Mags Ltd. has purchased a new machine for a cost of $500,000. The machine has just been
installed and the cost of installation is $30,000. The internal auditors have advised that the
cost of installation cannot be depreciated. The machine’s suppliers have requested a 20%
deposit on installation with the remainder to be paid within six months. The current
estimated before-tax net operating cash revenue for the coming four years are $300,000 in
the first year, $320,000 in the second year, $340,000 in the third year and $360,000 in the
fourth year. The new machine is expected to increase the expected before-tax net operating
cash revenue for the next four years by 70% of the current estimated value. Mags will take
out a business loan to fund the purchase of the machine and the interest payments on the
loan will be $100,000 per annum. The machine will be sold at the end of the fourth year and
its estimated market value at that time is $65,000. The company tax rate is 30% and
reducing balance depreciation is permitted. The required rate of return is 13% per year and
the prevailing market interest rate is 6% per year.
Prepare a cash flow analysis for the useful economic life of the machine, and use the cash
flow analysis to estimate the machine’s net present value. Show all workings.
CALCULATION OF DEPRECIATION TAX SHIELD | ||||||||
Depreciation Rate=r=1-((S/C)^(1/n)) | ||||||||
S=Residual value=$65000 | ||||||||
C=Original Cost=$500000 | ||||||||
n= Life =4 years | ||||||||
r=1-((65000/500000)^(1/4))=1-0.600462 | 1.0000000 | |||||||
r=0.3995376 | ||||||||
A | B=A*0.3995376 | C=A-B | D=B*30% | |||||
Year | Beginning book Value | Depreiation Amount | Ending Book Value | Depreciation Tax Shield | ||||
1 | $500,000 | $199,769 | $300,231 | $59,931 | ||||
2 | $300,231 | $119,954 | $180,278 | $35,986 | ||||
3 | $180,278 | $72,028 | $108,250 | $21,608 | ||||
4 | $108,250 | $43,250 | $65,000 | $12,975 | ||||
Annual Interest Tax Shield=100000*30% | $30,000 | |||||||
Payment for installation in year 0=30000*20% | $6,000 | |||||||
Balance Payment for installation at end of year=0.5 | $24,000 | (30000-6000) | ||||||
Present Value of balance Payment =24000/(1.13^0.5) | $22,577 | |||||||
Present Value of initial Cash Flow =6000+22577= | $28,577 | |||||||
N | Year | 0 | 1 | 2 | 3 | 4 | ||
A | Present Value of initial Cash out Flow | ($28,577) | ||||||
B | Interest Payment | ($100,000) | ($100,000) | ($100,000) | ($100,000) | |||
C | Principal Payment | ($500,000) | ||||||
D | Salvage Value cash flow | $65,000 | ||||||
E | Before tax net operating cash revenue | $300,000 | $320,000 | $340,000 | $360,000 | |||
F=E*70% | Increase in before tax revenue | $210,000 | $224,000 | $238,000 | $252,000 | |||
G=F*(1-0.3) | Increase in After tax revenue | $147,000 | $156,800 | $166,600 | $176,400 | |||
H | Depreciation tax shield | $59,931 | $35,986 | $21,608 | $12,975 | |||
I | Interest Tax Shield | $30,000 | $30,000 | $30,000 | $30,000 | |||
J=G+H+I | Net Increase in annual operating cash flows | $236,931 | $222,786 | $218,208 | $219,375 | |||
K=A+B+C+D+J | NET CASH FLOW | ($28,577) | $136,931 | $122,786 | $118,208 | ($315,625) | SUM | |
PV=K/(1.13^N) | Present Value of Net Cash Flow | ($28,577) | $121,178 | $96,160 | $81,924 | -$193,579 | $77,105 | |
NPV=sum of PV | NET PRESENT VALUE (NPV) | $77,105 | ||||||
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