Question

10.43 Gentry Machines, Inc., has just received a special job order from one of its clients. The following financial data on the order have been collected: • This two-year project requires the purchase of a special-purpose piece of equipment for $55,000. The equipment falls into the MACRS five-year class. . The machine will be sold at the end of two years for $27,000 (today's dollars). . The project will bring in an additional annual revenue of $114,000 (actual dollars), but it is expected to incur an additional annual operating cost of $53,800 (today's dollars). • To purchase the equipment, the firm expects to borrow $50,000 at 10% over a two-year period (equal annual payments of $28,810 in actual dollars). The remaining $5,000 will be taken from the firm's retained earnings. . The firm expects a general inflation of 5% per year during the project period. The firm's marginal tax rate is 40%, and its market interest rate is 18%

a) Determine the after-tax cash flows from year 0 - year 2

b) Determine the present worth of the project

c) Determine the IRR of the project

Answer 1

a) Computation of Cash Flows

Particulars	CF0	CF1	CF2
Purchase of Machinery	(5,000)
Repayment of the loan (WN#1)		(23,810)	(26,190)
Sale Proceeds of Machinery (5% general inflation p.a.)			29,768
Net Operating Cashflows after-tax (WN#2)		35,906	35,639
Cashflows from the Project	(5,000)	12,096	39,217

(Note- Benefit of Capital loss is ignored for the purpose of above)

Loan Schedule (WN#1)

Outstanding at Year Beg	Interest (Outstanding*10%)	Instalment	Principal part (Instalment-Interest)
50,000	5,000	28,810	23,810
26,190 [50,000-23,810]	2,620	28,810	26,190

Operating Cashflows (WN#2)

Particulars	CF1	CF2
Additional revenue	114,000	114,000
Additional Operating expense (5% general inflation p.a.)	(56,490)	(59,315)
Depreciation (55,000/5 years)	(11,000)	(11,000)
Finance Expense	(5,000)	(2,620)
Profit Before Tax	41,510	41,065
Tax (40%)	(16,604)	(16,426)
Profit after Tax	24,906	24,639
Add: Depreciation (Non-cash expense)	11,000	11,000
Net Operating Cashflows after tax	35,906	35,639

b) Computation of NPV

Particulars	CF0	CF1	CF2
Cashflows from the Project	(5,000)	12,096	39,217
Discount factor @ 18%*	1	.8475	.7182
Discounted cashflows	(5,000)	10,251	28,166
NPV	33,417

Since the inflation has already been adjusted in the cashflows, hence the nominal cost of capital should be used as discount rate for computing cash flows.

b) IRR for the above cashflows is 261%