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Problem Set

Question 1

MultiAlpha is considering replacing an old machine with a new one. Two months ago their chief

engineer completed a training workshop on the new machines operation and efficiency. The cost of

RM4000 cost for this workshop session has already been paid. If the new machine is purchased, it

would require RM5000 in installation and modification costs to make it suitable for operation in the

factory.

The old machine originally cost RM90000 five years ago and is being depreciated by RM15000 per year.

The new machine will cost RM80000 before installation and modification. It will be depreciated by

RM5000 per year. The old machine can be sold today for RM10000. The marginal tax rate for the firm

is 28%.

Y0 RM

Price of Equipment 80000

ADD:

Cost of Training 0 Sunk costs

Shipping costs 0

Modification costs 0

Installation 5000

Initial Outlay 85000

Less:

Cash Inflow Upon Sale of (10000)

Existing Machine

Tax Saving on Disposal of (1400)

Existing Machine

Net Cash Flow for 73600

Investment

Sale of Existing Machine RM Of Existing Machine

Cost Of Equipment 90000

Less: Accumulated Depreciation

RM15000 x 5 years (75000)

Book Value 15000

Disposal Price 10000 10000

Loss on Disposal 5000

Tax Saving 28% 1400 1400

1

Question 2

Canggih Sdn. Bhd. is considering a new product. The company currently manufactures several lines of

school uniform. The new product, Canggih Jean, is expected to generate sales of RM1.0 million per year

for the next 5 years. They expected that during this five-year period, they will lose about RM250000 in

sales of existing line of jean. The new line will require no additional equipment or space in the plant

and can be produced in the same manner as the apparel products. The new project will, however,

require that the company spend an additional RM80000 per year on insurance for raw materials. Also

an additional marketing manager would be hired to oversee the line at a salary of RM45000 per year in

salary and benefits, in additional to the current manager who is earning RM60000 per year in salary and

benefits. Depreciation of RM100000 of existing plant and machinery is expected to remain the same.

If the marginal tax rate is 28%, compute the incremental after tax cash flow for

years 1-5.

Revenue 1000000 1000000 1000000 1000000 1000000

Operating Expenses:

Additional Insurance (80000) (80000) (80000) (80000) (80000)

New Marketing Manager (45000) (45000) (45000) (45000) (45000)

Lost in Current Sale (250000) (250000) (250000) (250000) (250000)

(Opportunity Costs)

Depreciation - - - - -

(non-relevant costs)

Net Profit Before Tax 625000 625000 625000 625000 625000

(Tax Payable) / Tax Saving 28% (175000) (175000) (175000) (175000) (175000)

Profit After Tax 450000 450000 450000 450000 450000

Add: Depreciation - - - - -

Net Cash Flow 450000 450000 450000 450000 450000

2

Question 3

You have been asked by the president of your company to evaluate the proposed acquisition of new

equipment. The equipments basic price is RM193,000, and shipping costs will be RM7,700. It will cost

another RM23,200 to modify it for special use by your firm and an additional RM13,500 to install the

equipment. The equipment falls in the MACRS 3-year class, and it will be sold after 3 years for

RM30900. The equipment is expected to generate revenue of RM178,000 per year with annual

operating costs (excluding depreciation) of RM84,000. The firms tax rate is 28% and its cost of capital

is 10%..

What is the firms initial investment of the machine and what is the operating cash flow forom Year 1 -

3? Should the company invest in this new equipment?

Note: Under the MACRS 3-year class, depreciation is 33% in first year, 45% in second year, 15% in third

year and 7% in fourth year.

Y0 RM

Price of Equipment 193000

ADD:

Shipping costs 7700

Modification costs 23200

Installation 13500

Initial Outlay 237400

Revenue 178000 178000 178000

Operating Expenses (84000) (84000) (84000)

Depreciation (78342) (106830) (35610)

Net Profit Before Tax 15658 (12830) 58390

(Tax Payable) / Tax Saving 28% (4384.24) 3592.40 (16349.20)

Profit After Tax 11273.76 (9237.60) 42040.80

Add: Depreciation 78342 106830 35610

Cash Inflow 89615.76 97592.40 77650.80

PV Factor, Lump Sum, 10% 0.9091 0.8264 0.7513

PV of Inflow 81469.69 80650.36 58339.05 220459.0

9

RM Y3

Cost Of Equipment 237400

Less: Accumulated Depreciation (220782)

Book Value 16618

Disposal Price (30900) 30900

Gain on Disposal 14282

Tax on Gain 28% (4000) (4000)

Net Gain 10282

Terminal Year Cash Inflow 26900

PV Factor, Lump Sum, 10% 0.7513

Present Value 20201

Initial Outlay (237400)

Present Value of Future Cash Inflows 220459.09

Present Value Terminal Cash Flow Y3 20201

NPV 3260.09

Decision invest in the new equipment since the NPV is

positive.

3

Question 4

A machine was purchases 10 years ago at a cost of RM15000. The expected life of the machine was 15

years. Its salvage value was and is still zero. The machine is depreciated using the straight-line basis.

