Question

Savory Technology Limited produces a range of hi-tech kitchen utensils for industrial use. As a new product has been developed and patented, Savory plans to build a new production plant in Greater Bay Area, China. To stream-line the management control, Savory will close down all the existing production facilities at the M & H Island if the new production plant project in Greater Bay Area is confirmed to proceed.
The management of Savory decides to use a seven-year planning horizon for all of its capital budgeting decisions. The following cash flows are noted for the project:

(i) Savory will purchase a piece of land at a cost of $40 million to build the new production plant. It is anticipated that the land will be worth $60 million in 7 years.

(ii) The production plant will be constructed at a cost of $35 million. The production plant will be depreciated at its full cost on a straight-line basis over its estimated useful life of 7 years. The production plant could be sold for a salvage value of 5 million at the end of Year 7.

(iii) Machinery will have to be purchased for the new production plant at a cost of $10,500,000. For tax purpose, machinery will be fully depreciated at its full cost on a straight-line basis over its estimated useful life of 7 years. Salvage value of the machinery at the end of Year 7 will be $1,100,000.

(iv) Equipment will also have to be purchased at a cost of $7,000,000. Equipment will also be depreciated at its full costs on a straight-line basis over its estimated useful life of 7 years. The salvage value is estimated as equal to zero.

(v) An initial investment of $3 million in working capital is required today. The working capital will be fully recovered at the end of the project.

The management of Savory believes that the new production plant will generate pre-tax cash operating income of $18 million per annum at the end of each of the 7 years of operation. In comparison, the current pre-tax cash operating income produced by the existing production facilities at the M & H Island is $6 million annually.
Savory’s corporation tax rate is 40% and its cost of capital is 10%. Further, it is assumed that there is no capital gain tax imposed on the sale of land.
Round your answer to nearest dollar

(a) Calculate the cost of investment.                   (3 marks)

(b) Calculate the present value of after-tax cash operating income.             (3 marks)

(c) Calculate the present value of tax savings from depreciation for the production plant, machinery and  
equipment.                                                                                                                                  (6 marks)                

(d) Calculate the present value of after-tax salvage value for the production plant, machinery and the piece   of land.                                                                                                   (6 marks)

(e)   Based on the net present method, should the project be undertaken?          

Answer 1

Tax rate	40%
Cost of capital	10%

Year	0	1	2	3	4	5	6	7
Land cost	40,000,000
Salvage value of land								60,000,000
Production plant cost	35,000,000
Salvage value of plant								5,000,000
Depreciation of plant		5,000,000	5,000,000	5,000,000	5,000,000	5,000,000	5,000,000	5,000,000
Machinery cost	10,500,000
Salvage value of machinery								1,100,000
Depreciation of machinery		1,500,000	1,500,000	1,500,000	1,500,000	1,500,000	1,500,000	1,500,000
Equipment cost	7,000,000
Salvage value of Equipment								-
Depreciation of Equipment		1,000,000	1,000,000	1,000,000	1,000,000	1,000,000	1,000,000	1,000,000
Additional WC	3,000,000
Recovery of WC								3,000,000
Total initial investment	95,500,000
Total depreciation		7,500,000	7,500,000	7,500,000	7,500,000	7,500,000	7,500,000	7,500,000
Tax benefit (tax shield) from depreciation		3,000,000	3,000,000	3,000,000	3,000,000	3,000,000	3,000,000	3,000,000
Discounted PV		2,727,273	2,479,339	2,253,944	2,049,040	1,862,764	1,693,422	1,539,474
Total PV of depreciation tax shield	14,605,256
Additional EBIT from new plant		18,000,000	18,000,000	18,000,000	18,000,000	18,000,000	18,000,000	18,000,000
Lost EBIT from M&H plant		6,000,000	6,000,000	6,000,000	6,000,000	6,000,000	6,000,000	6,000,000
Net additional EBIT		12,000,000	12,000,000	12,000,000	12,000,000	12,000,000	12,000,000	12,000,000
Tax liability		4,800,000	4,800,000	4,800,000	4,800,000	4,800,000	4,800,000	4,800,000
After-tax operating income		7,200,000	7,200,000	7,200,000	7,200,000	7,200,000	7,200,000	7,200,000
Discounted PV		6,545,455	5,950,413	5,409,467	4,917,697	4,470,634	4,064,212	3,694,738
Total PV of after-tax operating income	35,052,615
FCFF of project	(98,500,000)	14,700,000	14,700,000	14,700,000	14,700,000	14,700,000	14,700,000	81,360,000
Discounted PV of FCFF	(98,500,000)	13,363,636	12,148,760	11,044,328	10,040,298	9,127,543	8,297,767	41,750,544
NPV of project	7,272,877

Undertake the project with +ve NPV

Salvage values calculation
Production plant cost	35,000,000
Machinery cost	10,500,000
Equipment cost	7,000,000
Total depreciation of production plant	35,000,000
Total depreciation of machinery	10,500,000
Total depreciation of equipment	7,000,000
Tax basis cost of production plant	-
Tax basis cost of machinery	-
Tax basis cost of equipment	-
Salvage value of plant	5,000,000
Salvage value of machinery	1,100,000
Salvage value of Equipment	-
Effective taxable profit from sale of plant	5,000,000
Effective taxable profit from sale of machinery	1,100,000
Effective taxable profit from sale of equipment	-
Tax liability of sale of plant	2,000,000
Tax liability of sale of machinery	440,000
Tax liability of sale of equipment	-
After tax salvage value of plant	3,000,000
After tax salvage value of machinery	660,000
After tax salvage value of equipment	-
Discounted PV of After tax salvage value of plant	1,539,474
Discounted PV of After tax salvage value of machinery	338,684
Discounted PV of After tax salvage value of equipment	-

Note- Operating income is net of depreciation. For determining profitability of a project, we base our calculation of FCFF. FCFF= EBIT*(1-tax)+ Depreciation- Change in WC- capex. The After tax salvage value of PP&E, sale of land, as well as the additional WC are released and added back to the terminal year cash flows for FCFF calculation.