Question

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217 CHAPTER 6 Capital Budgeting: Valuing Business Cash Flows 14. (C 14. (Cash-flow analysis) The ZZZ Company is considering investing in a new machine for one of its factories. The company can choose either Machine A or Machine B. The life span of each machine is 5 years, and depreciation is straight-line to zero salvage value. The widgets produced by the macmes are sold for $6 each. The company has a cost of capital of 12%, and its tax rate is 35%. are sold B A с ZZZ WIDGET MACHINE 2 Cost of capital 12% 3 Tax rate 35% 4 Widget sales price/unit 6.00 Machine A Machine B 6 Cost 4,000,000 10,000,000 7 Annual fixed cost 300,000 210,000 8 Variable cost per widget 1.20 0.80 9 Life span (years) 10 Annual depreciation 800,000 2,000,000 5 DIOD a. If the company manufactures 1,000,000 units per year, which machine should it buy? b. Plot a graph showing the profitability of investment in each machine type depending on the annual production.

Answer 1

Particulars	A	B
Revenue earned(units produced x selling price)	$ 6000000	$ 6000000
Cost of machine	($ 4000000)	($ 10000000)
Annual fixed cost	($ 300000)	($ 210000)
Variable cost	($ 1200000)	($ 800000)
Depreciation tax saving	$ 280000	$ 700000
Cost of capital	($ 480000)	($ 1200000)
Tax saving on cost of capital	$ 168000	$ 420000
Net inflow/(outflow)	$ 468000	($ 5090000)

Cost of capital is the opportunity cost of funds that would have generated the same return if invested elsewhere. There is a virtual tax saving on the cost of capital that otherwise have to be paid if the funds generated the same income.

Going by the first year one might think the company should buy machine A.

Analyzing the next four years:

Particulars	A	B
Revenue earned (no of units produced x selling price)	$ 6000000	$ 6000000
Annual fixed cost	($ 300000)	($ 210000)
Variable cost	($ 1200000)	($ 800000)
Depreciation tax saving	$ 280000	$ 700000
Cost of capital	($ 480000)	($ 1200000)
Tax saving on cost of capital	$ 168000	$ 420000
Net inflow/(outflow)	$ 4468000	$ 4910000

The next four years the company would earn ($ 4468000 x 4) = $ 17872000 from machine A and ($ 4910000 x 4) = $ 19640000 from machine B.

Summary of 5 years:

Particulars	A	B
Net inflow/(outflow) of year 1	$ 468000	($ 5090000)
Inflow/(outflow) of next four years	$ 17872000	$ 19640000
Total inflow/(outflow)	$ 18340000	$ 14550000

The company should buy machine A.