A new machine can be purchased for RM24000, which will result in cost savings for the firm of RM6000

per annum over the 5 year useful life. The new machine can be sold for RM4000 in 5 years time. The

old machines market value is RM2000, which is below its RM5000 book value. If the new machine is

purchased, the existing one will be sold immediately. The tax rate is 28%. Net working capital

requirements will increase by RM2000 at the time of replacement. The new machine falls into the 3-

year MACRS class (Depreciation in Year 1 33%; Year 2 45%; Year 3 15%; and, Year 4 - 7% on costs).

The cost of capital is 12%.

Y0 RM

Price of Equipment 24000

ADD:

Cost of Training -

Shipping costs -

Modification costs -

Installation -

Cost of Equipment 24000

Less:

Cash Inflow Upon Sale of (2000)

Existing Machine

Tax Saving on Disposal of (840)

Existing Machine

Net Cash Flow for 21160

Investment

Increase in Working 2000

Capital Requirement

Total Net Investment 23160

Sale of Existing Machine RM Of Existing Machine

Cost Of Equipment 15000

Less: Accumulated Depreciation

(RM15000/5years) x 10 years (10000)

Book Value 5000

Disposal Price 2000 2000

Loss on Disposal (3000)

Tax Saving 28% 840 840

Revenue (a) 6000 6000 6000 6000 6000

Operating Expenses: - - - - -

Saving on Depreciation of 1000 1000 1000 1000 1000

Existing Machine

Depreciation of New Machine (7920) (10800) (3600) (1680) nil

Cost RM24000:

(Net Increase) / Net Saving in (6920) (9800) (2600) (680) 1000

Depreciation Expenses (b)

(a) + (b)

(Tax Payable) / Tax Saving 257.60 1064 (952) (1489.60) (1960)

4

28%

Profit After Tax (662.40) (2736) 2448 3830.40 5040

Add: Depreciation 6920 9800 3600 1680 (1000)

Net Cash Flow 6257.60 7064 6048 5510.40 4040

PV Factor Due, 12%, 0.8929 0.7972 0.7118 0.6355 0.5674

PV of Future Cash Inflow 5587.41 5631.42 4304.97 3501.86 2292.30

Present Value of Future 21317.95

Cash Inflows

RM Y5

Cost Of Equipment 24000

Less: Accumulated Depreciation (24000)

Book Value nil

Disposal Price 4000 4000

Gain on Disposal 4000

Tax on Gain 28% (1120) (1120)

Net Gain 2880

Terminal Year Cash Inflow 2800

PV Factor, Lump Sum, 12% 0.5674

Present Value 1634.11

PV Factor, Lump Sum, 12% 0.5674

Present Value 1134.80

Initial Outlay (23160)

Present Value of Future Cash Inflows 21317.95

Present Value Terminal Cash Flow Y5 1634.11

Present Value of Return in Working Capital 1134.80

NPV 926.86

Decision invest in the new equipment since the NPV is POSITIVE.

Question 5

5

Bina Mahjaya Sdn. Bhd. is a medium-sized manufacturing company that plans to increase capacity by

purchasing new machinery at an initial cost of RM3m. The following are the most recent financial

statements of the company:

2002 2001

RM000 RM000

Production Costs 3,100 3,000

Gross Profit 1,900 2,000

Administration and Distribution Expenses 400 250

Profit before Interest and Tax 1,500 1,750

Interest 400 380

Profit before Tax 1,100 1,370

Tax 330 400

Profit after Tax 770 970

Dividends 390 390

Retained Earnings 380 580

The investment is expected to increase annual sales by 5,500 units. Investment in replacement

machinery would be needed after five years. Financial data on the additional units to be sold is as

follows:

RM

Selling price per unit 500

Production costs per unit 200

Variable administration and distribution expenses are expected to increase by RM220,000 per year as a

result of the increase in capacity. In addition to the initial investment in new machinery, RM400,000

would need to be invested in working capital. The investment on working capital is released at the end

of year 5. The full amount of the initial investment in new machinery of RM3 million will give rise to

capital allowances on a 25% per year reducing balance basis. The tax benefit is as follows:

Year 1 2 3 4 5

RM000 RM000 RM000 RM000 RM000

Capital Allowance 750 563 422 316 949

Tax Benefits (Saving) 225 169 127 95 284

The scrap value of the machinery after five years is expected to be negligible.

Tax liabilities are paid in the year in which they arise and Bina Mahjaya Sdn. Bhd. pays tax at 30% of

annual profits.

The Finance Director of Bina Mahjaya Sdn. Bhd. has proposed that the RM34 million investment should

be financed by an issue of debentures at a fixed rate of 8% per year.

Bina Mahjaya Sdn. Bhd. uses an after tax discount rate of 12% to evaluate investment proposals. In

preparing its financial statements, Bina Mahjaya Sdn. Bhd. uses straight-line depreciation over the

expected life of fixed assets.

6

Required:

Calculate the net present value of the proposed investment in increased capacity of Bina

Mahjaya Sdn. Bhd. , clearly stating any assumptions that you make in your calculations.

