500 |

*Book value is $0, so gain on sale is the full salvage value of $20,000.

NPV:
Manual:
NPV = PV of 9 year annuity