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25-01-2019

Product Code:Accounts-PH-264

 

Re-equipment Problem

Part A

  1. Should the company buy the proposed equipment?

Question 1

Year

Cash Flows

0

 -1,00,00,000.00

1

      20,00,000.00

2

      20,00,000.00

3

      20,00,000.00

4

      20,00,000.00

5

      20,00,000.00

6

      20,00,000.00

7

      20,00,000.00

8

      20,00,000.00

9

      20,00,000.00

10

      20,00,000.00

11

      20,00,000.00

12

      20,00,000.00

 

 

Rate

20%

NPV

       -9,34,638.79

 

As the NPV of the savings because of the new equipment and investment in the new equipment at 20% rate of return is negative the company should not buy the equipment.

 

  1. Assuming the depreciation in the old equipment?

The book value of the old equipment wont change anything, because depreciation is not a cash outflow but a tax deductible expenditure. In the above case tax is 0 therefore, depreciation won’t have any impact on decision and thus the decision remains the same i.e. not to invest in new equipment.

 

  1. If the old equipment has a salvage value?

Question 3

Year

Cash Flows

0

 -70,00,000.00

1

   20,00,000.00

2

   20,00,000.00

3

   20,00,000.00

4

   20,00,000.00

5

   20,00,000.00

6

   20,00,000.00

7

   20,00,000.00

8

   20,00,000.00

9

   20,00,000.00

10

   20,00,000.00

11

   20,00,000.00

12

   20,00,000.00

 

 

Rate

20%

NPV

   15,65,361.21

 

If the old equipment has a salvage value now it would reduce the initial cash outflow and thus the company should invest in the decision as it results in positive NPV.

Part B

  1. What should company do?

Part B

Question 1

Year

Cash Flows

0

 -2,00,00,000.00

1

      50,00,000.00

2

      50,00,000.00

3

      50,00,000.00

4

      50,00,000.00

5

      50,00,000.00

6

      50,00,000.00

7

      50,00,000.00

8

      50,00,000.00

9

      50,00,000.00

10

      50,00,000.00

 

 

Rate

20%

NPV

801967.02

 

The company should install the new equipment as it would result in positive NPV at 20% cost of capital

 

  1. Where company went wrong?

It is hard to say where the company went wrong because two year back if the company installed the new equipment they had no idea that a new equipment will come in the market in next two years. As per our previous calculations the company should not have gone for the decision but that was irrespective of whether a new equipment will come in the market. Therefore, before investing in any new equipment a company should properly research the current trends regarding the new product.

Part C

  1. Should the company buy equipment?

Question 1

Year

Cash Flows

 

 

 

0

 -1,00,00,000.00

 

Calculation of Annual Cash Flow

1

      15,33,333.00

 

Savings

2000000

2

      15,33,333.00

 

Less: Dep

833333

3

      15,33,333.00

 

PBT

1166667

4

      15,33,333.00

 

Tax @ 40%

466667

5

      15,33,333.00

 

PAT

700000

6

      15,33,333.00

 

Add: Dep

833333

7

      15,33,333.00

 

Cash Flow

1533333

8

      15,33,333.00

 

 

 

9

      15,33,333.00

 

 

 

10

      15,33,333.00

 

 

 

11

      15,33,333.00

 

 

 

12

      15,33,333.00

 

 

 

 

 

 

 

 

Rate

12%

 

 

 

NPV

-448179.9873

 

 

 

 

As tax has come into consideration, the savings will increase the tax of the company, whereas depreciation which is a non-cash expenditure will decrease the tax component of the company.But given the negative NPV the company still should not consider the new equipment as it still results in negative NPV.

 

  1. If the old machine has book value?

Question 2

Year

Cash Flows

 

Calculation of Initial Cash Outflow

0

    -80,80,000.00

 

Purchase of Machine

-10000000

1

      15,33,333.00

 

Sale of Old Mach

0

2

      15,33,333.00

 

Loss on Sale of Old Mach

4800000

3

      15,33,333.00

 

Tax Saved on Loss

1920000

4

      15,33,333.00

 

Net Outflow of Cash

-8080000

5

      15,33,333.00

 

 

 

6

      15,33,333.00

 

 

 

7

      15,33,333.00

 

 

 

8

      15,33,333.00

 

 

 

9

      15,33,333.00

 

 

 

10

      15,33,333.00

 

 

 

11

      15,33,333.00

 

 

 

12

      15,33,333.00

 

 

 

 

 

 

 

 

Rate

12%

 

 

 

NPV

1266105.727

 

 

 

 

If the old machinery has book value and zero salvage value than it would result in loss on sale of machinery which will reduce the overall profit of the company and thus reduce the tax burden on the company. Therefore, the tax of the old machinery’s loss is considered as a cash inflow.

The company should accept the project ass it results in positive NPV.

United Technologies

  1. Purchasing vs Assembling?

Year

Purchasing

Assembly

0

78500

0

1

-834400

-868500

2

-834400

-868500

3

-834400

-868500

4

-834400

-868500

5

-834400

-900000

6

-840000

-900000

7

-840000

-900000

 

 

 

NPV @ 20%

-57,73,500.00

-61,74,000.00

 

Purchasing

Initial Cash Flow

Sale of old Machinery

50000

Loss on Sale of Mach

310000

Tax Saved on Sale

108500

Purchase of New Equipment

80000

Total Cash Inflow/(Outflow)

78500

 

 

Annual

Purchase of Components

830000

Difference of Salary

10000

Tax Save on Dep

5600

Cash Outflow

834400

 

The company should go for Purchasing the new equipment, as it has higher NPV as compared to continuing the same equipment. The sale of old machinery will ultimately result in positive cash flow as the loss on sale of old machinery is tax deductible. The difference of the operator’s salary has been considered as the annual cash outflow. If the old machinery is continued the depreciation will be applied for 4 years and thus it is also a tax-deductible expense

 

  1. Other issues that could have taken into account are:
  1. The capacity of the warehouse, even though the warehouse is empty right now the but after 4 years the capacity wont be available thus company needs to plan that right now
  2. The quality of the material should be on par with the quality that we were producing
  3. Due to bigger lot size the company will have more cash stuck in the inventory which could have been invested somewhere else
  4. The credit period the supplier is willing to give

 

 

MCI

 

 

Cost of Equity

14.35%

             
 

Growth Rate

5%

             
                   

Q1

FCFE

-$295

-$442

-$872

-$1,042

-$1,451

$163

$716

$916

 

NPV

-1864.457

 

 

 

 

 

 

 

                   

Q2

FCFE

-$295

-$442

-$872

-$1,042

-$1,451

$163

$716

$916

 

Terminal Value

 

 

 

 

 

 

 

9796.791

 

Total Cash Flow

-$295

-$442

-$872

-$1,042

-$1,451

$163

$716

$10,713

 

NPV

1486.70

 

 

 

 

 

 

 

 

Share Outstanding

117.20

 

 

 

 

 

 

 

 

Price per Share

12.69

 

 

 

 

 

 

 

 

If there is no terminal value the current value of the company is $ -1864.457 million.

If we consider the terminal value of the company the price per share is $ 12.69 which means the share of the company is overvalued. 

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