Year 1 2 3 4 5

RM000 RM000 RM000 RM000 RM000

Capital allowance 750 563 422 316 949

Tax benefits 225 169 127 95 284

Year 0 1 2 3 4 5

RM000 RM000 RM000 RM000 RM000 RM000

Sales 2,750 2,750 2,750 2,750 2,750

Production costs (1,100) (1,100) (1,100) (1,100)

(1,100)

Admin expenses (220) (220) (220) (220) (220)

Net revenue 1,430 1,430 1,430 1,430 1,430

Tax payable (429) (429) (429) (429) (429)

Tax benefits 225 169 127 95 284

1,226 1,170 1,128 1,096 1,285

Working capital (400) 400*

Investment (3,000)

Project cash flows (3,400) 1,226 1,170 1,128 1,096 1,685

Discount factors 1000 0893 0797 0712 0636

0567

Present values (3,400) 1,095 9325 803 697

9555*

7

Question 6

You buy a transporter for $50 million. It will cost another $5 million to install. You will depreciate it over

10 years, (10% each year). You expect to make $15 million each year in revenues. Operating costs will

be $2 million each year. Increase in working capital is expected to be $30 million which will be reversed

at the end of 10 years when you get out of the transporting business. At the end of 10 years, the

transporter will be salvaged for $10 million. You are in the 30% tax bracket.

4. What is your terminal cash flow at the end of year 10? Do not include the operating cash flow.

( 4 marks)

Soln:

1. 50 + 5 + 30.= $85 milliom

2. Operating income $15 $2 = $13 depreciation (10% of 55 = 5.5) = $7.5 million before tax.

$7.5(1-.3) = $5.25 million after tax.

4. Sell for $10 million, book value is zero at this time so you have a gain of $10 million minus $3 million

in taxes for $7 million. Add back working capital of $30 million (no longer will need it so working capital

is now reduced by $30 million) so terminal cash flow is $37 million.

i

. Blair Bookstores is thinking about expanding its facilities. In considering the expansion, Blairs finance

staff has obtained the following information:

$5 million of equipment. The equipment will be depreciated over the following four years at the

following rate:

Year 1: 33%

Year 2: 45 Stock increase by $400000, Acc

Year 3: 15 receivables increase by $200000 and

Year 4: 7 payables by $100000

The expansion will require the company to increase its net operating working capital by

$500,000 today (t = 0). This net operating working capital will be recovered at the end of four

years (t = 4).

The equipment is not expected to have any salvage value at the end of four years.

The companys operating costs, excluding depreciation, are expected to be 60 percent of the

companys annual sales.

The expansion will increase the companys dollar sales. The projected increases, all relative to

current sales are:

Year 2: 3.5 million Year1 0.5m 3.5m

Year 3: 4.5 million Year2 0.8m 4.3m

Year 4: 4.0 million Year3 1.0m 5.5m

Year4 1.2m 5.2m

8

(For example, in Year 4 sales will be $4 million more than they would have been had the project

not been undertaken.) After the fourth year, the equipment will be obsolete, and will no longer

provide any additional incremental sales.

The companys tax rate is 40 percent and the companys other divisions are expected to have

positive tax liabilities throughout the projects life.

If the company proceeds with the expansion, it will need to use a building that the company

already owns. The building is fully depreciated; however, the building is currently leased out. The

company receives $300,000 before-tax rental income each year (payable at year end). If the

company proceeds with the expansion, the company will no longer receive this rental income.

The projects WACC is 10 percent.

a. -$1,034,876

b. -$1,248,378

c. -$1,589,885

d. -$5,410,523

e. -$ 748,378

9

i. New project NPV Answer: b Diff: T

MACRS

Depreciation Annual

Year Rates Depreciation

1 0.33 $1,650,000

2 0.45 2,250,000

3 0.15 750,000

4 0.07 350,000

01234Cost($5,000,000)Net operating working capital

(500,000)Sales$3,000,000$3,500,000$4,500,000$4,000,000Operating costs, excl. depr. (60%) 1,800,000 2,100,000

2,700,000 2,400,000Depreciation 1,650,000 2,250,000 750,000 350,000Operating income before taxes($ 450,000)($

850,000)$1,050,000$1,250,000Taxes (40%) (180,000) (340,000) 420,000 500,000After-tax operating income($

270,000)($ 510,000)$ 630,000$ 750,000Plus: Depreciation 1,650,000 2,250,000 750,000 350,000After-tax operating

cash flows$1,380,000$1,740,000$1,380,000$1,100,000After-tax loss of rental income (180,000)(180,000)(180,000)

(180,000)Recovery of net operating working capital$ 500,000

Net cash flow($5,500,000)$1,200,000$1,560,000$1,200,000$1,420,000

Enter the NCF amounts into the cash flow register (at 10%) and obtain the NPV

of the cash flows is -$1,248,378.

(10 MARKS )

Question 8

LitrakNPC Sdn. Bhd. is considering an investment proposal that requires initial investments of RM250000 in

plant and machinery. Fully depreciate existing equipment may be disposed off for RM40000 before tax. The

proposed project will have a five-year life, and is expected to produce additional revenue of RM80000 per

year. Expenses other than depreciation will be RM15000 per year. The new plant and machinery will be

depreciated to zero over the five year useful life, but it is expected to be sold for RM30000. The corporation

tax rate is 28%.

