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QUESTION 1

The company LT Ltd is considering the introduction of a new product.


Generally, the companys products have a life of about 5 years, after
which they are deleted from the range of products that the company
sells. The new product requires the purchase of new equipment costing
$400,000. The ATOs depreciation schedule allows an effective life of 10
years for such equipment and that the company chooses to use the
Diminishing Value Method for tax purposes meaning the annual tax
depreciation rate would be 100% higher than the rate connected with
prime cost depreciation. Assume that at the end of 5 years the equipment
can be disposed of easily and will generate proceeds of $157,500.

The new product will be manufactured in a factory already owned by the


company. The factory originally cost $150,000 to build and has a current
resale value of $350,000, which should remain fairly stable over the next
5 years. This factory is currently being rented to another company under
a lease agreement that has 5 years to run and provides for an annual
rental of $15,000. Under the lease agreement LT Ltd can cancel the lease
by paying the lessee an amount equal to 1 years rental payment.

It is expected that the product will involve the company in sales


promotion expenditures which will amount to $50,000 during the first
year the product is on the market. Additions to net operating working
capital will require $22,500 at the commencement of the project and are
assumed to be fully recoverable at the end of year 5. The new product is
expected to generate net operating cash flows as follows before tax:
Year 1 $200,000
Year 2 $250,000
Year 3 $325,000
Year 4 $300,000
Year 5 $150,000
Required rate of return is 10% and the company tax rate is 30%.
Calculate the NPV. Show all calculations and ignore the existence of
any applicable GST

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QUESTION 1 t=0 t=1 t=2 t=3 t=4 t=5

Investment in fixed assets -$ 400,000

Cancel lease -$ 15,000

Investment in NOWC -22,500

Lease revenue foregone -$ 15,000 -$ 15,000 -$ 15,000 -$ 15,000 -$ 15,000

Sales Promotion -$ 50,000

4,50
Taxes 30% $ 4,500.0 $ 19,500 $ 4,500 $ 4,500 $ 4,500 $ 0

Incremental EBITDA (outside


of items above) $200,000 $250,000 $325,000 $300,000 $150,000

Tax Depreciation -80,000 -64,000 -51,200 -40,960 -32,768

Operating income (EBIT) $120,000 $186,000 $273,800 $259,040 $117,232

Taxes 30% -36,000 -55,800 -82,140 -77,712 -35,170

Taxed EBIT $84,000 $130,200 $191,660 $181,328 $82,062

Tax Depreciation 80,000 64,000 51,200 40,960 32,768

Cash flow from operations $164,000 $194,200 $242,860 $222,288 $114,830

Recovery of working capital $ 22,500.0

Proceeds from salvage $ 157,500

-
7,92
Tax on salvage 30% $ 8

Total cash flows -$ 433,000 $118,500 $183,700 $232,360 $211,788 $276,402

317,3
NPV@10% $ 99 -$ 433,000 $107,727 $151,818 $174,576 $144,654 $171,624

Comments on solution above


Regarding alternative solutions to the presented solution

(a) Net Operating Cash flows of $200,000 in year 1 are already post the $50,000 promotional
expenditure. I would not have interpreted it that way but I do see how a student could have
interpreted it that way.

(b) The question is whether the company should have ignored the $15,000 p.a. in lost lease revenue
and instead have inserted an initial outflow of $350,000 representing the temporary lost ability to
sell the premises for $350,000. I am sympathetic to that argument ONLY if you believe the company
had this avenue in mind as a FIRST alternative to the use of the factory for processing the new
product. If you believe the company would have simply continued renting the premises out then you
cannot believe a sale was in mind. I draw your attention to the assignment information: This factory
is currently being rented to another company under a lease agreement that has 5 years to run. This
would normally be construed as meaning the company would have simply continued receiving the
$15,000 P.A. (at least for next 5 years)

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If you could establish the sale of premises theory as a first alternative to processing the new
product (and I do not believe you can), then you have many problems to resolve in the
economics

(c) Accumulated Depreciation (for tax purposes) of the building and its fittings at time zero of new
project. (We will assume the land component of the premises was not depreciable).

(d) Capital gains tax (CGT) on disposal of premises at time zero being 30% tax * ($350,000 selling
price minus selling fees minus cost of land component when procured less tax base of the
depreciable components being building and fittings). Tax base means original cost of the
components less accumulated tax depreciation.

