finance

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Capital markets and finance

Author – John Perfrement, Melbourne Polytechnic, T1 2017

General instructions

QUESTION 1

The company LT Ltd is considering the introduction of a new product. Generally, the company’s products have a life of about 5 years, after which they are deleted from the range of products that the company sells. The new product requires the purchase of new equipment costing $400,000. The ATO’s depreciation schedule allows an effective life of 10 years for such equipment and that the company chooses to use the Diminishing Value Method for tax purposes meaning the annual tax depreciation rate would be 50% higher than the rate connected with prime cost depreciation. Assume that at the end of 5 years the equipment can be disposed of easily and will generate proceeds of $157,500.

The new product will be manufactured in a factory already owned by the company. The factory originally cost $150,000 to build and has a current resale value of $350,000, which should remain fairly stable over the next 5 years. This factory is currently being rented to another company under a lease agreement that has 5 years to run and provides for an annual rental of $15,000. Under the lease agreement LT Ltd can cancel the lease by paying the lessee an amount equal to 1 year’s rental payment.

It is expected that the product will involve the company in sales promotion expenditures which will amount to $50,000 during the first year the product is on the market. Additions to net operating working capital will require $22,500 at the commencement of the project and are assumed to be fully recoverable at the end of year 5.The new product is expected to generate net operating cash flows as follows before tax:

Year 1 $200,000

Year 2 $250,000

Year 3 $325,000

Year 4 $300,000

Year 5 $150,000

Required rate of return is 10% and the company tax rate is 30%. Calculate the NPVShow all calculations and ignore the existence of any applicable GST

QUESTION 2

Nutson Bolz is an assembly business run by a sole proprietor whose marginal tax rate is 47%. The owner is considering the purchase of a new fully automated machine to replace an older, manually operated one. The machine being replaced, now five years old, originally had an expected life of ten years, and it was being depreciated using the straight-line method from a cost of $20,000 down to zero, and could be sold for $15,000. The old machine was operated by one operator who earned S15,000 per year in salary and $2,000 per year in fringe benefits. The annual costs of maintenance and defects associated with the old machine were 57,000 and $3,000 respectively.

The replacement machine being considered has a purchase price of $50,000, a salvage value after five years of $10,000, and would be fully depreciated over five years using the straight-line depreciation method. To get the automated machine in running order, there would be a $3,000 shipping fee and a $2,000 installation charge. In addition, because the new machine would work faster than the old one, investment in raw materials and goods-in-process inventories would need to be increased by a total of $5,000. The annual costs of maintenance and defects on the new machine would be $2,000 and $4,000 respectively. The new machine also requires maintenance workers to be specially trained; fortunately, a similar machine was purchased three months ago, and at that time the maintenance workers went through the $5,000 training program needed to familiarize themselves with the new equipment. The firm’s management is uncertain whether to charge half of this $5,000 training fee to the new project. Finally, to purchase the new machine, it appears the firm would have to borrow an additional $20,000 at 10% interest from its local bank, resulting in additional interest payments of $2,000 per year. The required rate of return on projects of this kind is 20%.

Required:

  • What is the project’s initial investment?
  • What are the incremental cash flows over the project’s life in years 1-4?
  • What is the incremental cash flow in terminal year (year 5 cash flow)?
  • What is the NPV?
  • What is the IRR? You may need an Excel spread-sheet to make this calculation.(work in excel)
  • Should the project be accepted (yes/no)? Why/why not?

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