Cash inflow from disposal of existing asset = RM40000 (1-28%) = (RM28800) 1

Net Initial Outlay = RM221200

(50000) - 1PBT15000Tax 28%(4200) PAT10800Add: depreciation50000 Cash inflow60800

3. What is the total cash flow at the end of year five (operating cash flow for year five plus terminal cash

flow)? (2 marks)

Cash inflow Year 5Amount (RM)Cash inflow60800 Disposal of AssetBook Value0Sold30000Gain 30000

Tax 28%8400 Cash inflow30000 - 840021600 Gross Inflow82400

4. What is the NPV for this project (cost of capital is 8%) (3 marks)

ItemPV 8% 5 yrs PVCash Inflow Year 1- 460800 per year60800 x 3.3121 - 1201375.68Terminal Cash

inflow YR58240082400 x 0.6806 - 156081.44257457.12Initial Outflow(221200) 1NPV36257.12

Question 9

Given the following information, calculate the NPV of a proposed project: Cost = $4,000; estimated life = 3

years; initial decrease in accounts receivable = $1,000, which must be restored at the end of the projects

life; estimated salvage value = $1,000; earnings before taxes and depreciation = $2,000 per year; tax rate =

40 percent; and cost of capital = 18 percent. The applicable depreciation rates are 33 percent, 45 percent,

15 percent, and 7 percent.

a. $1,137

b. -$ 151

c. $ 137

d. $ 544

Question 10: Relevant Cash Flows and Calculation of NPV and Payback Period. (14 marks)

a. The management of SevenDragon Restaurant has been experiencing losses in the most recent months and

is considering converting the operations to drive-in fast food takeaways.

The fitting-out of the premise will cost RM40,000, and the equipment will have a life of ten years with disposal

value of RM1000. However, RM8,000 overhaul is necessary at the end of the fifth (5 th) year.

Currently the restaurant incurred RM30,000 per annum to operate and did breakeven in this past year. The new

service will save RM10,000 of these costs.

Projected sales are 1,000 units per week, for full 52 weeks per year except in year 5 when the overhaul will force

a 4-weeks shutdown. Each unit will provide a contribution of RM0.20.

Ignore Tax

REQUIRED:

i. The annual cash inflows (and outflows) expected from the new project over the life of the asset..

ii. The Net Present Value of the operations if management is expecting a 20% rate of return.

(Ignore taxes)

(10 marks)

b. Calculate the Payback Period using the above example. (4 marks)

Solutions:

a.i.

Yr0Yr1Yr2Yr3Yr4Yr5Yr6Yr7Yr8Yr9Yr10Initial

Investment(40000)/Saving10000//100001000010000100001000010000100001000010000Sales

1000 x 0.20 x 52 weeks

1000 x 0.20 x 48 weeks10400//104001040010400

Inflow(40000)2040020400204002040016002040020400204002040021400Discount Factor 20% /

0.83330.69440.57870.48230.40190.33490.27910.23260.19380.1615PV of inflows /82161(40000)NPV42161/

(10 marks)

Payback

20400 20400

(4 marks)

Question 11

DIGITAL TWO plc, a software company, has developed a new game, Narugo, which it plans to launch in the

near future. Sales of the new game are expected to be very strong, following a favourable review by a popular

PC magazine. DIGITAL TWO plc has been informed that the review will give the game a Best Buy

recommendation. Sales volumes, production volumes and selling prices for Narugo over its four-year life are

expected to be as follows.

Year 1 2 3 4

Sales and production (units) 150,000 70,000 60,000 60,000

Selling price (RM per game) RM25 RM24 RM23 RM22

Direct material cost RM540 per game

Other variable production cost RM600 per game

Fixed costs RM600,000 per year

Advertising costs to stimulate demand are expected to be RM650,000 in the first year of production and

RM100,000 in the second year of production. No advertising costs are expected in the third and fourth years of

production. Narugo will be produced on a new production machine costing RM800,000. Although this

production machine is expected to have a useful life of up to ten years, government legislation allows DIGITAL

TWO plc to claim the capital cost of the machine against the manufacture of a single product. Capital allowances

will therefore be claimed on a straight-line basis over four years.

DIGITAL TWO plc pays tax on profit at a rate of 30% per year and tax liabilities are settled in the year in which

they arise. DIGITAL TWO plc uses an after-tax discount rate of 10% when appraising new capital investments.

Ignore inflation.

Required:

(a) Calculate the net present value of the proposed investment and comment on your findings. (14marks)

(324) (324) Variable production(900) (420) (360) (360) Advertising(650) (100) Fixed costs(600)

(600)(600)(600)Depreciation(200) (200) (200) (200) EBT590(18)(104)(164)Tax 30%(177)

5.431.249.2EAT413(12.6)(72.8)(114.8)+Depreciation200200200200Net cash

flow613187.4127.285.2Discount 10%0.9090.8260.7510.683PV557.2154.895.5358.2PV865.74Initial

Investment800NPV65.74

(b) Operating cash flows rather than operating profit formed the basis for capital budgeting decisions.

Briefly explain THREE (3) types of costs that need to be considered in determining incremental cash

flows. (3 marks)

Sunk Costs

Opportunity Externalities.

(c) Lists THREE reasons why the net present value investment appraisal method is preferred to other

investment appraisal methods such as payback, return on capital employed and internal rate of return.

(3 marks)

Any Three

NPV considers cash flows

NPV considers the whole of an investment project

NPV considers the time value of money

NPV is an absolute measure of return

NPV links directly to the objective of maximising shareholders wealth

Question 12

LBD Bina Sdn. Bhd., a manufacturer of electronic equipment, has prepared the following draft financial

statements for the year ended 2006. These financial statements have not yet been made public.

