Question

A risk manager is considering the installation of new safety guards for the machines in the...

A risk manager is considering the installation of new safety guards for the machines in the stamping process. The guards have an expected lifetime of 8 years and cost $250,000 to install. The presence of the guards have 3 negative effects: they increase annual maintenance costs by $5200 a year for the first 6 years and by $6000 a year for the last 2 years (because the machines are more difficult to service) and they increase production cost by $11,000 a year (because workers produce less output once the guards are installed). Both these expenses are realized at year end. Finally there is a training cost of $1000 a year at the beginning of the year to ensure that workers

Each year of their life, the guards are expected to reduce the employer’s retained work-injury costs and expenses related to employees injuring themselves on the production line by $10,000. These savings are realised at the end of each year. In addition the employer’s worker’s compensation insurance is willing to reduce the premium for coverage by $44,000 a year (payable at the beginning of the year) if the guards are installed. The employer faces a 34% tax rate on income and straight-line depreciation is used for the safety guards.

  1. Calculate the annual after tax cash flows from installing the ventilating equipment.
  2. If the firm’s cost of capital is 9%, should it install the safety guards?
  3. Will the installation of the safety guards affect the firm’s cost of capital? Why or why not?
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Answer #1

a)

0 1 2 3 4 5 6 7 8
Setup Cost 250000
Maintenance Cost 5200 5200 5200 5200 5200 5200 6000 6000
Production Cost 11000 11000 11000 11000 11000 11000 11000 11000
Training Cost 1000 1000 1000 1000 1000 1000 1000 1000
Injury Expense Saving 10000 10000 10000 10000 10000 10000 10000 10000
Insurance Savings 44000 44000 44000 44000 44000 44000 44000 44000
Depreciation Adjustment 31250 31250 31250 31250 31250 31250 31250 31250
Taxable Income 5550 5550 5550 5550 5550 5550 4750 4750
Tax Rate 34% 1887 1887 1887 1887 1887 1887 1615 1615
After Tax Cashflow -215087 34913 34913 34913 34913 34913 34385 34385

b) At 9% the NPV is -35896, but if we consider that firm has enough tax to be paid already then we can add the increased cashflow of tax payouts to the project. We don't use this for calculating post annual tax cash flows of earlier part as for project finance we consider only the project impact. But for decision of go no go we can consider the impact of tax as well. With that adjusted NPV will be $22910.52.

0 1 2 3 4 5 6 7 8
Setup Cost 250000
Maintenance Cost 5200 5200 5200 5200 5200 5200 6000 6000
Production Cost 11000 11000 11000 11000 11000 11000 11000 11000
Training Cost 1000 1000 1000 1000 1000 1000 1000 1000
Injury Expense Saving 10000 10000 10000 10000 10000 10000 10000 10000
Insurance Savings 44000 44000 44000 44000 44000 44000 44000 44000
Depreciation Adjustment 31250 31250 31250 31250 31250 31250 31250 31250
Taxable Income 5550 5550 5550 5550 5550 5550 4750 4750
Tax Rate 34% 1887 1887 1887 1887 1887 1887 1615 1615
After Tax Cashflow -215087 34913 34913 34913 34913 34913 34385 34385
Wacc 9% 1 0.917431 0.84168 0.772183 0.708425 0.649931 0.596267 0.547034 0.501866
Time Value -207000 32030.28 29385.57 26959.24 24733.25 22691.05 20817.48 18809.77 -4323.58
Cashflow with Tax impact of depreciation 41777.98 38328.42 35163.69 32260.27 29596.58 27152.82 24622.01 1008.751
NPV -35896.9
Adjusted NPV 22910.52

c) As we have assumed the cost of capital for discounting it implies that we are considering to finance it in the same proportion of debt and equity as the WACC.  In such case the installation shall have no impact on WACC. But in reality its difficult to maintain such ratio, and if financing for the project is done through some other source of funds then cost of capital gets impacts accordingly.

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