(e) You would then show a "theoretical" outflow being $350,000 less selling fees less CGT
being your lost sales opportunity. Lets call the "theoretical" outflow "x"

(f) You would then have to show the $15000 penalty (offset with a $4500 tax benefit) as an outflow at
time zero as we still need to get the industrial tenant out.

(g) You would then need to show a positive at the end of year 5 which reverses "x" above. This is very
similar in nature to the reversal of the $22,500 net operating working capital. The reason you would
do that is because you are "releasing" resources back to the business. You use the factory for 5
years to do production and then you release it back to the business.

If you were able to imagine the premises would be more valuable than $350,000 at the end of 5 years you
would factor in that knowledge but it would be best to be conservative and ignore as it is a very big
complication

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QUESTION 2

Required:

(a) What is the projects initial investment?

(b) What are the incremental cash flows over the projects life in
years 1-4?

(c) What is the incremental cash flow in terminal year (year 5


cash flow)?

(d) What is the NPV?

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(e) What is the IRR? You may need an Excel spread-sheet to make
this calculation.

(f) Should the project be accepted (yes/no)? Why/why not?

(a) What is the projects initial investment?

Answer: $47350

(a)
Initial Investment (Time = 0)
New unit ($55,000)
Old unit $15,000 BV(t=0) = $10,000
Less Tax ($2,350)
(b) What are the incremental cash flows over the projects life
in years 1-4?

Answer: $15360

Operational Cash Flows T = 1to 4 T=5

5
Incremental Revenue (New-Old) $0 $0

Salary Saving $17,000 $17,000

Incremental Saving $4,000 $4,000

Less Depreciation (new) ($11,000) ($11,000)

Plus Depreciation (old) $2,000 $2,000

EBIT $12,000 $12,000

Tax ($5,640) ($5,640)

EAT $6,360 $6,360

Add back Depreciation $9,000 $9,000

Operating Cash Flow $15,360 $15,360

What is the incremental cash flow in terminal year (year 5


cash flow)?
Answer: $25,660

Terminal Cash Flows T=5

Salvage Value $10,000


Tax paid on Capital Gain -$4,700
Recovery of NWC $5,000
Final year operating Cash Flow $15,360

Net Terminal Cash Flow $25,660

(D) What is the NPV?

Answer: $2725

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1 1 $25,660
NPV $47,350 $15,360 4

0.2 0.2(1.2) 1.25

NPV = $2,725.14

() What is the IRR?

IRR = 22.41% (Using Spreadsheet)

(f) Should the project be accepted (yes/no)? Why/why not?

Yes, NPV is positive, IRR > benchmark or required return

(i) NPV > 0


(ii) IRR > Cost of Capital

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QUESTION
A risk-averse male retiree in Australia has some savings to invest with the
objective of generating a stream of stable income to support his spending
needs. Advise him on whether he should invest in government
bonds or company shares. Your advice needs to be supported by two
valid reasons.

Ordinary shares ownership interest in a company, no guaranteed dividend,


sometimes fluctuating dividend, no guaranteed return of capital (possible to
make capital gain or losses), indefinite life, value will be buffeted by local and
world events/economic influences. As this investor is risk-adverse he or she
cannot afford to take many risks with their investments given they are in
retirement. There could be company shares that exhibit low or acceptable
risk, perhaps Woolworths, Wesfarmers (made up of Coles, Office Works, Target,
K-Mart, Bunnings and other companies/divisions), the APA group (gas
infrastructure) and the 4 big banks. Many of these pay strong dividends. Mining
companies would be too volatile in terms of returns for this investor.

Government bonds this investment class represents a non-guaranteed loan to the


government. A guarantee is not necessary as the government is not likely to go
bankrupt. Earnings to the investor will be low but safe. Moreover, they will provide a
stable and regular income stream. The coupon will pay fixed interest every 6 months.
This provides peace of mind.

This investor should show a preference for government bonds over


company shares (in general) and could be well advised to have a high
allocation to such bonds, or even to corporate bonds of high investment grade
but not mining companies. This investor will also be concerned about capital
preservation in all probability as he will need to keep earning income on his
investment. He should not take too many chances that it depletes in value.