Turnover 9,600

Cost of sales 5,568

Gross profit 4,032

Operating expenses 3,408

Profit before interest and tax 624

Interest 156

Profit before tax 468

Taxation 140

Profit after tax 328

Dividends 300

Retained profit 28

Balance Sheet RM000

Capital and reserves:

Ordinary shares, par value 50cents 1,000

Profit and loss 3,100

4,100

LBD Bina Sdn. Bhd. plans to invest RM1 million in a new product range and has forecast the following financial

information:

Year 1 2 3 4

Sales volume (units) 70,000 90,000 100,000 75,000

Average selling price (RM/unit) 40 45 51 51

Average variable costs (RM/unit) 30 28 27 27

Fixed costs (RM/year) 500,000 500,000 500,000 500,000

The above cost forecasts have been prepared on the basis of current prices and no account has been taken of

depreciation, inflation of 4% per year on variable costs and 3% per year on fixed costs.

Working capital investment accounts for RM200,000 of the proposed RM1 million investment and machinery for

RM800,000. LBD Bina uses a four-year evaluation period for capital investment purposes, but expects the new

product range to continue to sell for several years after the end of

this period. Capital investments are expected to pay back within two years on an undiscounted basis, and within

three years on a discounted basis. The company pays tax on profits in the year in which liabilities arise at an

annual rate of 26% and depreciation on machinery on a 25% per year basis.

The ordinary shareholders of LBD Bina Sdn. Bhd. require an annual return of 12%. Its ordinary shares are

currently trading on the stock market at RM180 per share. The dividend paid by the company has increased at a

constant rate of 5% per year in recent years and, in the absence of further investment, the directors expect this

dividend growth rate to continue for the foreseeable future.

Required:

(a) (i) Calculate the current dividend per share of LBD Bina Sdn. Bhd. (2 marks)

(ii) Calculate the ordinary share price of LBD Bina Sdn. Bhd. predicted by the dividend growth model. (4

marks)

Current dividend per share = 100 x (300,000/2,000,000) = 15p

(ii) Share price predicted by dividend growth model = (15 x 105)/(012 005) = 225p

(b) (i) Using LBD Bina Sdn. Bhd.s current average cost of capital of 10%, calculate the net present value

of the proposed investment. (14 marks)

Exhibit 1

Present Value Present Value of an Annuity

of RM1 at the End of n Periods: of RM1 per Period for n Periods:

1 0.9091 0.9091

2 0.8264 1.7355

3 0.7513 2.4869

4 0.6830 3.1699

5 0.6209 3.7908

Total: 20 Marks

Year 1 2 3 4

RM000 RM000 RM000 RM000

Sales revenue 2,800 4,050 5,100 3,825

Variable costs 2,184 2,722 3,024 2,349

Contribution 616 1,328 2,076 1,476

Fixed costs 515 530 546 563

Depreciation 200 200 200 200

Taxable cash flow -99 598 1,330 713

Taxation - 26% 26 -156 -346 -185

-73 442 984 528

Depreciation 200 200 200 200

After-tax cash flow 127 642 1,184 728

11% discount factors 09091 08264 07513 06830

Present values 116 531 890 497

RM000

Sum of present values of future benefits 2,034

Less initial investment 1,000

Net present value 1034

Because the investment continues in operation after the four-year period, working capital is not recovered in

the above calculation. It is possible to make an assumption concerning incremental investment in working

capital to accommodate inflation, but no specific inflation rate for working capital is provided. An assumption

of 34% inflation in working capital would be reasonable given the expected inflation in variable and fixed

costs.

(ii) Calculate, to the nearest month, the payback period and the discounted payback period of the

proposed investment. (4 marks)

1184

890

(iii) Discuss the acceptability of the proposed investment based on the calculation made in b(i) and b(ii)

and explain ways in which your net present value calculation could be improved.

(iii) The proposed investment has a positive net present value of RM833,000 over four years of operation

compared with an initial investment of RM1 million and so is financially acceptable. The company has

payback and discounted payback targets, but these are not a guide to project acceptability because of the

shortcomings of payback as an investment appraisal method. The proposed investment fails to meet the

payback target of two years, but meets the discounted payback target of three years. While discounted

payback counters the criticism that payback ignores the time value of money, it still ignores cash flows

outside of the discounted payback period and so cannot be recommended to evaluate

other than conventional investments.

The net present value calculation could be improved in several ways. One obvious improvement would be the

consideration of project cash flows beyond the four-year evaluation period used by Hendil plc. The company

expects the new product range to sell for several years after the end of the evaluation period and if these

sales are at a profit, the net present value would be higher than calculated. Another improvement would be

more detailed information about the new product range, for which only average selling price and average

variable cost data are provided. The basis for these averages is not stated and it is not known whether the

products in the new range are substitutes or alternatives, or whether a constant product mix is being

assumed. The basis for the changing annual sales volumes should also be explained.

The assumption of constant annual inflation for variable and fixed costs is questionable. The information

provided implies that inflation may have been taken into account in forecasting selling prices, but the selling

price growth rates are sequentially 125%, 133% and zero, and so some factor other than inflation has also

been used in the selling price forecast. The net present value evaluation could be improved if the basis for

the forecast was known and could be verified as reasonable.

Question 13

You have been asked by the president of your company to evaluate the proposed acquisition of new equipment.

