Question

A company is considering the plan of a more capital intensive structure. The plan involves the purchase of equipment costing 84,000, which will permit it to reduce its existing labour costs by 20,000 a year for 12 years. The company estimates that will have to spend 2000 every two years repairing the equipment. The equipment may be depreciated for tax purposes by the straight-line method, over a 12-year period. The company tax rate is 30 cents in the euro and after-tax cost of capital is 10% per annum. Assuming all cash flows, including tax payments, are made at the end of each year, should the company purchase the equipment? Comment on your results.

Answer 1

The following information has been provided:

Initial Investment = € 84000

Tax Rate = 30% (30 cents in a euro)

Depreciation of the machine = Cost of Machine- Salvage Value/Useful Life

Since there is no mention of salvage value, we consider it be to nill, therefore Depreciation = €84000/12 = €7000

The following sheet illustrates cashflows over these 12 years of investment

Here Net Benefit = Savings in Labour Cost - Repairing Expenses

Savings in Labour Cost Net Benefit Depreciation Income before Tax Tax Net Income After Tax Cashflow Year Reparing Expenses Depreciation 18000 11000 3300 00014700 11000 3300 00014700 11000 3300 000 14700 11000 3300 000 14700 11000 3300 000 14700 11000 3300 000 14700 7 11000 3300 000 14700 11000 3300 000 14700 11000 3300 000 14700 10 11000 3300 000 14700 11000 3300 000 14700 12 20000 2000 7000 11000 3300 000 14700

Since, Depreciation is a non-cash expense, it is added back to determine the actual cashflow

Now, after ascertaining the cashflows, we need to find the present value of these cashflows. The Present Value Interest Factor will be the after-tax cost of capital. It is the minimum return that the company expects to take up the project.

The following table illustrates the present value of the cashflows

Cash Inflow Present Value Year PVIF 14700 0.909090909 13363.63636 14700 0.826446281 12148.76033 3 14700 0.751314801 11044.32757 4 14700 0.683013455 10040.29779 5 14700 0.620921323 9127.543449 14700 0.564473938297.766772 7 14700 0.513158118 7543.424338 8 14700 0.46650738 6857.658489 9 14700 0.4240976186234.23499 10 14700 0.385543289 5667.486355 14700 0.350493899 5152.260322 12 14700 0.3186308184683.87302 Total Present Value 100161.2698

Present Value of a particular cashflow = PVIF * Cashflow of that particular year

Since the total Present Value of the Cashflow is €1,00,161 approx. Now, let's determine the net present value of the investment, if the NPV is greater than 0, the project should be accepted, if not the project should not be accepted.

So, NPV = $1,00,161 -$84,000 = $16,161

Since, NPV>0, the company should purchase the equipment as the net benefit it provides is more than the cost to be incurred on it today.