The equipments basic price is RM193000, and shipping costs will be RM7700. It will cost another RM23200 to

modify it for special use by your firm and an additional RM13500 to install the equipment. The equipment falls in

the MACRS 3-year class, and it will be sold after 3 years for RM30900. The equipment is expected to generate

revenue of RM178000 per year with annual operating costs (excluding depreciation) of RM84000. The firms tax

rate is 28% and its cost of capital is 10%..

REQUIRED:

ii. What is the operating cash flow form Year 1 - 3?

iii. Should the company invest in this new equipment?

Note: Under the MACRS 3-year class, depreciation is 33% in first year, 45% in second year, 15% in third year

and 7% in fourth year.

costs23200Installation13500Initial Outlay237400

(84000)Depreciation(78342)(106830)(35610)Net Profit Before Tax15658(12830)58390(Tax Payable) / Tax

Saving 28%(4384.24)3592.40(16349.20)Profit After Tax11273.76(9237.60)42040.80Add:

Depreciation7834210683035610Cash Inflow89615.7697592.4077650.80PV Factor, Lump Sum,

10%0.90910.82640.7513PV of Inflow81469.6980650.3658339.05220459.09

Value16618Disposal Price(30900)30900Gain on Disposal14282Tax on Gain 28%(4000)(4000)Net

Gain10282Terminal Year Cash Inflow26900PV Factor, Lump Sum, 10%0.7513Present Value20201

Value Terminal Cash Flow Y320201NPV3260.09Decision invest in the new equipment since the NPV is

positive.

Question 14

3. Cash Estimation

(a) Rupab Sdn. Bhd has in issue five million shares with a market value of $381 per share. The equity beta of

the company is 12. The yield on short-term government debt is 45% per year and the equity risk premium is

approximately 5% per year.

The debt finance of Rupab Sdn. Bhd consists of bonds with a total book value of $2 million. These bonds pay

annual interest before tax of 7%. The par value and market value of each bond is $100.

Rupab Sdn. Bhd pays taxation one year in arrears at an annual rate of 25%. Capital allowances (tax-allowable

depreciation) on machinery are on a straight-line basis over the life of the asset.

REQUIRED: Calculate the after-tax weighted average cost of capital of RupabSdn Bhd. (6 marks)

Cost of Equity : ke= krf + (km-krf )

Cost of equity = 45 + (12 x 5) = 105%

The companys bonds are trading at par and therefore the before-tax cost of debt is the same as the interest rate

on the bonds, which is 7%.

After-tax cost of debt = kd (1 T)

After-tax cost of debt = 7 x (1 025) = 525%

Market value of debt is equal to its par value of $2 million

Sum of market values of equity and debt = 1905 + 2 = $2105 million

WACC = weke + wdkd (1 T)

(b) Ruparb Sdn. Bhd is now considering a project where they would open a new facility in Johor Bharu. The

companys CFO has assembled the following information regarding the proposed project:

It would costs RM500,000 today (t=0) to construct the new facility. The cost of the facility will be

depreciated on a straight-line basis over five years.

If the company open the facility, it would need to increase its inventory by RM100,000 at t=0. RM70,000

of this inventory will be financed by account payable.

The CFO has estimated that the project will generate the following amount of revenue over the next 3

years:

Year 1 Revenue = RM1.0 million

Year 2 Revenue = RM1.2 million

Year 3 Revenue = RM1.5 million

Operating costs excluding depreciation equal to 70 percent of revenue.

The company plans to abandon the facility after three (3) years. At terminal year, the projects estimated

salvage value will be RM200,000.At the same time, the company will also recover the net operating

working capital investment that it made at t=0.

The company tax rate is 27 percent.

The project cost of capital is as per calculated in 3(a) above.

NPV = -530000 + 902699.3 = 372699.3

0

1

2

3Cost of Equipment-500000NOWC

(10000-70000)-30000sales100000012000001500000Operating Costs(70%)-700000-840000-

1050000Depreciation

(500000 / 5 yrs)-100000-100000-100000Income Before Tax200000260000350000Tax 27%-54000-70200-

94500Income AfterTax146000189800255500Add: depreciation100000100000100000Operating Cash

Flows246000289800355500Salvage Value (no gain no loss)200000Recovery of NOWC30000Operating

Cash Flows-530000246000289800585500PVIF 10%0.9090.8260.751PV Cash Flows-

530000223614239274.8439710.5902699.30

Question 15

Roslan Rose, CFA, is a financial analyst with Langkawi Marina Sdn. Bhd. a manufacturer of sailboats and

sailing equipment. Roslan is evaluating a proposal for Langkawi Marina to build sailboats for a foreign competitor

that lacks production capacity and sells in a different market. The sailboat project is perceived to have the same

risk as Langkawi Marinas other projects.

The proposal covers a limited time horizonthree yearsafter which the competitor expects to be situated in a

new, larger production facility. The limited time horizon appeals to Langkawi Marina, which currently has excess

capacity but expects to begin its own product expansion in slightly more than three years.

Roslan has collected much of the information necessary to evaluate this proposal in Exhibits 1 and 2.

(RM millions)Initial fixed capital outlay60Annual contracted revenues 60Annual operating costs 25Initial working

capital outlay (recovered at end of the project) 10Annual depreciation expense (both book and tax accounting)

20Economic life of facility (years) 3Salvage (book) value of facility at end of project 0Expected market value of

facility at end of project 5

Exhibit 2 : Selected Data for Langkawi Marina

28.6%Book value of equity/total assets 71.4%Market value of long-term debt/market value of company

23.1%Market value of equity/market value of company 76.9%Coupon rate on existing long-term debt

8.5%Interest rate on new long-term debt 8.0%Cost of equity 12.74%Marginal tax rate 35.0%Maximum

acceptable payback period 2 years

Roslan recognizes that Langkawi Marina is currently financed at its target capital structure and expects that the

capital structure will be maintained if the sailboat project is undertaken.

REQUIRED:

a. Determine the weighted cost of capital for Langkawi Marina (to the closest of),

b. Determine the projects net present value?

(The project cost of capital is as per calculated in (a) above.)

[Total 10 Marks]

= 0.231(8%)(1-0.35) + 0.769(12.74%)

= 1.20 + 9.8

= 11.00 //

b.

Year 0Year 1Year 2Year 3Initial Capital Outlay(60,000) /Initial WC(10,000) /Revenue60,000 /

60,00060,000Less:Operating costs(25,000) /(25,000)(25,000)Depreciation(20,000) /(20,000)

(20,000)EBT15,00015,00015,000Tax 35%(5250) /(5250)(5250)EAT9,7509,7509,750Add:

depreciation20,000 /20,00020,00029,75029,75029,750Recovery WC10,000 /Salvage Value5,000 /Less: tax

on Salvage Value(1750) /Cashflows(70,000)29,75029,75043,000PVIF, 11% /0.9009 0.81160.7312PV

Cash(70,000)26,80224,14531,442NPV(70000)+26802+24145+31442= 12389 /

Question 16

Harris SCIB Sdn. Bhd. is evaluating the proposed acquisition of a new milling machine. The

machines base price is RM108,000, and it would cost another RM12,500 to modify it for special use

by the firm. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for

RM65,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would

require an increase in net operating working capital (inventory) of RM5,500. The milling machine

would have no effect on revenues, but it is expected to save the firm RM44,000 per year in before-tax

and depreciation. Harriss marginal tax rate is 35%. The cost of capital for this project is 12%.

REQUIRED:

Year 0 1 2 3

Investment outlays

Machine RM(108,000) /

Modifications RM(12,500) /

Increase in WC RM(5,500) /

Operating Cash Flows

Total Costs RM44,000.00 / RM44,000.00 RM44,000.00

Depreciation [RM39,765.00] / [RM54,225.00] /

[RM18,075.00]/

EBIT RM4,235.00 RM(10,225.00) RM25,925.00

Taxes - 35% [RM1,482.25] / RM3,578.75 [RM9,073.75]

NOPAT RM2,752.75 RM(6,646.25) RM16,851.25

Depreciation RM39,765.00 / RM54,225.00 RM18,075.00

Operating Cash Flows RM42,517.75 RM47,578.75 RM34,926.25

Terminal Cash Flows

Return of WC RM5,500.00/

Net Salvage Value RM45,202.25/

Net Cash Flows RM(126,000.00) RM42,517.75 RM47,578.75

RM85,628.50

PVIF 12% 0.8929 / 0.7972 0.7118

PV Cash Inflow 37964.10 7929.78

60950.37

Initial Investment [126,000] /

NPV +10844.24

/ 12 @0.5 = 6 marks

Cash Flow

Net Salvage Value: Cost 120500

Acc Depr 93% [112065]

Book Value 8435

Sold 65000 65000

Gain 56565

Tax on gain 35% [19797.75] 19797.75

45202.25

b. i. Harris SCIB uses debt in its capital structure, so some of the money used to

finance the project will be debt. Given this fact, should the projected cash flows

be revised to show projected interest charges? Explain.

[1 mark]

No. The cost of capital already reflects the returns required by all investors in the

firm, including the bondholders. If we subtracted interest charges from revenues,

we

would essentially be counting the cost of debt twice.

ii. Suppose you learned that Harris SCIB had spent RM50,000 to renovate the

building last year, expensing these costs. Should this cost be reflected in the

analysis? Explain.

[1 mark]

No. The renovation expenses are a sunk cost and should not have any impact on

the decision to invest today.

iii. Now suppose you learn that Harris SCIB could lease its building to another party

and earn RM25,000 per year. Should that fact be reflected in the analysis? If so,

how?

[1 mark]

could be obtained from leasing the building should be considered as a real cost.

[Total 10 marks]

[a] The president of Fly Asia Airlines has asked you to evaluate the proposed acquisition of a new

airplane. The aircraft price is RM40,000 and it is classified in the 3-year MACRS class. The

purchase of the plane would require an increase in net working capital of RM2,000. The airplane

would increase the firm's before-tax revenues by RM20,000 per year, but would also increase

operating costs(excluding depreciation) by RM5,000 per year. The airplane is expected to be used

for 3 years and then sold for RM25,000. The firm's marginal tax rate is 40% and the project's cost

of capital is 12%. Use the following MACRS rates for 3-year property: 33%; 45%; 15%; 7%

[7 marks]

[5000]Depreciation MACRS[13200] /[18000]/[6000]/PBT1800-30009000Tax 40%[720] /

1200 /[3600]PAT1080-18005400ADD: Depreciation13200 /

180006000142801620011400Reversal NWC2000 /Disposal25000 /Tax on Gain[8880]/Cash

Inflow142801620029520PVIF 12%0.8929 /0.79720.7118PV Cash

Inflow12750.6112914.6421012.34Costs40000Acc. Depr[37200]PV Cash

inflows46677.86/Book Value2800Cash Outflow[42000]/Sold25000NPV4677.86Gain22200Tax

40%8880/ 14 items @ 0.50 = 7

[b] A firm plans to expand into a new product line. In preparation, it has spent RM275,000 in

unrecoverable planning and systems work and another RM225,000 on land and

improvements, which could be sold now for RM200,000. The future cash flows of the

division were originally estimated to have a present value of RM580,000, well worth the

original RM500,000 investment. Now, with new information, it estimates that an additional

RM150,000 must be spent and the project will be delayed six months. Estimates of returns

once the new product line is available have not changed.

Should the company continue the project? What costs and returns would you compare

and what considerations would you include?

[3 marks]

Solution:

RM500,000 are spent and cannot be recovered: RM275,000 + RM225,000 these

costs are SUNK COST / which are not relevant for the NPV analysis.

The relevant costs/ are the RM150,000 of new spending and the RM200,000 of recoverable

value on land and improvements(opportunity costs of not proceeding with the project),/

for a total of RM350,000. This is considerably less than the RM580,000 in estimated revenue,

so the project should be completed.

[Total 10 marks]

introducing a new detergent. The company's Chief Financial Officer has collected the

following information about the proposed product.

The project has an anticipated economic life of 4 years.

The company will have to purchase a new machine to produce the detergent. The machine has an

up-front cost of RM2.0 million. The machine is in the 4-year MACRS class (33%; 45%; 15%; 7%).

The company anticipates that the machine will have a salvage value will equal to RM175,000.

If the company goes ahead with the proposed product, it will have an effect on the company's net

working capital. At the outset, inventory will increase by RM140,000 and accounts payable will

increase byRM40,000. At year 4, the net working capital will be recovered after the project is

completed.

The detergent is expected to generate sales revenue of RM1 million the first year, RM2 million the

second year, RM4 million the third year, and RM8 million the final year. The project will add fixed

costs to the company of RM1,000,000. The variable cost of production (not including

depreciation)are expected to equal 50 percent of sales.

The new detergent is expected to reduce the sales of the company's existing products by

RM250,000 a year. These existing products have the same production cost factors as our new

detergent.

Because the project is expected to be profitable, the CEO has assigned the entire Companys

advertising budget to this project. Advertising is RM1,500,000 per year.

[Total 10 marks]

YoY1Y2Y3Y4Cost20000001000000200000040000008000000nwc [140-

40]100000FC1000000100000010000001000000VC500000100000020000004000

000INTEREST EXP0000OPP.COST250000250000250000250000ADvERT

COST1500000150000150000150000DEPRECIATION660000900000300000140000

PBT-2910000-13000003000002460000Tax 28%814800364000-84000-

688800PAT-2095200-

9360002160001771200DEPRECIATION660000900000300000140000-1435200-

360005160001911200Salvage Value175000Taxes-49000NWC100000Cash

Inflow2100000-1435200-360005160002137200PVIF

10%0.90910.82640.75130.683PV Cash Inflow2100000-1304740.32-

29750.4387670.81459707.6SUM512887.68initial Investment2100000NPV-

1587112.32Cost2000000Depreciation2000000Book

Value0Disposal175000Gain175000Tax49000

You are evaluating an investment that has an expected net income (net of all costs and taxes)

of RM250,000 per year over the next 15 years. The investment will require the purchase of

new machinery that will require an initial outlay of RM4,500,000. The machine can be

depreciated using a constant dollar amount (Straight Line) to an estimated salvage value of

zero. You estimate that you should be able to sell the machine at the end of the project for

RM750,000 even though it has been fully depreciated. For this analysis assume the

marginal tax rate is 40% on ordinary income. The firm is estimating its weighted average

after-tax cost of capital at 12%.

a. What yearly cash flows should be used to evaluate this investment in years 1-14?

The cash flow for this is equal to the Net Income plus Depreciation. Since depreciation

is a non-cash expense, it is added back to the Net Income. This treatment will result in

the tax shield from the depreciation being recognized as cash flow.

b. What is the expected cash flow from this investment in Year 15?

Disposal of Machine:

(RM750,000 less tax of 40%) = RM450,000

Total Cash Inflow = RM1,000,000

PV Lump Sum for Year 15 of the project at 12% = RM1,000,000 x PVIFA 12%, 15 yrs

= RM1,000,000 x 0.1827 = 182,700

Cash Outflow =(4,500,000)

NPV = (671,790)

d. What item should not be shown in the projected profit-and-loss accounts for the project,

but should nevertheless be taken into account when doing an NPV analysis? Why?

Depreciation should not be shown in the projected profit and loss accounts

since it is a non cash item but it is included due to its tax implication. But

nevertheless it is added back as part of the adjustment to determine the cash

inflow.

e. Why should you exclude interest from the cash flow analysis?

Interest, as a cost of fund has been imputed when deriving to the cost of capital.

To include interest in the cash analysis would have double effect on the

calculation.

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